Month: July 2020

A cash flow statement shows the inflows and outflows of cash and cash equivalents. Cash includes cash in hand and demand deposits with the banks while cash equivalents are highly liquid investments i.e., they can be readily converted into cash like marketable securities, commercial papers, and short-term government bonds. It explains the changes in the cash in hand and cash at bank at the beginning and the end of the accounting period.

Accounting standard 3 deals with the cash flow statement. It has been classified into three broad categories:

• Operating Activities: Representing movements of money due to regular business operations like the purchase, sale, production, etc. of goods.
• Investing Activities: Representing the movement of cash due to the purchase or sale of assets or any other investment activities of the business.
• Financing Activities: Accounts for the funds raised through the issue of shares or debentures, long term loans, etc. and utilised for the redemption of shares or debentures and payment of dividend, etc.

There are two methods of preparation of a Cash Flow Statement, they are:

• Direct Method
• Indirect Method

Fund Flow Statement

Funds refer to the working capital of the company, so fund flow statement is a statement that studies the changes in the working capital of the business between two accounting years. It shows the additions in the working capital through various sources like issuing shares, debentures or raising loans, etc. and reduction in it through different applications like the redemption of shares or debentures, repayment of loans, purchase of fixed assets, etc.

Fund Flow Statement explain the reasons for the change in the working capital of the business between two Balance Sheet dates through various Non-Current Assets and Non-Current Liabilities, which are responsible for the increase or decrease in the working capital. A fund flow statement displays the financial status of an organisation, which ensures easy comparison and analysis between two accounting periods. It clarifies the variability in the assets, liabilities and equity of the company.

It is prepared based on cash and cash equivalents.	It is prepared based on fund as working capital.
Cash from operation is calculated.	Funds from operation is calculated.
Statement of changes in working capital is not prepared.	Statement of changes in working capital is prepared.
It is started with cash flows from operating activities.	It is started with funds from operation or funds lost in operation.
It is ended with closing cash in hand and cash equivalents.	It is ended with either increase in working capital or decrease in working capital.
The reasons for the change in cash are known through cash flow statement.	The reasons for the change in working capital are known through fund flow statement.
Short term financial pIanning is done through cash flow statement.	Medium term and long term financial planning is done through funds flow statement.
Cash flow analysis is based on cash concept.	Funds flow analysis is based on accrual concept.
It is used for preparing cash budgeting.	It is used for preparing capital budgeting.
It shows only changes in cash position.	It is concerned with the changes in working capital between two balance sheet dates.
It is worked as an indicator of improved working capital.	It is not necessary that an improved fund position will be an indicator of improved and sound cash position.
Increase in current liability or decrease in current assets brings decrease in working capital and vice versa.	Increase in current liability or decrease in current asset brings increase in cash and vice versa.

Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. However, ratio analysis is not an end. It is only a means of better understanding of financial strengths and weaknesses of a firm.

Calculation of mere ratios does not serve any purpose unless several appropriate ratios are analyzed and interpreted. There are a number of ratios which can be calculated from the information given in the financial statements, but the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same keeping in mind the objective of analysis. The ratios may be used as a symptom like blood pressure, the pulse rate or the body temperature and their interpretation depends upon the calibre and competence of the analyst.

The following are the four steps involved in the ratio analysis:

(i) Selection of relevant data from the financial statements depending upon the objective of the analysis.

(ii) Calculation of appropriate ratios from the above data.

(iii) Comparison of the calculated ratios with the ratios of the same firm in the past, or the ratios developed from projected financial statements or the ratios of some other firms or the comparison with ratios of the industry to which the firm belongs.

(iv) Interpretation of the ratios.

Uses of Ratio Analysis:

The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyze and interpret the financial health of enterprise. Just like a doctor examines his patient by recording his body temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment, a financial analyst analyses the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise.

‘A ratio is known as a symptom like blood pressure, the pulse rate or the temperature of an individual.’ It is with help of ratios that the financial statements can be analyzed more clearly and decisions made from such analysis. The use of ratios is not confined to financial managers only. There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes.

The supplier of goods on credit, banks, financial institutions, investors, shareholders and management all make use of ratio analysis as a tool in evaluating the financial position and performance of a firm for granting credit, providing loans or making investments in the firm. With the use of ratio analysis one can measure the financial condition of a firm and can point out whether the condition is strong, good, questionable or poor. The conclusions can also be drawn as to whether the performance of the firm is improving or deteriorating.

Thus, ratios have wide applications and are of immense use today:

(a) Managerial Uses of Ratio Analysis:

1. Helps in decision-making:

Financial statements are prepared primarily for decision-making. But the information provided in financial statements is not an end in itself and no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements.

2. Helps in financial forecasting and planning:

Ratio Analysis is of much help in financial forecasting and planning. Planning is looking ahead and the ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for future from these ratios. Thus, ratio analysis helps in forecasting and planning.

3. Helps in communicating:

The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of ratios. The information contained in the financial statements is conveyed in a meaningful manner to the one for whom it is meant. Thus, ratios help in communication and enhance the value of the financial statements.

4. Helps in co-ordination:

Ratios even help in co-ordination which is of utmost importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better co­ordination in the enterprise.

5. Helps in Control:

Ratio analysis even helps in making effective control of the business. Standard ratios can be based upon proforma financial statements and variances or deviations, if any, can be found by comparing the actual with the standards so as to take a corrective action at the right time. The weaknesses or otherwise, if any, come to the knowledge of the management which helps in effective control of the business.

6. Other Uses:

These are so many other uses of the ratio analysis. It is an essential part of the budgetary control and standard costing. Ratios are of immense importance in the analysis and interpretation of financial statements as they bring the strength or weakness of a firm.

(b) Utility to Shareholders/Investors:

An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investment and then a return in the form of dividend or interest. For the first purpose he will try to asses the value of fixed assets and the loans raised against them. The investor will feel satisfied only if the concern has sufficient amount of assets.

Long-term solvency ratios will help him in assessing financial position of the concern. Profitability ratios, on the other hand, will be useful to determine profitability position. Ratio analysis will be useful to the investor in making up his mind whether present financial position of the concern warrants further investment or not.

(c) Utility to Creditors:

The creditors or suppliers extend short-term credit to the concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not. The concern pays short- term creditor, out of its current assets. If the current assets are quite sufficient to meet current liabilities then the creditor will not hesitate in extending credit facilities. Current and acid-test ratios will give an idea about the current financial position of the concern.

(d) Utility to Employees:

The employees are also interested in the financial position of the concern especially profitability. Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concern. The employees make use of information available in financial statements. Various profitability ratios relating to gross profit, operating profit, net profit, etc. enable employees to put forward their viewpoint for the increase of wages and other benefits.

(e) Utility to Government:

Government is interested to know the overall strength of the industry. Various financial statements published by industrial units are used to calculate ratios for determining short-term, long-term and overall financial position of the concerns. Profitability indexes can also be prepared with the help of ratios. Government may base its future policies on the basis of industrial information available from various units. The ratios may be used as indicators of overall financial strength of public as well as private sector, in the absence of the reliable economic information, governmental plans and policies may not prove successful.

(f) Tax Audit Requirements:

Section 44 AB was inserted in the Income Tax Act by the Finance Act, 1984. Under this section every assesse engaged in any business and having turnover or gross receipts exceeding Rs. 40 lakh is required to get the accounts audited by a chartered accountant and submit the tax audit report before the due date for filing the return of income under Section 139 (1). In case of a professional, a similar report is required if the gross receipts exceed Rs 10 lakh.

Clause 32 of the Income Tax Act requires that the following accounting ratios should be given:

(i) Gross Profit/Turnover

(ii) Net Profit/Turnover

(iii) Stock-in-trade/Turnover

(iv) Material Consumed/Finished Goods Produced.

Further, it is advisable to compare the accounting ratios for the year under consideration with the accounting ratios for the earlier two years so that the auditor can make necessary enquiries, if there is any major variation in the accounting ratios.

Limitations of Ratio Analysis:

The ratio analysis is one of the most powerful tools of financial management.

Though ratios are simple to calculate and easy to understand, they suffer from some serious limitations:

1. Limited Use of a Single Ratio:

A single ratio, usually, does not convey much of a sense. To make a better interpretation a number of ratios have to be calculated which is likely to confuse the analyst than help him in making any meaningful conclusion.

2. Lack of Adequate Standards:

There are no well accepted standards or rules of thumb for all ratios which can be accepted as norms. It renders interpretation of the ratios difficult.

3. Inherent Limitations of Accounting:

Like financial statements, ratios also suffer from the inherent weakness of accounting records such as their historical nature. Ratios of the past are not necessarily true indicators of the future.

4. Change of Accounting Procedure:

Change in accounting procedure by a firm often makes ratio analysis misleading, e.g., a change in the valuation of methods of inventories, from FIFO to LIFO increases the cost of sales and reduces considerably the value of closing stocks which makes stock turnover ratio to be lucrative and an unfavorable gross profit ratio.

5. Window Dressing:

Financial statements can easily be window dressed to present a better picture of its financial and profitability position to outsiders. Hence, one has to be very careful in making a decision from ratios calculated from such financial statements. But it may be very difficult for an outsider to know about the window dressing made by a firm.

6. Personal Bias:

Ratios are only means of financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in different ways.

7. Un-comparable:

Not only industries differ in their nature but also the firms of the similar business widely differ in their size and accounting procedures, etc. It makes comparison of ratios difficult and misleading. Moreover, comparisons are made difficult due to differences in definitions of various financial terms used in the ratio analysis.

8. Absolute Figures Distortive:

Ratios devoid of absolute figures may prove distortive as ratio analysis is primarily a quantitative analysis and not a qualitative analysis.

9. Price Level Changes:

While making ratio analysis, no consideration is made to the changes in price levels and this makes the interpretation of ratios invalid.

10. Ratios no Substitutes:

Ratio analysis is merely a tool of financial statements. Hence, ratios become useless if separated from the statements from which they are computed.

11. Clues not Conclusions:

Ratios provide only clues to analysts and not final conclusions. These ratios have to be interpreted by these experts and there are no standard rules for interpretation.

Based on function or test, the ratios are classified as liquidity ratios, profitability ratios, activity ratios and solvency ratios.

Liquidity Ratios:

Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability of the business to pay its short-term debts. The ability of a business to pay its short-term debts is frequently referred to as short-term solvency position or liquidity position of the business.

Generally a business with sufficient current and liquid assets to pay its current liabilities as and when they become due is considered to have a strong liquidity position and a businesses with insufficient current and liquid assets is considered to have weak liquidity position.

Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether the business has adequate current and liquid assets to meet its current obligations. Financial institutions hesitate to offer short-term loans to businesses with weak short-term solvency position.

Four commonly used liquidity ratios are given below:

• Current ratio or working capital ratio
• Quick ratio or acid test ratio
• Absolute liquid ratio
• Current cash debt coverage ratio

Unfortunately, liquidity ratios are not true measure of liquidity because they tell about the quantity but nothing about the quality of the current assets and, therefore, should be used carefully. For a useful analysis of liquidity, these ratios are used in conjunction with activity ratios (also known as current assets movement ratios). Examples of activity ratios are receivables turnover ratio, accounts payable turnover ratio and inventory turnover ratio etc.

Profitability Ratios:

Profit is the primary objective of all businesses. All businesses need a consistent improvement in profit to survive and prosper. A business that continually suffers losses cannot survive for a long period.

Profitability ratios measure the efficiency of management in the employment of business resources to earn profits. These ratios indicate the success or failure of a business enterprise for a particular period of time.

Profitability ratios are used by almost all the parties connected with the business.

A strong profitability position ensures common stockholders a higher dividend income and appreciation in the value of the common stock in future.

Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed dividend income if the business has good profitability position.

Management needs higher profits to pay dividends and reinvest a portion in the business to increase the production capacity and strengthen the overall financial position of the company.

Some important profitability ratios are given below:

• Net profit (NP) ratio
• Gross profit (GP) ratio
• Price earnings ratio (P/E ratio)
• Operating ratio
• Expense ratio
• Dividend yield ratio
• Dividend payout ratio
• Return on capital employed ratio
• Earnings per share (EPS) ratio
• Return on shareholder’s investment/Return on equity
• Return on common stockholders’ equity ratio

Activity Ratios:

Activity ratios (also known as turnover ratios) measure the efficiency of a firm or company in generating revenues by converting its production into cash or sales. Generally a fast conversion increases revenues and profits.

Activity ratios show how frequently the assets are converted into cash or sales and, therefore, are frequently used in conjunction with liquidity ratios for a deep analysis of liquidity.

Some important activity ratios are:

• Inventory turnover ratio
• Receivables turnover ratio
• Average collection period
• Accounts payable turnover ratio
• Average payment period
• Asset turnover ratio
• Working capital turnover ratio
• Fixed assets turnover ratio

Solvency Ratios:

Solvency ratios (also known as long-term solvency ratios) measure the ability of a business to survive for a long period of time. These ratios are very important for stockholders and creditors.

Solvency ratios are normally used to:

• Analyze the capital structure of the company
• Evaluate the ability of the company to pay interest on long term borrowings
• Evaluate the ability of the the company to repay principal amount of the long term loans (debentures, bonds, medium and long term loans etc.).
• Evaluate whether the internal equities (stockholders’ funds) and external equities (creditors’ funds) are in right proportion.

Some frequently used long-term solvency ratios are given below:

• Debt to equity ratio
• Times interest earned (TIE) ratio
• Proprietary ratio
• Fixed assets to equity ratio
• Current assets to equity ratio
• Capital gearing ratio

Classification on the basis of financial statements:

Income statement/profit and loss ratios:

Income statement/profit and loss account ratios are those ratios that are calculated by using the items of income statement/profit and loss account of a particular period only. Examples of income statement/profit and loss account ratios are net profit ratio, gross profit ratio, operating ratio, and times interest earned ratio etc.

Balance sheet ratios:

Balance sheet ratios are those ratios that are calculated by using figures from the balance sheet only. The figures must be used from the balance sheet of the same period. Examples of balance sheet ratios are current ratio, liquid ratio, and debt to equity ratio etc.

Composite ratios:

These ratios are calculated by using the items of both income statement and balance sheet for the same period. Composite ratios are, therefore, also known as mixed ratios and inter-statement ratios. Numerous composite ratios are computed depending on the need of analyst. Some examples are inventory turnover ratio, receivables turnover ratio, accounts payable turnover ratio, and working capital turnover ratio etc.

Classification on the basis of importance:

On the basis of importance or significance, the ratios are classified as primary ratios and secondary ratios.  The most important ratios are called primary ratios and less important ratios are called secondary ratios. Secondary ratios are usually used to explain the primary ratios.

Examples of primary ratios for a commercial undertaking are return on capital employed ratio and net profit ratio because the basic purpose of these undertakings is to earn profit.

Importance of ratios significantly varies among industries therefore each industry has its own primary and secondary ratios. A ratio that is of primary importance in one industry may be of secondary importance in another industry.

The management of a company cannot wait for the year to end to analyze their financial performance and their profits. This must be done year-round. These profitability ratios help the management determine an entity’s ability to use its assets and create earnings. The most useful comparisons for these ratios is to the performance of the previous years.

Profitability ratios are both revenue statement ratios and balance sheet ratios. They compare the revenue of a firm to different types of expense accounts within the Profit and Loss Statement. And then some profitability ratios also compare revenue to aspects of the balance sheet such as assets and equity.

There are a variety of profitability ratios calculated with the help of the Income Statement and the Balance Sheet.

Gross Profit Ratio

This ratio simply compares the gross profit of a company to its net sales. Both of these figures are obtained from the Income Statement. The ratio is also known as Margin ratio or the Rate of Gross Profit. The ratio is represented as a percentage of sales.

This ratio basically signifies the basic profitability of the firm. This is why it is one of the most important profitability ratios. It shows the margin in the selling price before the company will incur losses from operations. The formula is

Gross Profit Ratio = (Gross Profits / Net Revenue from Operations) × 100

Net Revenue from Operations = Net Sales = Sales – Sale Returns

Gross Profit = Sales – Cost of Sales

Operating Ratio

The second one of the profitability ratios is the operating ratio. This ratio measures the equation between the cost of operating activities and the net sales, or revenue from operations. This ratio expresses the cost of goods sold as a percentage of the net sales.

Operating ratio also takes into account operating expenses such as administration and office expenses, selling and distribution costs, salaries paid, depreciation expenses etc. Also, it ignores the non-operating incomes such as interests, commisions, dividends etc.

Operating Ratio = (COGS + Operating Expenses / Net Revenue from Operations) × 100

This ratio can actually help ascertain the efficiency of the organization along with its profitability. There is no standard ratio, but a trend analysis must be done on year on year basis to check the progress of the firm.

Net Profit Ratio

Unlike the operating ratio, the net profit ratio includes the total revenue of the firm. It takes into account both the operating income as well as the non-operating income. Then it compares net profit to these incomes. This ratio too is represented as a percentage. The formula for Net Profit ratio is,

Net Profit Ratio = (Net Profit / Net Revenue) × 100

Net Profit = Net Profit after Tax (NPAT)

This ratio helps measure the overall profitability of the firm. It indicates the portion of the net revenue that is available to the proprietors. It also reflects on the efficiency of the business and is a very important ratio for investors and financiers.

Return on Capital Employed

This ratio is one of the important ones of the profitability ratios. It measures the overall efficiency of the utilization of the firm’s funds. The ratio explores the relationship between the total income/profit earned by a firm and the total capital employed by the firm, or the total investment made.  The formula is as follows,

Return on Capital Employed = (PBIT / Capital Employed) × 100

PBIT = Profit Before Income and Tax

This ratio measures the efficiency with which the capital is being utilized and it indicates the productivity of the capital employed. It is a good tool to measure the overall profitability of the firm as well.

Earnings Per Share

This ratio represents the profit or the earnings of a company in the context of one share. It represents the earnings of a firm whether or not dividends were actually declared on such shares. The formula for this ratio is

Earnings Per Share (EPS) = (Profit available to Equity Shareholders / Number of equity Shareholders) × 100

Profit available to Equity Shareholders = NPAT – Preference Dividend

This is an important ratio for the shareholders, it helps them decide whether to hold onto the shares or sell them. It also is a good indicator of the dividends to be declared and/or bonus issues.

Solvency Ratios also known as leverage ratios determine an entity’s ability to service its debt. So, these ratios calculate if the company can meet its long-term debt. It is important since the investors would like to know about the solvency of the firm to meet their interest payments and to ensure that their investments are safe. Hence solvency ratios compare the levels of debt with equity, fixed assets, earnings of the company etc.

One thing to make note of is the difference between solvency ratios and liquidity ratios. These two are often confused for the other. Liquidity ratios compare current assets with current liabilities, i.e. short-term debt. Whereas solvency ratios analyze the ability to pay long-term debt.

1) Debt to Equity Ratio

The debt to equity ratio measures the relationship between long-term debt of a firm and its total equity. Since both these figures are obtained from the balance sheet itself, this is a balance sheet ratio. Let us look at the formula:

Debt to Equity Ratio = Long-Term Debt / Shareholders Funds

Long Term Debt = Debentures + Long Term Loans

Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves – Fictitious Assets

The debt-equity ratio holds a lot of significance. Firstly, it is a great way for the company to measure its leverage or indebtedness. A low ratio means the firm is more financially secure, but it also means that the equity is diluted.

In contrast, a high ratio indicates a risky business where there are more creditors of the firm than there are investors. In fact, a high debt to equity ratio may deter more investors from investing in the firm, and even deter creditors from lending money.

While there is no industry standard as such it is best to keep this ratio as low as possible. The maximum a company should maintain is the ratio of 2:1, i.e. twice the amount of debt to equity.

2) Debt Ratio

Next, we learn about debt ratio. This ratio measures the long-term debt of a firm in comparison to its total capital employed. Alternatively, instead of capital employed, we can use net fixed assets. So the debt ratio will measure the liabilities (long-term) of a firm as a percent of its long-term assets. The formula is as follows:

Debt Ratio = Long-Term Debt / Capital Employed OR Long-Term Debt / Net Assets

Capital Employed = Long Term Debt + Shareholders Funds

Net Assets = Non-Fictitious Assets – Current Liabilities

This is one of the more important solvency ratios. It indicates the financial leverage of the firm. A low ratio points to a more financially stable business, better for the creditors. A higher ratio points to doubts about the firms long-term financial stability.  But a higher ratio helps the management with trading on equity, i.e. earn more income for the shareholders. Again there is no industry standard for this ratio.

3) Proprietary Ratio 

The third of the solvency ratios is the proprietary ratio or equity ratio. It expresses the relationship between the proprietor’s funds, i.e. the funds of all the shareholders and the capital employed or the net assets. Like the debt ratio shows us the comparison between debt and capital, this ratio shows the comparison between owner’s funds and total capital or net assets. The ratio is as follows:

Proprietary Ratio = Shareholders Funds / Capital Employed OR Shareholders Funds / Net Assets

A high ratio is a good indication of the financial health of the firm. It means that a larger portion of the total capital comes from equity. Or that a larger portion of net assets is financed by equity rather than debt. One point to note, that when both ratios are calculated with the same denominator, the sum of debt ratio and the proprietary ratio will be 1.

4) Interest Coverage Ratio

All debt has a cost, which we normally term as an interest. Debentures, loans, deposits etc all have an interest cost. This ratio will measure the security of this interest payable on long-term debt. It is the ratio between the profits of a firm available and the interest payable on debt instruments. The formula is:

Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-Term Debt

Common size statements are also known as ‘Vertical analysis’. Financial statements, when read with absolute figures, can be misleading. Therefore, a vertical analysis of financial information is done by considering the percentage form. The balance sheet items are compared:

• To the total assets in terms of percentage by taking the total assets as 100.
• To the total liabilities in terms of percentage by taking the total liabilities as 100.

Therefore the whole Balance Sheet is converted into percentage form. And such converted Balance Sheet is known as Common-Size Balance Sheet. Similarly profit & loss items are compared:

• To the total incomes in terms of percentage by taking the total incomes as 100.
• To the total expenses in terms of percentage by taking the total expenses as 100.

Therefore the whole Profit & loss account is converted into percentage form. And such converted profit & loss account is known as Common-Size Profit & Loss account. As the numbers are brought to a common base, the percentage can be easily compared with the results of corresponding percentages of the previous year or of some other firms.

Advantages of Common-Size Statement:

(a) Easy to Understand:

Common-size Statement helps the users of financial statement to make clear about the ratio or percentage of each individual item to total assets/liabilities of a firm. For example, if an analyst wants to know the working capital position he may ascertain the percentage of each individual component of current assets against total assets of a firm and also the percentage share of each individual component of current liabilities.

(b) Helpful for Time Series Analysis:

A Common-Size Statement helps an analyst to find out a trend relating to percentage share of each asset in total assets and percentage share of each liability in total liabilities.

(c) Comparison at a Glance:

An analyst can compare the financial performances at a glance since percentage of increase or decrease of each individual component of cost, assets, liabilities etc. are available and he can easily ascertain his required ratio.

(d) Helpful in analysing Structural Composition:

A Common-Size Statement helps the analyst to ascertain the structural relations of various components of cost/expenses/assets/liabilities etc. to the required total of assets/liabilities and capital.

Limitations of Common-Size Statement:

(a) Standard Ratio:

Common-Size Statement does not help to take decisions since there is no standard ratio/percentage regarding the change of percentage in the various component of assets, liabilities, sales etc.

(b) Change in Price-level:

Common-Size statement does riot recognise the change in price level i.e. inflationary effect. So, it supplies misleading information’s since it is based on historical cost.

(c) Following Consistency:

If consistency in the accounting principle, concepts, conventions is not maintained then Common Size Statement becomes useless.

(d) Seasonal Fluctuation:

Common-Size Statement fails to convey proper records during seasonal fluctuations in various components of sales, assets liabilities etc. e.g. sales and closing stock significantly vary. Thus, the statement fails to supply the real information to the users of financial statements.

(e) Window Dressing:

Effect of window dressing in financial statements cannot be ignored and Common-Size Statements fail to supply the real positions of sales, assets, liabilities etc. due to the evil effects of window dressing appearing in the financial statements.

(f) Qualitative Element:

Common-Size Statement fails to recognise the qualitative elements, e.g. quality of works, customer relations etc. while measuring the performance of a firm although the same should not be ignored.

(g) Liquidity and Solvency Position:

Liquidity and solvency position cannot be measured by Common-Size Statement. It considers the percentage of increase or decrease in various components of sales, assets, liabilities etc. In other words it does not help to ascertain the Current Ratio, Liquid Ratio, Debt Equity Capital Ratio, Capital Gearing Ratio etc. which are applied in testing liquidity and solvency position of a firm.

The common-size statements, balance sheet and income statement are shown in analytical percentages. The figures are shown as percentages of total assets, total liabilities and total sales. The total assets are taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a part of total liabilities.

These statements are also known as component percentage or 100 per cent statements because every individual item is stated as a percentage of the total 100. The short-comings in comparative statements and trend percentages where changes in items could not be compared with the totals have been covered up. The analyst is able to assess the figures in relation to total values.

The common-size statements may be prepared in the following way:

(1) The totals of assets or liabilities are taken as 100.

(2) The individual assets are expressed as a percentage of total assets, i.e., 100 and different liabilities are calculated in relation to total liabilities. For example, if total assets are Rs 5 lakhs and inventory value is Rs 50,000, then it will be 10% of total assets (50,000×100/5,00,000)

Types of Common-Size Statements:

(i) Common-Size Balance Sheet:

A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common-size balance sheet.

For example, following assets are shown in a common-size balance sheet:

The total figure of assets Rs 2,00,000, is taken as 100 and all other assets are expressed as a percentage of total assets. The relation of each asset to total assets is expressed in the statement. The relation of each liability to total liabilities is similarly expressed.

The common-size balance sheet can be used to compare companies of differing size. The comparison of figures in different periods is not useful because total figures may be affected by a number of factors. It is not possible to establish standard norms for various assets. The trends of figures from year to year may not be studied and even they may not give proper results.

(ii) Common Size Income Statement:

The items in income statement can be shown as percentages of sales to show the relation of each item to sales. A significant relationship can be established between items of income statement and volume of sales. The increase in sales will certainly increase selling expenses and not administrative or financial expenses.

In case the volume of sales increases to a considerable extent, administrative and financial expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise.

Importance of Common Size Analysis

One of the benefits of using common size analysis is that it allows investors to identify drastic changes in a company’s financial statement. This mainly applies when the financials are compared over a period of two or three years. Any significant movements in the financials across several years can help investors decide whether to invest in the company. For example, large drops in the company’s profits in two or more consecutive years may indicate that the company is going through financial distress. Similarly, considerable increases in the value of assets may mean that the company is implementing an expansion or acquisition strategy, making the company attractive to investors.

Common size analysis is also an excellent tool to compare companies of different sizes but in the same industry. Looking at their financial data can reveal their strategy and their largest expenses that give them a competitive edge over other comparable companies. For example, some companies may sacrifice margins to gain a large market share, which increases revenues at the expense of profit margins. Such a strategy allows the company to grow faster than comparable companies because they are more preferred by investors.

Also known as ‘horizontal analysis, are financial statements showing financial position & profitability at different periods of time. These statements give an idea of the enterprise financial position of two or more periods. Comparison of financial statements is possible only when same accounting principles are used in preparing these statements.

Comparative Balance Sheet

The progress of the company can be seen by observing the different assets and liabilities of the firm on different dates to make the comparison of balances from one date to another. To understand the comparative balance sheet, it must have two columns for the data of original balance sheets. A third column is used to show increases/decrease in figures. The fourth column gives percentages of increases or decreases.

By comparing the balance sheets of different dates, one can observe the following aspects

• Current financial position and Liquidity position
• Long-term financial position
• Profitability of the concern

Comparative Income Statement

Traditionally known as trading and profit and loss A/c. Net sales, cost of goods sold, selling expenses, office expenses etc are important components of an income statement. To compare the profitability, particulars of profit & loss are compared with the corresponding figures of previous years individually. To analyze the profitability of the business, the changes in money value and percentage is determined.

By comparing the profits of different dates, one can observe the following aspects:

• The increase/decrease in gross profit.
• The study of operational profits.
• The increase or decrease in net profit
• Study of the overall profitability of the business.

Advantages of Comparative Financial Statement:

(a) Comparison:

The comparative statements show the figures of various firms or number of years side by side i.e. both for inter-firm comparison and intra-firm comparison.

(b) Horizontal Analysis:

The variables are arranged horizontally for the purpose of analysis and interpretations of data taken from financial statements for assessing profitability, overall efficiency and financial position of a firm.

(c) Trend Analysis:

The comparative financial statement helps to ascertain the ‘trend’ relating to sales, cost of goods sold, operating expenses etc. so that a proper comparison can easily be made which helps the analyst to understand the overall performance of a firm.

(d) Trend and Directions:

The comparative financial statement provides necessary information for comparison of trends in related items e.g. the analyst can compare the trend of sales with the trend of accounts receivable which gives very useful information. A 20% increase in accounts receivable and an increase of sales by only 10% warrants investigation into the reasons for this difference in the rate of increase.

(e) Evaluation of:

The comparative financial statement helps the analyst to compare Performance the performance of one firm with that of other similar firm in the industry and also compare the performance of the competitors in the line. This comparison helps to find out the weakness or strength of a firm and to take adequate steps.

(f) Measuring Financial:

Comparative financial statements help to measure important Distress financial ratios which are used for predicting financial distress and predicting corporate failure with the help of Multivariate Model.

Disadvantages of Comparative Financial Statement:

(a) Inter-firm Comparison:

Inter firm comparison will only be effective if both the firms follow the same accounting principles, method of valuations of stocks, assets etc. i.e. all the accounting concepts and conventions, which in real world situation, are not identically followed by both the firms e.g. Firm A follows the FIFO method of valuing stock whereas Firm B follows LIFO method for the same.

(b) Inflationary Effect:

Comparative financial statements do not recognise the change in prices level and, as such, it will be of no use.

(c) Ascertaining Correct Trend:

It is very difficult to ascertain the correct trend if there is a structural changes in a firm which are frequently happened.

(d) Supply Misleading Information:

Sometimes a comparative financial statement provides meaningless information, e.g. if a negative amount comes in base year, and a positive amount in the next year, it is not possible to find out the change in percentage.

(e) Uniformity in Principle:

There must be a consistency while following accounting principles, concepts and convention. But in practice, this is not done and as such, multi-year analysis becomes useless.

Types

Comparative Income Statement:

We know that an Income Statement presents the results of the operation i.e. net profit or net loss. A Comparative Income Statement shows the absolute figures of incomes and expenses of two or more years and also the absolute change of those figures, together with the percentage change of those figures which, in other words, help the analyst to understand the change both in terms of absolute figures, as well as in terms of percentage.

The analyst can draw a meaningful conclusion after analysing and scrutinizing the figures presented in absolute and percentage form, i.e. to record the change between the two figures at a glance. For example, as the figures are presented or shown side by side, the analyst can easily determine whether a particular item is increased or decreased, e.g. percentage of gross profit on sales.

Comparative Expenses Statement:

When we want to prepare a comparative income statement we consider also the amount of various expenses. Without considering the amount of expenses income can never be ascertained. We will explain here the various components of expenses both in absolute figure as well as in percentage figure.

Comparative Expenses statement helps to ascertain the changes of various component of expenses which will help the management to take decision in future. For expense, if it is found that percentage of direct expenses are comparatively high in succeeding years or previous year, the reason for such increase must be ascertained.

So comparative expenses statement will highlight the changes in various components of expenses which provide very useful information to the management and accordingly the management can look into the matter and will take necessary steps.

Comparative Balance Sheet:

A single Balance Sheet exhibits the final position at a particular date i.e. the position of assets and liabilities. Comparison from a single Balance Sheet is not possible, the same can be compared with the Balance Sheets of the previous years.

In other words, if we take two or more Balance Sheets and compare them with their respective figures of assets and liabilities, a meaningful conclusion can be drawn after analysing and scrutinizing their changed figures and the reason for such changes which is very helpful on the part of the management to take financial decisions and future courses of action.

A single Balance Sheet presents only the current information of the firm. That is why a meaningful or significant conclusion about the financial status can be drawn only when we take the Balance Sheets for at least 3 years to 5 years after ascertaining the changes of both assets and liabilities position in terms of absolute figures as well as in terms of percentage.

Analysis of Comparative Balance Sheet:

A comparative Balance Sheet can be analysed with the help of the following:

(a) Ascertaining short-term Solvency position/Liquidity position/Working Capital Position:

A comparative Balance Sheet presents the position of current assets and current liabilities of the two consecutive years for the purpose of ascertaining the Gross Working Capital (i.e. the sum total of current assets), Net Working Capital (i.e. Current Assets – Current liabilities) i.e. it helps to know the short-term liquidity position.

If it is found that the net working capital employed with the firm is found to be less in comparison with the previous year, causes of such reduction must be found out, or, if it is found that the period of realisation of accounts receivables is more in comparison with the previous year, rea­sons for the same must be enquired for. Thus, a comparative Balance Sheet highlights us to know the working capital positions (both gross and net) and the liquidity positions as well.

(b) Ascertaing Long-Term Solvency position:

A comparative Balance Sheet helps to ascertain the long-term solvency position of a firm with the comparative study of Debt-Equity Ratio, Capital Gearing Ratio and various other ratios. In other words, the analyst must consider the changes made in long-term liabilities, fixed assets or change in proprietor’s fund.

Thus, these three items have a special bearing on the long-term solvency position of a firm. For example if the amount of long-term liabilities increase there will be a higher capital Gearing ratio/Debt Equity Ratio which is not desirable from the standpoint of long-term solvency position of a firm.

It is interesting to note that if the amount of long-term liabilities increase with a corresponding increase in fixed assets that will not be a problem but problem will arise only when a part of long-term liabilities is used by way of working capital.

(c) Increase in Net Worth:

An analyst must see that the net worth must be increased which indicates the rate of growth. If net worth/proprietors’ fund increases due to increase in net profit, in indicates a healthy sign and vice-versa is the opposite case.

(d) Analysis/Interpretation/Comment:

An analyst with the help of analysis of comparative Balance Sheets must interpret or comment on the financial positions as a whole i.e., not in an isolated manner. He must analyse the liquidity and solvency position, profitability position, Capital structure position, as well as on management efficiency position.

If he only analyses the liquidity position alone the real picture of the financial position cannot be known. Thus, in order to arrive at a proper conclusion he must examine the various financial ratios that are frequently used in this regard.

Cost Accounting:

1. Deal with: Cost accounting deals with ascertainment, allocation, appointment and accounting aspect of costs.
2. Base: Cost accounting provides a base for management accounting.
3. Role: Cost accounting is helpful in collecting costing data for the management.
4. Status: The status of cost accountant comes after the management accountant.
5. Outlook: Cost accountant has a narrow approach. He has to refer to economic and statistical data for analysing cost effects.
6. Tools & Techniques: Cost accounting has standard costing, variable costing, break even analysis etc. as the basic tools and techniques.
7. Scope: Cost accounting does not include financial accounting, tax planning and tax accounting.
8. Period of planning: Cost accounting is concerned with short term planning.
9. Assistance: Cost accounting merely assists the management in its functions.
10. Approach: Cost accounting is historical in its approach.
11. Installation: It can be installed without management accounting.

Management Accounting:

1. Deal with: Management accounting deals with effect and impact of cost on the business.
2. Base: Management accounting is derived from both cost accounting and financial accounting.
3. Role: Management accounting has a greater degree of relevance and objectivity as the management accountant has a clear idea of the types of cost and items requiring analysis problems of business.
4. Status: Management accountant is senior in position to cost accountant.
5. Outlook: Management accountant reports the effect of cost on the business along with cost analysis.
6. Tools & Techniques: Along-with tools and techniques of cost accounting, the management accountant has funds and cash flow statement, ratio analysis etc. as his accounting tools and techniques.
7. Scope: Management accounting includes financial accounting, cost accounting, tax planning and tax accounting.
8. Period of planning: Management accounting Is concerned with short range and long range planning and uses techniques like sensitivity analysis, probability structure etc. its special field is evaluation of capital investment project.
9. Assistance: Management accounting assists and evaluates the management performance.
10. Approach: Management accounting is futuristic in its approach.
11. Installation: Management accounting needs financial and cost accounting as its base for its installation.