FINANCIAL MANAGEMENT

Sem II
 Introduction to finance function
• Finance is the lifeblood of every business, its
management requires special attention. Financial
management is that activity of management which is
concerned with the planning, procuring and controlling
of the firm's financial resources.
Scope of Finance Function / Financial Management

• Estimating the Requirement of Funds: For estimating the capital

requirements, the finance department must take help of the
budgets of various activities of the business e.g. sales budget,
production budget, expenses budget etc. prepared by the
concerned departments. Unless the financial forecast is correct,
business is likely to run into difficulties due to excess or shortage
of funds.
Correct estimates ensure the availability of funds as and when
they are needed. In estimating the requirement of funds, nature
and size of the business, modernization and expansion plan
should be given due consideration.
• Determining the Capital Structure: A business needs to fix the kind and
proportion of different securities for raising the required funds. Once the total
requirement of funds is determined, a decision regarding the type of securities
to be issued and the relative proportion between them is to be taken. The
finance department must determine the proper mix of debt and equity.

It should also decide the ratio between long term and short term debts. In
determining these ratios, cost of raising finance from different sources, period
for which funds are required and several other factors should be considered. A
proper balance between risk and returns should be maintained.
• Choice of Sources of Finance: The choice of the source of finance
should be made very carefully by taking a number of factors into
account such as cost of raising funds, conditions attached, charge
on assets, burden of fixed charges, dilution of ownership and
control etc. For example, if the company does not want to dilute
the ownership, it will depend on any source of finance other than
raising funds through shares.
A company can raise funds from different sources e.g.
shareholders, debenture holders, banks, financial institutions,
public deposits etc.
• Investment of Funds: While taking decision for the
investment of funds in long term assets, management
should be guided by three basic principles, viz. safety,
profitability and liquidity. In taking decisions for the
investment of funds in working capital, the finance
manager must seek cooperation of marketing and
production departments in estimating the funds which are
to be involved in carrying of inventories, finished product
and factory supplies of the production department.
• Management of Cash: It is the prime responsibility of the finance
manager to see that an adequate supply of cash is available at proper
time for the smooth running of the business. Cash is needed to
purchase raw materials, pay off creditors, to pay to workers and to
meet the day to day expenses of the business. Availability of cash is
necessary to maintain liquidity and credit- worthiness of the business.
Excess cash must be avoided as it costs money. A cash flow statement
should be prepared by the department to know the correct need of
cash is essential to achieve the goal of profitability and liquidity. The
finance manager should decide in advance how much cash he should
retain to meet current obligations of the company.
• Disposal of Surplus: One of the prime function of the
finance department is to allocate the surplus. After
paying all taxes, the available surplus of the business
can be allocated for three purposes -(a) for paying
dividend to the shareholders as a return on their
investment, (b) for distributing bonus to workmen and
company's contribution to other profit sharing plans,
and (c) for ploughing back of profits for the expansion
of business.
• Financial Controls: The financial manager is under an
obligation to check the financial performance of the
funds invested in the business. There are a number of
techniques to evaluate the performance viz. Return on
Investment (ROI), budgetary control, cost control,
internal audit, ratio analysis and break-even point
analysis.
 Major decisions in Financial Management
• Investment or Long Term Asset Mix Decision: A firms
investment decisions involve capital expenditure. Hence
such decisions involve capital budgeting decision
consisting of allocation of funds to long term assets that
would yield benefits in future. Few important aspects in it:
• Prospective profitability of new investment
• Measurement of risk
• Required rate of return
• Opportunity cost
• Financing or Capital Mix Decision: it consists of when,
where from and how to acquire funds to meet the
investment needs.
• Determining the appropriate proportion of equity and
debt (capital structure), it is considered best when
market value of shares is maximized.
• The use of debt always increases the return on equity
but it always increases the risk as well.
• Dividend or Profit Allocation Decision: A firm needs to
decide whether it should distribute all its profits or
retain them. Hence dividend payout ratio and
retention ratio should be determined carefully. The
optimum dividend policy is one which maximises the
market value of the firm’s shares. Dividends are
generally paid in cash but firms also issue bonus shares
• Liquidity or Short Term Asset Mix Decision:
Investment in current assets can affect the profitability
of the firm. If the firm does not invest sufficient funds
in current assets it may become illiquid, which would
be risky. But it can also end up loosing profitability as
idle current assets would not earn anything. Therefore
there is a profitability and liquidity trade off. It should
be made sure that funds are available when needed.
• Hence it involves committing and recommitting funds
to existing and new uses. This decision therefore
affects the size, growth, profitability, risk and
ultimately the value of the firm.
Objectives of Financial Management
• The primary objectives of financial management are to ensure the
financial stability, growth, and sustainability of an organization or
individual. Here's a breakdown:
• Profit Maximization: This is a core objective, aiming to generate the
highest possible profits for the business. This involves maximizing
revenues, minimizing costs, and optimizing resource utilization.
• Liquidity: Ensuring sufficient cash flow to meet short-term obligations
(like paying bills and salaries) is crucial for business survival. Liquidity
management involves managing cash inflows and outflows effectively.
• Solvency: Maintaining the ability to meet long-term financial obligations,
such as debt repayments. This ensures the long-term financial stability of
the organization.
• Efficiency: Utilizing resources effectively and minimizing waste.
This includes efficient use of assets, cost control, and
maximizing return on investment.
• Growth: Promoting the long-term growth and expansion of the
business. This involves making sound investment decisions and
securing adequate funding for future growth.Risk
Management: Identifying and mitigating potential financial
risks, such as market fluctuations, credit risk, and operational
risks.
• Wealth Creation: For businesses, the ultimate goal is to
maximize shareholder wealth. For individuals, it's about
achieving financial security and building wealth over time.
Profit Maximization Vs Wealth Maximization
• The main difference between wealth and profit maximization is
that wealth maximization requires you to think about how
your decisions will affect your company’s ability to generate
revenue for many years into the future.
• Profit maximization may be more difficult because it requires
you to make tough decisions about which aspects of your
business can be cut or reduced now without affecting long-
term revenue streams too much—but these kinds of decisions
can also help ensure that your business remains competitive
over time.
• While both wealth and profit are important, there are
other things that need to be considered when seeking
to maximize the wealth of a company. For example, it’s
not just profits that shareholders care about; they also
care about:
• The long-term value of their shares
• Their ability to maintain ownership in their company
(i.e., not be forced out)
• The sustainability of the business model
• The competency of management teams (and whether
those managers will stay on board)
 Time Value of the Money
• The Time Value of Money (TVM) is a concept that
refers to the present worth of money is more than the
worth of same money in the future. Time Value of
Money is a financial concept that says a sum of money
has different values at different times.
• Simply put, having Rs.100 today is more valuable than
having Rs. 100 next year. Why? Because with time,
prices of goods or services may go up due to inflation,
reducing the buying power of your money.
• In simple terms, the concept of TVM revolves around 3
parameters: Inflation, Opportunity cost, and risk.
• TVM highlights the preference for receiving money
sooner rather than later. For instance, if you have INR
100 today, you could invest it and earn interest,
making it worth more. Conversely, if you were
promised INR 100 in the future, its value would be less
due to the opportunity cost of not having that money
to invest now. Understanding TVM is crucial for
financial decisions like investing, loans, and savings, as
it helps evaluate the true value of money over time.
• Mr. X is having Rs 1000 in his saving bank account,
interest is paid @5 p.a. How much amount will be
there at the end of 3rd year?
• Mr. X is having Rs 1000 in his saving bank account,
interest is paid @6 semi annually. How much amount
will be there at the end of 2nd year?
 Multiple Cash Inflow
• Mr X deposits Rs 2000 at the end of every year for 5
years in his saving account paying 5 per cent interest
compounded annually. He wants to determine how
much sum of money he will have at the end of the 5th
year.
 Present Value Calculation
• Mr. X has been given an opportunity to receive Rs2,247
two year from now. He knows that he can earn 06 per
cent interest on his investments. The question is: what
amount will he be prepared to invest for this
opportunity?
Class Discussion on Financial Planning
and Forecasting
 Unit II
Comparative
Financial Statement
Introduction
• A financial statement is an official document of the firm,
which explores the entire financial information of the firm.
The main aim of the financial statement is to provide
information and understand the financial aspects of the firm.
TECHNIQUES OF
FINANCIAL STATEMENT ANALYSIS

• Financial statement analysis is interpreted mainly to

determine the financial and operational performance
of the business concern. A number of methods or
techniques are used to analyse the financial statement
of the business concern.
 Comparative financial statement analysis

• Comparative statement analysis is an analysis of financial

statement at different period of time.
• This statement helps to understand the comparative
position of financial and operational performance at
different period of time.
Comparative financial statements classification
Comparative Balance Sheet Format
 From the following information prepare comparative balance sheet

Particular 2019 Rs 2020.Rs

Equity and Liabilities
1. Shareholders Fund
a. Share Capital 50000 80000
a. Reserves and Surplus 20000 40000
Total Shareholders Fund 70000 120000
1. Total Non-Current Liabilities 60000 45000
1. Total Current Liabilities 25000 20000
1. Total Liabilities 85000 65000
1. Total Equity and Liabilities 155000 185000
Assets
A. Non- Current Assets
a. Total Fixed Assets 40000 50000
a. Non- Current Investment 35000 20000
a. Long term loans 40000 55000
a. Other non current assets 20000 30000
Total Non Current Assets 135000 155000
Total Current Assets 20000 30000
Total Assets 155000 185000
Particular 2019 Rs 2020.Rs
Equity and Liabilities
1. Shareholders Fund
a. Share Capital 50000 80000
a. Reserves and Surplus 20000 40000
Total Shareholders Fund 70000 120000
1. Total Non-Current Liabilities 60000 45000
1. Total Current Liabilities 25000 20000
1. Total Liabilities 85000 65000
1. Total Equity and Liabilities 155000 185000
Assets
A. Non- Current Assets
a. Total Fixed Assets 40000 50000
a. Non- Current Investment 35000 20000
a. Long term loans 40000 55000
a. Other non current assets 20000 30000
Total Non Current Assets 135000 155000
Total Current Assets 20000 30000
Total Assets 155000 185000
Examples
Comparative
Income
Statement
Examples
IMPORTANCE OF COMPARATIVE STATEMENTS

• Make the Data Simpler and More Understandable

• To Indicate the Trend
• To Indicate the Strong Points and Weak Points of the Concern
• To Compare the Firm’s Performance with the Average Performance of
the Industry
• To Help in Forecasting
LIMITATIONS OF COMPARATIVE FINANCIAL
STATEMENTS
• These statements do not present the change in various
items in relation to total assets, total liabilities or net
sales.
• These statements are not useful in comparing financial
statements of two or more business because there is
no common base.
 Trend Analysis
Also called trend
percent analysis
or index number
trend analysis.

Trend
Trend analysis
analysis is
is used
used to
to reveal
reveal patterns
patterns in
in data
data
covering
covering successive
successive periods.
periods.

Trend Analysis Period Amount

Percent = Base Period Amount
× 100%
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

2000 is the base period so its

amounts will equal 100%.
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item 2004 2003 2002 2001 2000
Revenues 105% 100%
Cost of sales 104% 100%
Gross profit 108% 100%

(290,000  275,000)  100% = 105%

(198,000  190,000)  100% = 104%
(92,000  85,000)  100% = 108%
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December

Item 2004 2003 2002 2001 2000

Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2004 2003 2002 2001 2000

Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%

How would this trend analysis

look on a line graph?
 Trend Analysis
We can use the trend percentages to construct
a graph so we can see the trend over time.

160

150

140
Percentage

130
Revenues
120
Cost of Sales
110 Gross Profit
100
2000 2001 2002 2003 2004
Year
 Vertical Analysis VV
ee
rr
Vertical Analysis is also called as tt
ii
common-size analysis cc
aa
ll
AA
nn
aa
ll
The term vertical analysis arises from the up- yy
down (down-up) movement of our eyes as we ss
review common-size financial statements. ii
ss
 Common-Size Statements
Calculate Common-size Percent

Common-size Analysis Amount

Percent
= Base Amount × 100%

Financial
Financial Statement
Statement Base
BaseAmount
Amount
Balance
BalanceSheet
Sheet Total
TotalAssets
Assets
Income
IncomeStatement
Statement Revenues
Revenues
• Common size statement that gives only the vertical
percentages or ratios for financing data without giving
rupee value are known as common size statements. A
comparison of two years figures of a concern is easily
made under the companies Act. Companies must show
in their profit and loss account and balance sheet the
corresponding figures for the previous year.
Sometimes however the figures do not signify anything
as the head of items are regrouped and are
incomparable. For a valid comparison, the previous
heads should be strictly compared.
Advantages

• Comparison of common size statement over a number

of years will clearly indicate the changing proportion of
the various components of asset, liabilities, costs, net
sales and profits.
• Comparison of common size statement of two or more
enterprises in the same industry or that of an
enterprise with the industry as a whole will assist
corporate evaluation and ranking.
Limitations
• These statements show percentage of each item to
total sum but do not show variations in the individual
items from period to period.
• Common size statement is regarded by many as
useless as there is no established standard proportion
of each item to total.
Working Notes: All the % will be calculated on the basis of net sales
 Ratio Analysis
• A ratio is a mathematical number calculated as a
reference to relationship of two or more numbers and
can be expressed as a fraction, proportion, percentage
and a number of times. When the number is calculated
by referring to two accounting numbers derived from
the financial statements, it is termed as accounting
ratio.
 Objectives
• Ratio analysis is indispensable part of interpretation of
results revealed by the financial statements.
• It provides users with crucial financial information and
points out the areas which require investigation.
• Ratio analysis is a technique which involves regrouping
of data by application of arithmetical relationships,
though its interpretation is a complex matter.
• It requires a fine understanding of the way and the
rules used for preparing financial statements
• Once done effectively, it provides a lot of information
which helps the analyst:
• To know the areas of the business which need more
attention;
• To know about the potential areas which can be
improved with the effort in the desired direction;
• To provide a deeper analysis of the profitability,
liquidity, solvency and efficiency levels in the business;
• To provide information for making cross-sectional
analysis by comparing the performance with the best
industry standards; and
• To provide information derived from financial
statements useful for making projections and
estimates for the future.
1. Liquidity Ratios
• Liquidity refers to the ability of a firm to meet its
obligations in the short run, usually one year.
• Liquidity ratio is generally based on the relationship
between current assets (the sources for meeting short-
term obligation) and current liabilities. The important
liquidity ratios are Current ratio, Acid test ratio, Cash
Ratio.
Current Ratio
• Current ratio is the proportion of current assets to current liabilities. It is
expressed as follows:
• Current Ratio = Current Assets : Current Liabilities or
• Current Assets / Current Liabilities
• Ideal ratio is 2:1
• Current assets include current investments, inventories, trade receivables
(debtors and bills receivables), cash and cash equivalents, short-term
loans and advances and other current assets such as prepaid expenses,
advance tax and accrued income, etc.
• Current liabilities include short-term borrowings, trade payables
(creditors and bills payables), other current liabilities and short-term
provisions.
Acid-test Ratio
• Acid-test Ratio also called the quick ratio; the acid-test
ratio is defined as:
• Quick assets/Current liabilities
• Quick assets are defined as current assets excluding
inventories and prepaid expenses, advance tax etc.
• Ideal ratio is 1:1
• Calculate Current Ratio from the following information:
• Inventories Rs 50,000
• Trade receivables Rs 50,000
• Advance tax Rs 4,000
• Cash and cash equivalents Rs 30,000
• Trade payables Rs 1,00,000
• Short-term borrowings (bank overdraft) 4,000
• Current Assets = Inventories + Trade receivables +
Advance tax + Cash and cash equivalents
• = Rs. 50,000 + Rs. 50,000 + Rs. 4,000 + Rs. 30,000
• = Rs. 1,34,000
• Current Liabilities = Trade payables + Short-term
borrowings
• = Rs. 1,00,000 + Rs. 4,000
• = Rs. 1,04,000
• Current Ratio = Rs.1,34,000/ Rs.1,04,000 = 1.29 :1
• Q2
Current ratios
Calculate the current ratio from the following information:

Total assets = Rs. 3,00,000

Non-current liabilities = Rs. 80,000
Shareholders’ Funds = Rs. 2,00,000
Non-Current Assets- Fixed assets = Rs. 1,60,000
Non-current Investments = Rs. 1,00,000
Solution
• Total assets = Non-current assets + Current assets
• Rs. 3,00,000 = Rs. 2,60,000 + Current assets
• Current assets = Rs. 3,00,000 – Rs. 2,60,000 = Rs. 40,000

• Total assets = Equity and Liabilities = Shareholders’ Funds + Non-current liabilities +

Current liabilities
• Rs. 3,00,000 = Rs. 2,00,000 + Rs. 80,000 + Current Liabilities
• Current liabilities = Rs. 3,00,000 – Rs. 2,80,000 = Rs. 20,000

• Current Ratio = Current Assets/Current Liabilities = Rs. 40,000/20,000 = 2:1

Cash Ratio or Absolute Liquidity Ratio
• Cash ratio is a measure of a company’s liquidity in which it is measured whether
the company has the ability to clear off debts only using the liquid assets (cash and
cash equivalents such as marketable securities). It is used by creditors for
determining the relative ease with which a company can clear short term liabilities.

• It is calculated by dividing the cash and cash equivalents by current liabilities.

• Cash ratio = Cash and equivalent / Current liabilities (Ideal ratio is 2:1)
Liquidity Ratios Formula

Current Ratio Current Assets / Current Liabilities

Quick Ratio (Cash + Marketable securities + Accounts

receivable)or Current Assets- inventories-
prepaid expenses- advance tax / Current
liabilities

Cash Ratio Cash and equivalent / Current liabilities

Solvency Ratios
Solvency means the ability of enterprises to meet its long-term financial obligations i.e,
liabilities as and when they become due.

Solvency ratio are the ratios which show whether the enterprise will be able to meet its
long-term financial obligations.

1. Debt to Equity ratio

Debt-Equity Ratio measures the relationship between long-term debt and equity.
If debt component of the total long-term funds employed is small, outsiders feel more
secure.
From security point of view, capital structure with less debt and more equity is considered
favorable as it reduces the chances of bankruptcy.
Normally, it is considered to be safe if debt equity ratio is 2 : 1.
Debt to Equity ratio
•Debt-Equity Ratio =

•where: Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus

•Share Capital = Equity share capital + Preference share capital or
•Shareholders’ Funds (Equity) = Non-current assets + Working capital – Non-current
liabilities
•Working Capital = Current Assets – Current Liabilities
• A low debt equity ratio reflects more security. A high ratio, on the other hand, is
considered risky as it may put the firm into difficulty in meeting its obligations to
outsiders.

• However, from the perspective of the owners, greater use of debt (trading on
equity) may help in ensuring higher returns for them if the rate of earnings on
capital employed is higher than the rate of interest payable.
2. Debt to Capital Employed Ratio
The Debt to capital employed ratio refers to the ratio of long-term debt to the total of
external and internal funds (capital employed or net assets). It is computed as follows:

•Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)
•Capital employed is equal to the long-term debt + shareholders’ funds.
• Alternatively, it may be taken as net assets which are equal to the total assets – current
liabilities taking the data of previous Illustration , capital employed shall work out to Rs.
5,00,000 + Rs. 15,00,000 = Rs. 20,00,000.
•Similarly, Net Assets as Rs. 25,00,000 – Rs. 5,00,000 = Rs. 20,00,000 and the Debt to
capital employed ratio as Rs. 5,00,000/Rs. 20,00,000 = 0.25:1.
Significance:
• Like debt-equity ratio, it shows proportion of long-term
debts in capital employed. Low ratio provides security
to lenders and high ratio helps management in trading
on equity.

• In the above case, the debt to Capital Employed ratio is

less than half which indicates reasonable funding by
debt and adequate security of debt.
3. Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by

assets. Ideal is 2:1
• It is calculated as
•Total assets to Debt Ratio = Total assets/Long-term debts
•Taking the data of previous Illustration, this ratio will be worked out as
follows:
•Rs. 14,00,000/Rs. 1,50,000 = 9.33 : 1
Significance
• The higher ratio indicates that assets have been mainly financed by
owners funds and the long-term loans is adequately covered by assets.

• Significance: This ratio primarily indicates the rate of external funds in

financing the assets and the extent of coverage of their debts are
covered by assets.
Interest Coverage Ratio
It is a measure of security of interest payable on long-term debts. It expresses the
relationship between profits available for payment of interest and the amount of
interest payable.

• Earnings Before Interest and Taxes = Gross Revenue – Cost of goods sold –
Administrative expenses – Office expenses- Selling and Distribution expenses
• Interest Expense = Debenture Interest + Preference Share Interest + Interest on
Bank Overdraft + Interest on Bank Loan

Significance: It serves as a solvency check for the business organisation, allowing

banks, industry experts, and investment advisors to assess a company’s or firm’s
capacity to pay off the accrued interest on the loan it’s holding.
It is used to determine whether a firm would be able to pay off the accumulated
interest on its borrowings or debt.
Generally, a higher interest coverage ratio is considered positive since it means that
the firm is earning enough to be able to cover the interest expense.
A lower interest coverage ratio, on the other hand, is questionable since it depicts a
high debt burden and hence, higher chances of bankruptcy.

It is expressed in times.
PRACTICE QUE:
From the following details, calculate interest coverage ratio:
Net Profit after tax Rs. 60,000; 15% Long-term debt 10,00,000; and Tax rate
40%.
Solution
Net Profit after Tax = Rs. 60,000 Tax Rate = 40%

Net Profit before tax = Net profit after tax × 100/(100 – Tax rate)
= Rs. 60,000 × 100/(100 – 40)
= Rs. 1,00,000

Interest on Long-term Debt = 15% of Rs. 10,00,000 = Rs. 1,50,000

Net profit before interest and tax = Net profit before tax + Interest
= Rs. 1,00,000 + Rs. 1,50,000 = Rs. 2,50,000

Interest Coverage Ratio = Net Profit before Interest andTax/Interest on long-term debt
= Rs. 2,50,000/Rs. 1,50,000
= 1.67 times.
Activity (or Turnover) Ratio
These ratios indicate the speed at which, activities of the business are being performed.

The activity ratios express the number of times assets employed, or, any constituent of
assets, is turned into sales during an accounting period.

Higher turnover ratio means better utilisation of assets and signifies improved efficiency
and profitability, and as such are known as efficiency ratios.

The result is expressed in no. of Times.

These ratios are calculated on the basis of Cost of Revenue from Operation i.e, COGS or
Revenue from Operations, i.e., Net Sales.
Important activity ratios are:
1. Inventory Turnover;
2. Trade receivable Turnover;
3. Trade payable Turnover;
4. Working capital Turnover.
 1. Inventory/Stock Turnover Ratio:
The Inventory/Stock Turnover Ratio is significant as it helps assess a company’s
inventory management efficiency.
A higher ratio suggests effective inventory management and a faster turnover rate,
indicating that the company is swiftly converting inventory into sales.
Conversely, a lower ratio may indicate slower sales, excessive inventory levels, or
inadequate inventory management.

Inventory Turnover Ratio

Where average inventory refers to arithmetic average of opening and

closing inventory, and the cost of revenue from operations means revenue
from operations less gross profit.
Practice Question
• From the following information, calculate inventory
turnover ratio:

• Revenue from operations = 4,00,000

• Average Inventory = 55,000
• Gross Profit Ratio = 10%
Solution
Revenue from operations = Rs. 4,00,000
Gross Profit = 10% of Rs. 4,00,000 = Rs. 40,000

Cost of Revenue from operations = Revenue from operations – Gross Profit

= Rs. 4,00,000 – Rs. 40,000 = Rs. 3,60,000

Inventory Turnover Ratio

=
 2. Trade Receivables Turnover Ratio
• It expresses the relationship between credit revenue from operations and trade receivable.

• The liquidity position of the firm depends upon the speed with which trade receivables are
realised.

• This ratio indicates the number of times the receivables are turned over and converted into
cash in an accounting period.

• Higher turnover means speedy collection from trade receivable.

• This ratio also helps in working out the average collection period.
Trade Receivables Turnover Ratio

or
= Revenue from operations – Cash Revenue from
operations

Where Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing
Debtors and Bills Receivable)/2
It needs to be noted that debtors should be taken before making any provision
for doubtful debts.

This ratio also helps in working out the average collection period, which is calculated by
dividing the days or months in a year by trade receivables turnover ratio.

Debt collection period =

Practice Question
Calculate the Trade receivables turnover ratio from the following
information:
Rs. Total Revenue from operations 4,00,000

Cash Revenue from operations 20% of Total Revenue from operations

Trade receivables as at 1.4.2016 Rs. 40,000

Trade receivables as at 31.3.2017 Rs. 1,20,000

Solution
Trade Receivables Turnover Ratio =Net Credit Revenue from Operations/Average
Trade Receivables

Credit Revenue from operations = Total revenue from operations – Cash

revenue from operations

Cash Revenue from operations = 20% of Rs. 4,00,000

= Rs. 4,00,000 *20/100
= Rs. 80,000

Credit Revenue from operations = Rs. 4,00,000 – Rs. 80,000 = Rs. 3,20,000
• Average Trade Receivables = Opening Trade Receivables + Closing Trade
Receivables / 2
• = Rs. 40,000 + Rs. 1,20,000 / 2 = Rs. 80,000

• Trade Receivables Turnover Rations = Net Credit Revenue Form

Operations /Average Inventory

• Trade Receivables Turnover Ratio = Rs. 3,20,000/Rs. 80,000 = 4 times.

Trade Payable Turnover Ratio
Trade Payable Turnover Ratio is a financial ratio that measures how efficiently a
company pays its suppliers for the goods and services it has purchased on credit.

Payable include both creditors and bill payables.

Trade payble Turnover Ratio

Where Average Trade Payable = (Opening Creditors and Bills Payable +Closing
Creditors and Bills Payable)/2

Average Payment Period =

Practice Question
• Calculate the Trade payables turnover ratio from the following figures:

• Credit purchases during 2016-17 = 12,00,000

• Creditors on 1.4.2016 = 3,00,000
• Bills Payables on 1.4.2016 = 1,00,000
• Creditors on 31.3.2017 = 1,30,000
• Bills Payables on 31.3.2017 = 70,000
Solution
• Trade Payables Turnover Ratio =

• Average Trade Payables = Creditors in the beginning + Bills payables in the beginning +
Creditors at the end + Bills payables at the end/ 2

= Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,30,000 + Rs. 70,000

2
= Rs. 3,00,000
= 4 Times
Practice
From the following information, calculate –
(i) Trade receivables turnover ratio
(ii) Average collection period
(iii) Trade rayable turnover ratio
(iv) Average payment period

Given :
Revenue from Operations 8,75,000
Creditors 90,000
Bills receivable 48,000
Bills payable 52,000
Purchases 4,20,000
Trade debtors 59,000
Working Capital Turnover Ratio
• Working capital turnover ratio establishes a relationship between the working
capital and the turnover(sales) of a firm.

• In other words, this ratio measures the efficiency of a firm in utilising its working
capital in order to support its annual turnover.

• A high working capital turnover ratio implies that the company is very efficient in
using its current assets and liabilities to support its sales.

• It is calculated as follows :
Calculate Working capital turnover ratios :
Profitability
• The profitability or financial performance is mainly summarised in the
statement of profit and loss.
• Profitability ratios are calculated to analyse the earning capacity of the
business which is the outcome of utilisation of resources employed in
the business.
• There is a close relationship between the profit and the efficiency with
which the resources employed in the business are utilised.
• The various ratios which are commonly used to analyse
the profitability of the business are:
1. Gross profit ratio
2. Net profit ratio
3. Return on Investment (ROI) or Return on Capital
Employed (ROCE)
4. Earnings per share
1. Gross profit ratio
Gross Profit ratio is a financial metric, that establishes a relationship
between the gross profit of a company and its net revenue from
operations.
It is used to determine the profit earned by a firm after bearing all its
direct expenses, i.e., the expenses directly tied to production. This ratio is
used to determine the earning efficiency of the firm.

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

Significance: Gross Profit Ratio is used to ascertain the amount of profit
available in hand to cover the firm’s operating expenses.

Change in gross profit ratio may be due to change in selling price or cost
of revenue from operations or a combination of both.

A low ratio may indicate unfavourable purchase and sales policy.

Higher gross profit ratio is always a good sign.
• Gross Profit = Net Revenue from Operations – Cost of Goods Sold

• Net Revenue from Operations = Gross Revenue – Sales Return – Discount – Allowances
or

• Net Revenue from Operations = Cash Revenue from Operations + Credit Revenue from
Operations – Return Revenue from Operations

• Cost of Revenue from Operations (C.O.G.S.) = Cost of Material Consumed + Purchase of

Stock-in-trade + Changes in Inventories of Finished Goods and Work-in-progress +
Direct Expenses
 Practice Question
• Following information is available for the year 2016-17, calculate gross profit ratio:
• Revenue from Operations: Cash 25,000
• Revenue from Operations: Credit 75,000
• Purchases : Cash 15,000
• Purchases : Credit 60,000
• Carriage Inwards 2,000
• Salaries 25,000
• Decrease in Inventory 10,000
• Return Outwards 2,000
• Wages 5,000
Solution:
Revenue from Operations = Cash Revenue from Operations + Credit Revenue from Operation
= Rs.25,000 + Rs.75,000 = Rs. 1,00,000

Net Purchases = Cash Purchases + Credit Purchases – Return Outwards

= Rs.15,000 + Rs.60,000 – Rs.2,000 = Rs. 73,000

Cost of Revenue from operations = Purchases + (Opening Inventory – Closing Inventory) +Direct
Expenses
= Rs.73,000 + Rs.10,000 + (Rs.2,000 + Rs.5,000)
= Rs.90,000

Gross Profit = Revenue from Operations – Cost of Revenue from Operation

= Rs.1,00,000 – Rs.90,000 = Rs. 10,000

Gross Profit Ratio = Gross Profit/Net Revenue from Operations ×100

= Rs.10,00
Net Profit Ratio
Net Profit Ratio shows the relationship between the net profit and net revenue from
operations based on the all-inclusive concept of profit.
It links operating revenue to net profit after operational and non-operational costs and
incomes.
Net Profit Ratio = Net profit/Revenue from Operations × 100
Generally, net profit refers to profit after tax (PAT)

Where,
Net Profit = Gross Profit – Indirect Expenses & Losses + Other Incomes – Tax

Indirect Expenses and Losses = Office Expenses + Selling Expenses + Interest on Long
term borrowings + Accidental Losses
• Significance: It is a measure of net profit margin in relation to revenue from
operations. Besides revealing profitability, it is the main variable in computation of
Return on Investment. It reflects the overall efficiency of the business, assumes
great significance from the point of view of investors.

• It establishes relationship between net profit and sales.

• It is an indicator of overall efficiency of the business.
• Higher the net profit ratio betters the business.
• An increase in the ratio over the previous period shows improvement in the
operational efficiency and decline means otherwise
Practice Questions
• Calculate the Net Profit Ratio from the following:
Solution
To calculate Net profit, all expenses are deducted from Gross profit.

Gross Profit= Revenue from Operations – Cost of Revenue from Operations

= Revenue from Operations – (Opening inventory + Purchases + Wages + Carriage
Inwards – Closing Inventory)
= 25,00,000 – ( 4,00,000 + 12,00,000 + 2,70,000 + 1,40,000 – 3,10,000)
= 25,00,000 – 17,00,000 = ₹8,00,000

Net Profit = Gross Profit – Administrative Expenses – Selling Expenses – Income Tax +
Profit on sale of fixed assets
= 8,00,000 – 75,000 – 25,000 -50,000 + 25,000 = ₹6,75,000
Net Profit Ratio =6,75,000/25,00,000*100= 27%
Return on Capital Employed or Investment
It explains the overall utilisation of funds by a business enterprise.
Capital employed means the long-term funds employed in the business and includes
shareholders’ funds, debentures and long-term loans.

Profit refers to the Profit Before Interest and Tax (PBIT) for computation of
this ratio. Thus, it is computed as follows:

Return on Investment (or Capital Employed) = Profit before Interest and Tax/
Capital Employed × 100
• Significance: It measures return on capital employed in the business.

• It reveals the efficiency of the business in utilisation of funds entrusted to it by

shareholders, debenture-holders and long-term loans.

• For inter-firm comparison, return on capital employed funds is considered a good

measure of profitability.

• It also helps in assessing whether the firm is earning a higher return on capital
employed as compared to the interest rate paid.
Earnings per Share
The ratio is computed as:
EPS = Profit available for equity shareholders/Number of Equity Shares

In this context, earnings refer to profit available for equity shareholders which is
worked out as:
Profit after Tax – Dividend on Preference Shares.

• This ratio is very important from equity shareholders point of view and also for the
share price in the stock market.
• This also helps comparison with other to ascertain its reasonableness and capacity
to pay dividend.
Solution
Profit before interest and tax = Profit after Tax + Debenture interest + Tax
= Rs. 1,50,000 + Rs. 40,000 + Rs. 50,000
= Rs.2,40,000

Capital Employed = Equity Share Capital + Preference Share Capital + Reserves + Debentures
= Rs. 4,00,000 + Rs. 1,00,000 + Rs. 1,84,000
+ Rs. 4,00,000 = Rs. 10,84,000

Return on Investment = Profit before Interest and Tax/ Capital Employed × 100
= Rs. 2,40,000/Rs. 10,84,000 × 100
= 22.14%
EPS = Profit available for Equity Shareholders/Number of Equity Shares

Profit available for Equity Shareholders = Profit after Interest and Tax – preference
dividend
=1,50,000-12,000 = Rs. 1,38,000
= Rs. 1,38,000/ 40,000 = Rs. 3.45

Preference Share Dividend = Rate of Dividend × Prefence Share Capital

= 12% of Rs. 1,00,000
= Rs. 12,000