18 Jan 08

Prof RS Sardesai
Financial Management
Syllabus
1.
2.
3.
4.
5.

Ratio Analysis
Mgmt of working Capital
Fund flow statement
Capital Budgeting
Other Theory topics

Financial statements are used by analysts to assess the financial state of a

company. However, the available figures in the financial statement in isolation give
only a macro view. It is well known that Statistics hide more than they reveal. It is
basically an art of coloring the truth without being accused of falsehood. In order to
pierce through the faade which management of the company may have put in the
balance sheet using accounting biases so generously permitted by the law, it is
necessary to get the raw data and work on them. It is here that financial ratios come
handy. Ratios are arithmetical relationship between two figures. Financial Ratio
analysis is a study of ratios between various items or group of items in financial
statements. But even Financial Ratios are useful to certain extent only unless inside
information is available.
There are five kind of Financial Ratios: (a)
(b)
(c)
(d)
(e)

Liquidity Ratios
Leverage Ratios
Turnover Ratios
Profitability Ratios
Valuation Ratios

Ratio Analysis
Ratio = Numerator/Denominator

Gross Profit
Sales
% Profit

2000
2 Cr
10 Cr
20%

2001
3 Cr
20 Cr
15%

Balance Sheet
Liability
1.
2.
3.
4.
5.
6.

Share Capital
Reserves & Surplus
Contingent Liabilities
Secured Loans
Unsecured Loans
Current Liabilities
provisions

Assets

and

1. Fixed Assets
2. Investments
3. Currents Assets and Loans and
Advances
4. Misc Expenditures (to the
extent not adjusted)
5. Debit
Balance
in
P&L
statement

Fixed Assets Fixed Assets are those, which are acquired with intention not to sell.
Current Assets Current assets are those, which are acquired with the intention to
sell them, or those, which are intended to be sold after conversion into assets meant
for sale.
An asset, which may be Current Asset for one company, may be Fixed Asset for
another since that company may be dealing in that product (asset) and hence this asset
becomes his trading goods/current assets. Even for the same company, out of two
pieces of the same asset, one may be classified as Fixed Asset since the same is
acquired for use by the company where as the other one may be classified as Current
Asset, if the trader is dealing in that asset. For example, a real estate developer, who
purchases land at different locations and sells them after developing
them/constructing buildings, may have acquired a particular plot of land for its office
building. While this plot would be categorized as Fixed Asset, other plots would be
termed as current asset.
Investment of surplus money outside business is called as Investment and is not
counted towards current asset.
There are two types of Share Capitals: (a)

Equity Share Capital This capital has not been defined by Company
Law. Only preferential Capital has been defined. So this is that capital
which is not preferential Share Capital.

(b)

Preferential Share Capital Preferential Share Capital more like a loan

than Equity Capital where is risk on the capital is limited. This capital
enjoys two basic preference rights. The preferential share capital has first
right on the profits to the extent of committed dividend. It also has first
servicing right over funds on liquidation of the company. Also, in case
there is no distribution of dividend in any year due to poor profits, etc, the

dividend does not lapse like in case of Equity Share Capital. The unpaid
dividend is carried forward and same would be paid from profits in the
subsequent years. Then are additional rights like Participating
Preferential Share where in they participate in case there is surplus cash
available on liquidation of the company, but they do not share any
additional losses.
Reserves.
Types : 1.
Capital Reserves Created out of profits generated from sale of capital
(fixed assets).

Revenue Reserves Created out of revenue (business activity) profits.

2.

Free Reserves
Non Free Reserves
Secret Reserves
Non Free Reserves- Like Debenture Redemption Fund (the money is already
committed to a specified purpose. So this reserve is not free for use for any other
purpose)
Secret Reserves Are those the existence of which is known only to the
management.
Creation of Secret Reserves
(a)
(b)
(c)
(d)
(e)
(f)
(g)

Excess Provision for liabilities

High depreciation
Conservative valuation of stock
Appreciation of fixed assets like land etc which are always to be
valued at purchase cost irrespective of current market valuation.
Hypothetical provisions
High provisions for debtors
High provisions for bad debts

Unsecured Loans General loans have only general security against companys
assets and no specific security, ie, no mortgage of any specific assets of company.
Current liabilities - are outstanding payments arising out of business transactions.
Like payment due to suppliers of raw materials/services, electricity/telephone bills,
taxes etc.
Loans Loans are the owings to and from where it is due to exchange of cash only.
No services or material transactions are involved in this case.

Liability When all the related events have already occurred (activity fully
completed)
Vs
Provisions When all the related events have not completed, like in case of announce
of dividend by the board of directors. Unless the proposal of the board is ratified by
the general body meeting, the funds earmarked for the purpose would be treated as
provisions. Once the proposal is ratified by the GBM, it converts into liability.
All provisions will become current liability one day and only then are they paid off.

Financial Ratios
1.

Balance Sheet Ratio Both Numerator and denominator are derived form
Balance Sheet figures only.

2.

Profit and Loss Ratios - Both Numerator and denominator are derived
form Profit and Loss statement figures only.

3.

Mixed Ratios In this case one of the figure is taken Profit and Loss A/c
and other is taken from Balance Sheet.

Balance Sheet Ratios

(a)

Solvency Ratios
(i)

Current Ratio Current Assets

(Standard Ratio = 2)
Current Liability
If ratio is < 2, solvency is affected. Short Term Solvency = 1 year
(ii)

Quick Ratio Quick Assets

Quick liabilities

This ratio is also called Acid Test Ratio and Liquid Ratio because it
indicates immediate solvency.
Quick assets are part of current assets which can be converted into cash
fast. Like, Cash and Bank, Debtors, loans etc.
There are certain current assets which can not be converted to cash at all. Like
Prepaid Expenses (Insurance premium), Advances to suppliers, etc.
Then, there are current assets which, if converted to cash, will seriously jeopardise the
business interests of the company. Like, raw material. If sold in the market, will send
wrong signals about the company. Finished goods are also not considered to be part of
the quick assets as the same cannot be sold at short notice and most of the sales are
not in cash but in credit.
Cash Cycle

Raw
Material

Cash

WIP

Cash Sales
Debtors
Finished
Goods
Quick Liabilities Part of the current liabilities which are to be paid in cash, like
(a)
(b)
(c)
(d)

Sundry Creditors
Outstanding Expenses
Taxes Payable
Dividend, etc

Advances from customers and Income received in advance are not part of the
quick liabilities as they are not required to be settled in cash and only
services/goods are to be supplied against them.
Standard Ratio = 1
Current Ratio = Current Assets
Current Liability
CR = CA/CL
CR 1 = CA/CL - 1
= CA CL
CL
= Working Capital
CL
CR = CA/CL
QR = QA/QL
QL CL if advances from customers is not there or negligible
Then QR = QA/CL
CR QR

CA/CL - QA/CL

CA QA

CL
closing Stock + Prepaid Exp
CL

Proprietary Ratio = Shareholders Funds

(long term solvency)
Total Assets
Higher the ratio, better it is for long term solvency.

--7

Lecture Date: 23 Jan. 08

Subject: Financial Mgmt

Professor: Mr RS Sardesai
Other Balance Sheet Ratios:
4. Debt Equity Ratio
=
(Indicates Financing Pattern of Co)
=

Loan funds
Share holders funds
Secured + Unsecured Loans
ESC + PSC + Reserves Losses

Where ESC = Equity Share Capital

PSC = Preferential Share Capital
This ratio is used by Financial Institutions to determine loan eligibility and health of the company.

These institutions fix different bench marks for different kind of industries depending
on capital requirement of particular kind of industry, profitability etc.
They permit higher D/E ratio in case of
(a) Import substitution product industries
(b) Prime Health Care Products
(c) Entrepreneur Projects
They permit lower D/E ratio in case of existing companies as they are expected to
have generated reserves from past operation.
5. Capital Gearing Ratio

Funds bearing fixed rate of return

Funds not bearing fixed rate of return

Secured + Unsecured loans + PSC

ESC + Reserves - Losses

Gearing of the funds for improving the return to equity share holders
Suppose total funds required for an starting an industry is Rs 400 Cr and provided for
as follows: Source
Equity Share Capital (ESC)
Loans @ 10% PA
Total

Case I
80 Cr
320 Cr
400 Cr

Operating Figures of the company Case I

2003
Sales
150
--8

Case II
320 Cr
80 Cr
400 Cr

2004
200

2005
100

Mfg Exp @ 40%

Gross Profit (GP)
Adm & Sales (incl Dep)
Profit before int and tax (PBIT)
Interest @ 10%
Profit before Tax
Income Tax @ 40%
Profit after tax
ESC
Return on ESC

60
90
20
70
32
38
15.2
22.8
80.0
28.5

80
120
30
90
32
58
23.2
34.8
80.0
43.5

Operating Figures of the company Case II

2003
2004
Sales
150
200
80
Mfg Exp @ 40%
60
Gross Profit (GP)
90
120
Adm & Sales (incl Dep)
20
30
Profit before int and tax (PBIT) 70
90
Interest @ 10%
8
8
Profit before Tax
62
82
32.8
Income Tax @ 40%
24.8
Profit after tax
37.2
49.2
ESC
320
320
Return on ESC
11.63%
15.8%
Profit & Loss A/c Ratios

1. Gross Profit Ratio

GP
Sales/cost of sales

Sales Cost of sales = GP

Case I

GP Ratio
= 20% of sales
Sales
= 4 lacs . Given
Therefore, GP = 80,000
Cost of sales = 3,20,000

Case II

GP Ratio
= 20% of sales
GP
= 3 lacs . Given
Therefore, Sales = 15 lacs
Cost of sales = 12 lacs

Case III

GP Ratio
= 20% of sales
Cost of Sales = 8 lacs . Given
Cost + GP
= Sales
(80)
(20)
(100)
GP = 20 x cost of sales = Rs 2 lacs
--9

40
60
18
42
32
10
4.0
6.0
80.0
7.5

2005
100
40
60
18
42
8
34
13.6
20.4
320
6.38%

80
Sales = cost + profit = 10 lacs
Higher the GP, better the product for the company. In case of choice of prefernce for
production, a product with higher GP potential should be given preference.
2. Net Profit Ratio

NP
x 100
Sales (Gross Income)
Higher the ratio, better the performance.

3. Expenditure Ratio
=
Raw Material Consumed
(There are many varieties)
Sales
Any reduction is better. It increases the profits.
Mixed Ratios: (a)
(b)

Asset Turnover Ratios

Profitability ratios

Asset Turnover Ratio

Turnover
Avg Value of asset

1. Stock Turnover Ratio =

(Utilisation of stock)

Cost of sales
Avg Value of stock

Cost of Sales
Opening Stock + Closing Stock
2

Ideally, to work out this ratio, monthly average of closing stock should be
available to arrive at any meaningful analysis. However, in the real life
situation, even both opening and closing stock figures may not be
available in the balance sheet and there may be need to calculate the ratio.
In such cases which ever figure is available is used as average stock
holding and ratio is worked out. However, not much meaning should be
read into such analysis, as it could be highly deceptive due to seasonal
variations of demand and hence production and stock.
2. Debtors Turnover Ratio

Credit Sales
Avg Receivables

Assuming that most of sales are on credit and very little on cash basis,
= Total Sales (= Credit sales)
Opn + Cl receivables
2
In case opening receivables are not available, assume that closing receivables are
avg receivables
= Total Sales
10
---

Cl receivables
3. Debtors Collection Period Ratio

4. Fixed Asset Turnover Ratio

Cost of Sales
Fixed Assets
FA/TO Ratio
Preference
Age of Company

Average Receivables
Credit sales/day

Closing Receivables
Total sales/day

Cost of Sales
Avg Fixed Assets

A Ltd
12 Cr
5 Cr
2.4 Cr
I
15 Yrs

B Ltd
15 Cr
10 Cr
1.5 Cr
II
5 Yrs

This ratio can give meaningful comparison when

(a) Two companies are in same age group as the difference in age will lead to one
company having depreciated asset thereby distorting the ratio.
(b) Related to same industry and have similar product as some industries are capital
intensive and others labour intensive.
Profitability Ratios (From owners point of view)
1. Return on Investment
(Very Long Term View)

Profit before Interest and Tax

Share Holders funds + Loans

2. Return on ESH Funds

(Long term view)

Profit after Int, tax & Pref Dividend

ESC + Reserves Losses

3. Retrun on ESC
(Medium Term View)

Profit after tax, int & Pref dividend

ESC

4. Dividend on ESC
(Short Term)

Dividend declared
ESC

Practice Sums
Q 1.

Given

Current Ratio
GP Ratio
Stock Turnover Ratio
NP Ratio

=
=
=
=
11
---

1.5
25 % of sales
5 times
8%

Return on Equity Share Capital

Debt/Equity Ratio
Debtors Collection Period
Current Assets
Long Term Loans
Closing Stock
Investments are 25 % of fixsed assets

=
=
=
=
=
=

80 %
3 times
73 days
9 lacs
12 lacs
3 lacs

Calculate
1. Fixed Assets
2. Debtors
3. Current Liabilities
4. NP
5. GP
6. Sales
7. Cost of sales
8. Investments
9. ESC
10. Reserves
Solution.
Current Ratio

Current Liabilities

= 1.5
= Current Assets
=
Current Liabilities

1.5

= Current Assets
Current Ratio

9
1.5

= 6 lacs

Debt Equity Ratio

= Long Term Loans =

ESH funds
=

12
ESH Funds

ESH Funds

= 4 lacs

Gross Profit Rartio

= 25 % of sales
= Cost + Profit = Sales
75
25
100
12
---

Profit
GP

= 1/3 cost
= 15/3
= 5 lacs

Sales

= Cost + GP
= 15 + 5
= 20 lacs

Net Profit Ratio

= Net profit
Sales

8%

= NP
20
NP

= 8 x 20,00,000
100
= 1,60,000

Debtors Collection Period = Avg Sales x 365 = 73 Days

Credit Sales
Credit Sales

= 73 x 20,00,000
365
= 4 lacs

Return on ESC

= NP = 0.8
ESC

ESC

= 1,60,000
0.8
= 2 lacs

Equity Share Holders Funds = ESC + Reserves

4 lacs
= 2 lacs + Reserves
Reserves
= 2 lacs
Balance Sheet
ESC
Reserves
Loans
Closing Stock

2
2
12
6

FA
Investments
Current Assets
13
---

13
9

22
10.4
2.6

Stock
Debt

3.0
4.0

Other Assets

Investments
FA

1 + Investments
FA

= 1+ 1
4

Investments + FA
FA

= 5
4

13
FA

=5
4

FA

= 10,40,000

2.0
22.0

1
4

Profit and Loss Account

Cost of Sales
GP

15
5
20

Expenditure find
NP (known)

3.4
1.6
5.0

Sales

20

GP

5.0
5.0

Q 2.
Given
Current Ratio
= 1.75
Quick Ratio
= 1.25
FA
.
= 0.80
Share Funds
GP Ratio
= 0.25
NP Ratio
= 10 %
Current Liabilities
= 1,00,000
Stock Turnover Ratio
= 6 times
Debtors Collection Period= 3 months
Return on Share Capital = 10 %
There are no long term loans, pre paid expenditure and losses or investments.
Calculate
1. Fixed Assets
14
---

2. Debtors
3. Current Liabilities
4. NP
5. GP
6. Sales
7. Cost of sales
8. Investments
9. ESC
10. Reserves
Solution:
Current Ratio

= 1.75
= Current Assets
Current Liabilities
= Current Assets
1,00,000

Current Assets

= 1,75,000

Quick Ratio

1.25

= Current Assets Stock

Current Liabilities
= 1.75 - Stock
1.00
= 50,000

Stock

Quick Assets
Quick Liabilities

= 1.25

Stock Turnover Ratio

= Cost of Sales
Stock

Cost of Sales

= 6 x 50000
= 3,00,000

Debt Equity Ratio

= Long Term Loans = 3

ESH Funds

Gross Profit ratio

Profit
GP

= 25 % of sales
Cost
+
Profit =
3,00,000
1,00,000
= 1/3 cost
= 1,00,000

Sales

= 4,00,000

15
---

=6

Sales
4,00,000

NP Ratio

= 10 %
=

10
100

NP .
Turn Over
=
NP .
4,00,000

NP

= 40,000

Debtors Collection Period = Avg Sales x 12

Credit Sales
= Avg Sales x 12
4,00,000
Debtors/ Avg Sales

= 3 months

= 400000x3
12
= 1,00,000

Return on Share Capital =

NP
= 10%
ESC
ESC
= 4,00,000
Now since no other ratio can be found from the given data, we have to prepare
Balance Sheet to find other ratios.
Equation of Balance Sheet
Total of Asset side = Total of Liability side
FA +CA
= SHF + CL
FA + 1,75,000
= SHF + 1,00,000
FA + 75,000
SHF

=1

0.8 + 75,000
SHF
SHF

=1

SHF

= 75,000
0.2
= 3,75,000

Therefore, there are negative reserves (losses) of Rs 25,000

Fixed Assets

= 0.8 x 3,75,000
= 3,00,000

16
---

Profit and Loss A/c

To cost of sales
To GP

3,00,000
1,00,000
4,00,000

To Expenditure
To Net Profit

60,000
40,000
1,00,000

Liability
Share capital
Loans
CL

4,00,000
NIL
1,00,000

Sales

4,00,000

By GP

4,00,000
1,00,000

Assets
FA
Investments
CA
Reserves/Losses

3,00,000
NIL
1,75,000
25,000

17
---

= Current Asset
Current Liability

385
205

Lecture Date:25Jan 08

Current Assets 2003 2004

Subject: Financial Mgmt
Stock
120
Professor: Mr RS Sardesai
Debtors
230
Cash & Bank 35
385
Balance Sheet of X Ltd
Current Liabilities
2003
2004
Liabilities
2003 2004
Assets
2003 2004
S. Creditors
72
O/s Expenses 58
Share
200 250 Fixed
350 420
Provn for tax 45
Capital
Assets
Proposed Div 50
Reserves
235 386 Investments
50
50
205
Current
Secured
145
64
Assets
Loans

Sundry
Creditors
O/s
Expenses
Provision
for Tax
Proposed
Dividend

72

81 Stock

38

39 Debtors

45

36

50

60

Total
785
Income Statement

916

Expenditure 2003 2004

To Raw
250 275
Material
To Wages
188 195
To mfg exp
75
78
To Adm Exp
35
32
To Provision
45
36
for tax
To sales exp
102 115
To Net Profit 227 309
Total
922 1040
Calculate various ratios.

Total

Income
By Sales
By Misc
Income

138
275
33
446

81
39
36
60
216

Quick Ratio
120 (b) 138
= Quick Assets
230
275 446-138
385-120
Quick Liability
205
216
= C/A Stock
1.29 1.43
Current Liability

785

916

Assessment: Performance is good

in both years as ratio is more than
standard
2003 ratio
2004of 1. However, in the
year
2004,
the performance has
900 1015
further improved.

22

25

(c) Profitability Ratio

435
785
55 %

= SHF
Total Assets
SHF
Share Cap
Reserves
Total

922 1040

2003
200
235
435

2004
250
386
636

(d) Debt Equity Ratio

= Long Term Loans
SHF

Sol:
1. Solvency Ratios: -

The debt equity of both

years is very low and

(a) Current Ratio

18---

145
435
33 %

therefore lenders art

very secure. Further, for
the second year the ratio
has improved from
lenders point of view

= Gross Profit
467
387
Sales
900
1015
43 %
Cost of sales
2004
250 RM 250
275
Wages 188
Mfg Exp
78
Cost of Sales
548
188 GP
195
387
900

2. Profit and Loss Ratios

(a)
Expense Ratios
(i)
RM
Sales
900
1015
28 % 27 %
(ii)

Wages
Sales
900
1015

(c)
21 % 19 %
(iii)

Mfg Exp
Sales
900
1015

46 %
2003
275
195
75
513
467
1015

Net Profit Ratio

= Net Profit
x 100
227
75
30978
Total Income
922
1040

8.3 % 7.7 %
(iv)

24.6 % 29.7 %
32
(d)
Operating Profit Ratio
Operating Profit
227 22
309 25
Sales
102
115
900 1015
35

Adm Exp
Sales
900
1015
4
% 3.1 %

(v)

Sales Exp
Sales
900
1015

205
11.33
11.4 %

%
900

All the expense ratios

have been reduced iin
2004 as compared to
2003. Therefore from
point of view of
expenses, 2004 is better
year as compared to
2003.

1015
22.8 % 28 %

The performance for the year

2004 is better than performance
for year 2003.
2. Mixed Ratios
(a)

(b)

284

Gross Profit Ratio

19---

Asset Turnover Ratio

= Cost of Sales
513
548
Closing Stock
120
138
(Assuming Avg Stock =
Cl Stock)
4.27
Times
3.97 Times
The stock turnover ratio is
lesser for year 2004 which
means that the stock has not
been effectively utilised as
compared to year 2003.
(b)

(d)

1.46
times
1.3 times
The fixed asset utilisation for
year 2003 is better than that for
year 2004.

Debtors
Collection
Period
= Avg Debtors x 365
230
x
365
265 x 365
Total Sales
900
1015
(Assuming avg debtors
are closing 93 days
99 days
debtors and all sales are
on credit)

3. Profitability Ratios
(a)

From the above, the avg credit

period allowed to lenders has
gone up form 93 days to 99
days in case of year 32004 as
against year 2003.
(c)

Fixed Asset Turnover

Ratio
= Cost of Sales
513
548
Cl Fixed Assets
340
420

Return on Investments
= Profit before tax & int
227
+
45
309 + 36
Total funds employed
435
+
145
636 + 64

272

335

580

700

47 % 49 %
Return on investment is better
for 2004 than 2003 (Minor
improvement)

Credit Payment Period

Cl Creditors x 365
72
x
365
81 x 365
RM Consumed
250
275

(b)

105
days
108 days
The creditors payment period
has increased by 3 days which
means that company could
convince the creditors for
higher credit period which is
good sign.

Return on SHF
= Net Profit after tax
227
309
SHF
435
636

52 % 49 %
Return on SHF has decreased
mainly due to increase in SH
capital and increase in reserves.
(c)

20---

Return on ESC ( = EPS)

= Net Profit after tax
227
309

200

Share Capital
250
3.

114 % 124 %
(d)
Dividend on Share
Capital
=
Dividend
Declared
50
60
Share Capital
200
250

4.

5.

25 % 24 %
(e)

Dividend payout Ratio

=
Dividend
Declared
50
60
Net Profit
227
309
22 % 20 %
Year 2004 shows conservative
mgmt
outlook
towards
declaration and payment of
dividend.
(f)
Sales
to
Working
1015
Capital Ratio
900
CA
385
446
180
230
-CL 205
216
5
times 4.4 times
WC 180
230
Working
capital
mgmt
worsened in year 2004. Credit
period could have been
increased to improve sales.
Overall Assessment: 1.

2.

The mgmt could reduce

all types of expenses
theref#by improving net
profit.
the
return
on
investments and to
shareholders
have
increased in 2004 but

21---

mgmt has not increased

the payout of dividend.
The
solvency
of
company is very good.
Improved slightly in
2004.
The gross profit and net
profit
ratios
have
improved in year 2004.
Utilisation of various
assets and working
capital was better in
year 2003 as compared
to 2004.

(b) all items of assets and

liabilities are taken to
balance sheet.
It is, therefore, necessary to
realise the importance of
distinction between capital
and revenue items inasmuch
as any error committed on
this account will lead to
mistake in preparing final
accounts.

A short Note :
(This note is to serve as a
guiding factor and is not to be
considered as an exhaustive
one.
Please
refer
to
recommended books on the
said subject for a detailed
reading on the topic)

What is Revenue expenditure ?

It is an expenditure which
organisation incurs to enable it
to carry on its day to day
activities.
It
is
basically
intended
to
benefit
the
organisation
in its normal
operation in a short period,
basically a years time. Thus
basically any expenditure which
benefits the organisation only
for current period (and not for
long period) is termed as
revenue expenditure.

Financial Accounting
Capital v/s Revenue
Expenditure / Receipts

Final accounts prepared at the

end of the year consist of
Trading and Profit & Loss
Account as well as Balance
Sheet. Closing balances of all
ledger accounts appearing in
the Trial Balance are taken to
be either in the trading and
profit and loss account or
balance sheet.

Examples of revenue expenses

are :
i. Expenses incurred for
manufacturing
operation like buying of
raw
material,
spare
parts,
components,
accessories,
utilities,
spares, fuels, etc.
ii. Expenses incurred to
maintain the economic
life of the assets with
the
help of which
activities
are
undertaken
by
the
organisation
e.g.,
normal
repairs
&
maintenance,
consumables
like

In order to understand how to

make such decision
i.e. to
decide as to which item will be
taken to which place, the
following accounting principle is
applied :
(a) All revenue expenditure
and incomes are taken to
trading and profit and
loss account and

22---

iii.

iv.
v.

vi.

vii.

look at the balance sheet shows

that such item could only be
fixed assets utilized by the
business for a number of years
to earn revenue. Thus we can
infer that capital expenditure
means an expenditure which :

greese, oil, insurance

premium paid for safety
of such assets etc.
Expenses incurred for
the operation of the
factory like its rent,
rates & taxes, security
charges,
maintenance
charges,
wages
to
workers & other staff,
license fee etc.
Cost
of
goods
purchased for resale.
Depreciation on fixed
asset, interests on loan
for business etc.
Expenses
of
administration
like
office rent, rates, taxes,
salary to staff, travelling
exp,
Printing
&
Stationery etc.
Sales
expenses
like
commission on sale,
distribution cost, freight
on goods sold etc.

I)

Increases
the
quantum
of
fixed
assets
II)
Helps
in
replacement of worn
out assets and
III)
Improves
the
quality of fixed assets
Increase in Quantum:
I] Addition
to
fixed
assets like purchase of
land, construction of
building, purchase of
plant etc. increases
the quantity of fixed
assets. Hence amount
spent on the purchase
of such fixed asset is
treated
as
capital
expenditure.

What is Capital expenditure ?

Capital expenditure is an
expenditure which is expected
to benefit the organisation for a
long period of time in carrying
out its activities. It means it is
incurred to get benefit for future
periods, in contrast to a
revenue expenditure, which
benefits only current period.

Note :It is to be noted

that
all
expenditure like
custom
duty,
octroi,
freight,
loading/unloadi
ng
charges,
expenses
on
erection
etc.
incurred
in
connection with
the
purchase,
receipt
or
erection of a
fixed asset are to
be
aggregated
and added to the
purchase price

From the above definition it

follows that normally capital
expenditure
refers
to
expenditure on those items
which last for a long period and
business avails its utility over
future years. This is possible
when money is spent in buying
those goods and services which
are of long term in nature. One

23---

of the assets to
ascertain
its
total cost. For
this purpose it is
immaterial
whether
company spends
actual sum on
such
expenses
or utilizes its
own
resources
(like labour) for
it.
II]

service capacity of
the fixed asset ;
e.g. by installing
some
balancing
equipment, overall
capacity
of
the
plant is increased.
(c) To
increase
the
efficiency of the fixed
asset;
e.g. here the rated
production capacity
of
the
plant
increases.
Say
earlier plant was
producing
100
pieces of bathing
soap in one minute,
but
after
expenditure
is
incurred, the rate of
production
increases to 120
pieces per minute.

Replacement means
acquiring new assets
or parts thereof on
account of decreased
utility
of
existing
assets [or parts thereof
]. This could also
happen
due
to
modernization of or
change
in
the
production process.
The note of para [I]
above equally applies
to replacement of fixed
assets.

(d) To
improve
the
operating economy of
the asset;
e.g. here the rated
production capacity
of
the
plant
remains the same
but
cost
of
production
decreases due to
reduction in the
rate
of
consumption of raw
material or increase
in the production
speed so that the
same amount of
overheads
are
spread over larger
quantum
of
production.

III]Improvement in quality
of fixed assets takes
place
when
expenditure
is
incurred :
(a) To
increase
the
useful life of the
fixed asset ;
e.g. Old dilapidated
factory building is
restored
/
renovated
by
undertaking heavy
repairs exp
(b) To
increase
production

the
/

24---

As it is necessary to
distinguish between
capital and revenue
expenditure, in the
same way it is
necessary to make
a proper distinction
between capital and
revenue
receipts.
Capital receipts are
shown
in
the
Balance Sheet as
liabilities whereas
revenue
receipts
are shown in the
Profit
&
Loss
account as income
of
the
current
period.
Money
received
from the sale of
fixed
asset,
or
money raised by
issue of shares,
debentures
or
obtained by way of
term
loan
are
example of capital
receipts.
Moneys
obtained
in
the
course of business
are
revenue
receipts. Examples
are:
money
obtained from sale
of goods, interest
on
deposits,
dividends
or
investments.
However, some of
the items of receipt
like subsidies or
grants
received
from government or
such
other
authorities (which
are non-refundable)
should be carefully
classified either as

It is to be further noted
that
whether
an
expenditure is revenue or
capital
expenditure
should be decided purely
on the basis of benefit
which is likely to accrue
there from. It means
benefit should accrue for
a long period. It is not
dependent upon :
1. the
amount
of
expenditure
(i.e.
quantum)
2. the time of payment
of such expenditure
3. the
mode
of
payment, whether
paid in lump sum
or in instalment.
4. the amount is paid
out of sale of fixed
assets or out of
funds raised from
long term sources
like share capital,
term
loan,
debentures etc.
However,
keeping
principle of materiality in
mind, normally
any
expenditure of say less
then Rs.5000/- may be
treated
as
revenue
expenditure
although
benefit may accrue for a
long period out of such
expenditure.
Even under the Income
Tax Act. 1962, such
expenditure
are
tax
deductible
Capital
and
receipts:

revenue

25---

capital receipt or
revenue
receipt
depending upon the
terms
and
conditions of such
receipt
and/or
benefit going to
accrue out of such
income.

26---

(B) other types

arises:

A short Note :
(This note is to serve as a
guiding factor and is not to be
considered as an exhaustive
one.
Please
refer
to
recommended books on the
said subject for a detailed
reading on the topic)
Revenue

Appreciation in the
value of Fixed assets
[land and building)
(2) Appreciation in the
value
of Current
assets
(Animals,
Forest
products,
agriculture produce)
(3) Changes in foreign
exchange rate [ say
depreciation of rupee ]
when goods have been
exported in the past
but
payment
is
received after such
devaluation.
(4) Paying less than for
an obligation amount
[
when
rupee
appreciates and loan
is repayable in foreign
currency ]

Recognition

Accrual
Going concern
Consistency

Revenue of an organisation
originates from :
( A)

revenue

[1]

Revenue
recognition is
fundamentally based on the
three assumption of accounting
concept:
1.
2.
3.

of

1. Sale of goods _( TV,

Garment, furniture etc)
2. Rendering of services
(hotels,
telephone,
laundry etc)
3. others income like (a)
interest

When
revenue
recognised?

should

be

(1) In Case Sale Of Goods

(a) Sale of goods:

(b)Dividend

[i] Revenue is
recognised
when transfer
of
property in goods takes
place between seller and
buyer.
Usually
such
transfer
of
property
coincides with transfer
of significant risk
and
reward of ownership from
seller to the buyer. Some
time transfer of property
does not coincide with
transfer of reward and
risk. It may arise when
either
buyer or seller

(c)
Royalty
(d)
Copy right etc.
4. Revenue from
Hire
Purchase,
Lease
agreement.
5.
Revenue
from
government grant
and
subsidies.
6.
Revenue
from
insurance contracts.
7.
Revenue
from
construction contracts.

27---

commits default
in
respect of delivery of
goods as per terms of
contract. In
such
a
situation
risk remains
with the party (either
buyer or seller) which
commits default.
Some
time party may agree that
risk will be transferred at
some different time.

(b)Proportionate Completion
method:
Under
this
method
of
accounting , revenue is
recognised
proportionately
with
the
degree
of
completion of services.
e.g. : An artist working in a
movie.

e.g.:
Insurance
for
overseas
journey. Here
risk starts only when
outward journey starts
although customer might
have paid premium in
advance and contract is
entered into.

(3)Forward contract:
Forward
contract,
as
opposed
to
existing
or
current contract, are those
contracts in which both
seller and buyer agree to do
something in future time as
per the terms and conditions
agreed now. This is so
because it takes time to
produce goods as per the
specification of the buyer.

(ii) All term of contracts are

agreed upon
by both
parties who also agree to
honour
their
commitments of agreed
time.
(iii) Time and mode
payment / delivery
goods is immaterial.

e.g. in industries like mining

or agriculture crops, forward
contracts are entered into for
supply of such goods at
future dates. In such cases
when
these
items
are
substantially
ready,
and
there is negligible risk of non
performance of sale contract
then
revenue
may
be
recognised say by way of
closing stock.

of
of

(2) In Case of Sale of Services:

In case of contract for
services,
revenue
is
recognised
under
two
distinct method :

Otherwise revenue should be

recognised when goods are
ready as per the requirement
of buyers, they are in
deliverable conditions and
buyer
has
shown
his
intention to take the delivery
of the same.

(a) Completed
service
contract method :
It is a method of accounting
under which revenue is
recognised
only
when
contract is completed.
e.g. :Painting of
portrait.
Services rendered by hotel or by
STD booth

28---

Revenue Recognition in respect

of Other Income:

when there is uncertainty about

its receipt itself, then revenue
should be recognised only when
such uncertainty is removed .

(a) Interest: it accrues on time

basis,
hence
interest
income is recognised on
time basis irrespective of
agreed date of payment.

e.g. subsidies & grants from

government authorities may be
recognised only when our claim
is accepted by the authorities.

(b) Dividends: it should be

recognised
only
when
right to receive it is
established
e.g.: when dividend is
approved in AGM & not
when it is declared by the
board. However interim
dividend,
the
income
should be recorded on
receipt basis .

When
uncertainty
about
realisation of revenue arises at
a stage subsequent to making
of sale we should not reverse
the Revenue Entry rather we
should make a provision of loss
on
the
basis
of
such
uncertainty
Revenue which is not recorded
at first stage due to uncertainty
about its receipt, should be
recorded subsequently when
uncertainty about its receipt is
eliminated.

(c) Royalty: In accordance

with terms of agreement
when any of the above
income is receivable from
foreign country
then
sometimes you need to
take exchange permission
from government . in such
cases revenue should be
recognised
only
when
such
permission
are
received.

Some Illustration: [ as to when

ownership passes / revenue
should be recognised ]
(1)Delivery is delayed at buyers
request but bill is accepted:
by buyers and goods are
ready for delivery and they
are
identifiable.
Here
delivery
should
be
recognised
irrespective of
the fact that delivery is
delayed at the request of
the buyer.

Effects of uncertainty in respect

of revenue recognition :
Revenue should be recognised
only when there is certainty
about its receipt irrespective of
the
fact whether exact
quantum thereof is known or
not.

(2)Goods are to be delivered

subject to some condition:

When uncertainty exist about

amount only, then reasonable
estimates may be made about
such amount provided there is
certainly about its receipt. But

sometimes goods are sold

subjected to inspection,
testing, etc .here revenue
should be recognised only

29---

It should be recognised when

the advertisement prepared
is released for public view
and media confirms about
the same. However, revenue
in respect of preparation of
such advertisement may be
recognised
when
the
production is completed and
preview of the same is
approved by the client.

when
customers
has
inspected /tested the goods
and accepted the delivery.
(3)Goods Sold on Approval:
Revenue
should
be
recognised
only
when
approval of the buyer is
received.
(4)Subscriptions for Magazines

[8]Insurance Income:
Revenue
should
be
recognised on time basis,
that is revenue with respect
to issues
not delivered
should not be recognised

It should be recognised when

full premium as per agreed
terms are received and the
risk commences.
[9] Entrance & Membership fee

(5)Sale on Instalment Basis

Normally entrance fee (say of

club
or
association)
is
normally
considered
as
Capital Receipt (although
they are received by the
organisation
frequently].
Membership fee is however
normally
considered
as
revenue receipt They should
be recognised when they are
due for payment by the
member.
However,
exact
time of revenue recognition
will
depend
upon
the
services which are to be
rendered to the members
and the degree of their
realisation from members..

In case of sale on instalment

basis, revenue includes sale
price of the goods sold plus
interest for credit granted.
Therefore revenue in respect
of sale of goods should be
recognised on the date of
sale.
However,
revenue
related to interest, income
should be recognised when
they
become
due
and
payable by the customers
(6) Commission & Brokerage:
Commission and brokerage
are recognised as revenue
when the parties (from whom
they are earned/receivable)
enters into legal contract
and
services
are
fully
rendered to earn such
revenue. Time of receipt of
payment is immaterial.
[7] Advertising commission

30---

Average stock
where, cost of goods sold = Opg stock +
Purchase + Direct Exp. - Cl. stock
The ratio indicates whether stock has
been efficiently used or not. The purpose
is to keep only the required minimum
invested in stock. Higher the ratio the
better as it indicates that more sales are
produced by a rupee of Invest in stock. In
directs the management attention to
control excess investment in stock and
helps reduce storage cost.

2.
What is meant by analysis of
financial statements? Briefly explain
vertical analysis.?
Analysis of financial statement is a
systematic process of evaluating and
establishing relationships between
different components of financial
statements to better understand the
performance of the firm. It determines the
meaning of the information disclosed in
the financial statement of have complete
results regarding profitability and financial
position of the firm.
Vertical analysis is the analysis of financial
statements of an enterprise for one
particular period. Thus, the interpretation
of balance sheet at the end of the
accounting period is vertical analysis.

Short Notes:

(i) Return on Investment,

(ii) Debt - Equity Ratio and
(iii) Stock Turnover Ratio. (Marks 5)
(i) Return on Investment :
The overall performance of a business is
judged by this ratio which is a measure of
relationship between profit earned and
capital employed. It ascertains how much
income the use of Rs. 100 of capital
generates. The ratio is expressed as %.
It is calculated as:
Profit before interest and tax x 100
Capital employed
Where capital employed = Share capital +
Reserve + Long term loan - Fictitious
assets and non-operating assets.
ROI is a fair measure of the profitability of
any concern which also helps in
comparing performance efficiency of
different industries.

3.
What are the alternatives
available to a company for the
allotment of debentures when there is
over-subscription of debentures?
(Marks 3)
Ans. In case of over-subscription of
shares :
(i) The company may reject same
applications, i.e the application money
received is returned back.
(ii) It may not allot any share to some
applicants, whereas it may make pro-rata
allotment to other applicants.
(iii) It may not allot any share to some
applicants, full allotment may be made to
some other applicants and pro-rata
allotment may be made to the rest.

(ii) Debt Equity Ratio :

This ratio indicates the relationship
between shareholders funds and long term
liabilities. Shareholders funds include
equity and preference share capital,
reserves less fictitious assets. It is
computed as :
Long term debts
Shareholders funds
The ratio is calculated to ascertain the
long term financial soundness of business.
It indicates the extent to which business
depends upon outsiders. It discloses the
firms ability to meet its long term
obligations. The lower the ratio, the better
for the firm.

4.
Briefly explain the meaning and
significance of any two of the following
ratios :
(i) Debt to total funds ratio;
(ii) Debtor's turnover ratio and
(iii) Net profit ratio. (Marks 5)
(i)Debtors Turnover Ratio :
This ratio indicates the relationship
between net credit sales and average
trade debtors
= Net credit sales
Average Trade Debtors

(iii) Stock Turnover Ratio :

This ratio gives the relationship between
cost of goods sold during a given period
and the average amount of inventory
during that period :
Cost of Goods Sold

31---

planning its capital structure.

Ans. A brief explanation of factors taken
into consideration while planning the
capital structure :- (any seven)

The debtors are gross, i.e. before

adjusting for provision for bad debts.
The ratio helps to evaluate efficiency in
management regarding collection of
amount from debtors. Higher the ratio, the
more prompt is collection from debtors.

1. Trading on equity
2. Stability of sales
3. Cost of capital
4. Cash flow ability
5. Control
6. Flexibility
7. Size of the company
8. Market condition

(ii)Net Profit Ratio :

It is a measure of relationship between net
profit and net sales. It is calculated as :
Net Profit x 100
Net sales
The term net profit means net profit before
tax or after tax.
It is a measure of operational efficiency of
the enterprise. It also indicates proportion
of sales available to management for
payment of dividend and creating reserves
for future growth. Higher the ratio, the
better is the firms capacity to withstand
economic risks and adverse conditions.

(1/2 mark for each point + 1/2, mark for

7
Explain briefly the steps
involved in the process of financial
planning.
Ans.
Process of financial planning
includes the following steps :
(a brief explanation of each point)
1. Estimating the amount of capital to be
raised.
2. Determining the form and proportionate
amount of securities to be issued.
3. Formulating policies for the
administration of capital.
(If an examinee conveys suitable
meaning in any format, full credit
should be given.)

(iii) Debt. to total funds Ratio = Long term

debts/(Long term funds + Shareholders
funds)
Long term funds + Shareholders funds
= 600000 + 500000 + 300000 + 100000
= 1500000
.
. . Debt to total funds ratio =
600000/1500000
=2:5
5

Intro to Fundamental Analysis

8
State any three advantages of
debenture issue as a source of finance.
Ans. Any three advantages of debentures
issued as a source of finance :1. The cost of servicing the debenture is
lowest.
2. It is a tax deductible expense.
3. No risk of loss of control due to absence
of voting right.
4. It leads to trading on equity/flexibility in
financial operations.
5. Fixed rate of interest even if rate of
earning is high.

The massive amount of numbers in a company's

financial statement can be bewildering and
intimidating to many investors. On the other hand, if
you know how to read them, the financial statements
are a gold mine of information.
Financial statement analysis is the biggest part of
fundamental analysis. Also known as quantitative
analysis, it involves looking at historical performance
data to estimate the future performance. Followers of
quantitative analysis want as much data as they can
find on revenue, expenses, assets, liabilities, and all
the other financial aspects of a company.
Fundamental analysts look at this information for
insight into the performance of in the future. They
don't ignore the company's stock price; they just
avoid focusing exclusively on it.

9
Explain any three effects of
under-capitalisation on a company.
(1*3=3 marks)
Ans.Any three effects of under
capitalisation on a company :1. The market value of shares goes up
since earnings are high.
2. Secrets reserves are built up.
3. Government interventions in the form of
higher taxes.

Before we learn different ways to estimate future

performance, it is important to understand the basics
of the financial statements (both quarterly and annual
reports).

6
Explain briefly the factors which
a company should consider while

32---

4. The high rate of earning may encourage

outsiders to enter the field and increase
competition.
5. The employees demand higher salaries
and wages and this leads to dissatisfaction
and labour tension.
10
What is financial planning?
Explain, in brief, the role of financial
planning in the management of finance.
6 marks
Ans. Financial planning : Its meaning
should include the following points :
1. Estimating the amount of capital.
2. Determining the composition of capital.
3. Determining the objectives, procedures,
programmes and budgets to deal with the
financial activities.
4. Formulating policies for the
administration of capital.
Role of Financial Planning in Management
of Finance
The following points should be explained
in brief :
1. Optimum availability of funds.
2. Ensuring co-ordination between
different functional areas of business.
3. Effective financial control.

11
What are the principal sources
of long-term finance for a business
enterprise? Explain
Ans. Principal sources of long-term
finance.
Any three of the following sources with
explanation :
1. Equity share capital
2. Preference share capital
3. Retained earnings
4. Debenture capital
5. Term loans
6. Public deposits

33---