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Curriculum for Financial Accounting

Income statement, Balance Sheet, Assets, Liabilities, Provisions, Capital, reserve, Cash flow statement, Consolidated Financial Statement, Annual Reports, Understanding and analyzing annual reports.

Types of Organization
Trading organization

Manufacturing organization

Service organization

Understanding Business organization

Cash from sales

receipt current

Raj Ltd.

Cash payment for materials Administrative expenses etc.

Process starts with

Cash left in Bank

Case-2
Cash from current sales
Creditors for material and expenses Cash payment for materials and expenses

Advance from customers

Raj Ltd Cash left in Bank account

Collection from debtors

Receivable from customers

Accounting Analysis

Accounting Analysis

Providing information for Planning and Control

Audience
Internal Investors

Financial Accounting

Financial Accounting

Used for reporting

Audience : outside world like government bodies etc.

Basics for understanding accounting


Sales, interest received, commission received, discount received etc. Salary, rent, purchases, commission, interest, advertisement etc.

Income

expenses

Assets
Building, plant, furniture, cash, bank, stock etc

Liabilities
Creditors, loan, outstanding expenses, income received in advance, capital

Accounting Information system

Input

Users

Processing

Output

Inputs
Business Transactions- purchase, sales, cash receipts and cash payments External events- fire, earth quake, change in tax laws.

Processing
Accounting principles Accounting standards Estimates Laws and regulations etc.

Outputs
Profit & Loss Account Balance Sheet Cash flow statement Analysis Tax returns etc.

Users
Share holders Security analysts Banks Rating agencies Managers Employees Suppliers Customers government Researchers etc

Income
It refers to all the revenue receipts during the accounting period. It includes sale proceeds, amount received from services, rent received, interest received , commission received and all other receipts which will can be considered as revenue

Various Incomes
Sales Income from services Rent received discount received commission received interest received bad debts recovered apprentice premium income from investment

Expenses
It includes all the revenue expenses which are incurred to run the organization. It includes all the day to day expenses. Like sales expenses, administrative expenses

Various expenses
Purchases Carriage Carriage inward Freight Freight inward Wages Factory expenses Stores consumed Royalty Motive Power Coal, coke Water Oil Octroi Dock charges Custom Duty

Contd.
salary rent, rate & taxes stationary postage and telegram audit fees legal charges telephone charges insurance premium entertainment expenses repairs depreciation interest trade expenses conveyance charity bank charges

Contd.
office expenses establishment exp stable expenses license fees brokerage commission office lighting advertisement export duty discount packing charges traveling exp bad debts provision for bad debts

Assets
Assets represent something that the organization possess, something that it owns, and which has been obtained by spending the money raised. In other words, assets tells us where the money was spent- the use of money.

Various assets
Cash in hand Cash at bank Bills receivable Sundry debtors Closing stock Finished goods Raw materials Work in progress Stationary Goods sent on consignment Long term investments Trade mark Patents Vehicle Furniture Investments Machinery and plant Tools Land and building Goodwill

Classification of Assets
Current Assets Fixed Assets Wasting Assets

Fictitious Assets

Contingent Assets

Current Assets
Cash, bank, goods Bills receivable, prepaid expenses, Raw materials, stock, work in progress etc.

Fixed Assets
Tangible fixed assets
Land, building, plant, furniture, motor vehicle and tools etc.

Intangible fixed assets

Patents, trade mark, copy rights, goodwill and research and development cost etc.

Wasting assets

Assets diminish in value when the assets are taken out of natural resources

Mines, Ores, oil wells etc.

Fictitious Assets

Which do not have any concrete value

Preliminary expenses, Issue expenses of shares and debentures, formation expenses

Contingent assets
An asset the existence, value and ownership of which depend upon the occurrence or non occurrence of a specified act.
The undecided suits for a property

Liabilities
Liabilities represent money that organization owes. This is money that it owes because it was borrowed by the organization. In other words, liabilities shows the sources of money, where the organization has received its funds.

Various liabilities
Bank overdraft Bills payable Sundry creditors Short term loans Bank loans Long-term loans Incomes received in advance Capital

Classification of Liabilities
Long-term liabilities-

Current liabilities

Contingent liablities

Long term liabilities

Which does not fall due for payment in relatively short period ( more than 12 months)

Long term loan taken from banks, financial institutions and debentures.

Current liability

Which falls due for payment in a relatively short period (less than 12 months)

Bills payable, Trade creditors, outstanding expenses, bank overdraft, income received in advance etc.

Contingent Liabilities

Depending upon the occurrence of certain event which are uncertain

Arrears of dividend on cumulative preference shares, Bills of exchange discounted, suit for damages against the company.

Transaction
Any exchange of goods or services for money or moneys worth by the business with any other business or person is called transaction. It is an economic activity of the business that changes its financial position.

Determinants of cash transaction


The transactions, where Goods sold for cash the terms on cash or on Rs1,000 cheques, by cash or by Rent paid by cash Rs cheques, for cash or for 500 cheques are used are Salary paid by cheque identified as cash Rs 2,000 transactions. Good are purchased for cash Rs 6000

Contd.
The transactions where in the terms paid, received, settled, cleared, deposited, withdrawn etc is used are identified as cash transactions. Charges paid Rs200 Shilpi settled her account of Rs1,000 Rs2,000 deposited in the bank Mr. Anirban cleared his account or Rs500 by paying Rs450

Contd.
The transactions where Goods sold to Sravani both cash and personal for Cash Rs1,000 names are mentioned Goods purchased from are termed as cash Suman for cash Rs6,000 transactions

Credit transactions
The transactions where Goods sold to Sravani in personal names or Rs1,000 name of a firm is Good returned from mentioned are Sreemoti Rs5,000 identified as credit Goods returned to transactions Sivani Rs1,000 Goods purchased from Suman Rs6,000

Account
An account is summarized record of relevant transactions relating to same activity or particular head that has taken place during a given period. Separate individual accounts are opened for every head of expenses, revenue, asset, liability and capital

Accounts involved
Transactions
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Purchased goods for cash Purchased plant Purchased furniture Purchased good on credit Sold goods on credit to X Rent received Salary paid Commission received Cash deposited in to bank Started business with capital

Accounts involved
Cash, goods Plant ,cash Furniture, cash Goods, creditor Goods, X Cash, rent Salary, cash Commission, cash Bank ,cash Cash, capital

Accounting equation
Asset= Liabilities + Equity

Asset- Liabilities = Equity

Assets Equity = Liabilities

Format of Accounting Equation


Transactions Cash Assets Goods Furniture Liability + Equity

Impact on Accounting Equation


Decrease in asset Decrease in owners capital Cash withdrawn for private purpose

Contd.
Decrease in asset

Decrease in liability
Amount paid to creditors

Furniture purchased

Increase in one asset Decrease in other asset

Contd.
Cash brought in to business Increase in capital

Increase in asset

Contd.
Goods purchased on credit Increase in Liability Increase in assets

Creditors paid by taking a fresh loan

Increase in one liability Decrease in another liability

Creditor becomes the partner or the contributor

Increase in capital
Decrease in liability

Capital transferred to loan

Increase in liability
Decrease in capital

Contd.

Increase in capital

Discharge of liability at discount

Decrease in liability

Decrease in assets

Contd.

Increase in assets

Amount collected from debtors at discount

Decrease in assets

Decrease in capital

Tips for Accounting equation

Whether expenses paid or outstanding both the cases the capital will be reduced

If expenses paid it will reduce from the cash

If outstanding it will increase the liability

Contd.

If income received in advance

Increase the liability

Increase the cash

Contd.

If any expenses paid in advance

Prepaid expenses column will be opened in asset side

It will reduce from the cash

Contd.

For accrued income ( income earned but not received)

A separate column will be opened in the asset side as accrued income

Added to the equity / capital

Balance Sheet
The Balance Sheet presents an enterprises assets, liabilities and equity at a point in time. It summarizes the resources, and the claim to those resources by owners and creditors of the enterprise on a certain date

Balance Sheet
Liabilities + equity Assets

Format of Balance Sheet


Items Details Amount

Assets
Office equipments Stock Bank Cash Building Total of assets

Liabilities
Creditors Outstanding expenses Overdraft

Equity
Share capital Retained earnings Total equity Total of liabilities and equity

Income Statement or Profit & Loss Account


It is a dynamic document which shows the results of operation of an enterprise for a particular period of time. In this statement revenue of a particular period are marched with the expenses of that period. The excess of revenue over expenses is known as net income and excess of expenses over revenue is known as net loss

Why Profit is important?


For business profit is like engine of a car. As the car ends when its engine is separated from it, similarly identity of business comes to an end when the word profit is removed from it. Profit is very important in any business.

Why Profit & Loss Account is prepared?


The answer to this question is simple and obvious . As the name suggests, this statement is prepared to find out whether an organization has made a profit or a loss.

Profit Cycle
Profit Expenses Revenue/ Income

Loss Cycle
Income Expenses Loss

Profit and Loss


Items Income Sales Income from services Other receipts Total Income Expenses Cost of sales Salary Expenses due Depreciation Rent Total of Income Profit ( Income Expenses) / Loss ( Expenses- Income) Amount

____________
____________

____________ ____________

Statement of retained earnings


Particulars Opening retained earnings Add Profit during the year Les Dividend paid during the year Closing balance of retained earnings Amount

Stake holders for Revenue generated in business


the share holders who also expect reward

employees, vendors, printing stationer etc. This group represents operating expenses.

Stake holders
the lenders also need to be rewarded.

government, which expects to collect tax

Capital Expenditure
It is the amount spent to acquire the assets not for resale them, it is for generating the income of the business unit. The benefit of this is not for one year, it is for the longer period. For example purchase of land and building, purchase of plant, brokerage or commission paid for acquiring the long term loan etc. These expenses are recorded in Balance Sheet.

Contd.
Purchase of land, building, plant and machinery, furniture, vehicle and any other fixed asset.

Cost of replacing petrol driven engine to a diesel driven engine

Capital expenditure

Expenditure incurred for increasing the sitting accommodation in a auditorium or restaurant.

Amount spent for erecting of plant

Revenue expenditure
It includes purchasing assets required for resale at a profit or being made into saleable goods, maintaining fixed assets in good working conditions, meeting the day to day expenses of carrying business, cost of goods, raw materials and replacements, renewals, repairs, depreciation of fixed assets, rent rates, taxes, wages and salaries, carriage, insurance etc.

Contd.
Rent, rates, salary, telephone expenses

Commissi on paid, rent paid, advertise ment

Revenue expenses

Cost of goods sold, repairs, stationary

Discount , interest, postage etc.

Revenue expenditure becomes capital expenditure


Repairs to second hand machine

Legal expenses at the time of purchase of fixed assets

Transport charges for Plant and Machinery

Contd.
Wages paid to work man for erecting of PM

Development expenditure for plantation, Collieries etc,


Interest paid during construction of building or plant etc.

Deferred Revenue Expenditure


It is the expenditure which would be normally treated as revenue expenditure but it not written off in one year as its benefit is not exhausted in one year but over a period of year. The nature of this is non-recurring and special nature. It may be spread over a number of years, a proportionate amount is charged to profit &loss account every year and the balance amount is treated as an asset and shown on the balance sheet asset side

Contd.

Huge advertisement expenses for business promotion

Heavy Insurance premium paid the benefit derived beyond the accounting period.

Revenue Profit

Profit from sale of goods

Income from investment

Commission received, interest received, discount received etc.

Capital receipt

Capital receipts

capital invested in the business, loans and the proceeds of sale of assets etc

Revenue receipt

Revenue receipts

cash from sales, discount received, commission, interest on investment, transfer fees received etc

Capital loss

Capital Loss

Loss while which occurs while selling fixed assets or raising share capital

Revenue loss

Revenue loss

Loss on sale of goods

Profit Before Interest and Tax (PBIT) or operating profit or EBIT


This is a measure of gross performance of a company with reference to its total capital employed. As the term suggests, interest and tax are not deducted while computing PBIT. Interest is a reward of borrowed capital and tax is a compulsory deduction imposed by law. It is also known as Earnings Before Interest and Tax ( EBIT). Generally it is used to measure managerial Performance.

Profit Before Tax (PBT) or EBT


This is a measure of net profit before charging tax. Since tax is a compulsory and non discretionary charge on the company, net profit is first presented before charging tax. By this the users can understand profit earning ability of the company and the tax impact separately. This also otherwise known as Earnings Before Tax (EBT).

Profit After Tax (PAT)


This is a measure of net profit. This is used to understand the profit earned after tax charge. It is otherwise known as Earnings After Tax (EAT).

Basics

PBIT PBT
PAT

Basics

DISTRUBUTABLE PROFIT

PAT + Previous years undistributed profit.

Basics

Non- operating income

Income from investment, profit on sale of assets etc.

Basics

Non- operating expenses

Loss on sale of assets or loss on sale of investments etc.

Order of Payment
Operating expenses

Interest

Tax

Share holders

Cash Flow Analysis


Explains reasons for changes in cash position of a concern. Transactions which increase the cash position of the concern are known as inflow of cash and those decreases the cash position are known as out flow of cash.

Cash flow Reporting


Cash flow from OPERATION

Cash flow from INVESTMENT

Cash flow from FINANCING

Operation Activity

Receipts from customers for sale of goods and services

Operating activities

Payments to suppliers and employees Payment to govt. for taxes and duties

Cash inflow

Cash outflow

Investing Activity

Sale of fixed assets, sale of investments, collection of loans, interest and dividend received etc.

Investing activity

Payment for purchase of fixed assets, Payment for purchased of investment and for making loans.

Cash inflow

Cash outflow

Financing Activity

Issue of share capital, debentures and other borrowings

Financing activity

Dividend paid, interest paid, payment of loan, capital . Debentures paid

Cash inflow

Outflow of cash

Cash from investing activities


Sale of fixed assets Sale of investment Purchase of fixed asset (-) Purchase of investment (-) Interest received Dividend received Loans to subsidiaries (-) Net cash from investing activities

Cash flow from financing activity


Issue of shares and debentures Proceeds from long-term borrowings Repayment of long-term borrowings (-) Redemption of preference shares and debentures (-) Dividend paid (-) Interest paid (-) Net cash from financing activities

Cash Flow Statement


Particulars I. Cash flow from Operating Activities Details Amount

II.

Cash flow from Investing Activities

III. Cash flow from Financing Activities Net Increase (Decrease) in cash + Beginning Balance of Cash End Balance of Cash ____________ ------

Trial Balance
Trial Balance is a statement, prepared with the debit and credit balances of ledger accounts to test the arithmetical accuracy of books of accounts.

Items shown in the trial balance


Debit side Cash in hand Cash at bank Bills receivable Drawings Land and building Furniture Plant and machinery Investments Opening stock Rent ,rates and taxes Wages Freight Discount allowed Export duty Horse and cart Goodwill Sales tax Credit side Capital Bank overdraft Creditors Sales Bills payable Loan (credit) Mortgage (payable) Purchase return Discount ,rent, interest (received) Provisions for bad debts General reserve Depreciation reserve Depreciation fund Provision for depreciation Apprentice premium Commission received Interest received

Provisions
set aside ,before ascertaining the net profits,

charge against profit for all anticipated losses

reasonably necessary for the purpose of providing for any liability or loss, which is likely or certain to be incurred;

Reserve
capital receipts( profit on sale of fixed assets or issue of shares at a premium) upward revaluation of assets( bringing the assets to current value from historical cost amount of money that is set aside until that is required for other purpose

Reserves are the items of owners' equity which arise from retention of profits (an appropriation of profits, sum of money set aside from distributable profits

Reserve

Classification of reserve
Capital reserve Revenue reserve

General reserve Specific reserve

Depreciation
Due to wear and tear

Due to out date of technology Decrease in value of an asset

Causes of Depreciation
Lapse of time Wear and tear due to constant use Depletion

Contd.
Exhaustion of assets
Accident Obsolescence

Ratio Analysis
In general words, a ratio is an expression of relationship of one figure with another. It may be defined as the relationship, or proportion that one amount bears to another. It is found by dividing a figure with another. A ratio may be expressed in percentage in which the base, is taken as equal to 100 and the quotient is expressed as per hundred of the base

Various ratios
Capital structure or leverage ratio

Liquidity ratios

Activity or turnover ratio

Profitability or profit earning capacity ratios.

Components

Current Assets

Cash in hand, cash at bank, debtors, prepaid expenses, short term deposits, bills receivable, money at call and short notice, stock ,finished goods, work in progress stock of raw materials and sundry supplies

Current Liabilities

Bills payable, income tax payable, creditors. Outstanding expenses, bank overdraft, provision for taxation, interest due on fixed liabilities, reserve for unbilled expenses, installment payable on long-term loans.

Short term ratio

Primarily short term creditors interested in liquidity or short term solvency of the firm. Since their claims are to be met in the short term.

It is the ability of the firm to meet short term obligations. This measures concerns ability to meet short term obligation

Short term solvency or liquidity ratios


Current Ratio

Liquid Ratio

Absolute Liquid Ratio

Current ratio or working capital ratio

Meaning Ratio Standard norm

This ratio establishes relationship between current assets and current liability

Current assets / Current liabilities

2:1

Liquid Ratio or quick ratio


Meaning Ratio Standard norm
This ratio establishes relationship between quick assets and current liability . Quick assets refer to those current assets which can be converted into cash immediately or at a short notice with out a loss of value.

Quick Assets/ Current liability or Quick assets / Quick liability

1:1 Note Quick assets are current assets- stock prepaid expenses and quick liabilities are current liability- bank overdraft.

Absolute liquid ratio


Meaning Ratio Standard norm
Establishes the relationship between absolute liquid assets and absolute liquid liabilities or current liabilities . Absolute liquid assets = Cash in hand, cash at bank and short term marketable securities

Absolute liquid assets / Absolute liquid liabilities or CL

.5:1

Activity or Turnover ratio


It measures the effectiveness with which a firm uses its available resources.

Activity or Turnover ratios


Stock or inventory turnover ratio

Debtors or receivable turnover ratio

Average collection period or debtor velocity

Creditors or payable turnover ratio

Average payment period

Contd.
Total assets turnover ratio

Fixed asset turnover ratio

Current asset turnover ratio

Working capital turnover ratio

Capital or net worth turnover ratio

Total capital turnover ratio

Stock or inventory turnover ratio


This ratio is an indicator of velocity of flow of inventory in business. This shows the rate of conversion of stock in to sales. In fact, inventory policy of management and liquidity of firm both may be tested by this ratio. This is also a measure of marketing capacity of the firm. No any standard rate or norm can be determined for this ratio because it based more on nature of industry and sales policy of the firm.

Contd.
Cost of goods sold / Average stock Cost of goods sold = opening stock + purchases+ direct expenses closing stock Average stock = opening stock + closing stock / 2 Note :1. If cost of goods sold cannot be calculated then sales will be taken as base 2. if opening and closing stock is not given in that case closing stock will be treated as average stock 3 Higher the ratio good for the organization. A low stock turnover ratio indicates that the goods do not sell quickly and efficiently, so the maximum inventory remains lying in the warehouse.

Debtors Turnover ratio or Receivable Turnover Ratio (DTR) This ratio is a qualitative analysis of a firms marketing and credit policy and debtors realizations. It is calculated to know the uncollected portion of credit sales in the form of debtors by establishing relationship between trade debtors and net credit sales of the business.

Contd.
DTR = Net credit sales / Average receivables Net credit sales = Total sales cash sales sales return Avg. receivables = opening receivable +closing receivable / 2 Receivable = Debtors + Bills receivable A decrease in this ratio each year is an indicator of efficiency of marketing and credit policy of the firm.

Average collection period:


This period indicates the period taken in the realization or collection of debtors. In other words, it represents the average number of days for which a firm has to wait before its receivables are converted into cash. The purpose of calculating this period is to find out the ratio of cash flow from collection of debtors

Contd.
Average collection period or average age of receivables= Trade receivables/ sales per day Or Trade receivables / net credit sales X 365 days Or 365/ DTR

Contd.
In this respect, the general rule is that average collection period should not exceed the stated credit period on trade terms plus 1/3rd of such period. If average collection period exceeds 4/3 of stated credit period, it will indicate either liberal credit policy or slackness of management in realizing debts. A higher average collection period also implies that chances of bad debts are larger.

Creditors Turnover Ratio


The short-term creditors ( i.e, suppliers of goods and bankers) are very much interested in this ratio, as it shows the firms trend of payment to its short-term creditors. This ratio shows the relationship of credit purchases and trade creditors. This ratio indicates the velocity with which the creditors are turned over in relation to purchases. Higher the creditors velocity, better it is. A fall in this ratio shows delay in payment to creditors.

Creditors or payable turnover ratio


CTR = Net credit purchases / Average payables (creditor +BP) Net credit purchase = Total purchase cash purchase purchase return Average payable = opening payable + closing payable / 2 Note : if opening and closing is not given then closing will be considered as average

Average payment period


While analyzing creditors, usually average period is also calculated. This period discloses the time taken by the firm in making payment to its trade creditors. Average disbursement period is compared with credit period allowed by suppliers of goods to know promptness or delay in payment

Contd.
Average payable / net credit purchase X no. of month or weeks or days Or No. of month or week or days / CTR

Total assets turnover ratio


Cost of goods sold or net sales / Total assets Total assets = Fixed assets + current assets fictitious assets- depreciation on fixed assets This relationship indicates the efficiency of the utilization of assets to attain the maximum turnover on sales. A rise in the ratio indicates more intensive utilization of assets, while fall in the turnover suggests under utilization of assets.

Fixed assets turnover ratio


Cost of goods sold or net sales / net fixed assets Net fixed assets = Fixed assets depreciation If there is an increase in this ratio, it will show that there is better utilization of fixed assets .If there is a fall in this ratio, it will show that investment in fixed has not been utilized efficiently. Ideal of this in a manufacturing company is 5:1

Current assets turnover ratio


Cost of goods sold or net sales / current assets This ratio measures the concerns efficiency in utilization of its current assets. This ratio also indicates the over investment or under investment position of current assets in a concern.

Working capital turnover ratio


Cost of goods sold or net sales / working capital The high ratio indicates efficient use of working capital in the concern while low working capital turnover ratio indicates under utilization of working capital in the concern

Capital or net worth turnover ratio


Net sales or cost of goods sold / net worth or share holders fund It indicates whether the capital employed by the shareholders in a business is used efficiently or not

Total capital turnover ratio


Cost of goods sold or net sales / capital employed Capital employed = long term and short term capital By calculating this ratio, efficiency of capital employed may be known. This ratio shows how many times capital has been rotated for generating the sales. The higher the ratio, better it is for the business concerns. No ideal standard can be fixed for this ratio.

Capital Structure Ratio or long term solvency ratios


Debt equity ratio Solvency ratio Proprietary ratio Fixed asset ratio Capital gearing ratio Debt service ratio or interest coverage ratio

Debt Equity Ratio


Debt equity ratio = Outsiders fund / shareholders fund Alternative: Debt equity ratio = long-term debt / share holders fund or net worth Note: in this case current liabilities will be ignored. Standard norm: 2 : 1, however lending institutions prefer 1:1 A low ratio signifies a smaller claim of creditors. More precisely, the greater the debt-equity ratio, greater the risk to the creditor.

Outsiders fund and share holders fund

Outsiders fund Share holders fund

Debt, long-term or short term, whether in the form of mortgage, bills or debentures

Preference share capital, equity share capital, capital reserves, retained earnings and any other reserves representing the accumulated profit

Proprietary Ratio
This is also known as equity ratio, net worth to total assets ratio. Proprietary ratio = Share holders fund / Total assets Higher the ratio better is the financial position of the firm.

Solvency Ratio or debt to total assets ratio


Solvency ratio = Total outside liabilities / total assets If the amount is enough to pay the external liabilities then the company is said to be solvent.

Fixed Asset Ratio


Fixed assets ratio = Net fixed assets / (shareholders fund + long term liability) Or Fixed asset ratio = Net fixed assets / Share holders fund Standard norm: 1 :1. It is well established that fixed assets should be financed only out of long-term funds. This ratio shows whether this is so.

Capital gearing ratio


CGR = Share holders fund / out siders fund Share holders fund = Equity capital + reserve +surplus Outsiders fund = Preference share capital + Debentures + Other long term loans. Note : If capital gearing ratio is less than 1, we will call it high gearing of capital and if gearing ratio is more than 1 then low gearing of capital is assumed

Debt service ratio or interest coverage ratio


Interest coverage ratio = Net profit before interest and tax /Interest on fixed long term loans or debentures. Note : This ratio measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of his periodical interest income. Normally, fixed interest charges should be covered six to seven times.

Profitability ratios: Based on sales


Gross profit ratio Operating ratio Expenses ratio Operating profit ratio Net profit ratio

Gross profit ratio


Gross profit / net sales X100 Net sales = Sales sales return Gross profit = net sales cost of goods sold. The gross profit ratio is primarily a test of the efficiency of purchases and sales management. No ideal standard is fixed for this ratio, but the gross profit ratio must be adequate.

Operating ratio
Cost of sales + operating expenses / net sales X 100 Operating expenses = office and administrative expenses + selling expenses + discount allowed + bad debts etc.

Other profitability ratios

Expenses ratio= Particular expenses/ nets sales X100

Operating profit ratio=Operating profit/net sales X100

Net profit ratio= Net profit/ net sales X100

Profitability ratios based on capital


Return on gross capital employed Return on net capital employed Return on proprietors net capital Return on average capital employed Return on total assets

Return on gross capital employed


EBIT / Gross capital employed X100 Gross capital = Equity share capital + preference share capital +reserve and surplus + all long and short term external loans Or All net fixed assets + current assets + including goodwill of the firm but fictitious assets are not included

Return on net capital


EBIT / Net capital employed X100 Net capital employed = Equity share capital + preference share capital + reserve and surplus + long term loans

Return on proprietors capital employed


Net profit after interest and tax / proprietors net capital employed X100 Proprietors net capital = Equity share capital + preference share capital + reserves and surplus accumulated losses, if any

Return on average capital employed


Net profit / average capital X100 Average capital = Opening capital + closing capital /2 Or Opening capital +1/2 of current years profit Or Closing capital of current years profit Return on capital employed reflects the overall profitability of the business

Return on total assets


Net profit / Total net assets X 100 Total net assets = Total assets fictitious assets

Return on proprietors fund or equity or return on net worth


Net profit / Proprietors fund X100 Proprietors fund =Equity share capital + preference share capital +reserves and surplus+ undistributed profit debit balance of profit & loss if any.

Ratios showing profitability on shares


Earning per share(EPS) Earning Yield Ratio(EYR) Dividend Per share (DPS) Pay-out Ratio (POR) Dividend Yield Ratio (DYR) Dividend coverage ratio (DCR) Price earning ratio (PER)

Earning per share(EPS)


Net profit after tax, interest and preference dividend / no of equity shares It indicates the amount of earnings that equity share commands.

EPS
Indicator

Earning Yield ratio (EYR)

EYR
Indicator

= EPS / Market price per share X 100

This ratio indicates the relationship between earning per share and market price per share

Dividend Per Share (DPS)

DPS
Indicator

Dividend for equity share holders/ no. of equity shares

Higher the ratio, the better is for equity share holders of the concern. This ratio shows the amount of dividend per share paid by the management of the company

Pay-out ratio (POR)

POR
Indicator

dividend per equity shares/ earning per share X100

This ratio helps us to calculate the percentage of dividend paid out of earned incomes and the percentage of earned profits retained in the business concern

Dividend Yield Ratio (DYR)

DYR
Indicator

Dividend per share / Market price per share X100

Dividend yield ratio helps investors to ascertain the effective return on the amount they invest or intend to invest in the equity shares of a company

Dividend cover ratio (DCR)

DCR
indicator

EPS / DPS

This ratio indicates the relationship between dividend per share and earning per share. This ratio calculated by dividing earning per share by dividend per share

Price Earning Ratio (PER)

PER
Indicator

MPS /EPS

This ratio indicates relationship between market price per equity shares and earning per share. In other words, this ratio indicates the number of times the earning per share is covered by its market price.

Analysis and Interpretation of Financial Statements


It is the process of identifying the financial strengths and weakness of the firm by properly establishing relationship between the items of the Balance Sheet and Profit & Loss Account and other operating data.

Meaning
Analysis
It is used to mean the simplification of financial data by methodical classification of the data given in the financial statements

Interpretation

It is the explaining the meaning and significance of the data so simplified.

Comparative Income Statement


This statement shows the operational results of the business for a number of accounting periods so that changes in absolute figures from one period to another period may be stated in terms of money and percentage.

Comparative Balance Sheet


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

Common- Size Statements


Common-size statements cover up the shortcomings of the comparative statements by expressing each item of the statements as a percentage of total. In common-size statements relative values of items are shown.

Common-Size Balance Sheet


In common-size balance sheets, various items of assets and liabilities of balance sheets of two or more years are shown at their relative values. That is ,each item of the assets is shown as percentage of total assets and each item of liabilities as percentage of total liabilities and capital fund.

Common-Size Income Statement


In this statement relationship is established between items of income statement and volume of sales in percentage form. In other words, in a common size income statement ,each item of income statement is shown in percentage based on net sales.

Consolidated Balance sheet


A Balance Sheet which is prepared by combining holding companys balance sheet and subsidiary companys balance sheet is called consolidated balance sheet. In preparing consolidated balance sheet, the assets and liabilities of both companies are added together but some adjustments are made.

Steps for preparing consolidated balance sheet


Step-I: Share of holding and subsidiary company Step-II: Capital reserve or goodwill Step-III: Minority Interest Step-IV: Consolidate profit Step-V: Consolidated reserve Step-VI: Consolidated Balance Sheet

Adjustments: Elimination of investments


The investment in shares of subsidiary is shown in the balance sheet of holding company on the assets side and share capital of subsidiary company is shown in its balance sheet on the liability side. If the holding company has purchased the entire share capital of the subsidiary company, the investment appearing in the balance sheet of holding company is adjusted with share capital appearing in the balance sheet of subsidiary company.

Goodwill or capital reserve


If the holding company has purchased shares in subsidiary company at above par value or below par value and the balance sheet of the subsidiary company has pre-acquisition profits and reserves and all the shares in subsidiary company are held by the holding company, the cost of investment in shares will be adjusted to share capital + pre-acquisition profits and reserves..

Contd.
If the cost of investment is more, the difference will be shown as goodwill on asset side in the balance sheet and if the cost of investment is less the difference will be shown on the liability side of consolidated balance sheet as capital reserve.

Minority interest
Minority interest includes nominal value of share held by minority share holders and proportionate reserves and profits. In the reserves and profits of the holding company, only. On the liability side of consolidated balance sheet minority interest is shown as a separate item.

Elimination of intercompany debts


Debtors and creditors Bills receivable and bills payable Bills discounted with the bank Mutual loans

Unrealized profit
Percentage profit on sales :- If percentage of profit on sales is known, the unrealized profit will be stock X % /100 For example, if stock of B Ltd. includes goods worth Rs10,000 purchased from A Ltd. charged profit of 20% on sales. Then unrealized profit will be 10,000 X20% = Rs2,000.

Contd.
Percentage of profit on cost :- If profit charged by vendor company is a certain percent on cost, then unrealized profit will be Stock X %/ 100 +% For example, stock of B Ltd includes goods worth Rs8,000 purchased from A Ltd. on which A Ltd earned a profit of 25% on cost. Then unrealized Profit will be 8,000 X25/125 = Rs1,600, as goods cost Rs100 was sold at Rs125, thus profit of Rs25 on goods sold of Rs125

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