MBA604_Financial Reporting and Analysis

Financial Statement Analysis I 195 to know whether the financial statements have been prepared in accordance with the legal provisions and whether the figures of production, sales and profits are correct for the purpose of assessment of GST and income tax, etc. (ix) Significance for Researchers: Analysis of financial statements of a company is of much importance to a researcher who is conducting research in respect of the profitability, efficiency, financial soundness and future growth potential of that company. (x) Significance for Other Parties: Some other parties may also be interested in the analysis of financial statements of a company from their own point of view, such as economics, trade associations, etc. 6.5 Summary Financial statement analysis also helps in making comparison between various groups to draw various conclusions. It helps in classifying the items contained in financial statements in convenient and rational groups. An income statement in which each account is expressed as a percentage of the value of the sales. This type of financial statement can be used to allow for easy analysis between companies or between time period of a company. On the other hand, a company balance sheet that displays all items as percentages of a common base figure. This type of financial statement can used to allow for easy analysis between companies or between time periods of a company. The comparative statements lines up a section of the income statement, balance sheet or cash flow statement with its corresponding section from a previous period. Objectives of financial statement analysis are: (1) assessment of past performance and current position, (2) prediction of net income and growth prospects, (3) prediction of bankruptcy and failure and (4) loan decision by financial institutions and banks. Various techniques used in the analysis of financial data to emphasise the comparative and relative importance of data are the following: (i) Comparative statements, (ii) Common size statements, (iii) Trend analysis and (iv) Ratio analysis. Comparative statements: Comparative analysis of financial statements refers to “over the period comparison” of various figures to understand the change and rate of change. It involves simultaneous presentation and analysis of income statements or balance sheets of the same firm for two or more accounting periods (intra-firm) or for different firm over an accounting period (inter- firm). Horizontal analysis is used for the same. Importance of Comparative Statements: (1) to make the data more simpler and understandable, (2) to indicate the trend of change by putting the figures of different items for a number of years side by side, (3) to indicates the strong and the weal points of the concern, (4) to compare the firms performance with the average performance of the industry and (5) to help in forecasting the profitability and financial soundness of the business. CU IDOL SELF LEARNING MATERIAL (SLM)

196 Financial Reporting and Analysis Common size statements involve expressing comparisons in percentages. Common size statements may be prepared in order to compare percentages of a current period with past periods, to compare individual business, or to compare one business with industry percentages published by trade associations and financial information services. Financial analysis is significant for: (i) Management of a firm is always interested in the solvency, profitability and the capital structure of the firm. (ii) Short-term creditors want to know the liquidity of the business whether the company will have sufficient current assets and cash to pay their debts or not. On the other hand, long-term creditors want to know that whether the company will be able to pay the interest consistently, and whether the company will be able to pay their debts when they fall due. (iii) Investors and shareholders of the business are interested in the longevity of the firm and therefore, they want to know the earning capacity of the business. (iv) Government can judge on the basis of analysis of financial statements, which industry is progressing on the desired way and which industry is in actual need of financial help. (v) Employees on the basis of profitability can ascertain as to how much bonus and increase in their wages is possible from the profits of the company. Analysing the financial statements also help the trade unions in negotiating wage agreements. (vi) By analysing the financial statements, stock exchange authorities determine the price earnings ratio and earning per share with the help of which the market price of a company’s share is determined. (vii) All the financial institutions which provide finance to the industries such as banks, insurance companies, etc. want to know the profit earning capacity of the businesses and its long-term solvency. (viii) Taxation authorities analyse the financial statement of a company to know whether the financial statements have been prepared in accordance with the legal provisions and whether the figures of production, sales and profits are correct for the purpose of assessment of GST and income tax, etc. (ix) Analysis of financial statements of a company is of much importance to a researcher who is conducting research in respect of the profitability, efficiency, financial soundness and future growth potential of that company. (x) Some other parties may also be interested in the analysis of financial statements of a company from their own point of view, such as economics, trade associations, etc. 6.6 Key Words/Abbreviations  Comparative statements: Comparative analysis of financial statements refers to “over the period comparison” of various figures to understand the change and rate of change. It involves simultaneous presentation and analysis of income statements or balance sheets of the same firm for two or more accounting periods (intra-firm) or for different firm over an accounting period (inter-firm).  Common size statements: Common size statements involve expressing comparisons in percentages. Common size statements may be prepared in order to compare percentages of a current period with past periods, to compare individual business, or to compare one business with industry percentages published by trade associations and financial information services. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis I 197 6.7 Learning Activity 1. Ram Ltd. was in the business of manufacturing. Following are the Balance Sheets of Ram Ltd. as at 31st March, 2018 and 2019: Particulars 31.03.19 31.03.18 I. EQUITY AND LIABILTIES: 10,00,000 5,00,000 1. Shareholder’s Funds: 2,00,000 3,00,000 (a) Share Capital (b) Reserve and Surplus 8,00,000 5,00,000 2. Non-current Liabilities Long-term Borrowings 4,00,000 2,00,000 3. Current Liabilities 24,00,000 15,00,000 Trade Payables TOTAL 14,00,000 8,00,000 3,00,000 2,00,000 II. ASSETS 1. Non-current Assets 5,00,000 4,00,000 2. Fixed Assets: 2,00,000 1,00,000 (a) Tangible Assets 24,00,000 15,00,000 (b) Intangible Assets 3. Current Assets (a) Inventories (b) Cash and Cash Equivalents TOTAL You are required to: (a) Prepare a Comparative Balance Sheet (b) Identify any two values which the company wants to communicate to the society. _________________________________________________________________ _________________________________________________________________ 2. Following is the statement of Profit and Loss of Megha Ltd. for the year ended 31st March, 2018: CU IDOL SELF LEARNING MATERIAL (SLM)

198 Financial Reporting and Analysis Particulars 31.03.2018 31.03.2017 Revenue from Operations 25,00,000 20,00,000 Other Incomes 1,00,000 5,00,000 50% of total revenue Employee Benefit Expenses 60% of total revenue Other Expenses 10% of employee 20% of employee 40% benefit expenses benefit expenses Tax Rate 50% The motto of Megha Ltd. is to produce and supply green energy in the rural areas of India. It has also taken up a project of constructing a road that will pass through five villages, so that these villages could be connected to the nearby town. It will use the local resources and employee local people for construction of the road. You are required to prepare a Comparative Statement of Profit and Loss of Megha Ltd. from the given statement of Profit and Loss. Also, identify any two values that the company wishes to convey to the society. ________________________________________________________________ ________________________________________________________________ 6.8 Unit End Questions (MCQ and Descriptive) A. Descriptive Type Questions 1. What do you mean by financial statement analysis? 2. What are comparative statements? Substantiate with example. 3. Explain common size statement and how are they used. 4. Give a specimen of Comparative Statement of Profit and Loss of two years. B. Multiple Choice/Objective Type Questions 1. Dividend is paid on: (a) Authorised Capital (c) Issued Capital (b) Subscribed Capital that is paid up (d) Reserve Capital 2. Debentures are shown in the Balance Sheet under the head of: (a) Long-term Borrowings (c) Current Liabilities (b) Long-term Provisions (d) Shareholders’ Fund CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis I 199 3. Gain on sale of fixed assets by a financial company is shown in the Statement of Profit and Loss as: (a) Revenue from operations (c) Other Income (b) Both (a) and (c) (d) None of the above 4. Which among the following is the tool of Financial Statement Analysis? (a) Comparative Statement (c) Common Size Statement (b) Ratio Analysis (d) All the above 5. Which among the following is the limitation of Financial Statement Analysis? (a) Ignores price level changes (c) Qualitative aspect ignored (b) Not free from bias (d) All the above 6. It is an arithmetical relationship between two accounting variables: (a) Cash Flow Statement (c) Ratio Analysis (b) Common Size Statement (d) Comparative Statement 7. Which among the following is the objective of Common Size Statement? (a) To analyse change in individual items of Income Statement (b) To study the trend in different items of incomes and expenses (c) To assess the efficiency (d) All the above 8. Which among the following is also termed as 100% Statement since in this statement all items are expressed as percentage of the base item: (a) Cash Flow Statement (c) Ratio Analysis (b) Common Size Statement (d) Comparative Statement 9. Comparative statements are prepared to show: (a) Absolute amount (b) Increase/Decrease in absolute amounts (c) Percentage of totals (d) All the above Answers: 1. (b), 2. (a), 3. (c), 4. (d), 5. (d), 6. (c), 7. (d), 8. (b), 9. (d) CU IDOL SELF LEARNING MATERIAL (SLM)

200 Financial Reporting and Analysis Unsolved Questions: 1. From the following information, prepare Comparative Balance Sheets of Neha Ltd. Particulars 31.03.2018 31.03.2017 Reserve and Surplus 12,00,000 6,00,000 Share Capital 10,00,000 10,00,000 Trade Payables 12,70,000 9,00,000 Land and Buildings 16,00,000 15,00,000 Plant and Machinery 6,30,000 5,00,000 Goodwill 1,00,000 Investments – 1,00,000 Current Assets 1,20,000 8,00,000 Long-term Borrowings 15,20,000 5,00,000 4,00,000 Ans: Absolute change (Increase or Decrease): 8,70,000 Percentage change (Increase or Decrease): 29.00 2. From the information given below, prepare Comparative Statement of Profit and Loss: Particulars 31.03.2017 31.03.2016 A. Revenue from Operations: Sales 24,00,000 21,00,000 B. Return Inward 4,00,000 1,00,000 C. Cost of Materials Consumed 50% of Revenue from 60% of Revenue from operations (net) operations (net) D. Other Expenses % (Net Revenue from Operations 10% 20% – Cost of materials consumed) 40% 40% E. Income Tax Ans: Absolute change (Increase or Decrease): 1,56,000 Percentage change (Increase or Decrease): 40.63 3. Prepare a common size Balance Sheet and comment on the financial position of Mani Ltd. and Rajeev Ltd. The Balance Sheet as at 31st March, 2018: Particulars Mani Ltd. Rajeev Ltd. I. EQUITIES AND LIABILTIIES: 3,00,000 4,00,000 1. Shareholders’ Funds 2,00,000 3,00,000 2. Non-current Liabilities 1,00,000 3. Current Liabilities 6,00,000 50,000 TOTAL 7,50,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis I 201 II. ASSETS: 2,50,000 3,00,000 1. Non-current Assets 1,50,000 1,00,000 (i) Tangible Assets 2,00,000 3,50,000 (ii) Intangible Assets 6,00,000 7,50,000 2. Current Assets TOTAL 4. Following the Statement of Profit and Loss of Raghav Ltd. for the year ended 31st March, 2019: Particulars Amount Income: 2,00,000 Revenue from Operations 15,000 Other Incomes Total Revenue 2,15,000 Expenses: Cost of Materials Consumed 1,10,000 Other Expenses 5,000 Total Expenses Tax 1,15,000 40,000 You are required to prepare a common size Statement of Profit and Loss of Raghav Ltd. for the year ended 31st March, 2019. Ans: Absolute amounts: 60,000; % of revenue from operations: 30 6.9 References 1. Baruch Lev, Financial Statement Analysis, New Approach, Prentice Hall, 1974, p. 5. 2. Accountingtools.com – Financial Statement Analysis. 3. Beginner’s Guide to Financial Statements by SEC.gov CU IDOL SELF LEARNING MATERIAL (SLM)

202 Financial Reporting and Analysis UNIT 7 FINANCIAL STATEMENT ANALYSIS II Structure: 7.0 Learning Objectives 7.1 Introduction 7.2 Types ofAnalysis 7.3 Summary 7.4 Key Words/Abbreviations 7.5 LearningActivity 7.6 Unit End Questions (MCQ and Descriptive) 7.7 References 7.0 Learning Objectives After studying this unit, you will be able to:  Explain what are different types of analysis  Compare different types of analysis 7.1 Introduction In the word of Finney and Miller: “Financial analysis consists in separating facts according to some definite plans, arranging them in groups according to certain circumstances and then presenting them in a convenient and easily read and understandable form.” CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis II 203 Main features of financial analysis are: 1. To present complex data contained in financial statements in simple and understandable form. 2. To classify the items contained in financial statements in convenient and rational groups. 3. To make comparisons between various groups to draw various conclusions. Financial analysis is an art and as such there are various approaches towards financial analysis. Meaning Financial Statement Analysis is an analysis which highlights important relationships in the financial statements. Financial statement analysis embraces the methods used in assessing and interpreting the results of past performance and current financial position as they relate to particular factors of interest in investment decisions. It is an important means of assessing past performance and in forecasting and planning future performance. According to Lev:1 “Financial Statement Analysis is an information processing system designed to provide data for decision making models, such as the portfolio selection model, bank lending decision models, and corporate financial management models.” 7.2 Types of Analysis Analysis On the basis of On the basis of information modus operandi of analysis (a) External analysis (a) Horizontal analysis (b) Internal analysis (b) Vertical analysis ExternalAnalysis: This analysis is based on information easily available to outsiders or externals for the business, e.g., outsiders include creditors, suppliers, investors, government agencies, etc. These parties do not have access to the internal records of the firm and generally they obtain data for analysis from the published financial statements. Hence, the analysis done by the externals is known as external analysis. Internal Analysis: This analysis is based on information obtained from the internal and unpublished records and books. It is being conducted by the internal analysts like executives, employees, Government officials, etc. Such an analysis serves a meaningful purpose of internal management and employees. CU IDOL SELF LEARNING MATERIAL (SLM)

204 Financial Reporting and Analysis Horizontal Analysis: This analysis is done by analysing the statements over a period of time. This type of analysis is also termed as ‘dynamic analysis’ or ‘trend analysis’. Under this analysis, we try to examine as to what has been the periodical trend of various items shown in the statement (whether they have increased or decreased with the passage of time). Such type of analysis is based on the data from year to year rather than only one year. Vertical Analysis: It is made by analysing a single set of financial statement prepared at a particular date. This type of analysis is also termed as ‘static analysis’ or ‘structural analysis’. Example of vertical analysis is common size statement. Hence, it studies the quantitative relationship existing among the items at a particular date. It defines the composition of financial statements by expressing balance sheet total or total revenue as 100% and expressing rest of the figures as a percentage of the same. Vertical analysis is based on the data of a single year, hence it is called ‘static analysis’. It is useful in comparing the performance of several companies in the same group or departments in the same company. Comparison between VerticalAnalysis and Horizontal Analysis Vertical analysis is not very useful for properly analysing the company’s financial position because it depends on the data of a single period whereas the business is a dynamic process. In comparison to vertical analysis, horizontal analysis is more useful because it brings out more clearly the nature and trends of current changes affecting the enterprise. Horizontal analysis emphasises on the fact that for a series of periods are far more significant than those for a single period. 7.3 Summary Financial analysis is an art, and as such, there are various approaches towards financial analysis. Features of financial analysis are: (1) to present complex data contained in financial statements in simple and understandable form; (ii) to classify the items contained in financial statements in convenient and rational groups and (iii) to make comparisons between various groups to draw various conclusions. Two basic approaches are on the basis of information (these are internal and external analysis) and on the basis of modus operandi (horizontal and vertical analysis). Here, horizontal analysis is an analysis where financial statements for a number of years are reviewed and analysed and vertical analysis is that type of analysis in which financial statements for a single year or on a particular date are reviewed and analysed with the help of proper tools like ratio analysis, etc. Horizontal analysis is done by analysing the statements over a period of time. This type of analysis is also termed as ‘dynamic analysis’ or ‘trend analysis’. Vertical analysis is made by analysing a single set of financial CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis II 205 statement prepared at a particular date. This type of analysis is also termed as ‘static analysis’ or ‘structural analysis’. External analysis is based on information easily available to outsiders or externals for the business. Outsiders include creditors, suppliers, investors, government agencies, etc. These parties do not have access to the internal records of the firm and generally they obtain data for analysis from the published financial statements. Internal analysis is based on information obtained from the internal and unpublished records and books. It is being conducted by the internal analysts like executives, employees, Government officials, etc. Under this analysis, we try to examine as to what has been the periodical trend of various items shown in the statement (whether they have increased or decreased with the passage of time). 7.4 Key Words/Abbreviations  Modus Operandi: A particular way or method. 7.5 Learning Activity 1. Illustrate with the help of an example how horizontal and vertical analysis are prepared by the companies. _________________________________________________________________ _________________________________________________________________ 2. Illustrate how shareholders are interested in the financial statement of the company. _________________________________________________________________ _________________________________________________________________ 7.6 Unit End Questions (MCQ and Descriptive) A. Descriptive Type Questions 1. What is meant by financial analysis? 2. Explain various types of analysis. 3. What is horizontal analysis of financial statement? 4. What is vertical analysis of financial statement? 5. Explain how financial statements ignores qualitative elements? CU IDOL SELF LEARNING MATERIAL (SLM)

206 Financial Reporting and Analysis B. Multiple Choice/Objective Type Questions 1. This analysis is based on information easily available to outsiders or externals for the business: (a) External analysis (b) Internal analysis (c) Horizontal analysis (d) Vertical analysis 2. Outsiders in an organisation doesn’t include: (a) Creditors (b) Suppliers (c) Investors (d) Executives 3. Horizontal analysis is also known as: (a) Dynamic analysis (b) Trend analysis (c) Both (a) and (b) (d) Static analysis 4. Vertical analysis is based on the data of a single year, hence it is called: (a) Dynamic analysis (b) Trend analysis (c) Static analysis (d) Internal analysis 5. This type of analysis refers to the composition of financial statements by expressing balance sheet total or total revenue as 100% and expressing rest of the figures as a percentage of the same. (a) External analysis (b) Internal analysis (c) Horizontal analysis (d) Vertical analysis Answers: 1. (a), 2. (d), 3. (c), 4. (c), 5. (d) 7.7 References 1. Baruch Lev, Financial Statement Analysis, New Approach, Prentice Hall, 1974, p. 5. 2. Accountingverse.com (2012), Users of Financial Statements [online], Available at: http:/ /www.accountingverse.com/ accounting basics/ users-of-financial statements.html [Accesses: 2 November, 2012]. 3. Thomas P. Edmonds, et al., Fundamental Financial Accounting Concepts, 2011. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 207 UNIT 8 FINANCIAL STATEMENT ANALYSIS III Structure: 8.0 Learning Objectives 8.1 Introduction 8.2 Advantages of Ratios 8.3 Classification of Ratios 8.4 Concept 8.5 Definitions in Ind AS-7 ‘Statement of Cash Flow’ 8.6 Presentation of Cash Flow Statement 8.7 Steps in Preparing the Cash Flow Statement 8.8 Summary 8.9 Key Words/Abbreviations 8.10 Learning Activity 8.11 Unit End Questions (MCQ and Descriptive) 8.12 References 8.0 Learning Objectives After studying this unit, you will be able to:  Calculate profitability, liquidity, turnover and solvency ratios  Critically discuss the strength and weakness of ratio analysis  Distinguish investing activities that affect a company’s cash flow statement from the business’s other transactions CU IDOL SELF LEARNING MATERIAL (SLM)

208 Financial Reporting and Analysis  Distinguish financing activities that affect a company’s cash flow statement from the business’s other transactions  Explain the significance of each component of the cash flow statement 8.1 Introduction Absolute figures expressed in monetary terms in financial statements by themselves are meaningless. These figures often do not convey much meaning unless expresses in relation to other figures. Ratio analysis is a financial statement analysis tool based on accounting data. It ascertains numerical relationship between various accounting terms to analyse financial performance with respect to different parameters like profitability, solvency (long-term and short-term), turnover, etc. It facilitates both intra- and inter-firm comparison and allows the stakeholders to take informed decisions. They cover key performance areas for any business enterprise. 8.2 Advantages of Ratios Ratio analysis offers the following advantages:  It aids financial statement analysis.  It facilitates intra-firm comparison and help chart trends.  Ratios are relative concepts and therefore support inter-firm comparison.  Ratios help in simplifying accounting terms by providing answers in percentages and times. It is the simplest tool of financial analysis for a layman.  It checks and highlights the performance of an enterprise on key parameters of liquidity, profitability and growth.  It identifies the points of concern for management and aids in decision making.  It can be used as a forecasting tool. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 209 8.3 Classification of Ratios The classification of ratios is as follows: 1. Liquidity Ratios (a) Current ratio (b) Acid test ratio (c) Cash ratio 2. Activity Ratios (a) Capital turnover ratio (b) Asset turnover ratio (c) Net working capital turnover ratio (d) Inventory turnover ratio (e) Debtors turnover ratio 3. Profitability Ratios (a) Related to investments (i) Earnings margin (ii) Return on capital employed (iii) Return on equity shareholders’ fund (iv) Return on total assets (b) Related to sales (i) Gross profit ratio (ii) Net profit ratio (iii) Operating ratio (iv) Operating profit ratio 4. Capital Structure/Gearing Analysis/Solvency Ratios (a) Debt-equity ratio (b) Dividend per share (b) Interest coverage ratio (d) Dividend cover (c) Proprietary ratio (f) Dividends to cash flow 5. Market Strength Analysis (h) Net asset value per share (a) Earnings per share (c) Gross dividend yield (e) Payout ratio (g) Price earnings ratio (i) Cash flow per share CU IDOL SELF LEARNING MATERIAL (SLM)

210 Financial Reporting and Analysis LIQUIDITY RATIOS Liquidity or short-term solvency analysis aims to determine the ability of a business to meet its financial obligations during the short-term and to maintain its short-term debt-paying ability. The aim of liquidity analysis for a company is to have adequate funds on hand to pay bills when they are due and to meet unexpected needs for cash. If a business enterprise cannot maintain its short-term debt paying ability, obviously it cannot maintain a long-term debt-paying ability or long-term solvency. Shareholders will not be satisfied with such a state of affairs of the company. Even a business enterprise on a very profitable course will find itself bankrupt it if fails to meet its obligations to short-term creditors. Liquidity analysis mainly focuses on balance sheet relationships that indicate the ability of a business to liquidate current and non-current liabilities. The ratios that evaluate liquidity relate to working capital or some part of it, because it is out of working capital that debts are paid as they mature. The comparisons and ratios that evaluate liquidity relate to working capital or some part of it, because it is out of working capital that debts are paid as they mature. The comparisons and ratios related to evaluating liquidity or short-term solvency are as follows: Current Ratio It is also referred to as working capital ratio and banker’s ratio. Current ratio expresses the relationship of current assets and current liabilities. It is widely used as a broad indicator of a company’s liquidity and short-term debt-paying ability. The current ratio formula is as follows: Current Ratio = Current Assets Current Liabilities Current ratio is more dependable indicator of solvency than is working capital. For many years, the guideline for the minimum current ratio has been 2 : 1. The assumption is even if the value of current assets declines 50%, the firm can still pay its current liabilities. But nowadays there has been a decline in the liquidity of many firms. It can be said that in some industries, a current ratio substantially below 2 is adequate, while some other industries may require a ratio much larger than 2. In general, the shorter the operating cycle, the lower the normal current ratio. The longer the operating cycle, higher the normal current ratio. A higher current ratio enables a firm to pay-off current obligations and provides adequate margin of safety to the creditors. A company’s current ratio can be compared with the company’s past current ratios and with the industry average as well. Such comparisons can help in determining if the current ratio is high or low, at this period of time. However, the comparisons do not indicate why the current ratio is high or low. Possible reasons for unsatisfactory current ratio can be found from an analysis of the individual accounts and items that make up the current assets and current liabilities. Example: The following are the current assets and current liabilities in respect of the two companies, Company X and Company Y. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 211 Company X (`) Company Y (`) 1,60,000 Current Assets 4,50,000 80,000 Current Liabilities 1,50,000 Company Y (`) 1,60,000/80,000 = 2.1 The current ratio will be as follows: Current Assets Current Ratio = Current Liabilities Company X (`) Current ratio 4,50,000/1,50,000 = 3.1 Acid Test Ratio or Quick Ratio The current ratio is generally used to evaluate an enterprise’s overall short-term solvency or liquidity position. The current ratio does not take into account the makeup or composition of current assets. For example, a rupee of cash or debtor is considered more readily available to meet obligations than the amount stuck in the form of inventory. The quick ratio addresses this issue and segregates near liquid assets from total current assets. Cash, marketable securities or short-term investments, receivables and prepaids are included within the meaning of most liquid assets; inventory is excluded. The acid test ratio is as follows: Acid Test Ratio = Current Assets – Inventory Current Liabilities It may be preferable to have a better view of liquidity by excluding some other items in current assets that may not represent relatively current cash flow. Examples of items to be excluded are prepaids and miscellaneous items such as assets held for sale. This is considered as a more conservative manner of computing the acid test ratio and the formula of acid test ratio in this situation will be as follows: Cash Marketable Securities Net receivables and Debtors Acid Test Ratio = Current LIabilities Inventory should be removed from current assets when computing the acid test ratio due to the reasons that inventory may be slow moving or possibly obsolete and parts of the inventory may have been pledged to specific creditors. For example, a winery has inventory that requires considerable time for aging and therefore a considerable time before sale. To include the wine inventory in the test computation would overstate the liquidity. There is also a valuation problem with inventory, because it is stated as a cost figure that is likely to be materially different from a fair current valuation. In summary, inventory should be left out of the computation because of possible misleading liquidity indications. CU IDOL SELF LEARNING MATERIAL (SLM)

212 Financial Reporting and Analysis The usual benchmark for acid test ratio is 1.00. However, some industries may find that a ratio less than 1.00 is adequate, while other need a ratio greater than 1.00. For example, a typical grocery store sells only for cash and therefore does not have receivables. This type of business can have an acid test substantially below the 1.00 guideline and still have adequate liquidity. Example: A firm has the following current assets and current liabilities. ` Debtors 5,000 Inventory 20,000 Cash 5,000 Total Current Assets 30,000 Total Current Liabilities 20,000 Quick Assets Acid Test Ratio = Current Liabilities 10,000 = 20,000 = 0.5 : 1 Cash Ratio Liquidity of a firm can be viewed from an extremely conservative point of view and the short-term liquidity of a company may be measured through cash ratio. The cash ratio relates cash and marketable securities to current liabilities. The cash ratio is computed as follows: Cash Marketable Securities Cash Ratio = Current LIabilities Cash ratio is not given much importance unless a firm is in deep financial trouble. It is not considered pragmatic to expect a business enterprise to have enough cash and marketable securities to cover current liabilities. However, in the case of very slow moving inventories and receivables and highly speculative companies, cash ratio is of great importance. A high cash ratio indicates that a business enterprise is not using its cash resources to best advantage. A low cash ratio reflects an immediate problem with paying bills. Activity Ratios Activity ratios, also known as turnover ratios, indicate the efficiency with which an enterprise’s resources are utilised. Liquidity or short-term analysis (current ratio and acid test ratio) will show misleading results if debtors are too high because of slow collection. Similarly, the current ratio will be misleading if inventory is not sold and thus remains at high levels. Since liquidity ratios (i.e., current ratio and acid test ratio) ignore the movement of current assets, it is necessary for CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 213 short-term creditors to make an analysis of how fast the debtors and stock are turned in to cash so that their claim can be met timely. Moreover, the overall profitability of the business depends upon: 1. The rate of return of capital employed 2. The turnover, i.e., the speed at which the capital employed in the business rotates. Hence, in order to find out which part of capital (i.e., assets) is efficiently employed and which part not, different activity or turnover ratios are calculated. Mainly activity ratios include: 1. Capital turnover ratio 2. Asset turnover ratio 3. Net working capital turnover ratio 4. Inventory turnover ratio 5. Debtors turnover ratio Capital Turnover Ratio This ratio measures the effectiveness with which a firm uses its financial resources. It indicates the number of times the capital has been rotated in the process of doing business. The ratio is computed as follows: Capital Turnover Ratio Net Sales (or Cost of goods sold) = Capital Empoyed or Owner ' sequity Net Sales = Total Sales – Returns (if any) Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock Or = Sales – Gross Profit Example: A firm has opening and closing stock of ` 30,000 and ` 20,000 respectively. Its administrative and selling expenses are ` 10,000; Purchases are ` 3,10,000; Sales ` 5,00,000; Debentures ` 50,000 (representing 1/3rd of owner’s equity). Cost of goods sold Capital Turnover Ratio = Owner ' s equity Opening stock purchases clo sin g stock = Owner 's sequity CU IDOL SELF LEARNING MATERIAL (SLM)

214 Financial Reporting and Analysis Capital Turnover Ratio = 30,000 3,10,000 – 20,000 = 50000 3 3,20,000 1 Fixed Asset Turnover Ratio = 1,50,000 = 2.133 times This ratio reveals the number of times net fixed assets (i.e., fixed assets less depreciation) are turned during the year. Strictly speaking, average net fixed assets should be used in calculating this ratio. But, invariably, net fixed assets at the end of the year are used. Turnover (Net Sales) Fixed Assets Turnover Ratio = Net Fixed Asset An improvement in assets turnover ratio as compared to the previous year indicates that the turnover of the company has improved. In cases where assets are not revalued or replaced, its magnitude will be the decreasing over the years due to depreciation. Then obviously, the ratio will be higher as the turnover figures for the future will reflect an increasing trend. This ratio indicates the extent to which the investment in fixed assets has contributed to sales. If compared with a previous period, it indicates whether investment in fixed assets has been judicious or not. The higher the ratio, the better it is because it indicates higher efficiency with respect to utilisation of fixed assets. A lower ratio may point to the underutilisation of certain assets. Example: Calculation of fixed asset turnover ratio with the following details: Particulars 2015-16 (3) 2016-17 (3) Fixed Assets at written down value 30,00,000 60,00,000 Sales less returns 1,20,00,000 1,60,00,000 Fixed Asset Turnover = Net Sales/Net Fixed Assets = Net Sales/Net Fixed Assets Ratio = 1,20,00,000/30,00,000 = 1,60,00,000/60,00,000 = 4 times = 2.67 times Comment: There has been a decline in fixed asset turnover ratio though the absolute figures of sales have gone up. It indicates that the increase in fixed assets over the year did not bring proportionate gains. Hence, the newly acquired assets seem to be underutilised. However, all the fixed assets do not yield gains in quick turnaround period. The gestation period also needs to be considered along with standard operating cycle. A reliable conclusion for fixed assets may be based on a minimum of three years. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 215 Net Working Capital Turnover Ratio This ratio indicates whether or not the working capital has been effectively utilised in making sales. This ratio is computed by dividing net sales or cost of goods sold by net working capital. Net working capital signifies the excess of current assets over current liabilities. The ratio is calculated as follows: Turnover (Net Sales) Net Working Capital Turnover Ratio = Net Fixed asset A high net working capital ratio (if it is expressed in percentage) indicates efficient use of working capital and quick turnover of current assets like stock and debtors. A low ratio indicates low turnover on these assets. Inventory Turnover Ratio Inventory turnover ratio measures the relative size of inventory and influences the amount of cash available to pay liabilities. A smaller, faster-moving inventory means that the company has less cash tied up in inventory. On the contrary, a buildup in inventory means that a recession or some other factor is preventing sales from keeping pace with purchasing and production. Ideally, inventory should be maintained at an optimum level to support production and sales. Inventory turnover ratio is calculated by using the following formula: Cost of goods sold Inventory Turnover Ratio = Average inventory Average inventory is obtained by using a simple average by dividing opening and closing inventory by two. Cost of goods sold is obtained by deducting gross profit from sales. Example: Calculate Inventory Turnover Ratio from following data: Opening Stock ` 56,000 Closing stock ` 44,000 Sales ` 5,00,000 Gross profit margin on sales 20% Cost of goods sold = (Sales – Gross profit) = 5,00,000 – 20% (5,00,000) Average inventory = 4,00,000 = (Opening Stock + Closing Stock)/2 = (56,000 + 44,000)/2 = 50,000 CU IDOL SELF LEARNING MATERIAL (SLM)

216 Financial Reporting and Analysis Inventory Turnover Ratio Cost of goods sold = Average inventory = 4,00,000 / 50,000 = 8 times per year Receivables Turnover Ratio The ability of a company to collect money from credit sales timely affects the company’s liquidity. The relationship between credit sales and accounts receivables may be stated as the receivables turnover. Receivables or debtors turnover determines the liquidity of one item of current assets and funds out how fast debts are being collected. The formula for computing Receivables Turnover is as follows: Net Credit Sales Receivables Turnover = Average Accounts Re ceivables or Debtors Receivables Turnover shows how many times, on average, the receivables were turned into cash during the period. A higher Debtors Turnover Ratio indicates shorter time span between occurrence and collection of money from credit sales. This ratio requires calculation on yearly basis. In case, credit sales are not given in the question, total sales may used for computational purposes. The presumption is that all the sales are carried out on credit basis. Example: Calculate Debtors Turnover Ratio and Average Collection Period from the following data: Amount ` Opening Debtors 40,000 Closing Debtors 75,000 Credit Sales 3,45,000 Debtors Turnover Ratio Net Credit Sales = Average Accounts Re ceivables or Debtors 3, 45, 000 = 40,000 75,000 2 Average Collection Period = 6 times per year 12 months = Debtors Turnover Ratio 12 months = 6 times = 2 months CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 217 PROFITABILITY RATIOS The long-term survival of our business enterprise depends on satisfactory income earned by it. An evaluation of a company’s past profits may give the investors, creditors and others a better understanding for decision making. The profitability positioned also affects the liquidity position that is vital to creditors as well. These ratios are: Return on Capital Employed or Return on Investment This ratio measures the profitability in relation to the total capital employed in a business enterprise. The terms invested capital; capital funds and total capital may be used interchangeably. It is a useful ratio when comparing the overall performances of companies, particularly where they have different proportions of debt in their capital structure. This ratio would also show whether the company’s borrowings policy is economically wise and whether the capital had been employed judiciously. For instance, assume that the funds have been borrowed at 7.5% and return on capital employed is 7%, it would be better not to borrow unless it is essential. It would also show that the firm had not been employing the funds efficiently. The business can survive only when the return on capital is more than the cost of capital employed in the business. According to some analysts, short-term borrowings, such as bank loans, commercial paper, deferred tax liability, should be included under capital. Current accrued payables, which are not interest bearing, should be excluded because their interest component is not observable. Example: Calculate Return on Capital Employed with the following information: Particulars Amount (`) Equity Share Capital 20,00,000 Reserves and surplus (including current year profit of ` 5,00,000) 9,00,000 10% Debentures 10,00,000 Current Liabilities 16,00,000 Fixed Assets 30,00,000 Current Assets 25,00,000 Solution: = Current Year’s Profit + Interest on Debentures Profit Before Interest = 5,00,000 + 10%(10,00,000) = 6,00,000 Total Capital Employed = Fixed Assets + Current Assets – Current Liabilities = 30,00,000 + 25,00,000 – 16,00,000 = 39,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

218 Financial Reporting and Analysis OR = Equity Share Capital + Reserves and Surplus + Long-term Debt = 20,00,000 + 9,00,000 + 10,00,000 = 39,00,000 Return on Capital Employed/ Pr ofit before Interest and tax ROI = Total Capital Employed × 100% 6,00,000 = 39,00,000 × 100% = 15.4% Return on Equity Shareholders’ Funds Taking net income and dividing it by shareholders’ equity give return on equity. This indicates the returns which the management is realising from the shareholders’ equity and shows how effectively ordinary shareholders’ funds are being utilised by the management. As long as it is above the current interest ratio, a company is considered to be doing fairly well. Return Equity = Pr ofit after tax – Pr eference Dividends × 100 Equity Shareholders' Funds It is obvious that both the ratios – returns on capital and return on equity – will be influenced when a company has raised new capital during the course of the year, i.e., in other words, the ratio will be artificially low. Also, the ratios do not take into account the effect of financial leverage which undesirably tends to increase the variability of earnings for the ordinary shares. In fact, ordinary shareholders of a company having higher dose of borrowings expect large returns to compensate for the high level of risk. Financial analysts, sometimes in such cases, find out the trade­off between higher earnings and increased variability of earnings to determine whether the management has chosen the optimum amount of financial leverage. Example: Calculate Return of Equity (ROE) from the following information: 10% Preference Share Capital (fully paid up) ` 10,00,000 1,60,000 Equity Shares of `10 each fully paid 16,00,000 Reserves and Surplus 64,00,000 Net Profit after Tax 23,75,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 219 Solution: ` 16,00,000 Returns on Equity = Net Profit – Preference Dividend 64,00,000 Preference Dividend = 10% on ` 10,00,000 = ` 1,00,0000 Equity Shareholders’ Funds: 80,00,000 Paid-up Equity Share Capital + Reserves as Surplus Return on Equity = 23,75,000 – 1,000,000 × 100 80,00,000 = 22,75,000/80,00,000 × 100 = 28.44% Return on Total Assets (ROTA) This ratio measures the effectiveness of assets invested in the business. It is based on Earnings before Interest and Tax (EBIT) and Total Assets Invested. It is expressed in percentage or decimal. ROTA follows ‘the higher, the better’ principle however no universal standardised metric is defined as ideal ROTA. It is based on book value of Total assets. Return on Total Assets = EBIT / Total Net Assets × 100 This ratio might be affected by depreciation expense as the total assets value may change. A simple average of opening and closing total assets may be used instead of closing figure only due to the assumption of uniformity in earning profits. It is a useful ratio for competing firms within the same industry. It may then be referred to as Return on Average Assets. Example: Calculate Return on Total Assets (ROTA) from the following information: ` Net Income 1,00,000 Interest Expenses 12,000 Taxes 28,000 Total Assets 40,00,000 Solution: Return on Total Assets = EBIT / Total Assets × 100 = Net Income + Interest + Taxes on Total Assets × 100 = 1,00,000 + 12,000 – 28,000/40,00,000 × 100 = 3.5% CU IDOL SELF LEARNING MATERIAL (SLM)

220 Financial Reporting and Analysis PROFITABILITY RATIOS RELATED TO SALES Gross Profit Ratio It is a profitability ratio that captures the relationship between Gross Profit and Net Sales. It is expressed in percentage terms. It helps in evaluating operational performance of the company. Gross Profit = Gross Profit / Net Sales × 100 where, Net Sales = Gross Sales – Sales Returns As gross profit reports profits left after deducting direct expenses, a gross profit ratio indicates quantum of profits left to meet indirect expense, financing expenses and remaining return. A steady gross profit may indicate stable profitability position of the company. Example: ` 20,00,000 Gross Sales 1,80,000 Sales Returns 4,00,000 Opening Stock 11,80,000 Purchases 1,40,000 Purchase Returns Closing Stock 90,000 Solution: Gross Profit = Gross Sales – Sales Returns + Closing Stock – Opening Stock – (Purchases – Purchase Returns) = 20,00,000 – 1,80,0000 + 90,0000 – 4,00,0000 – (11,80,0000 – 1,40,0000) = 4,70,000 Net Sales = Gross Sales – Sales Returns = 20,00,000 – 1,80,000 = 8,20,000 Gross Profit Ratio = Gross Profit / Net Sales × 100 = 4,70,000 / 18,20,000 × 100 = 25.82% CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 221 Net Profit Ratio It is the ratio of profits after tax with net sales. Net profits indicate the profits left after deducting selling, administration and financing expenses and taxes. It is a popular measure to capture overall profitability of the firm. ‘Net profit’ is an absolute term but “Net Profit Ratio” aids comparison amongst firms being a relative term. This ratio is expressed as percentage. It signifies the quantum of profits left for dividend distribution and retained earnings. A healthy net profit ratio does not necessarily indicate healthy cash flows because net profit is an accounting term calculated after deducting non-cash expenses too. Net Profit Ratio = Net Profit After Tax/Net Sales × 100 Example: Calculate Net Profit Ratio with the following, information: ` Sales 20,00,000 Sales return 80,000 Cost of goods sold Selling and administration expenses 11,00,000 Tax rate 35% 7,20,000 Solution: = Sales – Sales return – Cost of goods sold Profit before Tax – Selling and administration expenses Net Profit after tax = 20,00,000 – 80,000 – 11,00,000 – 7,20,000 Net Sales = 1,00,000 Net Profit Ratio = Profit Before Tax – Tax = 1,00,000 – 35% (1,00,000) = 65,000 = Sales – Sales Return = 20,00,000 – 80,000 = 19,20,000 = Net Profit After Tax/Net Sales × 100 = 65,000/ 19,20,000 × 100 = 3.385% CU IDOL SELF LEARNING MATERIAL (SLM)

222 Financial Reporting and Analysis Operating Ratio It is calculated as a percentage of operating profit by net sales. This ratio determines the operational efficiency of the firm. It indicates the profits of the company after meeting operational expenses. Operating Profit Ratio = Operating Profit / Net Sales × 100 Example: Calculate Operating Profit Ratio with the following information: Net sales ` Gross profit = 8,00,000 Income from investment = 2,80,000 Selling expenses = 2,000 Administration expenses = 70,000 Loss on sale of asset = 50,000 = 4,000 Solution: Operating Profit = Gross Profit – Selling Expenses – Administration Expenses Operating Profit Ratio = 2,80,000 – 70,000 – 50,000 = 1,60,000 = Operating Profit / Net Sales × 100 = 1,60,000 / 8,00,000 × 100 = 20% Operating Ratio It is an expense ratio calculated to capture the relationship between operating cost and net sales. Non-operating expenses like interest received or paid, taxes, etc. are excluded from the calculations. Operating Ratio = Operating Expenses / Net Sales × 100 Example: Calculate Operating Ratio with the following information: ` Net sales 4,00,000 Cost of goods gold 2,40,000 Selling expenses Administration expenses 40,000 40,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 223 Solution: Operating Cost = Cost of Goods Sold + Selling Expenses + Administration Expenses Operating Ratio = 2,40,000 + 40,000 + 40,000 = 3,20,000 = Operating Expenses / Net Sales × 100 = 3,20,000 / 4,00,000 × 100 = 80% SOLVENCY RATIOS Gearing ratio, i.e., the relationship of long-term debt to total capital is considered the most important by many investors and financial analysts. Popularly known as debt-equity ratio, this ratio has the utility to many shareholders, creditors, business managers, suppliers and other user groups. Gearing ratios are used to indicate:  The cushion of assets/profits available to holders of fixed income capital, should assets/ profits decline.  The gearing advantage of potentially higher assets/profits attributable to ordinary shareholders and the correspondingly higher risk that is incurred.  The scope for raising additional fixed-income capital at reasonable costs, from the point of view of the company. Debt-Equity Ratio The Debt-Equity Ratio is computed as follows: Debt-Equity Ratio = Loan Capital Pr eference Share Capital × 100 Net Tangible Assets Net tangible assets (or total capital) are obtained by subtracting the intangible assets and the current assets from total assets. Loan capital plus preference capital constitutes the amount of long-term debt. Alternatively, subtracting current liabilities from total liabilities can derive long- term debt. Other variants of Deb-Equity Ratio are as follows: Long term Liabilities  Equity (or Net Worth) × 100 External Equities  Internal Equities × 100 CU IDOL SELF LEARNING MATERIAL (SLM)

224 Financial Reporting and Analysis Long term debts  Owners' Equities × 100 Long term Debts  Shareholder 's funds Long term Debt × 100 Sometimes, capital gearing is calculated in terms of debt-equity ratio and not total capital. Capital gearing ratios, calculated in these two manners, provide essentially the same information. It is advisable that the investors select a standard method and follow it consistently throughout. It is said that as a rule of thumb, one should not opt for a company whose long-term debt exceeds two-thirds of its total capitalisation. Debt-equity ratio is very helpful in assessing a company – whether the company is marching steadily into or out of debt. In younger and aggressive companies, comparatively speaking the long-term debts may at times exceed the shareholders’ equity that means a company will not be able to get out of the difficult situation easily. A company depending on large amounts of debt should manage and perform well to avoid any worse contingencies. Debt-equity ratios should be analysed not for one but for many years to determine a trend. If it is found that equity component is continuously increasing than the long-term debt, there may not be any cause for concern. Example: Calculate Debt-Equity Ratio with the following information: Equity Share Capital: 10,000 equity shares of ` 100 each ` General Reserve 10,00,000 Surplus 4,50,000 Debentures 3,00,000 Sundry Trade Creditors 7,50,000 Outstanding Expenses 4,00,000 1,00,000 Solution: Debt-Equity Ratio External Equities = Internal Equities Debentures Trade Creditors Outstanding Expenses = Equity Share Capital General Reserve Surplus = (7,50,000 + 4,00,000 + l,00,000)/(10,00,000 + 4,50,000 + 3,00,000) = 12,50,000 / 17,50,000 = 0.71 : 1 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 225 Debt-Equity Ratio Long –term Debt = Owner's Equity Debentures = Equity Share Capital General reserve Surplus = (7,50,000) / (10,00,000 + 4,50,000 + 3,00,000) = 7,50,000 / 17,50,000 = 0.43 : 1 Long term Debt Debt-Equity Ratio = Shareholders' Funds Long– term Debt . Debentures = Equity Share Capital General Reserve Surplus Long term Debt = (7,50,000) / (10,00,000 + 4,50,000 + 3,00,000 + 7,50,000) = 7,50,000 / 25,00,000 = 0.3 : 1 Interest Coverage Ratio Interest coverage ratio determines the debt servicing capacity of a business enterprise keeping in view fixed interest on long-term debt. The formula for this ratio is: Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT) Interest If a business enterprise is able to earn a return on the assets higher than the rate of interest on long-term debt, the enterprise makes an overall profit. However, the enterprise runs the risk of not earning a return on assets equal to the interest cost of the long-term loan, the enterprise makes an overall loss. The interest coverage ratio measures the degree of protection of creditors has from default on the payment of interest by the company. Example: PQR Ltd. has earned a net profit of ` 7,00,000 during the year 2016-17. It has paid an income tax of ` 2,20,000 and interest on debentures as ` 2,30,000. The interest coverage ratio may be calculated as follows: EBIT Interest Coverage Ratio = Interest Pr ofits after Tax Tax Paid Interest Ch arg ed to Pr ofit and Loss Account = Interest CU IDOL SELF LEARNING MATERIAL (SLM)

226 Financial Reporting and Analysis = (7,00,000 + 2,20,000 + 2,30,000) / 2,30,000 = 11,50,000 / 2,30,000 = 5 times Net Worth to Total Assets (Proprietary) Ratio It indicates the proportion of investors fund in total assets of the business. It is of particular interest to shareholders as it signals stability of the firm and hints at long-term solvency too. A healthy proprietary ratio indicates less risk of default on firm’s part. Proprietary Ratio = Total Shareholders Fund × 100 Total Assets Example: Calculate Proprietary Ratio from the following information: Equity Share Capital ` Debentures 5,00,000 Reserves and Surplus 2,50,000 Total Non-current Assets 1,65,000 Total Current Assets 7,00,000 Cash at Bank 3,50,000 50,000 Solution: Total Shareholders Funds Proprietary Ratio = Total Assets (5,00,000 1,65,000) = 7,00,000 3,50,000) = 63.33% Note: Cash at Bank is a part of total current assets. Market Strength Analysis or Investor Analysis The market analysis or investor analysis are especially important for investors while analysing information about a company. This analysis helps the investors to decide about a company as an investment opportunity at a point of time. These ratios are also known as stock market ratios, investment ratios or market test ratios. The ratios under this category are as follows: CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 227 1. Earnings Per Share Dividing the profits of a company by the total number of shares outstanding derives earnings per share. Earnings here mean the net profit, net income or the net earnings. This is the amount by which the total revenues exceed the total expenses for the years. Earnings per Share = Earnings after Tax – Pr eference Dividends Number of Ordinary Shares The net earnings figure is the amount, which is completely free from any obligations and the company can plough it back into the company, pay to the ordinary shareholders as dividends or as a combination of both. This amount is also known as the earnings available for ordinary shareholders. Example: ` 100,000 Net Profit before tax Tax Rate 40% of Net Profit 10% Preferences Share Capital (` 10 each) ` 1,00,000 Equity Share Capital (` 10 Shares) ` 1,00,000 Earnings per Share Earnings after Tax – Pr eference Dividends = Number of Ordinary Shares = [1,00,000 – 40,000 (Tax) – 10,000 (Preference Dividend)] / 10,000 = 50,000 / 10,000 = ` 5 per share Earnings per share can either be primary or diluted. Primary earnings per share are the earnings per share for the number of ordinary shares outstanding as on the beginning of the reports period. Diluted earnings per share, on the other hand, is calculated after considering convertible debentures, bonds, etc. (which have been converted into ordinary shares) during the year. It is computed in the same manner as primary earnings per share except that it assumes that all investments with the convertibility clause were converted at the beginning of the year. In case a company have bonds and debentures, which are convertible into ordinary shares; it is always useful to compute fully diluted earnings pel share (assuming full conversion) as well as earnings per share on a normal basis. This implies adding back the interest aid on the convertibles, recalculating the numerator and then dividing, by the total number of ordinary shares on the assumption that conversions has taken place. CU IDOL SELF LEARNING MATERIAL (SLM)

228 Financial Reporting and Analysis Dividend Per Share The dividend per share can be net or gross. Net dividend per share is the dividend declared on a single ordinary share for the year, the net of basic rate tax. Net Dividend Per Share = Ordinary dividends paid to ordinary shareholders Number of ordinary shares Gross dividend per share is net dividend per share together with the associated tax credit. Net dividend per share Gross Dividend per Share = 1 Basic rate of tax Alternatively, Gross Dividend Per Share = Net Divined Per Share + Associated Tax Credit Gross Dividend Yield The gross dividend yield is the gross dividend per share dividend by the ordinary share price, expressed as a percentage. Gross dividend per share Gross Dividend Yield = Ordinary share price × 100% For example, if a company declares dividend at 20% on its shares, each having a paid-up value of ` 8 and market prices of ` 25, the dividend yield ratio will be calculated as follows: 20 Dividend Per Share = 100 × 8 = ` 1.60 Dividend per share Dividend Yield Ratio = Market Price per share = 1.6/25 × 100 = 6.4% The gross dividend yield indicates the current level of income from a share. Dividend yields are normally calculated using gross dividend rather that net dividends because it helps in better analysis and comparison with other types of investment. Also, investors pay income tax at rates other that the basic rate. If the dividend yield is calculated on a net basis, the level of tax rate which has been deducted should be made clear. Besides indicating the general level of the market, dividend, and yield reflects the market estimates of future dividend growth and risk. The higher the dividend growth expectations for a given share, the lower the current yield; the higher the market’s estimate of risk, the higher the current yield. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 229 Dividend Cover Dividend cover denotes the number of times the dividend per share is covered by earnings per share. Earnings per share Dividend Cover = Dividend per share Dividend cover helps in assessing the prospects for dividend increases. Or, alternatively, the possibility of a dividend cut, should profit decline. For the purpose of dividend cover, full distribution of earnings per share is normally taken into account. In other words, it is assumed that all profits are distributed as dividends. The gross dividend per share should be taken to ensure consistency in the resulting, figure of dividend cover. Payout Ratio Payout ratio measures the proportion of earnings per share which are paid out as dividends Net dividend per share Payout Patio = Net earnings per share × 100% The percentage of available earnings paid out as ordinary dividends has a vital influence on the market’s behaviour towards those shares that are not in the growth category. For these companies, which have paid dividends in the form of stock dividends and cash, only the cash dividend should be included in calculating, the payout ratio. In the case of dividends paid out as stock dividends, the investor receives nothing that was not already owned and the company gives up nothing, of value. Example: Compute the Payout Ratio and Retained Earnings Ratio from the following data: Profit Amount (`) Number of Equity Shares 20,000 Provision for Tax 3,000 Dividends per Equity Shares 10,000 Preference Dividend 0.80 4000 Solution: Net dividend per share Payout Ratio = Net earnings per share × 100% CU IDOL SELF LEARNING MATERIAL (SLM)

230 Financial Reporting and Analysis Earnings per Share Profit available to equity shareholders = No. of equity shares Dividend Payout Ratio = 20,000 – 10,000 – 4,000 / 3,000 Retained Earnings Ratio = 6,000 / 3,000 Retained Earnings = ` 2 per share Retained Earnings Ratio ` 0.80 = 2 × 100 = 40% Re tained Earnings = Total Earnings (after Tax and Pr ef . Divid.) × 100 = Profit Available for Equity Shareholders – Dividends Paid = 6,000 – 2,400 = ` 3,600 3, 600 = 6,000 × 100 = 60%. Dividends to Cash Flow ‘Dividends to cash flow’ is more useful ratio than the payout ratio. It helps in understanding the past trend in this regard and is greatly helpful in estimating, future dividends than the conventional payout ratio. Dividend paid on ordinary shares Dividend to Cash Flow = Net earnings available for ordinary shares Price/Earnings (P/E) Ratio It is the market price of shares expressed as a multiple of earnings per share. Pr ice per ordinary share Price Earnings (P/E) Ratio = Earnings per share Many investors consider P/E ratio as the best indicator of the ongoing performance of a company. This ratio along with the payout ratio indicates the market estimates of future dividend growth and risk. High growth shares have high P/E ratio, as investors are willing to pay a greater multiple of current earnings to achieve a higher future growth. If high risk is found in a share, it reduces its market price and hence automatically reduces its P/E ratio. Payout ratios can have a positive influence on P/E Ratio. High P/Es are not always bad. If investors are willing to pay a high price for a share in relations to its earnings, then they are doing so in the belief that the company has a brighter future. That it will continue to strengthen and grow in future. Buying, CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 231 a share with a high P/E is described as being a security with a high multiple. It should be understood here that the common share dividends come out of the earnings per share. Drop-in earnings could mean that dividend is in troubles. The elements that govern the P/E ratio are:  Those factors that and fully reflected in the financial data (tangible factors) – Growth of earnings and sales in the past; profitability or rate of returns on invested capital; stability of past earnings; dividend rate and record, and financial strength or credit standing.  Those factors that are reflected to an indefinite limit in the data (intangible factors) – quality of management; nature and prospects of the industry, and competitive position and individual prospects of the company. Net Asset Value Per Share This ratio is also known as book value per share. Net asset value per share is the value of net tangible assets attributable to one ordinary share. Net asset value is, simply put, the shareholders’ equity. Net asset value or book value has nothing, to do with the market value as shares usually sell in the stock market at several times its net asset or book value. Net Asset Value Per Share = Ordinary share capital Re serves – Intan gibles Number of ordinary shares outs tanding at balance sheet date Net assets value applies to ordinary shares only. However, it does not mean that investors can get that amount if the company is liquidated. The amounts attributable to the assets are only attempts at fair and systematic evaluation, not at guessing what these assets would bring if sold in the marketplace. Net asset or book value can be considered only as the theoretical value of ordinary shares if the assets of the company were liquidated at the amounts attributed to them on the balance sheet It is not usual for a share price to be very different from the net asset value per share, even where assets in the balance share have recently been revaluated. In general, earnings and the dividend paying potential of the company will influence the market price of a share. Share prices will not be significantly influenced by the net asset value per share except where:  The company is an investment vehicle for specific types of assets (e.g., investment trusts, property companies).  It seems probable that the company will be liquidated.  A takeover bid of the company seems likely. CU IDOL SELF LEARNING MATERIAL (SLM)

232 Financial Reporting and Analysis The net asset value per share figure is useful while comparing shares of one company with shares of other companies operating in the same industry. If it is found that a company is selling shares at a much lower ratio of market price to book value, then other companies in the same industry. If it is found that a company is selling shares at a much lower ratio of market price to book value, then other companies in the same industry, it indicates a good investment opportunity. When a share can be bought for less than its net asset value, it is an indication that share will have good value in the future. In the stock market, it is often found that a share is selling, five times, seven times (and more) than its book value. The lower the multiple, the greater will be probable value of the share. Cash Flow Per Share Cash flow per share is useful indicator of a company’s general ability to leverage itself, to pay dividends, to convert accounting earnings into cash and to enjoy financial flexibility. Cash flow from operations after taxes Cash Flow per Share = Ordinary shares outs tan ding at balance sheet date The amount of cash flow does not totally belong to ordinary shareholders, as the earnings belong; it is meant to pay the expenses and claims prior to the payment of dividend. Growth and Stability Analysis Growth and stability ratios measure the performance and financial strength of a company apart from market valuation. Stability ratios are useful in evaluating the quality of bonds, debentures, preference shares, etc. These ratios are calculated over time and relate to sales, total returns, and earnings per share. Such ratios are: Sales in final period 1. Growth in sales = Sales in base period Net earned for total capital in final period 2. Growth in total return = Net earned for total capital in base period Earnings per share in final period 3. Growth in earnings = Earnings per share in base period Worst year (or lowest year) 4. Maximum decline in coverage of interest charges = Average of previous three years Normally, interest charges may include any of the following combinations:  Interest on short and long-term debts, including capital leases  Interest on expenses plus an interest component for operating leases CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 233  Interest on expenses on short and long-term debts plus rentals on both capital and operating bases  Total fixed charges, rentals and preferred dividends. Worst year (or lowest year) 5. Per cent decline in return on total capital = Average of previous three years Worst year (or lowest year) 6. Per cent decline in return on ordinary capital = Average of previous three years Worst year (or lowest year) 7. Percentage decline in earnings per share = Average of previous three years LIMITATIONS OF FINANCIAL RATIOS Financial statement analysis through ratios is useful because they highlight relationships between items in financial statements. However, they have a number of limitations which should be kept in mind while preparing, or using them.  Ratios are based on accounting figures given in financial statements. However, accounting figures are themselves subject to deficiencies, approximations, and diversity in practice or even manipulation to some extent. Therefore, ratios are not very helpful in drawing, reliable conclusions.  Ratios have an inherent problem of comparability. Companies otherwise similar may employ different accounting methods, which can cause problem, in comparing certain key relationships. For example, inventory turnover can be different for a company using FIFO than the other company using, LIFO method of inventory valuation. Similarly, the differences in accounting methods related to depreciation methods, estimates of the life of assets, amortisation of intangibles and preliminary expenses, treatment of extraordinary items, etc. can create the problem of comparability among, the companies even in the same industry.  Inflation may limit the utility of accounting ratios. Due to inflation, historic cost-based financial statements and accounting figures do not reflect current value figures, especially in the case of assets purchased at different dates by the different enterprises. Since financial statements are not adjusted in terms of inflation effect, accounting ratios calculated (using varying costs or prices) have distortions and become defective. Sometimes, gains (reflected through ratios) over time in sales, net income and other key figures disappear when the accounting data are adjusted for change in price levels.  Accounting ratios are not totally dependable and they must be used after giving due weightage to general economic conditions, industry situation, position of firms within the industry, mode of operations, size of firms, diversity of product which can make the business enterprises completely dissimilar and thus, affect the computation of accounting ratios. CU IDOL SELF LEARNING MATERIAL (SLM)

234 Financial Reporting and Analysis  The different methods of computation also influence the utility of accounting ratios. The different concepts used for determining numerator and denominator in a particular accounting ratio will not help in drawing reliable conclusions even in identical situations. PRACTICAL PROBLEMS Problem 1. The working capital of Herald Ltd. has deteriorated in recent years and currently has the following status: Current Assets Amount (`) Inventory 5,60,000 Trade Receivables 3,50,000 Cash at Bank 70,000 9,80,000 Current Liabilities Trade Payables 4,90,000 Outstanding Liabilities 2,10,000 7,00,000 (a) Compute the current ratio and quick ratio. (b) An additional short-term bank loan of ` 50,000 is also under consideration. Calculate revised current ratio and quick ratio assuming the loan is received. (c) There is also a negotiation going on for discounting the debtors of ` 3,50,000 for ` 3,15,000 a collection agency for immediate cash. Also, obsolete stocks worth ` 1,25,000 are being sold for ` 80,000. Of the cash to be realised by the two transactions, the current liabilities are to be reduced to ` 1,00,000, Calculate the current ratio after these transactions are put through. Solution: Current Ratio Quick Ratio Current Assets Liquid Assets (Debtors Cash) Trade Receivables = Current Liabilities (a) = Current Liabilities = 4,20,000 9,80,000 7,00,000 = = 0.6 7,00,000 = 1.4 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 235 Current Assets Liquid Assets (b) = Current Liabilities = Current Liabilities = 4,20,000 = 9,80,000 7,50,000 7,50,000 = 1.3 = 0.6 (c) Revised Inventory = 5,60,000 – 1,25,000 = 4,35,000 Revised Trade Receivables = 3,50,000 – 3,50,000 = 0 Revised Cash = 70,000 + 3,15,000 + 80,000 – 1,10,000 = 3,55,000 Revised Current Assets = 4,35,000 + 0 + 3,55,000 = 7,90,000 Revised Current Liabilities = 4,90,000 + 1,00,000 = 5,90,000 Current Assets 7,90,000 New Current Ratio = Current Liabilities = 5,90,000 = 1.34 Problem 2. From the following accounts of New Era Ltd., you are required to calculate the following ratios and comment on results: (i) Gross Profit Percentage (ii) Net Profit Percentage (iii) Return on Total Assets (iv) Quick Assets Ratio (v) Debtors Collection Period (vi) Stock Turnover Ratio (vii) Fixed Assets Turnover (viii) Return on Shareholders’ Funds (ix) Current Ratio (x) Debt Ratio Balance Sheet as at 31st March, 2017 Particulars (` '000) (` '000) Equity and Liabilities 450 690 Share Capital: 240 700 Reserves and Surplus 700 665 Shareholders’ Funds 620 2,055 Non-current Liabilities: 45 Long-term Borrowings (12% Debentures) Current Liabilities: Trade Payables Other Current Liabilities Total CU IDOL SELF LEARNING MATERIAL (SLM)

236 Financial Reporting and Analysis Assets (` '000) (` '000) Non-current Assets: 875 Fixed Assets 875 Current Assets: 1,180 Inventories 310 2,055 Trade Receivables 770 Cash at Bank 100 Total Extract from Statement of Profit and Loss: (` '000) 31,00,000 Sales 17,25,000 Gross Profit 8,05,000 Expenses 2,50,000 Depreciation Solution: 1725 = 55.60% Gross Profit Percentage = 3100 × 100% = 21.60% Net Profit Percentage = 32.60% Return on Total Assets 670 = 1.3 : 1 Quick Assets Ratio = 3100 × 100% = 91 Days Debtors Collection Period 670 = 10 Times Stock Turnover Ratio = 2055 × 100% = 3.5 Times Fixed Assets Turnover = 84.90% Return on Shareholders’ Funds 870 = 1.8 : 1 Current Ratio = 665 = 66.40% Debt Ratio 770 = 3100 × 365 3100 = 310 3100 = 875 586 = 690 × 100% 1100 = 665 1365 = 2055 × 100% CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 237 Very few ratios have an absolute value but they are used in a relative way in intra- and inter- firm comparisons. Both gross and net margins are calculated using the profit before tax and interest to identify the trading profit, irrespective of the capital structure in force. Both these figures seem satisfactory but knowledge of the industry is necessary. Also, the returns on shareholders’ funds and on total assets both appear quite satisfactory. The quick ratio exceeds the 1 : 1 norm and the current ratio is near the 2 : 1 norm, but this requirement varies widely. On the other hand, the debt ratio seems high, as two-thirds of all assets are financed by debt. Assets turnover ratio also need comparisons to make judgement but the debtor collection period of 91 days would seem too long for most industries, especially if credit is granted on a net monthly basis. Problem 3. Angel Company’s financial statements provide the following information: Short-term investments 2015-16 (`) 2016-17 (`) Trade receivables 2,00,000 3,20,000 Cash and cash equivalents 3,20,000 4,00,000 Prepaid expenses 2,00,000 1,60,000 Inventories 28,000 12,000 Total current assets 18,40,000 21,60,000 Total fixed assets 25,88,000 30,52,000 Current liabilities 56,00,000 64,00,000 Long-term borrowings 6,40,000 8,00,000 Share capital 16,00,000 16,00,000 Reserves and surplus 20,00,000 20,00,000 4,68,000 8,12,000 Statement of Profit and Loss for the Current Year Particulars (` '000) Revenue from Operations 40,00,000 Total Revenue 40,00,000 Expenses: Cost of Goods Sold 28,00,000 Finance Costs 1,60,000 Total Expenses 29,60,000 CU IDOL SELF LEARNING MATERIAL (SLM)

238 Financial Reporting and Analysis Profit/(Loss) before Tax 10,40,000 Tax Expense @ 50% 5,20,000 Profit/(Loss) from Continuing Operations (After Tax) 2,60,000 From the above information, analyse the company’s position from Liquidity, Profitability and Activity point of view. Solution: Liquidity Ratios Current Assets 30,52,000 Current Ratio = Current Liabilities = 8,00,000 = 3.81:1 Quick Assets Ratio Quick Assets 30,52,000 = Current Liabilities = 21,72,000 = 1.1:1 Activity Ratios Debtors Turnover Ratio Sales 40,00,000 = Average Debtors = 3,60,000 = 11.1 Times Stock Turnover Ratio Cost of Goods Sold 28,00,000 = Average Stock = 20,00,000 = 1.4 Times Sales 40,00,000 Total Assets Turnover Ratio = Average Assets = 60,00,000 = 0.67 Times Profitability Ratio Gross Profit Ratio Gross Profit 12,00,000 = Sales × 100 = 40,00,000 × 100 = 30% = 13% Net Pr ofit 5, 20, 000 Net Profit Ratio = Sales × 100 = 40,00,000 × 100 Return on Investment = Pr ofit Before Interest and Tax × 100 Capital Employed 12,00,000 = 100 × 100 = 27.20% Return on Shareholders’ Funds = Pr ofit after Interest and Tax × 100 Shareholders' Funds 5, 20, 000 = 28,12,000 × 100 = 18.50% CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 239 On the basis of the above ratios, it can be said that the firm’s position is sound from the point of view of liquidity and profitability. However, activity ratios do not present a profitable position. Better position will be reflected after inter-firm comparison. Problem 4. Financial Statement Extracts of Om Company are given below: Share Capital 2016-17 (`in lakhs) General Reserve 250 Surplus (Current Year) 280 Long-term Borrowings 10 Short-term Borrowings 300 Trade Payables 360 Other Current Liabilities 150 Fixed Assets 30 Non-current Investments 400 Trade Receivables 50 Cash and Cash Equivalents 460 460 Additional information:  From the Surplus Account, ` 90 lakhs were transferred to General Reserve during the year.  Interest cost amounted to ` 120 lakhs.  Taxation @ 50%.  You are required to calculate: o Debt-Equity Ratio o Current Ratio o Interest Coverage Ratio Solution: Long term Debt 300 300 Debt-Equity Ratio = Equity Shareholders Funds = 250 280 10 = 540 = 0.56 Current Assets 460 460 10 930 Current Ratio = Current Liabilities = 360 150 10 = 540 = 1.72 Interest Coverage Ratio = EBIT[PAT(1 t) Intt] (10 90) / (1 0.5) 120 320 = = 120 Interest 120 = 2.67 CU IDOL SELF LEARNING MATERIAL (SLM)

240 Financial Reporting and Analysis Problem 5. Calculate P/E Ratio from following information: 2016-17 50,00,000 Equity share capital @ ` 20 each 5,00,000 General reserve 25,00,000 Secured borrowings @ 15% 10,00,000 Unsecured borrowings @ 12.5% 30,00,000 Fixed assets 5,00,000 Investments 25,00,000 Operating profit Income tax rate 50% Market price per share ` 50 Solution: Operating Profit 25,00,000 Less: Interest (3,75,000) Secured Borrowings @ 15% (25,00,000) (1,25,000) Unsecured Borrowings @ 12.5% (10,00,000) Profit before Tax 20,00,000 Less: Income Tax @ 50% (10,00,000) Profit after Tax 10,00,000 Number of Equity Shares 2,50,000 Profit after Tax 10, 00, 000 EPS = No. of Equity Shares = 2,50,000 = ` 4 Market price per share 50 P/E Ratio = = 4 = 12.50 : 1 EPS Problem 6. Following are the extracts from Balance Sheet of Benny Jay Ltd. as on 31st March, 2017: Equity share capital (5,00,000 @ ` 10 each) ` 9% Preference share capital (50,000 @ ` 100 each) 50,00,000 General reserve 50,00,000 Capital reserve 10,00,000 Debenture redemption fund 5,00,000 7% Debentures 15,00,000 50,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 241 Bank overdraft 85,00,000 Trade payables 25,00,000 Other current liabilities 15,00,000 Land 4,00,000 Building 21,00,000 Plant and machinery 1,19,00,000 Furniture and fittings 1,50,000 Office cars 1,50,000 Inventories 1,50,00,000 Trade receivables 6,00,000 Cash and cash equivalents 2,00,000 Compute the following: (b) Total Value of Equity (d) Total Fixed Assets (a) Net Worth (f) Working Capital (c) Shareholders’ Reserves (e) Total Current Assets (g) Long-term Liabilities Solution; 50,00,000 50,00,000 (a) Net Worth: It can be calculated from either assets or liabilities side. 10,00,000 Equity share capital (5,00,000 @ ` 10 each) 5,00,000 9% Preference share capital (50,000 @ ` 100 each) 15,00,0000 General reserve Capital reserve 1,30,00,000 Debenture redemption fund 4,00,000 Net Worth from Liabilities Approach 21,00,000 Land Building 1,19,00,000 Plant and machinery 1,50,000 Furniture and fittings 1,50,000 Office cars Inventories 1,50,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

242 Financial Reporting and Analysis Trade receivables 6,00,000 Cash and cash equivalents 2,00,000 Total Assets 3,05,00,000 Less: 7% Debentures 50,00,000 Bank Overdraft 85,00,000 Trade payables 25,00,000 Other current liabilities 15,00,000 Net Worth from Assets Approach 1,30,00,000 (b) Total Value of Equity Net Worth 1,30,000 Less: 9% Preference share capital (50,000 @ ` 100 each) 50,00,000 Total value of Equity 80,00,000 (c) Shareholders’ Reserves 10,00,000 General reserve 5,00,000 Capital reserve 15,00,000 Debenture redemption fund 30,00,000 Shareholders’ reserves 4,00,000 (a) Total Fixed Assets 21,00,000 Land 1,19,00,000 Building 1,50,000 Plant and machinery 1,50,000 Furniture and fittings 1,47,00,000 Office cars Total Fixed Assets 1,50,00,000 6,00,000 (b) Total Current Assets 2,00,000 Inventories 1,58,00,000 Trade receivables Cash and cash equivalents Total Current Assets CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 243 (c) Working Capital Total Current Assets 1,58,00,000 Less: Current liabilities Bank overdraft 85,00,000 Trade payables 25,00,000 Other current liabilities 15,00,000 Working Capital 33,00,000 (d) Long-term Liabilities 7% Debentures 50,00,000 Long-term liabilities 50,00,000 Problem 7. Calculate and comment upon the rate of return on total assets from the data about the following two companies: X Ltd (`) Y Ltd. (`) Sales – 2,52,75,000 Total Assets 42,50,000 – Net Profit in Sales Turnover of Assets 6% 4% Gross Margin 6 times 6 times 20,68,000 12% Solution: = 42,50,000 × 6 = 2,52,75,000 Sales = 2,55,00,000 = 2,52,75,000 ¸ 6 Total Assets = 42,50,000 = 42,12,500 6% of 2,55,00,000 4% of 2,52,75,000 Net Profit in Sales = 15,30,000 = 10,11,000 Rate of Return on Total Assets = 15,30,000 ¸ 42,50,000 = 10,11,000 ¸ 42,50,000 = 36% = 24% Problem 8. The following are the ratios relating to activities of Bentota Ltd.: Debtors Velocity 3 Months Stock Velocity 8 Months Creditors Velocity 2 Months Gross Profit Ratio 25% CU IDOL SELF LEARNING MATERIAL (SLM)

244 Financial Reporting and Analysis Gross profit for the current year ended 31ST March 2017 amounted to ` 8,00,000. Closing stock of the year is ` 30,000 above the opening stock. Bills receivables amounted to ` 50,000 and bills payables to ` 10,000 Find out:  Sales (all credit basis)  Sundry Debtors  Closing Stock  Sundry Creditors Solution: (a) Sales (all credit basis) Gross Profit Gross Profit Ratio = Sales = × 100 8,00,000 25 = Sales × 100 Sales = ` 32,00,000 Sundry Debtors Credit Sales (b) Debtors Turnover Ratio = Closing Debtors Bills Receivables 32,00,000 4 = Closing Debtors 50,000 Closing Debtors = ` 7,50,000 Note: Debtors velocity of 3 months implies that debtor turnover ratio will be 4 (12/3). (c) Closing Stock Stock Turnover Ratio Cost of Goods Sold 15 = Average Stock 24,00,000 (32,00,000 – 8,00,000) = Average Stock Average Stock = ` 16,00,000 Opening Stock Clo sing Stock 2 = 16,00,000 Closing Stock + Opening Stock = 32,00,000 Closing Stock – Opening Stock = 30,000 Closing Stock = ` 16,15,000 Opening Stock = ` 15,85,000 Note: Stock velocity of 8 months implies that Stock turnover ratio will be 1.5 (12/8). CU IDOL SELF LEARNING MATERIAL (SLM)