B.Com 5th Sem.

Subject- Management Accounting

SYLLABUS

Class – B.Com. V Sem.

Subject – Management Accounting

Unit-II Financial statement: meaning, limitations of financial

statements, objectives and methods of financial statements
analysis, ratio analysis, classification of ratios – profitability
ratios, turnover ratios and financial ratios, advantages of ratio
analysis, limitations of accounting ratios.

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 B.Com 5th Sem. Subject- Management Accounting

UNIT-II
Financial statements analysis: Meaning, objectives and methods
The term’ Financial Analysis’ Which is also known as ‘analysis and interpretation of financial
statements refer to process of determining financial strength and weaknesses of the firm by stabilizing
relationship between the items of balance sheet, profit & loss a/c and other operative data.
The purpose of financial analysis is to diagnose the information context in financial statement so as to
judge the profitability and financial position of the firm.’

TYPES OF FINANCIAL ANALYSIS

Financial analysis can be classified into different categories depending upon
1. Information used
2. Method of operation followed in analysis or the modes operandi of analysis

TYPES OF FINANCIAL ANALYSIS

On the basis of On the basis of On the basis of
used information firms involved modus operandi

External Internal Intera-firm Inter-firm Horizontal Vertical

analysis analysis analysis analysis analysis analysis

TOOLS OR METHODS OF FINANCIAL ANALYSIS

A number of methods are used to study the relationship between different statements
Following are het methods generally used for financial analysis
1. Comparative financial statements
2. Common size statements
3. Trends analysis
4. Fund flow analysis
5. Cash flow analysis
6. Ratio analysis
7. Cost-volume-profit analysis

COMPARATIVE FINANCIAL STATEMENTS

The comparative financial statements are the statements of the financial position at different periods of
time. The elements of financial position are shown in a comparative form to give an idea of the financial
position of two or more periods. Generally two financial statements (balance sheet and income
statements) are prepared in comparative form for the purpose of financial analysis.
For example, when figure of sales of previous periods are given along with the figures of current period,
the analyst will be able to see the trends of sales over different period of time.

THE COMPARATIVE STATEMENTS ARE-

1. Balance sheet
2. Income statement

COMPARATIVE BALANCE SHEET

Comparative balance sheet as on two different dates can be used for comparing assets and liabilities
and finding out on increase or decrease in those items.
While interpreting comparative balance sheet, the interpreter is expected to consider the following
points.

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B.Com 5th Sem. Subject- Management Accounting

a. Current financial position- For studying the current financial position, one should see the
working capital for both the year. A study of increase or decrease in current assets and current
liabilities enable to see the current financial position.
b. Long term financial position- The long term financial position of the concern can be analyzed
by studying the changes in fixed assets, long term liabilities & capital. An increase in fixed
assets should be compared to the increase in long term loans and capitals.
c. Profitability of the concern- The study of increase or decrease in retained earnings will
enable the interpreters to see cheater the profitability has improved or not.

COMPARATIVE INCOME STATEMENT-

The income statement shows net profit or net loss on accounts of operations of a business. The
comparative income statement gives an idea of the progress of a business over a period of time. The
interpretation of income statements will involve
a. The increase or decrease in sales should be compared with the increase or decrease of cost of
goods sold.
b. The second step is to study the operational profits.
c. The effect of non-operating expenses such as interest, loans on profit should be studied.

COMMON SIZE STATEMENTS

Common size statements are those in which the figures are converted into percentage on some
common basis. The use of these helps in making inter period & inter firm comparison and also in high
lighting upon the trends in performance, efficiency & financial position. However any material change
in the techniques procedure & principles would render these statements users & insignificant tool of
financial analysis.
a. Common size balance sheet- A statement in which balance sheet items are expressed as the
percentage of its total.
b. Common size income statements- in common size income statement various item of income
statements are shown as percentage of sales.

TRENDS ANALYSIS
The financial statement may be analyzed by computing trends of several years
The methods of calculating trend percentage involve the calculation of percentage relationship that
each items bears to the same item in the base year. It is very important from the point of view of
forecasting or budgeting. It discloses the change in the financial and operating data between specific
periods. However, no. of precautions should be taken, while using trends ratios as a tool.

Limitations of financial analysis: financial statement analysis is an important method of

determination of financial capabilities and weakness of any firm, but their analysis is based on the
information given in the financial statements. Some of the limitations are as follows
1. It is study of interim reports only.
2. Comparison of financial statements of one firm with another is not possible.
3. Validity of financial analysis is reduced when there are price changes.
4. Conclusion drawn from one year financial statements is worthless.
5. Profit and loss account is prepared on the basis of old conventions due to which correct
information of net profit is not provided.

Ratio Analysis
Meaning of Ratio : generally ratio means establishment of logical relationship between two or more
variable. Thus ratio is a numeric relation between two or more items of financial statement.
Ratio analysis : Ratio analysis is a techniques of analysis and interpretation of financial statements. It
is a process of establishing various ratios and their interpretation, to help top management in decision

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B.Com 5th Sem. Subject- Management Accounting

making. Ratio is not an end in itself but it is a means of understand strength and weakness of the firm
properly.
Interpretation of the ratio: as the calculations of ratios from the data given in the financial statements
is an important function. In the same manner interpretation of these ratios is also the most important
function. Calculation of ratio is a clerical work while for interpretation of ratios skill and
foresightedness are required. Normally the interpretation of ratios can be made by the following ways.
1. Single absolute ratio – Generally it is said that if a person interprets a single ratio.
2. Group of ratios – Some of ratios are not important by their own but provides meaning ful
conclusion when they are interpreted along with other ratios like study of profit on sale with
capital employed or current ratio with liquid ratio.
3. Historical comparison - When ratios of various years are compared then this study indicates
the direction of the change and shows whether there is a improvement, downfall or constancy
in the performance and financial position of the firm.
4. Project Ratios – Various ratios may be calculated as a standard from the projected financial
statements.
5. Inter-firm comparison – inter firm comparison of ratios of any firm with the ratios of other
firms or with the average ratios of all the firms.
Classification of Ratios : Various accounting ratios are broadly classified as under –
1. Short term financial position ratios or liquidity ratios.
2. Activity or turnover ratio.
3. Profitability ratios.
4. Long term financial positions or solvency ratios.

Short Term Financial Liquidity Ratios

Current Ratio = A liquidity ratio that measures a company’s ability to pay short term obligations.
Current Assets
Current Ratio = Current Liabilities
Interpretation – If the current ratio is low it represents that the liquidity position of the firm is not good
and the firm is not able to pay its current liabilities immediately.
On the other hand, if the current ratio is very high it indicates idle assets which are not properly
utilized. There should be proper balance between these two situations. A current ratio of 2:1 is
considered on ideal situation.
Significance – Current Ratio is an index of the firm’s financial stability. It provides a margin of safety of
the creditors and indicates strength of working capital.
Limitation-
1. It is crude measurement of liquidity because it measures only the quantity and not the quality of
current assets.
2. Ratio is computed from the figures of balance sheet which might be manipulated to show a better
position of the firm than what is actual.
Quick/Acid Test/Liquid Ratio.
Quick ratio is used as a measure of the company’s ability to meet its current obligation.
Liquid Assets
Quick/Liquid/Acid Test Ratio = Current Liabilities
Liquid Assets = Current Assets – (Stock and prepaid expenses)
Interpretation – A high quick ration is an indication that the firm has the ability to meet its current
liabilities in time and on the other hand, a low quick ratio represents that the firms liquidity position is
not good.
Quick ratio of 1:1 is considered satisfactory It indicates high solvent positions.
Significance
1. It is the real test of liquidity position.
2. It gives better picture of firms ability to meet its short term obligations.
3. It is used as a supplementary ratio to the current ratio.
4. It is more of a qualitative nature of test.

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B.Com 5th Sem. Subject- Management Accounting

(iii) Absolute Liquidity Ratio/Super Quick Ratio – Absolute liquid assets include cash in hand, cash at
bank readily saleable securities and short term investment because it is assumed that all creditors will
not demand their amount at once and mean while cash can be recovered from stock and debtors.
Absolute liquide Assets
Absolute liquid Ratio = Current Liabilities
(iv) Cash Ratio- This ratio is calculated to know how much cash and bank balance a business is having
against its current liabilities. It shows the availability of cash and bank balance.
Cash +Bank
Current Ratio = Current Liabilities

Solvency Ratio / Capital Structure Ratios:

1. Debt-Equity Ratio – It is also called as external internal equities ratio. It measures claims of
outsiders and owners (shareholders) against the firm.
This is calculated between external equities or external funds and internal equities or share holders
funds.
External equities or debt
Debt Equity = Internal equitieis or equity OR
= Long term borrowings/equity share capital + preference share capital + reserve & surplus –
fictitious Assets
Interpretation – This ratio indicates margin of safety to creditors on its liquidation.
2. Debt to Total Capital Ratio – This ratio shows the relationship between long term debts and total
permanent capital of the business.
Long term Debts
= Permanent capital (Share holder ′fund +Long term Debts OR
3. Debt to total Assets – This ratio establish the relationship between total debts to total assets- =
Total Debotrs
Total Assets
OR
4. Property Ratio or equity Ratio- This ratio establishes the relationship between shareholder’s funds
and total tangible assets of the firms -
Share holder ′funds
= Total Tangible Assets
Interpretation:- Higher ratio shows that firm is less dependent on outsiders for working capital.
Thus, higher ratio shows strength of the firm.
5. Capital Gearing Ratio :- This ratio is calculated between equity share capital and reserve and
surplus of the company with its debentures preference share capital and long term loans.
Equity capital +Reserve Funds
= Fixed Rate interest bearingfunds

Interpretation:- It the calculated ratio is greater than 1, it shows the firm in highly geared because
the burden of fixed interest bearing funds/debts is more than owners equity. It is indication of
higher risk.
On the other hand, if ratio is less than one, the firm is said to be low geared and the risk is also low.
6. Capital Employed to Net Work Ratio:- Capital employed is the value of the asset that contribute to a
company’s ability
Capital Employed
= Net worth
7. Reserve to Capital Ratio- Funds or material set aside saved or saved for future use
Reserves
= Capital
8. Fixed Assets Ratio – This ratio show the relationship between long term funds (Shareholder’s funds
+ long term loan) and fixed assets.
Long term funds (i.e.sh areholder funds +Long term Debts
= Net Fixed Assets
9. Debtors to Total Funds/Solvency Ratio- This ratio is used for measuring and analyzing long-term
solvency of the business.
This ratio explains that if the firm goes into liquidation then amount realized from sale of assets will
be sufficient for repayment of all debtor and liabilities or not.

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B.Com 5th Sem. Subject- Management Accounting

Total outisde liabilities

Solvency Ratio = Total Assets
Interpretation –
1. Higher ratio indicates more risk to creditor.
2. If capital gearing ratio is lower than 1 than it is a high gearing and if higher than 1 there it’s low
gearing.

B. Coverage Ratios/Income Based

10. Interest coverage/Fixed charges cover/Debtors Service Ratio- This ratio indicates how many times
the profit covers the interest. It shows the margin of cover to lenders of the company.
In other words, interest coverage ratio is helpful to test the firm’s debt servicing capacity.
Net profit before interest & 𝑡𝑎𝑥
= Fixed interest charges
11. Dividend Coverage Ratio:- This ratio indicates how many times the profit after tax covers the
dividend of preference share holders
Profit after tax (PAT )
= Preference Dividend

Activity Ratios or Turn over Ratios or Current Assets movement or Efficiency Ratios
In any business funds are invested in various assets to earn sale and profit. If the management of assets
is better, then amount of sale and profit will be higher. Efficiency ratios measures the efficiency and
effectiveness with which company manages its resources & assets. These are also called turn over
ratios, because these ratios indicate the speed with which assets are converted into sale like stock into
sale.
1. (a) Inventory /Stock turnover ratio- A firm must have reasonable stock of inventories in
comparison to sales. The level of inventory should neither be too high nor too low.
cost of goods sold
Inventory/ Stock turn over Ratio = average inventory
Net sales Net sales
or = average inventory
or = average inventory at selling price
(b) Inventory Conversion period- It is also important to see average time taken for clearing the
stocks.
365/ 360
=
inventory turn over ratio
Interpretation
This ratio measures the velocity of conversion of stock into sales.
A high inventory turnover indicates efficient management of inventory because if stock are sold
speedly lesser amount of money will be involved in inventory.
A low inventory turnover indicates dull business, accumulation of obsolete stock poor
investment in inventories.
2. Debtors/ Receivables turn over or debtors velocity- Generally all the business firms sales goods
on credit as well as for cash credit is considered as tool for higher sale. It is expected that
business debtors can be converted in cash within the short period, and due this they are
included in the current assets.
Net credit sa les
=
average accounts receivables
It should be noted that
i. Average account receivable = Average Debtors + Average B/R
opening debtors +closing debtors
ii. Average Debtors = 2
opening B/R+closingB /R
iii. Average B/R =
2

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B.Com 5th Sem. Subject- Management Accounting

Interpretation
Debtors velocity indicates the number of times the debtors are turned over during the year. If the
turnover is higher, it shows higher liquidity and efficiency of management. On the other hand low
debtors turnover implies poor liquidity and less efficient management.
3. Average collection period or debts collection period- By this ratio a form comes to know that in
how many days its receivables will be converted into cash.
average debtors and B/R
= net credit sales
x 365/12
4. Creditors turnover ratio or creditors velocity or payable turnover- creditors turnover ratio is
similar to creditors turnover ratio is similar to debtors turnover ratio. It indicates the speed
with which the payment are made to the creditors.
net credit purcahse
= average A/C payables
It should be noted that
i. Average accounts payable= Average Creditors + Average bills payable
opening creditors +closing creditors
ii. Average Creditors = 2
opening B/P+closingB /P
iii. Average bills payable = 2
5. Average payment period- It indicates the average days which a firm takes to make payment to
its creditors.
Average A/cpayable Months / Days in a year
= x 365/ 12 Or =
Credit Purcahse Creditor turnover
Significance
Both the creditors turn over ratio and the average payment period indicates the promptness in
making payments to creditors.
Generally, lower the ratio, better the liquidity position of the firm and higher ratio implies less
liquidity position of the firm.
6. Working capital turn over ratio- Working capital of every firm is directly related with its
sales because it increase and decrease with change in current assets & current liabilities
sales
= 2 average working capital
opening W/C+closingW /C
Average working capital =
2
If the sale is not given, the figure of COGS can be used
Sales / cost of sales
Working capital turnover ratio =
net working capital
7. Fixed Assets Turnover Ratio- This ratio measure the efficiency as well as profit earning
capacity of the firm
sales
= net fixed assets
Net fixed assets = value of assets – depreciation

Some Important Terminologies

1. Miscellaneous expenses.
Under this head we include fictitious assets which are as under-
a) Preliminary expenses
b) Underwriting Commission
c) Discount on issue of shares and debentures
d) Development expenditure
e) Debit balance of P/L A/c (loss)
2. Current Assets
a) Cash in hand b) Cash at bank
c) Bills receivables d) Debtors
e) Short term investments/Marketable securities/ Government securities
f) Accrued income g) Prepaid expenses h) Stock or inventory

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B.Com 5th Sem. Subject- Management Accounting

3. Liquid Assets
Assets Which can be easily converted into cash is known as liquid assets.
Liquid Assets = Current Assets – Stock – Prepaid Expenses

4. Absolute Liquid Assets

Cash + Bank + Marketable Securities

5. Current Liabilities
a) Creditors b) Bills Payables c) Outstanding Expenses
d) unearned income advance income e) Short term loans f) Bad debts reserves
g) Provision for tax h) Bank overdraft (i) Tax Payable
j) Dividend Payable/Unclaimed dividend
6. Liquid liabilities
Liquid liabilities = Current Liabilities – Bank overdraft

7. Working Capital
Working Capital = Current Assets – Current Liabilities
8. Long term loans / liabilities / Long term Debts
a) Debentures b) Mortgage loan c) Bank loan d) Unsecured loans e) Secured loans
9. Total debts/ total liabilities/ external liabilities

Total debts = Current liabilities +long term liabilities

10. Capital employed

Capital Employed =

Share capital + Reserves and Surplus + Secured loans + Unsecured loans – misc. Expenditure

11. Cost of goods sold

COGS = Sales – Gross profit

Or

12. Operating netOpening

profit stock + Purchases + Direct Expenses – Closing stock
Operating Net Profit = Gross Profit – Operating expenses

Or

13. Average Stock Net profit + non operating expenses – non operating income
Average Stock = Opening stock + Closing stock
2
14. Receivables
Receivables = Debtors + Bills receivables

15. Payables
Payables = Creditors + Bills payables

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B.Com 5th Sem. Subject- Management Accounting

16. Proprietors fund/ shareholders fund/ owners equity/ equity/ Net worth/ Net assets

Share capital + Reserve & Surplus – Miscellaneous expenditure

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B.Com 5th Sem. Subject- Management Accounting

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