3.1.

Funds Flow Analysis

INTRODUCTION :

Every business concern prepares two basic financial statements at the end of accounting period,
namely the Balance Sheet or position Statement and Profit and Loss Account or Income
Statement. Balance Sheet reveals the financial position of the business concern at a certain
point of time. It reveals the financial status of the business concern. The assets side of a Balance
Sheet shows the deployment of resources of an undertaking while the liabilities side indicates
its obligations i.e., the manner in which these resources obtained. The Profit and Loss Account
or Income Statement reveals the net results of operations over a period of time i.e., how much
profit was earned (or loss sustained) by the business enterprise during the accounting period.

The Balance Sheet provides only a static view of the business. It is a statement of assets and
liabilities on a particular date. It does not show the movement of funds. In business concerns,
funds flow from different sources and similarly funds are invested in various sources of
investment. It is a continuous process. The study and control of this funds flow process is the
main objective of financial management to assess the soundness and solvency of a business tell
little about its flow of funds, i.e., financing and investing activities over the related period. Like
the Balance Sheet, even the Profit and Loss Account does not depict the changes that have
taken place in financial condition of a business concern between two dates. Hence there is a
need to prepare an additional statement to know the changes in assets, liabilities and owners’
equity between dates of two Balance Sheets. Such a statement is called Funds Flow Statement
or Statement of Sources and uses of funds or where come and where gone statement.

The funds flow statement, which is also known as the Statement of Changes in financial position,
is yet another tool of analysis of financial statements.
MEANING AND CONCEPTS OF FUNDS :
Funds Flow Statement is a widely used tool in the hands of financial executives for analysing
the financial performance of a business concern. Funds keep on moving in a business which
itself is based on a going concern concept.
The term Funds has a variety of meanings.
(a) In a narrow sense - In a narrow sense fund means only cash. Funds Flow Statement prepared
on this basis is called as Cash Flow Statement. In this type of statement only in flow and outflow
of cash is taken into account.
(b) In a broader sense - In a broader sense the term fund refers to money value in whatever
form it may exist. Here funds mean all financial resources in the form of men, materials, money,
machinery etc.
(c) Popular sense - In a popular sense the term funds means Working Capital I.e., the excess of
current assets over current liabilities. When the funds move inwards or outwards they cause a
flow or rotation of funds. Here the word fund means net working capital. In short, if funds
mean working capital, then the statement prepared on the basis is called Funds Flow Statement.
The concepts of funds as working capital is the most popular one and in this chapter we shall
refer to fund working capital and a funds flow statement as a statement of sources and
application of funds.
MEANING AND DEFINITION OF FUNDS FLOW STATEMENT :
Funds Flow Statement is prepared to study the changes in the financial position of a business
over a period of time generally one year. Funds Flow Statement reveals both inflow and outflow
of funds. The inflow of funds is known as sources of the funds and the outflow of funds means
uses or application of the funds. Funds flow statement is also known as Statement of sources
and Applications of funds or where got-where gone statement. Funds Flow Statement highlights
and changes in the financial structure of an undertaking. It determines the financial
consequences of business operations.
Funds Flow Statement gives detailed analysis of changes in distribution of resources between
two Balance Sheet dates. This statement is widely used by the financial analysists and credit
granting institutions and financial and financial managers in performing their jobs. Thus, Funds,
Flow Statement, in general is able to present that information which either is not available or
not readily apparent from an analysis of other financial statements.
Definitions
A statement of sources and application of funds is a technical device designed to analyse the
changes in the financial condition of a business enterprise between two dates. - Foulke
Funds Flow Statement describes the sources from which additional funds were derived and
the use to which these sources were put. - Anthony
A statement of changes in financial position or statement of sources and application of funds
in which element of net income and working capital contribution to an understanding of the
whole of financial operations during the reporting period replace totals of these items. -
Kotler
A statement either prospective or retrospective, setting out the sources and applications of the
funds of an enterprise. The purpose of the statement is to indicate clearly the requirements of
funds and how they are proposed to be raised and the efficient utilisation and application of
the same.
FUNDS FLOW STATEMENT - POSITION IN INDIA :
The Funds Flow Statement is now regarded as an important part of financial reporting. The
necessity of this statement is now undoubtedly realised by all owners, managements, investors
and others. In India, though the funds flow statement or statement of changes in financial
position has not so far become a part of the financial reporting, banks and financial institutions
are insisting when a company approaches them for loans.
In India, under the existing legal requirements, companies are under no legal obligation to
publish a statement of changes in financial position along with their financial statement.
However there is a growing practice to publish such statement along with financial statement
especially in the case of companies listed on the stock exchanges and other large commercial,
industrial and business concerns in the public and private sectors.
SIGNIFICANCE, IMPORTANCE AND USES OF FUNDS FLOW STATEMENT :
Funds flow statement is prepared to know the changes in assets, liabilities and owners equity
between dates of two Balance Sheets. It is a statement of sources and uses of funds. Funds Flow
Statement is also known as Statement of Sources and Application of funds or movement of
Funds Statement etc.
Funds flow statement reveals both inflow and outflow of funds. The inflow of funds is known
as Sources of the funds and the outflow of funds means uses or Application of the funds.
In other words Financial Statement gives detailed analysis of changes in the distribution of
resources between two dates.
It is very useful tool in the financial managers analytical kit. It provides a summary of
management decisions on financing activities of the firm and investment policy. The following
are the advantages of Funds Flow Statement.
1. Analysis of financial operations - The Funds Flow Statement reveals the net affect of
various transactions on the operational and financial position of the business concern. It
determines the financial consequences of business operations. This statement discloses
the causes for changes in the assets and liabilities between two different points of time. It
highlights the effect of these changes on the liquidity position of the company.
2. Financial policies - Funds Flow Statement guides the management in formulating the
financial policies such as dividend, reserve etc.

347
IT
3. Control device - It serves as a measure of control to the management. If actual figures are
compared with budgeted/projected figures, management can take remedial action if there
are any deviations.
4. Evaluation of firm’s financing - Funds Flow Statement helps in evaluating the firm’s
financing. It shows how the funds were obtained from various sources and used in the
past. Based on this, the financial manager can take corrective action.
5. Acts as a future guide - Funds Flow Statement acts as a guide for future, to the management.
It helps the management to know various problems it is going to face in near future for
want of funds.
6. Appraising the use of working capital - Funds Flow Statement helps the management in
knowing how effectively the working capital put into use.
7. Reveals financial soundness - Funds Flow Statement reveals the financial soundness of
the business to the creditors, banks, financial institutions.
8. Changes in working capital - Funds Flow Statement highlights the changes in working
capital. This helps the management in framing its investment policy.
9. Assessing the degree of risk - Funds Flow Statement helps the bankers, creditors, financial
institutions in assessing the degree of risk involved in granting the credit to the business
concern.
10. Net results - This statement reveals the net results of operations during the year in terms
of cash.
National Association of Accountants (NAA)-National Association of Accountants states the
following uses of Funds Flow Statement :
(i) Estimating the amount of funds needed for growth.
(ii) Improving the rate of income on assets.
(iii) Planning the temporary investment of idle funds.
(iv) Securing additional working capital when needed.
(v) Securing economies in the centralised management of cash in organisation whose
management is centralised.
(vi) Planning the payment of dividends to shareholders and interest to creditors.
(vii) Easing the effects of an insufficient cash balance.
Limitations of Funds Flow Statement
The following are the important limitations of Funds Flow Statement
1. Funds Flow Statement is not a substitute of Income Statement or a Balance Sheet. It
furnished only some additional information as regards changes in working capital.
348

2. This statement lacks originality. It is simply rearrangement of data appearing in account

books.
3. It indicates only the past changes. It can not reveal continuous changes.
4. When both the aspects of the transaction are current, they are not considered.
5. When both the aspects of the transaction are non-current, even then they are not included
in funds flow statement.
6. Some Management Accountants are of the opinion that this statement is not ideal tool for
financial analysis.
7. Funds Flow Statement is historic in nature. Hence this projected funds flow statement
cannot be prepared with much accuracy.
Sources of Funds

1. Issue of share capital - If there is any increase in share capital it denotes issue of additional
shares during the period. Issue of shares is a source of funds as it constitutes inflow of
funds. Even calls received on partly paid shares constitute an inflow of funds. If shares are
issued at premium, the premium will also become a source of fund.
Note - If shares are issued and allotted for other than cash, consideration do not generate
fund.
2. Issue of debentures of long term loans - Issue of debentures, accepting public deposits,
and raising long term loans results in the flow of funds.
Note - If debentures like shares have been allotted to some body other than cash,
consideration do not generate fund.
3. Sale of fixed assets or long term investments - When any fixed asset like Land, Building,
Machinery, Furniture on long term investments etc. are sold, it generate funds and becomes
a source of funds.
4. Non-trading income - Any non-trading receipts like dividends, rent, interest etc.,

5. Decrease in working capital - If working capital is decreased during the accounting period,
when compared with previous period, it denotes release of funds from working capital
and it constitutes a source of funds.
APPLICATION OR USE OF FUNDS:
1. Redemption of preference share capital - If there is any decrease in preference share capital
during current year, when compared with previous year, we must assume that the
preference shares are redeemed. It results in the outflow of funds and is taken as Application
of funds.
2. Redemption of debentures - If any debentures are redeemed during the account period, it
constitute application of funds.
OST-VOLUME-PROFIT ANALYSIS

3. Repayment of long-term loans - Repayment of long-term loan also constitute an application

of funds.
4. Purchase of fixed assets or long term investments - If any fixed assets like land, buildings,
furniture, long-term investments etc., are purchased for cash, funds outflow from the
business.
Note - If any fixed asset is purchased for a consideration of issue of shares or debentures,
it does not involve any funds and hence not an application of funds.
5. Non-trading payment - Payment of dividends and tax etc. reduce the working capital and
is an application of funds. Mere declaration of dividend or creating a provision for taxation,
do not be treated as an outflow of funds.
6. Any other non-trading payment - Any payment or expense not related to the trading
operations of the business amounts to outflow of funds and also taken as application of
funds.
7. Funds lost in operations - If there is any loss during the accounting period, it amounts to
loss of funds in operations. Such loss of funds in trading operations treated as outflow of
funds.
CASH FLOW STATEMENT :
To underline the importance of Funds Flow Statement the Institute of Chartered Accountants
of India (ICAI) issued in June 1981 Accounting Standard - 3 dealing with the preparation of Statement
of changes in financial position during a particular period. While preparing this statement the term
funds was defined as Cash and Cash equipments or working capital. The main purpose of preparing
the Funds Flow Statement is to provide a meaningful link between the Balance Sheet at the
beginning and at the end of period and the Profit and Loss Account for the period.
In spite of its importance Accounting Standard - 3 suffers from the following limitations.
1. Accounting Standard - 3 did not provide any standard format for the preparation of Funds
Flow Statement.
2. When Funds Flow Statement is prepared on cash basis, it did not disclose cash flows from
operating, investing and financial activities separately. It nearly provided information regarding
inflows and outflows of funds.
3. Accounting Standard - 3 allowed considerable flexibility regarding the meaning of the
term Funds. As a result some business concerns prepared this statement on working capital
basis, whereas others prepared it on cash basis. However most of the business firms prepared
this statement on working capital basis. Working capital includes items like inventories
and prepaid expenses which are not easily convertible into cash within a short period. Further
these items do not contribute to the ability of the firm to pay the short term obligations as
and when they become due.
Due to these limitations there was a need for cash flow statement prepared in standard format.
The Financial Accounting Standard Board, U.S.A. also stressed the need of preparing the cash flow
statement in standard form.
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In June 1995 the Securities and Exchange Board of India (SEBI) amended clause 32 of the listing agreement
requiring every listed company to submit along with Balance sheet and Profit and Loss Account, a Cash
Flow Statement prepared in the prescribed format showing separately cash flow from operating activities,
investing activities and financing activities.
Recognizing the importance of cash flow statement, the Institute of Chartered Accountants of
India issued Accounting Standard - 3 Revised in March 1997. This revised accounting standard
supercedes Accounting Standard-3 changes in financial position issued in 1981.
Revised Accounting Standard - 3 has given the objectives of the Cash Flow Statement are as
under.
Information about the cash flows of an enterprise is useful in providing users of financial
statements with a basis to assess the ability of the enterprise to generate cash and cash
equivalents and the needs of enterprises to utilize those cash flows. The economic decisions
that are taken by users require an evaluation of the ability of an enterprise to generate cash and
cash equivalents and the timing and certainty of their generation.
This statement deals with the provision of information about the historical changes in cash
and cash equivalents of an enterprise by means of a cash flow statement which classified cash
flows during the period from operating, investing and financing activities.
Meaning - Cash Flow Statement reveals the causes of changes in cash position of business
concern between two dates of Balance Sheets. According to Accounting Standard - 3 (Revised)
an enterprise should prepare a cash flow statement and should present it for each period with
financial statements prepared. AS-3 (Revised) has also given the meaning of the words cash,
cash equivalent and cash flows.
1. Cash - This includes cash on hand and demand deposits with banks.
2. Cash equivalents - This includes purely short term and highly liquid investments which are
readily convertible into cash and which are subject to an insignificant risk of changes in
value. Therefore an investment normally qualifies as a cash equivalent only when it has a
short maturity, of say three months or less.
3. Cash flows - This includes inflows and outflows of cash and cash equivalents. If the
effect of transaction results in the increase of cash and its equivalents, it is called an inflow
(source) and if it results in the decrease of total cash, it is known as outflow (use cash of).
Classification Of Cash Flows
According to AS-3 (Revised) cash flows are classified into three main categories:
1. Cash flows from operating activities.
2. Cash flows from investing activities.
3. Cash flows from financing activities.
1. Cash flows from operating activities - Operating activities are the principal revenue-
producing activities of the enterprise and other activities that are not investing or financing
activities.

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 OST-VOLUME-PROFIT ANALYSIS

The amount of cash flows arising from operating activities is a key indicator of the extent to
which the operations of the enterprise have generated sufficient cash flows to maintain the
operating capability of the enterprise, pay dividends, repay loans, and make new investments
without recourse to external sources of financing.
Cash flows from operating activities are primarily derived from the principal revenue-producing
activities of the enterprise. The following are the important operating activities.
(i) Cash receipts from the sale of goods and the rendering of services.

(ii) Cash receipts from royalties, fees, commissions and other revenue.

(iii) Cash payments to suppliers for goods and services.

(iv) Cash payments to and on behalf employees.

(v) Cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities and other policy benefits,
(vi) Cash payments or refunds of income taxes unless they can be specifically identified
with financing and investing activities and
(vii) Cash receipts and payments relating to future contracts, forward contracts, option
contracts and swap contracts when the contracts are held for dealing or trading purposes.
(viii) Some transactions such as the sale of an item of plant, may give rise to a gain or loss
which is included in the determination of net profit or loss. However, the cash flows
relating to such transactions are cash flows from investing activities.
An enterprise may hold securities and loans for dealing or trading purposes, in which case
they are similar to inventory acquired specifically for sale. Therefore, cash flows arising from
the purchase and sale of dealing or trading activities are classified as operating activities.
Similarly cash advances and loans made by financial enterprises are usually classified as
operating activities since they relate to the main revenue producing activity of that enterprise.
2. Cash flows from investing activities - Investing activities are the acquisition and disposal
of long-term assets and other investments not included in cash equivalents. The separate
disclosure of cash flows arising from investing activities is important because the cash
flows represent the extent to which expenditures have been made for resources intended
to generate future income and cash flows.
Examples of cash flows arising from investing activities are
(i) Cash payments to acquire fixed assets (including intangibles). These payments include
those relating to capitalised research & development costs and self constructed fixed assets.
(ii) Cash receipts from disposal of fixed assets (including intangibles)
(iii) Cash payments to acquire shares, warrants, or debt instruments of other enterprises and
interests in joint ventures.

352
(iv) Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises
and interests in joint venture.
(v) Cash advances and loans made to third parties (other than advances and loans made by
a financial enterprise).
(vi) Cash receipts from the repayment of advances and loans made to third parties (other
than advances and loans of a financial enterprise).
(vii) Cash payments for future contracts, forward contracts, option contracts, and swap contracts
except when the contracts are held for dealing or trading purposes or the payments are
classified as financing activities and
(viii) Cash receipts from future contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading purpose, or the receipts are
classified as financing activities.
When a contract is accounted for as a hedge of an identifiable position, the cash flows of
the contract are classified in the same manner as the cash flows of the position being
hedged.
3. Cash flows from financing activities - Financing activities are activities that result in
changes in the size and composition of the owners capital (including preference share capital in
the case of a company) and borrowing of the enterprise.
The separate disclosure of cash flows arising from financing activities is imporant because
it is useful in predicting claims on future cash flows by providers of funds (both capital
and borrowing) to the enterprise.
Examples Of Cash Flows Arising From Financing Activities Are
(a) Cash proceeds from issuing shares or other similar instruments.
(b) Cash proceeds from issuing debentures, notes, bonds and other short-or long-term
borrowings and
(c) Cash repayments of amounts borrowed such as redemption of debentures, bonds,
preference shares.
Treatment of some typical items - AS - 3 (Revised) has also provided for the treatment of cash
flows from some peculiar items as discussed below :
1. Extraordinary Items - The cash flows associated with extraordinary items should be
classified as arising from operating, investing or financing activities as appropriate and
separately disclosed in the cash flows statement to enable users to understand their nature
and effect on the present and future cash flows of the enterprise.

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 COST-VOLUME-PROFIT ANALYSIS

2. Interest and Dividends - Cash flows from interest and dividends received and paid should
be disclosed separately. Further, the total amount of interest paid during the period should
be disclosed in the cash flow statement whether it has been recognised as an expense in
the statement of profit and loss or capitalised. The treatment of interest and dividends
received and paid depends upon the nature of the enterprise. For this purpose, the
enterprises are classified as (i) Financial enterprises, and (ii) Other enterprises.
(i) Financial enterprises - In the case of financial enterprises, cash flows arising from
interest paid and interest and dividend received should be classified as cash flows
arising from operating activities.
(ii) Other enterprises - In the case of other enterprises, cash flows arising from interest
paid should be classified as cash flows from financing activities while interest and
dividends received should be classified as cash flows from investing activities.
Dividends paid should be classified as cash flows from financing activities.
3. Taxes on income - Cash flows arising from taxes on income should be separately disclosed
and should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities.
Taxes on income arise on transactions that give rise to cash flows that are classified as operating
investing or financing activities in a cash flows statement. While tax expense may be readily
identifiable with investing or financing activities, the related tax cash flows are often
impracticable to identify and may arise in a different period from the cash flows of the underlying
transactions. Therefore, taxes paid are usually classified as cash flows from operating activities.
However, when it is practicable to identify the tax cash flow with an individual transaction
that gives rise to cash flows that are classified as investing or financing activities the tax cash
flow is classified as an investing or financing activity as appropriate. When tax cash flows are
allocated to ever more than one class of activity, the total amount of taxes paid is disclosed.
4. Acquisitions and disposals of subsidiaries and other business units - The aggregate
cash flows arising from acquisitions and from disposals of subsidiaries or other business
units should be presented separately and classified as investing activities. An enterprise
should disclose, in aggregate in respect of both acquisition and disposal of subsidiaries or
other business units during the period each of the following:
(i) The total purchase or disposal consideration and
(ii) The portion of the purchase or disposal consideration discharged by means of cash
and cash equivalents.
The separate presentation of the cash flow effects of acquisitions and disposals of subsidiaries
and other business units as single line items helps to distinguish those cash flows from other
cash flows, the cash flow effects of disposals are not deducted from those of acquisitions.
5. Foreign currency cash flows - Cash flows arising from transactions in a foreign currency
should be recorded in an enterprise’s reporting currency by applying to the foreign
currency amount the exchange rate between the reporting currency and the foreign

354
 currency at the date of the cash flow. A rate that approximates the actual rate may be used
if the result is substantially the same as would arise if the rates at the dates of the cash
flows were used. The effect of changes in exchange rates on cash and cash equivalents
held in a foreign currency should be reported as a separate part of the reconciliation of
the changes in cash and cash equivalents during the period.
Unrealised gains and losses arising from changes in foreign exchange rates are not cash
flows. However, the effect of exchange rate changes on cash and equivalents held or due
in a foreign currency is reported in the cash flow statement in order to reconcile cash and
cash equivalents at the beginning and the end of the period. This amount is presented
separately from cash flows from operating, investing and financing activities and includes
the difference, if any had those cash flows been reported at the end of period exchange
rates.
6. Non-cash transactions - Many investing and financing activities do not have a direct
impact on current cash flows although they do affect the capital and asset structure of an
enterprise. Examples of non-cash transactions are :
(a) The acquisition of assets by assuming directly related activities.
(b) The acquisition of an enterprise by means of issue of shares; and
(c) The conversion of debt to equity.
Investing and financing transactions that do not require the use of cash or cash equivalents
should be excluded from a cash flow statement. Such transactions should be disclosed elsewhere
in the financial statements in a way that provides all the relevant information about these
investing and financing activities.
Methods of Calculating Cash flows (Used in) Operating Activities
There are two methods of reporting cash flows from operating activities namely (1) Direct
Method and (2) Indirect Method.
1. The Direct Method - Under the direct method, cash receipts (inflows) from operating
revenues and cash payments (outflows) for operating expenses are calculated to arrive at
cash flows from operating activities. The difference between the cash receipts and cash
payments is the net cash flow provided by (or used in) operating activities. The following
are the examples of cash receipts and cash payments (called cash flows) resulting from
operating activities :
(a) Cash receipts from the sale of goods and the rendering of services.
(b) Cash receipts from royalties, fees commissions and other revenues
(c) Cash payment to suppliers for goods and services
(d) Cash payment to and on behalf of employees.
(e) Cash receipts and cash payment of an insurance enterprise for premiums and claims
annuities and other policy benefits.
COST-VOLUME-PROFIT ANALYSIS

(f) Cash payments or refund of income taxes unless they can be specifically indentified
with financing and investing activities and
(g) Cash receipts and payments relating to future contracts, forward contracts, option
contracts and swap contracts when the contracts are held for dealing or trading
purposes.
(h) The formation about major classes of gross cash receipts and gross cash payments
may be obtained either:
(i) From accounting records of the enterprise; or
(ii) By adjusting sales, cost of sales (interest and similar income and interest expense
and similar charges for a financial enterprise) and other items in the statement
of profit and loss for;
(i) Changes during the period in inventories and operating receivables and payables,
(j) Other non-cash items, and

(k) Other items for which the cash effects are investing or financing cash flows.

Format of Cash Flows Statement - AS-3 (Revised) has not provided any specific format for
preparing a cash flows statement. However, an idea of the suggested format can be inferred
from the illustrations appearing in the appendices to the accounting standard. The cash flow
statement should report cash flows during the period classified by operating, investing and
financing activities; a widely used format of cash flow statement is given below:
Cash Flow Statement (for the year ended.....)
Particulars Rs. Rs.
Cash Flows from Operating Activities
Cash receipts from customers xxx
Cash paid to suppliers and employees (xxx)
Cash generated from operations xxx
Income tax paid (xx)
Cash flow before extraordinary items xxx
Extraordinary items xxx
Net cash from (used in) Operating activities xxx
(Or)
Net profit before tax and extraordinary items xxx
Adjustments for non-cash and non-operating items
(List of individual items such as depreciation,
foreign exchange loss, loss on sale of fixed assets,
interest income, dividend income, interest expense etc.) xxx

356
Fianancial Management & international finance
 Rs. Rs.
Particulars xxx
Operating profit before working capital changes
Adjustments for changes in current assets and current liabilities
xxx
(List of individual items) xxx
Cash generated from (used in) operations before tax xxx
Income tax paid xxx
Cash flow before extraordinary items xxx
Extraordinary items (such as refund of tax) xxx
Net Cash from (used in) Operating activities
Cash Flows from Investing Activities
Individual items of cash inflows and xxx
outflows from financing activities
(such as purchase/sale of fixed assets, purchase
or sale of investments,
xxx
interest received, dividend received etc.
xxx
Net cash from (used in) investing activities
Cash Flows from Financing Activities
Individual items of cash inflows and outflows xxx
from financing activities
(such as) proceeds from issue of shares, long-term
borrowings, repayments
of long-term borrowings, interest paid, dividend paid etc.) xxx xxx
Net increase/ (decrease) in cash and cash equivalents xxx
Cash and cash equivalents at the beginning of the period xxx
Cash and cash equivalents at the end of the period xxx

357
Format of Cash Flow Statement approved by Sebi is given below:
Cash Flow Statement
(for the year ended.....)
Particulars
(A) Cash Flow from operating activities Rs. Rs.

Net Profit / Loss before tax and extraordinary items

Adjustments for :
Depreciation
Gain / Loss on sale of fixed assets
Foreign exchange
Miscellaneous expenditure written off
Investment income
Interest
Dividend
Operating profit before working capital changes
Adjustments for :
Trade and other receivables
Inventories
Trade payables
Cash generated from operations
Interest paid
Direct taxes paid
Cash flow before items extraordinary items
Net cash from operating activities
(B) Cash Flow from investing activities
Purchase of fixed assets
Sales of fixed assets
Purchase of investments
Sale of investments
Interest received
Dividend received
Net cash from / used in investing activities

358
 (C) Cash flow from financing activities
Proceeds from issue of share capital
Proceeds from long-term borrowings/banks
Payment of long-term borrowings
Dividend paid
Net cash from / used in financing activities xxx
Net increase / (decrease) in cash and cash equivalents xxx
Cash and cash equivalents as at... (Opening Balance) xxx
Cash and cash equivalent as at.... (Closing Balance) xxx

2.The Indirect Method - Under the indirect method, the net cash flow from operating activities is
determined by adjusting net profit or loss for the effect of :
(a) Non-cash items such as depreciation, provisions, deferred taxes, and unrealised foreign
exchange gains and losses’ and
(b) Changes during the period in inventories and operating receivables and payables.
(c) All other items for which the cash effects are investing or financing cash flows.
The indirect method is also called reconciliation method as it involves reconciliation of net
profit or loss as given in the profit and loss account and the net cash flow from operating
activities as shown in the cash flow statement. In other words, net profit or losses adjusted for
non-cash and non-operating items which may have been debited or credited to profit and loss
account as follows.
Calculation of Cash Flow From Operating Activities

Particulars Rs. Rs.

Cash Flows from Operating activities
Cash receipts from customers xxx
Cash paid to suppliers and employees (xxx)
Cash generated from operations xxx
Income tax paid (xx)
Cash flow before extraordinary items xxx
Extraordinary items xxx
Net cash from (used in) Operating activities xxx
(Or)

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COST-VOLUME-PROFIT ANALYSIS

Particulars Rs. Rs.

Net profit before tax and extraordinary items xxx
Add : Non-cash and non-operating items which have already been debited
to P.L. Account
(a) Depreciation xxx
(b) Transfer to reserves and provisions xxx
(c) Goodwill written off xxx
(d) Preliminary expenses written off xxx
(e) Other intangible assets written off such as discount or loss on
issue of shares / debentures, underwriting commission etc. xxx
(f) Loss on sale or disposal of fixed assets xxx
(g) Loss on sale of investments xxx
(h) Foreign exchange loss xxx
Less : Non-cash and non-operating items xxx xxx
which have already been credited to P.L. Account
(a) Gain on sale of fixed assets xxx
(b) Profit on sale of investments xxx
(c) Income from interest or dividends on investments xxx
(d) Appreciation xxx
(e) Reserves written back xxx
(f) Foreign exchange gain xxx xxx
xxx
Operating Profit Before Working Capital Changes
Adjustments for changes in current operating assets and liabilities:
Add : Decrease in Accounts of Current Operating Assets
(except cash and cash equivalents) such as :
Decrease in trade debts xxx
Decrease in bills receivables xxx
Decrease in inventories / stock-in-trade xxx
Decrease in prepaid expenses etc. xxx
Add : Increase in accounts of current operating liabilities
(except Bank overdraft) such as :
Increase in creditors xxx
Increase in bills payable xxx
Increase in outstanding expenses xxx xxx
xxxx

360
 Particulars Rs. Rs.
Less : Increase in accounts of current operating assets
(as stated above) xxx
xxx
Less : Decrease in accounts of current operating liabilities
(as stated above) xxx
xxx xxx
Cash generated from (used in) operations before tax xxx
Less : Income tax paid xxx
Cash flows before extraordinary items xxx
Add / Less : Extraordinary items if any xxx
Net cash flow from (used in) operating activities xxx
Important note to Students

1. An increase in liability Cash inflow

2. A decrease in liability Outflow of cash
3. An increase in an asset Outflow of cash
4. A decrease in an asset Cash inflow
Need of Preparing Cash flow Statement

Funds Flow Statement highlights the changes that have taken place in the financial structure
of the business concern since the last reporting date. In other words Funds Flow Statement
takes into account the inflow and outflow of funds in terms of working capital, during the
period under consideration. Funds Flow Statement did not reveal the quantum of inflow and
outflow of cash. In short it did not explain the changes in cash balance.
The cash plays an important role in the business firm’s economic life. What blood is to human
body, cash is to business enterprise. Therefore, the major responsibility of financial manage-
ment of the business firm is to maintain adequate cash in the business is one of the prerequi-
sites for successful operation. A business firm needs cash to make payments for purchase of
goods or raw materials, to meet day to day expenses and to pay salaries, wages, interest and
dividends etc. The movement of cash is of vital importance to management. If the inflows of
cash are not sufficient to meet the outflows of cash, the firm cannot meet its current obliga-
tions. Hence the need of proper planning and control of cash flow arises. Cash constitutes the
basic foundation of all business transactions without which the other components of current
assets have little significance. Hence there is a need for cash analysis. For analysis of cash, a
separate statement is to be prepared known as cash flow statement.
In a narrow sense the term Funds means cash and the statement of changes in the financial
position prepared on cash basis is called a Cash Flow Statement.

361
 Cash Flow Statement is a statement of cash flow. Cash flow studies the movements of cash in
and out of a business concern. Inflow of cash is known as source and outflow of cash is called
use of cash. The term Cash here stands for cash and bank balance.
Cash Flow Statement shows the changes in cash position between two Balance Sheet dates. It
provides the details in respect of cash generated through operating, investing and financial
activities and utilised for operating, investing and financial activities. The transactions which
increase the cash position of the business are known as Inflows of cash (ex : Sale of current and
fixed assets, Issue of shares and debentures etc.) The transactions which decrease the cash
position are known as outflows (ex : Purchase of current and fixed assets, redemption of de-
bentures, and preference shares and other long term debts). Cash Flow Statement concentrates
on transactions that have a direct impact on cash. This statement depicts factors responsible
for such inflow and out of flow of cash. In brief, cash flow statement summaries the causes of
changes in cash position between dates of two balance sheets.
1. Cash Flow Statement reveals the causes of changes in cash balances between two bal-
ance sheet dates.
2. This statement helps the management to evaluate its ability to meet its obligations i.e.,
payment to creditors, the payment of bank loan, payment of interest, taxes, dividend etc.
3. It throws light on causes for poor liquidity in spite of good profits and excessive liquid-
ity in spite of heavy losses.
4. It helps the management in understanding the past behaviour of cash cycle and in con-
trolling the use of cash in future.
5. Cash Flow Statements helps the management in planning repayment of loans, replace-
ment of assets etc.
6. This statement is helpful in short-term financial decisions relating to liquidity.
7. This statement helps the management in preparing the cash budgets properly.
8. This statement helps the financial institution who lends advances to business concerns
in estimating their repaying capacities.
9. Since a Cash Flow Statement is based on the cash basis of accounting it is very useful in
evaluation of cash position of a firm.
10. Cash Flow Statement discloses the complete story of cash movement. The increase in, or
decrease of cash and the reason therefore can be known.
11. Cash Flow Statement provides information of all activities such as operating, investing,
and financing activities separately.
12. Since Cash Flow Statement provides information regarding the sources and utilisation
of cash during a particular period, it is easy for the management to plan carefully for the
cash requirements in the future, for the purpose of redeeming long-term liabilities or /
and replacing some fixed assets.

362
13. A projected Cash Flow Statement reveals the future cash position of a concern. Through
this cash flow statement the firm can know how much cash it can generate and how
much cash will be needed to make various payments.
14. Cash Flow Statement prepared according the AS-3 (Revised) is more suitable for mak-
ing comparison than the funds flow statements as there is no standard formats used for
the same.
Limitations of Cash Flow Statement
Cash Flow Statement suffers from the following limitations.
1. A Cash Flow Statement only reveals the inflow and outflow of cash. The cash balance
disclosed by the Cash Flow Statement may not represent the real liquid position of the
concern.
2. Cash Flow Statement is not suitable for judging the profitability of a firm as non-cash
changes are ignored while calculating cash flows from operating activities.
3. Cash Flow Statement is not a substitute for Income Statement or Funds Flow Statement.
Each of them has a separate function to perform. Net Cash Flow disclosed by cash flow
statement does not necessarily be the net income of the business, because net income is
determined by taking into account both cash and non-cash items.
4. Cash Flow Statement is based on cash accounting. It ignores the basic accounting con-
cept of and accrual basis.
5. Cash Flow Statement reveals the movement of cash only. In preparation it ignores most
liquid current assets (ex: Sundry debtors, Bills Receivable etc.)
6. It is difficult to precisely define the term cash. There are controversies among accoun-
tants over a number of near cash items like cheques, stamps, postal orders etc., to be
included in cash.
7. Cash Flow Statement does not give a complete picture of financial position of the con-
cern.

363
COST-VOLUME-PROFIT ANALYSIS

Differences Between Funds Flow Statement And Cash Flow Statement

The following are the main differences between a Funds Flow Statement and a Cash
Flow Statement.

Funds Flow Statement Cash Flow Statement

1. Funds Flow Statement reveals the change Cash Flow Statement reveals the changes in
in working capital between two balance cash position between two balance sheet
sheet dates dates.

2. Funds Flow Statement is based on Cash Flow Statement is based on cash basis
accounting of accounting

3. In the case of Funds Flow Statement a No such schedule of changes in working

schedule of changes in working capital is capital is prepared for a Cash Flow
prepared. Statement.

4. Funds Flow Statement is useful in Cash Flow Statement as a tool of financial

planning, Intermediate and long term analysis is more useful for short-term
financing. analysis and cash planning.

5. Funds Flow Statement deals with all Cash Flow Statement deals only with cash
components of working capital. and cash equivalents.

6. Funds Flow Statement reveals the sources Cash Flow Statement is prepared by taking
and application of funds. The difference into consideration the inflows and outflows
represents net increase or decrease in in terms of operating, investing and
working capital. financing activities. The net difference
represents the net increase or decrease in
cash and cash equivalents.

364 Fianancial Management & international finance

PROBLEMS AND SOLUTIONS
Illustration 1
The following are the balance sheets of the Andhra Industrial Corporation Ltd. as on 31st
December 2006 and 2007.
BALANCE SHEET
Assets: 2006 2007
Fixed Assets: Property 1,48,500 1,44,250
Machinery 1,12,950 1,26,200
Goodwill —— 10,000
Current Assets: Stock 1,10,000 92,000
Trade Debtors 86,160 69,430
Cash at Bank 1,500 11,000
Pre-payments 3,370 1,000
4,62,480 4,53,880
Liabilities:
Shareholders funds: Paid up Capital 2,20,000 2,70,000
Reserves 30,000 40,000
Profit and Loss Account 39,690 41,220
Current Liabilities: Creditors 39,000 41,660
Bills Payable 33,790 11,000
Bank Overdraft 60,000 ——
Provision for taxation 40,000 50,000
4,62,480 4,53,880
During the year ended 31st December, 2007, a divided of Rs.26,000 was paid and assets of
another company were purchased for Rs.50,000 payable in fully paid-up shares. such assets
purchased were:
Stock Rs.21,640; Machinery Rs.18,360; and goodwill Rs.10,000. In addition Plant at a cost of
Rs.5,650 was purchased during the year; depreci-ation on property Rs.4,250; on Machinery
Rs.10,760. Income tax during the year amounting to Rs.28,770 was charged to provision for
taxation. Net profit for the year before tax was Rs.76,300.
Prepare a statement of changes in Financial Position of the Co.
Solution
Funds Flow Statement
Sources Applications
Issue of shares for stock 21640 increase in working capital 52530
Funds from operation 91310 purchase of machinery 5650
tax paid 28770
dividend paid 26000
112950 112950

365
COST-VOLUME-PROFIT ANALYSIS

Working notes no 1:
Provision for tax Account
To cash paid 28770 By P&L a/c (b/f) 38770
To balance c/d 50000 By balance b/d 40000
78770 78770

Working notes no 2: Verification of P & L A/c Balance

1. Opening P & L a/c 39690

(+) net profit as per P & L a/c 76300
(-) provision for tax 38770
37530
(-) dividend 26000
(-) transfer to reserve 10000
Retained 1530
Profit at the end of the year 41220

Working notes no. 3: Changes in working capital

Opening Closing
Current assets :
Stock 110000 92000
Debtors 86160 69430
Cash 1500 11000
Prepaid 3370 1000
201030 173430
Current liabilities
Creditors 39000 41660
Bills payable 33790 11000
Overdraft 60000 ________
132790 52660
Net working capital 68240 120770
Increase in working capital 52530

366
Working notes no. 4: Depreciation provided during the year
On property 4250
On machinery 10760
15010

Working notes no. 5: Purchase/sale of fixed assets

Property Machinery
WDV opening 148500 112950
(-) depreciation 4250 10760
102190
(+) purchases Nil 18360 (by issue of shares)
5650 (by cash)
WDV at the end 144250 126200

Working notes no. 6:

P & L adjustment a/c

To depreciation 15010 By balance b/d 39690
To dividend 26000 By funds from operations(b/f) 91310
To transfer to reserve 10000
To provision for tax 38770
To balance c/d 41220
131000 131000

Illustration 2
From the fallowing figures, prepare a statement showing the changes in the working capital
and funds flow statement during the year 2007.

ASSETS: Dec.31, 2006 Dec.31, 2007.

Fixed Assets (net) Rs. 5,10,000 6,20,000
Investments 30,000 80,000
Current Assets 2,40,000 3,75,000
Discount on debentures 10,000 5,000
7,90,000 10,80,000

367
 Liabilities:
Equity share capital
Preference share capital
3,00,000 3,50,000
Debentures
2,00,000 1,00,000
Reserves
1,00,000 2,00,000
Provision for doubtful debts
1,10,000 2,70,000
Current liabilities
10,000 15,000
70,000 1,45,000
You are informed that during the year: 7,90,000 10,80,000
a. A machine costing Rs.70,000 book value Rs.40,000 was disposed of for Rs.25,000.
b. Preference share redemption was carried out at a premium of 5% and
c. Dividend at 15% was paid on equity shares for the year 2006.

Further:
1. The provision for depreciation stood at Rs.1,50,000 on 31.12.06 and at Rs.1,90,000
on 31.12.07; and
2. Stock which was valued at Rs.90,000 as on 31.12.06; was written up to its cost,
Rs.1,00,000 for preparing profit and loss account for the year 2007.
Solution
Funds Flow Statement
Sources Applications
Sale of fixed assets 25000 Increase in working capital 50000
Funds from operation 295000 Purchase of fixed assets 220000
Issue of shares 50000 Purchase of investments 50000
Debentures 100000 Redemption of preference shares 105000
Dividend paid 45000
470000 470000

Working note No. 1: Changes in working capital

2006 2007
Current assets 240000 375000
(+) Stock under valued 10000
250000 375000
Current liabilities 70000 145000
Net working capital 180000 230000
Increase in working capital 50000

368
Working note No. 2: Depreciation

Opening Provision 150000

(-) provided on sale of asset 30000
120000
(+) provided during the year (b/f) 70000
Closing provision 190000
Working note No. 3: Purchase & sale of fixed assets
Opening (2007) 510000
(-) sold 40000
470000
(-) depreciation provided 70000
400000
(+) purchases (b/f) 220000
Closing 2007 620000
Working note No. 4:
P&L adjustment a/c
To depreciation 70000 By balance b/d (110000+10000) 120000
To Loss on sale of fixed assets 15000 By funds from operations 295000
To loss on redemption of shares 5000
To discount written off 5000
To provision for R.B.D 5000
To dividend 45000
To balance c/d 270000
415000 415000

Illustration 3
The directors of Chintamani Ltd. present you with the Balance sheets as on 30th June, 2006
and 2007 and ask you to prepare statements which will show them what has happened to the
money which came into the business during the year 2007.
Liabilities: 30.6.06 30.6.07
Authorised capital 15,000 shares of Rs.100 each 15,00,000 15,00,000
Paid up capital 10,00,000 14,00,000
Debentures (2007) 4,00,000 ———
General Reserve 60,000 40,000
P & L Appropriation A/c 36,000 38,000
Provision for the purpose of final dividends 78,000 72,000

369
 Sundry Trade Creditors
Bank Overdraft
Bills Payable 76,000 1,12,000
Loans on Mortgage 69,260 1,29,780
40,000 38,000
Assets: —— 5,60,000
Land & Freehold Buildings 17,59,260 23,89,780
Machinery and Plant
Fixtures and Fittings 9,00,000 9,76,000
Cash in hand 1,44,000 5,94,000
Sundry Debtors 6,000 5,500
Bills Receivable 1,560 1,280
Stock 1,25,600 1,04,400
Prepayments 7,600 6,400
Share in other companies 2,44,000 2,38,000
Goodwill 4,500 6,200
Preliminary expenses 80,000 2,34,000
2,40,000 2,20,000
You are given the following additional information: 6,000 4,000
17,59,260 23,89,780
a. Depreciation has been charged (i) on Freehold Buildings @ 2½% p.a. on cost Rs.10,00,000.
(ii) on Machinery and plant Rs.32,000 (iii) on Fixtures and Fittings @5% on cost,
Rs.10,000. No depreciation has been written off on newly acquired Building and Plant
and Machinery.
b. A piece of land costing Rs.1,00,000 was sold in 2007 for Rs.2,50,000. The sale proceeds
were was credited to Land and Buildings.
c. Shares in other companies were purchased and dividends amounting to Rs.6,000
declared out of profits made prior to purchase has received and use to write down the
investment (shares).
d. Goodwill has been written down against General Reserve.
e. The proposed dividend for the year ended 30th June 2006 was paid and, in additions,
an interim dividend, Rs.52,000 was paid.
Solution
Funds Flow Statement
Sources Applications
Decrease in working capital 121500 Purchase of land and building 351000
Sale proceed of land 250000 Purchase of plant and machinery 482000
Dividend received 6000 Purchase of shares 160000
Issue of shares 400000 Redemption of debentures 400000
Loan 560000 Dividends for 2006 paid 78000
Funds from operations 185500 Interim dividend paid 52000
1523000 1523000

370
Working note No. 1: Changes in working capital

2006 2007
Current assets
Cash 1560 1280
Debtors 125600 104400
Bills receivable 7600 6400
Prepaid 4500 6200
Stock 244000 238000
383260 356280
Current liabilities
Creditors 76000 112000
Overdraft 69260 129780
Bills payable 40000 38000
185260 279780
Working capital 198000 76500
Decrease in working capital 121500
Working note No. 2:
Depreciation
On buildings 25000
On plant & machinery 32000
On furniture & fittings 500
57500
Working note No. 3: Purchase or sale of fixed assets / Investments:
Land and buildings:
2006 (WDV) 900000
(-) depreciation 25000
875000
(-) land sold 100000
775000
(+) purchases (b/f) 351000
1126000
(-) loss on sale 150000
2007(WDV) 976000

371
COST-VOLUME-PROFIT ANALYSIS

Plant & machinery:

WDV 144000
(-) depreciation 32000
112000
(+) purchase (b/f) 482000
594000
Investments:
2006 80000
(-) dividend in capital nature 6000
74000
(+) purchases (b/f) 160000
2007 234000
Working note No. 4:
P & L adjustment a/c
To depreciation 57500 by balance b/d 36000
To dividend proposed 72000 by funds from operation (b/f) 185500
To preliminary expenses written off 2000
To interim dividend 52000
To balance c/d 38000
221500 221500

Illustration 4
The following are the summarised balance sheets of A Limited as on 31st December.

2003 2004 2003 2004

6% Preference shares Fixed assets at
redeemable 2000-06 at 10% 1,00,000 80,000 cost 2,40,070 2,53,730
premium
Ordinary shares 75,000 1,20,000 Less: Dep. 90,020 98,480
Plant replacement reserve 15,000 10,000 1,50,050 1,55,250
Profit & Loss A/c 1,00,350 1,02,700 Subsidiary co.
shares at cost 61,000 76,000
6% Debentures ——- 40,000 Stock 98,000 1,04,000
Bank Loan 22,000 —— Debtors 88,000 85,000
Creditors accruals 84,450 75,550 Cash 11,750 32,000
Proposed ordinary dividends 12,000 24,000
4,08,800 4,52,250 4,08,800 4,52,250

372
You are to ascertain that during 2004
a. Rs.25,000 part of un-appropriated balance on profit and loss account was capitalized
and applied in paying up Rs.0.25 per share on the issued ordinary shares making them
fully paid up.
b. ON 31st December 20,000 preference shares were redeemed at the specified premium
out of the proceed of a right issue of 20,000 new ordinary shares issued for cash at Rs.1
per share. The premium was written off to profit and loss account.
c. The movement on plant replacement reserve represents a transfer to profit and loss
account.
d. The ordinary dividend for the year 2003 was paid in addition to interim dividend on
the ordinary shares thus absorbing Rs.4,000. The preference dividend was paid on 31st
December in each year.
e. In regard to fixed assets (i) Rs.3,000 was added to the book value of a property following
a revalua-tion, and credited to profit and loss account (ii) expenditure totaling Rs.1,700
which at 31-12-2003 had been carried forward in suspense (included in “debtors”) was
transferred to fixed assets. (iii) depreciation of fixed assets of Rs.13,260 was charge to
profit and loss account, and (iv) plant (cost Rs.6,000 depreciation provided Rs.4,800)was
sold for Rs.250 and the loss written off to profit and loss account.
f. The increase in the investment in the subsidiary company represents the cost of
additional shares purchased during the year. You are required to prepare a statement
showing the sources and applications of fund during the year.
Solution
Funds Flow Statement
Sources Applications
Sale proceeds of fixed asset 250 Increase in working capital 33850
Issue of ordinary shares 20000 Purchase of
Issue of Debentures 40000 fixed assets 14960
Funds from operations 69560 investments 15000
Redemption of preference shares 22000
Bank loan repaid 22000
Dividends paid (2003) 12000
Interim dividend paid 4000
Preference dividend 6000
129810 129810

373
COST-VOLUME-PROFIT ANALYSIS

Working note No. 1: Changes in working capital

2003 2004
Current assets
Stock 98000 104000
Debtors 86300 85000
Cash 11750 32000
196050 221000
Current liabilities:
Creditors 84450 75550
Working capital 111600 145450
Increase in working capital 33850

Working note No. 2: Depreciation

Fixed assets 13260
Accumulated dep (2003) 90020
(+) provided 13260
103280
(-) provided on plant sold 4800
Closing 2004 98480

Working note No. 3: Purchase or sale of fixed assets and investments:

Fixed assets (WDV) 150050
(-) Depreciation provided 13260
136790
(-)WDV of asset sold 1200
135590
(+) profit on revaluation 3000
138590
(+) capital expenditure 1700
140290
(+) additions (b/f) 14960
155250
Shares 2003 61000
(+) purchased (b/f) 15000
Closing 2004 76000

374
Working note No. 4:
P& L adjustment a/c
To depreciation 13260 by balance b/d 100350
To premium on redemption of by transfer from reserve 5000
Preference shares 2000 by profit on revaluation 3000
To bonus shares 25000 by funds from operation 69560
To proposed dividend 24000
To Interim dividend 4000
To preference dividend 6000
To loss on sale of plant 950
To balance c/d 102700
177910 177910
Illustration 5
The following is the Balance Sheet of ABC Ltd.,
(Rs. in lakhs)
As at As at As at As at
30.6.08 Liabilities 30.6.09 30.6.08 Assets 30.6.09
10.00 Share Capital (Equity shares of
Rs.100 each) 20.00 13.00 Plant 18.00
7.50 10% redeemable shares of Rs.100 each 2.50 8.00 Stock 9.50
0.50 Share premium 0.25 15.00 Debtors 14.50
0.00 Cap. Red. Reserve 5.00 3.00 Bank Balance 2.50
8.00 Reserve 4.50 1.00 Miscellaneous 1.00
3.00 P & L A/c 5.00
5.00 Provision for taxation 6.00
6.00 Current Liabilities 2.25
40.00 45.50 40.00 45.50
The following further information is furnished:-
a. The Company declared a dividend of 20% for the year ended 30th June 2008 to equity
shareholders on 30th September, 2008. Dividend on preference share capital for the
year ended 30th June, 2008 was paid on 30th June, 2008.
b. The company issued notice to preference shareholders holding preference shares of
the face value of Rs.5 lakhs for redemption at a premium of 5% on 1st December, 2008
and the entire proceedings were completed before 31-12-2008 in accordance with the
law.

Fianancial Management & international finance 375

 c. The company provided depreciation at 10% on the closing balance of plant. During the
year one plant whose book value was Rs.2,00,000 was sold at a loss of Rs.30,000.
d. Miscellaneous expenditure incurred during the year ended 30th June 2009 Rs.25,000
for share issue and other expenses.
e. A sum of Rs.4 lakhs has been provided for taxation during the year.
Prepare statement of sources and application of funds for the year ended 30th June, 2003.
Also prepare a statement showing changes in working capital.

Solution
Funds Flow Statement
Sources Applications
Sale of fixed assets 170000 Increase in working capital 425000
Funds from operations 1255000 Purchase of fixed assets 900000
Issue of equity 1000000 Redemption preference shares 525000
Tax paid 300000
Dividend 2002 200000
Preference dividend 2003 50000
Miscellaneous expenditure 25000
2425000 2425000

Working note No. 1: Changes in working capital

2008 2009
Current assets
Stock 800000 950000
Debtors 1500000 1450000
Bank 300000 250000
2600000 2650000
Current liabilities 600000 225000
Working capital 2000000 2425000
Increase in working capital 425000

Working note No. 2: Depreciation

WDV of fixed assets @ 90 % 1800000

For 100 % 2000000
Therefore depreciation provided 200000

376
 Working note No. 3: Purchase or sale of fixed assets

Fixed assets 1300000

(-) depreciation 200000
(-) book value of asset sold 200000
900000
(+) additions (b/f) 900000
1800000

Working note No. 4: P & L adjustment a/c

To depreciation 200000 By balance b/d 300000
To transfer to reserve 150000 By funds from operations (b/f) 1255000
(950000- 800000)
To provision for tax 400000
To miscellaneous expenditure 25000
written off
To loss on sale of assets 30000
To equity dividend 2002 200000
To preference dividend 2003 50000
To balance c/d 500000
1555000 1555000

Illustration 6

The summarised balance sheet of Ex Ltd., as on 31st December, 2007 and 2008 are as follows:
Liabilities 31-12-07 31-12-08 Assets 31-12-07 31-12-08
Share Capital 3,00,000 4,00,000 Fixed Assets:
Capital Reserve —— 10,000 Cost 8,00,000 9,50,000
General Reserve 1,70,000 2,00,000 Less: Dep. 2,30,000 2,90,000
Profit & Loss Account 60,000 75,000 5,70,000 6,60,000
Debentures 2,00,000 1,40,000 Trade Investments 1,00,000 80,000
Liabilities for goods &
services 1,20,000 1,30,000 Current Assets 2,80,000 3,30,000
Provision for Income tax 90,000 85,000 Preliminary
Expenses 20,000 10,000
Proposed Dividends 30,000 36,000
Unpaid Dividend —- 4,000
9,70,000 10,80,000 9,70,000 10,80,000

377
During 2008, the Company:
1. Sold one machine for Rs.25,000 the cost of the machine was Rs.50,000 and the
depreciation provided on it amounted to Rs.21,000.
2. Provided Rs.95,000 as depreciation.
3. Redeemed 30% of Debentures @103.
4. Sold some trade investments at a profit credited to capital reserve.
5. Decided to value the stock at cost where as previously the practice was to value stock
at cost less 10%. The stock according to books on 31-12-07 was Rs.54,000, the stock on
30.12.08 was Rs.75,000 was correctly valued at cost.
You are required to prepare the statement of sources and application of funds during 2008.
Solution
Funds Flow Statement

Sources Applications
Sale of fixed assets 25000 Increase in working capital 34000
Sale of investments 30000 Purchase of fixed assets 214000
Funds from operation 270800 Dividend paid 26000
Issue of shares 100000 Redemption of debentures 61800
Tax paid 90000
4258000 425800

Working note No. 1: Changes in working capital

2005 2006
Current assets
Under valued Stock 280000 330000
6000
286000 330000
Current liabilities:
Goods and services 120000 130000
Working capital 166000 200000
Increase in working capital 34000

378
Working note No. 2: Depreciation

2007 230000
(+) provided 95000
325000
(-) depreciation on asset sold 21000
304000
(-) depreciation on asset discarded 14000
290000

Working note No. 3: Purchase or sale of fixed assets and investments

=> Fixed assets 2007 800000
(-) cost of asset sold 50000
(-) cost of asset discarded 14000
736000
(+) additions (b/f) 214000
Closing 2008 950000
=> Trade investments(2007) 100000
(-) cost of investment sold 20000
2008 80000
Sale proceed of investments 30000

Working note No. 4:

P & L adjustment a/c
To depreciation 95000 by balance b/d 66000
To reserve 30000 by funds from operation (b/f) 270800
To premium on redemption 1800
(6000) x 30%To tax provision 85000
To proposed dividend 36000
To preliminary expense written off 10000
To loss on sale of machinery 4000
To balance c/d 75000
336800 336800

379
COST-VOLUME-PROFIT ANALYSIS

Illustration 7
From the following Balance Sheet of M/s Anu Ltd. as on 31-12-07 and Fund Flow Statement
for the year ended 31-12-08. You are required to prepare the Balance Sheet of M/s Anu Ltd. as
on 31-12.08.
BALANCE SHEET AS ON 31-12-07
Liabilities Rs. Assets Rs.
Equity Share Capital 2,00,000 Free hold land at cost 60,000
8% Preference Share Capital 50,000 Plant & Machinery, at cost 2,50,000
Share Premium 10,000 Stock 50,000
General Reserve 25,000 Sundry Debtors 22,000
P & L appropriation A/c 20,000 Cash and Bank 15,000
Provision for Depreciation on
Plant & Machinery A/c 60,000
Provision for Taxation 10,000
Sundry Creditors 22,000
3,97,000 3,97,000

FUNDS FLOW STATEMENT FOR THE YEAR ENDED 31-12-04

Sources Applications
Net profit as per P & L A/c 26,000 i) Redemption of 8% Pref. Shares at
a premium of 10% 55,000
Add-back non fund charges: ii) Purchase of Machinery 1,30,000
Dep. on plant & Machinery 40,000 iii) Purchase of Furniture 24,000
Loss on sale of Machinery 5,000 iv) Appropriation of Current
year’s Net Profit for ‘Provision
for Taxation’ 9,000
71,000 v) Increase in Working Capital 13,000
Less: Profit on sale of land 10,000
61,000
ii) Issue of Equity Shares at
a premium of 5% 1,05,000
iii) Sale of Machinery 25,000
iv) Sale of Land 40,000
2,31,000 2,31,000

380
Notes:
a) The actual amount of Tax paid and charged to provision for Taxation account was
Rs.9,000
b) The accumulated Depreciation on Machine sold on the date of sale was Rs.15,000
c) Furniture was purchased on 31-12-08.
d) The total of Current Assets on 31-12-08 was Rs. 1,10,000. Stock, Debtors and Bank were
in the ratio of 8:2:1.
Solution
Balance sheet as on 31 – 12 -2008

Liabilities Assets
Equity share capital 300000 Land 60000
(-) cost of land sold 30000 30000
Share premium 10000 10000 Plant & machinery 259000
(+) on equity 5000 (+)Purchases 130000
(-) on preference 5000 (-) cost of machine sold 45000
(-) depreciation 85000 250000
General reserve 25000 Stock 80000
P & L appropriation 46000 Debtors 20000
(-) tax provision 9000 37000
Provision for tax 10000 Bank 10000
Creditors 32000 Furniture 24000
414000 414000

Working note No. 1: Changes in Working Capital

2007 2008
Current assets 87000 110000
Current liabilities 22000 32000
Working capital 65000 78000
Increase in working capital 13000

381
COST-VOLUME-PROFIT ANALYSIS

Illustration 8
Balance Sheet of X Ltd. as at 31-3-08
Rs. in lakhs
Equity Share Capital (Rs.10 Share) 10 Land & Buildings 4
10% Pref. Share Capital 1 Plant and machinery 10
General Reserve 3 Investment in subsidiary shares 3
Investment Allowance Reserve 2 Stock 6
Capital Redemption Reserve 1 Debtors 6
P & L A/c 2 Less: Provision 0.3 5.7
12% Bonds 4 Marketable Securities 1.5
Creditors 3 Cash and bank 2
Tax provision 5 Prepaid expenses 0.3
Proposed equity Dividend 2 Discount on shares 0.5
33 33
Projected profit and loss a/c for the year ended on 31-3-09
Rs. in lakhs
To Opening Stock 6 By Sales 40
To Purchases 20 By closing stock 8
To Wages 3 By Income from investment 1
To Factory expenses 5 By Profit on sale of plant (WDV 2) 1
To Admn. & Selling exp 2 By profit on sale trade investments (cost 1) 1
To Interest 0.48
To Depreciation:
Building 0.2
Plant 1
To Provision for doubtful
debts 0.1
To tax provision 6
Add: past year’s short
provision 1 7
To Pref. Dividend 0.1
To proposed equity dividend 1.5
To Prem. on redemption of
Pref. Shares 0.1
To General reserve 1
To Investment allowance
reserve 1.5
To Capital redemption
reserve 1
To discount on shares 0.1
To Net profit c/d 0.92
51 51

382
The following further data re also available.
1. Summary of fixed assets (Rs. lakhs):
As at 31.3.2008 As at 31.3.2009
Cost (Plant) 14 (Projected) 14.90
Accumulated depreciation 4 4.90
Cost (Building) 5 6.00
Accumulated depreciation 1 1.20
2. Preference share capital was redeemed at the beginning of 2008-09 at a premium of 10%.
3. Debtors velocity is five times and provision for doubtful debts is 5%.
4. Suppliers allow 72 days’ credit on an average.
5. Wages and all expenses are paid 15 days in arrears.
6. Prepaid expenses as on 31-3-09 are expected to be Rs.0.50 lakhs.
Required: 1) Projected balanced sheet as at 31-3-09. (2) Funds flow state-ment. (3) Cash Flow
statement (Indirect Method)
Solution
1) PROJECTED BALANCE SHEET AS ON 31- 3 -2009
Rs in Rs in
Lakhs Lakhs
Equity share capital 10.000 Land and buildings 6
(-)depreciation 1.2 4.800
10%pref share capital 1
(-) redeemed 1 Plant and machinery 14.9
(-) depreciation 4.9 10.000
General reserve 3
(+) provided 1 4.000 Investment in subsidiary 3
(-) sold 1 2.000
Investment allowance 2 Stock 8.000
(+) transfer 1.5 3.500
Capital redemption
reserve 1 Debtors 8
(+) transfers 1 2.000 (-) RBD 0.4 7.600
P & L a/c 2
(+) current year profit 0.92 2.920 Marketable securities 1.500
12% bonds 4.000 Cash and bank (b/f) 3.537
Creditors [20(72 / 360)] 4.000 Prepaid expenses 0.500
Tax provision 6.000 Discount on shares 0.5
(-) write off 0.1 0.400
Proposed equity dividend
[10 x (15 / 100)] 1.500
o/s wages and expenses 0.417
38.337 38.337

383
COST-VOLUME-PROFIT ANALYSIS

2) FUNDS FLOW STATEMENT:

Sources Applications
Sale proceeds of plant 3.00 Increase in working capital 4.22
Sale proceeds of investments 2.00 Purchase of plant 3.00
FFO 11.42 Purchase of building 1.00
Income from investments 1.00 Redemption of PSC 1.10
Tax paid 6.00
Equity dividend paid 2.00
Preference dividend paid 0.10
17.42 17.42

3) CASH FLOW STATEMENT (INDIRECT METHOD):

Cash from operational activities:

cash from operations before tax 9.217
(-) tax paid 6.000 3.217
Cash from investment activities:
Purchase of plant (3)
Purchase of building (1)
Sale of plant 3
Sale proceeds of investments 2
Income from investments 1 2.000
Cash from financial activities:
Redemption of preference share capital (1.1)
Dividend paid : preference (0.1)
Equity (2.0)
Interest paid (0.48) (3.68)
Cash generated during the year 1.537
(+) opening balance 2.000
Closing cash balance 3.537

384
Working Notes No. 1
l changes in working capital:
1998 1999
Current assets:
Stock 6.00 8.00
Debtors 5.70 7.60
Marketable securities 1.50 1.50
Cash and bank balance 2.00 3.53
Prepaid expenses 15.5 21.13
15.5 21.13
Current liabilities:
Creditors 3.00 4.00
o/s wages and expenses 0.41
3.00 4.41
Working capital 12.5 16.72
Increase in working capital 4.22

Working Notes No. 2

l Depreciation as per P&L a/c on building 0.20
On plant 1.00
1.20
Working Notes No. 3
l Plant:
Accumulated depreciation at the beginning 4.00
(+) provided 1.00
5.00
(-) accumulated depreciation on asset sold 0.10
4.90
l Purchase of building = Rs100000

Working Notes No. 4

l Plant at the beginning 14.00
(-) cost of plant sold 2.10
11.90
(+) purchases 3.00
14.90

385
COST-VOLUME-PROFIT ANALYSIS

Working Notes No. 5

Computation of FFO:

NP as per P & L a/c 0.92

(+) depreciation 1.20
Tax provision 7.00
Preference dividend 0.10
Proposed equity dividend 1.50
Premium on redemption of pref share capital 0.10
Transfer to general reserve 1.00
Investment allowance reserve 1.50
Capital redemption reserve 1.00
Discount on shares written off 0.10 13.50
14.42
(-) income from investments 1.00
Profit on sale of plant 1.00
Profit on sale of trade investments 1.00 3.00
11.42
Working Notes No. 6
l Cash from operations:
FFO 11.420
(+) interest 0.480
Increase in creditors 1.000
o/s wages 0.417 1.897
13.317
(-) increase in stock 2.000
Increase in debtors 1.900
Increase in prepaid expenses 0.200 4.100
9.217

386
 3.2. Ratio Analysis
This Section includes:

l Significance and Classification of Ratios

l Advantages of Ratio Analysis

l Limitation of Accounting Ratios

l DUPONT Control Chart

l Difficulties in DU PONT Analysis

INTRODUCTION :
Accounting ratios are relationships expressed in mathematical terms between figures which
are connected with each other in some manner. Obviously, no purpose will be served by
comparing two sets of figures which are not at all connected with each other. Over the past
few years, financial ratios have been subjected to empirical analysis to find their other uses.

CLASSIFICATION OF RATIOS : Ratios can be classified as

Classification in View of
Financial Analysis

Profitability Ratios Activity Ratios Solvency Ratios

Long Term Short Term

A) In Relation to Sales 1. Inventory Turnover
Solvency Ratios Solvency Ratios
1. Gross profit Ratio Ratio
2. Operating Ratio 2. Debtors Turnover
3. Operating Profit Ratio Ratio 1. Debt Equity Ratio 1. Current Ratio
4. Net Profit Ratio 3. Creditors Turnover 2. Liquidity Ratio
2. Proprietary Ratio
5. Expense Ratio Ratio 3. Interest Coverage
3. Fixed Assets Ratio
B) In Relation to Investment 4. Fixed Assets Turnover Ratio
4. Capital Gearing
1. Return on Investment Ratio 4. Absolute Liquid
Ratio
2. Return on Equity Ratio
5. Working Capital
Shareholders Fund Turnover Ratio
3. Return on Total 6. Capital Turnover
Resources Ratio

387
COST-VOLUME-PROFIT ANALYSIS

1. Profitability Ratios
These ratios give an indication of the efficiency with which the operations of business are
carried on. The following are the important profitability ratios:
(i) Overall Profitability Ratio
This is also called as Return on Investment (ROI) or Return on Capital Employed
(ROCE) ratio. It indicates the percentage of return on the total capital employed in the
business. It is calculated as follows:
ROI = Operating Profit/Capital Employed
The term ‘Operating Profit’ means “profit before interest and tax while the term ‘capital
employed’ refer to the sum-total of long-term funds employed in the business.
Significance of ROI. ROI measures the profit which a firm earns on investing a unit
of capital. It is desirable to ascertain this periodically. The profit being the net result of
all operations, ROI, expresses all efficiencies or inefficiencies of a business collectively.
Thus, it is a dependable measure for judging the overall efficiency or inefficiency of
the business.
(ii) Price Earning Ratio (PER)
This ratio indicates the number of times the earning per share is covered by its market
price. It is calculated as follows:
Market Price Per Equity Share
PER = Earning Per Share
For example, if the market price of an equity share is Rs.20 and earning per share is Rs.5, the
price earning ratio will be 4 (i.e., 20 + 5). This means for every one rupee of earning people are
prepared to pay Rs.4. In other words, the rate of return expected by the investors is 25%
Significance. PER helps the investors in deciding whether to buy or not to buy the shares of a
company at a particular price. For Instance, in the example given, if the EPS falls to Rs.3, the
market price of the share should be Rs. 12 (i.e. 3 x 4). In case the market price of the share is Rs.
15, it will not be advisable to purchase the company’s shares at that price.
(iii) Gross Profit Ratio (GPR)
This ratio expresses the relationship between gross profit and net sales. It can be computed as
follows:
Significance. The ratio indicates the overall limit within which a business must manage its
operating expenses. It also helps in ascertaining whether the average percentage of mark-up
on the goods is maintained.

388
(iv) Net Profit Ratio (NPR)
The ratio indicates net margin earned on a sale of Rs. 100. It is calculated as follows:

NPR =NetProfit×100
Net Sales
Significance. The ratio helps in determining the efficiency with which the affairs of a business
are being managed. Constant increase in the above ratio year after year is a definite indication
of improving conditions of the business.
(v) Operating Ratio
This ratio is a complementary of net profit ratio. In case the net profit ratio is 20%, the operat-
ing ratio will be 80%. It is calculated as follows:

Operating Ratio = Operating Cost×100

Net Sales
Operating cost includes cost of direct materials, direct labour, direct expenses and all overheads.
Financial charges such as interest, provision for taxation, etc. are not to be included in operat-
ing cost.
Significance. The ratio is the test of the operational efficiency with which the business has
carried on. The operating ratio should be low enough to leave a portion of sales for giving a fair
return to the investors.
(vi) Fixed Charges Cover Ratio (FCCR)
The ratio indicates the number of times the fixed financial charges are covered by income
before interest and tax. This ratio is calculated as follows:

FCCR = Income before Interest and Tax

Interest
Significance. The ratio is significant from the lender’s point of view. It indicates whether the
business would earn sufficient profits to pay periodically the interest charges. Higher the ratio,
better it is.
(vii) Pay-out Ratio
The ratio indicates what proportion of earning per share has been used for paying dividend. It
can be calculated as follows:

− = Dividend per equity share

Pay out Ratio Earning per equity share

389
COST-VOLUME-PROFIT ANALYSIS

Significance. The ratio is an indicator of the amount of earnings that have ploughed back in
the business. The lower the pay-out ratio, the higher will be the amount of earnings ploughed
back in the business. A lower pay-out ratio means a stronger financial position of the com-
pany.
(vii) Dividend Yield Ratio (DYR)
The ratio is calculated by comparing the rate of dividend per share with its market value. It is
calculated as follows:
Divident Per Share
DYR = × 100
Market Price Per Share
Significance. The ratio helps an intending investor in knowing the effective return he is going
to get on his investment. For example, if the market price of a share is Rs. 25, paid-up value is
Rs.10 and dividend rate is 20%. The dividend yield ratio is 8 % (i.e. 100 x 2/25). The intending
investor can now decide whether it will be advisable for him to go for purchasing the shares of
the company or not at the price prevailing in the market.
2. Turnover Ratios
These ratios indicate the efficiency with which capital employed is rotated in the business. The
various turnover ratios are as follows:
(i) Over-all Turnover Ratio
The ratio indicates the number of times the capital employed has been rotated in the
process of doing a business. The ratio is computed as follows:

Overall Turnover Ratio = Net Sales

Capital Employed
Significance. The overall profitability of a business depends on two factors, viz, (a) the
profit margin, and (b)turnover. The profit margin is disclosed by the net profit ratio
while the turnover is indicated by the overall turnover ratio. A business with a lower
profit margin can achieve a higher ROI if its turnover is high. This is the reason for
wholesalers earning a larger return on their investment even when they have a lower
profit margin. A business should not, therefore, increase its profit margin to an extent
that it results in reduced turn-over resulting in reduction of overall profit.
(ii) Fixed Assets Turnover Ratio
The ratio indicates the extent to which the investment in fixed assets has contributed
towards sales. The ratio can be calculated as follows:

= Net Sales
Net Fixed Assets

390
 Significance. The comparison of fixed assets turnover ratio over a period of time indi-
cates whether the investment in fixed assets has been judicious or not. Of course, in-
vestment in fixed assets does not push-up sales immediately but the trend of increas-
ing sales should be visible. If such trend is not visible or increase in sales has not been
achieved after the expiry of a reasonable time it can be very well said that increased
investments in fixed assets has not been judicious.
(iii) Debtors’ Turnover Ratio
The ratio indicates the speed with which money is collected from the debtors. It is
computed as follows:

= Credit Sales
Average Accounts Receivable

The term average account receivable includes trade debtors and bills receivable. Aver-
age accounts receivable are computed by taking the average receivables in the begin-
ning and at the end of the accounting year. The higher the ratio, better it is.
Debtors turnover ratio is used for computing the debit collection period. The formula
for its computation is as follows:

= Months or days in a year

Debtors turnover Ratio
For example, if the credit sales are Rs. 80,000, average accounts receivable Rs. 20,000,
the debtors’ turn-over ratio and debt collection period will be computed as follows:

Debtors Turnover Ratio =80,000=4

20,000
Debtors Collection Period =12months=3 month
4
This means on an average three months credit is allowed to the debtors. An increase in
the credit period would result in unnecessary blockage of funds and with increased
possibility of losing money due to debts becoming bad.
Significance. Debtors Turnover Ratio or Debt Collection Period Ratio measures the
quality of debtors since it indicates the rapidity or slowness with which money is col-
lected from the debtors. A shorter collection period implies prompt payment by debt-
ors. A longer collection period implies too liberal and inefficient credit collection per-
formance. The credit policy should neither be too liberal nor too restrictive. The former
will result in more blockage of funds and bad debts while the latter will cause lower
sales which will reduce profits.

391
COST-VOLUME-PROFIT ANALYSIS

(iv) Creditors Turnover Ratio

This is similar to Debtors Turnover Ratio. It indicates the speed with which payments
for credit purchases are made to creditors. It can be computed as follows:

Credit Purchases
=
Average Accounts Payable
The term ‘accounts payable’ include trade creditors and bills payable.
From the creditors turnover, ratio, credit period enjoyed can be computed as follows:

Credit Period = Months or days in a year

Creditors Turnover
For example, if the credidt purchases during a year are Rs. 1,00,000, Average accounts
payable Rs. 25,000, the Creditors Turnover Ratio will be ‘4’ (i.e., 1,00,000 / 25,000) while
the credit period enjoyed ratio would be 3 months (i.e., 12 months/4).

Significance. The creditors turnover ratio and the credit period enjoyed ratio indicate
about the promptness or otherwise in making payment for credit purchases. A higher
creditors turnover ratio or a lower credit period enjoyed ratio signifies that the credi-
tors are being paid promptly thus enhancing the credit-worthiness of the company.
However, a very favourable ratio to this effect also shows that the business is not tak-
ing full advantage of credit facilities which can be allowed by the creditors.

(v) Stock Turnover Ratio

The ratio indicates whether the investment in inventory is efficiently used and whether
it is within proper limits. It is calculated as follows:

Stock Turnover Ratio = Cost of Goods Sold during the year

Average Inventory
Average inventory is calculated by taking the average of inventory at the beginning
and at the end of the accounting year.
Significance. The ratio signifies the liquidity of inventory. A high inventory turnover
ratio indicates brisk sales and vice-versa. The ratio is therefore a measure to discover
possible trouble in the form of over-stocking or over-valuation of inventory.
3. Financial Ratios
They are also termed as ‘Solvency Ratios’. These ratios indicate about the financial position of
the company. A company is considered to be financially sound it it is in a position to carry on
its business smoothly and meet all its obligations both short-term and long-term without strain.

392
The Financial or Solvency Ratios can therefore be classified into following categories:
(i) Long-term Solvency Ratios, which include fixed assets ratio, debt equity ratio and propri-
etary ratio;
(ii)Short-term Solvency Ratios, which include current ratio, liquidity ratio, super-quick ratio
and defensive interval ratio.
Each of these ratios are now being discussed in detail in the following pages:
Long-term Solvency Ratios
(i) Fixed Assets Ratio
The ratio indicates the extent to which fixed assets have been acquired by use of long-term
funds. The ratio is expressed as follows:

Fixed Assets Ratio =NetFixed Assets

Long -term Funds
The term ‘Net Fixed Assets’ means original cost of fixed assets less depreciation to date. The
ratio should not be more than ‘1’ . The ideal ratio is .67.
Significance. It is sound principle of finance that fixed assets should be financed out of long-
term funds. As a matter of fact a part of working capital termed as core-working capital, should
also be financed by long-term funds. The ratio is therefore an indication of the fact whether the
company has followed sound financial policy or not. In case the ratio is more than ‘1’, it shows
that a part of working capital has also been used to acquire fixed assets, which may prove quite
troublesome for the company.

(ii) Debt-Equity Ratio

The ratio is determined to ascertain the proportion between the outsiders’ ‘funds and share-
holders’ funds in the capital structure of an enterprise. The term outsiders’, funds is generally
used to represent total long-term debt. The ratio can be computed as follows:

− = Total long - term Debt

Debt Equity Ratio Shareholder's Funds
The ratio may also be calculated for ascertaining proportion of long-term debt in the total long-
term funds. In such a case the ratio will be computed as follows:

= Total long - term Debt

Total Long -term Funds
The ratio is considered to be ideal if the shareholders’ funds are equal to total long-term debt.
However, these days the ratio is also acceptable if the total long-term debt does not exceed
twice of shareholders’ funds.
Significance. The ratio is an indication of the soundness of the long-term financial policies
pursued by the business enterprise. The excessive dependence on outsiders’ funds may cause

393
COST-VOLUME-PROFIT ANALYSIS

insolvency of the business. The ratio provides the margin of safety to the creditors. It tells the
owners the extent to which they can gain by maintaining control with a limited investment.
(iii) Proprietary Ratio
It is a variant of Debt-Equity Ratio. It establishes relationship between the proprietors’
or shareholders’ funds and the total tangible assets. It may be expressed as follows:
Shareholders Funds
=
Total Tangible Assets
Significance. The ratio focuses attention on the general financial strength of the busi-
ness enterprise. The ratio is of particular importance to the creditors who can find out
the proportion of shareholders funds in the total assets employed in the business. A
high proprietary ratio will indicate a relatively little danger to the creditors or vise-
versa in the event of forced reorganization or winding up of the company.

Short-term Solvency Ratios

(i) Current Ratio
The ratio is an indicator of the firm’s commitment to meet its short-term liabilities. It is
expressed as follows:

= Current Assets
Current Liabilities
An ideal current ratio is ‘2’. However, a ratio of 1.5 is also acceptable if the firm has
adequate arrangements with its bankers to meet its short-term requirements of funds.
Significance: The ratio is an index of the concern’s financial stability, since, it shows
the extent to which the current assets exceed its current liabilities. A higher current
ratio would indicate inadequate employment of funds, while a poor current ratio is a
danger signal to the management.

(ii) Liquidity Ratio

The ratio is also termed as Acid Test Ratio or Quick Ratio. The ratio is ascertained by
comparing the liquid assets i.e., current assets (excluding stock and prepaid expenses)
to current liabilities. The ratio may be expressed as follows:
Liquid Assets −
= =
Current Liabilities Current Assets Stock
Current Liabilities − Bank Overdraft
Some accountants prefer the term liquid liabilities for current liabilities. The term ‘liq-
uid liabilities’ means liabilities payable within a short period. Bank overdraft and cash
credit facilities (if they become permanent modes of financing) are excluded from cur-

394
 rent liabilities for this purpose. The ratio may be expressed as follows:

= Liquid Assets
Liquid Liabilities
The ideal ratio is ‘1’.
Significance: The ratio is an indicator of short-term solvency of the company. A com-
parison of the current ratio to quick ratio should also indicate the inventory hold-ups.
For instance, if two units have the same current ratio but different liquidity ratios, it
indicates over-stocking by the concern having low liquidity ratio as compared to the
firm which has a higher liquidity ratio.
(iii) Super-quick Ratio
It is a slight variation of quick ratio. It is calculated by comparing the super quick
assets with the current liabilities (or liquid liabilities) of a firm. The ratio may be ex-
pressed as follows:

= Super Quick Assets

Current Liabilities
The term ‘Super-Quick Assets’ means current assets excluding stock, prepaid expenses
and debtors. Thus, super-quick assets comprise mainly cash, bank balance and mar-
ketable securities.

Significance : This ratio is the most rigorous test of a firm’s liquidity position. In case
the ratio is ‘1’, it means the firm can meet its current liabilities any time.
The ratio is a conservation test and not widely used in practice.

ADVANTAGES OF RATIO ANALYSIS :

Ratio Analysis is (useful) relevant in assessing the performance of a firm in respect of the
following purposes:

1. To measure the liquidity position - The purpose of ratio analysis is to measure the li-
quidity position of a firm. Whether the firm is able to meet its current obligations when
they become due or not? A firm-can be said to be liquid, if it has sufficient liquid funds to
pay the interest charges on short-term debt within a year. The liquidity ratio are useful
in credit analysis by banks and other financial institutions.

2. To know the solvency position - Ratio analysis is helpful for assessing the long-term
financial liability of the firm. The long term solvency is measured through the leverage,
and profitability ratios. These ratios reveal the strengths and weaknesses of a firm in
respect of the solvency position. The leverage ratios indicates the proportion of various
sources of finance in the firms capital structure, particularly the ratio of debt and equity
share capital.

395
COST-VOLUME-PROFIT ANALYSIS

3. Operating efficiency or turnover of the firm - The ratios are helpful in measuring the
operating efficiency or the turnover of the firm. These ratios indicate the efficiency in
utilizing the assets of the firm such as fixed assets turnover ratio, total resources turnover
ratio etc.

4. To assess the profitability position of the firm - The ratio are useful to assess and mea-
sure the profitability of the firm in respect of sales and the investments. These ratios are
concerned about the over –all profitability of the firm.

5. Inter - firm and intra – firm comparison - Ratios not only reflect the financial position of
a firm, but also serves as a tool for remedial actions. This is made possible only due to
inter-firm comparison. This would demonstrate the relative position of the firm vis-à-
vis its competitors. If there is any variance in the ratios either with the industry average
or with, those of competitors, the firm has to identify the reasons and would take reme-
dial measures.
6. Trend Analysis - The trend analysis of ratios of a firm indicates whether the financial
position of a firm is improving or deteriorating over the years. The significance of a trend
analysis of ratio lies in the fact that the analyst can know the direction of movement
whether the movement is favourable or unfavourable.
Thus, ratio analysis is considered better than a mere comparison of figures in carrying out an
over – all appraisal of a company’s business.
Management use of Ratio Analysis
Management in a company at all levels, top to middle and at operations level makes use of
ratio analysis for evaluating their own achievements and making decisions appropriate to
their levels. The following examples would illustrate the management use of ratio analysis:
1) Production Manager
Production Managers require data regarding output of the various divisions of the firm in a
form that facilitates comparison both with production of the previous period and also with the
results of the same period in the previous year. This data may be for a month quarter or a week
as per the requirement of analysis. Production at different levels may be related to number of
employees, number of hours, the factory worker, production per hour per worker, production
per unit of capital employed, and so on. Any decline in output or any enhancement in output
can be ascribed to the cause which may be investigated for taking appropriate decision in each
circumstance. The following are the import ratios:
a) Ratios Relating to capacity utilization.
b) Input and Output Ratios.
c) Resource consumption Ratios
d) Ratios relating to volume of production.

396
2) Sales Manager
Outlet of production is essential for an industrial unit. Sales managers can make good use of
the ratio analysis for making sales decisions by comparing the past sales performance with the
present sales and projecting a sales programme for the future. Sales Manager may locate changes
in sales and related sales to income. Changes in sales may be observed by relating sales to total
industry sales, sales per division to total sales of the firm, output to sales, and current sales to
sales in previous period, and so on. Similarly, analysis can relate sales to selling expenses,
sales to debtors sales to assets etc. The following are the important ratios:
i) Expenses to sales ratio.
ii) Debtors to sales ratio
iii) Sales volume comparison ratios
3) Ratios used in hotel industry
The variety of ratios used by hotel industry which are:
1. Room Occupancy Ratio
2. Bed Occupancy Ratio
3. Double Occupancy Ratio
4. Seat Occupancy Ratios etc.
4) Ratios used in transport industry
The following important ratios are used in transport industry.
1. Passenger Kilometers
2. Seat occupancy Ratios
3. Operating cost per kilometer
5) Bank Industry
The following important ratios are used in Bank Industry.
1. Operating expenses ratios for various periods
2. Loans to deposits ratios
3. Operating income ratios for various periods
6) Financial Manager
Financial Manager is more concerned with supervision of a company’s financing on a current
basis as distinct from over all management. His concern at this stage is much more with the
analysis of current payments to current income, financial ratios, cost flow data etc., for making
future predictions of financial requirements and laying needs for credit facilities to be availed
of from the money or capital market. The following important ratios used by Financial Man-
ager:

397
COST-VOLUME-PROFIT ANALYSIS

1. Over all return on investment

2. Return on total resources
3. Capital turnover ratio
4. Working capital turnover ratio etc.
7) Executive Manager or General Manager
At this level of management the main concern is to oversee the entire management of the
company and view the relative position of marketing or sales, production, finance, inventory
position, personnel planning etc. The executive manager or/and general manager has to take
strategic decisions and that is possible by studying the relative position of performance in all
directions through the ratio analysis of past and present performance and on future projec-
tions.
8) Investor use of Ratio Analysis
Investors in a company mean the shareholder. Creditors are to be differentiated with inves-
tors. The interests of the two are a contradiction. Shareholders’ major interest in the company
is not the day-to-day management of its affairs but in the net result of its functioning in terms
of profitability and reduction of the degree of risk.
Ratios used by investors may be divided into three main forms viz.
1) Profitability Ratios
2) Risk Ratios; and
3) Market performance of shares owned by shareholders
1) Profitability Ratios - Shareholders are interested in the profits earned by the company as
well as the profits accrued on their own investment. Profitability ratios which are of interest to
shareholders can be divided into following firms:
a) Profitability of total investment i.e., gross profits earned on total funds invested in the
company irrespective of the capital structure.
b) Profits as percentage of sales i.e., profits earned from normal business activity. This indi-
cates shareholders proportion of profits earned from normal business.
c) Profits after payment of interest as a ratio of shareholders equity. This indicates the actual
earnings per share for investors.
d) Dividend per share or dividend as a percentage of profits. Dividend ratio can be com-
puted to develop a trend over a number of years.
All the above sets of ratios can be compared to the performance of the company in the
previous period – quarterly, half-yearly or annually – or with other firms in the same indus-
try.
2) Risk Ratios - Investors while making investment in a company undertake i) Risk of capital
loss due to decline in share price which may be due to lower profitability of the company or on
account of general economic depression; ii) Risk of bankruptcy of the company and iii) Risk of

398
non-payment of dividend causing suffering to investors. Ratio analysis serves as indicator of
the impending risk to shareholders who would appraise company’s performance monthly,
quarterly or annually. Dividend coverage ratio issued for this purpose. Dividend coverage
ratio is given by = Profit after tax  No. of Equity Shares.
3) Share Performance - Shareholders main concern remains the market performance of the
shares with the role objective of capital gains realization. Earnings per share and market price
per share can be compared for over the years for inter-firm comparison of the performance in
an industry.
9) Creditor use of Ratio Analysis
Creditors frequently make use of ratio analysis to assess the company’s financial position and
standing. These creditors include financial Institutions, banks, debenture holders, as well as
investment institutions. The main concern of the creditors is in assessing company’s financial
position with reference to its capacity to repay the loan and service the interest charges. Where
creditors exert conversion rights they remain interested in the capital gains like ordinary share-
holders through appreciation in market price for share as well as enhanced dividend rate
through earnings per share.
LIMITATIONS OF ACCOUNTING RATIOS:
Accounting ratios are subject to certain limitations. They are given below:
Comparative study required - Ratios are useful in judging the efficiency of the business only
when they are compared with the past results of the business or with the results of a similar
business. However, such a comparison only provides a glimpse of the past performance and
forecasts for future may not be correct since several other factors like market conditions, man-
agement policies, etc., may affect the future operations.
Limitations of financial statements - Ratios are based only on the information which has been
recorded in the financial statements. As indicated in the preceding chapter financial state-
ments suffer from a number limitations, the ratios derived there from, are also subject to those
limitations. For example, non-financial statements. If the management of the company changes,
it may have ultimately adverse effects on the future profitability of the company but this can-
not be judged by having a glance at the financial statements of the company.
Similarly, the management has a choice about the accounting policies. Different accounting
policies may be adopted by management of different companies regarding valuation of inven-
tories, depreciation, research and development expenditure and treatment of deferred rev-
enue expenditure, etc. The comparison of one firm with another on the basis of ratio analsyis
without taking into account the fact of companies having different accounting policies, will be
misleading and meaningless. Moreover, the management of the firm itself may change its
accounting policies from one period to another. It is, therefore, absolutely necessary that fi-
nancial statements are themselves subjected to close scrutiny before an analysis is attempted
on the basis of accounting ratios. The financial analyst must carefully examine the financial
statements and make necessary adjustments in the financial statements on the basis of disclo-
sure made regarding the accounting policies before undertaking financial analysis.

399
COST-VOLUME-PROFIT ANALYSIS

The growing realization among accountants all over the world, that the accounting policies
should be standardized, has resulted in the establishment of International Accounting Stan-
dards Committee which has issued a number of International Accounting Standards. In our
country, the Institute of Chartered Accountants of India has established Accounting Standards
Board for formulation of requisite accounting standards. The Accounting Standards Board has
already issued fifteen standards including AS – 1: Disclosure of Accounting Policies. The stan-
dard AS – 1 has been made mandatory in respect of accounts beginning on or after 1.4.1991. It
is hoped that in the years to come, with the progressive standardization of accounting policies,
this problem will be solved to a great extent.
Ratios alone are not adequate - Ratios are only indicators, they cannot be taken as final re-
garding good or bad financial position of the business. Other things have also to be seen. For
example, a high current ratio does not necessarily mean that the concern has a good liquid
position in case current assets mostly comprise outdated stocks. It has been correctly observed,
“Ratios must be used for what they are – financial tools. Too often they are looked upon as
ends in themselves rather than as a means to an end. The value of a ratio should not be re-
garded as good or bad inter se. It may be an indication that a firm is weak or strong in a
particular area but it must never be taken as proof.” “Ratios may be linked to railroads. They
tell the analyst, stop, look and listen.”
Window dressing - The term window dressing means manipulation of accounts in a way so as
to conceal vital facts and present the financial statements in a way to show a better position
than what it actually is. On account of such a situation, presence of a particular ratio may not
be a definite indicator of good or bad management. For example, a high stock turnover ratio is
generally considered to be an indication of operational efficiency of the business. But this
might have been achieved by unwarranted price reductions or failure to maintain proper stock
of goods.
Similarly, the current ratio may be improved just before the Balance Sheet date by postponing
replenishment of inventory. For example, if a company has got current assets of Rs. 4,000 and
current liabilities of Rs, 2,000 the current ratio is 2, which is quite satisfactory. In case the
company purchases goods of Rs. 2,000 on credit, the current assets would go up to Rs. 6,000
and current liabilities to Rs. 4,000. Thus reducing the current ratio to 1.5. The company may,
therefore, postpone the purchases for the early next year so that its current ratio continues to
remain at 2 on the Balance Sheet date. Similarly, in order to improve the current ratio, the
company may pay off certain pressing current liabilities before the Balance Sheet date. For
example, if in the above case the company pays current liabilities of Rs. 1,000, the current
liabilities would stand reduced to Rs. 1,000, current assets would stand reduced to Rs. 3,000
but the current ratio would go up to 3.
Problems of price level changes - Financial analysis based on accounting ratio will give mis-
leading results if the effects of changes in price level are not taken into account. For example,
two companies set up in different years, having plant and machinery of different ages, cannot
be compared, on the basis of traditional accounting statements. This is because the deprecia-
tion charged on plant and machinery in case of old company would be at a much lower figure
as compared to the company which has been set up recently. The financial statements of the
companies should, therefore, be adjusted keeping in view the price level changes if a meaning-
ful comparison is to be made through accounting ratios. The techniques of current purchasing
power and current cost accounting are quite helpful in this respect.

400 Fianancial Management & international finance

No fixed Standards - No fixed standards can be laid down for ideal ratios. For example, cur-
rent raio is generally considered to be ideal if current assets are twice the current liabilities.
However, in case of those concerns which have adequate arrangements with their bankers for
providing funds when they require, it may be perfectly ideal if current assets are equal to
slightly more than current liabilities.
It is, therefore, necessary to avoid many rules of thumb. Financial analysis is an individual
matter and value for a ratio which is perfectly acceptable for one company or one industry may
not be at all acceptable in case of another.
Ratios are a composite of many figures - Ratio are a composite of many different figures.
Some cover a time period, others are at an instant of time while still others are only averages. It
has been said that “a man who has his head in the oven and his feet in the ice-box is on the
average, comfortable” Many of the figures used in the ratio analysis are no more meaningful
than the average temperature of the room in which this man sits. A balance sheet figure shows
the balance of the account at one moment of one day. It certainly may not be representative of
typical balance during the year.
It may, therefore, be concluded that ratio analysis, if done mechanically, is not only misleading
but also dangerous. It is indeed a double edged sword which requires a great deal of under-
standing and sensitivity of the management process rather than mechanical financial skill. It
has rightly been observed: “The ratio analysis is an aid to management in taking correct deci-
sions, but as a mechanical substitute for thinking and judgment, it is worse than useless. The
ratios if discriminately calculated and wisely interpreted can be a useful tool of financial analy-
sis.
DUPONT CONTROL CHART:
DU PONT Analysis - Return on Investment (ROI) is one of the most important techniques
ever conceived to aid the management both in decision making and performance evaluation.
The DU PONT company of the United States pioneered this system of financial analysis which
has received wide spread recognition and acceptance. This technique was developed by the
DU PONT company for analyzing and controlling financial performance. The analysis con-
siders important inter relationships based on information available in financial statements.
The system of analysis brings together the net profit margin (NPM) and the total assets turn
over ratio (TATR) and shows how these ratios interact to determine profitability of assets.
Thus, the Return on Total Assets (ROTA) or Return on Investment (ROI) is defined as the
product of the net profit margin and the total assets turnover ratio.
Symbolically, it can be expressed as follows:

⎡ Net profit Sales ⎤

Return on Investments (ROI) or Return On Total Assets (ROTA) = ⎢ Sales × ⎥
⎣ Total Assets ⎦
= ROI = [Net Profit Margin × Total Assets Turnover Ratio]
The analysis helps in understanding how the net return on Investments is influenced by the
net profit margin and the total assets turnover ratio.

Fianancial Management & international finance 401

COST-VOLUME-PROFIT ANALYSIS

The relation ship between the Return on Investment and the net profit margin and total assets
turnover is explained in detail in the following chart. This chart is developed by the DU PONT
Company. Hence, it is known as DU PONT chart or DU PONT Analysis.

Return on
Investment ROI

Net Profit Total Assets

Margin Ratio X Turnover Ratio

Net Profit Sales Net Sales Total Assets

Net Sales - Total Cost Current Assets + Fixed Assets

Cost of Operating Interest Inventory Account Cash and

Goods Sold + Expenses + and Taxes + Receivables + bank balance

At the top of the DU PONT chart is the Return on Investments. The left hand side of the chart
shows the details of net profit margin. Net profit margin is determined as net profit divided by
sales. Net income is arrived at by deducting total cost i.e. (cost of goods sold plus operating
expenses, Interest and Taxes) from net sales. Thus, the analysis indicates certain areas where
cost reductions may be effected to improve the net profit margin and where cost control efforts
should be directed.
The right hand side of the chart focuses on the total assets turnover ratio. The ratio is calcu-
lated as sales divided by total assets. Total assets are a composition of fixed assets and current
assets (i.e., cash, bank, marketable securities, inventories, receivables or Debtors and others).
If the total assets turnover is supplemented by a study of other turnover ratios, like Inventory,
debtors, cash and fixed assets turnover ratios, a deeper insight can be gained into efficiencies
or inefficiencies of asset utilization. The basic DU PONT analysis may also be extended to
expose the determinants of the return on equity.
In order to make the analysis more meaningful the Return on Investment of the company must
be compared with industry averages and with the company’s own return on Investments of
the previous years. The DUPONT analysis provides relevant clues to deficiency in asset man-
agement or lack of cost control or both, where the company’s return on Investment is below
the industry average. Further a detailed comparison of return on Investment of the company
over the past few years reveals a declining tendency, it focuses attention of the management

402 Fianancial Management & international finance

loosing control over expenses and inefficiently of assets management. At this point of time,
DU PONT analysis calls for prompt corrective action before the situation goes out of control.
DIFFICULTIES IN DU PONT ANALYSIS - Despite of the basic simplicity of the return on –
investment concept, it suffers from some difficulties in respect of its computation and use.
1) Valuation of assets - The first and important limitation of the analysis is the selection
and valuation of the assets comprising the investment base. In the analysis the gross
value of the assets are considered and no deduction is made for depreciation. More-
over, the time value of money and price level changes are not considered while com-
puting the return on Investments of the concern.
2) Delegation of responsibility - Another serious problem of the concept of Return of In-
vestment is delegation of responsibility. The management has to delegate the author-
ity with responsibility to some responsible level of management for collection of costs
and revenues so as to accomplish the targeted level of Return on Investment otherwise,
the whole exercise is fertile.
Du-Pont Chart was developed by the USA based company Du-Point.
This chart is a chart of financial ratio, which analyses the Net Profit Margin in terms of
asset turn out.
This chart shows that the ROI is ascertained as a product of Net profit margin ratio and
investment turnover ratio
There are three components in the calculation of return on equity using the traditional
Du Pont model-the net profit margin, asset turnover, and the equity multiplier. By
examining each input individual, the sources of a company’s return on equity can be
discovered and compared to its competitors.
Return of Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier)

Profit Margin = EBIT +

Sales
Return on Net
Assets (RONA) =
EBIT + NA Assets Turnover = Sale
+ NA

Financial Leverage
Return on Equity (ROE)
(Income) = PAT +
= (PAT  NW) EBIT

Financial Leverage
(Balance Sheet) =
NA + NW