7,500
Less sale proceeds
6,800
--------
Loss on sale
700
--------
2.1.3.7 Annuity Method Of Depreciation
Under the first two methods of depreciation the interest aspect has
been ignored. Under this method, the amount spent on the acquisition of
an asset is regarded as investment which is assumed to earn interest at a
certain rate. Every year the asset is debited with the amount of interest and
credited with the amount of depreciation. This interest is calculated on the
debit balance of the asset account at the beginning of the year. The amount
to be written off as depreciation is calculated from the annuity table an
extract of which is given below:
Years 3%
3.5%
4%
4.5%
5%
3 0.353530
0.359634
0.360349
0.363773
0.367209
4
0.269027
0.272251
0.275490
0.278744
0.282012
5 0.218355
0.221481
0.224627
0.227792
0.230975
The amount to be written off as depreciation is ascertained from
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the annuity table and the same depends upon the rate of interest and the
period over which the asset is to be written off. The rate of interest and the
amount of depreciation would be adjusted in such a way that at the end of
its working life, the value of the asset would be reduced to nil or its scrap
value.
Evaluation:
This method has the merit of treating purchase of an asset as an
investment within the business, and the same is supposed to earn interest.
However, calculations become difficult when additions are made to the
asset. The method is suitable only for long leases and other assets to which
additions are not usually made and as such in case of machinery, this
method is not found suitable.
Illustration 4:
A lease is purchased for a term of 4 years by payment of rs.1,00,000.
It is proposed to depreciate the lease by annuity method charging 4%
interest. If annuity of re.1 for 4 years at 4% is 0.275490, show the lease
account for the full period.
Amount of annual depreciation =rs.1,00,000 x re.0.275490
= rs.27,549
Lease Account
Date
Particulars
Rupees
Date
Particulars
Rupees
1 s t
To Bank
100000.00 1st By Depreciation
27549.00
Year To Interest At 4%
4000.00 Year By Balance C/D
76451.00
------------
------------
104000.00
104000.00
------------
------------
2nd To Balance B/D
76451.00 2nd By Depreciation
27549.00
Year To Interest At 4%
3058.04 Year By Balance C/D
51960.04
------------
------------
79509.04
79509.04
------------
------------
3 r d To Balance B/D
51960.04 3rd By Depreciation
27549.00
Year To Interest At 4%
2078.40 Year By Balance C/D
26489.44
------------
------------
54038.44
54038.44
------------
------------
98
4th To Balance B/D
26489.44 4th By Depreciation
27549.00
Year To Interest At 4%
1059.56 Year
(Adjusted)
-----------
-----------
27549.00
27549.00
-----------
-----------
2.1.3.8 Summary
Though depreciation to a common man means a fall in the value
of an asset, actually it is not a process of valuation. It is a process of cost
allocation. Through depreciation accounting the cost of a tangible asset
less salvage value, if any, is distributed over the estimated useful life of
the asset. Depreciation is to be accounted to know the true profit earned
by the concern, to exhibit a true and fair view of the state of assets of
the concern and to provide funds for replacement of the asset when it is
worn out. Among the number of methods of depreciation available three
methods, viz. Straight line method, diminishing balance method and
annuity method are discussed.
2.1.3.9 Key Words
Depreciable Asset: It is that asset on which depreciation is written off.
Depreciation: It is the allocation of the depreciable amount of an asset
over estimated useful life.
Useful Life: It is the period over which a depreciable asset is expected to
be used by the enterprise.
Depreciable Amount: The depreciable amount of a depreciable asset is
its historical cost less estimated residual value.
Residual Value: It is the expected recovery or sales value of an asset at the
end of its useful life.
2.1.3.10 Self Assessment Questions
Question 1:
A manufacturing concern, whose books are closed on 31st
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march, purchased machinery for rs.1,50,000 on 1st april 2002. Additional
machinery was acquired for rs.40,000 on 30th september 2003 and for
rs.25,000 on 1st april 2005. Certain machinery which was purchased for
rs.40,000 on 30th september 2003 was sold for rs.34,000 on 30th september
2005. Give the machinery account for the year ending 31st march 2006
taking into account depreciation at 10% p.a. On the written down value.
Question 2:
A seven years lease has been purchased for a sum of rs.60,000
and it is proposed to depreciate it under the annuity method charging 4%
interest. Reference to the annuity table indicates that the required result
will be brought about by charging annually rs.9996.55 to depreciation
account. Show how the lease account will appear in each of the seven years.
Question 3:
Examine the need for providing depreciation.
2.1.3.11 Key To Self Assessment Questions
Question 1: Machinery Account
2005 2005
April 1 to balance b/d
1,43,550
Sep 30 by depreciation 1,710
Sep 30 to bank
25,000
by bank
34,000
to p&l a/c
1,510
2006 by depreciation 13,435
(profit on sale)
mar 31 by balance c/d 1,20,915
1,70,060
1,70,060
Question 2:
Interest for seven years:
1st year: rs.2,400; 2nd year: rs.2,096.14; 3rd year: rs.1,780.12; 4th year:
Rs.1,451.46; 5th year: rs.1,109.66; 6th year: rs.754.19; 7th year: rs.384.28.
2.1.3.12 Case Analysis
Pondicherry roadways ltd. Which depreciates its machinery at
10% p.a. On written down value desires to change the basis to straight
line method, the rate remaining the same. The decision is taken on 31st
december 2005 to be effective from 1st january 2003.
On 1st january 2005, the balance in the machinery account is rs.29,16,000.
On 1st july 2005, a part of machinery purchased on 1st january 2003 for
100
rs.2,40,000 was sold for rs.1,35,000. On the same day a new machine is
purchased for rs.4,50,000 and installed at a cost of rs.24,000.
Analyze the above case and answer the following questions:
(i)
What was the loss incurred on the machine sold?
(ii)
What was the book value of unsold machinery on 1-1-2003.
(iii)
What would be the additional depreciation due to change in
method?
(iv)
What should be the depreciation to be charged for 2005?
Answers:
(i) Rs.49,680
(ii) Rs.33,60,000
(iii)Rs.33,600
(iv)Rs.3,59,700
----
101
102
UNIT-II
Lesson 2.2: Ratio Analysis
2.2..1 Introduction
Financial statements by themselves do not give the required
information both for internal management and for outsiders. They
are passive statements showing the results of the business i.e. Profit or
loss and the financial position of the business. They will not disclose
any reasons for dismal performance of the business if it is so. What is
wrong with the business, where it went wrong, why it went wrong, etc.
Are some of the questions for which no answers will be available in the
financial statements. Similarly, no information will be available in the
financial statements about the financial strengths and weaknesses of
the concern. Hence, to get meaningful information from the financial
statements which would facilitate vital decisions to be taken, financial
statements must be analysed and interpreted. Through the analysis and
interpretation of financial statements full diagnosis of the profitability and
financial soundness of the business is made possible. The term ànalysis of
financial statements’ means methodical classification of the data given in
the financial statements. The term ìnterpretation of financial statements’
means explaining the meaning and significance of the data so classified. A
number of tools are available for the purpose of analysing and interpreting
the financial statements. This lesson discusses in brief tools like common
size statement, trend analysis, etc., and gives a detailed discussion on ratio
analysis.
2.2.2
After reading this lesson the reader should be able to:
understand the nature and types of financial analysis
know the various tools of financial analysis
understand the meaning of ratio analysis
ppreciate the significance of ratio analysis
understand the calculation of various kinds of ratios
calculate the different ratios from the given financial statements
interpret the calculated ratios
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2.2.3 Contents
2.2.3.1 Nature Of Financial Analysis
2.2.3.2 Types Of Financial Analysis
2.2.3.3 Tools Of Financial Analysis
2.2.3.4 Meaning And Nature Of Ratio Analysis
2.2.3.5 Classification Of Ratios
2.2.3.6 Capital Structure Or Leverage Ratios
2.2.3.7 Fixed Assets Analysis
2.2.3.8 Analysis Of Turnover (Or) Analysis Of Efficiency
2.2.3.9 Analysis Of Liquidity Position
2.2.3.10 Analysis Of Profitability
2.2.3.11 Analysis Of Operational Efficiency
2.2.3.12 Ratios From Share Holders’ Point Of View
2.2.3.13 Illustrations
2.2.3.14 Summary
2.2.3.15 Key Words
2.2.3.16 Self Assessment Questions
2.2.3.17 Key To Self Assessment Questions
2.2.3.18 Case Analysis
2.2.3.1 Nature Of Financial Analysis
The focus of financial analysis is on the key figures contained
in the financial statements and the significant relationship that exists
between them. “analyzing financial statements is a process of evaluating
the relationship between the component parts of the financial statements
to obtain a better understanding of a firm’s position and performance”.
The type of relationship to be investigated depends upon the objective and
purpose of evaluation. The purpose of evaluation of financial statements
differs among various groups: creditors, shareholders, potential investors,
management and so on. For example, short-term creditors are primarily
interested in judging the firm’s ability to pay its currently-maturing
obligations. The relevant information for them is the composition of
the short-term (current) liabilities. The debenture-holders or financial
institutions granting long-term loans would be concerned with examining
the capital structures, past and projected earnings and changes in the
financial position. The shareholders as well as potential investors would
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naturally be interested in the earnings per share and dividends per share
as these factors are likely to have a significant bearing on the market price
of shares. The management of the firms, in contrast, analyses the financial
statements for self-evaluation and decision making.
The first task of the financial analyst is to select the information
relevant to the decision under consideration from the total information
contained in the financial statements. The second step involved in
financial analysis is to arrange the information in such a way as to highlight
significant relationships. The final step is the interpretation and drawing
of inferences and conclusions. In brief, financial analysis is the process of
selection, relation and evaluation.
2.1.3.2 Types Of Financial Analysis
Financial analysis may be classified on the basis of parties who are
undertaking the analysis and on the basis of methodology of analysis. On
the basis of the parties who are doing the analysis, financial analysis is
classified into external analysis and internal analysis.
External Analysis:
When the parties external to the business like creditors, investors,
etc. Do the analysis, the analysis is known as external analysis. This analysis
is done by them to know the credit-worthiness of the concern, its financial
viability, its profitability, etc.
Internal Analysis:
This analysis is done by persons who have control over the books
of accounts and other information of the concern. Normally this analysis
is done by management people to enable them to get relevant information
to take vital business decision.
On the basis of methodology adopted for analysis, financial analysis may
be either horizontal analysis or vertical analysis.
105
Horizontal Analysis:
When financial statements of a number of years are analysed, then
the analysis is known as horizontal analysis. In this type of analysis, figures
of the current year are compared with the standard or base year. This
type of analysis will give an insight into the concern’s performance over a
period of years. This analysis is otherwise called as dynamic analysis as it
extends over a number of years.
Vertical Analysis:
This type of analysis establishes a quantitative relationship of the
various items in the financial statements on a particular date. For e.g. The
ratios of various expenditure items in terms of sales for a particular year
can be calculated. The other name for this analysis is `static analysis’ as it
relies upon one year figures only.
2.1.3.3 Tools Of Financial Analysis
The following are the important tools of financial analysis which
can be appropriately used by the financial analysts:
1. Common-size financial statements
2. Comparative financial statements
3. Trend percentages
4. Ratio analysis
5. Funds flow analysis
6. Cash flow analysis
Common-Size Financial Statements:
In this type of statements, figures in the original financial statements
are converted into percentages in relation to a common base. The common
base may be sales in the case of income statements (profit and loss account)
and total of assets or liabilities in the case of balance sheet. For e.g. In the
case of common-size income statement, sales of the traditional financial
statement are taken as 100 and every other item in the income statement is
converted into percentages with reference to sales. Similarly, in the case of
common-size balance sheet, the total of asset/liability side will be taken as
100 and each individual asset/liability is converted into relevant percentages.
106
Comparative Financial Statements:
This type of financial statements are ideal for carrying out
horizontal analysis. Comparative financial statements are so designed to
give them perspective to the review and analysis of the various elements of
profitability and financial position displayed in such statements. In these
statements, figures for two or more periods are compared to find out the
changes both in absolute figures and in percentages that have taken place in
the latest year as compared to the previous year(s). Comparative financial
statements can be prepared both for income statement and balance sheet.
Trend Percentages:
Analysis of one year figures or analysis of even two years figures will
not reveal the real trend of profitability or financial stability or otherwise
of any concern. To get an idea about how consistent is the performance of
a concern, figures of a number of years must be analysed and compared.
Here comes the role of trend percentages and the analysis which is done
with the help of these percentages is called as trend analysis.
Trend analysis:
Is a useful tool for the management since it reduces the large
amount of absolute data into a simple and easily readable form. The trend
analysis is studied by various methods. The most popular forms of trend
analysis are year to year trend change percentage and index-number trend
series. The year to year trend change percentage would be meaningful and
manageable where the trend for a few years, say a five year or six year
period is to be analysed.
Generally trend percentage are calculated only for some important
items which can be logically related with each other. For e.g. Trend ratio for
sales, though shows a clear-cut increasing tendency, becomes meaningful
in the real sense when it is compared with cost of goods sold which might
have increased at a lower level.
107
Ratio Analysis:
Of all the tools of financial analysis available with a financial analyst
the most important and the most widely used tool is ratio analysis. Simply
stated ratio analysis is an analysis of financial statements done with the
help of ratios. A ratio expresses the relationship that exists between two
numbers and in financial statement analysis a ratio shows the relationship
between two interrelated accounting figures. Both the accounting figures
may be taken from the balance sheet and the resulting ratio is called a
balance sheet ratio. But if both the figures are taken from profit and loss
account then the resulting ratio is called as profit and loss account ratio.
Composite ratio is that ratio which is calculated by taking one figure from
profit and loss account and the other figure from balance sheet. A detailed
discussion on ratio analysis is made available in the pages to come.
Funds Flow Analysis:
The purpose of this analysis is to go beyond and behind the
information contained in the financial statements. Income statement tells
the quantum of profit earned or loss suffered for a particular accounting
year. Balance sheet gives the assets and liabilities position as on a particular
date. But in an accounting year a number of financial transactions take
place which have a bearing on the performance of the concern but which
are not revealed by the financial statements. For e.g. A concern collects
finance through various sources and uses them for various purposes. But
these details could not be known from the traditional financial statements.
Funds flow analysis gives an opening in this respect. All the more, funds
flow analysis reveals the changes in working capital position. If there is an
increase in working capital what resulted in the increase and if there is a
decrease in working capital what caused the decrease, etc. Will be made
available through funds flow analysis.
Cash Flow Analysis:
While funds flow analysis studies the reasons for the changes in
working capital by analysing the sources and application of funds, cash
flow analysis pays attention to the changes in cash position that has taken
place between two accounting periods. These reasons are not available
in the traditional financial statements. Changes in the cash position can
108
be analysed with the help of a statement known as cash flow statement.
A cash flow statement summarises the change in cash position of the
concern. Transactions which increase the cash position of the concern are
labelled as ìnflows’ of cash and those which decrease the cash position as
òutflows’ of cash.
2.2.3.4 Meaning And Nature of Ratio Analysis
Ratio expresses numerical relationship between two numbers.
In the words of kennedy and mcmullen, “the relationship of one item to
another expressed in simple mathematical form is known as a ratio”. Thus,
the ratio is a measuring device to judge the growth, development and
present condition of a concern. It plays an important role in measuring the
comparative significance of the income and position statement. Accounting
ratios are expressed in the form of time, proportion, percentage, or per
one rupee. Ratio analysis is not only a technique to point out relationship
between two figures but also points out the devices to measure the
fundamental strengths or weaknesses of a concern. As james c.van horne
observes: “to evaluate the financial condition and performance of a firm,
the financial analyst needs certain yardsticks. One of the yardsticks
fre