CBSE Notes

By going through these CBSE Class 11 Accountancy Notes Chapter 1 Introduction to Accounting, students can recall all the concepts quickly.

Introduction to Accounting Notes Class 11 Accountancy Chapter 1

In the period when ownership and management were treated, the prime objective of accounting was to ascertain profit and loss and the financial position of the enterprise. In the modern world, the growth of business required large investments and this brought in the period when ownership and management got separated, taking the place of professional management.

Accounting became an important tool In helping decision-making by the management as it makes available the required information. Accounting, therefore, means an information system that provides the accounting information to users thereof to arrive at the correct decision.

Meaning of Accounting
“Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are in part at least, of financial character and interpreting the result thereof.”.

– The American Institute of Certified Public Accountants
“Accounting is the art of recording and classifying business transactions and events, basically of a financial nature and the art of making significant summaries, analysis and interpretation of those transactions and events and communicating the results to persons who must make decisions or firm judgment.” – Smith and Ashburne.

Accounting can therefore be defined as the process of identifying, measuring, recording, and communicating the required information relating to the economic events of an organization to the interesting uses of such information.

Relevant aspects of the definition of accounting

1. Economic events
2. Identification, measurement, recording, and communication
3. Organization
4. The interested user of information

1. Economic Events: An economic event is known as a happening of consequence to a business organization which consists of transactions and which are measurable in monetary terms.

2. Identification, measurement, recording, and communication:
1. Identification: It means determining what transactions to record i.e. to identify events that are to be recorded.

2. Measurement: It means quantification (including estimates) of business transactions into financial terms by using monetary units.

3. Recording: Once the economic event is identified and measured in financial terms, these are recorded in books of accounts in monetary terms and in chronological order.

4. Communication: The economic events are identified, measured, and recorded in order that the pertinent information is generated and communicated in a certain form to
management and other internal and external users.

3. Organisation: It refers to a business enterprise, whether for profit or not-for-profit motive.

4. Interested user of information: Accounting is a means by which necessary financial information about business enterprise is communicated and is also called the language of business. Many users need financial information in order to make important decisions.

Accounting as a source of information: Accounting is a service activity. Its function is to provide qualitative information primarily financial in nature, about economic entities that are intended to be useful in making economic decisions.

It is universally accepted that making available qualitative accounting information is an important objective because it is the basis to make decisions by its users. The accounting information expected by its users is provided through financial statements. Financial statements are Profit and Loss Account and the Position statement or Balance sheet made available the Information relating to profit and loss, and information relating to financial position.

Similarly, investors, lenders, creditors, employees, and the Government agencies by analyzing the financial statements can make decisions about investments pattern, lending and making credit available, information relating to providing funds & other dues, and natural accounts of government agencies respectively.

Branches of Accounting
1. Financial Accounting: It assists in keeping a systematic record of financial transactions, the preparation, and presentation of financial reports in order to arrive at a measure of organizational success and financial soundness.

2. Cost Accounting: It assists in analyzing the expenditure for ascertaining the cost of various products manufactured or services provided by the firm and fixation of prices thereof.

3. Management Accounting: It deals with the provisions of necessary accounting information to people within the organization to enable them in decision-making, planning, and controlling business operations.

Qualitative Characteristics of Accounting Information:
1. Reliability: An accounting information should be objective and reliable. To be reliable, it should be free from errors and bias and should represent what it should represent.

2. Relevance: An accounting information should be relevant for decision making. To be relevant, information must be made available in time and help in prediction and feedback.

3. Understandability: An accounting information should be readily understandable by its user. It should be presented in simple terms and form.

4. Comparability: An accounting information will be useful and • beneficial to the different users only when it is comparable over time and with other enterprises. For this, there should be consistency, i.e. use of the common unit of measurement, common format of reporting, and common accounting policies.


Objectives of Accounting

1. To keep systematic records of the business.
2. To ascertain the financial results, i.e. profit or loss of the firm during a particular period.
3. To show the financial position of the firm by preparing a position statement on a particular date.
4. To communicate the accounting information to its users.

Role of Accounting: An accountant with his education training, analytical mind, and experience are best qualified to provide multiple need-based services to the end growing society. The accountants of today can do full justice not only to matters relating to taxation, costing, management accounting, financial layout, company legislation, and procedures but they can act in the fields relating to financial policies, budgetary policies, and even economic principles.

The service recorded by accountants to the society include the following:
(a) To maintain the Books of Account in a systematic manner.
(b) To act as a Statutory Auditor.
(c) To act as an Internal Auditor.
(d) To act as a Taxation Advisor.
(e) To act as a Financial Advisor. ,
(f) To act as a Management information system consultant.

Basic Terms in Accounting
1. Entity: It means a thing that has a definite individual existence.

2. Transaction: A event involving some value between two or more entities.

3. Assets: Anything which is in the possession or is the property of business enterprises including the amount due to it from others is called assets. Assets may be classified as Fixed Assets and Current Assets.

4. Liabilities: It refers to the amount which the business enterprise owes to outsiders excepting the amount owned to proprietors.

Liabilities may be classified as follows:

1. Long-term Liabilities
2. Current Liabilities

5. Capital: Amount invested in an enterprise in form of money or assets by its owner is known as capital.

6. Sales: Sales are total revenues from goods or services sold or provided to customers. It may be cash sales or credit sales.

7. Revenues: Amounts which business earned or received. Revenue in accounting means the income of a recurring nature from any source.

8. Expenses: Costs incurred by a business in the process of earning revenue are known as expenses.

9. Expenditure: Spending money or incurring liability for some benefits, service, or property received is called expenditure. It is of two types: Revenue expenditure and Capital expenditure.

10. Profit: The excess of revenue of a period over its related expenses during the accounting year is profit.

11. Gain: It is a monetary benefit, profits, or advantages resulting from events or transactions which are incidental to the business.

12. Loss: In accounting, this term conveys two different meanings:

1. The result of the business for a period when total expenses exceed the total revenue.
2. Some facts or activities against which the firm receives no benefit.

13. Discount: Discount is the deduction in the price of the goods sold. It is of two types:

1. Trade discount and
2. Cash discount.

14. Voucher: The documentary evidence in support of a transaction is known as a voucher.

15. Goods: It refers to the products in which the business unit is dealing, i.e. in terms of which it is buying and selling or producing and selling.

16. Drawings: Withdrawal of money and/or goods by the owner from J the business for personal use is known as drawings.

17. Purchases: Purchases are the total amount of goods procured by a business on credit and on cash, for use or sale.

18. Stock: Stock is a measure of something on hand – goods, spares, and other items in a business.

19. Debtors: They are persons and/or other entities who owe to an enterprise an amount for buying goods and services on credit.

20. Creditors: They are persons and/or other entities who have to be paid by an enterprise an amount for providing the enterprise goods and services on credit.

By going through these CBSE Class 12 Accountancy Notes Chapter 11 Cash Flow Statement, students can recall all the concepts quickly.

Cash Flow Statement Notes Class 12 Accountancy Chapter 11

The Income Statement and the Balance Sheet (Position Statement) are the two important and basic financial statements prepared by every business enterprise. Income Statement shows the profit or loss incurred by the enterprise for the accounting period and the Balance Sheet discloses the financial condition or position at a particular date. But many of those who study these statements are, for different reasons, also interested in knowing the inflow and outflow of cash.

Hence, many companies presented along with the final accounts, a statement called ‘Cash Flow Statement’ which shows inflows and outflows of the cash and cash equivalent. In June 1995, the Securities and Exchange Board of India, (SEBI) amended clause 32 of the Listing Agreement requiring every listed company to give along with its balance sheet and profit and loss account, a Cash Flow Statement prepared in the prescribed format showing separately cash flows from operating activities, investing activities and financing activities.

Meaning of Cash Flow Statement
A Cash Flow Statement is a statement that shows inflow (receipts) and outflow (payments) of cash and its equivalents in an enterprise during a specified period of time. Accounting Standard (AS-3) Revised issued by the Institute of Chartered Accountant of India on Cash Flow Statement in March 1997 has defined Cash Flow Statement as “a statement which shows inflows (receipts) and outflows (payment) of cash and its equivalents in an enterprise during a specified period of time.” According to the revised accounting standard 3, an enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented.

The terms, Cash, Cash Equivalents, and Cash Flows explained below:
Cash: It comprises cash in hand and demand deposits with banks.

Cash Equivalents: They are short term highly liquid investments that are readily convertible into cash and which are subject to an insignificant risk of change in value. An investment normally qualifies as a cash equivalent only when it has a short maturity, of say three months or less from the date of acquisition. Cash equivalent is held for the purpose of meeting short-term cash commitments rather than for investment or another purpose.

Cash Flows are inflows and outflows of cash and cash equivalents. An inflow increases the total cash and cash equivalents at the disposal of the enterprise whereas an outflow decreases them.

As per AS 3, Cash Flows exclude movements between items that constitute cash or cash equivalents because these components are part of the cash management of an enterprise rather than part of its operating, investing, or financing activities.

Objectives of Cash Flow Statement
The basic objective of the Cash Flow Statement is to highlight the change in the cash position including the sources from which cash was obtained by the enterprise and specific uses to which cash was applied.

The Cash Flow Statement serves a number of objectives which are following:
1. Depict Inflows and Outflows of Cash: The cash Flow Statement gives information about cash inflows and cash outflows of an enterprise during a particular period from operating activities, investing activities, and financing activities. It is an effective tool for managing cash.

2. Cash Flow information helps in Planning: Cash Flow Statements provide information for planning for short-range cash needs of the enterprise. It helps in the formulation of financial policies.

3. Helping in understanding the Liquidity of the Enterprise: Cash Flow Statement helps the enterprise to assess whether it would meet its current obligations or not. It also helps the lending institutions like banks etc to ascertain the liquidity of the enterprise.

4. Help in preparing Cash Budget: A cash Flow Statement helps the management of the firm in preparing a Cash Budget.

5. Analysis Management of Cash: CashFlow Statement reveals good and bad points relating to the management of Cash.

According to AS-3 (Revised) the objectives of the Cash How Statement are as follows: ” Information about the cash flow of an enterprise is useful in providing users of financial statements with a basis of assessing the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilize these cash flows.

The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their generation. The statement deals with the provision of information about the historical changes in cash and cash equivalent of an enterprise by means of a cash flow statement which classifies cash flows during the period from operating, investing and financing activities.”

Advantages of Cash Flow Statement
A Cash Flow Statement is a useful financial statement and provides the following benefits:
(a) It enables the management to identify the magnitude and directions of changes in cash.
(b) It enables the users to evaluate the changes in the economic resources of an enterprise.
(c) It enables the users to evaluate the changes in financial structure. ‘
(d) It enables the users to evaluate the changes in net assets of enterprises.
(e) It enables the users to evaluate the enterprise’s ability to alter the amounts and timings of cash flows in order to adapt to changing circumstances and opportunities.
(f) It is useful in assessing the ability of the enterprise to generate Cash and Cash Equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises.
(g) As a tool of planning, the Projected Cash Flow Statement enables the management to plan its future investments, operating, and financial activities such as repayment of long-term loans and interest thereon, modernization or expansion of the plant, payment of cash dividend, etc.
(h) It helps in efficient cash management. The management can know the adequacy or otherwise of cash and can plan for the effective use of surplus cash or can make the necessary arrangement in case of inadequacy of Cash.
(i) It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events.

Classification of Cash Flows
A Cash Flow Statement shows the inflow and outflow of cash and cash equivalents from various activities of a company during a specific period. As per AS-3, these activities can be classified into three categories which are following:

1. Operating activities
2. Investing activities
3. Financing activities

1. Operating Activities: Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. Cash flows from operating activities generally result from the transactions and other events that enter into the determination of net profit or loss.

The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise to pay dividends, repay loans and make investments without resources to extent source of financing. Examples of Cash Flows from operating activities are:

Cash Inflows from Operating Activities:

1. Cash receipts from the sale of goods and rendering of services.
2. Cash receipts from royalties, fees, commissions, and other revenues.
3. Cash receipts relating to future contracts, forward contracts, option contracts, and swap contracts when the contracts are held for dealing or trading purpose.
4. Cash receipts as income tax refunds unless they can be specifically identified with financing and investing activities.

Cash Outflows from Operating Activities:

1. Cash payments to suppliers of goods and services.
2. Cash payments to and on behalf of employees for wages, salaries, etc.
3. Cash payments of income tax unless they can be specified as financing or investing activities.
4. Cash payments for future contracts, forward contracts, etc.
5. Cash Payments for interest etc.

2. Investing Activities: As per AS-3 investing activities are the acquisition and disposal of long-term assets (such as land, building, plant, machinery, etc.) and other investment not included in cash equivalents. It is important to make a separate disclosure of cash flows arising from investing activities because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

Cash Inflows from Investing Activities:

1. Cash receipts from disposal of fixed assets.
2. Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and interest in joint ventures other than cash equivalents.
3. Cash receipts from the repayment of advances and loans made to third, parties (other than advances and loans of the financial enterprise.)
4. Interest received in cash from loans and advances.
5. Dividend received from investment in other enterprises.

Cash Outflows from Investing Activities:

1. Cash payments to acquire fixed assets.
2. Cash payment, relating to capitalized research and development costs.
3. Cash payment, to acquire shares, warrants, etc. other than cash equivalent.
4. Cash advances and loans made to a third party (other than advances and loans made by a financial enterprise wherein it is operating activities.)

3. Financing Activities: As per AS-3, financing activities are activities that result in changes in the size and composition of the owner’s capital (including preference share capital in the case of a company) and borrowings of the enterprise. The separate disclosure of cash flows from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise.

Cash Inflows from Financing Activities:

1. Cash proceeds from issuing shares or other similar instruments.
2. Cash proceeds from issuing debentures, loans, bonds, and other short or long-term borrowings.

Cash Outflows from Financing Activities:

1. Cash repayments of the amounts borrowed.
2. Payment of dividend, Interest, etc.
3. Redemption of Preference Shares.

Classification of Business Activities as per AS-3, showing Inflow and Outflow of Cash.



Treatment of Important Items:
1. Extraordinary Items: Extraordinary items are not the regular phenomenon for example loss due to theft or fire or flood, winning of a lawsuit, or a lottery. They are non-recurring in nature and hence cash flow associated with extraordinary items is disclosed separately as arising from operating, investing, or financing activities in the cash flow statement, to enable users to understand their nature and effect on the present and future cash flows of the enterprise.

2. Interest and Dividend: Treatment of cash flows from interest and dividends can be described under two heads which are the followings:
1. In the case of a financial enterprise (whose main business is lending and borrowing), cash flows arising from interest paid and interest and dividend received are classified as cash flows from operating activities, while dividend paid is classified as a financing activity.

2. In the case of a non-financial enterprise, cash flows arising from interest and dividends paid should be classified as cash flows from financing activities while interest and dividend received should be classified as cash flows from investing activities.

3. Taxes on Income and Gains: Taxes may be income tax, capital gains tax, dividend tax, etc. As per AS-3, cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities.

This clearly implies that:

1. Tax on Operating Profit i.e. Income Tax should be classified as operating cash flows.
2. Dividend tax i.e. tax on the amount distributed as a dividend to shareholders should be classified as financing activity along with dividend paid.
3. Capital Gains Tax i.e. tax on capital profits like tax paid on the sale of fixed assets should be classified under investing activities.
4. Non-Cash Transactions: As per AS-3, investing and financing transactions which do not involve inflow or outflow of cash or cash; equivalent, are excluded from the cash flow statement. But significant such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities.

Examples of the non-cash transaction are:

1. Acquisition of fixed assets by the issue of share or on Credit.
2. Redemption of debenture by conversion into equity share.
3. Acquisition of an enterprise by means of an issue of share. s

Preparation of Cash Flow Statement: (Main Heads Only):

Cash Flows from Operating Activities:
Operating activities are the main source of revenue and expenditure in an enterprise. Therefore, the ascertainment of cash flows from operating activities is of prime importance.

As per AS-3, an enterprise should report cash flows from -N * operating activities using either by.
Direct Method
or
Indirect Method
In Direct Method, major classes of gross cash receipts and gross cash payments, are disclosed.
or
In the Indirect Method, net profit or loss is adjusted for the effects of

1. Transactions of a non-cash nature.
2. any deferrals or accruals of past/future operating cash receipts.
3. Items of income or expenses associated with investing or financing cash flows.

Direct Method:
As we know that items are recorded on an accrual basis in profit and loss accounts therefore certain adjustments are made to convert them into cash bases.

These adjustments are discussed below:
1. Cash Inflow from Sales: Total Sales include Cash Sale and Credit Sale both. Cash sales is a cash inflow, but in the case of credit sales, cash receipts from Debtors are calculated as follows:

Cash receipts from Customers = Credit Sales + Opening Debtors and Bills Receivable: Closing Debtors and Bills Receivable – Bad Debts – Discount Allowed – Sales Returns.

2. Cash Outflow from Purchases: Total Purchases include both cash purchases and credit purchases. Cash purchases are cash outflow, but in the case of credit purchases, cash paid to the suppliers is calculated as follows:

Cash paid to Suppliers = Credit Purchases + Opening Creditors and Bills Payable – Closing Creditors and Bills Payable – Discount received – Purchases Returns.

Purchases = Cost of Goods Sold – Opening Stock + Closing Stock

3. Cash Outflow on Expenses Incurred: The figures of expenses given in the Profit and Loss Account have to be adjusted to find out cash outflow. The amount outstanding and the amount paid in advance have to be adjusted for this purpose.
Cash Paid for Expenses = Expenses as given in Profit & Loss A/c – Prepaid Expenses in the beginning and Outstanding Exp. at the end + Prepaid Expenses at the end and Outstanding Expenses in the beginning.

However, the following items are not to be considered:
1. All non-cash items are ignored as no cash is involved in them. Examples are:
(a) Depreciation
(b) Discount on issue of Shares written off
(c) Goodwill written off.
(d) Preliminary Expenses are written off
(e) Discount on issue of Debenture written off
(f) Patents and Copyright wrote off
(g) Underwriting commission written off.

2. Appropriations of transfer to different reserves and provisions like to General Reserve, Provision for Taxation, and Proposed Dividend should be ignored.

3. Items that are classified as investing or financing activities like profit or loss on sale of fixed assets, interest received, the dividend paid, etc. are also ignored.

Cash Flows From Operating Activities (Direct Method)

Indirect Method:
In this method, net profit or loss is adjusted for the effects of transactions of a non-cash nature flow. In other words, Net profit or loss is adjusted for items that affected net profit but did not affect cash.

As per AS-3, (Revised), under the indirect method, net cash flow from operating activities is determined by adjusting net profit or loss for the effects of:
1. Non-cash items are to be added back. Non-cash items like
(a) Depreciation
(b) Goodwill has written off
(c) Patents and Copyrights are written off
(d) Appropriation to General Reserve
(e) Interim dividend
(f) Deferred taxes etc.

2. All other items for which the cash effects are investing or financing cash flows. The treatment of such items depends upon their nature. All investing and financing incomes are to be deducted from the number of net profits while all such expenses are to be added back.

3. Changes in current assets and liabilities during the period. An increase in current assets and a decrease in current liabilities are to be deducted while the increase in current liabilities and a decrease in current assets are to be added up.

Cash Flows from Operating Activities (Indirect Method)

Cash Flow from Investing Activities:
Investing activities are the acquisition and disposal of long terms assets and other investments not included in cash equivalent. Accordingly, cash inflow and outflow relating to fixed assets, shares, and debentures of other enterprises, advances, and loans to third parties and their repayments are shown separately under Investing activities in the Cash Flow Statement.

It is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

Cash Flow from Investing Activities

Cash Flows from Financing Activities:
The Financing Activities of an enterprise are those activities that result in a change in size and composition of owners capital and borrowing of the enterprise. It includes separate disclosure of proceeds from the issue of shares or other similar instruments, issue of debentures, loans, bonds, other short-term or long-term borrowings, and repayment of amounts borrowed. It is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings to the enterprise.)

Cash Flow from Financing Activities

Format for Cash Flow Statement (As Per AS-3 (Revised))
1. Direct Method
Cash Flow Statement for the year ended………….



2. Indirect Method
Cash Flow Statement for the year ended…………

By going through these CBSE Class 12 Accountancy Notes Chapter 10 Accounting Ratios, students can recall all the concepts quickly.

Accounting Ratios Notes Class 12 Accountancy Chapter 10

As we know that, the financial statements are prepared to meet the common information needs of users of information. Financial Statements include:

1. Income Statement or Profit & Loss A/c
2. Position Statement or Balance Sheet
3. Cash Flow Statement.

→ “The first and most important function of financial statements is, of course, to serve those who control and direct the business, to the end of securing the profits and maintaining a sound financial condition.” -Harry Guthman

The financial statement analysis is of much interest to a number of groups of persons. This analysis is done through the various tools

• Comparative Statement
• Common Size Statements
• Trend Analysis
• Ratio Analysis etc.

These tools of analysis help to understand the financial state of a business in a better manner. The analysis comprises resolving the statements by breaking them into simpler statements by a process of rearranging and regrouping different items. Thus, analysis is the mental process of understanding the terms of such statements and forming opinions or inferences about the financial health, profitability, efficiency, and such other aspects of the company.

Meaning of Ratio-Analysis:
Ratio analysis is the most important and popular tool of financial analysis. It is a combination of two terms ‘ratio’ and ‘analysis. A ‘ratio’ is an arithmetic expression of the relationship between two variables. Two variables must be significantly related to producing meaningful results. ‘Accounting Ratios’ are computed by taking data from the financial statements of business entities and express the relationship between two financial variables from the financial statements.

In other words, the Accounting ratio is the arithmetical relationship between two accounting variables but they assume significance if these variables have cause and effect relationships.

The accounting ratio provides a quantitative relationship that the analyst may use to make a qualitative judgment about various aspects of the financial position and performance of an enterprise.

→ “The term accounting ratio is used to describe the significant relationship which exists between>figures shown in a balance sheet, in a profit and loss account, in a budgetary control system or in any part of the accounting organization.” – J. Betty

Accounting Ratios express the relationship between two financial variables of the financial statements. They may be expressed in either of the following ways.

→ Pure or in Proportion: In this, the relationship between two items is directly expressed in proportion.

→ Percentage: In this, a quotient obtained by dividing one figure by another is multiplied by 100 and it becomes the ‘percentage’ form of expression.

→ Time: It is expressed a number of times a particular figure is compared to another figure.

→ Fraction: It is expressed infraction. For example, net profit is 1/4th of sales.

Objectives of Ratio Analysis

1. To simplify the comprehension of financial statements and to summarise a large number of figures.
2. To highlight the changes in the financial position of the business.
3. To facilitate intra-firm comparison of the performance of the different divisions of the firm.
4. To facilitate inter-firm comparison.
5. To facilitate planning and control and thus decision-making.

Advantages of Ratio Analysis:
1. Useful in the analysis of financial statements:
It is easy to understand the financial position of a business enterprise in respect of short-term solvency, capital structure position, etc; with the help of various ratios.

2. Useful in judging the operating efficiency of business:
Ratio enables the users of financial information to determine the operating efficiency of business firms by relating the profit figures to the capital employed for a given period.

3. Useful in simplifying accounting figures:
“Financial Ratios are useful because they summarise briefly the results of detailed and complicated computation.” Birman and Dribin Ratios help in simplifying complex accounting figures and bring out their relationships. They help to summarize the financial information effectively.

4. Useful in Inter-firm and Intra-firm comparison:
With the help of ratios, a firm can compare its performance with that of other firms and of industry in general.
The ratio also helps firm to compare the performance of different units belonging to the same firm. Even the progress of a firm from year to year cannot be measured without the help of ratios.

5. Useful in Comparative analysis:
The ratios need not be calculated for one year only. When many years figures are kept side by side, they help a great deal in exploring the trend visible in the business.

6. Useful in locating the weak spots (problem areas) of the business:
Ratios help businesses in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to have still better results.

7. Useful in SWOT (Strength-Weakness-Opportunity-Threat) analysis:
Ratios help a great deal in explaining the changes occurring in the business. The information of change helps the management a great deal in understanding the current threats and opportunities and allows the business to do its own SWOT analysis.

Limitations of Ratio Analysis
1. Ratio ignores qualitative factors: The ratios are obtained from the figures expressed in money. In this way, qualitative factors, which may be important, are ignored.

2. Defective accounting information: The ratios are calculated from the accounting data in the financial statements. It means that defective information would give the wrong ratio.

3. Ignores Price-Level Changes: Change in price level affects the comparability of ratios. But no consideration is given to price level changes in the accounting variables from which ratios are computed. This really affects the utility of ratios.

4. Change in accounting procedures: A comparison of results of two firms becomes difficult when we find that these firms are using different procedures in respect of certain items.

5. Variations are general operating conditions: While interpreting the results based on ratio analysis, all business enterprises have to work within given general economic conditions, conditions of the industry in which the firms operate, and the position of individual companies within the industry.

6. Means and not the end: Ratios are means to an end rather than the end itself.

7. Lack of ability to resolve problems: The ratios have a lack of ability to solve the problems arising due course of business.

8. Lack of standardized definitions: There is a lack of standardized definitions of various concepts used in ratio analysis. There are only generally accepted forms available in the literature.

9. Lack of universally accepted standard levels: There is no universal yardstick that specifies the level of ratio which is acceptable.

10. Ratio based on unrelated figures: A ratio may be calculated for unrelated figures which would essentially be a meaningless exercise.
Types of Ratios

On the basis of financial statements:
1. Income Statement Ratios: A ratio of two variables from the income statement is known as Income Statement Ratio. For example, the ratio of gross profit to sales known as gross profit ratio is calculated using both figures from the income statement.

2. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as Balance Sheet Ratios. For example, the ratio of current assets to current liabilities known as the current ratio is calculated using both figures from the balance sheet.

3. Composite Ratios: If a ratio is computed with one variable from the income statement and another variable from the balance sheet, it is called a composite ratio. For example, the ratio of credit sales to debtors and bills receivable known as debtors turnover ratio is calculated using one figure from the income statement (credit sales) and another figure from the balance sheet (Debtors and Bills receivable).

Ratios, as tools for establishing true profitability and financial position of a business, maybe classified as:
1. Liquidity Ratios: It measures the short-term solvency i.e. the firm’s ability to pay its current dues.

2. Solvency Ratios: These ratios are computed to judge the ability of a firm to pay off its long-term liabilities. It shows the proportion of the fund which is provided by outside creditors in comparison to owners.

3. Activity (or Turnover) Ratios: Activity ratios are used to indicate the efficiency with which assets such as stock, debtors, fixed assets, etc. of the firm are being utilized. These ratios are also known as a Turnover ratio because they indicate the speed with which assets are being converted or turned over into sales.

4. Profitability Ratios: The efficiency of a business is measured in terms of profits. Thus, profitability ratios are computed to measures the efficiency of a business.

A Relook at the Financial Statements
Position Statements

Income Statements

1. Liquidity Ratio
The liquidity ratios are used to determine the short-term solvency position of a business enterprise. The term liquidity means the conversion of the assets into cash without much loss. The objective is to find out the ability of the business enterprise to meet short-term liabilities.

The ratio included in this category is the Current Ratio and Liquid Ratio.
1. Current Ratio:
The current ratio is the proportion of current assets to current liabilities.
Current Ratio = \(\frac{\text { Current Assets }}{\text { Current Liabilities }}\)

Current Assets: which mean the assets which are held for their conversion into cash within a year. Tire following are the examples of Current Assets:

• Cash Balances.
• Marketable Securities
• Bank Balance Debtors
• Bills Receivable
• Stock
• Prepaid Expenses etc.
• Short term loans Accrued Income

Current Liabilities: which mean the liabilities which are expected to be matured within a year. The following are the examples of Current Liabilities:

• Creditors
• Provision for tax
• Bank overdraft
• Unclaimed dividend
• Bills Payable
• Income-received in
• Short Term Loans
• advance etc.

Significance: An ideal ratio is 2:1. A higher ratio indicates poor investment policies of management and poor inventory control while a low ratio indicates lack of liquidity and shortage of working capital. The current ratio, thus, throws good light on the short-term financial position and policy of a firm.

2. Liquid Ratio or Quick Ratio
It is the ratio of quick (or liquid) assets to current liabilities.

Quick Ratio = \(\frac{\text { Quick Assets }}{\text { Current Liabilities }}\)

Quick Assets (or Liquid Assets) = Current Assets – Stock – Prepaid Expenses.

Tire objective of computing this ratio is to measure the ability of the firm to meet its short-term obligation as and when due without relying upon the realization of stock. Significance: A quick ratio of 1: 1 is supposed to be good for the reason that it indicates the availability of funds to meet the liabilities 100%.

If this ratio is more than 1: 1 it can be said that the financial position of the business enterprise is sound and good. On the other hand, if the ratio is less than 1:1 i.e. liquid assets are less than current liabilities, the financial position of the concern shall be deemed to be unsound and additional cash will have to be provided for the payment of current liabilities.

2. Solvency Ratios
This ratio shows the long-term financial solvency and measures the enterprise’s ability to pay the interest regularly and to repay the principal on maturity or in pre-determined installments at due dates. The following ratios are normally computed for solvency analysis,
(a) Debt equity ratio;
(b) Total assets to debt ratio
(c) Proprietary ratio
(d) Interest Coverage ratio

(a) Debt Equity Ratio: The debt-equity ratio is worked out to ascertain the soundness of the long-term financial policies of the firm. This ratio establishes a relationship between long-term debt and shareholders’ funds.
Debt-Equity Ratio = \(\frac{\text { Long term Debts }}{\text { Shareholder’s Funds }}\)
Long term Debts = Debentures + Long Term Loans

Shareholder’s Funds = Preference Share Capital + Equity Share Capital + General Reserve + Capital Reserves + Securities Premium balances + Credit balances of Profit & Loss A/c – Preliminary Expenses (Fictitious Assets) – Share Issue Expenses- Discount on Issue of Share/Debenture – Underwriting Commission
Or
Shareholder’s Fund = Fixed Assets + Current Assets – Current Liabilities

Shareholder’s Fund is alternatively termed as internal funds and long-term debts are termed as external funds as well. Hence debt-equity ratio is computed as
Debt equity ratio = External Funds/Internal Funds

Significance: The debt-equity ratio of 2:1 is generally accepted as ideal. A low ratio is considered favorable from an external investor’s point of view as they get more security. On the other hand, a high debt-equity ratio indicates that the claims of the creditors are greater than those of the owners.

(b) Total Assets to Debt Ratio: This ratio shows the relationship between total assets and the long-term debts of the firms.
Total Assets to Debt Ratio = \(\frac{\text { Total Assets }}{\text { Long Term Debts }}\)

Total Assets = Fixed Assets + Current Assets – Fictitious Assets Significance: This ratio measures the proportion of total assets funded by long-term debt. Tire higher the ratio, the lesser role is played by loaned funds in financing the assets engaged in profit-generating activities of an organization and vice-versa.

(c) Proprietary Ratio: The objective of computing the Proprietary Ratio is to establish the relationship between proprietor’s funds and total assets.

Total Assets: Fixed Assets + Current Assets – Fictitious Assets.

Significance: Proprietary ratio attempts to indicate the part of total assets funded through equity. The higher the ratio, the more profitable it is for the creditors and the management will have to depend less on outside funds. If the ratio is low, the creditors can be suspicious about the repayment of their debt.

(d) Interest Coverage Ratio: The objective of this ratio is to measure the debt servicing capacity of a business firm in respect of fixed interest on the long-term debts. It also shows whether the firm has sufficient income to pay interest on maturity dates.

Interest Coverage Ratio = \(\frac{\text { Net Profit before Interest and Tax }}{\text { Interest on long term debts }}\)

Significance: It reveals the number of times interest is covered by the profits available for interest. A higher ratio ensures the safety of return on the amount of debt and it also ensures the availability of surplus for shareholders.

3. Turnover (or Activity) Ratios:
These ratios measure the effectiveness with which a firm uses its available resources. These ratios are called ‘Turnover Ratios’ since they indicate the speed with which the resources are being turned into sales. These ratios, thus express the relationship between the cost of goods sold or sales and various assets and are expressed in a number of times.

Tire following are the important ratios of this category:

1. Stock Turnover Ratio
2. Debtors Turnover Ratio
3. Creditors Turnover Ratio
4. Working Capital Turnover Ratio
5. Fixed Assets Turnover Ratio
6. Current Assets Turnover Ratio

1. Stock or Inventory Turnover Ratio: This ratio establishes a relationship between the cost of goods sold and average inventory. The objective of computing this ratio is to determine the efficiency in which the inventory is utilized.
Cost of Goods Sold
Stock Turnover Ratio = \(\frac{\text { Cost of Goods Sold }}{\text { Average Stock }}\)

Cost of Goods Sold = Sales – Gross Profit
OR = Opening Stock + Purchases + Direct Expenses – Closing Stock

Average Stock = \(\frac{\text { Opening Stock + Closing Stock }}{2}\)

If the figure of Average Stock cannot be ascertained due to the absence of the figure of opening stock, the figure of closing stock may be used as average stock.

Significance: This ratio shows the rate at which stocks are converted into sales. The higher the ratio, the better it is for the business, since it means that stock is being quickly converted into sales. Industries which has a very high stock turnover ratio may be operating with a low margin of profit and vice-versa.

2. Debtors Turnover Ratio or Receivable Turnover Ratio: This ratio is computed to establishes the relationship between net credit sales and average debtors (or receivables) of the year. It shows the rate at which cash is generated by the turnover of debtors.

Debtors Turnover Ratio = \(\frac{\text { Net Credit Sales }}{\text { Average Accounts Receivable }}\)

Average Accounts Receivable:
Net Credit Sales = Total Sales – Cash Sales Account Receivables = Debtors + Bills Receivable
Average Accounts Receivables = \(\frac{\text { Opening Debtors and } \mathrm{B} / \mathrm{R}+\text { Closing Debtors and } \mathrm{B} / \mathrm{R}}{2}\)

It is important to note that doubtful debts are not deducted from total debtors.

In case details regarding opening and closing receivables and credit sales are not given, the ratio may be worked out as follows:

Debtor’s Turnover Ratio = \(\frac{\text { TotalSales }}{\text { Accounts Receivable }}\)

Significance: This ratio indicates the number of times the receivable are turned over in a year in relation to sales. It shows, how quickly debtors are converted into cash. The higher the ratio, the better it is, since it means speedier collection and lesser amount being blocked up in debtors and vice versa.

3. Creditors Turnover Ratio or Payable Turnover Ratio:
Creditors Turnover Ratio indicates the pattern of payment of accounts payable. As accounts payable arise on account of credit purchases, it expresses the relationship between credit purchases and accounts payable.

Net Credit Purchases = Total Purchases – Cash Purchases Accounts Payable = Creditors + Bills Payable Average

Accounts Payable = \(\frac{\text { Opening Creditors and } \mathrm{B} / \mathrm{P}+\text { Closing Creditors and } \mathrm{B} / \mathrm{P}}{2}\)

In case details regarding opening creditors and closing creditors and credit purchases are not given, the ratio may be worked out as follows

Creditor’s Turnover Ratio = \(\frac{\text { TotalPurchases }}{\text { Accounts Payable }}\)

Significance: It shows the average payment period. By comparing it with the credit period allowed by the suppliers, the conclusion may be drawn. A lower ratio means the credit allowed by the supplier is not enjoyed by the business. A higher ratio means a delayed payment to the supplier which is not a very good policy as it may affect the reputation of the business.

Investment (Net Assets) Turnover Ratio:
Investment creates assets. These ratios study the velocity of utilization of long-term funds. It throws light on the rotation of capital employed in the business. Efficient utilization means better liquidity and ‘ profitability.
Net Sales
Investment Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Capital Employed }}\)

Net Sales = Total Sales – Sales Return
Capital Employed= Fixed Assets + Working Capital

4. Working Capital Turnover Ratio: This ratio indicates
whether the working capital has been effectively utilized or not in making sales. In fact, in the short run, it is the current assets and current liabilities which play a major role. Careful handling of current assets and current liabilities will mean a reduction in the amount of capital employed thereby improving turnover.

Working Capital Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Working Capital }}\)

Working Capital = Current Assets – Current Liabilities

Significance: A high working capital turnover ratio show the efficient utilization of working capital in generating sales. A low ratio, on the other hand, may indicate an excess of working capital or working capital has not been utilized efficiently.

5. Fixed Assets Turnover Ratio: This ratio established the relationship of Fixed assets with sales.
Fixed Assets Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Net Fixed Assets }}\)

6. Current Assets Turnover Ratio: This ratio established the relationship of current assets with sales.
Current Assets Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Net Current Assets }}\)

4. Profitability Ratios: As we know that the efficiency in business is measured by profitability. Thus, profitability ratios are computed to measures the efficiency of the business. Profit earning capacity may be expressed in the form of sales.

Some important Profitability Ratios are following:

1. Gross Profit Ratio
2. Operating Ratio
3. Net Profit Ratio
4. Return on Investment Ratio
5. Earnings per Share Ratio
6. Dividend per Share
7. Book Value per Share
8. Price Earning Ratio

1. Gross Profit Ratio: The main objective of computing this ratio is to determine the efficiency with which production and/or purchase operations are carried on. It establishes a relationship of gross profit on sales of a firm, which is calculated in percentage.
Gross Profit Ratio = \(\frac{\text { Gross Profit }}{\text { Net Sales }}\) × 100

Gross Profit = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock

Net Sales = Total Sales – Sales Return

Significance: It is a reliable guide to the adequacy of selling price and efficiency of trading activities. No ideal ratio is fixed but normally a higher ratio is always considered good so as to cover not only the remaining costs but also to allow proper returns to the owner.

2. Operating Ratio: This ratio establishes the relationship between the dying cost of goods sold plus other operating expenses to net sales. The lower percentage of operating ratio, the higher the net profit ratio.
Operating Ratio = \(\frac{\text { Cost of Goods Sold + Operating Expenses }}{\text { Net Sales }}\) × 100
OR
Operating Ratio = \(\frac{\text { Operating Cost }}{\text { Net Sales }}\) × 100

Operating Expenses = Office or Financial Expenses + Administrative

Expenses + Selling and Distribution Expenses + Discount + Bad Debts + Interest on Short-term Loans
Cost of Goods Sold = Sales – Gross Profit

Significance: The operating ratio is the yardstick to measure the efficiency with which a business is operated. It shows the percentage of net sales that is absorbed by the cost of goods sold and operating expenses. A high operating ratio is considered unfavorable because it leaves a smaller margin of profit to meet non-operating expenses but, a lower operating ratio is considered better.

3. Operating Profit Ratio: It is calculated to reveal operating margin. It may be computed directly or as a residual of the operating ratio.

Operating Profit Ratio = 100 – Operating Ratio

Alternatively,
Operating Profit Ratio = \(\frac{\text { Operating Profit }}{\text { Sales }}\) × 100
Operating Profit = Sales – Operating Cost

Significance: Operating profit ratio helps to analyze the performance of the business and throws light on the operational efficiency of the business. It is very useful for inter-firm as well as intra-firm comparison.

4. Net Profit Ratio: Net profit ratio is based on the all-inclusive concept of profit. It relates sales to net profit after operational as well as non-operational expenses and income.

Net Profit Ratio = \(\frac{\text { Net Profit }}{\text { Sales }}\) × 100
Net Profit is taken after income tax.

Significance: It is a measure of net profit margin in relation to sales. It expresses the overall efficiency of the business.

A high net profit ratio would enable the firm

1. to pay higher dividends,
2. to face bad economic conditions
3. to create adequate general reserves. A low net profit ratio has opposite results.

Overall Profitability Ratios
The overall profitability ratio establishes the relationship of profits to the number of funds employed.
Overall Profitability Ratio = \(\frac{\text { Profit }}{\text { Investment of Funds }}\) × 100

(a) Investment refers to Equity Shareholder’s Fund: Profits are considered after preference dividend. The investment includes Equity Share Capital + Reserves and Surplus – Fictitious Assets.

(b) Investment refers to Shareholder’s Fund: Profit is considered before the dividend. The investment includes Equity Share Capital + Preference Share Capital + Reserves and Surplus – Fictitious Assets.

(c) Investment refers to Long-Term Fund Employed: Profit before tax and interest is compared with capital employed to calculate return on capital employed.

The investment includes Equity Share Capital + Preference Share Capital + Long Term Funds +Reseryes and Surplus – Fictitious Assets.

5. Return on Shareholder’s Fund: This ratio reflects the return on the shareholder’s fund that the business enterprise was able to earn.

Return on Shareholder’s Fund = \(\frac{\text { Profit after appropriation }(\text { except Preference dividend })}{(\text { Share Capital + Reserves \& Surplus) }}\) × 100

Significance: The proprietors or shareholders are primarily interested in the profit-earning capacity of the business in which their funds are invested. If the profits earned by the firm are insufficient, it will fail to attract funds for expanding operations since additional capital will not be available.

6. Return on Equity Shareholder’s Fund: It is computed to draw an idea about the return available to equity shareholders.

Return on Equity Capital = \(\frac{\text { Profit available for Equity Shareholder }}{\text { Equity Share Capital }}\)

Profit available for Equity Shareholder

7. Return on Capital Employed or Investment (ROCE or ROI): This ratio, also known as return on investment, is a basic ratio of profitability. It is calculated by establishing a relationship between the profit earned and the capital employed to earn the profits. It is therefore an indicator of the earning capacity of the capital invested in the business.

Return on Capital Employed or Return on Investment = \(\frac{\text { Profit before Interest and Tax }}{\text { Capital Employed }}\) × 100

Capital Employed = Fixed Assets + Working capital = Long Term Funds + Share Capital + Reserves & Surplus – Fictitious Assets (Miscellaneous Expenditure)

Significance: It measures the return on funds employed by the business. It reveals the efficiency of the business in the utilization of funds invested to it by shareholders, debenture holders, and long-term liabilities. For inter-firm comparison, return on capital employed, which reveals overall utilization of funds and return on capital employed, is considered better measures of profitability as compared to return on shareholder funds.

8. Earnings Per Share
EPS = \(\frac{\text { Profit available for equity Shareholders }}{\text { No. of Equity Shares }}\)

9. Book Value Per Share = \(\frac{\text { Equity Shareholder’s Funds }}{\text { No. of Equity Shares }}\)

10. Dividend Per Share = \(\frac{\text { Total Equity Dividend }}{\text { No. of Equity Shares }}\)

11. Price Earning Ratio = \(\frac{\text { Market Price of a Share }}{\text { Earning per Share }}\)

Important Formulas

Liquidity Ratios:
1. Current Ratio = \(\frac{\text { Current Assets }}{\text { Current Liabilities }}\)

2. Quick Ratio
Quick Ratio = \(\frac{\text { Quick Assets }}{\text { Current Liabilities }}\)

Quick Assets = Current Assets – Stock – Prepaid Expenses

Solvency Ratio
1. Debt Equity Ratio = \(\frac{\text { Long Term Debts }}{\text { Shareholder’s Fund }}\)

Shareholder’s Fund = Pref. Share capital + Eq. Share cap. + Gen. Reserve + Cap. Res. + Securities Premium balance + Credit balance of P & L A/c – Preliminary Expenses (Fictitious Assets) – Share Issue Expenses – Discount on issue of Share/Debenture – Underwriting Commission
OR
= Fixed Assets + Current Assets – Current Liabilities

2. Total Assets to Debt Ratio
Total Assets to Debt Ratio = \(\frac{\text { Total Assets }}{\text { Long Term Debts }}\)
Total Assets = Fixed Assets + Current Assets – Fictictious Assets

3. Proprietary Ratio
Proprietory Ratio = \(\frac{\text { Shareholder’s Fund }}{\text { Total Assets }}\)

4. Interest Coverage Ratio Interest Coverage Ratio
Interest Coverage Ratio Interest Coverage Ratio = \(\frac{\text { Net Profit before Interest and Tax }}{\text { Interest on long term debts }}\)

Turnover Ratios
1. Stock Turnover Ratio
Stock Turnover Ratio = \(\frac{\text { Cost of Goods Sold }}{\text { Average Stock }}\)

Cost of Goods Sold = Sales – Gross Profit OR = Opening Stock + Purchases + Direct Expenses – Closing Stock
Opening Stock + Closing Stock

Average Stock = \(\frac{\text { Opening Stock + Closing Stock }}{2}\)

2. Debtors Turnover Ratio
Debtors Turnover Ratio = \(\frac{\text { Net Credit Sales }}{\text { Average Account Receivables }}\)

Average A/c Receivable = \(\frac{\text { Opening Debtor and } \mathrm{B} / \mathrm{R}+\text { Closing Debtor and } \mathrm{B} / \mathrm{R}}{2}\)

3. Creditor Turnover Ratio
Creditor Turnover Ratio = \(\frac{\text { Net Credit Purchases }}{\text { Average Account Payable }}\)

Average Account Payable
Average A/c Payable = \(\frac{\text { Opening Creditors and } \mathrm{B} / \mathrm{P}+\text { Closing Creditors and } \mathrm{B} / \mathrm{P}}{2}\)

4. Investment Turnover Ratio
Investment Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Capital Employed }}\)
Capital Employed = Fixed Assets + Working Capital

5. Working Capital Turnover Ratio
Working Capital Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Working Capital }}\)
Working Capital = Current Assets – Current Liabilities

6. Fixed Assets Turnover Ratio
Fixed Assets Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Net Fixed Assets }}\)

7. Current Assets Turnover Ratio
Current Assets Turnover Ratio = \(\frac{\text { Net Sales }}{\text { Net Current Assets }}\)

Profitability Ratio
1. Gross Profit Ratio

Gross Profit Ratio = \(\frac{\text { Gross Profit }}{\text { Net Sales }}\) × 100
Gross Profit = Net Sales – Cost of Goods Sold

2. Operating Ratio
Operating Ratio = \(\frac{\text { Cost of Goods Sold + Operating Expenses }}{\text { Net Sales }}\) × 100
Or
= \(\frac{\text { Operating Cost }}{\text { Net Sales }}\) × 100

Operating Expenses = Office and Financial Expenses + Administrative Expenses+Selling and Distribution Expenses + Discount + Bad debts + Interest on Short Term Loans.

3. Operating Profit Ratio
Operating Profit Ratio = 100 – Operating Ratio
OR Operating Profit Ratio= \(\frac{\text { Operating Profit }}{\text { Sales }}\)× 100
Operating Profit = Sales – Operating Cost 4. Net Profit Ratio

4. Net Profit Ratio
Net Profit Ratio = \(\frac{\text { Net Profit }}{\text { Sales }}\) × 100

5. Overall Profitability Ratios
Overall Profitablility Ratio = \(\frac{\text { Profit }}{\text { Investment of Funds }}\) × 100

6. Return on Shareholders Fund
Return on Shareholders Fund = \(\frac{\text { Profit after appropriation (except Preference dividend) }}{(\text { Share Capital + Reserve and Surplus) }}\) × 100

7. Return on Equity Shareholders Fund
Return on Equity Capital = \(\frac{\text { Profit available for Equity Shareholder }}{\text { Equity Share Capital }}\) × 100

8. Return on Capital Employed or Investment (ROCE or ROI)
Return on Capital Employed Or Return on Investment = \(\frac{\text { Profit before Investment and Tax }}{\text { Capital Employed }}\) × 100

Capital Employed = Fixed Assets + Working Capital
= Long terms Funds + Share Capital + Reserve and Surplus – Fictitious Assets (Miscellaneous Expenditure)

9. Earnings Per Share (EPS)
EPS = \(\frac{\text { Profit available for Equity Shareholders }}{\text { No. of Equity Shares }}\)

10. Book Value Per Share
Book Value Per Share = \(\frac{\text { Equity Shareholders’s Funds }}{\text { No. of Equity Shares }}\)

11. Dividend Per Share
Dividend Per Share = \(\frac{\text { Total Equity Dividend }}{\text { No. of Equity Shares }}\)

12. Price Earning Ratio
Price Earning tio = \(\frac{\text { Market Price of a Share }}{\text { Earning Per Share }}\)

By going through these CBSE Class 12 Accountancy Notes Chapter 9 Analysis of Financial Statements, students can recall all the concepts quickly.

Analysis of Financial Statements Notes Class 12 Accountancy Chapter 9

Meaning of Financial Statement Analysis: The process of critical examination of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm is called the ‘Financial Statement Analysis’.

Basically, it is a study of the relationship among various financial facts and figures as given in a set of financial statements.

→ “Financial statement analysis is designed to indicate the strength and weaknesses of business undertaking through the establishment of certain crucial relationship by regrouping and analysis of figures contained in financial statements.” —J.N. Myres

→ “Financial statement analysis is a judgemental process which aims to estimate current and past financial position and the results of the operations of enterprises with the primary objective of determining the best possible estimated and predictions about future conditions.” —Bernstein

Thus, Analysis of Financial Statements is the process of identifying the financial strengths and weaknesses of the firm by properly establishing a relationship between the items of the Balance Sheet and Income Statement.

The term ‘Financial Analysis’ includes both ‘analysis and interpretation’. The term analysis means simplification of financial data by the methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of the data so simplified.

Significance of Financial Analysis: As we know that Financial Analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the Balance Sheet and the Profit and Loss Account.

It can be undertaken by the management of the firm, or by parties outside the firm like Creditors, Lenders, Investors, Unions, etc. The nature and technique used for analysis will differ depending on the interests of the analysis.

Financial Analysis is useful and significant to different users in the following way:
1. To The Finance Manager: Financial Analysis focuses on the facts and relationships related to managerial performance, corporate efficiency, financial strengths and weaknesses, and credit worthiness of the company. The Finance Manager has to make rational decisions for the firm, so he must be well equipped with the different tools for analysis. These tools help him in studying accounting data, so as to determine the continuity of the operating policies, the investment value of the business.

Credit rating and testing the efficiency of operations. The technique is equally important in the area of financial control, enabling the Finance Manager to make constant reviews of the actual financial operations of the firm as a whole and in part, to analyze the cause of major deviations, which result in corrective action wherever indicated.

2. To The Management: It is the responsibility of the management to see that the resources of the firm are used most efficiently and that the firm’s financial condition is sound.

Financial analysis helps the management in measuring the success or otherwise of the company’s operations, appraising the individual’s performance, and evaluating the system of internal control.

3. To The Trade Creditors: Trade Creditors are particularly interested in the firm’s ability to meet their claims over a very short period of time. Their analysis will, therefore, confine to the evaluation of the firm’s liquidity position.

4. To The Lenders: Lenders are mainly concerned with the firm’s long-term solvency and survival. They analyze the firm’s profitability over time, its ability to generate cash to be able to pay interest and repay principal, and the relationship between various sources of funds. They do analyze the historical financial statements as well as projected financial statements to make an analysis about its future solvency and profitability.

5. To The Investors: Investors who invested their money in the firm’s shares, are interested to know about the firm’s earnings. They mainly concentrate on the analysis of the firm’s present and future profitability. The investors evaluate the efficiency of the management and determine whether a change is needed or not. In large companies, the shareholder’s interest is limited to decide whether to buy, sell or hold the shares.

6. To The Labour Unions: They analyze the Financial Statements to assess whether the company is earning a fair rate of return on invested capital, whether it can presently afford a wage increase and whether it can absorb a wage increase through increased productivity or by rising the prices.

7. To the Economists, Government, etc.: The economists, researchers analyze the Financial Statements to study the present business and economic conditions. The Government agencies need financial analysis for price regulations, tax fixation, and another similar purpose.

Purpose or Objectives of Financial Statement Analysis: Financial Statement Analysis reveals important facts and relationships concerning the managerial performance and the efficiency of the firms. The main objectives of the analysis are to understand the information contained in financial statements with a view to knowing the weaknesses and strengths of the firms and making a forecast about the future prospects of the firm and thereby enabling the financial analysis to take different decisions regarding the operations of the firm.

The following are generally considered to be the objectives of analysis:

1. To find out the financial stability and soundness of the business enterprises.
2. To assess and evaluate the earning capacity of the business.
3. To estimate and evaluate the Fixed Assets, Stock, etc. of the concern.
4. To estimate and determine the possibilities of future growth of the business.
5. To assess and evaluate the firm’s capacity and ability to repay short-term and long-term loans.
6. To evaluate the administrative efficiency of the business enterprises.

Tools of Financial Analysis.

1. Comparative Statement Analysis.
2. Common Size Statement Analysis.
3. Trend Analysis.
4. Ratio Analysis.
5. Cash Flow Analysis.

1. Comparative Statement Analysis: Comparative statements compares financial numbers at two points of time and helps in deriving meaningful conclusions regarding the changes in financial positions and operating results and to enable the reader to understand the significance of such changes.

Such comparison of Financial Statements is accomplished by setting up a Balance Sheet and Profit and Loss Account side by side and studying the changes that have occurred in the individual figure therein from year to year and over the years. Thus, Comparative Statements are those which summarise and present relating data for a number of years incorporating therein the changes in individuals items of Financial Statements. This analysis is also known as Florizontal Analysis.

2. Common Size Statement Analysis: These Statements indicate the relationship of different items of Financial Statements with some common item by expressing each item as a percentage of the common item. The percent thus calculated can be easily compared with the corresponding percentages of some other firms, as the number is brought to a common base. This analysis is also known as ‘Vertical Analysis’.

3. Trend Analysis: It is a technique of studying several Financial Statements over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. Trend analysis is important because, with its long-run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising, or remaining relatively constant.

4. Ratio Analysis: Accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency, and efficiency of an enterprise through the techniques of ratio analysis.

5. Cash Flow Analysis: It refers to the analysis of the actual movement of cash in and out of an organization. Cash Flow Statements is prepared to project the manner in which the cash received has been utilized during an accounting year. It is a statement, which shows the sources of cash receipts and also the purposes for which payments are made. Thus, it summarises the causes for the changes in the cash position of a business enterprise between the dates of two Balance Sheets.

Comparative Financial Statements Analysis: Financial Statements include Income Statements (Trading and Profit and Loss A/c) and Position Statement (Balance Sheet). The study of financial statements with a view to indicating the trend of the profitability, efficiency, and financial soundness of the business is known as a comparison of financial statements.

Purpose:

1. To study the magnitude and direction of changes in the financial position and performance of the enterprise.
2. To ascertain the strengths and weaknesses of the enterprise in terms of liquidity, solvency, and profitability.

Importance:

1. Inter-period and/or inter-firm comparisons are very much facilitated by such comparative statements. t
2. With the help of Comparative Statements, weakness in the operating cycle, financial health, etc. can be identified and suitable remedial steps may be taken.
3. These statements highlight the trends in a number of accounting data relating to performance, efficiency, and financial position which are useful for future estimates.
4. The Profit and Loss A/c of a business show the result of operation while a Comparative Balance Sheet shows the effect of operations on its assets and liabilities. Thus, the Comparative Balance Sheet contains a connecting link between Balance Sheet and Profit and Loss A/c.

Comparative Balance Sheet: In the comparative balance sheet, the items and data of balance sheets prepared at two different dates are presented in such a way that the changes in each item between two dates are easily found out and determined.

→ “Comparative balance sheet is the study of the trend of the same item, group of items and computed items in two or more balance sheets of the same business enterprise on different dates.”—Prof. Foulkes.

Comparative Profit and Loss Account: A comparative income statement is prepared to show the net profit or loss for a number of years in comparative form. A comparative study of Income Statements for more than one period may enable us to have definite knowledge about the progress of the business concern.

Steps:
The following steps may be followed to prepare the comparative statements:
1. Draw a table with the five columns like;
Comparative Statement

2. List out absolute figures in rupees at two different points of time.
3. Find out the change in absolute figures by subtracting the first year from the second year and indicate the change as an increase (+) or decrease (-).
4. Calculate the Percentage change as:
\(\frac{\text { SecondyearabsoluteFigure }}{\text { First year absoluteFigure }}\) × 100 – 100

Common-Size Financial Statement Analysis: Common-Size Statement also known as a component percentage statement, is a financial tool for studying the key changes and trends in the financial position (Balance Sheet) and financial result (Profit and Loss A/c) of a company.

These figures reported are converted into percentages of some common base. For example, total assets may be chosen as a measured size for the Balance Sheet and sales may act as a measured size for Profit and Loss A/c.

These statements are known as common size statements because all the figures are converted into a common size.

Purpose: An analysis of the common size statement will help better to understand the important changes which have occurred in the enterprise over a period of time. This analysis constitutes a vertical study within one column of the comparative statement therefore, it is also called vertical analysis.

Importance: An analysis of common size statement is of immense use which comparing business enterprise which differs substantially in size as it provides an insight into the structure of financial statements.

Common Size Balance Sheet
In Common Size Balance Sheet, each item of assets is shown as a percentage of total assets and each item of liability is shown as a percentage of total liabilities. The total of the assets and that of liabilities is taken as 100 percent and each item, appearing on the assets side as well as liabilities side is shown as the proportion of the total of 100. It is known as the Percentage Balance Sheet.

Common Size Income Statement: Income Statements are reduced to common size by expressing each item as a percentage of net sales. Thus the common size Income Statement captures the relationship between sales and expenses.

Steps:
The following steps may be followed to prepare the common size statements:
1. Draw a table with the five columns.
Common Size Statements

2. List out absolute figures in rupees at two different points in time.
3. Choose a common base (as 100) for example, Sales revenue total may be taken as a base (100) in case of Profit and Loss A/c and total assets or total liabilities (100) in case of Balance Sheet.
4. Convert all items of Col. 2 and Col. 4 as a percentage of that total. Columns 3 and 5 portray these percentages.

The purpose of the common-size analysis is to know the importance of each item in the total. Hence, this analysis can be done for one year also.

Trend Analysis: The Financial Statements may be analyzed by computing trends emeries of information. Trend analysis determines the direction upwards or downwards and involves the computation of the percentage relationship that each item bears to the same item in the base year. In Trend Analysis, we would like to know the behavior of some item over the period, say during the last 5 years.

In other words, Comparative and Common Size Statements present the percentage of each item to the total sum. These percentages could be calculated for a number of successive years in order to understand the trend of the Financial Statement item and this analysis is called trend analysis.

The trend in general term signifies a Tendency. The review and appraisal of tendency in accounting data are nothing but trend analysis. It discloses the change in the financial and operating data between specific period and makes possible for the analyst to form an opinion as to whether favorable or unfavorable tendencies are reflected by the accounting data.

Purpose and Importance:
1. It helps in future forecasts of various items as the basis of data of the previous year.
2. In this method, mass complex accounting data are converted into % and presented in brief, so the direction of the business can be easily detected.
3. There is less chance of mistakes because changes in percentages can be compared to changes in absolute data.
4. It is a very easy method to calculate that even a layman can also use this method.

Procedure: Generally, the first or the last year is taken as the base year. The figure for the base year is taken as 100. The trend percentages are calculated in relation to this base year. Each year’s figure is divided by the base year figure.
Trend Percentage = \(\frac{\text { Present year value }}{\text { Base year value }}\) × 100

The base period should be carefully selected. The accounting procedures and conventions used for collecting data and preparation of Financial Statements should be similar, otherwise, the figures will not be compared.

Limitations of Financial Analysis
Though financial analysis is quite powerful in determining the financial strengths and weaknesses of a firm, the analysis is based on the information available in financial statements. As such, financial analysis also suffers from the serious limitations of financial statements.

Some other limitations of financial analysis are:

1. It does not consider price level changes.
2. It may be misleading an account of changes in accounting procedure followed by a firm.
3. It is just a study of interim reports.
4. Monetary information alone is considered in financial analysis while non-monetary factors are ignored.
5. The financial statements are prepared on the basis of ongoing concepts as such, it does not give an exact position.

By going through these CBSE Class 12 Accountancy Notes Chapter 8 Financial Statements of a Company, students can recall all the concepts quickly.

Financial Statements of a Company Notes Class 12 Accountancy Chapter 8

Financial Statements are the end products of the accounting process. They are prepared following the consistent accounting concept principles, procedures and also tire legal environment in which the business organization operates. These statements are the outcome of % the summarizing process of accounting and are, therefore the sources of information/on the basis of which conclusions are drawn about the profitability and the financial position of a business enterprise.

Meaning of Financial Statements: Financial Statements are the summarized statements of accounting data produced at the end of the accounting process by an enterprise through which it communicates accounting information to the external users as well as internal users.

These are the basic and formal means through which the corporate management communicates financial information to various users. External user includes investors, tax-authorities, government, employees, etc.

Financial information, which is the information relating to the financial position of any firm, when presented in a concise and capsule form, is known as the financial statement.

“Financial Statements are prepared for the purpose of presenting a periodical review or report on progress made by the management and deal with the status of investment in the business and the results achieved during the period under review.”

—American Institute of Certified Public Accountants (AICPA)
“The end product of financial accounting in a set of financial statements prepared by the accounts of a business enterprise that purport to reveal the financial position of the enterprise, the result of its recent activities and an analysis of what has been done with earnings.” -Smith and Assume

“The Finacial Statements provide a summary of accounts of a business enterprise, the balance sheet reflecting the assets, liabilities, and capital as on a. certain date and the income statement showing the results of operations during a certain period.”. -John N. Myer

“Financial Statement, essentially, are interim reports presented annually and reflect a division of the life of an enterprise into more or less arbitrary accounting period more frequently a year.” -Anthony

Thus, Financial Statements are the final product of accounting work done during the accounting period which shows the financial position and result of business activities for that accounting period. In other words, Financial Statements are the end products of the accounting process. It may be defined as the reports prepared for the purpose of presenting a periodical review of the performance and the financial position of a business enterprise. Financial statements are the indicators of profitability and financial soundness of a corporate sector.

Nature of Financial Statements:
Viewpoints of the Professional Bodies and Researchers about the nature of Financial Statements:
According to the American Institute of Certified Public Accountants

(AICPA), “Financial statements are prepared for the purpose of presenting a periodical review of the report on progress by the management and deal with the status of investment in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting principles and personal judgments.”

In the words of the American Accounting Association, “Every corporate statement should be based on accounting principles, which are sufficiently uniform, objectives and well understood to justify opinion as to the condition and progress of the business enterprise. Its basic assumption was that the purpose of periodic financial statements of a corporation is to furnish information that is necessary for the formation of dependable judgments.”

According to John. N. Mayer, “The financial statements are composed of data which are the result of a combination of

1. Recorded facts concerning the business transactions;
2. Conventions adopted to facilitate the accounting technique;
3. Postulates or assumptions made; and
4. Personal judgments used in the application of the conventions and postulates.”

The following points explain the nature of financial statements:
1. Recorded Facts: The basis of recording transactions in financial statements is the original cost or historical cost. The assets purchased at different times and at different prices are put together and shown at cost price. The financial statements do not show current financial conditions, as they are based on original costs not on replacement costs.

2. Accounting Conventions: For preparing financial statements, certain accounting conventions are followed. For example, the convention of valuing inventory at cost or market price, whichever is lower, is followed. Small items like pencils, pens, postage, stamps, etc. although assets in nature but treated as expenditure in the year in which they are purchased. The Stationery is valued at cost. The use of accounting conventions makes financial statements comparable, simple and realistic.

3. Postulates: Financial Statements are prepared on certain basic \ assumptions known as postulates such as going concern postulates, money-measurement postulate, realization postulate, etc. Going concern postulates assumes that the enterprise is run for a long time. Money FC measurement postulate assumes that the value of money will remain the same in different periods.

4. Personal Judgements: Under more than one circumstance, facts and figures presented through financial statements are based on personal opinion, estimates, and judgment. For example, depreciation is calculated with a written-down method or at the original cost.

Provisions for doubtful debts are made on estimates and personal judgments. Personal opinion, judgments, and estimates are made while preparing the financial statements to avoid any possibility of overstatement of assets and liabilities, income, and expenditure, keeping in mind the, convention of conservation.

Thus, Financial Statements are the summarized reports of recorded facts and are prepared following the accounting concepts, conventions, and requirements of law.

Objectives of Financial Statements
1. To provide information about economic resources and obligations of a business: Financial Statements are prepared to provide adequate, accurate, reliable, and periodical information to investors and other external parties regarding economic resources and obligations of a business firm.

2. To provide information about the earning capacity of the business: Financial Statements are prepared to provide the information about the earning capacity of the business, which can be very useful and important for decision-making purposes for internal as well as external users. They provide very useful financial information, which can be utilized to predict, compare and evaluate the firm’s earning capacity.

3. To provide information about cash flows: Financial Statements can also provide vital information useful to investors and creditors for predicting, comparing and evaluating, potential cash flows in terms of amount, timing, and related uncertainties.

4. To judge the effectiveness of management: With the help of financial statements, we can judge the management’s ability to utilize the resources of a business effectively.

5. Information about activities of business affecting the society: They have to report the activities of the business organization affecting the society, which can be determined and described or measured and which are important in its social environment.

6. Meeting the informational needs of users: These statements have to disclose, to the extent possible, other information related to the financial statements that are relevant to the needs of users of these statements.

7. Disclosing accounting policies: These reports have to provide the significant policies, concepts followed in the process of accounting, and changes are taken up in them during the year to understand these statements in a better way.

8. To provide information about solvency: Solvency determined the ability of a business concern to meet its short-term debt such as creditors, bills payable and -bank overdraft, etc., and long-term debts such as debentures, bank loans, etc. The financial statements of the firm provide information regarding the solvency of the firm.

9. Helps in comparison: With the help of information provided by the financial statements, comparison between the different firms made easy.

Types of Financial Statements: Financial Statements generally includes:

1. Income Statement (or Profit & Loss Account)
2. Position Statement (or Balance Sheet)

The statement, which takes care of matching revenue receipts with revenue payments (of nominal nature) is known as Income Statement.

Items of capital nature that have potential uses and future obligations known as assets and liabilities. The statement which shown total assets and liabilities is known as the position statement (or Balance Sheet).

These two basic statements are required for external reporting and also for the internal needs of the management. These two basic statements are supported by a number of schedules, annexures, supplementing the data contained in the balance sheet and income statement.

1. Balance Sheet: It is a component of a financial statement that shows the balance of liabilities, equities, and assets of a business entity as on a particular date. The balance sheet is not an account. Balance of liabilities, equities, and assets are not closed by transferring to Balance Sheet, balance of those accounts are simply carried forward to the next accounting period.

The balance sheet displays the liabilities, equities, and assets position generally at the end of the accounting period. It is a sheet of the balance of ledger accounts that are still open after the transfer of all nominal accounts to the Income Statement. The balance of all the personal and real accounts are grouped as assets and liabilities. Liabilities are shown on the left side of the Balance Sheet and Assets on the right side.

According to the American Institute of Public Accountants, Balance\ Sheet is “A tabular statement of summary of balance (debits and credits) carried forward after an actual and constructive closing of books of accounts and kept according to principles of accounting.”

→ “A business form showing what is owed and what the proprietor is forth is called a Balance Sheet.” —Karlson exi

→ “The Balance Sheet is a statement prepared with a view to measure the ICT financial position of a business on a certain fixed date.”—J. R. Batliboi side

→ “The Balance Sheet is a statement at a particular date showing on one (he trader’s property and possession and on the other hand the liabilities.” -A. Palmer

It is the report about the properties owned by the enterprise and the claims of the creditors and owner against these properties. Thus, a Balance Sheet is a statement prepared with a view to measure the exact financial position of a business on a certain date.

2. Income Statement or Profit and Loss Account: It is the accounting report, which summarizes the revenues expenses, and incomes, and the difference between them for a specified accounting period. An income statement gives a mathematical interpretation of policies, expenses, knowledge, foresight, and aggressiveness of the management of a business from the point of view of income, expenses, gross profit, operating profit, and net profit or loss.

As per the accounting concept of income, profit or loss is the difference between the realized revenues of the period and the related expired costs. Income measurement is based on concepts like going concerned, accounting period, realization, matching, and objectives evidence, etc. Normally accrual basis of accounting is followed in income measurement.

Uses and Importance of Financial Statements
Financial Statements, which are prepared to depict true relevant, easily understandable, comparable, analytically represented, and promptly presented financial position, help the user in their economic decisions.

The main uses and importance of financial statements are following:
1. Provide Information to Shareholders: Financial statements provide information about the management performance to the shareholders. Shareholders are the suppliers of the basic capital to run the concern and as such, they are very much interested in the well-being of the business.

They are interested to know the profitability and prospects of future growth of the business. They come to know about the financial position and operating results of the business through these financial statements only.

2. Basis for Fiscal Policies of the Government: Financial Statement provides the basis for fiscal policies of the Government. Financial Statement provides useful information to various government departments like Income Tax, Sale Tax, Excise duty, etc to determine the tax liability of the concern. So, on the basis of financial statements, the government determines tax policy, import-export policy, industry policy, etc.

3. Basis for Dividend Policies: The dividend policies of the corporate sector are linked with the government regulation and financial performance of the undertaking. Hence, financial statements form the basis for dividend policies of companies.

4. Basis for Granting of Credit: Corporate undertaking has to borrow funds from banks and other financial institutions for different purposes. All financial institutions which provide loan to the corporate undertaking are interested to know the profit earning capacity of the business and its long term solvency. They make decisions based on the financial performance of the undertaking. Thus financial statements form the basis for granting credit.

5. Guide to the Value of the Investment Already Made: Shareholders of companies are interested in knowing the status, safety, and return on their investment. They may also need the information to make decisions about the continuation or discontinuation of their investment in the business. Financial statements provide information to the shareholder in taking such important decisions.

6. Basis for Prospective Investors: In addition to the existing investor there may be people who may be interested in investing money in the company. But before doing that they would be interested to know the long-term and short-term solvency as well as the profitability of the concern. Financial statements provide adequate information to such potential investors to enable them to take the necessary decisions.

7. Aids Government in Policy Framework: Financial statements help Government to assess the role of corporate undertaking in the economic development of the country. It also assesses the economic situation of the country from these statements in terms of industrial production, employment, etc. These statements enable the government to know whether a business is following various rules and regulations or not. These statements also form the basis for framing and amending various laws for the regulation of the business.

8. Aids Trade Associations in Helping their Members: Trade Associations can judge, on the basis of financial statements the profitability of the business enterprises. They can compute as to how much bonus and increase in their wages are possible from the profits of the business concern. Trade unions negotiate the wages and salaries with the company, the financial statements reveal the financial soundness of the company and thus provide the basis to the trade unions to go in for negotiations.

9. Helps Stock Exchanges: Financial Statements help the stock exchanges to understand the extent of transparency in reporting on financial performance and enable them to call for the required information to protect the interest of investors. The financial statements enable the stockbrokers to judge the financial position of different concerns and take decisions about the price to be quoted.

10. Helps Trade Creditors: Trade creditors and suppliers of goods are interested in knowing the short-term solvency of the business. They are interested to know whether the business firm will be making payment on time or not. Financial statements provide adequate information to them to take the necessary decisions.

Limitations of Financial Statements
Financial Statements suffer from the following limitations.
1. Do not reflect the current situation: Financial Statements are prepared on the basis of historical cost and do not throw light on the current and present position of the business. The purchasing power of money is changing, the value of assets and liabilities shown in the financial statement does not reflect the current market situation. It does not indicate the current position of the business.

2. Dividends out of Capital: Net profit is ascertained on the basis of historical cost. If profits are adjusted to changing price levels, it may lead to loss and consequently, dividends may be paid out of capital.

3. Incomplete Information: Financial statements do not include all of the relevant information necessary for evaluating the status, progress, and future prospects of a business enterprise. The Balance Sheet does not disclose information relating to the loss of markets and cessation of agreements that have a vital bearing on the enterprise.

4. Assets may not realize: Some of the assets may not realize the stated value if the liquidation is forced on the company. Assets shown in the balance sheet reflect the merely unexpired or unamortized cost.

5. Different accounting policies: Various concepts and conventions of accounting affect the value of assets and liabilities as shown in the Balance Sheet and profit as shown by the Profit and Loss Account. For example, different firms may adopt different methods of stock valuation.

6. No Qualitative Information: The financial statements do not reflect complete information about the firm. Only that information, which can be expressed in monetary terms, is given. Qualitative information is however ignored like industrial relations, industrial climate, labor relations, etc.

7. No free from Bias: Financial statements are prepared on the basis of certain established concepts and conventions yet they are greatly affected by personal bias and personal judgment of various factors.

8. Aggregate Information: Financial Statements show aggregate information but not specific information. Hence they may not satisfy the user in decision making unless modified suitably.

9. Interim reports: Financial Statements are merely interim reports, not final reports. Profit and Loss Account discloses only interim profits but not final profits. Final profits can be known only when an enterprise is liquidated, assets are sold and liabilities are paid off.

10. Affected by window-dressing: Some business firms have given too much attention to decorate their financial statements in such a way that they fulfilled all the legal requirements and show the sound financial position of the firm. In fact, these statements may be far from the truth.

Income Statement may be divided into three components

1. Trading Account → To show Gross Profit Earned or Gross Loss incurred.
2. Profit and Loss Account → To show Net Profit earned or Net Loss incurred.
3. Profit and Loss Appropriation Account → To show all appropriation from the current year and balance of profit or loss of last year and surplus or deficit at the end of the period.

Note: If the company is a manufacturing concern, apart from the above components manufacturing account is also required.

→ Trading Account: Trading Account is the first part of the financial statements. The trading account is designed to show the gross profit on the sale of goods. The trading account contains the transactions of the company relating to the commodities in which it deals, throughout the accounting period.

All expenses either related to purchasing of raw material or production are charged to the Trading A/c i.e. Debited to Trading A/c. It is prepared to find out Gross Profit or Gross Loss. If the sales are more than purchases and expenses the result is Gross Profit and vice versa. Its main components are sales, services rendered and cost of such sales or service rendered. A trading account provides the data for comparison, analysis, and planning for future growth.

Form of Trading Account
Trading Account of…………………. Co. Ltd.
for the year ended……………………..

→ Profit and Loss Account: The profit and Loss Account is the second part of the financial statement. The company is more interested in knowing its net income or net profit, which increases its equity. Net profit represents the excess of gross profit plus other revenue income over indirect expenses.

The indirect expenses are not shown in Trading Account. On the debit side of the Profit and Loss Account, the indirect expenses are shown whereas on the credit side revenue incomes. If the debit side is less than of credit side, it would be net profit and if the credit side is less than of debit side it would be a net loss.

“A Profit and Loss account is an account into which all gains and losses are collected in order to ascertain the excess of gain over the losses or vice-versa.” -Prof. Carter

Form of Profit & Loss Account
Profit & Loss Account of………… Co. Ltd.
for the year ended…………………………..

→ Profit and Loss Appropriation Account: The account which shows the disposition of profit is called the Profit and Loss Appropriation Account. The disposition of profit means the distribution of net profits by way of dividends, transfer of profits to various reserves, adjustment of arrears of depreciation, if any, bonus to shareholders, and so on.

Form of Profit and Loss Appropriation Account
Profit and Loss Appropriation Account of…………… Co. Ltd
for the year ending…………………………

Income statements may also be presented in vertical form with detailed data. Verticle form income statements are suitable for further analysis and providing suitable data for decision making.

Form of Vertical Income Statement
Income Statement of……………………. Co. Ltd.
for the year ending……………………..


Process for Preparation of Income Statement:
The following process is to be followed for the preparation of the income statement (in T form):

1. Preparation of trial balance on the basis of balances of all the accounts available in the ledgers of the concern.
2. Recording all the revenue receipts appearing on the credit side of tire trial balance on the credit side of income statement after making suitable adjustments for revenues received in advance or revenues realized but not received etc.
3. Recording all the revenue expenditure items that appeared on the debit side of the trial balance on the debit side of the income statement after making adjustments for outstanding, prepaid expenses, depreciation, provisions for bad debts, taxes, etc.
4. Recording non-operating incomes and gains on the credit side of the income statement.
5. Recording non-operating losses on the debit side of the income statement.
6. Finding the difference between totals of credit items and totals of debit items.
7. If the credit items are more than the debit items, it is known as net profit and vice versa.
8. In India, the accounting year for preparing financial statements for companies is 1st April to 31st March (same as that of the financial year of the Government).

→ Form and Contents of Balance Sheet: A balance Sheet is a component of a financial statement that shows balances of liabilities, equities, and assets of a business entity as on a particular date. It is prepared with a view to measure the exact financial position of a business on a certain fixed date. It is usually prepared in horizontal T form. The assets are shown on the right-hand side and capital and liabilities are shown on the left-hand side. These can be arranged either on:
(a) Liquidity basis or on
(b) Permanency basis

(a) Liquidity Basis: According to this method an asset that is most easily convertible into cash such as cash in hand is written first and then will follow those assets which are comparatively less easily convertible so that the least liquid assets such as Goodwill are shown last.

In the same way, those liabilities which are to be paid at the earliest will be written first, in other words, current liabilities are written, first of all, then fixed or long-term liabilities, and lastly the equity of the owner.

(b) Permanency Basis: This method is just opposite to the first method. Assets that are most difficult to be converted into cash such as Goodwill are written first and the assets which are most liquid such as cash in hand are written last.

Those liabilities which are to be paid last will be written first. The owner equity is written, first of all, then long-term liabilities, and lastly the current liabilities.

The Companies Act adopted the permanency approach form in the preparation of the balance sheet. The registered companies are required to follow Part I of Schedule VI of the Companies Act, 1956 recording assets and liabilities in the tire balance sheet in a particular order. According to section 211 (i) of the Companies Act, the balance sheet shall be prepared in prescribed format from time to time, depict the true and fair view of financial position, and follow general instructions for the preparation of the balance sheet under the heading notes at the end of that part.

This format is not applicable to Banking and Insurance Companies. These companies follow the formats prescribed by their respective legislation.

Horizontal Form Of Balance Sheet Schedule Vi, Part I (See Section 211)
A-Horizontal Form Of Balance Sheet Balance Sheet Of ……………………..
(Here enter the name of the company) as on (Here enter the date at which the balance sheet is made out)




Notes:
(a) Fixed assets are shown at original cost less total depreciation to date.
(b) Investments should be divided into two parts:

• Quoted, and
• unquoted. In the case of quoted investments market price must be disclosed.

(c) Contingent liabilities are not included in the total of the liability side. Following are the usual types of contingent liabilities:

1. Claim against the company not acknowledged as debt.
2. Uncalled liability on shares partly paid.
3. Arrears of fixed cumulative dividends.
4. The estimated amount of contracts remaining to be executed on capital account and not provided for, ‘
5. Other money for which the company is contingently liable.
   The Balance Sheet can be prepared in the abridged form also which is shown below:

Abridged Balance Sheet
Form of Balance Sheet (Horizontal Form),
Balance Sheet of ……………..Co. Ltd.
as on……………..

Note: A footnote to the Balance sheet may be added to show separately the contingent liabilities.

Vertical Form of Balance Sheet Form of Balance Sheet (Vertical Form)
Balance Sheet of………………….. CO. LTD.
as on…………………….

Note: Usually detail under each of the above items is given by way of a separate schedule. The number of the schedule incorporating the information is mentioned against the item in the column.

Explanation to Balance Sheet Items
Statutory Contents of Liabilities Side of Company’s Balance Sheet
1. Share Capital: It is the first item on the liabilities side of the balance sheet and shows details about the following:

1. Authorized Capital
2. Issued Capital
3. Subscribed Capital.
4. Called up Capital
5. Paid-up Capital

In terms of the number of shares of each kind along with the nominal value. If forfeited shares are reissued then this amount is added to the paid-up capital.

2. Reserves and Surplus: As per Schedule VI to the Companies Act, 1956, ‘Reserves and Surplus’ includes the following items:

1. Capital Reserves
2. Capital Redemption Reserves
3. Share Premium Account or Securities Premium
4. Other reserves
5. Surplus
6. Proposed Addition to reserves
7. Sinking fund

These reserves may be classified broadly as revenue and capital reserves.

3. Secured Loans: If any company given security for the loan by a mortgage or charge on all or any of its property, the loan will be called ‘Secured Loans’. It includes:

1. Debentures
2. Loans and Advances from Banks
3. Loans and Advances from subsidiaries
4. Other Loans and Advances if any

Information regarding the nature of security given for each secured loan should be given along with the respective loans.

4. Unsecured Loans: Loans and advances for which no security is given are shown under this heading. This include:

1. Fixed deposits
2. Loans and Advances from Subsidiary Companies
3. Loans and Advances from other sources.
4. Short-term loans from banks and others.

5. Current Liabilities and Provisions: Current Liabilities include:

1. Acceptances (or Bills Payable)
2. Sundry Creditors
3. Advance Payments
4. Un-expired Discounts
5. Unclaimed dividends
6. Accrued Interest but not paid
7. Other liability (if any)

Provisions include:

1. Provisions for taxation
2. Proposed Dividend
3. Provisions for Contingencies
4. Provision for provident fund
5. Provision for Pension
6. Provision for Insurance
7. Similar staff benefit schemes etc.
8. Other provisions

Statutory Contents of Assets Side of Company’s Balance Sheet 1. Fixed Assets: These are those assets that are used for a long time in business to earn profit. They are acquired with an intention of using them in the main activity of the concern but not for resale.

It includes:

• Goodwill
• Land and Building
• Leaseholds
• Plant and Machinery
• Furniture
• Railway Lines
• Patents etc.

These assets are shown at cost less depreciation till the date.

2. Investments: It includes

1. Investment in Government Securities
2. Investment in Trust securities
3. In shares, debentures, bonds, etc.
4. Investment in immovable property etc.

3. Current Assets, Loans, and Advances: Current Assets includes:

1. Inventories
2. Sundry Debtors
3. Cash and Bank Balances
4. Loose Tools
5. Accrued Interest

Loans and Advances include:

1. Loans and Advances to Subsidiary Company
2. Bills of Exchange
3. Balance with customs, port trust, etc.

4. Miscellaneous Expenditure: Expenditure, which is not debited to Profit and Loss Account fully and deferred for some years, is shown under this heading.

It includes:

1. Preliminary Expenses
2. Advertisement Expenditure
3. Discount on issue of shares and debenture etc.

5. Profit and Loss Account: If there is any debit balance in the Profit and Loss Account, it will be shown as the assets side of the Balance Sheet.