Financial Statement (Balance Sheet,

Manufacturing Account, Trading Account, Profit

and loss account), Ratio analysis

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Introduction
Financial statements are the end products of the accounting process, which reveals
the financial results of the specified period and financial position as on particular
date. It is the basic and formal annual report through which a business communicates
financial information to its various user groups.

Nature of financial statement -

1. Recorded facts
2. Accounting conventions
3. Postulates(Assumptions)
4. Personal Judgements

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Objectives of Financial Statement
1. To provide information about the earning capacity of a
business firm.
2. To provide reliable financial information about the economic
resources(assets) and obligations(liabilities) of a business
firm
3. To disclose, to the extent possible, other related information
to financial statement that is relevant to the needs of the users.
4. To disclose , the various accounting policies followed in
preparing the financial statement to its various user groups.
5. To provide reliable information about the changes in
resources and obligations arising out of business activities.

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Characteristics of Ideal financial statement
1. Reliability
2. Relevency
3. Understandibility
4. Comparability

Importance of financial statement

1. Importance to management
2. Importance to Creditors
3 Importance to Bankers
4. Importance to Investors
5. Importance to Government

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Limitation of financial statement
1. Based on specific time period. A user of financial statements can gain an incorrect view of
the financial results or cash flows of a business by only looking at one reporting period. Any
one period may vary from the normal operating results of a business, perhaps due to a sudden
spike in sales or seasonality effects. It is better to view a large number of consecutive
financial statements to gain a better view of ongoing results.
2. Not always comparable across companies. If a user wants to compare the results of
different companies, their financial statements are not always comparable, because the
entities use different accounting practices. These issues can be located by examining the
disclosures that accompany the financial statements.
3. Subject to fraud. The management team of a company may deliberately skew the results
presented. This situation can arise when there is undue pressure to report excellent results,
such as when a bonus plan calls for payouts only if the reported sales level increases. One
might suspect the presence of this issue when the reported results spike to a level exceeding
the industry norm.
4. Dependence on Historical costs - Transactions are initially recorded at their cost. This is a
concern when reviewing the balance sheet, where the values of assets and liabilities may
change over time. Some items, such as marketable securities, are altered to match changes in
their market values, but other items, such as fixed assets, do not change. Thus, the balance
sheet could be misleading if a large part of the amount presented is based on historical costs.
5. No discussion of non-financial issues - The financial statements do not address non-
financial issues, such as the environmental attentiveness of a company's operations, or how
well it works with the local community. A business reporting excellent financial results might
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be a failure in these other areas.
6. Inflationary effects. If the inflation rate is relatively high, the amounts associated with
assets and liabilities in the balance sheet will appear inordinately low, since they are not
being adjusted for inflation. This mostly applies to long-term assets.
7. Dependence on historical costs. Transactions are initially recorded at their cost. This is
a concern when reviewing the balance sheet, where the values of assets and liabilities
may change over time. Some items, such as marketable securities, are altered to match
changes in their market values, but other items, such as fixed assets, do not change.
Thus, the balance sheet could be misleading if a large part of the amount presented is
based on historical costs.

Constituents of financial statement

1. Balance Sheet
2. Income Statement
(a)Manufacturing Account
(b)Trading account
(c)Profit and loss account

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1. Balance Sheet
Balance sheet is one of the financial statements and is prepared to ascertain the exact
financial position of a business on a particular date.

Importance of Balance Sheet :

1. Helpful in the preparation of books of account in the next year
2. Ascertains the financial position
3. Ascertains the Information about the exact amount of capital

Characteristics of a Balance Sheet :

 The balance sheet is a statement not at all an account. It Shows the financial
position
of the business according to the going concern concept.
 The word ‘to’ and ‘By’ are not used before the names of the accounts shown in the
balance sheet.
 The total of the two sides of the balance sheet must be equal.
 The balance sheet does not have Debit or Credit Side. The two sides of the balance7
Liabilities –
1. Fixed (or long-term) liabilities – Liabilities due to be paid after one year or more are
termed as long –term liabilities. Liabilities like long term loans, public deposits ,
debentures etc belong to this category of liabilities.
2. Current Liabilities - Liabilities due to be paid within one year are known as current
liabilities. These includes bills payable, outstanding expenses, creditors, bank overdraft
etc.

Assets –
1. Fixed Assets – Assets which are acquired for continued usage and last for many years.
Example – Land, building, plant, machinery etc.
2. Current Assets – Assets which are either in the cash form or can be easily converted in
cash within the current financial year are known as current assets. For example – cash
in bank account, sundry debtors etc.
3. Tangible Assets –The assets which have physical existence and can be touched, seen
and felt are called tangible assets. Example – furniture, machine etc.
4. Intangible assets – Assets which do not have any physical existence and cant be seen or
felt by touching are called intangible assets. Example – goodwill etc.
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Forms of Balance Sheet –
A Balance Sheet can be prepared in two forms –
1. Horizontal form
2. Vertical form

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Horizontal Form – Under this form of presentation of Balance Sheet ,the Assets are shown
on the right hand side whereas the Liabilities are shown on the Left Hand Side . This form
is also called ‘T’ form. A Balance Sheet in Horizontal Form will be as follows -

Balance Sheet as on …………………………

Liabilities Amount Assets Amount
Current Liabilities- Current Assets-
Bills payable Cash in Bank account
Bank Overdraft Cash in Hand
Sundry Creditors Bills Receivable
Unearned Income Short term investments
Outstanding Expenses Sundry Debtors
Fixed Liabilities- Closing Stock
Long Term Loans Prepaid Expenses
Reserves Fixed Assets-
Capital Long Term Investments
Add: Net Profit Motor Vehicle
Subtract: Income tax Tools (loose)
Subtract: Life Insurance Plant and Machinery
Premium Patents
Subtract: Drawings Goodwill

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Vertical Form – Under vertical form, the liabilities and assets are shown one after another in
vertical order. A Balance Sheet in Vertical Form will be something like as follows -
Balance Sheet as on …………………………
Amount
Liabilities and Capital:-
Current Liabilities:
Bills payable
Bank Overdraft
Sundry Creditors
Unearned Income
Outstanding Expenses
Fixed Liabilities-
Long Term Loans
Total Liabilities
Assets:-
Current Assets:
Cash in Bank account
Cash in Hand
Bills Receivable
Short term investments
Sundry Debtors
Closing Stock
Prepaid Expenses
Fixed Assets:
Long Term Investments
Motor Vehicle
Tools (loose)
Plant and Machinery
Patents
Goodwill
Total Assets
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Problem 1. As on 31st November, 2016, ABC Ltd. has the following details
pertaining to it financial transactions –

Capital 2,00,000 INR

Drawings 25,000 INR
Net Profit 50,000 INR
Plants and Machinery 75,000 INR
Lands and Building 50,000 INR
Furniture 10,000 INR
Cash in Hand 1,000 INR
Bank Overdraft 15,000 INR
Sundry Debtors 30,000 INR
Sundry Creditors 25,000 INR
Bills Receivables 59,000 INR
Bills Payable 10,000 INR
Closing Stock 39,000 INR
Short Term Investments 11,000 INR

Prepare a balance sheet on the basis of aforementioned information.

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Solution -
BALANACE SHEET
As on 31st November, 2016

Liabilities Amount Assets Amount

Bills payable 10,000 Cash in Hand 1,000

Bank Overdraft 15,000 Bills Receivable 59,000
Sundry Creditors 25,000 Short term investments 11,000
Capital 2,00,000 Sundry Debtors 30,000
Add: Net Profit 50,000 Closing Stock 39,000
Furniture 10,000
2,50,000 2,25,000 Plant and Machinery 75,000
Subtract: Drawings 25,000 Land & Building 50,000

2,75,000 2,75,000

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Solution -
BALANACE SHEET
As on 31st November, 2016
Amount
Liabilities and Capital
Bills payable 10,000
Bank Overdraft 15,000
Sundry Creditors 25,000
Capital 2,00,000
Add: Net Profit 50,000
25,000
Subtract: Drawings 2,75,000

Total Liabilities
1,000
Assets 59,000
Cash in Hand 11,000
Bills Receivable 30,000
Short term investments 39,000
Sundry Debtors 10,000
Closing Stock 75,000
Furniture 50,000
Plant and Machinery 2,75,000
Land & Building
Total Assets

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Income Statement

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2 (a) Manufacturing Account
The firms converting the raw materials into finish goods are required to find out the
cost of goods manufactured. These are manufacturing cum trading concerns. In order
to have full information about the cost of goods manufactured, the concerns firstly
prepare Manufacturing Account & then prepare the Trading & Profit & Loss Account.

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Performa of a Manufacturing Account –

Dr. Cr .
Particulars Amount Particulars Amount
To Raw Materials Consumed: By Cost of Goods
(Opening Stock of raw Material Manufactured
Add: Purchases During The Year transferred to Trading A/c
Less: Closing Stock Of Raw Materials)

To Direct Wages
To Direct Expenses(as carriage on
purchases)
Prime Cost

Factory Expenses:
To Factory Lighting
Factory Rent
Indirect Expenses
Supervisor’s Salary
Stores Consumed etc.

To Work In Progress
Beginning
Less: Closing Work In Progress
Sale of Scrap
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2 (b) Trading Account
An account which tells about the gross profit or gross loss, is known as Profit and Loss
(P&L) account.

It can be prepared in two forms –

1. Horizontal form
2. Vertical form

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Horizontal form - Horizontal form is also called ‘T form’ . There are two sides in this
form. The side on the left is debit side while the side on the right is credit side. Debit side is
presented by acronym Dr. Whereas the credit side is presented by acronym Cr. The actual
format of Horizontal form will be as follows –

Dr. Trading Account for the year ended on………….. Cr.

Particulars Amount Particulars Amount
To Opening Stock By Sales
To Purchases Less: Sales Return
Less: Purchase Return
To Wages By Closing Stock
To Wages and Salaries
To Direct Expenses By Profit & Loss A/C
To Carriage, Carriage Inward or To Gross Loss Transferred
Carriage on Purchase
To Duty On Purchase
To Gas ,Fuel And Power
To Freight/Cartage
To Octroi
To Dock Charges
To Excise Duty
To Import Duty on custom duty
To Profit & Loss A/C
(GROSS PROFIT TRANSFER)

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Vertical form – This form is prepared in vertical order i.e. in the form of a statement.. The
actual format of Vertical form will be as follows –

Trading Account for the year ended on………….. .

Particulars Amount (in rupees) Amount (in rupees)
Dr. Cr.
Sales
Less: Sales Return

Less: Cost of Good Sold:

Opening stock
Purchases less Returns
Wages
Carriage

Less: Closing Stock

Gross Profit

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2 (c) Profit and Loss Account
An account into which all gains and losses are collected, in order to ascertain the
excess of gains over the losses or vice-versa, is known as Profit and Loss (P&L)
account.

Net Profit=Operating Profit – Non operating expenses + Non operating Income

It can be prepared in two forms –

1. Horizontal form
2. Vertical form

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Horizontal form - Performa of a Horizontal form of Profit and Loss Account is as follows –

Dr. Cr.
Particulars Amount Particulars Amount
To Trading A/c By Trading Account
(Gross Loss transferred) (GROSS Profit Transferred)

Office & Administration By Rent

Expenses: By DISCOUNT Received
To Salaries By Commission Received
To Salaries and Wages By Interest on investment
To Rent, Rates & Wages By Sundry Receipts
To Printing & Stationary BY Bad Debt Recovered
To Postage & Telegram By Sale of scrapes
To Lighting By Interest on Drawings
To Insurance Premium(Office)
To Telephone Charges By Capital a/c
To Legal Charges (net loss transferred)
To Audit Fees
To travelling expenses
To Establishment Expenses
To Trade Expenses
To General Expenses

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Vertical form - Performa of a Vertical form of Profit and Loss Account is as follows –
Particulars Amount
A. Net Sales
B. Cost of Goods Sold
C. Gross Profit (A-B)
D. Less: Salaries ,
E. Less: Salaries and Wages
F. Less: To Rent, Rates & Wages
G. Less: Printing & Stationary
H. Less: Postage & Telegram
I. Less: Lighting
J. Less: Insurance Premium(Office)
K. Less: Telephone Charges
L. Less: Legal Charges Note – Here alphabets
M. Less: Audit Fees
N. Less: travelling expenses
like A, B, C,…….and X
O. Less: Establishment Expenses are just used to make
P. Less: Trade Expenses you understand how
Q. Less: General Expenses does profit after tax is
R. Operating Income (C-D-E-F-G-H-I-J-K-L-M-N-O-P-Q) calculated i.e. how
S. Add: Income from other Sources
T. Earning before Interest And Taxes (R+S) calculations are done.
U. Less: Interest Otherwise, there is no
V. Profit before Tax (T-U) need to use these
W. Provision for Tax alphabets while
X. Profit After Tax (V-W) preparing a P & L
account. 23
Ratio Analysis

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Ratio Analysis is a tool by which the relationship of items or groups of items in
the financial statements are computed, and presented.

It is used to interpret the financial statements so that the strengths and weaknesses of a
firm, its historical performance and current financial condition can be better
determined.

Classification of Ratios
Ratios can be broadly classified into four groups :
1. Liquidity ratios
2.Capital structure/leverage ratios
3. Profitability ratios
4. Activity ratios

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1. Liquidity ratios – Liquidity or Solvency ratios analyse the short-term
financial position of a firm and indicate the ability of the firm to meet its short-term
commitments (current liabilities) out of its short-term resources (current assets).

Liquidity ratios are calculated on the basis of data provided in a balance sheet.

There are three types of liquidity ratios –

(a) Current ratio
(b) Liquidity ratio or Quick ratio or acid test ratio
(c) Absolute liquidity ratio

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(a) Currant Ratio - It is determined by dividing current assets by current liabilities. Current
asset include cash and all other assets which can be converted into cash within one
financial year. Current asset of a firm are namely cash in hand, cash in bank account,
sundry debtors/receivables, bills receivables, marketable securities, prepaid expenses,
short term investments, closing stock, and inventories of raw material, work in
progress/process and finished goods. Current liabilities, on the other hand, are obligations
to be paid within a financial year. They include – short term loan, a long term loan
maturing in this financial year, advances received, outstanding expenses, bills payable,
sundry creditors, provision for taxation, proposed dividend, and bank overdraft. Normally
a current ratio of 2:1 is considered satisfactory.

Problem 1– Calculate the current ratio for the following balance sheet -
Liabilities Amount Assets Amount
Bills payable 10,000 Cash in Hand 1,000
Bank Overdraft 15,000 Bills Receivable 59,000
Sundry Creditors 25,000 Short term investments 11,000
Capital 2,00,000 Sundry Debtors 30,000
Add: Net Profit 50,000 Closing Stock 39,000
Furniture 10,000
2,50,000 2,25,000 Plant and Machinery 75,000
Subtract: Drawings 25,000 Land & Building 50,000

2,75,000 2,75,000

Solution. Current Ratio = = 2.8 or 2.8 : 1 27

Problem 2– Calculate the current ratio for the following balance sheet -

Liabilities Amount Assets Amount

Equity share capital 10,00,000 Fixed Assets 50,00,000
10% Preference share capital 20,00,000 Stock 1,55,000
Reserves 16,00,000 Prepaid Expenses 3,40,000
10% Debentures 10,00,000 Bills receivable 40,000
Sundry Creditors 1,50,000 Cash 2,20,000
Bank-overdraft 1,30,000 Fictitious Assets 1,80,000
Bills payable 40,000
Outstanding expenses 15,000

59,35,000 59,35,000

Solution. Current Ratio =

here current assets = Stock + prepaid expenses+ Bills receivable + Cash

Current Liabilities = sundry Creditors + bank overdraft + Bills payable + Outstanding expenses

So, current ratio = 755000/ 335000 = 2.2537

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 (b) Quick Ratio or Acid Test Ratio – Quick ratio is a ratio between quick current assets
and liquid liabilities (alternatively quick liabilities). QUICK ASSETS are current assets less
prepaid expenses and inventories while LIQUID LIABILITIES are current liabilities (as
stated earlier) less bank overdraft and incomes received in advance. Normally a quick ratio
of 1:1 is considered satisfactory.

Problem 1– Calculate the quick ratio for the following balance sheet -
Liabilities Amount Assets Amount
Equity share capital 10,00,000 Fixed Assets 50,00,000
10% Preference share capital 20,00,000 Stock 1,55,000
Reserves 16,00,000 Prepaid expenses 3,40,000
10% Debentures 10,00,000 Bills receivable 40,000
Sundry Creditors 1,50,000 Cash 2,20,000
Bank‐overdraft 1,30,000 Fictitious Assets 1,80,000
Bills payable 40,000
Outstanding expenses 15,000

59,35,000 59,35,000

Solution. Quick Ratio = quick assets/liquid liabilities

here quick assets = stock+ bills receivables + cash = 155000 + 40000 + 220000 = 315000
Liquid liabilities= sundry Creditors + Bills payable + Outstanding expenses = 150000+40000+15000
So Quick Ratio = 315000/205000 = 1.54
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 (c) Absolute liquidity ratio - It is determined by dividing Absolute Liquid Assets by
Liquid liabilities. To calculate ABSOLUTE LIQUID ASSETS, debtors (or bills
receivables) are subtracted from QUICK ASSETS. Finally, ABSOLUTE LIQUID ASSETS
include cash in hand and at bank, short-term investments and marketable securities only.
LIQUID LIABILITIES, on the other hand, are current liabilities (as stated earlier) less bank
overdraft and incomes received in advance.

Problem 1– Calculate the absolute liquidity ratio for the following balance sheet -
Liabilities Amount Assets Amount
Equity share capital 10,00,000 Fixed Assets 50,00,000
10% Preference share capital 20,00,000 Stock 1,55,000
Reserves 16,00,000 Prepaid expenses 3,40,000
10% Debentures 10,00,000 Bills receivable 40,000
Sundry Creditors 1,50,000 Cash 2,20,000
Bank‐overdraft 1,30,000 Fictitious Assets 1,80,000
Bills payable 40,000
Outstanding expenses 15,000

59,35,000 59,35,000

Solution. Absolute Liquidity Ratio = Absolute Liquid assets/liquid liabilities

here Absolute Liquid assets = cash = 2,20,000
Liquid liabilities= sundry Creditors + Bills payable + Outstanding expenses = 150000+40000+15000
So Absolute Liquidity Ratio = 220000/205000 = 1.07 30
2. Capital structure/ leverage ratios - These ratios indicate the
long term solvency of a firm and indicate the ability of the firm to meet its long-term
commitment with respect to – (i) repayment of principal on maturity or in
predetermined instalments at due dates and (ii) periodic payment of interest during the
period of the loan.

Different leverage ratios are as follows:

(a) Debt Ratio or Solvency ratio
(b) Debt equity ratio
(c) Proprietary ratio
(d) Interest coverage ratio or Debt Service Ratio

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(a) Debt Ratio (or Solvency Ratio)- In this ratio the outside liabilities are related to the total
capitalisation of the firm. It indicates what proportion of the permanent capital of the firm is in
the form of Outsiders’ Funds. It is calculated by dividing Outsiders’ Funds (or Outsiders’
Liabilities) by Total Assets.
Outsider’ Funds means Debentures + total loan (or debt) while
Total assets means Outsiders’ Funds + Shareholder’s funds where shareholder’s funds is Equity
Share Capital + Reserves & Surplus + Preference Share Capital – Fictitious Assets
Problem 1– Calculate the debt ratio for the following balance sheet -
Liabilities Amount Assets Amount
Equity Share Capital 40,000 Plant and Machinery 24,000
Capital Reserve 12,000 Land and Buildings 40,000
Preference Share Capital 8,000 Furniture & Fixtures 16,000
8% Loan on Mortgage 32,000 Stock 12,000
Creditors 20,000 Debtors 12,000
Tax 8,000 Investments (Short-term) 4,000
Cash in hand 12,000

120000 120000

Solution. Debt Ratio = Outsiders’ Funds/Total Assets

here total debt= 8% Loan on Mortgage + creditors = 32000 + 20000 = 52000
Total assets = 8% Loan on Mortgage + creditors + Equity Share Capital +Capital Reserve +Preference Share Capital
= 32000+20000+40000+12000+8000 = 112000
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So Debt Ratio = 52000/112000 = 0.46
(b) Debt equity ratio - This ratio indicates the relative proportion of debt and equity
in financing the assets of the firm. It is calculated by dividing Outsiders’ Funds by
Shareholders’ Funds.

OUTSIDERS’ FUNDS are long-term or short term loans (whether secured or unsecured)
like – debentures, bonds, loans from financial institutions etc.

SHAREHOLDERS’ FUNDS are equity share capital plus preference share capital plus
reserves and surplus minus fictitious assets (eg. Preliminary expenses, past accumulated
losses, discount on issue of shares etc.)

Generally, financial institutions favour a ratio of 2:1.

Debt equity ratio = Outsiders’ Funds / Shareholders’ funds

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Problem 1– Calculate the debt equity ratio for the following balance sheet -
Liabilities Amount Assets Amount
Equity Share Capital 40,000 Plant and Machinery 24,000
Capital Reserve 12,000 Land and Buildings 40,000
Preference Share Capital 8,000 Furniture & Fixtures 16,000
8% Loan on Mortgage 32,000 Stock 12,000
Creditors 20,000 Debtors 12,000
Tax 8,000 Investments (Short-term) 4,000
Cash in hand 12,000

120000 120000

Solution. Debt Equity Ratio = Outsiders’ Funds / Shareholders’ funds

here Outsiders’ Funds = 8% Loan on Mortgage + creditors = 32000 + 20000 = 52000
Shareholders’ funds = Equity Share Capital +Capital Reserve +Preference Share Capital
= 40000+12000+8000 = 60000
So Debt Equity Ratio = 52000/60000 = 0.87

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(c) Proprietary (or Equity ratio) - This ratio indicates the general financial strength of the firm
and the long- term solvency of the business. This ratio is calculated by dividing Shareholders’
funds by Total Assets. TOTAL FUNDS are all fixed assets and all current assets.
Proprietary ratio = Shareholders’ funds / Total Assets

As a rough guide a 65% to 75% proprietary ratio is advisable

Problem 1– Calculate the Proprietary (or equity ratio) for the following balance sheet -
Liabilities Amount Assets Amount
Equity Share Capital 40,000 Plant and Machinery 24,000
Capital Reserve 12,000 Land and Buildings 40,000
Preference Share Capital 8,000 Furniture & Fixtures 16,000
8% Loan on Mortgage 32,000 Stock 12,000
Creditors 20,000 Debtors 12,000
Tax 8,000 Investments (Short-term) 4,000
Cash in hand 12,000

120000 120000
Solution. Equity Ratio = Shareholders’ funds / Total Assets
here Shareholders’ funds = Equity Share Capital +Capital Reserve +Preference Share Capital
= 40000+12000+8000 = 60000
Total assets = 8% Loan on Mortgage + creditors + Equity Share Capital +Capital Reserve +Preference Share Capital
= 32000+20000+40000+12000+8000 = 112000
So Debt Equity Ratio = 60000/92000 = 0.65 or 65 % 35
(d) Interest coverage ratio or Debt Service Ratio - This ratio is calculated by dividing the
Profit Before Interest and Tax (PBIT) by Total Fixed Interest Charges.
Interest coverage ratio or Debt Service Ratio = PBIT/ Total Fixed Interest Charges.
Problem 1– If tax rate is 20 percent, then calculate the Interest Coverage ratio for the
following P & L account –
Dr.
Cr.
Particulars Amount Particulars Amount
To Salaries 1,00,000 By GROSS Profit 2,10,000
To Printing & Stationary 20,000 By Rent 29,000
To Postage & Telegram 1,000 By DISCOUNT Received 25,000
To Interest 52,000 By Commission Received 50,000
To Legal Charges 7,000
To Audit Fees 20,000
To Export Duty 7,000
To Net Profit (before Tax) 1,07,000

3,14,000 3,14,000

Solution. Interest Coverage Ratio = PBIT/ Total Fixed Interest Charges

here PBIT= Net Profit (before Tax) + Interest = 1,07,000 + 52000 = 1,57,000
Total Interest = 52,000
Interest Coverage Ratio = 157000/52000 = 3.01

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 Problem 2– Calculate the Interest Coverage ratio for the following P & L account –

Particulars Amount
A. Net Sales 27,00,000
B. Cost of Goods Sold 1,20,000
C. Gross Profit (A-B) 25,80,000
D. Less: Selling and Admin. Expenses 3,52,000
E. Operating Income (C-D) 22,28,000
F. Add: Income from other Sources 20,000
G. Earning before Interest And Taxes (E+F) 22,48,000
H. Less: Interest 2,48,000
I. Profit before Tax (G-H) 20,00,000
J. Provision for Tax 3,00,000
K. Profit After Tax 17,00,000

Solution. Interest Coverage Ratio = PBIT/ Total Fixed Interest Charges

here PBIT= 22,48,000
Total Interest = 2,48,000
Interest Coverage Ratio = 22,48,000/2,48,000 = 9.07

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3. Profitability ratios – These ratios are calculated to measure the operating
efficiency of a firm. It is from the perspective of a financial manager. From the creditors
and investors point of view, on the other hand, they are calculated to measure the return on
investment.

Mainly, there are five types of profitability ratios -

(a) Gross Profit Ratio
(b) Net Profit Ratio
(c) Operating Ratio
(d) Operating Profit Ratio

All the profitability ratios are calculated on the basis of data given in P & L account.

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 (a) Gross Profit Ratio – It reflects the efficiency with which a firm produces and it
provides the extent to which selling price per unit may fall without resulting in losses
on operations. It is calculated by dividing GROSS PROFIT by NET SALES. GROSS
PROFIT is the excess of sales over cost of sales i.e. gross profit is nothing but net sales
minus cost of goods sold. Net Sales means Total Sales minus sales returns.
There is no standard for this ration, but higher this ratio is, better it is for the firm.
Gross Profit Ratio = Gross Profit / Net Sales
Problem 1– Calculate the Gross Profit ratio for the following P & L account –
Particulars Amount
A. Net Sales 27,00,000
B. Cost of Goods Sold 1,20,000
C. Gross Profit (A-B) 25,80,000
D. Less: Selling and Admin. Expenses 3,52,000
E. Operating Income (C-D) 22,28,000
F. Add: Income from other Sources 20,000
G. Earning before Interest And Taxes (E+F) 22,48,000
H. Less: Interest 2,48,000
I. Profit before Tax (G-H) 20,00,000
J. Provision for Tax 3,00,000
K. Profit After Tax 17,00,000

Solution. Gross Profit Ratio = Gross Profit / Net Sales

here Gross Profit = 25,80,000 while Net Sale = 27,00,000
so, Gross Profit Ratio = 25,80,000/27,00,000 = 0.9555 or 95.55 %
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 (b) Net Profit Ratio –It is calculated by dividing PROFIT AFTER TAXES by NET
SALES.
NET Profit Ratio = Profit After Taxes / Net Sales

Problem 1– Calculate the Net Profit ratio for the following P & L account –
Particulars Amount
A. Net Sales 27,00,000
B. Cost of Goods Sold 1,20,000
C. Gross Profit (A-B) 25,80,000
D. Less: Selling and Admin. Expenses 3,52,000
E. Operating Income (C-D) 22,28,000
F. Add: Income from other Sources 20,000
G. Earning before Interest And Taxes (E+F) 22,48,000
H. Less: Interest 2,48,000
I. Profit before Tax (G-H) 20,00,000
J. Provision for Tax 3,00,000
K. Profit After Tax 17,00,000

Solution. Net Profit Ratio = Profit After Taxes / Net Sales

here Profit After Taxes= 17,00,000 while Net Sale = 27,00,000
so, Net Profit Ratio = 17,00,000/27,00,000 = 0.6296 or 62.96 %
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 (c) Operating Ratio –It tells what percentage of sales is consumed by operating cost. It is
calculated by dividing OPERATING COST by NET SALES.
OPERATING COST is calculated by adding all the expenses like cost of goods sold,
selling expenses, general and administrative expenses (excluding interest).
Operating Ratio = Operating Cost/ Net Sales
Problem 1– Calculate the Operating Ratio for the following P & L account –
Particulars Amount
A. Net Sales 27,00,000
B. Cost of Goods Sold 1,20,000
C. Gross Profit (A-B) 25,80,000
D. Less: Selling and Admin. Expenses 3,52,000
E. Operating Income (C-D) 22,28,000
F. Add: Income from other Sources 20,000
G. Earning before Interest And Taxes (E+F) 22,48,000
H. Less: Interest 2,48,000
I. Profit before Tax (G-H) 20,00,000
J. Provision for Tax 3,00,000
K. Profit After Tax 17,00,000

Solution. Operating Ratio = Operating Cost/ Net Sales

here Operating Cost = Cost of Goods Sold + Selling and Admin. Expenses = 1,20,000+3,52,000
= 4,72,000
while Net Sale = 27,00,000
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so, Net Profit Ratio = 4,72,000/27,00,000 = 0.1748 or 17.48 %
 (d) Operating Profit Ratio –It tells the operating efficiency of a firm. It is calculated by
dividing OPERATING INCOME by NET SALES. OPERATING INCOME is
calculated by subtracting all the expenses like cost of goods sold, selling expenses,
general and administrative expenses (excluding interest) from Net Sales.
Operating Profit Ratio may also be calculated by subtracting Operating Ratio from 100.
Operating Profit Ratio = Operating Income/ Net Sales
Problem 1– Calculate the Operating Ratio for the following P & L account –
Particulars Amount
A. Net Sales 27,00,000
B. Cost of Goods Sold 1,20,000
C. Gross Profit (A-B) 25,80,000
D. Less: Selling and Admin. Expenses 3,52,000
E. Operating Income (C-D) 22,28,000
F. Add: Income from other Sources 20,000
G. Earning before Interest And Taxes (E+F) 22,48,000
H. Less: Interest 2,48,000
I. Profit before Tax (G-H) 20,00,000
J. Provision for Tax 3,00,000
K. Profit After Tax 17,00,000

Solution. Operating Profit Ratio = Operating Income/ Net Sales

here Operating Income = 22,28,000
while Net Sale = 27,00,000
so, Operating Profit Ratio = 22,28,000/27,00,000 = 0.8251 or 82.51 %
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4. Activity Ratios – Activity Ratios are used to judge the ability of a firm to
convert various asset, liability and capital accounts into cash or sales. The faster a firm
is able to convert its assets into cash or sales, the more efficiently it runs.

Mainly, there are four types of Activity ratios -

(a) Debtors Turnover Ratio
(b) Creditors Turnover Ratio
(c) Stock Turnover Ratio
(d) Working Capital Turnover Ratio

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(a) Debtors Turnover Ratio – It is calculated by dividing credit sales by average
debtors. Net Credit Sales means Total Sales after adjusting the returns while
average debtors is calculated by aggregating the debtors (including bills
receivables) at the beginning of the year and the debtors at the end of the year
divided by two.

Debtors Turnover Ratio = Net Credit Sales/Average Debtors

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Problem 1– Calculate the Debtors Turnover Ratio for the following Balance Sheet and P & L
account accounts –
Profit and Loss Account of ABC Ltd. Balance Sheet of ABC Ltd. as n 31st March 2017
for the year ending on 31st March 2017
Particulars Amount Particulars Amount
Liabilities and Capital
A. Net Sales 27,00,000 Bills payable 40,000
B. Cost of Goods Sold 1,20,000 Bank Overdraft 15,000
C. Gross Profit (A-B) 25,80,000 Sundry Creditors 20,000
D. Less: Selling and Admin. Expenses 3,52,000 Capital 2,00,000
E. Operating Income (C-D) 22,28,000 Total Liabilities 2,75,000
Assets
F. Add: Income from other Sources 20,000 Cash in Hand 1,000
G. Earning before Interest And Taxes (E+F) 22,48,000 Bills Receivable 59,000
H. Less: Interest 2,48,000 Short term investments 11,000
I. Profit before Tax (G-H) 20,00,000 Debtors 30,000
J. Provision for Tax 3,00,000 Closing Stock 39,000
K. Profit After Tax 17,00,000 Furniture 10,000
Plant and Machinery 75,000
Land & Building 50,000
Total Assets 2,75,000

Solution. Debtors Turnover Ratio = Net Credit Sales/Average Debtors

Here Net Credit Sales = 27,00,000
Whereas Average Debtors = Bill Receivables + Debtors = 59,000 + 30,000 = 89,000

So, Debtors Turnover Ratio = 27,00,000/89,000 = 30.34 times

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(b) Creditors Turnover Ratio – It tells the velocity with which the creditors are turned
over in relation to purchases. It is calculated by dividing Net Credit Purchases by
Average Trade Creditors.

Creditors Turnover Ratio = Net Credit Purchases/Average Trade Creditors

If the information about Net Credit Purchases and Average Trade Creditors is not
available, the Total Purchases and Closing Creditors may be used to calculate this
ratio. So,
Creditors Turnover Ratio = Total Purchases/ Closing Creditors

The total purchases number is usually not provided in any general purpose financial
statement. So, total purchases can be calculated by adding the ending inventory to the
cost of goods sold and subtracting the beginning inventory. Most companies will have
a record of supplier purchases, so this calculation may not need to be made.

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Problem . ABC PVT. Ltd., a trading firm, has very good relations with its suppliers and
makes all the purchases on credit. The following data has been extracted from the
financial statements of ABC PVT. Ltd. for the year 2016 and 2017:
Purchases during 2017: Rupees 2,00,000
Purchases returns during 2017: Rupees 40,000
Accounts payable on 31 December, 2016: Rupees 60,000
Accounts payable on 31 December, 2017: Rupees 40,000
Notes payable on 31 December, 2016: Rupees 14,000
Notes payable on 31 December, 2017: Rupees 16,000

Solution - Creditors Turnover Ratio = Net Credit Purchases/Average Trade Creditors

Here Net Credit Purchases = Purchases During 2017 – Purchases Returns During 2017
= 2,00,000 – 40,000 = 1,60,000
Average Trade Creditors = [(Accounts payable on 31 December, 2016 + Notes payable
on 31 December, 2016) + (Accounts payable on 31
December, 2017 + Notes payable on 31 December, 2017)]/2
= [(60,000+14,000)+ (40,000+16,000)]/2
= 65,000
So, Creditors Turnover Ratio = 1,60,000/65,000
= 2.46 times
It means, on an average, ABC PVT. LTD. pays its creditors 2.46 times in a year.
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(c) Stock Turnover Ratio - For a company to be profitable, it must be able to manage
its stock/inventory.. A higher stock turnover ratio indicates more effective cash
management and reduces the incidence of inventory obsolescence. The best measure of
stock utilization is the Stock turnover ratio, which is the cost of goods sold divided by
average inventory.
It is also known as Inventory Turnover Ratio.
Average Inventory is calculated by calculating the average of opening and closing
balances of inventory.

Cost of Goods Sold

Stock Turnover Ratio = Opening Stock + Closing Stock
2

Inventory turnover ratio vary significantly across the industries. A high ratio shows fast
moving inventories while a low ratio, on the other hand, shows slow moving or obsolete
inventories in stock. A low ratio may also be the result of maintaining excessive
inventories needlessly. Maintaining excessive inventories unnecessarily indicates poor
inventory management because it involves tiding up funds that could have been used in
other business operations. So, the users must also observe various factors that can effect
inventory turnover ratio (ITR) before interpreting or making any decision.

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Problem 1– Calculate the Stock Turnover Ratio for the following Manufacturing account –

Particulars Amount
Raw Material 1,00,000
Direct Labor 25,000
Depreciation 2,000
Other Manufacturing Expenses 14,000
1,41,000
Add: Opening Stock in Process 20,000
1,61,000
Less: Closing Stock in Process 16,000
Cost of Production 1,45,000
Add: Opening Finished Stock 23,000
1,68,000
Less: Closing Finished Stock 18,000
Cost of Goods Sold 1,50,000

Solution. Stock Turnover Ratio = Cost of Goods Sold/ Average Inventory

Here Cost of Goods Sold = 1,50,000
Whereas Average Inventory = (opening finished stock + closing finished stock)/2
= (23,000+18,000)/2
= 20,500
So, Stock Turnover Ratio = 1,50,000/20,500 = 7.317 times 49
(d) Working Capital Turnover Ratio – It measures the efficiency with which working
capital is being used in the firm and is calculated by dividing cost of goods sold by net
working capital.

Working Capital Turnover Ratio = Cost of Goods Sold/ Net Working Capital

The net working capital is calculated by subtracting the current liabilities from the
current assets. Data regarding Current assets and Current Liabilities is provided in
Balance sheet.
Whereas, Cost of Goods sold is mostly given in P & L account.

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Problem 1– Calculate the Working Capital Turnover Ratio for the following Balance Sheet
and P & L account accounts –
Profit and Loss Account of ABC Ltd. Balance Sheet of ABC Ltd. as n 31st March 2017
for the year ending on 31st March 2017
Particulars Amount Particulars Amount
Liabilities and Capital
A. Net Sales 27,00,000 Bills payable 40,000
B. Cost of Goods Sold 1,20,000 Bank Overdraft 15,000
C. Gross Profit (A-B) 25,80,000 Sundry Creditors 20,000
D. Less: Selling and Admin. Expenses 3,52,000 Capital 2,00,000
E. Operating Income (C-D) 22,28,000 Total Liabilities 2,75,000
Assets
F. Add: Income from other Sources 20,000 Cash in Hand 1,000
G. Earning before Interest And Taxes (E+F) 22,48,000 Bills Receivable 59,000
H. Less: Interest 2,48,000 Short term investments 11,000
I. Profit before Tax (G-H) 20,00,000 Debtors 30,000
J. Provision for Tax 3,00,000 Closing Stock 39,000
K. Profit After Tax 17,00,000 Furniture 10,000
Plant and Machinery 75,000
Land & Building 50,000
Total Assets 2,75,000

Solution. Working Capital Turnover Ratio = Cost of Goods Sold/ Net Working Capital
Here Cost of Goods Sold = 1,20,000
Whereas Net working Capital = Current Assets – Current Liabilities
= (1,000+59,000+11,000+30,000+39,000) – ( 40,000+15,000+20,000)
= 1,40,000 – 75,000 = 65,000
So, Working Capital Turnover Ratio = 1,20,000/ 65,000 = 1.85 times
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Limitations of Ratio Analysis –

1. Many conglomerates operate different SBUs (Strategic Business Units) across

different industries. For these firms it is always difficult to find a meaningful set of
industry-average ratios.
2. Seasonal factors can also distort ratio analysis. Understanding seasonal factors that
affect a business can reduce the chance of misinterpretation. For example, a retailer's
inventory may be high in the summer in preparation for the back-to-school season. As
a result, the company's accounts payable will be high and its ROA (very) low.
3. It is always difficult to generalize about whether a ratio is good or not. A high cash
ratio in a historically classified growth company may be interpreted as a good sign,
but could also be seen as a sign that the company is no longer a growth company and
should command lower valuations.
4. Different accounting practices can distort comparisons even within the same firm
(leasing versus buying equipment, LIFO(last in first out) inventory versus FIFO (First
in First out inventory), etc.).
5. A firm may have some good and some bad ratios, making it difficult to tell if it's a
good or not so strong company.
6. Inflation may have badly distorted a company's balance sheet. In this case, profits will
also be affected. Thus a ratio analysis of one company over time or a comparative
analysis of companies of different ages must be interpreted with judgment.

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