SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.

Scope/Elements

1. Investment decisions: Includes investment in fixed assets (called as capital budgeting).

Investment in current assets are also a part of investment decisions called as working
capital decisions.

One of the most important finance functions is to intelligently allocate capital to long term
assets. This activity is also known as capital budgeting. It is important to allocate capital
in those long term assets so as to get maximum yield in future. Following are the two
aspects of investment decision

a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected
return. Along with uncertainty comes the risk factor which has to be taken into
consideration. This risk factor plays a very significant role in calculating the expected
return of the prospective investment. Therefore while considering investment proposal it
is important to take into consideration both expected return and the risk involved.

2. Financial decisions: They relate to the raising of finance from various resources which
will depend upon decision on type of source, period of financing, cost of financing and the
returns thereby.

It is important to make wise decisions about when, where and how should a business
acquire funds. Funds can be acquired through many ways and channels. Broadly speaking
a correct ratio of an equity and debt has to be maintained. This mix of equity capital and
debt is known as a firm’s capital structure.

A firm tends to benefit most when the market value of a company’s share maximizes this
not only is a sign of growth for the firm but also maximizes shareholders wealth. On the
other hand the use of debt affects the risk and return of a shareholder. It is more risky
though it may increase the return on equity funds.

A sound financial structure is said to be one which aims at maximizing shareholders return
with minimum risk. In such a scenario the market value of the firm will maximize and
hence an optimum capital structure would be achieved. Other than equity and debt there
are several other tools which are used in deciding a firm capital structure.
 3. Dividend decision: The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.

The key function a financial manger performs in case of profitability is to decide whether
to distribute all the profits to the shareholder or retain all the profits or distribute part of the
profits to the shareholder and retain the other half in the business

4. Liquidity Decision

It is very iportant to maintain a liquidity position of a firm to avoid insolvency. Firm’s

profitability, liquidity and risk all are associated with the investment in current assets. In
order to maintain a tradeoff between profitability and liquidity it is important to invest
sufficient funds in current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current assets.

Current assets should properly be valued and disposed of from time to time once they
become non profitable. Currents assets must be used in times of liquidity problems and
times of insolvency.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized
in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital so
that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in
an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis.
This will depend upon the proportion of equity capital a company is possessing and
additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
 b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of
financing.

4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques
like ratio analysis, financial forecasting, cost and profit control, etc.

Financial Planning - Definition, Objectives and Importance

Definition of Financial Planning
Financial Planning is the process of estimating the capital required and determining it’s
competition. It is the process of framing financial policies in relation to procurement, investment
and administration of funds of an enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

a. Determining capital requirements- This will depend upon factors like cost of current and
fixed assets, promotional expenses and long- range planning. Capital requirements have to
be looked with both aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e.,
the relative kind and proportion of capital required in the business. This includes decisions
of debt- equity ratio- both short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized
in the best possible manner at least cost in order to get maximum returns on investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes and budgets
regarding the financial activities of a concern. This ensures effective and adequate financial and
investment policies. The importance can be outlined as-
 1. Adequate funds have to be ensured.
2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of
funds so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in companies
which exercise financial planning.
4. Financial Planning helps in making growth and expansion programmes which helps in
long-run survival of the company.
5. Financial Planning reduces uncertainties with regards to changing market trends which can
be faced easily through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth
of the company. This helps in ensuring stability an d profitability in concern.

Role of a Financial Manager

A financial manager is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that the
funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth
and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain
a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally
used. In order to allocate funds in the best possible manner the following point must be
considered

 The size of the firm and its growth capability

 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activity

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to proper
usage of the profit generated by the firm.
 Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of variable
and fixed factors of production can lead to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production. An opportunity cost must be calculated in
order to replace those factors of production which has gone thrown wear and tear. If this is
not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there involves
a huge amount of risk involved. Therefore a financial manger understands and calculates
the risk involved in this trading of shares and debentures.

It’s on the discretion of a financial manager as to how to distribute the profits. Many
investors do not like the firm to distribute the profits amongst shareholders as dividend
instead invest in the business itself to enhance growth. The practices of a financial manager
directly impact the operation in capital market.
 CASH FLOW STATEMENT
Cash Flow Statement deals with flow of cash which includes cash equivalents as well as cash. This
statement is an additional information to the users of Financial Statements. The statement shows
the incoming and outgoing of cash. The statement assesses the capability of the enterprise to
generate cash and utilize it.
Thus a Cash-Flow statement may be defined as a summary of receipts and disbursements of cash
for a particular period of time. It also explains reasons for the changes in cash position of the firm.
Cash flows are cash inflows and outflows. Transactions which increase the cash position of the
entity are called as inflows of cash and those which decrease the cash position as outflows of cash.

The statement of cash flow serves a number of objectives which are as follows :
 Cash flow statement aims at highlighting the cash generated from operating activities.
 Cash flow statement helps in planning the repayment of loan schedule and replacement
of fixed assets, etc.
 Cash is the centre of all financial decisions. It is used as the basis for the projection of
future investing and financing plans of the enterprise.
 Cash flow statement helps to ascertain the liquid position of the firm in a better manner.
Banks and financial institutions mostly prefer cash flow statement to analyse liquidity of
the borrowing firm.
 Cash flow Statement helps in efficient and effective management of cash.
 The management generally looks into cash flow statements to understand the internally
generated cash which is best utilised for payment of dividends.
 It is very useful in the evaluation of cash position of a firm.

The statement of cash flow shows three main categories of cash inflows and cash outflows,
namely operating, investing and financing activities.
(a) Operating activities are the principal revenue generating activities of the enterprise.
(b) Investing activities include the acquisition and disposal of long term assets and other
investments not included in cash equivalents.
(c) Financing activities are activities that result in change in the size and composition of the
owner’s capital (including Preference share capital in the case of a company) and borrowings of
the enterprise
.
1. The following information is available from the books of Exclusive Ltd. for the year ended
31st March, 2016:

(a) Cash sales for the year were Rs.10,00,000 and sales on account Rs.12,00,000.
(b) Payments on accounts payable for inventory totalled Rs.7,80,000.
(c) Collection against accounts receivable were Rs.7,60,000.
(d) Rent paid in cash Rs.2,20,000, outstanding rent being Rs.20,000.
(e) 4,00,000 Equity shares of Rs.10 par value were issued for Rs.48,00,000.
(f) Equipment was purchased for cash Rs.16,80,000.
(g) Dividend amounting to Rs.10,00,000 was declared, but yet to be paid.
(h) Rs.4,00,000 of dividends declared in the previous year were paid.
(i) An equipment having a book value of Rs.1,60,000 was sold for Rs.2,40,000.
(j) The cash account was increased by Rs.37,20,000.
Prepare a cash flow statement using direct method.
2. Madhuri Ltd. gives you the following information for the year ended 31st March, 2016:
(a) Sales for the year totalled Rs.96,00,000. The company sells goods for cash only.
(b) Cost of goods sold was 60% of sales.
(c) Closing inventory was higher than opening inventory by Rs.43,000.
(d) Trade creditors on 31st March, 2016 exceeded those on 31st March, 2015 by Rs.23,000.
(e) Tax paid amounted to Rs.7,00,000.
(f) Depreciation on fixed assets for the year was Rs.3,15,000 whereas other expenses totalled
Rs.21,45,000. Outstanding expenses on 31st March, 2015 and 31st March, 2016 totalled Rs.82,000 and
Rs.91,000 respectively.
(g) New machinery and furniture costing Rs.10,27,500 in all were purchased.
(h) A rights issue was made of 50,000 equity shares of Rs.10 each at a premium of Rs.3 per share. The
entire money was received with applications.
(i) Dividends totalling Rs. 4,00,000 were distributed among shareholders.
(j) Cash in hand and at bank as at 31st March, 2015 totalled Rs.2,13,800.
You are required to prepare a cash flow statement using direct method.

Proceeds from issue of share capital:

Issue price of one share =Rs. 10 + Rs.3 = Rs.13
Proceeds from issue of 50,000 shares = Rs. 13 x 50,000 = Rs. 6,50,000
3. The summary of cash transactions extracted from the books of Happy Ltd. are:

You are required to prepare a cash flow statement of the company for the period ended
31st March, 2016 in accordance with the Indian Accounting Standard-3(Revised).
4. Following information is available from the books of Standard Company Ltd.:

Calculate cash flow from operations.

5. From the following calculate cash from operations:

6. Swastik Oils Ltd. has furnished the following information for the year ended 31 st
March, 2016:

You are required to prepare the cash flow statement for the year ended 31 st March,
2016.(Make assumption wherever necessary).
 WORKING CAPITAL: MEANING, CONCEPT & NATURE
Working Capital is basically an indicator of the short-term financial position of an organization
and is also a measure of its overall efficiency. Working Capital is obtained by subtracting the
current liabilities from the current assets. This ratio indicates whether the company possesses
sufficient assets to cover its short-term debt.

In ordinary sense, working capital denotes amount of funds needed to meet day-to-day operations
of a concern.

Working Capital indicates the liquidity levels of companies for managing day-to-day expenses and
covers inventory, cash, accounts payable, accounts receivable and short-term debt that is due.
Working capital is derived from several company operations such as debt and inventory
management, supplier payments and collection of revenues.

Concept of Working Capital:

The funds invested in current assets are termed as working capital. It is the fund that is needed to

run the day-to-day operations. It circulates in the business like the blood circulates in a living body.

Generally, working capital refers to the current assets of a company that are changed from one

form to another in the ordinary course of business, i.e. from cash to inventory, inventory to work

in progress (WIP), WIP to finished goods, finished goods to receivables and from receivables to
cash.

Types of working capital:

On the basis of Value
 Gross Working Capital: It denotes the company’s overall investment in the current
assets.
 Net Working Capital: It implies the surplus of current assets over current liabilities.
A positive net working capital shows the company’s ability to cover short-term
liabilities, whereas a negative net working capital indicates the company’s inability in
fulfilling short-term obligations.
On the basis of Time
 Temporary working Capital: Otherwise known as variable working capital, it is that
portion of capital which is needed by the firm along with the permanent working
capital, to fulfil short-term working capital needs that emerge out of fluctuation in the
sales volume.
 Permanent Working Capital: The minimum amount of working capital that a
company holds to carry on the operations without any interruption, is called permanent
working capital

Working Capital Cycle

Working Capital Cycle or popularly known as operating cycle, is the length of time between the
outflow and inflow of cash during the business operation. It is the time taken by the firm, for the
payment of materials, wages and other expenses, entering into stock and realizing cash from the
sale of the finished good.
In short, the working capital cycle is the average time required to invest cash in assets and
reconverting it into cash by selling the assets produced.

The working capital cycle may vary from enterprise to enterprise depending on various factors,
such as nature and size of business, production policies, manufacturing process, fluctuations in
trade cycle, credit policy, terms and conditions for purchase and sales, etc.

Components of Working Capital:

1. Current assets include:

(a) Inventories or Stocks
(i) Raw materials
(ii) Work in progress
(iii) Consumable Stores
(iv) Finished goods
(b) Sundry Debtors
(c) Bills Receivable
(d) Pre-payments
(e) Short-term Investments
(f) Accrued Income and
(g) Cash and Bank Balances
2. Current Liabilities:
Current liabilities are those which are generally paid in the ordinary course of business within a
short period of time, i.e. one year.
Current liabilities include:
(a) Sundry Creditors
(b) Bills Payable
(c) Accrued Expenses
(d) Bank Overdrafts
(e) Bank Loans (short-term)
(f) Proposed Dividends
(g) Short-term Loans
(h) Tax Payments Due
Ex. Calculate the amount of working capital requirement for SRCC Ltd.from the following
information

Rs
Raw material 160
Direct labour 60
Overheads 120
Total cost 340
Profit 60
Selling price 400
Raw Materials are held in stock on an average for one month. Materials are in process on an
average for half month.
Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month and credit allowed to debtors is two months.
Time lag in payment of wages is 1 ½weeks.
Time lag in payment of overheads expenses is one month.
One fourth of the sales are made on cash basis.
Cash in hand and at the bank is expected to be Rs. 50,000; expected level of production amount
to 1,04,000 units for a year of 52 weeks.
You may assume that production is carried on evenly throughout the year and a time period of
four weeks is equivalent of month
A. Current Assets (CA): Amt. (Rs.) Amt.(Rs.)
Cash Balance 50,000
Stock of Raw Materials (2,000x160x4) 12,80,000
Work in progress:
Raw Materials (2,000 x 160 x 2) 6,40,000
Labour (2,000 x 60 x 2) x50% 1,20,000
Overheads (2,000 x 120 x 2) x50% 2,40,000 10,00,000
Finished Goods (2,000 x 340 x 4) 27,20,000
Debtors (2,000 x 75% 340 x 8) 40,80,000
Total Current Assets 91,30,000
A. Current Liabilities (CL):
Creditors (2,000 Rs. 160 x 4) 12,80,000
Creditors for wages (2,000 Rs. 60 x 1½) 1,80,000
Creditors for overheads (2,000 Rs. 120 x 4) 9,60,000
Total Current Liabilities 24,20,000
Net Working Capital (CA – CL) 67,10,000
 RATIO ANALYSIS
Ratio analysis is one of the oldest methods of financial statements analysis. It was developed
by banks and other lenders to help them chose amongst competing companies asking for their
credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in
different industries and having different styles of conducting business can make it almost
impossible to come up with a conclusion as to which company is a better investment. Ratio analysis
helps creditors solve these issues.
What are Financial Ratios?

 Shortcut: Financial ratios provide a sort of heuristic or thumb rule that investors can apply
to understand the true financial position of a company. There are recommended values that
specific ratios must fall within. Whereas in other cases, the values for comparison are
derived from other companies or the same companies own previous records. However,
instead of undertaking a complete tedious analysis, financial ratios helps investors shortlist
companies that meet their criteria.
 Sneak-Peek: Investors have limited data to make their decisions with. They do not know
what the state of affairs of the company truly is. The financial statements provide the
window for them to look at the internal operations of the company. Financial ratios make
financial analysis simpler. They also help investors compare the relationships between
various income statement and balance sheet items, providing them with a sneak peek of
what truly is happening behind the scenes in the company.
 Connecting the Dots: Over the years investors have realized that financial ratios have
incredible power in revealing the true state of affairs of a company. Analyses like the
DuPont Analysis have brought to the forefront the inter-relationship between ratios and
how they help a company become more profitable.

Sources of Data
Here is where the investors get the data they require for ratio analysis:

 Financial Statements: The financial data published by the company and its competitors
is the prime source of information for ratio analysis.
 Best Practices Reports: There are a wide range of consulting firms that collate and publish
data about various companies. This data is used for operational benchmarking and can also
be used for financial data analysis.
 Market: The data generated by all the activity on the stock exchange is also important
from ratio analysis point of view. There is a whole class of ratios where the stock price is
compared with earnings, cash flow and such other metrics to check if it is fairly priced.

Techniques used in ratio analysis

Ratio, as the name suggests, is nothing more than one number divided by the other. However, they
become useful when they are put in some sort of context. This means that when an analysts looks
at the number resulting out of a ratio calculation he/she must have a reasonable basis to compare
it with. Only when the analyst looks at the number and compares it what the ideal state of affairs
should be like, do the numbers become powerful tool of management and financial analysis.
Dividing numbers and obtaining ratios is therefore not the main skill. In fact this part can be
automated and done by the computer. Companies wouldn’t want to pay analysts for doing simple
division, would they? The real skill lies in being able to interpret these numbers. Here are some
common techniques used in the interpretation of these numbers.
Horizontal Analysis
Horizontal analysis is an industry jargon for comparison of the same ratio over time. Once a ratio
is calculated, it is compared with what the value was in the previous quarter, the previous years,
or many years in case the analyst is trying to make a trend. This provides more information of two
grounds. They are:

 Horizontal analysis clarifies whether the company has a stable track record or is the value
of the ratio influenced by one time special circumstances.
 Horizontal analysis helps to unveil trends which help analysts unveil trends in the
performance of the business. This helps them make more accurate future projections and
value the share correctly.

Cross-Sectional Analysis
Cross sectional ratio analysis is the industry jargon used to denote comparison of ratios with other
companies. The other companies may or may not belong to the same industry. Cross sectional
analysis helps an analyst understand how well a company is performing relative to its peers. In a
way this removes the effect of business cycles. There are many variations of cross sectional
analysis. They are as follows:

 Industry Average: The most popular method is to take the industry average and compare
it with the ratios of the firm. This provides a measure of how the company is performing
in comparison to an average firm.
 Industry Leader: Many companies and analysts are not satisfied with being average. They
want to be the industry leader and therefore benchmark against them.
 Best Practice: In case, the company is the industrial leader, then it usually crosses the
industry border and seeks inspiration from anyone anywhere in the world. They benchmark
with the best practices across the globe.

Limitations of ratio analysis

Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any
investor, who wants to be more efficient at their job, must devote more time towards understanding
ratios and ratio analysis. However, this does not mean that it is free of limitations. Like all
techniques, financial ratios have their limitations too. Understanding the limitations will help
investors understand the possible shortcomings with ratios and avoid them. Here are the
shortcomings:
 Misleading Financial Statements
The first and foremost threat to ratio analysis is deliberate misleading statements issued by
the management. The management of most companies is aware that investors look at
certain numbers like sales, earnings, cash flow etc very seriously. Other numbers on the
 financial statements do not get such attention. They therefore manipulate the numbers
within the legal framework to make important metrics look good. This is a common
practice amongst publically listed companies and is called “Window Dressing”. Investors
need to be aware of such window dressing and must be careful in calculating and
interpreting ratios based on these numbers.
 Incomparability
Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be
compared with other companies or over time. However, many times companies have
accounting policies that do not match with each other. This makes it impossible to have
any meaningful ratio analysis. Regulators all over the world are striving to make financial
statements standardized. However in many cases, companies can still choose accounting
policies which will make their statements incomparable.
 Qualitative Factors
Comparison over time is another important technique used in ratio analysis. It is called
horizontal analysis. However, many times comparison over time is meaningless because
of inflation. Two companies may be using the same machine with the same efficiency but
one will have a better ratio because it bought the machine earlier at a low price. Also, since
the machine was purchased earlier, it may be closer to impairment. But the ratio does not
reflect this.
 Subjective Interpretation
Financial ratios are established “thumb of rules” about the way a business should operate.
However some of these rules of thumb have become obsolete. Therefore when companies
come with a new kind of business model, ratios show that the company is not a good
investment. In reality the company is just “unconventional”. Many may even call these
companies innovative. Ratio analysis of such companies does not provide meaningful
information. Investors must look further to make their decisions.

Types of Ratios
In general, financial ratios can be broken down into four main categories:

1. Profitability Ratios 2. Liquidity Ratios 3. Leverage Ratios 4. Activity Ratios.

Type # 1. Profitability Ratios:

The main objective of any organization is to earn profit. Profit is both a means and end to the
organization. The profitability ratios are used to measure how well a business is performing in
terms of profit. The profitability ratios are considered to be the basic bank financial ratios.

In other words, the profitability ratios give the various scales to measure the success of the firm.
If a company is having a higher profitability ratio compared to its competitor, it can be inferred
that the company is doing better than that particular competitor.
Type # 2. Liquidity Ratios:
Liquidity reflects the ability of a company to meet its short-term obligations using assets that are
most readily converted into cash. Assets that can be converted into cash in a short period of time
are referred to as liquid assets. These are listed in financial statements as current assets. Current
assets are used to satisfy short-term obligations.

Liquidity ratios measure the amount of cash or investments that can be converted to cash to pay
expenses and short-term debts. Liquidity ratios determine company’s ability to meet current
liabilities.

The two commonly used liquidity ratios are:

i. Current ratio.

ii. Quick ratio.

Type # 3. Leverage Ratios:

Leverage ratios look at the extent that a company has depended upon borrowing to finance its
operations. As a result, these ratios are reviewed closely by bankers and investors. Most leverage
ratios compare assets or net worth with liabilities. A high leverage ratio may increase a company’s
exposure to risk and business downturns, but along with this higher risk also comes the potential
for higher returns.
Type # 4. Activity Ratios:
Activity ratios are measures of how well assets are used. Activity ratios or turnover ratios can be
used to evaluate the benefits produced by specific assets, such, as inventory or accounts receivable.
 Problem: From the data calculate :
(i) Gross Profit Ratio (ii) Net Profit Ratio (iii) Return on Total Assets
(iv) Inventory Turnover (v) Working Capital Turnover (vi) Net worth to Debt

Sales 25,20,000 Other Current Assets 7,60,000

Cost of sale 19,20,000 Fixed Assets 14, 40,000
Net profit 3,60,000 Net worth 15,00,000
Inventory 8,00,000 Debt. 9,00,000
Current Liabilities 6,00,000
Solution:
1. Gross Profit Ratio = (GP/ Sales) * 100 = 6
Sales – Cost of Sales= Gross Profit
25,20,000 – 19,20,000 = 6,00,000
2. Net Profit Ratio = (NP / Sales)* 100 = 3
3. Inventory Turnover Ratio = (Turnover / Total Assets) * 100= 1920000/800000= 2.4 times. Turnover
Refers Cost of Sales
4. Return on Total Assets = NP/ Total Assets = (360000/3000000)*100 = 12%
FA+ CA +inventory [14,40,000 + 7,60,000 + 8,00,000] = 30,00,000
5. Net worth to Debt = Net worth/ Debt= (1500000/900000)* 100 = 1.66 times
6. Working Capital Turnover ratio = Turnover/Working capital
Working Capital = Current Assets – Current Liabilities
= 8,00,000 + 7,60,000 – 6,00,000
=15,60,000 – 6,00,000= 9,60,000
Working Capital Turnover Ratio = 19,20,000/960000 = 2 times.

Problem : The Balance sheet of Naronath & Co. as on 31.12.2000 shows as follows:
Liabilities $ Assets $
Equity capital 1,00,000 Fixed Assets 1,80,000
15% Preference shares 50,000 Stores 25,000
12% Debentures 50,000 Debtors 55,000
Retained Earnings 20,000 Bills Receivable 3,000
Creditors 45,000 Bank 2,000
2,65,000 2,65,000
Comment on the financial position of the Company i. e., Debt – Equity Ratio, Fixed Assets Ratio, Current
Ratio, and Liquidity.
Solution:
Debt – Equity Ratio = Debt – Equity / Long – Term Debt
Long-term Debt = Debentures = 50,000
Shareholder’s Fund = Equity + Preference + Retained Earnings
= 1,00,000 + 50,000 + 20,000 = 1,70,000
Therefore debt-equity ratio= 50000/1700000= 0·29
Fixed Assets Ratio= Fixed Assets / Proprietor’s Fund= -1,80,000
Proprietor’s Fund=Equity Share Capital + Preference Share Capital+ Retained Earnings
=1,00,000 + 50,000 + 20,000 = 1,70,000
Fixed Assets Ratio = 1,80,000 / 1,70,000= 1.05
Current Ratio = Current Assets / Current Liabilities
Current Assets = Stores + Debtors + BR + Bank= 25,000 + 55,000 + 3,000 + 2,000 = 85,000
Liquid Ratio=45,000 / 85,000= 1.88
Liquid Assets = 45,000
Liquid Liabilities = Debtors + Bill Receivable + Cash=55,000 + 3,000 + 2,000 = 60,000
Liquid Ratio = 60,000 / 45,000 = 1.33

Problem 6. From the following details of a trader you are required to calculate :
(i) Purchase for the year.
(ii) Rate of stock turnover
(iii) Percentage of Gross profit to turnover
Sales $ 33,984 Stock at the close at cost price 1814
Sales Returns 380 G.P. for the year 8068
Stock at the beginning at cost price 1378
Solution :
Trading Account
To Opening stock 1378 By Sales 33984
To Purchase (BD 25972 Sales Return 380
To gross profit 8068 33604
By closing Stock 1814
Total 35418 35418
(i) Purchase for the year $ 25,972
(ii) Stock Turnover = Cost of Goods Sold
Cost of Goods Sold = Cost of Goods Sold / Average Stock
Average Stock = (Opening Stock + Closing Stock)/ 2
= (1372 + 1814 )/2 = 25916/1596 =16.23 times
(iii) Percentage of Gross Profit to Turnover = Gross Profit / Sales *100
= 8068 / 33 ,984 * 100 = 23.74%.
Problem 7. Calculate stock turnover ratio from the following information :
Opening stock 5 8,000
Purchases 4,84,000
Sales 6,40,000
Gross Profit Rate – 25% on Sales.
Solution :
Stock Turnover Ratio = Cost of Goods Sold / Average Stock
Cost of Goods Sold = Sales- G.P = 6,40,000 – 1,60,000 = 4,80,000
Stock Turnover Ratio= 4,80,000 /58000 = 8.27 times
Here, there is no closing stock. So there is no need to calculate the average stock.

Problem 8. Calculate the operating Ratio from the following figures.

Items ($ in Lakhs)
Sales 17874
Sales Returns 4
Other Incomes 53
Cost of Sales 15440
Administration and Selling Exp. 1843
Depreciation 63
Interest Expenses (Non- operating 456
Solution:
Operating Ratio = (Cost of Goods Sold + Operating Expenses * 100) / Sales
= ((15,440 + 1,843)/ 17,870)*100 = 97%