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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 = \(\frac{\text { Market Price of a Share }}{\text { Earning Per Share }}\)