UNIT 10 FINANCIAL STATEMENTS: ANALYSIS AND

INTERPRETATION (Accounting Ratios)

 Financial Statements:

UNIT 10 FINANCIAL STATEMENTS: Analysis and Interpretation

(Accounting Ratios)

ANALYSIS AND
NOTES
INTERPRETATION
(Accounting Ratios)

Structure
10.0 Introduction
10.1 Unit Objectives
10.2 Relationship between Analysis and Interpretation
10.3 Steps Involved in the Financial Statements Analysis
10.4 Ratio Analysis
10.5 Classification of Ratios
10.6 Profitability Ratios
10.7 Turnover Ratios
10.8 Financial Ratios
10.9 Advantages of Ratio Analysis
10.10 Limitations of Accounting Ratios
10.11 Summary
10.12 Key Terms
10.13 Answers to Check Your Progress
10.14 Questions and Exercises
10.15 Practical Problems
10.16 Further Reading

10.0 INTRODUCTION
Financial statements are prepared with the objective of knowing the profitability and
financial soundness of the business. This requires proper analysis and interpretation of
financial statements. This aspect has been discussed in detail in this unit.

10.1 UNIT OBJECTIVES

z Concept of financial statement analysis
z Difference between analysis and interpretation of financial statements
z Steps involved in financial analysis
z Utility of ratio analysis as a tool for financial analysis
z Classification of accounting ratios into different categories
z Understanding and computation of different accounting ratios
z Critical analysis of financial statements on the basis of accounting ratios

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Material 205
Financial Statements:
Analysis and Interpretation 10.2 RELATIONSHIP BETWEEN ANALYSIS AND
(Accounting Ratios)
INTERPRETATION
NOTES Financial statements, as stated earlier, are indicators of the two significant factors:
1. Profitability
2. Financial soundness
Analysis and interpretation of financial statements, therefore, refers to the
treatment of the information contained in the income statement and the balance
sheet so as to afford full diagnosis of the profitability and the financial soundness
of the business.
A distinction here can be made between the two termsanalysis and
interpretation. The term analysis means the methodical classification of the
data given in the financial statements. The figures given in the financial statements
will not help one unless they are put in a simplified form. For example, all
items relating to Current Assets are put at one place, while all items relating
to Current Liabilities are put at another place. The term interpretation means
explaining the meaning and significance of the data so simplified.
However, both analysis and interpretation are complementary to each
other. Interpretation requires analysis, while analysis is useless without
interpretation. Most of the authors have used the term analysis to cover the
meanings of both analysis and interpretation, since analysis involves interpretation.
According to Myers, financial statement analysis is largely a study of the
relationship among the various financial factors in a business as disclosed by a single
set of statements and a study of the trend of these factors as shown in a series
of statements. For the sake of convenience, we have also used the term financial
statements analysis throughout the unit to cover both analysis and interpretation.

10.3 STEPS INVOLVED IN THE FINANCIAL

STATEMENTS ANALYSIS
The analysis of the financial statements requires:
(1) Methodical classification of the data given in the financial statements.
(2) Comparison of the various interconnected figures with each other which
is popularly termed as ratio analysis.
Each of the above steps has been explained in the following pages:
(1) Methodical Classification. In order to have a meaningful analysis it
is necessary that figures should be arranged properly. Usually, instead of the
two-column (T form) statements, the statements are prepared in single (vertical)
column form which should throw up significant figures by adding or subtracting.
This also facilitates showing the figures of a number of firms or number of
years side by side for comparison purposes.
OPERATING (INCOME) STATEMENT
for the year ending
Particulars Rs Rs
Gross Sales .... ....
Less: Sales Returns
Sales Tax/Excise .... ....
Net Sales (or sales) for the year (1) ....
(Contd.)
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Less: Cost of Sales: (2) Financial Statements:
Raw Materials consumed .... Analysis and Interpretation
Direct Wages .... (Accounting Ratios)
Manufacturing Expenses .... ....
Add: Opening Stock of Finished Goods ....
Less: Closing Stock of Finished Goods NOTES
Gross Profit (1) (2) = (3) ....
Less: Operating Expenses: (4)
Administration Expenses ....
Selling and Distribution Expenses .... ....
Net Operating Profit (OPBIT) (3) (4)= (5) ....
Add. Non-trading Income ....
(such as dividends, interest received, etc.) ....
Less: Non-trading Expenses (such as discount on ....
issue of shares written off) .... ....
Income or Earning before Interest and Tax (EBIT) (6) ....
Less: Interest on Debentures (7) ....
Net Income or Earning before Tax (EBT) (8) ....
Less: Tax (9) ....
Income or Profit After Tax (PAT) (10) ....

BALANCE SHEET
as on.......
Particulars Rs
Cash in Hand ....
Cash at Bank ....
Bills Receivable ....
Book Debts (less provision for bad debts) ....
Marketable Trade Investments ....
Liquid Assets (1) ....
Inventories (stock of raw materials, finished goods, etc.) ....
Prepaid Expenses ....
Current Assets (2) ....
Bills Payable ....
Trade Creditors ....
Outstanding Expenses ....
Bank Overdraft ....
Other Liabilities Payable within a year ....
Current Liabilities (3) ....
Provision for Tax ....
Proposed Dividends ....
Other Provisions ....
Provisions (4) ....
Current Liabilities and Provisions (3) + (4) = (5) ....
Net Working Capital ....
[Current Assets Current Liabilities and Provisions (2) (5)] (6) ....
Goodwill at cost* ....
Land and Building ....
Plant and Machinery ....
Loose Tools ....
Furniture and Fixtures ....
Investments in Subsidiaries ....
Patents, Copyright, etc.** ....
Fixed Assets (7) ....
Capital Employed (6) + (7) = (8) ....
Other Assets: (9) ....
Investment in Government Securities, Unquoted Investments, etc. ....
Other Investments (non-trading) ....
Advances to Directors ....
Companys Net Assets (8) + (9) = (10) ....
Debentures ....
Other Long-term Loans (payable after a year) ....
Long-term Loans (11) ....
(Contd.) Self-Instructional
Material 207
Financial Statements: Shareholders Net Worth (10) (11) = (12) ....
Analysis and Interpretation (or total tangible net worth) ....
(Accounting Ratios) Preference Share Capital (13) ....
Equity Shareholders Net Worth (12) (13) = (14) ....
Equity Shareholders Net Worth is represented by: ....
NOTES Equity Share Capital ....
Forfeited Shares ....
Reserves ....
Surplus ....
Equity Shareholders Claims ....
Less: Accumulated Losses .... ....
Miscellaneous Expenditure
(such as preliminary expenses, discount on issue of shares or
debentures not written off) .... ....
Equity Shareholders Net Worth ....

* Goodwill to be included only when it has been paid for and has the value.
** Patents, Copyrights, etc., should be shown only when they have the value. In case these
assets are valueless, they should not be included here but should be written off against
shareholders' claims with other losses.
The process of methodical classification of the data will be clear with the
help of the following illustration:
Illustration 10.1: Below is, given the Balance Sheet of Prospective Ltd as
on 31 March, 1996, together with the Profit and Loss Account.
BALANCE SHEET
as on 31 March, 1996 (Rs in thousand)
Liabilities Rs Assets Rs
Equity Share Capital 500 Trade Investments 200
Dividend Equilisation Reserve 70 Patents 30
General Reserve 110 Land and Building (at cost) 320
Profit and Loss A/c 190 Plant and Machinery (at cost) 650
6 per cent Debentures 250 Cash at Bank 88
Bank Overdraft 150 Stock:
Staff Provident Fund 80 Materials 90
Creditors 210 Finished goods 160
Unpaid Dividend 10 Work-in-progress 60 310
Proposed Dividend 60 Sundry Debtors 230
Provision for Taxation 170 Less: Provision for
Provision for Depreciation 250 doubtful debts 8 222
Bills Receivable 30
Staff provident fund investment 80
Deposits with Customs Authorities 20
Advance for Purchase of Machinery 60
Preliminary Expenses 30
2,050 2,050

PROFIT AND LOSS ACCOUNT

for the year ended 31 March, 1996 (Rs in thousand)
Particulars Rs Particulars Rs
To Stock: By Sales 2,000
Materials 90 By Stock:
Finished goods 120 Materials 90
Work-in-progress 40 250 Finished goods 160
To Purchase of Materials 850 Work-in-progress 60 310
To Wages 280 By Dividend on Investment 30
To Power 40 By Sales of Scrap 8
(Contd.)
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To Miscellaneous Factory Expenses 110 Financial Statements:
To Office Salaries 80 Analysis and Interpretation
(Accounting Ratios)
To Miscellaneous Expenses 90
To Selling and Distribution Expenses 120
To Advertisements 80
NOTES
To Preliminary Expenses 5
To Debenture Interest 15
To Depreciation:
Plant 60
Land and Building 12 72
To Provision for Taxation 170
To Proposed Dividend 60
To Balance of Profit 126
2,348 2,348

You are required to present the information suitably summarized in single-column

statements (vertical form) showing distinctly the following:
(i) Total capital employed
(ii) Shareholders' funds
(iii) Gross profit
(iv) Net operating profit
(v) Cost of goods sold
Solution:
Prospective Limited
BALANCE SHEET
as on 31 March 1996 (Rs in thousand)
Cash at Bank 88
Book Debts (net) 222
Bills Receivable 30
Liquid Assets (1) 340
Deposit with Customs 30
Stock:
Materials 90
Finished goods 160
Work-in-progress 60 310
Current Assets (2) 680
Bank Overdraft 150
Creditors 210
Unpaid Dividend 10
Current Liabilities (3) 370
Proposed Dividend 60
Provision for Taxation 170
Current Liabilities and Provisions (4) 600
Net Working Capital (2) (4) = (5) 80
Land and Building (at cost) 320
Plant and Machinery (at cost) 650
Patents 30
Fixed Assets 1,000
Less: Provision for Depreciation (6) 250
Net Fixed Assets 750
Advance against Machinery 60
Trade Investments 200
Total Fixed Investment (7) 1,010
Staff Provident Funds Investments 80
Less: Staff Provident Funds 80 Nil
Total Capital employed (8) 1,090
Less: 6 per cent Debentures (9) 250
Shareholders' Funds (10) 840
(Contd.) Self-Instructional
Material 209
Financial Statements: Represented by:
Analysis and Interpretation Equity Share Capital 500
(Accounting Ratios) General Reserve 110
Dividend Equalisation Reserve 70
Profit and Loss A/c (Less: Preliminary Expenses) 160
840
NOTES
PROFIT AND LOSS ACCOUNT
for the year ended 31 March 1996 (Rs in thousand)
Sales 2,000
Less: Cost of goods sold 1,284
Gross Profit 716
Less: Operating Expenses:
Salaries 80
Miscellaneous Expenses 90
Selling and Distribution Expenses 120
Advertisements 80 370
Net Operating Profit 346
Add: Non-operating Income
(Dividends on Investments) 30
Less: Non-operating Expenses
(interest on debentures) 15 15
361
Less: Preliminary Expenses written off 5
Profit before Tax 356
Less: Income Tax payable 170
Profit after Tax 186
Less: Proposed Dividend 60
Profit retained in the business 126

STATEMENT OF COST OF GOODS SOLD

for the year ended 31 March 1996 (Rs in thousand)
Cost of goods manufactured:
Work-in-progress on 1 April, 1995 40
Materials consumed: Opening stock 90
Purchases 850
940
Less: Closing Stock 90 850
Wages 280
Power 40
Miscellaneous Factory Expenses 110
Depreciation 72
1,392
Less: Sale of Scrap 8
Work-in-progress on 31 March, 1996 60 68
Cost of goods manufactured 1,324
Add: Opening stock of Finished Goods 120
1,444
Less: Closing Stock of Finished Goods 160
Cost of goods sold 1,284

10.4 RATIO ANALYSIS

Accounting ratios are relationships expressed in mathematical terms between figures
which are connected with each other in some manner. Obviously, no purpose will
be served by comparing two sets of figures which are not at all connected with
each other. Moreover, absolute figures are also unfit for comparison.

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 Financial Statements:
10.5 CLASSIFICATION OF RATIOS Analysis and Interpretation
(Accounting Ratios)
Ratios can be classified into different categories depending upon the basis of
classification.
NOTES
Traditional Classification. This classification has been on the basis of the
financial statements to which the determinants of a ratio belong. On this basis,
the ratios could be classified as:
1. Profit and Loss Account Ratios, i.e., ratios calculated on the basis of
the items of the profit and loss account only, e.g., gross profit ratio,
stock turnover ratio, etc.
2. Balance Sheet Ratios, i.e., ratios calculated on the basis of the figures
of balance sheet only, e.g., current ratio, debt-equity ratio, etc.
3. Composite Ratios or Inter-statement Ratios, i.e., ratios based on figures
of profit and loss account as well as the balance sheet, e.g., fixed assets
turnover ratio, overall profitability ratio, etc.
Functional Classification. The traditional classification has been found to
be too crude and unsuitable because analysis of balance sheet and income statement
cannot be done in isolation. They have to be studied together in order to determine
the profitability and solvency of the business. In order that ratios serve as a
tool for financial analysis, they are classified according to their functions as
follows:
1. Profitability Ratios
2. Turnover Ratios
3. Financial Ratios
In the following pages we will explain the ratios covered by each of the
above categories in detail.

10.6 PROFITABILITY RATIOS

Profitability is an indication of the efficiency with which the operations of the business
are carried on. Poor operational performance may indicate poor sales and hence
poor profits. A lower profitability may arise due to the lack of control over the
expenses. Bankers, financial institutions and other creditors look at the profitability
ratios as an indicator of whether or not the firm earns substantially more than it
pays interest for the use of borrowed funds, and whether the ultimate repayment
of their debt appears reasonably certain. Owners are interested to know the profitability
as it indicates the return which they can get on their investments. The following
are the important profitability ratios. Check Your Progress
1. Overall Profitability Ratio. It is also called as Return on Investment 1. What does
(ROI). It indicates the percentage of return on the total capital employed in analysis and
interpretation of
the business. It is calculated on the basis of the following formula: financial
statements mean?
Operating Profit
100 2. What does the
Capital Employed term analysis
The term capital employed has been given different meanings by different mean?

accountants. Some of the popular meanings are as follows: 3. What is the basis
for traditional
(i) Sum-total of all assets, whether fixed or current classification?
(ii) Sum-total of fixed assets
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Financial Statements: (iii) Sum-total of long-term funds employed in the business, i.e.:
Analysis and Interpretation
(Accounting Ratios) Share Reserves Long-term Non-business Fictitious
+ + + +
Capital and Surplus Loans Assets Assets
In management accounting, the term capital employed is generally used in
NOTES the meanings given in the point (iii) above.
The term operating profit means profit before interest and tax. The term
interest means interest on long-term borrowings. Interest on short-term
borrowings will be deducted for computing operating profit. Non-trading incomes
such as interest on government securities or non-trading losses or expenses such
as loss on account of fire, etc., will also be excluded.
Significance of ROI. The return on capital invested is a concept that measures
the profit which a firm earns on investing a unit of capital. Yield on capital
is another term employed to express the idea. It is desirable to ascertain this
periodically. The profit being the net result of all operations, the return on capital
expresses all efficiencies or inefficiencies of a business collectively and, thus,
is a dependable measure for judging its overall efficiency or inefficiency. On
this basis, there can be comparisons of the efficiency of one department with
that of another, of one plant with that of another, one company with that of
another and one industry with that of another. For this purpose, the amount
of profits considered is that before making deductions on account of interest,
income tax and dividends and capital is the aggregate of all the capital at
the disposal of the company, viz., equity capital, preference capital, reserves,
debentures, etc.
Return on capital, as explained, may also be calculated on equity shareholders
capital. In that case, the profit after deductions for interest, income tax and
preference dividend will have to be compared with the equity shareholders funds.
It would not indicate operational efficiency or inefficiency, but merely the
maximum rate of dividend that might be declared.
A business can survive only when the return on capital employed is more
than the cost of capital employed in the business.
2. Earning Per Share (EPS). In order to avoid confusion on account of
the varied meanings of the term capital employed, the overall profitability can
also be judged by calculating earning per share with the help of the following
formula:
Net profit after tax and preference dividend1
Earning per equity share =
Number of equity shares
Illustration 10.2: Calculate the earning per share from the following data:
Net profit before tax Rs 1,00,000
Taxation at 50 per cent of net profit
10 per cent preference share capital (Rs 10 each) Rs 1,00,000
Equity Share Capital (Rs 10 shares) Rs 1,00,000
Solution:
Net profit after tax and pref. dividend
Earning per share =
Number of equity shares

1
Profit available for equity shareholders.
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 Rs 40,000 Financial Statements:
= = Rs 4 per share Analysis and Interpretation
10,000 (Accounting Ratios)
Significance. Earning per share helps in determining the market price of the
equity share of the company. A comparison of earning per share of the company
NOTES
with another will also help in deciding whether the equity share capital is being
effectively used or not. It also helps in estimating the companys capacity to
pay dividend to its equity shareholders.
Illustration 10.3: From the following details, compute the basic earnings per
share:
Net profit for the year ending 31 December 2002 after tax and
preference dividend Rs 21,000
Equity as on 1 January 2002 1,800
Issued equity shares for cash on 31 May 2002 600
Bought-back equity shares on 1 November 2002 300
Solution:
Weighted average number of
equity shares outstanding = (1,800 12/12 + 600 7/12 300 2/12)
= 2,100 shares

Net profit for the period

attributable to equity shareholders
Basic earnings per share =
Weighted average no. of equity shares
outstanding during the year

21,000
=
2,100
= Rs 10 per share
3. Price Earning Ratio (PER). This ratio indicates the number of times
the earning per share is covered by its market price. This is calculated according
to the following formula:
Market price per equity share

Earning per share
For example, the market price of a share is Rs 30 and earning per share
is Rs 5, the price earning ratio would be 6 (i.e., 30 5). It means the market
value of every one rupee of earning is six times or Rs 6. The ratio is useful
in financial forecasting. It also help in knowing whether the shares of a company
are under or overvalued. For example, if the earning per share of AB Limited
is Rs 20, its market price Rs 140 and earning ratio of similar companies is
8, it means that the market value of a share of AB Limited should be Rs 160
(i.e., 8 20). The share of AB Limited is, therefore, undervalued in the market
by Rs 20. In case the price earning ratio of similar companies is only 6, the
value of share of AB Limited should have been Rs 120 (6 20), thus the share
is overvalued by Rs 20.

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Financial Statements: Significance. Price-earning ratio helps the investor in deciding whether not
Analysis and Interpretation
(Accounting Ratios)
to buy the shares of a company at a particular market price.
4. Gross Profit Ratio. This ratio expresses the relationship between gross
profit and net-sales. Its formula is:
NOTES
Gross Profit
100
Net Sales
Illustration 10.4: Calculate the gross profit ratio from the following figures:
Sales Rs 1,00,000 Purchases Rs 60,000
Sales returns 10,000 Purchases returns 15,000
Opening stock 20,000 Closing stock 5,000
Solution:
Gross profit
Gross Profit Ratio = 100
Net sales
Net sales Cost of goods sold
= 100
Net sales
Rs 90,000 Rs 60,000
= 100
Rs 90,000
Rs 30,000
= 100
Rs 90,000
1
= 33 per cent
3
Significance. This ratio indicates the degree to which the selling price of
goods per unit may decline without resulting in losses from operations to the
firm. It also helps in ascertaining whether the average percentage of mark up
on the goods is maintained.
There is no norm for judging the gross profit ratio, therefore, the evaluation
of the business on its basis is a matter of judgment. However, the gross profits
should be adequate to cover the operating expenses and to provide for fixed
charges, dividends and building up of reserves.
5. Net Profit Ratio. This ratio indicates the net margin earned on a sale
of Rs 100. It is calculated as follows:

Net Operating Profit

100
Net Sales
Net operating profit is arrived at by deducting operating expenses from
the gross profit.
Illustration 10.5: Calculate the net profit ratio from the following data:
Sales less returns Rs 1,00,000 Selling Expenses Rs 10,000
Gross profit 40,000 Income from Investments 5,000
Administration expenses 10,000 Loss on account of fire 3,000
Solution:
Net Operating Profit
Net Profit Ratio = 100
Net Sales

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 20,000 Financial Statements:
= 100 Analysis and Interpretation
1,00,000 (Accounting Ratios)
= 20 per cent
Significance. This ratio helps in determining the efficiency with which
affairs of the business are being managed. An increase in the ratio over the
NOTES
previous period indicates improvement in the operational efficiency of the business,
provided the gross profit ratio is constant. The ratio is thus an effective measure
to check the profitability of a business.
An investor has to judge the adequacy or otherwise of this ratio by taking
into account the cost of capital, the return in the industry as a whole and market
conditions such as boom or depression period. No norms can be laid down.
However, constant increase in the above ratio year after year, is a definite indication
of improving conditions of the business.
6. Operating Ratio. This ratio is a complementary of net profit ratio. In
case the net profit ratio is 20 per cent, it means that the operating ratio is
80 per cent. It is calculated as follows:
Operating costs
100
Net sales
Operating costs include the cost of direct materials, direct labour and other
overheads, viz., factory, office or selling. Financial charges such as interest,
provision for taxation, etc., are generally excluded from operating costs.
Significance. This ratio is the test of the operational efficiency with which
the business is being carried. The operating ratio should be low enough to leave
a portion of sales to give a fair return to the investors.
A comparison of the operating ratio will indicate whether the cost component
is high or low in the figure of sales. In case the comparison shows that there
is an increase in this ratio, the reason for such increase should be found out
and the management advised to check the increase.
7. Fixed Charges Cover. This ratio is very important from the lenders
point of view. It indicates whether the business would earn sufficient profits
to pay the interest charges periodically. The higher the number, the more secure
the lender is in respect of his periodical interest income. It is calculated as
follows:
Income before interest and tax
=
Interest charges
This ratio is also known as Debt Service Ratio.
The standard for this ratio for an industrial company is that interest charges
should be covered six to seven times.
Illustration 10.6: The operating profit of A Ltd after charging interest on
debentures and tax is a sum of Rs 10,000. The amount of interest charged is
Rs 2,000 and the provision for tax has been made of Rs 4,000.
Calculate the interest charges cover ratio.
Solution:
Net profit before interest and tax
Interest Charges Cover =
Interest charges
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Material 215
Financial Statements: Rs 16,000
Analysis and Interpretation = = 8 times
(Accounting Ratios) Rs 2,000
In case it is desired to compute the fixed dividend cover, it can be computed
NOTES on the following basis:
Net profit after interest and tax
Fixed dividend cover =
Preference dividend
In the above illustration if the amount of preference dividend payable is
a sum of Rs 1,000, the fixed dividend cover will be computed as follows:
Rs 10,000
= = 10 times
Rs 1,000
8. Payout Ratio. This ratio indicates what proportion of earning per share
has been used for paying dividends. The ratio can be calculated as follows:
Dividend per equity share

Earning per equity share
A complementary of this ratio is retained earning ratio. It is calculated
as follows:
Retained earning per equity share
=
Earning per equity share
or
Retained earnings
= 100
Total earning
Illustration 10.7: Compute the Payout Ratio and the Retained Earning Ratio
from the following data:
Net Profit Rs 10,000 No. of Equity Shares 3,000
Provision for Tax 5,000 Dividend per Equity Share Re 0.40
Preference Dividend 2,000
Solution:
Dividend per equity share
Payout Ratio = 100
Earning per equity share
Re 0.40
= 100 = 40 per cent
Re 1
Retained earnings
Retained earning ratio = 100
Total earning
Rs 1,8000
= 100 = 60 per cent
Rs 3,000
Retained earning per share
= 100
Total earning per share
Re 0.60
= 100 = 60 per cent
Re 1
Significance. The payout ratio and the retained earnings ratio are indicators
of the amount of earnings that have been ploughed back into the business. The
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lower the payout ratio, the higher will be the amount of earnings ploughed back Financial Statements:
Analysis and Interpretation
into the business and vice versa. Similarly, the lower the retained earnings ratio, (Accounting Ratios)
the lower will be the amount of earnings ploughed back into the business and
vice versa. A lower payout ratio or a higher retained earnings ratio means a
stronger financial position of the company. NOTES
9. Dividend Yield Ratio. This ratio is particularly useful for those investors
who are interested only in dividend incomes. The ratio is calculated by comparing
the rate of dividend per share with the market value. Its formula can be put
as follows:
Dividend per share

Market price per share
For example, if a company declares dividend at 20 per cent on its shares,
each having a paid-up value of Rs 8 and market price of Rs 25, the dividend
yield ratio will be calculated as follows:
20
Dividend per share = 8 = Rs 1.60
100
Dividend per share 1.6
Dividend Yield Ratio = 100 = 100 = 6.4 per cent
Market price per share 25
Significance. The ratio helps an intending investor in knowing the effective
return he will get on the proposed investment. For example, in the above case
though the company is paying a dividend of 20 per cent on its shares, a person
who purchases the shares of the company from the market will get only an
effective return of 6.4 per cent. Therefore, he can decide whether or not he should
opt for this investment.

10.7 TURNOVER RATIOS

Turnover ratios or activity ratios indicate the efficiency with which the capital employed
is rotated in the business. The overall profitability of the business depends on two
factors: (i) the rate of return of capital employed; and (ii) the turnover, i.e., the
speed at which the capital employed in the business rotates. Higher the rate of
rotation, the greater will be the profitability.
Overall Turnover Ratio. This ratio is calculated as follows:
Sales
Overall Turnover Ratio =
Capital employed
Turnover ratio indicates the number of times the capital has been rotated in
the process of doing business.
In order to find out which part of capital is efficiently employed and which
part is not, different turnover ratios are calculated. These ratios are as follows:
Fixed assets turnover ratio. This ratio indicates the extent to which the
investments in fixed assets contributed towards sales. If compared with a previous
period, it indicates whether the investment in fixed assets has been judicious or
not. The ratio is calculated as follows:

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Financial Statements: Net sales
Analysis and Interpretation .
(Accounting Ratios) Fixed assets (net)
Illustration 10.8: The following details have been given to you for Messrs Reckless
NOTES Ltd for two years. You are required to find out the fixed assets turnover ratio
and comment on it.
1997 1998
Fixed assets at written down value Rs 1,50,000 Rs 3,00,000
Sales Less Returns 6,00,000 8,00,000
Solution:
Sales
Fixed assets turnover ratio =
Fixed assets
1997 1998
6,00,000 8,00,000
= = 4 times = 2.67 times
1,50,000 3,00,000
There has been a decline in the fixed assets turnover ratio though absolute
figures of sales have gone up. It means increase in the investment in fixed
assets has not brought about commensurate gain. However, the results for next
two or three years must also be seen before commenting on the judiciousness
or otherwise of increase in investment in the fixed assets.
Working capital turnover ratio. This is also known as working capital
leverage ratio. This ratio indicates whether or not the working capital has been
effectively utilized in making sales. In case a company can achieve higher
volume of sales with relatively small amount of working capital, it is an
indication of the operating efficiency of the company. This ratio is calculated
as follows:
Net Sales
Working Capital
Working capital turnover ratio may take different forms for different purposes.
Some of them are explained below:
(i) Debtors turnover ratio (debtors velocity). Debtors form an important
constituent of current assets and therefore the quality of debtors to a great extent
determines a firms liquidity. Two ratios are used by financial analysts to judge
the liquidity of a firm. They are (i) Debtors turnover ratio, and (ii) Debt collection
period ratio.
Debtors turnover ratio is calculated as under:

Credit Sales
Average Accounts Receivable
The term Accounts Receivable include trade debtors and bills
receivable.

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Illustration 10.9: Calculate the debtors turnover ratio from the following Financial Statements:
Analysis and Interpretation
figures: (Accounting Ratios)
Total Sales for the year 1998 Rs 1,00,000
Cash Sales for the year 1998 20,000
Debtors as on 1 January 1998 10,000
NOTES
Debtors as on 31 December 1998 15,000
Bills Receivable as on 1 January 1998 7,500
Bills Receivable as on 31 December 1998 12,500

Credit Sales Rs 80,000

= = = 3.56 times
Average Accounts Receivable Rs 22,500*
*
1/2 of (Rs 17,500 + Rs 27,500).
In case details regarding opening and closing receivables and credit sales
are not available the ratio may be calculated as follows:
Total Sales

Accounts Receivable
Significance. Sales to accounts receivable ratio indicates the efficiency of
the staff entrusted with the collection of book debts. The higher the ratio, the
better it is, since it would indicate that debts are being collected more promptly.
For measuring the efficiency, it is necessary to set up a standard figure; a ratio
lower than the standard will indicate inefficiency.
The ratio helps in cash budgeting since the flow of cash from customers
can be worked out on the basis of sales.
(ii) Debt collection period ratio. The ratio indicates the extent to which
the debts have been collected in time. It gives the average debt collection period.
The ratio is very helpful to the lenders because it explains to them whether
their borrowers are collecting money within a reasonable time. An increase in
the period will result in greater blockage of funds in debtors. The ratio may
be calculated by any of the following methods:

Months (or days) in a year

(a)
Creditors turnover
Average accounts receivable months (or days) in a year
(b)
credit Sales for the year
Accounts receivable
(c) .
Average monthly or daily credit sales
Illustration 10.10: The following is the trading account of Skylarks Ltd. Calculate
the stock turnover ratio:
Dr. TRADING ACCOUNT Cr.
Particulars Rs Particulars Rs
To Opening Stock 40,000 By Sales 2,00,000
To Purchases 1,00,000 By Closing Stock 20,000
To Carriage 10,000
To Gross Profit 70,000
2,20,000 2,20,000
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Material 219
Financial Statements: Solution:
Analysis and Interpretation
(Accounting Ratios) Cost of Sales Rs 1,30,000
Stock Turnover Ratio = = = 4.33 times.
Average Stock 30,000
NOTES Significance of the ratio. As already stated, the inventory turnover ratio
signifies the liquidity of the inventory. A high inventory turnover ratio indicates
brisk sales. The ratio is, therefore, a measure to discover the possible trouble
in the form of overstocking or overvaluation.
(iii) Creditors turnover ratio (creditors velocity). It is similar to debtors
turnover ratio. It indicates the speed with which the payments for credit purchases
are made to creditors. The ratio can be computed as follows:
Credit Purchases
Average Accounts Payable
The term Accounts Payable include trade creditors and bills payable.
In case the details regarding credit purchases, opening and closing accounts
payable have not been given the ratio may be calculated as follows:
Total Purchases
Accounts Payable
(iv) Debt payment period enjoyed ratio (average age of payable). The ratio
gives the average credit period enjoyed from the creditors. It can be computed
by any one of the following methods:
Months (or days) in a year
(a)
Creditors turnover

Average accounts payable Months (or days) in a year

(b)
Credit purchases in the year

Average accounts payable

(c)
Average monthly (or daily) credit purchases
Illustration 10.11: From the following figures calculate the creditors turnover ratio
and the average age of accounts payable:
Rs Rs
Credit purchases during 1998 1,00,000 Bills Payable on 1 January, 1998 4,000
Creditors on 1 January, 1998 20,000 Bills Payable on 31 December 1998 6,000
Creditors on 31, December, 1998 10,000
Solution:
Credit purchases Rs 1,00,000
Creditors turnover ratio = 5 times
Average accounts payble Rs 20,000
Average age of accounts payable (or credit period enjoyed)
Months in a year 12
= = = 2.4 months
Creditors turnover 5

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220 Material
 Financial Statements:
Analysis and Interpretation
Average accounts payable Months in a year 20,000 12 (Accounting Ratios)
= = = 2.4 months
Credit purchases in the year 1,00,000
NOTES
Average accounts payable 20,000
= = = 2.4 months
Average monthly credit purchases 8,333.33
Significance. Both the creditors turnover ratio and the debt payment period
enjoyed ratio indicate about the promptness or otherwise in making payment
of credit purchases. A higher creditors turnover ratio or a lower credit period
enjoyed ratio signifies that the creditors are being paid promptly, thus enhancing
the creditworthiness of the company. However, a very favourable ratio of this
effect also shows that the business is not taking full advantage of credit facilities
which can be allowed by the creditors.
Stock Turnover Ratio. This ratio indicates whether the investment in
inventory is efficiently used or not. It, therefore, explains whether investment
in inventories is within proper limits or not. The ratio is calculated as follows:
Cost of goods sold during the year
Average inventory
The average inventory is calculated on the basis of the average of inventory
at the beginning and at the end of the accounting period.

Inventory at the beginning of the accounting period

+ Inventory at the end of the accounting period
Average Inventory =
2
Illustration 10.12: Following is the Trading Account of Skylarks Ltd. Calculate
the stock turnover ratio:
Dr. TRADING ACCOUNT Cr.
Rs Rs
To Opening Stock 40,000 By Sales 2,00,000
To Purchase 1,00,000 By Closing Stock 20,000
To Carriage 10,000
To Gross Profit 70,000
2,20,000 2,20,000
Solution:
Cost of Sales Rs 1,30,000
Stock Turnover Ratio = 4.33 times
Average stock 30,000
Significance. As already stated, the inventory ratio signifies the liquidity Check Your Progress
of the inventory. A high inventory turnover ratio indicates brisk sales. The ratio 4. What is
is, therefore, a measure to discover the possible trouble in the form of overstocking profitability?
or overvaluation. The stock position is known as the graveyard of the balance 5. What is price
earning ratio?
sheet. If the sales are quick such a position would not arise unless the stocks
6. What is debt
consist of unsaleable items. A low inventory turnover ratio results in blocking of collection period
funds in inventory which may ultimately result in heavy losses due to inventory ratio?
becoming obsolete or deteriorate in quality.
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Material 221
Financial Statements:
Analysis and Interpretation 10.8 FINANCIAL RATIOS
(Accounting Ratios)
Financial ratios indicate the financial position of the company. A company is deemed
to be financially sound if it is in a position to carry on its business smoothly and
NOTES
meet all its obligationsboth long-term as well as short-term without strain. Thus,
its financial position has to be judged from two angleslong-term as well as short-
term. It is a sound principle of finance that long-term requirements of funds should
be met out of long-term funds and short-term requirements should be met out of
short-term funds. For example, if fixed assets are purchased out of funds provided
by bank overdraft, the company will come to grief because such assets cannot
be sold away when payment is demanded by the bank. We are giving below some
of the important ratios which are calculated in order to judge the financial position
of the company.
1. Fixed Assets Ratio. This ratio is expressed as follows:
Fixed Assets

Long-term Funds
The ratio should not be more than one. If it is less than one, it shows
that a part of the working capital has been financed through long-term funds.
This is desirable to some extent because a part of the working capital termed
as core working capital is more or less of a fixed nature. The ideal ratio
is 0.67.
Fixed assets include net fixed assets (i.e., original costdepreciation to
date) and trade investments including shares in subsidiaries. Long-term funds
included share capital, reserves and long-term loans.
Illustration 10.13: From the following compute the fixed assets ratio:
Particulars Rs Particulars Rs
Share Capital 1,00,000 Furniture 25,000
Reserves 50,000 Trade Debtors 50,000
12 per cent Debentures 1,00,000 Cash Balance 30,000
Trade Creditors 50,000 Bills Payable 10,000
Plant and Machinery 1,00,000 Stock 40,000
Land and Buildings 1,00,000

Solution:
Fixed Assets 2,25,000
Fixed Assets Ratio = = = 0.9
Long-term Funds 2,50,000
2. Current Ratio. This ratio is an indicator of the firms commitment to
meet its short-term liabilities. It is expressed as follows:
Current Assets

Current Liabilities
Current assets include cash and other assets convertible or meant to be
converted into cash during the operating cycle of the business (which is of not
more than a year). Current liabilities mean liabilities payable within a years time
either out of the existing current assets or by the creation of new current liabilities.
A list of items included in current assets and current liabilities has already been
given in the proforma analysis balance sheet in the preceding pages.
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222 Material
 Book debts outstanding for more than six months and loose tools should not Financial Statements:
Analysis and Interpretation
be included in current assets. Prepaid expenses should be taken into current assets. (Accounting Ratios)
3. Liquidity Ratio. This ratio is also termed as acid test ratio or quick
ratio. This ratio is ascertained by comparing the liquid assets (i.e., assets which
are immediately convertible into cash without much loss) to the current liabilities. NOTES
Prepaid expenses and stock are not taken as liquid assets. The ratio may be
expressed as under:
Liquid Assets

Current Liabilities
On the basis of figures given in the Illustration 1.15 the liquidity ratio
will be computed as under:
Liquid Assets Rs 90,000 Rs 40,000 Rs 50,000
= = = = 1.
Current Liabilities Rs 50,000 Rs 50,000
Some accountants prefer the term Liquid Liabilities for Current Liabilities
for the purpose of ascertaining this ratio. Liquid liabilities mean liabilities which are
payable within a short period. The bank overdraft (if it becomes a permanent mode of
financing) and cash credit facilities will be excluded from the current liabilities in such a
case:
Liquid Assets

Liquid Liabilities
The ratio is also an indicator of short-term solvency of the company.
A comparison of the current ratio to quick ratio shall indicate the inventory
hold-ups. For example, if two units have the same current ratio but different
liquidity ratios, it indicates overstocking by the concern having low liquidity
ratio as compared to the concern which has a higher liquidity ratio.
4. Debt-equity Ratio. The debt-equity ratio is determined to ascertain the
soundness of the long-term financial policies of the company. It is also known
as external-internal equity ratio. It may be calculated as follows:
External equities
Debt-equity Ratio =
Internal equities
The term external equities refers to total outside liabilities and the term
internal equities refers to shareholders funds or the tangible net worth (as used
in the proforma balance sheet given in the preceding pages). In case the ratio is
1 (i.e., outsiders funds are equal to shareholders funds), it is considered to be
quite satisfactory.
Total long-term debt
(i) Debt-equity Ratio =
Total long-term funds
Shareholders funds
(ii) Debt-equity Ratio =
Total long-term funds
Total long-term debt
(iii) Debt-equity Ratio =
Shareholders funds

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Material 223
Financial Statements: Method (iii) is the most popular.
Analysis and Interpretation
(Accounting Ratios) Ratios (i) and (ii) give the proportion of long-term debts/shareholders funds
in total long-term funds (including borrowed as well as owned funds). While
ratio (iii) indicates the proportion between shareholders funds (i.e., tangible net
NOTES worth), and the total long-term borrowed funds.
Ratios (i) and (ii) may be taken as ideal if they are 0.5 each while ratio
(iii) may be taken as ideal if it is 1. In other words, the investor may take
debt-equity ratio as quite satisfactory if the shareholders funds are equal to
the borrowed funds. However, a lower ratio, say 2/3rds, borrowed funds and
1/3rd owned funds may also be considered as satisfactory if the business needs
heavy investment in fixed assets and has an assured return on its investment,
e.g., in case of public utility concerns.
It is to be noted that preference shares redeemable within a period of twelve
years from the date of their issue should be taken as a part of debt.
5. Proprietary Ratio. It is a variant of debt-equity ratio. It establishes
the relationship between the proprietors or shareholders funds and the total
tangible assets. It may be expressed as under:
Shareholders Funds

Total Tangible Assets
Illustration 10.14: From the following calculate the proprietary ratio:
Liabilities Rs Assets Rs
Preference share capital 1,00,000 Fixed assets 2,00,000
Equity share capital 2,00,000 Current assets 1,00,000
Reserves and surplus 50,000 Goodwill 50,000
Debentures 1,00,000 Investments 1,50,000
Creditors 50,000
5,00,000 5,00,000

Solution:
Shareholders funds Rs 3,00,000
Proprietary ratio = = = 0.67 or 67 per cent
Total tangible assets Rs 4,50,000
Significance. This ratio focuses the attention on the general financial strength
of the business enterprise. The ratio is of particular importance to the creditors
who can find out the proportion of shareholders funds in the total assets employed
in the business. A high proprietary ratio will indicate a relatively little danger
to the creditors, etc., in the event of forced reorganization or winding up of
the company. A low proprietary ratio indicates greater risk to the creditors, since
in the event of losses a part of their money may be lost besides loss to the proprietors
of the business. The higher the ratio, the better it is. A ratio below 50 per cent
may be alarming for the creditors, since they may have to lose heavily in the event
of companys liquidation on account of heavy losses.

10.9 ADVANTAGES OF RATIO ANALYSIS

The following are some of the advantages of ratio analysis:
1. Simplifies Financial Statements. Ratio analysis simplifies the comprehension
of financial statements. Ratios tell the whole story of changes in the financial condition
of the business.
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224 Material
 2. Facilitates Inter-firm Comparison. Ratio analysis provides data for inter- Financial Statements:
Analysis and Interpretation
firm comparison. Ratios highlight the factors associated with successful and unsuccessful (Accounting Ratios)
firms. They also reveal strong firms and weak firms, over-valued and under-valued
firms.
3. Makes Intra-firm Comparison Possible. Ratio analysis also makes possible NOTES
comparison of the performance of the different divisions of the firm. The ratios are
helpful in deciding about their efficiency or otherwise in the past and likely
performance in the future.
4. Helps in Planning. Ratio analysis helps in planning and forecasting.
Over a period of time a firm or industry develops certain norms that may indicate
future success or failure. If the relationship changes in the firm's data over different
time periods, the ratios may provide clues on trends and future problems.
Thus, ratios can assist management in its basic functions of forecasting,
planning, coordination, control and communication.

10.10 LIMITATIONS OF ACCOUNTING RATIOS

Accounting ratios are subject to certain limitations. They are given below:
1. Comparative Study Required. Ratios are useful in judging the efficiency
of the business only when they are compared with the past results of the business
or with the results of a similar business. However, such a comparison only provides
a glimpse of the past performance and forecasts for the future may not prove
correct since several other factors like market conditions, management policies,
etc., may affect the future operations.
2. Based only on financial statements. Ratios are based only on the
information which has been recorded in the financial statements. As indicated in
the preceding pages, financial statements suffer from a number of limitations, the
ratios derived therefrom, therefore, are also subject to those limitations. For example,
non-financial charges though important for the business are not revealed by the
financial statements. If the management of the company changes, it may have ultimately
adverse effects on the future profitability of the company, but this cannot be judged
by having a glance at the financial statements of the company.
Similarly, the management has a choice about the accounting policies. Different
accounting policies may be adopted by the management of different companies
regarding valuation of inventories, depreciation, research and development expenditure
and treatment of deferred revenue expenditure, etc. The comparison of one firm
with another on the basis of ratio analysis without taking into account the fact of
companies having different accounting policies, will be misleading and meaningless.
Moreover, the management of the firm itself may change its accounting policies
from one period to another. It is, therefore, absolutely necessary that financial statements
are themselves subjected to close scrutiny before an analysis is attempted on the
basis of accounting ratios. The financial analyst must carefully examine the financial
statements and make necessary adjustments in the financial statements on the basis
of disclosure made regarding the accounting policies before undertaking financial
analysis.
The growing realization among accountants all over the world, that the accounting
policies should be standardized, has resulted in the establishment of International
Accounting Standard Committee, which has issued a number of International Accounting
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Material 225
Financial Statements: Standards. In our country, the Institute of Chartered Accountants of India has established
Analysis and Interpretation
(Accounting Ratios) Accounting Standards Board of formulation of requisite accounting standards. The
Accounting Standards Board has already issued twenty-three accounting standards
including AS 1: Disclosure of Accounting Policies. The standard has become mandatory
NOTES in respect of accounts for periods commencing on or after 1 April 1991.
3. Ratios Alone are not Adequate. Ratios are only indicators, they cannot
be taken as final regarding the good or bad financial position of the business.
Other things have also to be seen. For example, a high current ratio does not necessarily
mean that the concern has a good liquid position in case current assets mostly
comprise outdated stocks. It has been correctly observed, No ratio may be regarded
as good or bad inter se. It may be an indication that a firm is weak or strong
but it must never be taken as the proof of either one. Ratios may be linked to
rail roads. They tell the analysist, stop, look and listen.
4. Window Dressing. The term window dressing means manipulation of accounts
in a way so as to conceal vital facts and present the financial statements in a
way to show a better position than what it actually is. On account of such a situation,
the presence of a particular ratio may not be a definite indicator of good or bad
management. For example, a high stock turnover ratio is generally considered to
be an indication of operational efficiency of the business. But this might have been
achieved by unwarranted price reductions or failure to maintain proper stock of
goods.
Similarly, the current ratio may be improved just before the balance sheet date
by postponing replenishment of inventory. For example, if a company has got current
assets of Rs 4,000 while current liabilities of Rs 2,000, the current ratio is 2, which
is quite satisfactory. In case the company purchases goods of Rs 2,000 on credit,
the current assets would go up to Rs 6,000 and current liabilities to Rs 4,000, thus
reducing the current ratio to 1.5. The company may, therefore, postpone the purchases
for the early next year so that its current ratio continues to remain at 2 on the
balance sheet date. Similarly, in order to improve the current ratio, the company
may pay off certain pressing current liabilities before the balance sheet date. For
example, if in the above case, the company pays current liabilities of Rs 1,000,
the current liabilities would stand reduced to Rs 1,000, current assets would stand
reduced to Rs 3,000 but the current ratio would go up to 3.
5. Problem of Price Level Changes. Financial analysis based on accounting
ratios will give misleading results if the effects of changes in price level are
not taken into account. For example, two companies set up in different years, having
plant and machinery of different ages, cannot be compared on the basis of traditional
Check Your Progress accounting statements. This is because, the depreciation charged on plant and machinery
7. When is a
in the case of the old company would be at a much lower figure as compared
company to the company which has been set up recently. The financial statements of the
considered to be companies should, therefore, be adjusted keeping in view the price level changes
financially sound?
if a meaningful comparison is to be made through accounting ratios. The techniques
8. What are liquid
liabilities? of current purchasing power and current cost accounting are quite helpful in this
9. State one respect.
advantage of ratio 6. No Fixed Standards. No fixed standards can be laid down for ideal ratios.
analysis?
For example, current ratio is generally considered to be ideal if current assets are
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226 Material
twice the current liabilities. However, in the case of those concerns which have Financial Statements:
Analysis and Interpretation
adequate arrangements with their bankers for providing funds when they require, (Accounting Ratios)
it may be perfectly ideal if current assets are equal to or slightly more than current
liabilities.
NOTES
It may, therefore, be concluded that ratio analysis, if done mechanically, is
not only misleading but also dangerous. It is indeed a double-edged sword which
requires a great deal of understanding and sensitivity of the management process
rather than mechanical financial skill. It has rightly been observed, The ratio analysis
is an aid to management in taking correct decisions, but as a mechanical substitute
for thinking and judgment, it is worse than useless. The ratios, if discriminately
calculated and wisely interpreted, can be a useful tool of financial analysis.2

10.11 SUMMARY
z Accounting ratio is a mathematical relationship expressed between two
interconnected accounting figures. It may be expressed in times or percentage.
z Ratios are useful only when they are given in a comparative form. Moreover,
ratios are only indicators. They cannot be taken as final regarding good or bad
financial position of the business. Other things have also to be seen.
z No fixed standards can be laid down for ideal ratios. Moreover, a particular
ratio may be calculated in more than one way without violating any basic principle
of accounting. It is, therefore, advisable for a student to give the basis for
computing a particular ratio.
z While making inter-firm (comparison of one firm with another) or intra-firm
(comparison within the firm itself) comparison on the basis of accounting ratios,
it must be seen that the different firms or departments, which are being compared,
have the same accounting policies and adopt the same accounting procedures.

10.12 KEY TERMS

z Accounting Ratio: It is the relationship expressed in mathematical terms between
two accounting figures related to each other.
z Balance Sheet: It is a statement of financial position of business at a specified
moment of time.
z Balance Sheet Ratios: These are ratios calculated on the basis of the figures
of balance sheet only.
z Composite Ratios: These are ratios based on figures of profit and loss account
as well as the balance sheet. They are also known as Inter-statement Ratios.
z Financial Analysis: These are critical evaluation of data given in the financial
statements.
z Financial Ratios: These are ratios disclosing the financial position or solvency
of the firm. (They are also known as solvency ratios.)

2
Batty J. Management Accounting (1978), p. 413.
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Material 227
Financial Statements: z Financial Statement: This is an organized collection of data according to logical
Analysis and Interpretation
(Accounting Ratios) and consistent accounting procedures conveying an understanding of some financial
aspects of a business firm.
z Interpretation: This is the act of explaining the meaning and significance of
NOTES the financial data.
z Profitability Ratios. These are ratios which reflect the final results of business
operations.
z Turnover Ratios. These are ratios measuring the efficiency with which the
assets are employed by a firm. They are also known as activity or efficiency
ratios.

10.13 ANSWERS TO CHECK YOUR PROGRESS

1. Analysis and interpretation of financial statements, therefore, refers to the
treatment of the information contained in the income statement and the balance
sheet so as to afford full diagnosis of the profitability and the financial soundness
of the business.
2. The term analysis means the methodical classification of the data given in the
financial statements.
3. This classification has been on the basis of the financial statements to which the
determinants of a ratio belong.
4. Profitability is an indication of the efficiency with which the operations of the
business are carried on.
5. The price earning ratio indicates the number of times the earning per share is
covered by its market price.
6. The debt collection period ratio indicates the extent to which the debts have
been collected in time. It gives the average debt collection period.
7. A company is deemed to be financially sound if it is in a position to carry on its
business smoothly and meet all its obligationsboth long-term as well as short-
termwithout strain.
8. Liquid liabilities are liabilities which are payable within a short period.
9. Ratio analysis simplifies the comprehension of financial statements. Ratios tell
the whole story of changes in the financial condition of the business.

10.14 QUESTIONS AND EXERCISES

Short-Answer Questions
1. Discuss the concepts regarding financial statements and limitations of financial
statements.
2. Explain the role of ratio analysis in the interpretation of financial statements.
Examine the limitations of ratio analysis.
Long-Answer Questions
1. How do you analyse and interpret financial statements of a company for reporting
on the soundness of its capital structure and solvency?
2. Ratios like statistics have a set of principles and finality about them which at
Self-Instructional times may be misleading. Discuss with illustrations.
228 Material
 3. Accounting ratios are mere guides and complete reliance on them in decision- Financial Statements:
Analysis and Interpretation
making is suicidal. Elucidate. (Accounting Ratios)

10.15 PRACTICAL PROBLEMS NOTES

Computation of Ratios
1. From the following statements of X Ltd. for the year ending 31 March 1997, you are
required to rearrange the items for purposes of financial analysis and calculate the following
ratios:
(i) Current Ratio, (ii) Quick Ratio, (iii) Operating Ratio, (iv) Stock Turnover Ratio, (v) Fixed
Assets Turnover Ratio, (vi) Debtors Turnover Ratio, and (vii) Net Profit to Capital
employed.
BALANCE SHEET
Liabilities Rs Assets Rs
Share Capital: Land and Buildings 5,00,000
Issued and fully paid up 50,000 Plant and Machinery 2,00,000
Equity shares of Rs 10 each 5,00,000 Stock 1,50,000
General Reserve 4,00,000 Sundry Debtors 2,50,000
Profit and Loss A/c 1,50,000 Cash and Bank balances 1,50,000
Sundry Creditors 2,00,000
12,50,000 12,50,000

PROFIT AND LOSS ACCOUNT

for the year ending 31 March 1997
Particulars Rs Particulars Rs
To opening stock 2,50,000 By Sales 18,00,000
To purchases 10,50,000 By Closing Stock 1,50,000
To gross profit 6,50,000
19,50,000 19,50,000
To selling and distribution By Gross Profit 6,50,000
expenses 1,00,000 By Profit on sale of fixed
To administration expenses 2,30,000 assets 50,000
To finance expenses 20,000
To net profit 3,50,000
7,00,000 7,00,000

[Ans. (i) 2.75, (ii) 2, (iii) 0.82, (iv) 5.75, (v) 18/7 = 2.6 or 11.5/7,
(vi) 7.2, i.e., 51 days, (vii) 30 per cent]
2. The following data has been abstracted from the annual accounts of a company:
Share Capital Rs in lakhs
20,000 Equity Shares of Rs 10 each 200.00
General Reserve 156.00
Investment Allowance Reserve 50.00
Share Capital Rs in lakhs
15% Long-term Loan 300.00
Profit before Tax 140.00
Provision for Tax 84.00
Proposed Dividends 10.00
Calculate from the above the following details:
(i) Return on Capital Employed, and
(ii) Return on Net Worth. [Ans. (i) 26.4 per cent, (ii) 14 per cent]

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Material 229
Financial Statements:
Analysis and Interpretation 10.16 FURTHER READING
(Accounting Ratios)

Maheshwari, S.N., S.K. Maheshwari. An Introduction to Accountancy. New Delhi:

NOTES Vikas Publishing House, 2003.
Maheshwari, S.N., S.K. Maheshwari, Sharad K., A Textbook of Accounting for
Management. New Delhi: Vikas Publishing House, 2010.

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230 Material
Authors: S N Maheshwari, Sharad K Maheswari & Suneel K Maheshwari
Copyright Authors, 2011

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