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V UNIT
Introduction toAccounting & Financial Analysis

Business organizations:
Business organizations provide goods and services in order to earn a profit. Goods have form and
substance and the seller of goods physically transfers them to the buyer. Soaps, pens, computers, cars
and medicines etc. examples for products. Services are work done by one person that benefits
another. Examples are hairstyling, writing computer programs etc.
Business organizations are of three types
Merchandizing or trading organizations: Buy and sell goods without any processing.
Manufacturing organizations: Buy materials, process them into finished products and sell them.
Service organizations; Provide services.
Meaning of accounting:
Accountancy means the complication of accounts in such a way that one is in position to know the
state of affairs of the business.
Definition of Accounting
The systematic and comprehensive recording of financial transactions pertaining to a business.
Accounting also refers to the process of summarizing, analyzing and reporting these transactions.
_____R. N. Anthony______
Accounting is often called the language of business
Single entry system & Double entry system
Meaning Of Single Entry System
Single entry system is an incomplete form of recording financial transactions. It is the system,
which does not record two aspects or accounts of all the financial transactions. It is the system,
which has no fixed set of rules to record the financial transactions of the business. Single entry
system records only one aspect of transaction. Thus, single entry system is not a proper system of
recording financial transactions, which fails to present complete information required by the
management. Single entry system mainly maintains cash book and personal accounts of debtors and
creditors. Single entry system ignores nominal account and real account except cash account. Hence,
it is incomplete form of double entry system, which fails to disclose true profit or loss and financial
position of a business organization.
Features Of Single Entry System
The following are the main features of single entry system:
1. No Fixed Rules
Single entry system is not guided by fixed set of accounting rules for determining the amount of
profit and preparing the financial statements.
2. Incomplete System
Single entry system is an incomplete system of accounting, which does not record all the aspects of
financial transactions of the business.
3. Cash Book
Single entry system maintains cash book for recording cash receipts and payments of the business
organization during a given period of time.

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4. Personal Account
Single entry system maintains personal accounts of all the debtors and creditors for determining the
amount of credit sales and credit purchases during a given period of time.
5. Variations In Application
Single entry system has no fixed set of principles for recording financial transactions and preparing
different financial statements. Hence, it has variations in its application from one business to another.
The following are the notable disadvantages of single entry system:
1.Unscientific And Unsystematic
The single entry system is unsystematic and unscientific system of recording financial transactions. It
does not have any set of fixed rules and principles for recording and reporting the financial
transactions.
2. Incomplete System
Single entry system is incomplete system because it does not record the two aspects or accounts of
all the financial transactions of the business. It does not maintain any record of the transactions
relating to the nominal account and real account except cash account.
3. Lack Of Arithmetical Accuracy
Single entry system is not based on the principles of debit and credit. It fails to provide the
arithmetical accuracy of the books of accounts. Trial balance can not be prepared under this system
to check the arithmetical accuracy of books of accounts.
4. Does Not Reflect True Profit Or Loss
Under single entry system, the true amount of profit or loss can not be ascertained because it does
not maintain the nominal accounts.
5. Does Not Reflect True Financial Position
The single entry system does not maintain real accounts except cash book. Therefore, it can not
reveal the true financial position of the business.
6. Frauds And Errors
The single entry system of book-keeping is incomplete, inaccurate and unscientific. It does not help
to check the arithmetical accuracy of the books of accounts. Therefore, there is always a possibility
of committing frauds and errors in the books of accounts.
7. Unacceptable For Tax Purpose
The single entry of book keeping has incomplete records of the financial transactions of the business.
Hence, the tax office cannot accept the account maintained under this system for the purpose of
assessment of tax.
Double entry system:
Double entry system is a scientific way of presenting accounts. As such all the business
concerns feel it convenient to prepare the accounts under double entry system.
Under dual aspect concept the accountant deals with the two aspects of business transaction I. e., (I)
receiving aspect and (II) giving aspect, receiving aspect is known as Debit aspect and giving aspect

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is known as credit aspect. In double entry book keeping system these two aspects are recorded
facilitating the preparation of trial balance and the final accounts.
The principle under which both debit and credit aspects are recorded is known as the principle of
double entry. According to this principle every debit must necessarily have a corresponding credit
and vice versa.
Features of Double Entry System of Book-keeping
The following are some features or characteristics of double-entry book-keeping.
1. Double effecting: It follows the principle of double aspect by debiting and crediting the
transaction.
2. Equal effect: It assumes that debit must be equal to credit mount i.e. It considers the effect of equal
amount.
3. Debit and credit: It has two sides i.e. debit and credit. For example, the benefit receive is given the
name debit and the benefit giver is given credit.
4. Account: It maintains the records of personal, real as well as nominal accounts.
5. Arithmetical accuracy: another feature of double entry system of book keeping to check
arithmetical accuracy by preparing trial balance.
Importance or Advantage of Double Entry Book-Keeping System
The following are the advantages of double-entry book-keeping.
1. Complete records of each transaction: Double entry system presents a complete record of
transaction. Because it records both the aspect of every transaction, which relates to personal or
impersonal.
2. Checking of arithmetical accuracy: Arithmetical accuracy can be checked by preparing trial
balance from all ledgers concerned.
3. Profit or loss: Profit and loss account can easily be prepared. The exact reason for profit and loss
can be ascertain.
4. Financial position: It provides full particulars of various assets and liabilities of the business, so
financial position can be known by preparing balance sheet. A comparative study of the balance sheet
for various years shows a firm's progress.
5. Frauds and errors: It prevents frauds and errors and makes their detection easier.
6. Accepted by court and tax authorities: This system keeps a complete record of financial
transaction therefore, it is accepted by court, tax authorities and banking institutions.
7. Scientific and systematic: Double entry system of book-keeping is scientific and systematic
records of financial transaction.
Disadvantage of Double Entry Book Keeping System
1. Expensive: It is an expansive system of book-keeping which is not favorable for small business.
2. Complicated: It is complicated system where certain rules and regulations are to be followed.
3. Fails: It fails to disclose the error of omission, error of principles, errors of commission, and
compensating error

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Differences between single entry system & Double entry system

Single-entry

Double-entry

Definition

Single-entry system of
bookkeeping requires inputting the
entry only once in either the credit
column or the debit column.

Double-entry system requires

putting one entry twice, once in the
credit column and once in the debit
column of another account.

Duality

Is not based on the concept of

duality.

Is based on the concept of duality.

Accounts

Maintains simple and personal

accounts of debtors, creditors and
cashbook.

Maintains all personal, real and

nominal accounts.

Profit Or Loss

Cannot help in making the

companys profit or loss statement.

Can help in making the companys

profit or loss statement.

Suitability

Small businesses where

transactions are small and simple.

Big businesses and corporations

that deal with complex transactions
and huge inventories.

Trial Balance

Cannot prepare trial balance

Can prepare trial balance

Tax Purpose

Is not acceptable for tax purposes.

Is acceptable for tax purposes.

Financial Position

Cannot ascertain the true financial

position of the business.

Can ascertain financial position of

the business.

Advantages

Simple, less-expensive, easier to

manage, provides general view of
earnings and expenditure.

Complete data is available,

provides an arithmetic check on
bookkeeping, helps track debits
and credits, can help ascertain the
financial position of the business,
makes it easier to produce year-end
accounts.

Disadvantages

Incomplete data, are not able to

provide a check against clerical
error, does not record all
transactions, does not provide a
detailed record of assets, theft and
loss cannot be detected.

Expensive, harder to understand,

requires hiring external staff and
time-consuming.

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Accounting concepts
The Business Entity Concept
The business entity concept provides that the accounting for a business or organization be
kept separate from the personal affairs of its owner, or from any other business or organization. This
means that the owner of a business should not place any personal assets on the business balance
sheet. The balance sheet of the business must reflect the financial position of the business alone.
Dual Aspect Concept:
Under dual aspect concept the accountant deals with the two aspects of business transaction I.
e., (I) receiving aspect and (II) giving aspect, receiving aspect is known as Debit aspect and giving
aspect is known as credit aspect.
The Continuing Concern Concept
It is assumed that the business will continue for a long time. With this assumption fixed assets
are recorded in the books at their original cost. Keeping this assumption in view, prepaid expenses
are not treated as the expenses of the year in which they are incurred. It is assumed that the business
derives benefit out of it in the years to come.
The Principle of Conservatism
The principle of conservatism provides that accounting for a business should be fair and
reasonable. Accountants are required in their work to make evaluations and estimates, to deliver
opinions, and to select procedures. They should do so in a way that neither overstates nor understates
the affairs of the business or the results of operation.
The Objectivity Principle
The objectivity principle states that accounting will be recorded on the basis of objective
evidence. Objective evidence means that different people looking at the evidence will arrive at the
same values for the transaction. Simply put, this means that accounting entries will be based on fact
and not on personal opinion or feelings.
The Revenue Recognition Convention or Accrual Concept
The revenue recognition convention provides that revenue be taken into the accounts
(recognized) at the time the transaction is completed. Usually, this just means recording revenue
when the bill for it is sent to the customer. If it is a cash transaction, the revenue is recorded when the
sale is completed and the cash received. If this is not done, the earnings statements of the company
will be incorrect and the readers of the financial statement misinformed.
The Matching Principle
The matching principle is an extension of the revenue recognition convention. The matching
principle states that each expense item related to revenue earned must be recorded in the same
accounting period as the revenue it helped to earn. If this is not done, the financial statements will
not measure the results of operations fairly.
The Cost Principle
Usually all the transactions will be recorded at cost in the books. However, at the end of
every year the accountant shows the reduced value of the assets, after providing for depreciation.
This approach preferred because it is difficult and time consuming to ascertain the market values.
The Consistency Principle
The consistency principle requires accountants to apply the same methods and procedures
from period to period. When they change a method from one period to another they must explain the
change clearly on the financial statements.

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The consistency principle prevents people from changing methods for the sole purpose of
manipulating figures on the financial statements.
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The Materiality Principle
The materiality principle requires accountants to use generally accepted accounting principles
except when to do so would be expensive or difficult, and where it makes no real difference if the
rules are ignored. If a rule is temporarily ignored, the net income of the company must not be
significantly affected, nor should the reader's ability to judge the financial statements be impaired.
The Full Disclosure Principle
The full disclosure principle states that any and all information that affects the full
understanding of a company's financial statements must be include with the financial statements.
Accounting period concept:
Accounting period is the period followed by a business concern for maintaining accounts to
know profit or loss. Usually, one year will be the accounting period starting from 1 st April to 31st
march.
Branches of accounting
Accounting has three branches and each branch of accounting is inter - related with other branch. No one
branch is perfect without other branch of accounting. Every branch of accounting works only if other branch
of account will perform best.
Financial Accounting
Financial accounting is the old branch of accounting which is related to make profit and loss account and
balance sheet after maintaining daily record of business transactions. Profit and loss shows net profit or net
loss for a specific period and balance sheet shows the financial position on the specific date.
Cost Accounting
Cost accounting is that branch of accounting which is related to calculate of total cost or per unit cost of goods
or services. Its aim is to reduce cost of production and increase businessmans profitability. In other words , it
is used in an organization for controlling the cost .
Management Accounting
Management accounting is that branch of accounting which is related to use accounting information for
determination of policies and other business decisions . It uses the accounting information for analysis the
efficiency of different department of an organization.

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Users of accounting information

Accounting information is useful in making a number of decisions that affect the income or
wealth of individuals and organizations. Examples of decisions that are based on accounting
information include the following.
1. Decide when to buy, hold or sell an equity investment
2. Assess the stewardship or accountability of management
3. Assess the ability of the enterprise to pay and provide other benefits tom its employees.
4. Assess the security for amounts lent to the enterprise
5. Determine taxation policies
6. Determine distributable profits and dividends
7. Prepare and use national income statistics
8. Regulate the activities of enterprises
Users of accounting information
Users of financial information may be both internal and external to the organization.
Internal users (Primary Users) of accounting information include the following:
1. Owners
Stockholders of corporations need financial information to help them make decisions on what to do
with their investments (shares of stock), i.e. hold, sell, or buy more.
2. Management
In small businesses, management may include the owners. In huge organizations, however,
management is usually made up of hired professionals who are entrusted with overall responsibility
of operating the business or a part of the business. They act as agents of the owners.
The managers, whether owner or hired, regularly face economic decisions How much supplies will
we purchase? Do we have enough cash? How much did we make last year? Did we meet our targets?
All those, and many other decisions, require analysis of accounting information.
3. Employees
Employees are interested in the companys profitability and stability. They are after the ability of the
company to pay salaries and provide employee benefits. They may also be interested in the
companys financial position and performance to assess the possibility of company expansion and
career opportunities.
External users (Secondary Users) of accounting information include the following:
1. Lenders
Lenders of funds such as banks and other financial institutions are interested in the companys ability
to pay liabilities upon maturity (solvency).
2. Trade creditors or suppliers
Like lenders, trade creditors or suppliers are interested in the companys ability to pay obligations
when they become due. They are nonetheless especially interested in the company's liquidity -- its
ability to pay short-term obligations.
3. Government
Governing bodies of the state, especially the tax authorities, are interested in an entity's financial
information for taxation and regulatory purposes. Taxes are computed based on the results of
operations and other tax bases. In general, the state would like to know how much the taxpayer is
making to determine the tax due thereon.
4. Customers
When there is a long-term involvement or contract between the company and its customers, the
customers may be interested in the companys ability to continue existence and its stability of
operations. This need is also heightened in cases where the customers depend upon the entity.

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For example, a distributor (reseller), the customer in this case, is dependent upon the manufacturing
company from which it purchases the items it resells.
5. General Public
Anyone outside the company such as researchers, students, analysts and others are interested in the
financial statements of a company for some valid reason.
Internal users refer to managers who use accounting information in making decisions related
to the company's operations.
External users, on the other hand, are not involved in the operations of the company but hold
some financial interest. The external users may be classified further into users with direct financial
interest the owners, investors, lenders and creditors, and users with indirect financial interest
government, employees, customers and the others.
Accounting cycle
Accounting cycle is a step-by-step process of recording, classification and summarization of
economic transactions of a business. It generates useful financial information in the form of financial
statements including income statement, balance sheet, cash flow statement and statement of changes
in equity.
The time period principle requires that a business should prepare its financial statements on periodic
basis. Therefore accounting cycle is followed once during each accounting period. Accounting Cycle
starts from the recording of individual transactions and ends on the preparation of financial
statements and closing entries.
Major Steps in Accounting Cycle

Journal entries
The recording of financial data (taken usually from a journal voucher) pertaining to business
transactions in a journal such that the debits equal credits. Journal entries provide an audit trail and a means of
analyzing the effects of the transactions on an organization's financial position. See also journalizing.
Ledger
Collection of an entire group of similar accounts in double-entry bookkeeping. Also called book of final entry,
a ledger records classified and summarized financial information from journals (the 'books of first entry')
as debits and credits, and shows their current balances. In manual accounting systems, a ledger is usually a
loose leaf binder with a separate page for each ledger account.
In

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computerized systems, it consists of interlinked digital files, but follows the same accounting principles as the
manual system.
Structure of ledger
Date

Particulars

2005
Dec. 17 Cash A/C

J.R

Amount

Date

1,200

2005
Dec. 17

Particulars

J.R

Amount
2,000

Purchases A/C

Trial balance
Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards the
preparation of financial statements. It is usually prepared at the end of an accounting period to assist in the
drafting of financial statements. Ledger balances are segregated into debit balances and credit balances. Asset
and expense accounts appear on the debit side of the trial balance whereas liabilities, capital and income
accounts appear on the credit side. If all accounting entries are recorded correctly and all the ledger balances
are accurately extracted, the total of all debit balances appearing in the trial balance must equal to the sum of
all credit balances.
Purpose of a Trial Balance
Trial Balance acts as the first step in the preparation of financial statements. It is a working paper that
accountants use as a basis while preparing financial statements.
Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been
recorded in the books in accordance with the double entry concept of accounting. If the totals of the
trial balance do not agree, the differences may be investigated and resolved before financial
statements are prepared. Rectifying basic accounting errors can be a much lengthy task after the
financial statements have been prepared because of the changes that would be required to correct the
financial statements.
Trial balance ensures that the account balances are accurately extracted from accounting ledgers.
Trail balance assists in the identification and rectification of errors.

TRADING AND PROFIT AND LOSS ACCOUNT

Final Accounts of sole Traders: show the calculation of profit earned or the loss incurred
during the period and the financial position of the business at the end of the period. Final
accounts usually prepared from a trial balance.
1. Trading Account: deals with trading (buying and selling). The account shows the
calculation of profit earned on goods sold.
Gross Profit = Sales Cost of Goods Sold
Cost of goods sold = opening stock + purchases + carriage inwards - closing stock
Drawings of goods for personal use is deducted from
purchases
Carriage inwards is added to the purchases

2. Profit and Loss Account: shows the calculation of final or true profit. This is the profit
after all running expenses and any other items of income.
Net Profit = Gross profit + other incomes - Expenses

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3. Balance Sheet: is a statement of the financial position of the business on a certain date. It
shows what the business
owns, and amounts owing to the business- the assets and what
the business owes, the liabilities and the capital
Proforma of balance sheet

List of some common Expenses, Income, Assets and Liabilities

EXPENSES.
Carriage inwards, carriage
outwards
Purchases, wages and salaries,
Rent and insurance, electricity
charges, advertising charges, bank
charges,
Discount allowed, bad debts,
Depreciation of fixed assets,
Provision for bad debts, office
expenses,
Provision for discount on debtors
General expenses, motor expenses,
Motor vehicle expenses
Repairs to building or machinery
Interest on loan

FIXED ASSETS
Plant and Machinery
Land and Buildings
Premises
Equipment
Furniture and Fittings
Fixtures and Fittings
Lawn Mover
Computers
Motor van/Motor vehicle
Motor car

CURRENT LIABILITY
Creditors for goods
Creditors for expenses:
Eg. Rent owing,
Salary accrued
Wages unpaid
General expenses unpaid
Commission outstanding
Bank overdraft
[ all unpaid amounts]

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CURRENT ASSETS
Cash in hand
Cash at bank
Debtors
Closing stock
Prepaid rent, insurance, rates
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INCOMES:
Sales, discount received,
Commission received
Interest received, rent received,
profit on sale of old fixed assets

LONG TERM LIABILITIES

Loan from bank
Mortgage loans
Debenture

Ratio analysis:
Ratio analysis is the process of determining and interpreting numerical relationships based on
financial statements. By computing ratios it is easy to understand the financial position of the firm.
What is ratio?
Ratio is simply a number expressed in terms of another. It refers to the numerical or
quantitative relationship between two variables which are comparable.
Importance of ratios:
1. Liquidity Portion:
The liquidity portion of a firm would be satisfactory if it is able to meet its current obligations when
they become due. A firm can be said to have the ability to meet its short maturing debt usually
within a year as well as the principal. This ability is reflected in the liquidity ratios 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 or capital structure and profitability ratio which focus on
earning power and operating efficiency. Ratio analysis reveals the strength and weakness of a firm.
3. Operating efficiency
Ratio Analysis throws light on the degree of efficiency in the management and utilization of its
assets. It would be recalled that the various activity ratios measures this kind of operational
efficiency.
4. Overall profitability
The management is constantly concerned about the over all profitability of the enterprises they are
concerned about the ability of the firm to meet its short term as well as long term obligation to its
creditors to ensure a reasonable return to its owners and secure optimum utilization of the assets of
the firm.
5. Inter firm comparison
An inter firm comparison would demonstrate the relative portion vis--vis its competitors. If the
results are at variance either with the industry average or with those of the competitors the firm can
seal to identify the probable reasons and in the light take remedial measures.
6. Ratios serve as an instrument of management control
7. They facilitate and help in forecasting future events
8. They help management in exercising effective decisions
9. They help management take corrective actions
Limitations of ratios:
Ratio analysis despite its wide applications, is not free from limitations
1) Accounting ratios are retrospective: The ratios are computed based on the past data or
previous performance. They may not necessarily hold good in the future and may not be
helpful in making projections into future.
2) Accounting methods, policies and procedures are not common
3) Inflationary tendencies cannot be highlighted: in times of inflation the accounting data of
several years cannot be compared. Any analysis of such data based on ratios cannot be
meaningful

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4) Concepts of ratios are not the same

5) Qualitative factors cannot be considered: factors such as managerial abilities cannot be
considered here.
6) Ratio by itself has no utility: ratios to be meaningful have to be read along with other Ratios.
Any single ratio is meaning less by itself.
7) Ratios can be manipulated: during festival season there will be good turnover of stocks when
compared to the earlier periods. It is necessary to consider the average inventories to present
a fair view of the business activity.
Current Assets and Current Liabilities listed:
Current assets: cash hand, cash at bank, bills receivable, sundry debtors, marketable/temporary
investments, advances(short term), closing inventory of finished goods/work in progress/raw
materials, prepaid expenses, accrued income.
Current liabilities: bank overdraft, sundry creditors, bills payable, outstanding expenses, dividends
payable, tax payable, provision for taxation, provision for dividends, unearned income
Noncurrent assets and Noncurrent liabilities listed:
Noncurrent or fixed assets: good will, patents, trademarks and copy rights, land and buildings, plant
and machinery, furniture and fittings, long term investments, preliminary expenses, discount on issue
of shares and debentures, other deferred revenue expenditure such as advertising
Noncurrent or long term liabilities and owners equity/share holders funds: Equity share capital,
preference share capital, share premium, shares forfeited, reserve fund or general reserve, works men
compensation fund, capital reserve, depreciation fund or provision for depreciation, debentures, long
term loans
Types of Ratios:
Based on their nature the ratios can broadly be classified into 4 categories.
1) Liquidity Ratios
2) Activity Ratios
3) Capital Structure Ratios or Leverage Ratios or Solvency ratios.
4) Profitability Ratios
1) Liquidity Ratios:This expresses the ability of the firm to need its short term commitments as and

when they become due. Creditors are interested to know whether the firm will be in a position to
meet its commitments on time or not. If the firm is not in a position to meet its short term
commitment then it cannot continue in business for long despite its strong capital base. Liquidity
ratios help in identifying the danger signals for the firm in advance. Apart from the firm itself all the
financing companies offering short-term finances are interested in these ratios.
Liquidity ratios can be classified into two types
Current ratio: This is the ratio between current assets and current liabilities. The firm is said to be
comfortable in its liquidity position if the current ratio is 2:1.
The current assetsinclude cashin hand, cash at bank, debtors, bills receivable, prepaid expenses and
so on
The current liabilities include creditors , bills payable , bank overdraft less than one year period,
outstanding expenses , Income receive in advance , all provisions , dividends payable and so on
The current ratio is also called working capital ratio. It is because it is related to the working capital
of the firm.
Quick ratio or liquid ratio or acid test ratio: It measures the firms ability to convert its current
assets quickly into cash inorder to meet its current liabilities. It is the ratio between quick assets and
quick liabilities.

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2) Profitability ratios: Profitability ratios throw light on how well the firm is organizing its activities
in a profitable manner. The owners expect reasonable rate of return on their investment. The firm
should generate enough profits not only to meet the expectations of the owners, but also to finance
the expansion activities.
The following are the various profitability ratios
a) Gross profit ratio: Gross profit ratio is the ratio between gross profit to sales during a given
period it is expressed in terms of percentage. Gross profit is the difference between the net
sales and the cost of goods sold.
b) Net profit ratio: Net profit ratio is the ratio between net profit after taxes and net sales. It
indicates what portion of sales is left to the owners after operating expenses.
c) Operating ratio: Operating ratio is the ratio between cost of goods sold plus operating
expenses and the net sales. This is expressed as a percentage to net sales. The higher the
operating ratio the lower is the profitability and vice versa.
d) Return on investment (ROI): return on investment is one of the very important parameters
affecting business plan. The profitability of the firm is measured in terms of return on
investment. The term investment may refer to total assets, capital employed or owners
equity. Its classified into return on capital employed & return on equity
e) Earnings per share: EPS is the relationship between net profits and the number of shares
outstanding at the end of the given period. This can be compared with previous years to
provide a basis for assessing the companys performance.
f) Dividend yield: Yield refers to the amount of total return the investor will receive for a given
period of time for the amount of his investment.
g) Price earnings ratio: This is the share price divided by the earnings per share.
3) Solvency Ratios:
Solvency ratio is also called capital structure ratios or leverage ratios. It is defined as the
financial ratio, which focuses on the long term solvency of the firm. The long term solvency of the
firm is always reflected in its ability to meet its long term commitments such as payment of interest
periodically without fail.
The following are the most commonly used capital structure ratios
a) Debt equity ratio: Debt equity ratio is the ratio between outsiders funds (debt) and insiders
fund (equity). This is used to measure the firms obligations to creditors in relation to the
owners funds. It is measure of solvency. The yardstick for this ratio is 1:1.
b) Interest coverage ratio: interest coverage ratio is calculated to judge the firms capacity to
pay the interest on debt it borrows. It gives an idea of the extent the firms earnings may
contract before it is unable to pay interest payments out of current earnings.
c) Ratios of proprietors funds to total assets: This establishes the relationship between
proprietors funds and the total assets. Here the total assets include the tangible fixed assets
plus current assets. As a guideline the ratio of around 0.5:1 or 50% is considered as the
minimum desirable.
FUNDS FLOW ANALYSIS
Meaning of funds:
By the term funds we generally mean cash. But from the point of view of accountant and
finance managers funds means working capital or net working capital.
Net working capital or working capital:
Net working capital refers to excess of current assets over current liabilities. The current
assets are those assets which get convert into cash through business operation within one year. The
current liabilities refer to those liabilities which are to be cleared within one year.
The net working capital can either be positive value or negative

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1) Net working capital = current assets current liabilities

2) Gross working capital = sum of current assets
3) Positive net working capital = current assets > current liabilities
4) Negative working capital = current assets < current liabilities
Funds flow:
The funds flow statement Fund flow statement also referred to as statement of source and
application of funds provides insight into the movement of funds and helps to understand the
changes in the structure of assets, liabilities and equity capital. The information required for the
preparation of funds flow statement is drawn from the basic financial statements such as the Balance
Sheet and Profit and loss account. Funds Flow Statement can be prepared on total resource basis,
working capital basis and cash basis. The most commonly accepted form of fund flow is the one
prepared on working capital basis.
It reflects the movement of working capital that is the funds flow statement presents the increase or
decrease in the working capital. The transactions which result in increase of working capital will be
treated as sources of funds and the transactions which result in decrease of working capital will be
treated as application of funds.
Objectives of funds flow statements:
The funds flow statement is prepared to identify different sources and application of funds.in
other words it explains the sources of rising funds and how the same has been utilized. The funds
flow statements answers the following specific questions.
1) How could the firm pay dividends at a higher rate despite declining profits in the year
2) How does the firm have more working capital, when the profits have declined drastically
3) Is the firm solvent or not?
4) How has the company financed its fixed assets
5) Why does the company find it difficult to pay dividends though it has made good profits
Steps in preparation of funds flow statements:
1) Preparation of statement showing changes in working capital
Preparation of statement showing changes in working capital
a) Increase in current assets will result in increase of working capital
b) Decrease in current assets will result in decrease of working capital
c) Increase in current liabilities will result in decrease of working capital
d) Decrease in current liabilities will result in increase of working capital
2) Calculation of funds from operations
3) Preparation of funds flow statements
Advantages of fund flow are as follows:

management of various companies are able to review their cash budget with the aid of fund
flow statements
Helps in the evaluation of alternative finance and investments plan
Investors are able to measure as to how the company has utilized the funds supplied by them
and its financial strengths with the aid of funds statements.
It serves as an effective tool to the management of economic analysis
It explains the relationship between the changes in the working capital and net profits.
Help in the planning process of a company
It is an effective tool in the allocation of resources
Helps the management of companies to forecast in advance the requirements of additional
capital and plan its capital issue accordingly.

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Helps in determining how the profits of a company have been invested: whether invested in
fixed assets or in inventories or ploughed back.
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Preparation of funds flow statement

Funds flow statement