Ratio analysis fund flow and cash flow
Ratio Analysis: Nature, Uses and Limitations
Nature of Ratio Analysis:
Ratio analysis is a technique of analysis and interpretation of
financial statements. It is the process of establishing and interpreting
various ratios for helping in making certain decisions. However, ratio analysis
is not an end in itself. It is only a means of better understanding of
financial strengths and weaknesses of a firm.
Calculation of mere ratios does not serve any purpose, unless several
appropriate ratios are analyzed and interpreted. There are a number of ratios
which can be calculated from the information given in the financial statements,
but the analyst has to select the appropriate data and calculate only a few
appropriate ratios from the same keeping in mind the objective of analysis. The
ratios may be used as a symptom like blood pressure, the pulse rate or the body
temperature and their interpretation depends upon the calibre and competence of
the analyst.
The following are the four
steps involved in the ratio analysis:
(i) Selection of relevant data from the financial statements depending
upon the objective of the analysis.
(ii) Calculation of appropriate ratios from the above data.
(iii) Comparison of the calculated ratios with the ratios of the same
firm in the past, or the ratios developed from projected financial statements
or the ratios of some other firms or the comparison with ratios of the industry
to which the firm belongs.
(iv) Interpretation of the ratios.
Uses of
Ratio Analysis:
The ratio analysis is one of the most powerful tools of financial
analysis. It is used as a device to analyze and interpret the financial health
of enterprise. Just like a doctor examines his patient by recording his body
temperature, blood pressure, etc. before making his conclusion regarding the
illness and before giving his treatment, a financial analyst analyses the
financial statements with various tools of analysis before commenting upon the
financial health or weaknesses of an enterprise.
‘A ratio is known as a symptom like blood pressure, the pulse rate or
the temperature of an individual.’ It is with help of ratios that the financial
statements can be analyzed more clearly and decisions made from such analysis.
The use of ratios is not confined to financial managers only. There are
different parties interested in the ratio analysis for knowing the financial
position of a firm for different purposes.
The supplier of goods on credit, banks, financial institutions,
investors, shareholders and management all make use of ratio analysis as a tool
in evaluating the financial position and performance of a firm for granting
credit, providing loans or making investments in the firm. With the use of
ratio analysis one can measure the financial condition of a firm and can point
out whether the condition is strong, good, questionable or poor. The
conclusions can also be drawn as to whether the performance of the firm is
improving or deteriorating.
Thus, ratios have wide
applications and are of immense use today:
(a) Managerial Uses of Ratio
Analysis:
1. Helps in decision-making:
Financial statements are prepared primarily for decision-making. But the
information provided in financial statements is not an end in itself and no
meaningful conclusion can be drawn from these statements alone. Ratio analysis
helps in making decisions from the information provided in these financial
statements.
2. Helps in financial
forecasting and planning:
Ratio Analysis is of much help in financial forecasting and planning.
Planning is looking ahead and the ratios calculated for a number of years work
as a guide for the future. Meaningful conclusions can be drawn for future from
these ratios. Thus, ratio analysis helps in forecasting and planning.
3. Helps in communicating:
The financial strength and weakness of a firm are communicated in a more
easy and understandable manner by the use of ratios. The information contained
in the financial statements is conveyed in a meaningful manner to the one for
whom it is meant. Thus, ratios help in communication and enhance the value of
the financial statements.
4. Helps in co-ordination:
Ratios even help in co-ordination which is of utmost importance in
effective business management. Better communication of efficiency and weakness
of an enterprise results in better coordination in the enterprise.
5. Helps in Control:
Ratio analysis even helps in making effective control of the business.
Standard ratios can be based upon proforma financial statements and variances
or deviations, if any, can be found by comparing the actual with the standards
so as to take a corrective action at the right time. The weaknesses or
otherwise, if any, come to the knowledge of the management which helps in
effective control of the business.
6. Other Uses:
These are so many other uses of the ratio analysis. It is an essential
part of the budgetary control and standard costing. Ratios are of immense
importance in the analysis and interpretation of financial statements as they
bring the strength or weakness of a firm.
(b) Utility to
Shareholders/Investors:
An investor in the company will like to assess the financial position of
the concern where he is going to invest. His first interest will be the
security of his investment and then a return in the form of dividend or
interest. For the first purpose he will try to asses the value of fixed assets
and the loans raised against them. The investor will feel satisfied only if the
concern has sufficient amount of assets.
Long-term solvency ratios will help him in assessing financial position
of the concern. Profitability ratios, on the other hand, will be useful to
determine profitability position. Ratio analysis will be useful to the investor
in making up his mind whether present financial position of the concern
warrants further investment or not.
(c) Utility to Creditors:
The creditors or suppliers extend short-term credit to the concern. They
are interested to know whether financial position of the concern warrants their
payments at a specified time or not. The concern pays short- term creditor, out
of its current assets. If the current assets are quite sufficient to meet
current liabilities then the creditor will not hesitate in extending credit
facilities. Current and acid-test ratios will give an idea about the current
financial position of the concern.
(d) Utility to Employees:
The employees are also interested in the financial position of the
concern especially profitability. Their wage increases and amount of fringe
benefits are related to the volume of profits earned by the concern. The
employees make use of information available in financial statements. Various
profitability ratios relating to gross profit, operating profit, net profit,
etc. enable employees to put forward their viewpoint for the increase of wages
and other benefits.
(e) Utility to Government:
Government is interested to know the overall strength of the industry.
Various financial statements published by industrial units are used to
calculate ratios for determining short-term, long-term and overall financial position
of the concerns. Profitability indexes can also be prepared with the help of
ratios. Government may base its future policies on the basis of industrial
information available from various units. The ratios may be used as indicators
of overall financial strength of public as well as private sector, in the
absence of the reliable economic information, governmental plans and policies
may not prove successful.
(f) Tax Audit Requirements:
Section 44 AB was inserted in the Income Tax Act by the Finance Act,
1984. Under this section every assesse engaged in any business and having
turnover or gross receipts exceeding Rs. 40 lakh is required to get the
accounts audited by a chartered accountant and submit the tax audit report
before the due date for filing the return of income under Section 139 (1). In
case of a professional, a similar report is required if the gross receipts
exceed Rs 10 lakh.
Clause 32 of the Income Tax Act
requires that the following accounting ratios should be given:
(i) Gross Profit/Turnover
(ii) Net Profit/Turnover
(iii) Stock-in-trade/Turnover
(iv) Material Consumed/Finished Goods Produced.
Further, it is advisable to compare the accounting ratios for the year
under consideration with the accounting ratios for the earlier two years so that
the auditor can make necessary enquiries, if there is any major variation in
the accounting ratios.
Limitations of Ratio Analysis:
The ratio analysis is one of the most powerful tools of financial
management.
Though ratios are simple to
calculate and easy to understand, they suffer from some serious limitations:
1. Limited Use of a Single
Ratio:
A single ratio, usually, does not convey much of a sense. To make a
better interpretation a number of ratios have to be calculated which is likely
to confuse the analyst than help him in making any meaningful conclusion.
2. Lack of Adequate Standards:
There are no well accepted standards or rules of thumb for all ratios
which can be accepted as norms. It renders interpretation of the ratios
difficult.
3. Inherent Limitations of
Accounting:
Like financial statements, ratios also suffer from the inherent weakness
of accounting records such as their historical nature. Ratios of the past are
not necessarily true indicators of the future.
4. Change of Accounting Procedure:
Change in accounting procedure by a firm often makes ratio analysis
misleading, e.g., a change in the valuation of methods of inventories, from
FIFO to LIFO increases the cost of sales and reduces considerably the value of
closing stocks which makes stock turnover ratio to be lucrative and an
unfavorable gross profit ratio.
5. Window Dressing:
Financial statements can easily be window dressed to present a better
picture of its financial and profitability position to outsiders. Hence, one
has to be very careful in making a decision from ratios calculated from such
financial statements. But it may be very difficult for an outsider to know
about the window dressing made by a firm.
6. Personal Bias:
Ratios are only means of financial analysis and not an end in itself.
Ratios have to be interpreted and different people may interpret the same ratio
in different ways.
7. Un-comparable:
Not only industries differ in their nature but also the firms of the
similar business widely differ in their size and accounting procedures, etc. It
makes comparison of ratios difficult and misleading. Moreover, comparisons are
made difficult due to differences in definitions of various financial terms
used in the ratio analysis.
8. Absolute Figures Distortive:
Ratios devoid of absolute figures may prove distortive as ratio analysis
is primarily a quantitative analysis and not a qualitative analysis.
9. Price Level Changes:
While making ratio analysis, no consideration is made to the changes in
price levels and this makes the interpretation of ratios invalid.
10. Ratios no Substitutes:
Ratio analysis is merely a tool of financial statements. Hence, ratios
become useless if separated from the statements from which they are computed.
11. Clues not Conclusions:
Ratios provide only clues to analysts and not final conclusions. These
ratios have to be interpreted by these experts and there are no standard rules
for interpretation.
Ratio
Analysis: Classification
A ratio is a simple arithmetical expression of the relationship of one
number to another. It may be defined as the indicated quotient of two
mathematical expressions. According to Accountant’s Handbook by Wixon, Kell and
Bedford, a ratio “is an expression of the quantitative relationship between two
numbers'” According to Kohler, a ratio is the relation, of the amount, a, to
another, b, expressed as the ratio of a to b; a: b (a is to b) ; or as a simple
fraction, integer, decimal, fraction or percentage.”
In simple language ratio is one number expressed in terms of another and
can be worked out by dividing one number into the other.
Ratio analysis is the process of determining and interpreting numerical
relationships based on financial statements. A ratio is a statistical yardstick
that provides a measure of the relationship between two variables or figures.
Ratio analysis is the
process of determining and interpreting numerical relationships based on
financial statements. A ratio is a statistical yardstick that provides a
measure of the relationship between two variables or figures.
This relationship can be expressed as a percent or as a quotient. Ratios
are simple to calculate and easy to understand. The persons interested in the
analysis of financial statements can be grouped under three heads,
i) owners or investors
ii) creditors and
iii) financial executives.
Although all these three groups are interested in the financial
conditions and operating results, of an enterprise, the primary information
that each seeks to obtain from these statements differs materially, reflecting
the purpose that the statement is to serve.
Investors desire primarily a basis for estimating earning capacity.
Creditors are concerned primarily with liquidity and ability to pay interest
and redeem loan within a specified period. Management is interested in evolving
analytical tools that will measure costs, efficiency, liquidity and
profitability with a view to make intelligent decisions.
Classification of Ratios:
Significance of Profitability Ratios:
Profitability is a measure of efficiency and control. It indicates the
efficiency or effectiveness with which the operations of the business are
carried on. Poor operational performance may result in poor sales and,
therefore, low profits.
Low profitability may be due to lack of control over expenses resulting
in low profits. Profitability Ratios are employed by management in order to
assess how efficiently they carry on business operations. Profitability is the
main base for liquidity as well as solvency.
Creditors, banks, and financial institutions are interested in
profitability ratios since they indicate liquidity or capacity of the business
to meet interest obligations, and regular and improved profits to enhance the
long-term solvency position of the business.
Owners are interested in profitability for they indicate the growth of
and also the rate of return on their investments. The amount and rate of
profits earned depend on the quantum of investment committed.
Hence, the profitability ratios are calculated relating the profits
either to sales or to investments.
Principal Profitability Ratios:
The profitability ratios are calculated by relating profits either to
sales or investments.
Profitability ratios based on
sales are as follows:
Gross Profit Ratio (G.P.Ratio) :
Meaning:
G P Ratio is the ratio of gross profit to net sales expressed as a
percentage. It expresses the relationship between gross profit margin and
sales. The basic components are gross profit and sales. Net Sales means total
sales minus sales returns.
Gross profit would be the difference between net sales and cost of goods
sold. Cost of goods sold in the case of a trading concern would be equal to
opening stock plus purchases and all direct expenses relating to purchases
(i.e., all expenses charged to trading a/c) minus closing stock.
In the case of manufacturing concerns, it would be equal to opening
stock plus cost of production minus closing stock.
Formula:
Significance:
G P Ratio may indicate as to what extent the selling prices of goods per
unit may be reduced without incurring losses on operations. It is useful to
ascertain whether the average of the mark up on the goods sold is maintained.
There is no standard G P Ratio for evaluation.
Trend observed may be used for the analysis. However, the gross profit
earned should be sufficient to recover all operating expenses and to build up
reserves after paying all fixed interest charges and dividends.
Factors Influencing the Gross
Profit Ratio:
It should be observed that an
increase in G P ratio might be due to the following factors:
(a) Increase in the selling price of goods sold without any
corresponding increase in the cost of goods sold.
(b) Decrease in cost of goods sold without corresponding decrease in
selling price.
(c) Omission of purchase invoices from accounts.
(d) Under-valuation of opening stock or over-valuation of closing stock.
On the other hand, the decrease
in the G P Ratio may be due to the following factors:
(a) Decrease in the selling price of goods sold without corresponding
decrease in cost of goods sold.
(b) Increase in cost of goods sold without any increase in selling
price.
(c) Unfavorable purchasing or mark-up policies
(d) Inability of management to improve sales volume, or omission of
sales
(e) Over-valuation of opening stock or under-valuation of closing stock
Hence, an analysis of GP margin should be carried out in the light
information relating to purchasing, mark-ups and markdowns, credit and
collections as well as merchandising policies. However, these items of
information may not be easily available to the external analyst.
Net Profit Ratio (N P Ratio):
This is the ratio of net income or profit after taxes to net sales. Net
Profit as used here, is the balance of Profit and Loss Account, which is
arrived at after considering all non-operating income such as interest on
investments, dividends received, etc., and all non-operating expenses like loss
on sale of investments, provision for contingent liabilities, etc.
Formula:
This is used as a measure of overall profitability and is useful to the
owners. It is both an index of efficiency as well as profitability when used
along with GP Ratio and Operating Ratio.
Operating Ratio (O R Ratio):
This is the ratio of operating cost to net sales. The term ‘operating
cost’ refers to cost of goods sold plus operating expenses. This is closely
related to the ratio of operating profit to net sales. For example, if the
operating ratio is 80%, then the operating profit ratio would be 20% (i.e., 1 –
operating cost ratio).
Components:
The main items are operating
cost and net sales. Operating expenses normally include the following items:
(a) Office and administrative expenses;
(b) Selling and distribution expenses.
Financial charges such as interest, provision for taxation, etc., are
generally excluded from operating expenses.
Formula:
An alternative form of this
ratio may be expressed as follows:
Computation of any one of these two would be adequate, since the other
one can be found out by deducting the first one from 100.
Significance:
This ratio indicates the operational efficiency with which the business
is being carried on. It shows the percentage of net sales that is absorbed by
the cost of goods sold and operating expenses.
Hence, the lower the operating ratio, the higher will be the operating
profit. While the ratio serves as an index of overall efficiency, its
usefulness is limited by a number of financial and extraordinary factors.
While interpreting the ratio, it is important to note that changing
management decisions may create possible variations in expenses from year to
year, or company to company.
An operating ratio ranging between 75% and 85% is generally considered
as standard for manufacturing concerns.
It is not necessary that the management should be concerned only when
the operating ratio rises. If the operating ratio falls, while the selling
price per unit remains the same, it may be the sum total of efficiency in some
departments, and inefficiency in others.
A dynamic management should be interested in making a full analysis. It
is therefore necessary to examine each of the individual components of the
operating ratio into various expenses ratios.
Expenses Ratios:
These ratios supplement the
information given by the operating ratio.
Some of the important expense
ratios are as follows:
Turnover Ratio
These ratios indicate the speed at which,
activities of the business are being performed. The activity ratios express the
number of times assets employed, or,for that matter, any constituent of assets,
is turned into sales during an accountingperiod. Higher turnover ratio means
better utilisation of assets and signifiesimproved efficiency and
profitability, and as such are known as efficiency ratios.
The important activity ratios calculated
under this category are
1. Inventory Turnover;
2. Trade receivable Turnover;
3. Trade payable Turnover;
4. Investment (Net assets) Turnover
5. Fixed assets Turnover; and
6. Working capital Turnover.
Inventory Turnover Ratio
It determines the number of times inventory
is converted into revenue from operations during the accounting period under
consideration. It expresses the relationship between the cost of revenue from
operations and average inventory.
The formula for its calculation is as
follows:
Inventory Turnover Ratio = Cost of Revenue
from Operations / Average Inventory
Where average inventory refers to arithmetic
average of opening and closing inventory, and the cost of revenue from
operations means revenue from operations less gross profit.
Significance : It studies the frequency of
conversion of inventory of finished goods into revenue from operations. It is
also a measure of liquidity. It determines how many times inventory is
purchased or replaced during a year. Low turnover of inventory may be due to
bad buying, obsolete inventory, etc., and is a danger signal. High turnover is
good but it must be carefully interpreted as it may be due to buying in small
lots or selling quickly at low margin to realise cash. Thus, it throws light on utilisation of
inventory of goods.
Trade Receivables
Turnover Ratio
It expresses the relationship between credit
revenue from operations and trade receivable. It is calculated as follows :
Trade Receivable Turnover ratio = Net Credit
Revenue from Operations/Average
Trade Receivable
Where Average Trade Receivable = (Opening
Debtors and Bills Receivable + Closing
Debtors and Bills Receivable)/2
It needs to be noted that debtors should be
taken before making any provision for doubtful debts.
Significance: The liquidity position of the
firm depends upon the speed with which trade receivables are realised. This
ratio indicates the number of times the receivables are turned over and
converted into cash in an accounting period. Higher turnover means speedy
collection from trade receivable. This ratio also helps in working out the
average collection period. The ratio is calculated by dividing the days or
months in a year by trade receivables turnover ratio.i.e.,
Number of days or Months/Trade receivables
turnover ratio
Trade Payable Turnover
Ratio
Trade payables turnover ratio indicates the
pattern of payment of trade payable. As trade payable arise on account of
credit purchases, it expresses relationship between credit purchases and trade
payable. It is calculated as follows:
Trade Payables Turnover ratio = Net Credit
purchases/
Average trade payable
Where Average Trade Payable = (Opening
Creditors and Bills Payable +
Closing Creditors and Bills Payable)/2
Average Payment Period =
No. of days/month in a year/Trade Payables
Turnover Ratio
Significance : It reveals average payment
period. Lower ratio means credit allowed by the supplier is for a long period
or it may reflect delayed payment to suppliers which is not a very good policy
as it may affect the reputation of the business. The average period of payment
can be worked out by days/months in a year by the Trade Payable Turnover Ratio
Net Assets or Capital
Employed Turnover Ratio
It reflects relationship between revenue from
operations and net assets (capital employed) in the business. Higher turnover
means better activity and profitability.It is calculated as follows :
Net Assets or Capital Employed Turnover ratio
= Revenue from Operation/Capital Employed
Capital employed turnover ratio which studies
turnover of capital employed (or Net Assets) is analysed further by following
two turnover ratios :
(a)
Fixed Assets Turnover Ratio : It is computed as follows: Fixed asset turnover Ratio =
Net Revenue from Operation/Net Fixed Assets
(b) Working Capital Turnover Ratio : It is
calculated as follows :
Working Capital Turnover Ratio = Net Revenue from
Operation/Working Capital
Significance : High turnover of capital
employed, working capital and fixed assets is a good sign and implies efficient
utilisation of resources. Utilisation of capital employed or, for that matter,
any of its components is revealed by the turnover ratios. Higher turnover
reflects efficient utilisation resulting in higher liquidity and profitability in the business.
Financial
Ratios
Liquidity Ratios
Liquidity ratios are calculated to measure
the short-term solvency of the business,i.e. the firm’s ability to meet its
current obligations. These are analysed by looking at the amounts of current
assets and current liabilities in the balance sheet. The two ratios included in
this category are current ratio and liquidity ratio.
Current Ratio
Current ratio is the proportion of current
assets to current liabilities. It is expressed as follows:
Current Ratio = Current Assets : Current
Liabilities or Current Assets/Current Liabilities
Current assets include current investments,
inventories, trade receivables (debtors and bills receivables), cash and cash
equivalents, short-term loans and advances and other current assets such as
prepaid expenses, advance tax and accrued income, etc.
Current liabilities include short-term
borrowings, trade payables (creditors and bills payables), other current
liabilities and short-term provisions.
Significance: It provides a measure of degree
to which current assets cover current liabilities. The excess of current assets
over current liabilities provides a measure of safety margin available against
uncertainty in realisation of current assets and flow of funds. The ratio
should be reasonable. It should neither be very high or very low. Both the
situations have their inherent disadvantages. A very high current ratio implies
heavy investment in current assets which is not a good sign as it reflects
under utilisation or improper utilisation of resources. A low ratio endangers
the business and puts it at risk of facing a situation where it will not be
able to pay its short-term debt on time. If this problem persists, it may
affect firms credit worthiness adversely. Normally, it is safe to have this ratio
within the range of 2:1.
Quick Ratio
It is the ratio of quick (or liquid) asset to
current liabilities. It is expressed as Quick ratio = Quick Assets : Current
Liabilities or Quick Assets/Current Liabilities The quick assets are defined as
those assets which are quickly convertible into cash. While calculating quick
assets we exclude the inventories at the end and other current assets such as
prepaid expenses, advance tax, etc., from the current assets. Because of
exclusion of non-liquid current assets it is considered better than current
ratio as a measure of liquidity position of the business. It is calculated to
serve as a supplementary check on liquidity position of the business and is
therefore, also known as ‘Acid-Test Ratio’.
Significance: The ratio provides a measure of
the capacity of the business to meet its short-term obligations without any
flaw. Normally, it is advocated to be safe to have a ratio of 1:1 as
unnecessarily low ratio will be very risky and a high ratio suggests
unnecessarily deployment of resources in otherwise less profitable short-term
investments.
Financial Ratios related to sovency
The persons who have advanced money to the
business on long-term basis are interested in safety of their periodic payment
of interest as well as the repayment of principal amount at the end of the loan
period. Solvency ratios are calculated to determine the ability of the business
to service its debt in the long run. The following ratios are normally computed
for evaluating solvency of the business.
1. Debt-Equity Ratio;
2. Debt to Capital Employed Ratio;
3. Proprietary Ratio;
4. Total Assets to Debt Ratio;
5. Interest Coverage Ratio.
Debt-Equity Ratio
Debt-Equity Ratio measures the relationship
between long-term debt and equity. If debt component of the total long-term
funds employed is small, outsiders feel more secure. From security point of view,
capital structure with less debt and more equity is considered favourable as it
reduces the chances of bankruptcy.
Normally, it is considered to be safe if debt
equity ratio is 2 : 1. However, it may vary from industry to industry. It is
computed as follows:
Debt-Equity Ratio = Long term
Debts/Shareholders' Funds
where:
Shareholders’ Funds (Equity) = Share capital
+ Reserves and Surplus + Money received against share warrants
Share Capital = Equity share capital +
Preference share capital
or
Shareholders’ Funds (Equity) = Non-current
sssets + Working capital – Non-current liabilities
Working Capital = Current Assets – Current
Liabilities
Significance: This ratio measures the degree
of indebtedness of an enterprise and gives an idea to the long-term lender
regarding extent of security of the debt. As indicated earlier, a low debt
equity ratio reflects more security. A high ratio, on the other hand, is
considered risky as it may put the firm into difficulty in meeting its
obligations to outsiders. However, from the perspective of the owners, greater
use of debt (trading on equity) may help in ensuring higher returns for them if
the rate of earnings on capital employed is higher than the rate of interest
payable.
2 Debt to Capital Employed Ratio
The Debt to capital employed ratio refers to
the ratio of long-term debt to the total of external and internal funds
(capital employed or net assets). It is computed as follows:
Debt to Capital Employed Ratio = Long-term
Debt/Capital Employed (or Net Assets)
Capital employed is equal to the long-term
debt + shareholders’ funds.
Alternatively, it may be taken as net assets
which are equal to the total assets –current liabilities taking the data of
Illustration 7, capital employed shall work out to Rs. 5,00,000 + Rs. 15,00,000
= Rs. 20,00,000. Similarly, Net Assets as Rs. 25,00,000 – Rs. 5,00,000 = Rs.
20,00,000 and the Debt to capital employed ratio as Rs. 5,00,000/Rs. 20,00,000
= 0.25:1.
Significance: Like debt-equity ratio, it
shows proportion of long-term debts in capital employed. Low ratio provides
security to lenders and high ratio helps management in trading on equity. In
the above case, the debt to Capital Employed ratio is less than half which
indicates reasonable funding by debt and adequate security of debt.
It may be noted that Debt to Capital Employed
Ratio can also be computed in relation to total assets. In that case, it
usually refers to the ratio of total debts (long-term debts + current
liabilities) to total assets, i.e., total of non-current and current assets (or
shareholders, funds + long-term debts + current liabilities), and is expressed
as
Debt to Capital Employed Ratio =Total
Debts/Total Assets
Proprietary Ratio
Proprietary ratio expresses relationship of
proprietor’s (shareholders) funds to net assets and is calculated as follows :
Proprietary Ratio = Shareholders,
Funds/Capital employed (or net assets)
Based on data of Illustration 7, it shall be
worked out as follows:
Rs. 15,00,000/Rs. 20,00,000 = 0.75 : 1
Significance: Higher proportion of
shareholders funds in financing the assets is a positive feature as it provides
security to creditors. This ratio can also be computed in relation to total
assets instead of net assets (capital employed). It may be noted that the total
of debt to capital employed ratio and proprietary ratio is equal to 1.
Total Assets to Debt Ratio
This ratio measures the extent of the
coverage of long-term debts by assets. It is calculated as
Total assets to Debt Ratio = Total
assets/Long-term debts
The higher ratio indicates that assets have
been mainly financed by owners funds and the long-term loans is adequately
covered by assets. It is better to take the net assets (capital employed)
instead of total assets for computing this ratio also. It is observed that in
that case, the ratio is the reciprocal of the debt to capital employed ratio.
Significance: This ratio primarily indicates
the rate of external funds in financing the assets and the extent of coverage
of their debts are covered by assets.
Interest Coverage Ratio
It is a ratio which deals with the servicing
of interest on loan. It is a measure of security of interest payable on
long-term debts. It expresses the relationship between profits available for
payment of interest and the amount of interest payable. It is calculated as
follows:
Interest Coverage Ratio = Net Profit before
Interest and Tax/ Interest on long-term debts
Significance: It reveals the number of times
interest on long-term debts is covered by the profits available for interest. A
higher ratio ensures safety of interest on debts.
What is Du Pont Control Chart ?
The Du Pont Control Chart is called as such because Du Pont Company of
the USA first used it. The various factors affecting the Return on Investment
(ROI) are illustrated through this chart. ROI represents the earning power of
the business.
It depends on two ratios:
(a) Net Profit ratio and
(b) Capital Turnover Ratio.
A change in any one of the two ratios will change the business earning
power (i.e., ROI), and they are affected by many factors. The chart shown below
exhibits that ROI is affected by a number of factors.
Any change in these factors will affect the return on capital employed.
For example, if the cost of goods sold decreases without any corresponding
decrease in selling price, the net profit will increase and therefore, ROI will
also increase.
Similarly if there is decrease in working capital, the total capital
employed will decrease and therefore, in the absence of any decrease in the net
profit, ROI will decrease.
The Du Pont Chart helps management to identify the areas of problems,
which affect profit, In other words, management can easily visualize the
different forces affecting profits, and profits could be improved either by
putting capital into effective use, which will result in higher turnover ratio,
or by better sales efforts, which will result in higher profit ratio.
The same rate of return could be obtained either by a higher net profit
ratio but low turnover ratio, or by a higher turnover ratio but a low net profit
ratio.
Funds
Flow Statement
Meaning of Funds Flow
Statement:
Funds flow statement is
a statement which discloses the analytical information about the different
sources of a fund and the application of the same in an accounting cycle. It
deals with the transactions which change either the amount of current assets
and current liabilities (in the form of decrease or increase in working
capital) or fixed assets, long-term loans including ownership fund.
It gives a clear picture
about the movement of funds between the opening and closing dates of the
Balance Sheet. It is also called the Statement of Sources and Applications of
Funds, Movement of Funds Statement; Where Got—Where Gone Statement: Inflow and
Outflow of Fund Statement, etc. No doubt, Funds Flow Statement is an important
indicator of financial analysis and control. It is valuable and also helps to
determine how the funds are financed. The financial analyst can evaluate the
future flows of a firm on the basis of past data.
This statement supplies an
efficient method for the financial manager in order to assess the:
(a) Growth of the firm,
(b) Its resulting
financial needs, and
(c) To determine the
best way to finance those needs.
In particular, funds
flow statements are very useful in planning intermediate and long-term
financing.
Objective of Preparing a Fund
Flow Statement:
The main purpose of
preparing a Funds Flow Statement is that it reveals clearly the important items
relating to sources and applications of funds of fixed assets, long-term loans
including capital. It also informs how far the assets derived from normal
activities of business are being utilized properly with adequate consideration.
Secondly, it also
reveals how much out of the total funds is being collected by disposing of fixed
assets, how much from issuing shares or debentures, how much from long-term or
short-term loans, and how much from normal operational activities of the
business.
Thirdly, it also
provides the information about the specific utilization of such funds, i.e. how
much has been applied for acquiring fixed assets, how much for repayment of
long-term or short-term loans as well as for payment of tax and dividend etc.
Lastly, it helps the
management to prepare budgets and formulate the policies that will be adopted
for future operational activities.
Significance and Importance of
Funds Flow Statement:
Since traditional
reports (i.e. Income Statement/Profit and Loss Account, and Balance Sheet) are
not very informative, a financial analyst has to depend on some other
report—Funds Flow Statement. In other words, along with the traditional sources
of information, some other sources of information are absolutely required in
order to take the challenge offered by modern business.
Funds Flow Statement, no
doubt, caters to the needs of management. This is because a Funds Flow
Statement not only presents the Balance Sheet values for consecutive two years,
it also ascertains the changes of working capital—which is a very important
indicator.
It not only reveals the
source from which additional working capital has been financed but also, at the
same time, the use of such funds. Moreover, from a projected funds flow
statement the management can easily ascertain the adequacy or inadequacy of
working capital, i.e., it helps in decision-making in a number of ways.
The significance and importance
of Funds Flow Statements may be summarized as:
(a) Analysis of Financial
Statement:
The traditional
financial statements, viz. Profit and Loss Account and Balance Sheet, exhibit
the result of the operation and financial position of a firm. Balance Sheet
presents a static view about the resources and how the said resources have been
utilized at a particular date with recording the changes in financial
activities. But Funds Flow Statement can do so, i.e., it explains the causes of
changes so made and effect of such change in the firm accordingly.
(b) Highlighting Answers to
Various Perplexing Questions:
Funds Flow Statement highlights
answers of the following questions:
(i) Causes of changes in
Working Capital;
(ii) Whether the firm
sells any Non-Current Asset; if sold, how were the proceeds utilized?
(iii) Why smaller amount
of dividend is paid in spite of sufficient profit?
(iv) Where did the net
profit go?
(v) Was it possible to
pay more dividend than the present one?
(vi) Did the firm
pay-off its scheduled debts? If so, how, and from what sources?
(vii) Sources of
increased Working Capital, etc.
(c) Realistic Dividend Policy:
Sometimes it may so
happen that a firm, instead of having sufficient profit, cannot pay dividend
due to lack of liquid sources, viz. cash. In such a circumstance, Funds Flow
Statement helps the firm to take decision about a sound dividend policy which
is very helpful to the management.
(d) Proper Allocation of
Resources:
Resources are always
limited. So, it is the duty of the management to make its proper use. A
projected Funds Flow Statement helps the management to take proper decision
about the proper allocation of business resources in a best possible manner
since it highlights the future.
(e) As a Future Guide:
A projected Funds Flow
Statement acts as a business guide. It helps the management to make provision
for the future for the necessary funds to be required on the basis of the
problem faced. In other words, the future needs of the fund for various
purposes can be known well in advance which is a very helpful guide to the
management. In short, a firm may arrange funds on the basis of this statement
in order to avoid the financial problem that may arise in future.
(f) Appraising of the Working
Capital:
A projected Funds Flow
Statement, no doubt, helps the management to know about how the working capital
has been efficiently used and, at the same time, also suggests how to improve
the working capital position for the future on the basis of the present problem
faced by it, if any.
Preparing Funds Flow Statement: Steps, Rules
and Format
Steps for Preparing Funds Flow
Statement:
The
steps involved in preparing the statement are as follows:
1. Determine the change (increase
or decrease) in working capital.
2. Determine the
adjustments account to be made to net income.
3. For each non-current
account on the balance sheet, establish the increase or decrease in that
account. Analyze the change to decide whether it is a source (increase) or use
(decrease) of working capital.
4. Be sure the total of
all sources including those from operations minus the total of all uses equals
the change found in working capital in Step 1.
General Rules for Preparing
Funds Flow Statement:
The following general rules
should be observed while preparing funds flow statement:
1. Increase in a current
asset means increase (plus) in working capital.
2. Decrease in a current
asset means decrease (minus) in working capital.
3. Increase in a current
liability means decrease (minus) in working capital.
4. Decrease in a current
liability means increase (plus) in working capital.
5. Increase in current
asset and increase in current liability does not affect working capital.
6. Decrease in current
asset and decrease in current liability does not affect working capital.
7. Changes in fixed
(non-current) assets and fixed (non-current) liabilities affects working
capital.
Format of Funds Flow Statement:
A funds flow statement
can be prepared in statement form or ‘T’ form.
Both the formats are
given below:
Schedule of Changes in Working
Capital:
Many business
enterprises prefer to prepare another statement, known as schedule of changes
in working capital, while preparing a funds flow statement, on a working
capital basis. This schedule of changes in working capital provides information
concerning the changes in each individual current assets and current
liabilities accounts (items).
This schedule is a part
of the funds flow statement and increase (decrease) in working capital
indicated by the schedule of changes in working capital will be equal to the
amount of changes in working capital as found by funds flow statement. The
schedule of changes in working capital can be prepared by comparing the current
assets and current liabilities at two periods.
The format of schedule of
changes in working capital is as follows:
Cash
Flow statement
Cash plays a very important role in the economic life of a business. A
firm needs cash to make payment to its suppliers, to incur day-to-day expenses
and to pay salaries, wages, interest and dividends etc. In fact, what blood is
to a human body, cash is to a business enterprise. Thus, it is very essential
for a business to maintain an adequate balance of cash. For example, a concern
operates profitably but it does not have sufficient cash balance to pay
dividends, what message does it convey to the shareholders and public in
general. Thus, management of cash is very essential. There should be focus on
movement of cash and its equivalents. Cash means, cash in hand and demand
deposits with the bank. Cash equivalent consists of bank overdraft, cash
credit, short term deposits and marketable securities. Cash Flow Statement
deals with flow of cash which includes cash equivalents as well as cash. This
statement is an additional information to the users of Financial Statements.
The statement shows the incoming and outgoing of cash. The statement assesses
the capability of the enterprise to generate cash and utilize it. Thus a
Cash-Flow statement may be defined as a summary of receipts and disbursements
of cash for a particular period of time. It also explains reasons for the
changes in cash position of the firm. Cash flows are cash inflows and outflows.
Transactions which increase the cash position of the entity are called as
inflows of cash and those which decrease the cash position as outflows of cash.
Cash flow Statement traces the various sources which bring in cash such as cash
from operating activities, sale of current and fixed assets, issue of share
capital and debentures etc. and applications which cause outflow of cash such
as loss from operations, purchase of current and fixed assets, redemption of
debentures, preference shares and other long-term debt for cash. In short, a
cash flow statement shows the cash receipts and disbursements during a certain
period.The purpose of the cash flow statement or statement of
cash flows is to provide
information about a company's gross receipts and gross payments for a specified
period of time.The gross receipts and gross payments will be reported in the
cash flow statement according to one of the following classifications:
operating activities, investing activities, and financing activities. The net
change from these three classifications should equal the change in a
company's cash and cash equivalents during the reporting period. For instance, the
cash flow statement for the calendar year 2013 will report the causes of the
change in a company's cash and cash
equivalents between its balance sheets of December 31, 2012 and December 31, 2013.In
addition to the cash amounts being reported as operating, investing, and financing
activities, the cash flow statement
must disclose other information, including the amount of interest paid, the
amount of income taxes paid, and any significant investing and financing
activities which did not require the use of cash.The statement of cash flows is
to be distributed along with a company's income statement and balance sheet.
The statement of cash flow serves a number of objectives which are as
follows :
l Cash flow statement aims at highlighting the cash generated from operating activities.
2 Cash flow statement helps in planning the repayment of loan schedule and replacement of fixed assets, etc. l Cash is the centre of all financial decisions. It is used as the basis for the projection of future investing and financing plans of the enterprise.
3 Cash flow statement helps to ascertain the liquid position of the firm in a better manner. Banks and financial institutions mostly prefer cash flow statement to analyse liquidity of the borrowing firm.
4,Cash flow Statement helps in efficient and effective management of cash.
5 The management generally looks into cash flow statements to understand the internally generated cash which is best utilised for payment of dividends
6 Cash Flow Statement based on AS-3 (revised) presents separately cash generated and used in operating, investing and financing activities.
7 It is very useful in the evaluation of cash position of a firm
Cash flow statements –
benefits
Cash flow information
provided in the statement of cash flows can be beneficial, for example:
·
Cash flow information is harder to manipulate as it just reflects cash
in and cash out, it isn’t affected by accounting policies or accruals.
·
The statement of cash flows provides information about all cash inflows
and outflows, from all sources.
·
Cash flow information can provide more detail about the quality of the
entity’s revenue, for example, whether customers are (in general) paying their
bills.
·
Cash accounting methods used in the statement of cash flows can be
easier for non-accountants to understand.
Cash flow statements –
limitations
We’ve looked at all the
benefits of a statement of cash flows, but there are limitations and drawbacks.
One of the major
drawbacks is how information can be manipulated in the statement of cash flows:
·
Management can delay paying suppliers to increase the net cash inflows
·
Management can buy goods using leasing arrangements, to avoid paying
cash
Cash flows also don’t
reflect the earnings of the entity, although a company should be cash positive
to trade in the short term, if it is doing this at the expense of sales, or is
lossmaking, it may eventually cease trading.
None of the individual
financial statements on their own show a full view of the entity’s performance.
Users of the financial
statements should consider all parts of the financial statements together, and
also other non-financial information about the company to assess its
performance.
Cash and relevant terms as per AS-3 (revised) As per AS-3 (revised)
issued by the Accounting Standards Board 1.
(a) Cash fund : Cash Fund includes
(i) Cash in hand
(ii) Demand deposits with banks, and (iii) cash equivalents.
(b) Cash equivalents are short-term, highly liquid investments, readily
convertible into cash and which are subject to insignificant risk of changes in
values.
2. Cash Flows are inflows and outflows of cash and cash equivalents. The statement of cash flow shows three main categories of cash inflows and cash outflows, namely : operating, investing and financing activities.
(a) Operating activities are the principal revenue generating activities of the enterprise.
(b) Investing activities include the acquisition and disposal of longterm assets and other investments not included in cash equivalents.
(c) Financing activities are activities that result in change in the size and composition of the owner’s capital (including Preference share capital in the case of a company) and borrowings of the FIRM.
PREPARATION OF CASH FLOW STATEMENT
Step -I
(i) Operating Activities Cash flow from operating activities are
primarily derived from the principal revenue generating activities of the
enterprise. A few items of cash flows from operating activities are (i) Cash
receipt from the sale of goods and rendering services.
(ii) Cash receipts from royalties, fee, Commissions and other
revenue.
(iii) Cash payments to suppliers for goods and services.
(iv) Cash payment to employees
(v) Cash payment or refund of Income tax.
Determination of cash flow from operating activities There are two stages for arriving at the cash flow from operating activities
Stage-1 Calculation of operating profit before working capital changes,
It can be calculated in the following manner.
Net profit before Tax and extra ordinary Items
Add Non-cash and non operating Items which have already been debited to
profit and Loss Account i.e. Depreciation xxx
Amortisation of intangible assets xxx
Loss on the sale of Fixed assets. xxx
Loss on the sale of Long term Investments xxx
Provision for tax xxx
Dividend paid xxx xxx xxx
Less : Non-cash and Non-operating Items which have already been credited to Profit and Loss Account i.e.
Profit on sale of fixed assets xxx
Profit on sale of Long term investment xxx xxx
Operating profit before working Capital changes. xxx
Stage-II
After getting operating profit before working capital changes as per
stage I, adjust increase or decrease in the current assets and current
liabilities. The following general rules may be applied at the time of
adjusting current assets and current liabilities.
A. Current assets
(i) An increase in an item of current assets causes a decrease in cash
inflow because cash is blocked in current assets
(ii) A decrease in an item of current assets causes an increase in cash
inflow because cash is released from the sale of current assets.
B. Current liabilities
(i) An increase in an item of current liability causes a decrease in
cash outflow because cash is saved. (ii) A decrease in an item of current
liability causes increase in cash out flow because of payment of liability.
Thus,
Cash from operations = operating profit before working capital changes + Net decrease in current assets + Net Increase in current liabilities – Net increase in current assets – Net decrease in current liabilities
Step - II - Investing Activities
Investing Activities refer to transactions that affect the purchase and
sale of fixed or long term assets and investments. Examples of cash flow
arising from Investing activities are
1. Cash payments to acquire fixed Assets
2. Cash receipts from disposal of fixed assets
3. Cash payments to acquire shares, or debenture investment.
4. Cash receipts from the repayment of advances and loans made to third
parties. Thus, Cash inflow from investing activities are
– Cash sale of plant and machinery, land and Building, furniture,
goodwill etc.
– Cash sale of investments made in the shares and debentures of other
companies
– Cash receipts from collecting the Principal amount of loans made to
third parties.
Cash outflow from investing activities are :
– Purchase of fixed assets i.e. land, Building, furniture, machinery
etc.
– Purchase of Intangible assets i.e. goodwill, trade mark etc.
– Purchase of shares and debentures
– Purchase of Government Bonds
– Loan made to third parties
Step- III - Financing Activities
The third section of the cash flow statement reports the cash paid and
received from activities with non-current or long term liabilities and
shareholders Capital. Examples of cash flow arising from financing activities
are
– Cash proceeds from issue of shares or other similar
instruments.
– Cash proceeds from issue of debentures, loans, notes, bonds, and other
short-term borrowings
– Cash repayment of amount borrowed Cash Inflow from financing
activities are
- Issue of Equity and preference share capital for cash only.
– Issue of Debentures, Bonds and long-term note for cash only
Cash outflow from financing activities are :
– Payment of dividends to shareholders
– Redemption or repayment of loans i.e. debentures and bonds
– Redemption of preference share capital
– Buy back of equity shares.
TREATMENT OF SPECIAL ITEMS
(i) Payment of Interim Dividends The following procedure is followed
(i) The amount of interim dividend paid during the year is shown as
outflow of cash in cash flow statement.
(ii) It will be added back to the profits for the purpose of calculating
cash provided from operating activities.
(iii) No adjustment is necessary if the cash provided from operating
activities is calculated on the basis of revised figure of net profit
(ii) Proposed dividend The dividend is always declared in the general meeting after the preparation of Balance Sheet. It is therefore, a non-operating item which should not be permitted to affect the calculation of cash generated by operating activities. Thus, the amount of proposed dividends would be added back to current years profit and payments made during the year in respect of dividends would be shown as an outflow of cash.
(iii) Share Capital The increase in share capital is regarded as inflow of cash only when there is a increase in share capital. For example, if a company issues 10000 equity shares of Rs.10 each for cash only, Rs. 100,000 would be shown as inflow of cash from financing activities. Similarly, the redemption of preference share is an outflow of cash. But where the share capital is issued to finance the purchase of fixed assets or the debentures are converted into equity shares there is no cash flow. Further, the issue of bonus shares does not cause any cash flows.
(iv) Purchase or sale of fixed Assets The figures appearing in the comparative balance sheets at two dates in respect of fixed assets might indicate whether a particular fixed asset has been purchased or sold during the year. This would enable to determine the inflows or outflows of cash. For example, If the plant and machinery appears at Rs 60,000 in the current year and Rs.50,000 in the previous year, the only conclusion, in the absence of any other information is that there is a purchase of fixed assets for Rs.10000 during the year. Hence, Rs.10000 would be shown as outflow of cash.
(v) Provision for Taxation It is a non-operating expenses or an item of appropriation in the Income statement/Profit and Loss Account and therefore should not be allowed to reduce the cash provided from operating activities. Hence, if the profit is given after tax and the amount of the provision for tax made during the year is given, the same would be added back to the current year profit figure. In the cash flow statement, the tax paid would be recorded separately as an outflow of cash. The item of provision for taxation, would not be treated as current assets. Sometimes, the only information available about provision for taxation is two figures appearing in the opening balance sheet and closing balance sheet. In such a case the figure in the opening balance sheet is treated as an outflow of cash while the figure in the closing balance sheet is treated as a non-cash and non-operating expense and thus is added back to net Income figure to find out the cash provided from operating activities.
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