Managerial Economics and Financial Analysis

Unit- V: Financial Accounting and Analysis

Syllabus: Introduction – Concepts and Conventions- Double-Entry Bookkeeping, Journal, Ledger, Trial Balance- Final
Accounts (Trading Account, Profit and Loss Account and Balance Sheet with simple adjustments). Introduction to
Financial Analysis, Analysis and Interpretation of Liquidity Ratios, Activity Ratios and Capital structure Ratios and
Profitability.

Financial Accounting:
 Financial accounting is the process of recording, summarizing, and reporting a company's financial
transactions to external stakeholders, like investors and creditors, through financial statements like the
balance sheet, income statement, and cash flow statement.
 Purpose:
 Financial accounting aims to provide a clear and accurate picture of a company's financial health and
performance to external users who need this information to make decisions.
 Key Activities:
o Recording: Financial accountants meticulously document all financial transactions, including sales,
purchases, payments, and other financial events.
o Summarizing: These transactions are then organized and summarized to create financial statements
that provide a concise overview of the company's financial position.
o Reporting: The financial statements are then prepared and disseminated to external stakeholders, such
as investors, creditors, and regulatory bodies.

Financial Statements: The primary financial statements used in financial accounting are:
 Balance Sheet: Provides a snapshot of a company's assets, liabilities, and equity at a specific point in
time.
 Income Statement: Reports a company's revenues, expenses, and net income (or loss) over a specific
period.
 Cash Flow Statement: Tracks the movement of cash and cash equivalents into and out of a company
over a specific period.
 Statement of Retained Earnings: Shows how a company's retained earnings (profits not distributed as
dividends) have changed over a period.
Importance: Financial accounting is crucial for:
 Transparency: It ensures that stakeholders have access to reliable information about a company's
financial performance.
 Decision-Making: Investors, creditors, and other stakeholders use financial statements to assess a
company's financial health and make informed decisions.
 Compliance: Financial accounting practices are governed by accounting standards to ensure accuracy
and consistency in reporting.

Accounting
Accounting is the process of recording financial transactions pertaining to a business. The accounting
process includes summarizing, analyzing, and reporting these transactions to oversight agencies,
regulators, and tax collection entities.
What is Accounting Process?
The primary objective of financial accounting is to record financial transactions to arrive at the results
of the operations of the business during a year. This is done by preparing financial
statements, i.e. Profit and Loss Account and Balance Sheet at the end of the year. For preparing
1
these financial statements, a business transaction has to pass through a number of stages in the
accounting process. This means when a business transaction occurs, the process begins to record the
transaction in the account books.
The accounting process is a series of steps that begin with a transaction taking place and ends with
closing of the account books at the end of the year. Because the complete sequence of accounting
procedure is repeated in the same order during each accounting year, it is also referred to as accounting
cycle.
Steps in Accounting Process
The main steps in the accounting process are described- These steps are:
1. Source documents
2. Journal
3. Ledger
4. Trial balance
5. Final accounts
1. Source Documents
The starting point in the accounting process is to record the transaction on the basis of a documentary
evidence. This means that the origin of a transaction is the source document. In other words, source
document is the voucher or written evidence on the basis of which transactions are recorded in the
books of account. Such voucher may be generated within the business or may flow into the business
from outside. Examples of vouchers are pay-in-slips of the bank deposit, cash memos, bills, invoices,
rent receipts, order received, etc. These documents are the foundation of all accounting records.

2. Journal in Accounting Process

Journal is a book of first entry. It is a preliminary book to provide a chronological record of
transactions in which each transaction is recorded with relevant supplementary information. Journal is
known as a book of original entry because the transactions are first recorded in journal and it is from
this record that various accounts are posted in the ledger. Journal is also known as subsidiary book or
day book. The process of recording transactions in journal is known as journalizing.
A standard form of a journal is given below :
Journal

Amount
L.F.
Date Particulars
(Ledger Folio)
Debit Credit
` `

Journal has the following five columns:

1. Date: This column records the date when transaction is entered in journal.
2. Particulars: In this column the accounts to be debited and credited are entered. The name of the
account to be debited is written first and in the next line, the account to be credited is written preceded
by the word ‘To’. A brief explanation of the transaction known as ‘Narration’ is also given below the
account to be credited. (see Illustration 3.1)
3. L.F. i.e. Ledger Folio means the page numbers of the ledger in which these accounts appear in the
ledger.
4. Debit (Dr): Amount In this column, amount to be debited is entered.
5. Credit (Cr): Amount In this column, amount to be credited is entered.

2
A. Recording in Journal
The transactions in journal are recorded on the basis of rules of debit and credit of double entry system.
All financial transactions are classified into three categories:
(i) transactions relating to persons,
(ii) transactions relating to business assets and properties, and
(iii) transactions relating to business expenses and incomes.
On the basis of this classification of transactions, accounts are classified as explained below.
B. Types of Accounts
There are three types of accounts, i.e., personal, real and nominal.

Types of Accounts
Note: One should know that short form of account is written as a/c.
(a) Personal Accounts: This includes:
(i) Accounts of natural persons, e.g., debtor’s a/c, creditor’s a/c, Ram’s a/c, etc.
(ii) Accounts of artificial persons and body of persons e.g., partnership firm’s a/c, company’s a/c, bank
a/c, club’s a/c, insurance company’s, etc.
(iii) Representative personal accounts: When an account represent a certain person, it is called
representative personal account. For example, if salary of 10 employees has not been paid, the total
amount due to these employees will be added and shown under one common account called ‘salaries
outstanding a/c’, but in the books the names of employees will appear. Therefore, salaries outstanding
a/c is a personal account because it represents certain persons. Similarly, insurance prepaid a/c, rent
outstanding a/c, interest accrued a/c, etc. are personal accounts.
(b) Real Accounts: These are accounts of things tangible or intangible, e.g., furniture a/c, cash a/c,
goodwill a/c, patent rights a/c, machinery a/c, land and building a/c, etc.
(c) Nominal Account: These are accounts of expenses (and losses) and incomes (and gains), e.g.,
interest paid a/c, wages a/c, interest earned a/c, commission a/c, rent a/c, discount a/c, profit on sale of
old machine a/c, etc.

C. Compound Journal Entries

Sometimes two or more transactions of the same nature take place on the same date. Instead of passing
a separate entry for each transaction, a combined entry (known as compound entry) may be passed to
record all these transactions. Such compound entries may be of three types:
1. One account to be debited and two or more accounts to be credited.
2. Two or more accounts to be debited and one account to be credited
3. Two or more accounts to be debited and two or more accounts to be credited.
3
3. Ledger in Accounting Process
The ledger is a set of accounts. In other words, the book which contains various accounts is known as
ledger. It may be a bound book or a set of loose leaf pages or punched cards. Each account is opened on
a separate page or card in the ledger.
A ledger has the following columns:

Dr. Name of the Account Cr.

Journal Amount Journal Amount

Date Particulars Date Particulars
Folio (JF) ` Folio (JF) `

Features or Points to be noted in the ledger:

1. Every account in the ledger has a name which is written at the top of the account.
2. Ledger account is divided in two equal parts. The left side part is known as debit (Dr.) side and the
right side is known as credit (Cr.) side.
3. JF column denotes the page (folio) number on which journal entry of this transaction has been
recorded.
6.2 Distinction between Journal and Ledger
The main points of distinction between journal and ledger are as under :
6.2.1 Subsidiary Book and Principal Book
Journal is a subsidiary book. It is also called a book of original entry or first entry. Ledger is the
principal book, also known as a book of second entry. In other words, journal an original record while
ledger is a derived record.
6.2.2 Chronological and Analytical Record
Journal is a chronological record of day-to-day business transactions while a ledger is an analytical
record of these transactions.
6.2.3 Narrations
Journal entries are supported by narrations to help in properly understanding the entries. Ledger entries
are not supported by narrations.
6.2.4 Balancing
Journal is not balanced while ledger accounts are balanced.
6.3 Ledger Posting
The process of transferring the debits and credits from the journals to the ledger accounts is called
posting. Each amount listed in the debit column of the journal is posted by entering it on the debit side
of the account in the ledger and each amount listed in the credit column of the journal is posted to the
credit side of the ledger account. The following sequence is used for posting to ledger:
(i) Open (or locate) in the ledger the first account named in the journal entry.
(ii) Enter in the debit column of the ledger account the amount of the debit as shown in the journal. It is
customary to write ‘To’ on the debit side with the name of the account and ‘By’ on the credit side with
the name of the account.
(iii) Enter the date of the transaction in the date column of the ledger account.
(iv) Enter in journal folio column the number of the journal page from which the entry is being posted.
(v) The recording of the debit in the ledger account is now complete. Return to the journal and enter in
the ledger folio column, the number of the ledger page to which the debit was posted.
(vi) Repeat the above five steps for the credit side of the journal entry.

4
The two ledger accounts affected by this entry are:
1. Cash Account
2. Sales Account
These two accounts will appear in the ledger as follows :

Dr. Sales Account Cr.

Journal Amount Date Journal Amount

Date Particulars Particulars
Folio ` 2013 Folio `

Jan.
By Cash 10 840
1

4. Balancing of Ledger Accounts

Balancing is the process of equalizing the two sides of an account. After posting has been completed,
the difference between the totals of debit and credit sides is ascertained. This is known as balancing of
accounts. If the total of the debit side is more than that of credit side, it is said to have a debit balance
and vice versa, if credit side total is more than that of debit side, it is a case of credit balance. The
difference between the two is placed on the shorter side by writing “To or By Balance c/d” so that the
two sides become equal. Thus the total of the bigger side is written on both sides. In the next period, the
account will start with the balance as “To or By Balance brought down”. This is written on the side
which has a bigger total.
If the totals of the two sides are equal, the account is said to be in balance.
5. Trial Balance in Accounting Process
When all ledger accounts have been prepared and balanced off, a list of all debit balances and credit
balances is prepared. In double entry system, the debits must be equal to credits. In other words, the
total of the debit balances must be equal to the total of the credit balances. The proof of the equality of
debit balances and credit balances is called a ‘Trial Balance’. Thus a trial balance may be defined as ‘a
two-column schedule listing the balances of all the accounts as they appear in the ledger. The debit
balances are listed in the left hand column and the credit balances in the right hand column’. The total
of the two columns should agree. If the debit side and credit side of the trial balance are equal, it is
proved that the account books are arithmetically correct. But it is not a conclusive proof that there no
errors.

Objectives
The main objectives of preparing a trial balance are follows:
1. To test the arithmetic accuracy. When a trial balance agrees, it is taken as a proof that double entry of
all transactions is complete and arithmetically the books of account are correct. But it should not be
taken as a conclusive proof that there no errors because certain errors are not disclosed by trial balance.
2. To detect errors. When the total of the debit balances is not equal to the total of the credit balances, it
means that there are certain errors.
3. To provide data for preparing financial statements. Profit and Loss Account and Balance Sheet are
prepared on the basis of trial balance data and additional information.
7.2 Solution

5
 Debit and Credit Items in Trial Balance

Debit Balances Credit Balances

Personal Accounts Personal Accounts

Bank Capital

Sundry debtors Bank (overdraft)

Drawings Sundry creditors

Loan (given) Loan (taken)

Prepaid insurance or other expenses Outstanding wages or other expenses

Real Accounts Real Accounts

Opening stock Sales

Purchases Purchases returns

Sales returns Nominal Accounts

Plant Discount received

Furniture Cash Dividend received

Goodwill Commission received

Investments Interest received and other incomes

Other fixed assets received

Nominal Accounts Provisions and reserves

Wages, salaries, bad debts and other expenses and

losses

Single-entry bookkeeping and Double-entry bookkeeping

What is single-entry bookkeeping?
Single-entry bookkeeping is a simple and straightforward method of bookkeeping in which each
transaction is recorded as a single-entry in a journal. This is a cash-based bookkeeping method that tracks
incoming and outgoing cash in a journal.
How does the single-entry system work?
In single-entry bookkeeping, you maintain a cash book in which you record your income and
expenses. Start with your existing cash balance for a given period, then add the income you receive and
subtract your expenses. After you factor in all these transactions, at the end of the given period, you
calculate the cash balance you are left with.
6
A typical cash book will have the following information:
 Date: The date on which the transaction takes place
 Description: A brief note on the transaction
 Transaction value: The value can be either incoming (debit) or outgoing (credit)
 Balance: Running total of how much cash you have in hand
In the following example, suppose you’re a business owner recording the debit and credit entries for all
of the transactions that take place in a week.
1. Let’s assume you have a $5000 cash balance at the beginning of the first week in June. So this will be
your first entry.
2. On the second day of the week you pay your rent, which is $1000. Since this is an expense, you
subtract this amount from your cash balance. This leaves you with $4000.
3. Your customer pays an invoice for $500, which is income. So this amount is debited to your account
and raises the account balance to $4500.
4. You buy office furniture for $1500. So you subtract this amount from the existing balance.
5. At the end of the week, you are left with $3000 in cash.

What is double-entry bookkeeping?

Double-entry bookkeeping is a method of recording transactions where for every business transaction, an
entry is recorded in at least two accounts as a debit or credit. In a double-entry system, the amounts
recorded as debits must be equal to the amounts recorded as credits.
How does the double-entry system work?
The key feature of this system is that the debits and credits should always match for error-free
transactions.
The double-entry bookkeeping system works on the basic accounting equation, which is as follows:

Assets: The money that the company owns

Liabilities: Anything that the business owes
Owner’s equity: Owner’s investment in the company

7
Income: Money the business earns by selling its products
Expense: Money the company spends to run the business
You should always remember that each side of the equation must balance out. This is how we arrive at
the term “balancing the books.” A small example will help you understand this equation.
Let us take the same example that we used above, but this time use double-entry bookkeeping.
Assume you are recording debit and credit entries for the transactions that take place in a week, using
double-entry bookkeeping.
The starting balance for the week is $5000. In one week, you pay your rent ($1000).

You purchase some office furniture ($1500).

Meanwhile, Excel Technologies pays an invoice with a value of $500.

If you look at all three transactions, you can observe that total credit and total debit are the same: they
both add up to $3000.

What documents are used to record entries?

In single-entry bookkeeping, the income and expenses for the transactions are recorded in a cash register,
whereas the double-entry system starts with a journal, followed by a ledger, a trial balance, and finally
financial statements.
1. Journal: This is an accounting book where the transactions are recorded sequentially, in
chronological order. It need not be balanced.
2. Ledger: This is a book of final entries where the transactions are divided and recorded in separate
accounts. It must be balanced.
3. Trial balance: This is a bookkeeping worksheet that reflects the credit and debit balance of all ledger
accounts. One of the important features of the trial balance is that it maintains the arithmetic accuracy
of transactions.
4. Financial statements: These are a collection of summary-level reports that reflect the organization’s
financial results, position, and cash flow.

How is double-entry bookkeeping better than single-entry?

The double-entry system has several advantages over the single-entry system:
1. Recording method: Single-entry bookkeeping gives a one-sided picture of transactions recorded in
the cash register. In double entry, changes due to one transaction are reflected in at least two
accounts. The double-entry system is preferred by investors, banks and buyers because it gives them a
more complete financial picture of an organization.

8
2. Error detection: In double entry, debits and credits must always be the same. If that is not the case,
then there is an error. This makes it easy to spot errors and ensure that they are not carried forward to
other journals and financial statements. In single entry, there is no method for error correction or
detection.
3. Company size: The single-entry system is only appropriate for small enterprises, whereas the double-
entry system can be used by all sizes of businesses, including large ones.
4. Preparation of financial statements: The information recorded in a single-entry system isn’t
adequate for financial reporting or preparing profit and loss statements. Bigger organizations rely on
these reports to track their performance, so they need the extra information captured by double-entry
accounting.

What Is Financial Analysis?

A company's success is measured by its financials. Their accounts and statements contain a lot of
information represented in figures. Financial analysis aims to turn these numbers into actionable intel.
Ratios are generally preferred over looking at individual numbers. Relationships between different
pieces of financial data are explored by dividing one figure on a financial statement by another. The
results can then be compared against the company’s historical performance or other companies.
Financial analysis also tries to be forward-thinking, which involves extrapolating from the data for
projections.
Who Uses Financial Analysis?
Other than company leaders, many stakeholders—investors, investment analysts, lenders, and
auditors—have an interest in financially analyzing a firm.
Investors and Analysts
Investors and analysts assess a company’s financials to determine if investing in it or lending money
to it is worthwhile. They undertake ratio analysis, examining liquidity, cash flow, leverage, and
profitability to see if the company is healthy and well-run compared with its past performance or peer
firms. Analysts and investors will also want to know if the company is being fairly valued—an
important fact not just for the stock market but also for auditors, unions, regulators, and private equity
firms.
Company Management
Accountants and others within a company analyze financial data to improve business decision-making.
Analyzing financials can help identify weaknesses before they turn into a crisis and is also used to set
budgets, ensure the right amount of inventory is ordered, assess the return on investment on specific
strategies, and calculate a fair price to pay for an asset or acquisition.

Liquidity Ratios: Meaning, Examples, and Calculations

A Liquidity Ratio measures a company’s ability to cover its short-term obligations using its “most
liquid” assets (i.e., the assets that are easiest to turn into cash quickly). There are several types of
liquidity ratios, and each includes different components of a company’s assets and liabilities.
What Are Liquidity Ratios?
The three most common liquidity ratios include:
1) Current Ratio: This assesses a company’s ability to pay off its short-term liabilities with all its
current assets, including Inventory, which may be more difficult to convert into Cash quickly. The
formula is:
Current Ratio = Current Assets / Current Liabilities
Here’s an example calculation for Illinois Tool Works [ITW]:
2) Quick Ratio: Measures a company’s ability to meet its short-term obligations using only its most-
liquid assets: Cash & Cash-Equivalents and Accounts Receivable. The formula is:
9
 Quick Ratio = (Cash & Cash-Equivalents + Accounts Receivable) / Current Liabilities
And here’s the calculation for the same company:
3) Cash Ratio: A stricter liquidity ratio that compares only Cash and Cash-Equivalents to the
company’s obligations. The formula is:
Cash Ratio = (Cash + Cash-Equivalents) / Current Liabilities
4) Working Capital / Revenue: This ratio highlights the relationship between a company’s operational
capital (working capital) and its sales. A higher ratio could suggest that a company requires more
capital to generate sales, which might indicate a greater need to borrow or raise outside funding.
5) Change in Working Capital / Change in Revenue: This ratio tells you how much the company
needs to re-invest in its operations to grow its net sales. It’s particularly useful for businesses in growth
phases or undergoing significant operational shifts, and it is often used as a driver in financial models,
such as the DCF, to project a company’s Free Cash Flow.
6) Net Debt, Debt / Total Capital, and Net Debt / Net Capital: While these aren’t pure liquidity
ratios, they are important in understanding a company’s financial structure, leverage, and overall risk.
For instance, high Net Debt might indicate some refinancing risk for the company when its Debt
matures and needs to be repaid.

Activity Ratios:
Activity ratios are used to determine the efficiency of the organization in utilizing its assets for
generating cash and revenue. It is used to check the level of investment made on an asset and the
revenue that it is generating. For this reason, the activity ratio is also known as the efficiency ratio or
the more popular turnover ratio.
The role of activity ratio or turnover ratio is in the evaluation of the efficiency of a business by careful
analysis of the inventories, fixed assets and accounts receivables.
Let us discuss the types of activity ratios.

Types of Activity Ratios

1. Stock Turnover ratio or Inventory Turnover Ratio
2. Debtors Turnover ratio or Accounts Receivable Turnover Ratio
3. Creditors Turnover ratio or Accounts Payable Turnover Ratio
4. Working Capital turnover ratio.
5. Investment Turnover Ratio
The following are discussed below.
1. Stock Turnover Ratio
This is one of the most important turnover ratios which highlights the relationship between the
inventory or stock in the business and cost of the goods sold. It shows how fast the inventory gets
cleared in an accounting period or in other words, the number of times the inventory or the stock gets
sold or consumed. For this reason, it is also known as the inventory turnover ratio.
It is calculated by the following formula
Stock Turnover Ratio = Cost of Goods Sold / Average Inventory
A high stock turnover ratio is indicative of fast moving goods in a company while a low stock turnover
ratio indicates that goods are not getting sold and are being stored at warehouses for an extended period
of time.
2. Debtor Turnover Ratio
This ratio is an important indicator of a company which shows how well a company is able to provide
credit facilities to its customers and at the same time is also able to recover the due amount within the
payment period.

10
 It is also known as accounts receivable turnover ratio as the payments for credit sales that will be
received in the future are known as accounts receivables.
The formula for calculating Debtor Turnover ratio is
Debtor Turnover Ratio = Credit Sales / Average Debtors
A higher ratio indicates that the credit policy of the company is sound, while a lower ratio shows a
weak credit policy.
3. Creditors Turnover Ratio
Creditors turnover ratio is a measure of the capability of the company to pay off the amount for credit
purchases successfully in an accounting period.
It shows the number of times the account payables are cleared by the company in an accounting period.
For this reason, it is also known as the Accounts payable turnover ratio.

The formula for calculating creditors turnover ratio is

Creditors Turnover ratio = Net Credit Purchases / Average Creditors
Where average creditors are also known as average accounts payable.
A high ratio is indicative that a company is able to finance all the credit purchases and vice versa.
4. Working Capital Turnover Ratio
This ratio is helpful in determining the effectiveness with which a company is able to utilise its working
capital for generating sales of its goods.
The formula for calculating working capital turnover ratio is
Working capital turnover ratio = Sale or Costs of Goods Sold / Working Capital
If a company has a higher level of working capital it shows that the working capital of the business is
utilized properly and on the other hand, a low working capital suggests that business has too many
debtors and the inventory is unused.

5. Investment Turnover Ratio or Net Asset Turnover Ratio

Investment Turnover Ratio is related to the sales taking place in the business and the net assets or the
capital employed. It determines the ability of the business to generate sales revenue by the use of net
assets of the business. The ratio is calculated using the following formula
Investment Turnover Ratio = Net Sales/ Capital Employed

Capital structure:

What is Capital Structure

The most crucial component of starting a business is capital. It acts as the foundation of the company.
Debt and Equity are the two primary types of capital sources for a business. Capital structure is defined
as the combination of equity and debt that is put into use by a company in order to finance the overall
operations of the company and for its growth.
Types of Capital Structure
The meaning of Capital structure can be described as the arrangement of capital by using different
sources of long term funds which consists of two broad types, equity and debt. The different types of
funds that are raised by a firm include preference shares, equity shares, retained earnings, long-term loans
etc. These funds are raised for running the business.
Equity Capital
Equity capital is the money owned by the shareholders or owners. It consists of two different types
a) Retained earnings: Retained earnings are part of the profit that has been kept separately by the
organization and which will help in strengthening the business.

11
b) Contributed Capital: Contributed capital is the amount of money which the company owners have
invested at the time of opening the company or received from shareholders as a price for ownership of the
company.
Debt Capital
Debt capital is referred to as the borrowed money that is utilised in business. There are different forms of
debt capital.
1. Long Term Bonds: These types of bonds are considered the safest of the debts as they have an
extended repayment period, and only interest needs to be repaid while the principal needs to be
paid at maturity.
2. Short Term Commercial Paper: This is a type of short term debt instrument that is used by
companies to raise capital for a short period of time
Optimal Capital Structure
Optimal capital structure is referred to as the perfect mix of debt and equity financing that helps in
maximizing the value of a company in the market while at the same time minimizes its cost of capital.
Capital structure varies across industries. For a company involved in mining or petroleum and oil
extraction, a high debt ratio is not suitable, but some industries like insurance or banking have a high
amount of debt as part of their capital structure.
Financial Leverage
Financial leverage is defined as the proportion of debt that is part of the total capital of the firm. It is also
known as capital gearing. A firm having a high level of debt is called a highly levered firm while a firm
having a lower ratio of debt is known as a low levered firm.
Importance of Capital Structure
Capital structure is vital for a firm as it determines the overall stability of a firm. Here are some of the
other factors that highlight the importance of capital structure
1. A firm having a sound capital structure has a higher chance of increasing the market price of the
shares and securities that it possesses. It will lead to a higher valuation in the market.
2. A good capital structure ensures that the available funds are used effectively. It prevents over or
under capitalization.
3. It helps the company in increasing its profits in the form of higher returns to stakeholders.
4. A proper capital structure helps in maximising shareholder’s capital while minimising the overall
cost of the capital.
5. A good capital structure provides firms with the flexibility of increasing or decreasing the debt
capital as per the situation.
Factors Determining Capital Structure
Following are the factors that play an important role in determining the capital structure:
1. Costs of capital: It is the cost that is incurred in raising capital from different fund sources. A firm
or a business should generate sufficient revenue so that the cost of capital can be met and growth
can be financed.
2. Degree of Control: The equity shareholders have more rights in a company than the preference
shareholders or the debenture shareholders. The capital structure of a firm will be determined by
the type of shareholders and the limit of their voting rights.
3. Trading on Equity: For a firm which uses more equity as a source of finance to borrow new funds
to increase returns. Trading on equity is said to occur when the rate of return on total capital is
more than the rate of interest paid on debentures or rate of interest on the new debt borrowed.
4. Government Policies: The capital structure is also impacted by the rules and policies set by the
government. Changes in monetary and fiscal policies result in bringing about changes in capital
structure decisions.

The formula to determine a company's capital structure, expressed in percentage form, is as follows.
Where:
12
 Common Equity Weight (%) = Common Equity ÷ Total Capitalization.
Debt Weight (%) = Total Debt ÷ Total Capitalization.

Profitability:
Profitability is a measure of how efficiently a business converts its expenses into profits for its owners.
Profit margin is perhaps the most common profitability measurement. It shows what portion of each sale
goes toward meeting costs, and what portion goes into the bank.
What Is Profitability?
Profitability is a measurement of efficiency. It is not an absolute number. Rather, it's a metric used to
determine the scope of a company's profit compared to the size of the business and ultimately its success
or failure.
Profitability ratios : os
Profitability ratios are a type of accounting ratio that helps in determining the financial performance of
business at the end of an accounting period. Profitability ratios show how well a company is able to make
profits from its operations.
Let us now discuss the types of profitability ratios.
Types of Profitability Ratios
The following types of profitability ratios are discussed for the students of Class 12 Accountancy as per
the new syllabus prescribed by CBSE:
1. Gross Profit Ratio
2. Operating Ratio
3. Operating Profit Ratio
4. Net Profit Ratio
5. Return on Investment (ROI)
6. Return on Net Worth
7. Earnings per share
8. Book Value per share
9. Dividend Payout Ratio
10. Price Earning Ratio
Gross Profit Ratio
Gross Profit Ratio is a profitability ratio that measures the relationship between the gross profit and net
sales revenue. When it is expressed as a percentage, it is also known as the Gross Profit Margin.
Formula for Gross Profit ratio is
Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100
A fluctuating gross profit ratio is indicative of inferior product or management practices.
Operating Ratio
Operating ratio is calculated to determine the cost of operation in relation to the revenue earned from the
operations.
The formula for operating ratio is as follows
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/
Net Revenue from Operations ×100
Operating Profit Ratio
Operating profit ratio is a type of profitability ratio that is used for determining the operating profit and
net revenue generated from the operations. It is expressed as a percentage.
The formula for calculating operating profit ratio is:
Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100
Or Operating Profit Ratio = 100 – Operating ratio

13
Net Profit Ratio
Net profit ratio is an important profitability ratio that shows the relationship between net sales and net
profit after tax. When expressed as percentage, it is known as net profit margin.
Formula for net profit ratio is
Net Profit Ratio = Net Profit after tax ÷ Net sales
Or
Net Profit Ratio = Net profit/Revenue from Operations × 100
It helps investors in determining whether the company’s management is able to generate profit from the
sales and how well the operating costs and costs related to overhead are contained.

Profitability vs. Profit

As noted above, profitability is a metric used to determine the success or failure of a company. It is
closely related to profit with one key difference. While profitability is a relative concept, profit is an
absolute amount. As such, profit is determined by the amount of income or revenue above and beyond
the costs or expenses a company incurs.

Difference between Profit and Profitability:

Profit Profitability

Interpretation by Businesses

Profit is measured by a total amount. Profitability can be interpreted in the form of a percentage.
Comparison of the Two

Profit cannot be compared as it is not Profitability can be measured by the use of ratios.
relative.
Expression

Profits are the net gain made after Profitability is based on the extent to which a business
deducting all expenses. makes or earns its profits.

**************

14