UNIT - I

NATURE AND SCOPE OF MANAGEMENT ACCOUNTING

INTRODUCTION
Financial accounting is concerned with recording transactions and preparing financial
and other reports to be used internally by management and externally by investors, creditors,
potential investors, and government agencies. Management accounting, on the other hand, is
primarily concerned with providing information for use by people within the organization.

DEFINITIONS OF MANAGEMENT ACCOUNTING

1. Anglo-American Council on Productivity: "Management Accounting is the presentation
of accounting information in such a ways as to assist management in the creation of
policy and the day-to -day operation of an undertaking.
2. Robert N. Anthony: "Management Accounting is concerned with accounting
information that is useful to management"
3. T.G. Rose: "Management Accounting is the adaptation and analysis of accounting
information and its diagnosis and explanation in such a way as to assist management."
4. J. Batty: ―Management Accounting is the term used to describe the accounting
methods, systems and techniques which, coupled with special knowledge and ability,
assist management in its task of maximizing profits or minimizing losses‖.
5. The Institute of Chartered Accountants of India: "Such of its techniques and procedures
by which accounting mainly seeks to aid the management collectively have come to be
known as management accounting."
6. The Institute of Cost & Works Accountants of India: it defines Management Accounting
as "a system of collection and presentation of relevant economicinformation relating to
an enterprise for planning. Controlling and decision making.''
7. The American Accounting Association: "Management Accounting includes the methods
and concepts necessary for effective planning, for choosing among alternative business
actions and for control through the evaluation and interpretation of performances."
NATURE OF MANAGEMENT ACCOUNTING

The following are the main characteristics of management accounting:

i. Providing Accounting Information. Management accounting is based on accounting

information. The collection and classification of data is the primary function of
accounting department. The accounting data is used for reviewing various policy
decisions. Management accounting is a service function and ft provides necessary
information to different levels of management
ii. Cause and Effect Analysis. Financial accounting is limited to the preparation of profit
and loss accounting and finding out the ultimate result. If there is a profit the factors
directly influencing the profitability are also studied. So the study of cause and effect
relationship is possible in management accounting.
iii. Use of Special Techniques and Concepts. Management accounting uses special
techniques and concepts to make accounting data more useful. The techniques usually
used include financial planning and analysis, standard costing, budgetary control,
marginal costing, project appraisal, control accounting, etc. The type of technique to be
used will be determined according to the situation and necessity.
 iv. Taking important decisions: management accounting helps in taking various important
decisions. It supplies necessary information to the management which may base its
decisions on it.
v. Achieving of Objectives. In management accounting, the accounting information is used
in such a way that it helps in achieving organizational objectives.
vi. No Fixed Norms Followed. In financial accounting certain rules are followed for
preparing different accounting books. On the other hand, no specific rules are followed
in management accounting
vii. Increase in efficiency: The purpose of using accounting information is to increase
efficiency the concern. The efficiency can be achieved by setting up goals for each
department or section.
viii. Supplies Information and not Decision. The management accountant supplies
information management. The decisions are to be taken by the top management. It is
only to guide and not to supply decisions.
ix. Concerned with Forecasting. The management accounting is concerned with the future.
It helps the management in planning and forecasting.

SCOPE OF MANAGEMENT ACCOUNTING

The following facts of management accounting are of a great significance and form the
scope of this subject.
1. Financial Accounting. Financial accounting deals with the historical data. The recorded
facts about an organization are useful for planning the future course of action.
2. Cost Accounting. Cost accounting provides various techniques for determining cost of
manufacturing products or cost of providing service. It uses financial data for finding out
cost of various jobs, products or processes.
3. Financial Management: Financial management is concerned with the planning and
controlling of the financial resources of the firm. It deals with raising of funds and their
effective utilization.
4. Budgeting and Forecasting. Budgeting means expressing the plans, policies and goals of
the enterprise for a definite period in future.
5. Inventory Control. Inventory is used to denote stock of raw materials, goods in the
process of manufacture and finished products.
6. Reporting to Management One of the functions of management accountant is to keep
the management informed of various activities of the concern so as to assist it in
controlling the enterprise. The reports are presented in the form of graphs, diagrams,
index numbers or other statistical techniques so as to make them easily understandable.
The management accountant sends interim reports to the management and these
reports may be monthly, quarterly, half-yearly.
7. Interpretation of Data. The management accountant interprets various financial
statements to the management. These statements give an idea about the financial and
earning position of the concern. These statements may be
8. Control procedures and Methods. Control procedures and methods are needed to use
various factors of production in a most economical way.
9. Internal Audit. Internal audit system is necessary to judge the performance of every
department. The actual performance of every department and individual is compared
with the pre-determined standards.
 10. Tax Accounting. In the present complex tax systems, tax planning is an important part of
management accounting. Income statements are prepared and tax liabilities are
calculated. The management is informed about the tax burden from central government
state government and local authorities.
11. Office Services. Management accountant may be required to control an office. He will
be expected to deal with data processing, filing, copying, duplicating, communicating,
etc. He will also be reporting about the utility of different office machines.
LIMITATIONS OF MANAGEMENT ACCOUNTING
1. Based on Accounting Information: Management accounting is based on data supplied
by financial and cost accounting. Historical data is used to make future decisions.
2. Lack of Knowledge: The use of management accounting requires the knowledge of a
number of related subjects. Management should be conversant with accounting
principles, statistics, economics, principles of management etc., and only then
management accounting can be effectively utilized.
3. Intuitive Decisions: Intuitive decisions limit the usefulness of management accounting.
4. Not an Alternative to Administration: Management accounting does not provide an
alternative to administration
5. Top Heavy Structure: The installation of a management accounting system needs an
elaborate organizational system. Smaller units cannot afford to use this system because
of heavy cost.
6. Evolutionary Stage: Management accounting is only in a developmental stage, it has not
yet reached a final stage. The techniques and tools used by this system give varying and
differing results.
7. Personal Bias: Personal prejudices and bias affect the objectivity of decisions.
8. Psychological Resistance: The installation of management accounting involves basic
change in organizational set up. New rules and regulations are also required to be
framed which affect a number of personnel.
FUNCTIONS OF MANAGEMENT ACCOUNTING
Some of the functions of management accounting are given as follows:
1. Planning and Forecasting: Management fixes various targets to be achieved by the
business in near future. Planning and forecasting are essential for achieving business
objectives. One of the important functions of the management accounting is to help
management in planning for short-term and long term periods and also in making
forecasts for the future. Management accountants use various techniques such as
budgeting, standard costing, marginal costing, fund flow statements, probability and
trend ratios, etc. for fixing targets. So management accounting tools are useful in
planning and forecasting.
2. Modification of Data: Management accounting helps in modifying accounting data. The
information is modified in such a way that it becomes useful for the management. If
sales data is required, it can be classified according to product area, season-wise, type of
customers and time taken for getting payments. Management accountant classifies and
modifies information according to the requirements of the management.
3. Financial Analysis and Interpretation: Management accountant undertakes the job of
presenting financial data in a simplified way. Management accountant analyses and
interprets financial data in a simple way and presents it in a non-technical language. He
 gives facts and figures about various policies and evaluates them in monetary terms. He
gives his opinion about various alternative courses of action so that h; becomes easy for
the management to take a decision.
4. Facilitates Managerial Control: Management accounting is very useful in controlling
performance. All accounting efforts are directed towards control of the enterprise. The
standards of various departments and individuals are set-up. The actual performance is
recorded and deviations are calculated. It enables the management to assess the
performance of everyone in the organization. Performance evaluation is -possible
through standard costing and budgetary control which are an integral part of
management accounting.
5. Communication: Management accounting establishes communication within the
organization and with the outside world. The management accountant prepares reports
for the benefit of different levels of management and employees.
6. Use of Qualitative Information: The field of management accounting is not restricted to
the use of monetary data only. It collects and uses qualitative information also. While
preparing a production budget, management accountant may not only use past
production figures, but he may rely on the assessment of persons dealing with
production, productivity reports, consumer surveys and many other business
documents.
7. Co-ordination: The co-ordination among different departments is essential for smooth
running of the concern. Management accountant acts as a co-ordinator among different
financial departments through budgeting and financial reports.
8. Helpful in taking Strategic Decisions: Management accounting helps in taking strategic
decisions. It supplies analytical information regarding various alternatives and the
choice of management is made easy.
9. Supplying Information to Various Levels of Management: Management accountant
feeds information to different levels of management so that further decisions are taken.
The supply of adequate information at the proper time will increase efficiency of the
management.
TOOLS AND TECHNIQUES OF MANAGEMENT ACCOUNTING
The tools and techniques used in management accounting are discussed as follows

1. Financial Policy and Accounting: The proportion between share capital and loans should
also be decided. All these decisions are very important and management accounting
provides techniques for financial planning.
2. Analysis of Financial Statements: The analysis of financial statements is meant to
classify and present the data in such a way that it becomes useful for the management.
3. Historical Cost Accounting: The system of recording actual cost data on or after the date
when it has been incurred is known as historical cost accounting.
4. Budgetary Control: It is a system which uses budgets as a tool for planning and control.
5. Standard Costing: Standard costing is an important technique for cost control purposes.
In standard costing system, costs are determined in advance. The determination of
standard cost is based on a systematic analysis of prevalent conditions.
6. Marginal Costing: This is a method of costing which is concerned with changes in costs
resulting The measuring rod of efficiency of a concern should be a return on capital
 employed. It should from changes m the volume of production. Under this system, cost
of product is divided into marginal (variable) be consistently and fixed cost.
7. Decision Accounting: Decision taking involves a choice from various alternatives.
8. Revaluation Accounting: This is also known a Replacement Accounting. The
preservation of capital in the business is the main object of management. The profits are
calculated in such a way that capital is preserved in real terms;
9. Control Accounting: Control accounting is not a separate accounting system. Different
systems have their control devices and these are used in control accounting.
10. Management Information Systems: With the development of electronic devices for
recording and classifying data, reporting to management has considerably improved.
RELATIONS OF MANAGEMENT ACCOUNTING WITH FINANCIAL ACCOUNTING
Financial accounting is concerned with the recording of day-to-day transactions of the business.
On the other hand, management accounting uses financial accounts and taps other sources of
information too. The accounts are used in such a way that they are helpful to the management
in planning and forecasting various policies.

The main points of distinction are discussed as below:

Object:
The object of financial accounting is to record various transactions with the purpose of
maintaining accounts and to know the financial positionand to find out profit loss the end of
the financial year. These records are useful to shareholders, creditors, bankers, debenture
holders, etc. On the other hand, management accounting is essential to help management in
formulating policies and plans.

Nature:
Financial accounting is mainly concerned with the historical data.
Managementaccounting projected or estimated figure are used.

Subject-matter:
Financial accounting is concerned with assessing the results of the whole business while
management accounting deals separately with different units, departments and cost centers. In
financial accounting overall performance is judged, while in management accounting the results
of different departments are evaluated separately to find out their performance differently.

Compulsion:
The preparation of financial accounts is compulsory. Management accounting-is not
compulsory.

Precision:
In management accounting no emphasis is given to actual figures. The approximate
figures are considered more useful than the exact figures. In financial accounting only actual
figures are recorded.

Reporting:
 Financial accounts are prepared to find out profitability and financial position of the
concern. These reports are useful for outsiders like bankers, investors, shareholders,
Government agencies, etc. Management accounting reports are meant for internal use only.

Description:
Only those things are recorded in financial accounting which can be measured in
monetary terms. Management Accounting uses both monetary and non-monetary events.

Quickness:
Reporting of management accounting is very quick. Management is fed with reports at
regular intervals. Various figures are required to take managerial decisions at different levels of
management. On the other hand, reporting of financial accounting is slow and time consuming.
Accounting Principles:
Financial accounts are governed by the generally accepted principles and conventions.
No set principles are followed in management accounting.

Period:
Financial accounts are prepared for a particular period. Management accountant
supplies information from time to time during the whole year. These are no specific
periods for which, management accounts are prepared.

Publication:
Financial accounts like profit and loss account and balance sheet are published for the
benefit of the public. Under companies law every registered company is supposed to supply a
copy of Profit and Loss Account add Balance Sheet to the Registrar of Companies at the end of
the financial year. Management accounting statements are prepared for the benefit of the
management only and these are not published.

Audit:
Financial accounts can be got audited. It is not possible to get management accounts
audited.
RELATIONSHIP BETWEEN COST AND MANAGEMENT ACCOUNTING
The following are the main points of distinction between COST and MANAGEMENT
accounting:
Object:
The purpose of management accounting is to provide information to the management
for planning and co-ordinating the activities of the business.

Scope:
The scope of management accounting is very wide. Cost accounting deals primarily with
cost ascertainment.

Nature:
Management accounting is generally concerned with the projection of figures for future.
The policies and-plans are prepared for providing future guidelines. Cost accounting uses both
past and present figures.

Data used:
 Only quantitative aspect is recorded in cost accounting. Management accounting uses
both quantitative and qualitative information.

Development:
The development of cost accounting is related to industrial revolution. Management
accounting has developed only in the last thirty years.

UNIT - II
FUNDS FLOW STATEMENT

The Funds Flow Statement is a statement which shows the movement of funds and is a
report of the financial operations of the business undertaking. It indicates various means by
which funds were obtained during a particular period and the ways in which these funds were
employed In simple words, it is a statement of sources and applications of funds.

MEANING AND DEFINITION OF FUNDS FLOW STATEMENT

Funds Flow Statement is a method by which we study changes in the financial position
of a business enterprise between beginning and ending financial statements dates. It is a
statement showing sources and uses of funds for a period of time.

Foulke defines this statements as:

A statement of sources and application of funds is a technical device designed to
analyses the changes in the financial condition of a business enterprise between two dates.

In the words of Anthony - The funds flow statement describes the sources from which
additional funds were derived and the use to which these sources were put.
Funds flow statement is called by various names such as Sources and Application of
Funds Statement of Changes in Financial Position.

USES OF FUNDS FLOW STATEMENT

A funds flow statement is an essential tool for the financial analysis and is of primary
importance to the financial management. The basic purpose of a funds flow statement is to
reveal the changes in the working capital on the two balance sheet dates. It also describes the
sources from which additional working capital has been financed and the uses to which working
capital has been applied.

The uses of funds flow statement can be well followed from its various uses given below:
a. It helps in the analysis of financial operations. The financial statements reveal
the net effect of various transactions on the operational and financial position of
a concern.
b. It throws light on many perplexing questions of general interest which otherwise
may be difficult to be answered.
c. It helps in the formation of a realistic dividend policy
d. It helps in the proper allocation of resources.
e. It acts as a future guide.
f. It helps in appraising the use of working capital.
g. It helps knowing the overall creditworthiness of a firm.
PROCEDURE FOR PREPARING A FUNDS FLOW STATEMENT
The preparation of a funds flow statement consists of two parts:
a. Statement or Schedule of Charges in Working Capital.
b. Statement of Sources and Application of Funds.

a. Statement or Schedule of Changes in Working Capital:

Working Capital means the excess of current assets over current liabilities. Statement of
changes in working capital is prepared to show the changes in the working capital between the
two balance sheet dates. This statement is prepared with the help of current assets and current
liabilities derived from the two balance sheets.

As, Working Capital = Current Assets - Current Liabilities.

So,
I. An increase in current assets increases working capital.
II. A decrease in current assets decreases, working capital.
III. An increase in current liabilities decreases working capital
IV. A decrease in current liabilities increases working capital.

Statement of Schedule of Changes in Working Capital

Effect on Working Capital
Particulars Previous Year Current Year Increase Decrease
Current Assets:
Cash in hand
Cash at bank
Bills Receivable
Sundry Debtors
Temporary Investments
Stocks/Inventories
Prepaid Expenses
Accrued Incomes
Total Current Assets
Current Liabilities:
Bills Payable
Sundry Creditors
Outstanding Expenses
Bank Overdraft
Short-term advances
Dividends Payable
Proposed dividends*
Provision for taxation*
Total Current Liabilities
Working Capital (CA-CL)
Net Increase or Decrease
in Working Capital
Illustration:
Funds flow statement is a statement which indicates various sources from which funds
(Working capital) have been obtained during a certain period and the uses or applications to
which these funds have been put during that period.

Generally, this statement is prepared in two formats:

a. Report Form
b. T Form or an Account Form or Self Balancing Type.

Specimen of Report From of Funds Flow Statement

Sources of Funds: Rs.

Funds from Operations
Issue of Share Capital
Raising of long-term loans
Receipts from partly paid shares, called up
Sales of non current (fixed) assets
Non-trading receipts, such as dividends received
Sale of Investments (long-term)
Decrease in Working Capital (as per schedule ofchanges in Working
Capital)
Total
Applications or Uses of Funds:
Funds Lost in Operations
Redemption of Preference Share Capital
Redemption of Debentures
Repayment of long-term loans
Purchase of non-current (fixed) assets
Purchase of long-term Investments
Non-trading payments
Payments of dividends*
Payment of tax*
Increase in Working Capital (as per schedule of changesin working
capital)
Total

CASH FLOW STATEMENT

Cash plays a very important role in the entire economic life of a business. Recognizing
the importance of cash flow statement, the Institute of Chartered Accountants of India (ICAT)
issued. AS-3 Revised : Cash flow Statements in March, 1997.

Meaning:
Cash Flow Statement is a statement which describes the inflows (sources) and outflows
(uses) of cash and cash equivalents in an enterprise during a specified period of time. A cash
flow statement summarizes the causes of changes in cash position of a business enterprise
between dates of two balance sheets. According to AS-3 (Revised), an enterprise should
prepare a cash flow Statement and should present it for each period for which financial
statements are prepared.

The terms cash, cash equivalents and cash flows are used in this statement with the following
meanings:
a. Cash comprises cash on hand and demand deposits with banks.
b. Cash equivalents are short term, highly liquid investments.
c. Cash flows are inflows and outflows of cash
 UNIT - IV
RATIO ANALYSIS
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”. For example, if the current assets of a firm
on a given date are 5,00,000 and the current liabilities are Rs. 2,50,000. Then the ratio of
current assets to current liabilities will work out to be 500000 / 250000 or 2. A ratio can also be
expressed as percentage by simply multiplying the ratio by 100.

Thus, the ratio of two figures 200 and 100 may be expressed in any of the following ways:

(a) 2 : 1 (b) 2 (c) 2/1 (id) 2 to 1 (e) 200%

CLASSIFICATION OF RATIOS:
There aredifferentpartiesinterestin the ratio analysis for knowing the financial position
of a firm for different purposes.

RATIOS
Traditional Functional Classification Significance Ratiosor
Classificationor or Classification Ratios According toImportance
Statement Ratios According toTests

Balance Sheet Ratiosor Liquidity Ratios Primary Ratios

Postion StatementRatio

Leverage Ratios Secondary Ratios

Profit and Loss A/c Ratios

Or Activity Ratios
Revenue / income Statement
Ratio
Profitability Ratios

Composite /
MixedRatiosor
Inter Statement Ratios

Traditional classification or classification according to the statement, from which these ratios
are calculated, is as follows:
 Traditional Classification or Statement Ratios

Balance Sheet Ratios Profit and Loss A/c

Or Ratios or Composite / Mixed Ratios
Revenue / income Inter Statement Ratios
Position Statement Statement Ratio
Ratio

Current Ratio Stock Turnover Ratio

Liquid Ratio(acid Test Debtors Turnover
or Quick Ratio) Payable Turnover Ratio
Gross profit Ratio
Absolute Liquidity Fixed Assets Turnover
Ratio Operating Ratio Ratio
Debt Equity Ratio Operating Profit Return on Equity
Preparatory Ratio Ratio Return on
Net Profit Ratio Shareholders' Funds
Capital Gearing Ratio
Return on Capital
Assets - Cash Profit Ratio Employed
Proprietorship Ratio Expenses Ratio Capital Turnover Ratio
Capital Inventory to Interest Coverage Working Capital
Working Capital Ratio Ratio Turnover Ratio
Ratio of current Return on Total
Assets to Fixed Resources
Assets Total Assets Turnover

Balance Sheet or Position Statement Ratios:

Balance Sheet ratios deal with the relationship between two balance sheet items, e.g.
the ratio of current assets to current liabilities, or the ratio of proprietors' funds to fixed-assets.
Profit and Loss Account or Revenue/Income Statements Ratios: These ratios deal with
the relationship between two profit and loss account items, e.g., the ratio of gross profit to
sales, or the ratio of net profit to sales.

Composite/Mixed Ratios or Inter Statement Ratios:

These ratios exhibit the relation between a profit and loss account on income statement
item and a balance sheet item, e.g., stock turnover ratio, or the ratio of total assets to sales.

Functional Classification or Classification According to Tests

Liquidity Ratios:
These are the ratios which measure the short-term solvency or financial position of a
firm: These ratios are calculated to comment upon the short-term paying capacity of a concern
or the firm's ability to meet its current obligations. The various liquidity ratios are: current ratio,
liquid ratio and absolute liquid ratio.

Long-term Solvency and Leverage Ratios:

 Long-term solvency ratios convey a firm's ability to meet the interest costs and
repayments schedules of its long-term obligations e.g. Debt Equity Ratio and Interest Coverage
Ratio.

The leverage ratios can further be classified as:

a. Financial Leverage,
b. Operating Leverage,
c. Composite Leverage.
Activity Ratios:
Activity ratios are calculated to measure the efficiency with which the resources of a
firm have been employed. These ratios are also called turnover ratios.
Profitability Ratios:
These ratios measure the results of business operations or overall performance and
effectiveness of the firm, e.g., gross profit ratio, operating ratio or return on capital employed.

ANALYSIS and interpretations of different ratios:

The short-term creditors of a company like suppliers of goods of credit and commercial
banks providing short-term loan, are primarily interested in knowing the company's ability to
meet its current or short-term obligations as and when these become due. The short-term
obligations of a firm can be met only when there are sufficient liquid assets. Therefore, a firm
must ensure that it does not suffer from lack of liquidity or the capacity to pay its current
obligations.

Two types of ratios can be calculated for measuring short-term financial position or short-
term solvency of a firm:
a) Liquidity Ratios
b) Current Assets Movement or Efficiency Ratios.

a) LIQUIDITY RATIOS
Liquidity refers to the ability of a concern to meet its current obligations as and when
these become due. The short-term obligations are met by realising amounts from current,
floating or circulating assets. These should be convertible into cash for paying obligations of
short-term nature. If current assets can pay off current liabilities, then liquidity position will be
satisfactory. On the other hand, if current liabilities may not be easily met out of current assets
en liquidity position will be bad.

The following ratios can be calculated:

1. Current Ratio
2. Quick or Acid Test or Liquid Ratio
3. Absolute Liquid Ratio or Cash Position Ratio

b) CURRENT RATIO
Current ratio may be defined as the relationship between current assets and current
liabilities. This ratio, also known as working capital ratio, is a measure of general liquidity and is
most widely used to make the analysis of a short-term financial position or liquidity of a firm. It
is calculated by dividing the total of current assets by total of the current liabilities.
CurrentRatio= Current Assets / CurrentLiabilities
Or Current Assets : CurrentLiabilities
The two basic components of this ratio are:
Current assets and current liabilities:
Current assets include cash and those assets which can be easily converted into cash
within a short period of time generally, one year/ such as marketable securities, bills
receivables, sundry debtors, inventories, work-in-progress, etc. Prepaid expenses should also be
included in current assets because they represent payments made in advance which will not
have to be paid in near future. Current Liabilities are those obligations which are payable within
a short period of generally one year and include outstanding expenses, bills payables, sundry
creditors, accrued expenses, short-term advances, income-tax payable, dividend payable, etc.
Bank over-draft.

COMPONENTS OF CURRENT RATIO

S.N Current Assets Current Liabilities

1 Cash in Hand Outstanding Expenses/Accrued Expenses

2 Cash at Bank Bills Payable

3 Marketable Securities (Short-term) Sundry Creditors

4 Short-term Investments Short-term Advances

5 Bills Receivable Income-tax Payable
6 Sundry Debtors Dividends Payable
7 Inventories (stocks) Bank Overdraft (if not a permanent arrangement)

8 Work-in-process

9 Prepaid Expenses

As a convention the minimum of 'two to one ratio' is referred to as a banker's rule of

thumb or arbitrary standard of liquidity for a firm. A ratio equal or near to the rule of thumb of
2 : 1 i.e., current assets double the current liabilities is considered to be satisfactory.

SIGNIFICANCE AND LIMITATIONS OF CURRENT RATIO

Current ratio is a general and quick measure of liquidity of a firm. It represents the
'margin of safety' or cushion' available to the creditors and other current liabilities. It ismost
widely used for making short-term analysis of the financial position or short-term solvency of a
firm.

Current Ratio:
It is a crude ratio because it measures only the quantity and not the quality of Current
assets.

Window Dressing:
Valuation of current assets and window dressing is another problem of current. Current
assets and liabilities are manipulated in such a way that current ratio loses its significance.
Window dressing may be indulged in the following ways: Over-valuation of closing stock.
 Calculation of Current Ratio:
This ratio is calculated by comparing current assets with current liabilities. Take for
example, current assets of a concern as Rss.250000 and current liabilities as Rs. 100000; current
ratio will be calculated as follows:

Current Ratio = Current Assets / Current Liabilities Current Ratio = 250000 / 100000 = 2.5

The current ratio of 2.5 means that current assets are 2.5 times of current liabilities. This
ratio can also be presented as 2.5:1. In current ratio, current liabilities are taken as 1 and
current assets are given in comparison to it.

Illustration
Calculate current ratio from the following information:
Rs. Rs.

Stock 60,000 Sundry Creditors 20,000

Sundry Debtors 70,000 Bills Payable 15,000

Cash Balances 20,000 Tax Payable 18,000

Bills Receivables 30,000 Outstanding Expenses 7,000

Prepaid Expenses 10,000 Bank Overdraft 25,000

Land and Building 1,00,000 Debentures 75,000

Goodwill 50,000

Solution:
Current Ratio = Current Assets / Current Liabilities
Current Assets = Rs. 60,000 + 70,000 + 20,000 + 30,000 + 10,000 = Rs. 1,90,000
Current Liabilities = Rs. 20,000 + 15,000 + 18,000 + 7,000 + 25,000 = Rs. 85,000
Current Ratio = 1,90,000 / 85,000 = 2.24:1

QUICK OR ACID TEST OR LIQUID RATIO

Quick Ratio, also known as Acid Test or Liquid Ratio, is a more rigorous test of liquidity
than the current ratio. The term 'liquidity' refers to the ability of a firm to pay its short-term
obligations as and when they become due. Quick ratio may be defined as the relationship
between quick/liquid assets and current or liquid liabilities.
Quick / Liquid or Acid Test Ratio = Quick or Liquid Assets / Current Liabilities

Components of Quick/Liquid Ratio

Quick/Liquid Assets Current Liabilities

Cash in hand Outstanding or accrued

Cash at bank expenses Bills payable
 Bills receivables Sundry creditors

Sundry debtors Short-term advances

Marketable (payable shortly)

Securities Income-tax payable

Temporary Dividends payable

Investments Bank overdraft

Quick assets can also be calculated as:

Current Assets-(Inventories +Prepaid Expenses)
Quick/Acid Test / Liquid Ratio = Liquid Assets / Current Liabilities
Quick / Liquid or Acid Test Ratio = Quick or Liquid Assets / Current Liabilities
=200000/150000 = 1.33:1

Interpretation of Quick Ratio

Usually, a high acid test ratio is an indication that the firm is liquid and has the ability to
meet its current or liquid liabilities in time and on the other hand a low quick ratio represents
that the firm's liquidity position is not good. As a rule of thumb or as a convention quick ratio of
1 : 1 is considered satisfactory.

Significance of Quick Ratio:

The quick ratio is very useful in measuring the liquidity position of a firm it measures the
firm's capacity to pay off current obligations immediately and is a more rigorous test of liquidity
than the current ratio. It is used as a complementary ratio to the current ratio.

ABSOLUTE LIQUID RATIO OR CASH RATIO

Absolute Liquid Ratio = Absolute Liquid Assets / Current Liabilities
OR
Cash Ratio = Cash & Bank + Short-term Securities / CurrentLiabilities

Absolute Liquid Assets include cash in hand and at bank and marketable securities or
temporary investments. The acceptable norm for this ratio is 50% or 05:1 or 1:2 i.e.

Problem:
The following is the balance sheet of New India Ltd., for the year ending 31st Dec. 2016.
Rs. Rs.
9% Preference Share Capital 500000 Goodwill 100000
Equity Share Capital 1000000 Land and Building 650000
8%Debentures 200000 Plant 800000
Long-term Loan 100000 Furniture & Fixture 150000
 Bills Payable 60000 Bills Receivables 70000
Sundry Creditors 70000 Sundry Debtors 90000
Bank Overdraft 30000 Bank Balance 45000
Outstanding Expenses 5000 Short-term Investments 25000
Prepaid expenses 5000
Stock 30000
1965000 1965000
From the balance sheet calculate
a. Current Ratio
b. Acid Test Ratio
c. Absolute Liquid Ratio
Solution:
a) Current Ratio = Current Assets / Current Liabilities
Current Assets= Rs. 70000 + Rs. 90000 + Rs. 45000 + Rs. 25000 + Rs.5000
+ Rs. 30000 = Rs. 265000
Current Liabilities = Rs. 60000 + Rs. 70000 + Rs. 30000 + Rs. 5000 = Rs. 165000
Current Ratio = 265000 / 165000 = 1.61

b) Acid Test Ratio = Liquid Assets / Current liabilities

Liquid Assets = Rs. 70000 + Rs. 90000 + Rs. 45000 + Rs. 25000= Rs. 230000
Stock and prepaid Expenses have been excluded from current assets in order to arrive at
liquid assets.
Current Liabilities = Rs. 165000
Acid Test Ratio = Rs. 230000 / Rs. 165000 = 1.39

c) Absolute Liquid Ratio = Absolute Liquid Ratio / Current Liabilities Absolute Liquid Assets
= Rs. 45000 + Rs. 25000 = Rs. 70000 Absolute Liquid Ratio = 70000 / 165000 = 0.42

Problem:
The following information of a company is given :
Current Ratio, 2.5 : 1 : Acid-test ratio, 1.5 : 1; Current liabilities Rs. 50000
Find out:
a) Current Assets
b) Liquid Assets
c) Inventory
Solution:
a) Current Ratio = Current Assets / Current Liabilities
2.5 = Current assets / Rs. 50000
Current Assets = 50000 x 2.5 = Rs. 125000
b) Acid Test Ratio = Liquid Assets / Current liabilities
1.5 = Liquid Assets / Rs. 50000
Liquid Assets = 50000 x 1.5 = Rs. 75000
c) Inventory = Current Assets – Liquid Assets
= Rs. 125000 – Rs. 75000 = Rs. 50000

Problem:
Given:
Current Ratio = 2.8 Acid –test Ratio = 1.5
Working Capital = Rs. 1,62,000
Find out:
a. Current Assets
b. Current Liabilities
c. Liquid Assets

Solution:
Working Capital = Current Assets- Current Liabilities 1,62,000
=2.8x-1.0x
1,62,000 = 1.8xOr ,
X Current liabilities = 162000 / 1.8 = Rs. 90,000
Current assets = 90,000x2.8 = Rs. 252000
Acid Test Ratio = Liquid Assets / Current Liabilities
1.5 = Liquid Assets / 90000
Liquid assets = 90000 x 1.5 = Rs. 135000

INVENTORY TURNOVER OR STOCK TURNOVER RATIO

Every firm has to maintain a certain level of inventory of finished goods so as to be able
to meet the requirements of the business. But the level of inventory should neither be too high
nor too low. It will therefore, be advisable to dispose of inventory as early as possible. On the
other hand, too low inventory may mean loss of business opportunities. Thus, it is very
essential to keep sufficient stocks in business.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory at Cost
Problem:
The cost of goods sole of E.S.P. Limited is Rs. 5,00,000.
The opening stock/inventory is Rs. 40,000 and the closing inventory is Rs. 60,000 (at cost).Find
out inventory turnover ratio.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory at Cost
= 500000/ 40000 + 60000 / 2 = 500000 / 50000 = 10 times

Problem:
If Inventory Turnover Ratio is 5 times and average stock at cost is Rs. 75000, find out cost of
goods sold.

Solution:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory at Cost 5 = Cost of Goods
Sold / Rs. 75000
Cost of Goods Sold = 75000 x 5 = Rs. 375000

Interpretation of Inventory Turnover Ratio

Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually,
a high inventory turnover/Stock velocity indicates efficient management of inventory because
more frequently the stocks are sold, the lesser amount of money is required to finance the
inventory. A low inventory turnover ratio indicates an inefficient management of inventory.
Illustration
Determine the sales of a firm with the following financial data:
Current ratio 1.5
Acid test ratio 1.2
Current liabilities Rs. 400000
Inventory turnover ratio 5 times
Solution:
Current Ratio = Current Assets / Current Liabilities
1.5 = Current assets / 400000
Current Assets= 400000 x 1.5 = Rs. 600000
Acid Test Ratio = Liquid Assets / Current Liabilities
1.2 = Liquid Assets / 400000
Liquid Assets = 400000x 1.2 = Rs. 480000
Inventory = Current Assets – Liquid Assets
= Rs. 600000 – Rs. 480000 = Rs. 120000
Inventory Turnover Ratio = Sales / Inventory
5 = Sales / 120000
Sales = 120000 x 5 = Rs. 600000
DEBTORS OR RECEIVABLE TURNOVER RATIO AND AVERAGE COLLECTION PERIOD:
A concern may sell goods on cash as well as on credit. Credit is one of the important
elements of sales promotion. The volume of sales can be increased by following a liberal credit
policy.
a)Debtors/Receivables Turnover or Debtors Velocity
Debtors turnover ratio indicates the velocity of debt collection of firm. In simple words,
it indicates the number of times average debtors (Receivables) are turned over during a year,
thus:
Debtors(Receivables)Turnover/Velocity = Net CreditAnnualSales/Average Trade debtors
= No. of Times

Trade Debtors = Sundry Debtors + Bills Receivables and Accounts Receivables Average Trade
Debtors = Opening Trade Debtors + Closing Trade Debtors / 2

Interpretation of Debtors Turnover/Velocity

Debtors velocity indicates the number of times the debtors are turned over during a
year. Generally, the higher the value of debtors turnover the more efficient is the management
of debtors/sales or more liquid are the debtors.

Average Collection Period Ratio

The average collection period represents the average number of days for which a firm
has to wait before its receivables are converted into cash.
The ratio can be calculated as follows:
AverageCollectionPeriod = Average Trade Debtors (Drs+B/R)/Sales per day
= Average Trade Debtors x No. of Working Days / Net sales
Find out
a) Debtors Turnover
B) Average Collection period from the following information:

31st March2015 31st March 2016

Rs. Rs.
Annual credit sales 500000 600000
Debtors in the beginning 80000 100000
Debtors at the end 100000 120000
Days to be taken for the year: 360.

Solution:
Average Debtors = Opening Debtors + ClosingDebtors
/2
Debtors Turnover Net Credit Annual Sales /
AverageDebtors
Year 2007 Year 2008
Average Debtors 80,000+1,00,000 / 2 1.00,000+1,20,000 / 2
= Rs. 90,000 Rs. 1,10,000

(a) Debtors Turnover 5,00,000 / 90,000 6,00,000 / 1,10,000

5.56 times 5.45 times
(b) Average CollectionPeriod No. of Working Days / Debtors
Turnover
Year 2007 Year 2008
Average Collection Period = 360 / 5.56 360 / 5.45
= 64.7 days = 66.05 days
= 65 days (approximately) = 66 days (appx.)

The analysis for creditor’s turnover is basically the same as of debtor’s turnover ratio
except that in place of trade debtors, the trades creditors are taken as one of the components
of the ratio and in place of average daily sales, average daily purchases are taken as the other
component of the ratio. Same as debtor’s turnover ratio, creditors turnover ratio can be
calculated in two forms:
CREDITORS/PAYABLES TURNOVER RATIO =Net Credit Annual Purchases / Average Trade
Creditors
AVERAGE PAYMENT PERIOD RATIO=Average Trade Creditors (Creditors + Bills Payable) / Average
Daily
 Purchases
AVERAGE DAILY PURCHASES = Annual Purchases / No. of Working Days in a Year
AVERAGE PAYMENT PERIOD = Trade Creditors x No. of Working Days / Net Annual Purchases

Illustration:
From the following information calculate creditors turnover ratio average payment period:
Total purchases 400000
Cash purchases (included in above) 50000
Purchase returns 20000
Creditors at the end 60000
Bills payable at the end 20000
Reserve for discount on creditors 5000
Take 365 days in a year 5000

CREDITORS TURNOVER RATIO = Annual Net Purchases / Average Trade Creditors

Rs.
Net Credit purchases
Total purchases 400000
Less: Cash purchases 50000
350000
Less: Returns 20000
330000
Creditors Turnover Ratio = 330000 / 60000 + 20000
(Trade creditor include creditors and bills payable)= 330000 / 80000 = 4.13 times
AVERAGE PAYMENT PERIOD = No. of Working Days / Creditors Turnover Ratio= 365 / 4.13 = 88
Days

Alternatively:
AVERAGE PAYMENT PERIOD = 60000 + 20000 / 330000 x 365=80000 / 330000 x 365 = 88 Days

WORKING CAPITAL TURNOVER RATIO:

Working capital of a concern is directly related to sales. The current assets like debtors,
bills receivables, cash, stock etc. change with the increase or decrease in sales. the working
capital is taken as :Working Capital = Current assets - Current Liabilities

Working Capital turnover ratio indicates the velocity of the utilization of net working
capital. This ratio indicates the number of times the working capital is turned over in the course
of a year.
Working Capital Turnover Ratio=Cost of Sales / Average Working Capital
Average Working Capital = Opening Working Capital+ClosingWorkingCapital \ 2
Working CapitalTurnoverRatio=Cost of Sales (or, Sales) / Net Working Capital
Illustration
Find out working capital turnover ratio:
Rs.
Cash 10,000
Bills Receivables 5,000
Sundry Debtors 25,000
Stocks 20,000
Sundry Creditors 30,000
Cost of Sales 1,50,000
Solution
Working Capital Turnover Ratio = Cost of Sales / Net Working Capital Current assets
=Rs. 10,000 + 5,000 + 25,000 + 20,000
= Rs.60,000
Current liabilities = Rs.30,000
Net working capital = CA - CL = Rs. 60,000 -30,000 = Rs.30,000
So, Working Capital Turnover Ratio = 1,50,000 / 30000 = 5 Times

Illustration
The following information is given about M/s. S.P. Ltd. for the year ending Dec. 31, 2017
1. Stock turnover ratio = 6 times
2. Gross profit ratio = 20% on sales
3. Sales for 2007 =Rs. 3,00,000
4. Closing stock is Rs. 10,000 more than the opening stock
5. Opening creditors = Rs. 20,000
6. Closing creditors =Rs. 30,000
7. Trade debtors at the end = Rs. 60,000
8. Net Working Capital =Rs. 50,000
Find out:
a. Average Stock
b. Creditor Turnover Ratio
c. Purchases
d. Average Collection period
e. Average Payment Period
f. Working Capital Turnover Ratio
Solution:
Cost of goods sold = Sales – Gross Profit
= 300000 - (20% of sales)
= 300000 – 60000
= Rs. 240000
Average Stock:
Stock Turnover Ratio = Cost of goods sold / Average Stock
6 = 240000 / Average Stock
Average Stock = 240000 / 6 = Rs. 40000
Calculation of Purchases:
Cost of goods sold = Opening Stock + purchases – Closing stock
Purchases = Cost of goods sold + Closing Stock - Opening stock
Average Stock = Opening Stock + Closing stock / 2
Since, Closing stock is Rs. 10000 more than the opening stock so, Rs. 40000
= Opening Stock + (Rs. 10000 + opening stock) / 2
Rs. 80000 = 2 Opening stock + Rs. 10000
Opening stock = 70000 / 2 = Rs. 35000
Closing stock = 35000+10000 = Rs.45000
Purchases = 240000 + 45000 + 35000 = Rs.250000
Credit Turnover Ratio = Net annual Credit Purchases / Average Trade Creditors
All purchases are taken as credit purchases = 250000 / (20000+30000 / 2)
Credit turnover ratio = 250000 / 25000 = 10 Times
Average Payment Period = Average Trade Creditors x No. of Working days/ Net Annual
Purchases = 25000 / 250000 x 365 = 36.5 days or 37 days
Average collection period = Average Trade Debtors x No. of Working Days / Net Annual Sales
= 60000 x 365 / 300000 = 73 Days
Working Capital Turnover Ratio = Cost of Goods Sold / Net Working Capital
= 240000 / 50000 = 4.8 times.
ANALYSIS OF LONG-TERM FINANCIAL POSITION OR TESTS OF SOLVENCY
The term 'solvency' refers to the ability of a concern to meet its long term obligations.
The long-term indebtedness of a firm includes debenture holders, financial institutions
providing medium and long-term loans and other creditors selling goods on installment basis.

ANALYSIS OF LONG-TERM FINANCIAL POSITION OR TEST OF SOLVENCY

Capital Structure Ratios
1. Debt-Equity Ratio.
2. Funded-Debt to Total Capitalization Ratio.
3. Proprietary Ratio or Equity Ratio.)
4. Solvency Ratio or Ratio of Total Liabilities to Total Assets.
5. Fixed Assets to Net Worth or Proprietor's Funds Ratio.
DEBT-EQUITY RATIO
Debt-Equity Ratio, also known as External -Internal Equity Ratio is calculated to measure
the relative claims of outsiders and the owners (i.e., shareholders) against the firm's assets. This
ratio indicates the relationship between the external equities or the outsiders funds and the
internal equities or the shareholders' funds, thus:
Debt- Equity Ratio = Outsiders Funds / Shareholders' Funds
or
Debt to Equity Ratio =External Equities / Internal Equities
The two basic components of the ratio are outsiders' funds, i.e., external equities and
share holders’ funds, i.e., internal equities. The outsiders' funds include all debts/liabilities to
outsiders.

Long- termDebt to Shareholders' Funds (Debt-Equity Ratio) = Long term Debt / Shareholders
Illustration
Liabiliti Rs. Assets Rs.
es
2,000 Equity Shares of Rs. 100 each 200000 Fixed Assets 400000
1,000 9% Preference Shares of Rs. 100 each 100000 Current Assets 200000
1,000 10% Debentures of Rs. 100 each 100000
Reserves:
General Reserve 50000
Reserves for contingencies 50000
Current liabilities 100000
Calculate Debt-Equity Ratio.

Solution:
Debt - Equity Ratio = Outsiders‘ Fund / Shareholders‘ Funds
=100000 (Debentures) + 100000(Current Liabilities) / 200000 +100000+
50000+50000
= 200000 / 400000 = 1:2
Debt Equity Ratio = Long term Debt / Shareholder’s Funds
= 100000 / 400000 = 1:4

Interpretation of Debt-Equity Ratio

The debt-equity ratio is calculated to measure the extent to which debt financing has
been used a business. The ratio indicates the proportionate claims of owners and the outsiders
against the firm‘s assets.

PROPRIETORY RATIO OR EQUITY RATIO

A variant to the debt-equity ratio is the proprietary ratio which is also known as equity
ratio or shareholders to total equities ratio or net worth to Total asset ratio. This ratio
establishes the relationship between shareholders‘ funds to total assets of the firm. The ratio of
proprietors‘ funds to total funds proprietors outsiders‘ funds or total funds or total assets is an
important ratio for determining long-term solvency of a firm.

Proprietary Ratio or Equity Ratio = Shareholder‘s Funds / Total Assets

If shareholder's funds are Rs. 4,00,000 and total assets are Rs. 6,00,000. Proprietary Ratio or
Equity Ratio = 400000 / 600000 = 2.3

Interpretation of Equity Ratio

As equity ratio represents the relationship of owner's funds to total assets, higher the
ratio or the share of the shareholders in the total capital of the company, better is the long-
term solvency position of the company.

SOLVENCY RATIO OR THE RATIO OF TOTAL LIABILITIES TO TOTAL ASSETS

This ratio is a small variant of equity ratio and can be simply calculated as 100-equity
ratio, i.e., continuing the example taken for the equity ratio, solvency ratio = 100 - 66.67 or say
33.33%. The ratio indicates the relationship between the total liabilities to outsiders to total
assets of a firm and can be calculated as follows:
Solvency Ratio= Total Liabilities to Outsiders / Total Assets
If the total liabilities to outsiders are Rs. 2,00,000 and total assets are Rs. 6,00,000, then
Solvency Ratio = 200000 / 600000 x 100=33.33%

FIXED ASSETS TO NET WORTH RATIO OR FIXED ASSETS TO PROPRIETOR'S FUNDS:

The ratio establishes the relationship between fixed assets and shareholder's funds, i.e.,
share capital plus reserves, surpluses and retained earnings. The ratio can be calculated as
follows:
Fixed Assets to Net Worth Ratio = Fixed Assets (After Depreciation) / Shareholders’ Funds

Thus, where the deprecated book value of fixed asset is Rs. 400000 and shareholders‘
funds are also Rs. 400000 the ratio of fixed assets to net worth / proprietors‘ funds represented
in terms of percentage would be= 400000 / 400000 x 100 = 100%

ANALYSIS OF PROFITABILITY OR PROFITABILITY RATIOS

The various profitability ratios are discussed below:
(A) GENERAL PROFITABILITY RATIOS

The following ratios are known as general profitability ratios :

1. Gross Profit Ratio
2. Operating Ratio
3. Operating Profit Ratio
4. Expenses Ratio
5. Net Profit Ratio

GROSS PROFIT RATIO

Gross profit ratio measures the relationship of gross profit to net sales and is usually
represented as a percentage. Thus, it is calculated by dividing the gross profit by sales :
Gross Profit Ratio = Gross Profit / Net Sales x 100
= Sales - Cost of Goods Sold / Sales x 100

Illustration
Calculate,
Gross Profit Ratio :
Solution:
Gross Profit Ratio = Gross Profit / Net Sales x 100 Net sales = Total sales – Sales returns
= Rs. 520000 – 20000 = Rs. 500000
Gross Profit = Net Sales – Cost of Goods Sold
500000 -400000 = Rs. 100000
Gross Profit Ratio = 100000 / 500000 x 100 20%

Interpretation of Gross Profit Ratio

The gross profit indicates the extent to which selling prices of goods per unit may
decline without resulting in losses on operations of a firm.

OPERATING RATIO
Operating ratio establishes the relationship between cost of goods sold and other
operating expenses on the one hand and the sales on the other.
Operating Ratio = Operating Cost / Net Sales X 100
= Cost of goods sold + operating expenses / Net sales x 100
Illustration
Find out operating Ratio:
Rs.
Cost of goods sold 350000
Selling and distribution Expenses 20000
Administrative & office Expenses 30000
Net sales 500000
Solution:
OPERATING RATIO = Cost of goods sold + operating expenses / Net sales x 100
= 3,50,000+20,000+30,000 / 500000 X 100
= 400000 / 500000 x 100 = 80%

Interpretation of Operating Ratio

Operating ratio indicates the percentage of net sales that is consumed by operating cost.

OPERATING PROFIT RATIO

This ratio is calculated by dividing operating profit by sales.

Operating profit is calculated as:

Operating Profit = Net Sales-Operating Cost or= Net Sales-(Cost of goods sold +
Administrative and OfficeExpenses + Selling and Distributive Expenses)
Operating Profit can also be calculated as:
Operating Profit = Net Profit + Non-operating Expenses - Non-operating income
So, Operating Profit Ratio = Operating profit / sales x 100
This ratio can also be calculated as:
Operating Profit Ratio = 100-Operating Ratio.

Illustration
From the information given below, calculate operating profit ratio
Cost of Goods Sold = Rs. 4,00,000
Administrative & Office Expenses = Rs. 35,000
Selling & Distributive Expenses =Rs.45,000
Net Sales= Rs. 6,00,000.
Solution:
Operating Profit Ratio= Operating Profit / Net Sales x 100
Operating Profit = Sales - (Cost of goods sold + Administrative Office
expenses+ Selling & Distributive Expenses)
=Rs. 6,00,000-(Rs. 4,00,000+Rs. 35,000+Rs. 45,000)=Rs. 1,20,000
Operating profit ratio = 120000 / 600000 x 100 = 20%
EXPENSES RATIOS
Expenses ratios indicate the relationship of various expenses to net sales. The operating
ratiosare the average total variations in expenses.
Cost of goods soldratio = Particular Expenses / Net Sales x100 Administrative & Office
ExpensesRatio= Administrative & Office Expenses / Sales x 100
Selling&DistributiveExpensesRatio=selling&DistributiveExpenses/Salesx100
 Non-OperatingExpensesRatio = Non-Operating Expenses / Sales x100

NET PROFIT RATIO

Net Profit ratio establishes a relationship between net profit (after taxes) and sales, and
indicates the efficiency of the management m manufacturing, selling, administrative and other
activities of the firm This ratio is the overall measure of firm's profitability and is calculated as:
Net Profit Ratio = Net Profit after Tax / Net Sales x 100
Net profit Ratio = Net Operating Profit / Net Sales x 100

Illustration:
Following is the Profit and Loss Account to Royal Matrix Ltd. for the ended 31st December
2016.
Dr. Rs. Cr. Rs.
To Opening stock 100000 By Sales 560000
To Purchases 350000 By Closing stock 100000
To Wages 9000
To Gross profit c/d 201000
660000 660000
To Administrative expenses 20000 By Gross profit b/d 201000
To Selling and distribution expenses 89000 By Interest on investments 1000
(outside business)
To Non-operating expenses 30000 By ProfitonsalesofInvestments 8000
To Net profit 80000
219000 219000
Calculate:
1. Gross profit Ratio
2. Net profit Ratio
3. Operating Ratio
4. Operating profit Ratio
5. Administrative Expenses Ratio.

Solution:
1. Gross profit = Gross profit / Net sales x 100
= 201000 / 560000 x 100 = 35.9%
2. Net profit ratio = Net profit (after tax) / Net sales x 100
= 80000 / 560000 x 100 = 14.3%
Alternatively,
Net Profit Ratio = Net operating profit /Net sales x 100
= (80000 + 30000) – (10000 + 8000)/ 560000 x 100
= 92000 / 560000 x 100 = 16.4%

3. Operating Ratio = Cost of goods sold + operating Exp. / Net sales

Cost of goods sold = Op. stock + Purchases + Wages - Closing Stock
= 100000+350000 + 9000 – 100000 = Rs. 359000
Operating Expenses = Administrative + Selling & Distribution Exp.
 = 20000 + 89000 = 109000
Operating Ratio = 359000 + 109000 / 560000 x 100 = 83.6%

4. Operating profit Ratio = 100 – Operating Ratio

= 100 – 83.6% = 16.4%

5. Administrative Expenses Ratio = Administrative Expense / Net sales x 100

= 20000 / 560000 x 100 = 3.6%
USE OF RATIO ANALYSIS
The ratio analysis is one of the most powerful tools of financial analysis. It is used as a
device to analyses and interprets the financial health of enterprise. Ratios have wide
applications and are of immense use today.

Managerial Uses of Ratio Analysis

a. Helps in decision-making: Financial statements are prepared primarily for
decision-making.
b. Helps in financial forecasting and planning: Ratio Analysis is of much help in
financial forecasting and planning.
c. 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.
d. Helps in co-ordination: Ratios even help in co-ordination which is of utmost
importance in effective business management.
e. Helps in Control: Ratio analysis even helps in making effective control of the
business.
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 of interest.

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.

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 concerns.

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
financial position of the concerns.

LIMITATIONS OF RATIO ANALYSIS:

Limited Use of a Single Ratio:
"A single ratio, usually, does not convey much of a sense. To make better interpretation
a number of ratios have to be calculated which is likely to confuse the analyst than help making
any meaningful conclusion”.
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.

Inherent Limitations of Accounting:

Like financial statements, ratios also suffer from the inherent weakness of
accounting records such as their historical nature.

Change of Accounting Procedure:

Change in accounting procedure by a firm often makes ratio analysis misleading.

Window Dressing:
Financial statements can easily be window dressed to present a better
picture of its financial and profitability position to outsiders.

Personal Bias:
Ratiosare 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.

Uncomparable:
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.

Absolute Figures Distortive:

Ratios devoid of absolute figures may prove distortive as ratio analysis is
primarily a quantitative analysis and not a qualitative analysis.

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.

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.

Clues not Conclusions:

Ratios provide only clues to analysts and not for conclusions. These ratios
have to be interpreted by these experts and there are no standard rules for
interpretation.
 UNIT ‐ III
Budgets & Budgetary
Control
Practical Problems
(with solutions)
 Flexible Budget

(1) Prepare a Flexible budget for overheads on the basis of the following data. Ascertain the
overhead rates at 50% and 60% capacity.

Variable overheads: At 60% capacity (Rs)

Indirect Material 6,000

Labour 18,000

Semi‐variable overheads:

Electricity: (40% Fixed & 60% variable) 30,000

Repairs: (80% fixed & 20% Variable) 3,000

Fixed overheads:

Depreciation 16,500

Insurance 4,500

Salaries 15,000

Total overheads 93,000

Estimated direct labour hours 1,86,000

Solution:
Flexible Budget

Items Capacity

50% 60%

Variable overheads: Rs. Rs.

Material 5,000 6,000

Labour 15,000 18,000

Semi‐variable

Electricity 27,000 30,000

 Repairs 2,900 3,000

Fixed overheads:

Deprecation 16,500 16,500

Insurance 4500 4500

Salaries 15,000 15,000

Total Overheads 85,900 93,000

Estimated direct labour hours 1,55,000 1,86,000

Overhead Rate 0.55 0.50

Working Note:

Electricity

At 50% capacity = 18,000 * 50

60

= Rs. 15,000

Rs. 12,000 + Rs. 15,000 = Rs. 27,000

60% capacity = Rs 18,000 + Rs. 12,000 = Rs. 30,000

Repairs

For 60% capacity = Rs.600

=Rs. 2400 + Rs.600 =Rs.3,000

At 50% capacity : = 600/60 * 50

= RS. 500

=Rs.2400 + 500

=Rs.2,900
 (2) Prepare a flexible budget for overheads on the basis of the following data. Ascertain the
overhead rates at 60% and 70% capacity.

Variable overheads: At 60% capacity(Rs)

Material 6,000

Labour 18,000

Semi‐variable overheads:

Electricity: 30,000

40% Fixed

60% variable

Repairs:

80% fixed 3,000

20% Variable 3,000

Fixed overheads:

Depreciation 16,500

Insurance 4,500

Salaries 15,000

Total overheads 93,000

Estimated direct labour hours 1,86,000

Solution:

Working:

Repairs

For 60% capacity Fixed 80/100 * 3,000 = Rs.2400

Variable = 20/100 * 3,000 = Rs. 600

=Rs. 2400 + Rs.600 =Rs.3,000

Electricity Exp.:

At 60% capacity Fixed= 40/100 *30,000 = 12,000

Variable = 60/100 * 30,000=

18,000 At 70% capacity: Fixed = 40/100 * 30,000

= Rs. 12,000

Variable = 18,000/60 *70 = Rs. 21,000

Total Rs. =33,000

Flexible Budget

Items Capacity

60% 70%

Variable overheads: Rs. Rs.

Material 6,000 7,000

Labour 18,000 21,000

Semi‐variable

Electricity 30,000 33,000

Repairs 3,000 3,100

Fixed overheads:

Deprecation 16,500 16,500

Insurance 4,500 4,500

Salaries 15,000 15,000

Total Overheads 93,000 1,00,100

Estimated direct labour hours 1,86,000 2,17,000

Overhead Rate 0.50 0.46

 (3) The expenses budgeted for production of 1,000 units in a factory are furnished below:
Particulars Per Unit Rs.

Material Cost 700

Labour Cost 250

Variable overheads 200

Selling expenses (20% fixed) 130

Administrative expenses (Rs. 2,00,000) 200

Total Cost 1,480

Prepare a budget for production of 600 units and 800 units assuming administrative
expenses are rigid for all level of production.

Solution: Flexible Budget

Particulars For 600 units For 800 units

Per unit Rs. Total Rs. Per unit Rs. Total Rs.

Variable Cost:

Materials 700 4,20,000 700 5,60,000

Labour 250 1,50,000 250 2,00,000

Variable overheads 200 1,20,000 200 1,60,000

(A) 1,150 6,90,000 1,150 9,20,000

Semi variable cost:

Variable selling expenses 104 62,400 104 83,200

Fixed selling expenses 43.33 26,000 32.50 26,000

(B) 147.33 88,400 136.50 1,09,200

Fixed cost:

Administrative expenses 333.33 2,00,000 250.00 2,00,000

Total Cost(A+B+C) 1,630.66 9,78,400 1,536.50 12,29,200

(4) The budgeted output of aindustry specializing in the production of a one product at the
optimum capacity of 6,400 units per annum amounts to Rs. 1,76,048 as detailed below:

Particulars Rs. Rs.

Fixed costs 20,688

Variable costs:

Power 1,440

Repairs etc. 1,700

Miscellaneous 540

Direct material 49,280

Direct Labour 1,02,400 1,55,360

Total cost 1,76,048

The company decides to have a flexible budget with a production target of 3,200 and
4,800 units (the actual quantity proposed to be produced being left to a later date
before commencement of the budget period)

Prepare a flexible budget for production levels of 50% and 75%. Assuming, selling price
per unit is maintained at Rs. 40 as at present, indicate the effect on net profit.

Administrative , selling and distribution expenses continue at Rs.3,600.

Solution:

The production at 100% capacity is 6400 units, so it will be 3,200 units at 50% and 4,800
units at75% capacity. The variable expenses will change in that proportion.

Flexible Budget

Particulars 100% 75% 50%

(i)Sales (per unit 2,56,000 1,92,000 1,28,000

Rs.40)

Cost of Sales:
 (a)variable costs:

Direct material 49,280 36,960 24,640

Direct Labour 1,02,400 76,800 51,200

Power 1,440 1,080 720

Repairs 1,700 1,275 850

Miscellaneous 540 405 270

Total variable costs 1,55,360 1,16,520 77,680

(b)Fixed Costs: 20,688 20,688 20,688

(ii) Total Costs 1,76,048 1,37,208 98,368

Gross Profit(i)‐ (ii) 79,952 54,792 29,632

Less: Adm., selling and 3,600 3,600 3,600

Dist. Costs

Net Profit 76,352 51,192 26,032

(5) A factory engaged in manufacturing plastic buckets is working at 40% capacity and produces
10,000 buckets per month.

The present cost break up for one bucket is as under:

Materials

Rs.10Labour

Rs.3

Overheads Rs.5 (60% fixed)

The selling price is Rs.20 per bucket. If it is desired to work the factory at 50%
capacity the selling price falls by 3%. At 90% capacity the selling price falls by 5%
accompanied by a similar fall in the price of material.

You are required to prepare a statement the profit at 50% and 90% capacities and also
calculate the break‐ even points at this capacity production.
Solution

Flexible Budget

Particulars Capacity

40% 50% 90%

Production and sales 10,000 12,500 22,500

units

Sales price per unit 20 19.40 19.00

Sales Amount 2,00,000 2,42,500 4,27,500

Marginal Cost:

Material: Rs.10 per 1,00,000 1,25,000 2,13,750

unit(at 90% ‐ Rs.9.50
per unit)

Labour 30,000 37,500 67,500

Variable overhead 20,000 25,000 45,000

Total 1,50,000 1,87,500 3,26,250

Contribution 50,000 55,000 1,01,250

Less: Fixed Cost 30,000 30,000 30,000

Profit 20,000 25,000 71,250

Contribution per unit 5 4.40 4.50

BEP (units) (F /C) 6,000 6,818 6,667

 CASH BUDGET

(1) Saurashtra Co. Ltd. wishes to arrange overdraft facilities with its bankers from the period August
to October 2010 when it will be manufacturing mostly for stock. Prepare a cash budget for the
above period from the following data given below:

Month Sales Purchases Wages Mfg. Exp. Office Exp. Selling

(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) Exp. (Rs.)

June 1,80,000 1,24,800 12,000 3,000 2,000 2,000

July 1,92,000 1,44,000 14,000 4,000 1,000 4,000

August 1,08,000 2,43,000 11,000 3,000 1,500 2,000

September 1,74,000 2,46,000 12,000 4,500 2,000 5,000

October 1,26,000 2,68,000 15,000 5,000 2,500 4,000

November 1,40,000 2,80,000 17,000 5,500 3,000 4,500

December 1,60,000 3,00,000 18,000 6,000 3,000 5,000

Additional Information:

(a) Cash on hand 1‐08‐2010 Rs.25,000.

(b) 50% of credit sales are realized in the month following the sale and the remaining 50% in
the second month following. Creditors are paid in the month following the month of
purchase.

(c) Lag in payment of manufacturing expenses half month.

(d) Lag in payment of other expenses one month.

Solution:

CASH BUDGET

For 3 months from August to October 2010

Particulars August (Rs.) September (Rs.) October (Rs.)

Receipts:

Opening balance 25,000 44,500 (66,750)

Sales 1,86,000 1,50,000 1,41,000

Total Receipts(A) 2,11,000 1,94,500 74,250

Payments:

Purchases 1,44,000 2,43,000 2,46,000

Wages 14,000 11,000 12,000

Mfg. Exp. 3,500 3,750 4,750

Office Exp. 1,000 1,500 2,000

Selling Exp. 4,000 2,000 5,000

Total payments(B) 1,66,500 2,61,250 2,69,750

Closing Balance(A‐B) 44,500 (66,750) (1,95,500)

Working Note:

1. Manufacturing Expense:

Particular August September October

July (4000/2) 2000 ‐‐‐ ‐‐‐

August (3000/2) 1500 1500 ‐‐‐

September (4500/2) ‐‐‐ 2250 2250

October (5000/2) ‐‐‐ ‐‐‐‐ 2500

Total 3500 3750 4750

 2. Sales

Particular August September October

June (180000/2) 90000 ‐‐‐ ‐‐‐

July (192000/2) 96000 96000 ‐‐‐

August (108000/2) ‐‐‐ 54000 54000

September (174000/2) ‐‐‐ ‐‐‐‐ 87000

Total 186000 150000 141000

(2) S. K. Brothers wish to approach the bankers for temporary overdraft facility for the period from
October 2010 to December 2010. During the period of this period of these three months, the firm
will be manufacturing mostly for stock. You are required to prepare a cash budget for the above
period.

Month Sales (Rs.) Purchases (Rs.) Wages (Rs.)

August 3,60,000 2,49,600 24,000

September 3,84,000 2,88,000 28,000

October 2,16,000 4,86,000 22,000

November 3,48,000 4,92,000 20,000

December 2,52,000 5,36,000 30,000

(a) 50% of credit sales are realized in the month following the sales and remaining 50% in the
second following.

(b) Creditors are paid in the month following the month of purchase

(c) Estimated cash as on 1‐10‐2010 is Rs.50,000.

 CASH BUDGET

For 3 months from October to December 2010

Particulars October (Rs.) November(Rs.) December(Rs.)

Receipts:

Opening balance 50,000 1,12,000 (94,000)

Collection from 3,72,000 3,00,000 2,82,000

Debtors

Total Receipts(A) 4,22,000 4,12,000 1,88,000

Payments:

Payments to 2,88,000 4,86,000 4,92,000

Creditors

Wages 22,000 20,000 30,000

Total payments(B) 3,10,000 5,06000 5,22,000

Closing Balance(A‐B) 1,12,000 (94,000) ‐3,34,000

Working Note : Collection from debtors

Particulars October (Rs.) November(Rs.) December(Rs.)

Sales

August 1,80,000 ‐

September 1,92,000 1,92,000 ‐

October ‐ 1,08,000 1,08,000

November ‐ 1,74,000

3,72,000 3,00,000 2,82,000

(3) TATA Co. Ltd. is to start production on 1st January 2011. The prime cost of a unit is expected to
be Rs. 40 (Rs. 16 per materials and Rs. 24 for labour). In addition, variable expenses per unit are
expected to be Rs. 8 and fixed expenses per month Rs. 30,000. Payment for materials is to be
made in the month following the purchase. One‐third of sales will be for cash and the rest on
credit for settlement in the following month. Expenses are payable in the month in which they
are incurred. The selling price is fixed at Rs. 80 per unit. The number of units to be produced and
sold is expected to be:

January 900; February 1200; March 1800; April 2000; May 2,100 June

2400 Draw a Cash Budget indicating cash requirements from month to

month.

CASH BUDGET of TATA LTD.

For 6 months from January to June 2011
Month Jan. Feb. March April May June

Receipts

Opening Balance (34,800) (37,600) (32,400) (5,867) (27,600)

Cash sales 24,000 32,000 48,000 53,333 56,000 64,000

Collection from 48,000 64,000 96,000 1,06,667 1,12,000

Debtors

Total receipts(A) 24,000 45,200 74,400 1,16,933 1,56,800 1,48,400

Payments

Creditors 14,400 19,200 288,00 32,000 33,600

Wages 21,600 28,800 43,200 48,000 50,400 57,600

Variable Exp. 7,200 9,600 14,400 16,000 16,800 19,200

Fixed Exp. 30,000 30,000 30,000 30,000 30,000 30,000

Total Payment(B) 58,800 82,800 1,06,800 1,22,800 1,29,200 1,40,400

Closing Balance ‐34,800 ‐37600 ‐32400 ‐5867 ‐27,600 8,000

(4) Prepare a Cash Budget from the data given below for a period of six months (July to December)
(1) Month Sales Raw Materials

May 75,000 37,500

June 75,000 37,500

July 1,50,000 52,500

August 2,25,000 3,67,500

September 3,00,000 1,27,500

October 1,50,000 97,500

November 1,50,000 67,500

December 1,37,500

(2) Collection estimates:

 Within the month of sale: 5%

 During the month following the sale: 80%

 During the second month following the sale: 15%

(3) Payment for raw materials is made in the next month.

(4) Salary Rs. 11,250, Lease payment Rs. 3750, Misc. Exp. Rs. 1150, are paid each month

(5) Monthly Depreciation Rs. 15,000

(6) Income tax Rs. 26,250 each in September and December.

(7)Payment for research in October Rs.75,000

(8) Opening Balance on 1st July Rs.55,000.

 CASH BUDGET
For the six months from July to December
Particulars July Aug. Sep. October Nov. December

Receipts

Opening Balance 55,000 80,100 1,53,950 ‐38450 24150 83000

Collection from 78,750 1,42,500 2,17,500 2,81,250 1,725,00 1,49,375

Debtors

Total receipts(A) 1,33,750 2,22,600 3,71,450 2,42,800 1,96,650 2,32,375

Payments

Payment to 37,500 52,500 3,67,500 1,27,500 97,500 67,500

suppliers

Salary 11,250 11,250 11,250 11,250 11,250 11,250

Lease payment 3750 3750 3750 3750 3750 3750

Misc. expense 1,150 1,150 1,150 1,150 1,150 1,150

Income tax 26,250 26,250

Payment for 75,000

Research

Total Payment(B) 53,650 68,650 4,09,900 2,18,650 1,13,650 1,09,900

Closing Balance 80,100 1,53,950 ‐38,450 24,150 83,000 1,22,475

Note: Depreciation is a non‐cash item. It does not involve cash flow. Hence, depreciation will
not beconsidered as payment through cash.
(5) Prepare a cash Budget of R.M.C. LTD. for April, May and June 2012:
Months Sales(Rs.) Purchases(Rs.) Wages(Rs.) Expenses(Rs.)

Jan.(Actual) 80,000 45,000 20,000 5,000

Feb.(Actual) 80,000 40,000 18,000 6,000

March (Actual) 75,000 42,000 22,000 6,000

April (Budget) 90,000 50,000 24,000 7,000

May(Budget) 85,000 45,000 20,000 6,000

June(Budget) 80,000 35,000 18,000 5,000

Additional Information:

(i) 10% of the purchases and 20% of sales are for cash.

(ii) The average collection period of the company is ½ month and the credit purchases are paidregularly after
one month.

(iii) Wages are paid half monthly and the rent of Rs. 500 included in expenses is paid monthly andother
expenses are paid after one month lag.

(iv) Cash balance on April 1,2012 may be assumed to be Rs.15,000

CASH BUDGET

(For the months ending April, May & June 2012)

Particulars April (Rs.) May (Rs.) June (Rs.)

Receipts

Opening Balance 15,000 27,200 35,700

Cash Sales 18,000 17,000 16,000

Collection from 66,000 70,000 66,000

Debtors

Total Receipts(A) 99,000 1,14,200 1,17,700

Payments

Cash Purchases 5,000 4,500 3,500

Payment to creditors 37,800 45,000 40,500

Wages 23,000 22,000 19,000

Rent 500 500 500

Other Exp. 5,500 6,500 5,500

Total Payments(B) 71,800 78,500 69,000

Closing balance 27,200 35,700 48,700

*********************ALL THE BEST***************