UNIT-V

INTRODUCTION TO FINANCIAL ACCOUNTING

Meaning of Accounting

Accounting is a process of recording, classifying and summarizing business transactions which are
of financial character and analyzing and interpreting and communicate the results to interested
parties.
Definitions of Accounting:

According to Smith and Ashburne, “Accounting is the science of recording and

classifying business transactions and events, primarily of financial character and art of making
significant summaries, analysis and interpretations of those transactions and events and
communicating the results to persons who must make decisions or form judgments”.

According to committee on terminology of American Institute of Certified

Public Accountants (AICPA), “Accounting is the art of recording, classifying andsummarizing in a
significant manner and in terms of money transactions and events which are in part, at least of
financial character and interpreting the results thereof.”

Another definition given by the same professional body, namely, AICPA stated
that: “Accounting is the collection, measurement, recording, classification and communication of
economic data relating to an enterprise for the purpose of reporting, decision making and control.

In 1966, the American Accounting Association defined accounting as follows:

“Accounting is the process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by the users of the information.”

Functions / Nature of Financial Accounting:

1. Systematic record of business transactions / Recording: Recording is the basic function of

accounting. Accounting records business transactions in terms of money. It is essentially concerned
with ensuring that all business transactions of financial nature are properly recorded. Recording is
done in Journal in chronological order. To keep systematic record of transactions, post them into
ledger and ultimately to prepare the final accounts is the first function of accounting.

2. Classifying: Accounting also facilitates classification of all business transactions recorded in the
journal. Items of similar nature are classified under appropriated heads. It deals withclassification of
recorded transactions so as to group similar transactions at one place. The work of classification is
done in a book called the Ledger, where similar transactions are recorded at one place under
individual account heads. Eg. In sales account all sale of goods are recorded. In purchases account all
purchase of goods are recorded.

3. Summarizing: It involves presenting classified transactions in a manner useful to both its internal
 and external users. It involves preparation of financial statements i.e profit& loss account and
Balance sheet etc., Accounting summarizes the classified information. This process leads to the
preparation of Trial balance, Income statement and balance sheet.

4. Analyzing: The recorded data in financial statement is analyzed to make useful interpretation.
The figures given in financial statements need to be put in a simplified manner. Eg. All items
relating to fixed assets are placed at one place while long term liabilities areplaced at one place.

5. Interpretation: It deals with explaining the meaning and significance of the data simplified. The
accountants should interpret the statements in a manner useful to the users. Interpretation of data
helps management, outsiders and shareholders in decision making. It aims at drawing meaningful
conclusions from the information. Different parties can make meaningful judgments about the
financial condition and profitability of business operations.

6. Communicating Results to Interested Parties: Accounting also serves as an information system.

It is the language of the business. It supplies the meaningful information about the financial activities of
the business to varies parties i.e., owners, creditors, investors, employees, government, public, research
scholars and managers at the right time. It is a service function. It is not an end itself but a means
to an end. It involves preparation and distribution of reports to the users to make decisions.
Significance of Accounting:
Maintaining proper/systematic record of Business Transactions: Accounting replaces the limitations
of human memory. The main purpose of accounting is to identify business transactions of financial nature
and enter them into appropriate books of accounts. Accounting helps to keep record of all financial
transactions and events systematically in proper books of accounts.

To ascertain the financial results of the enterprise: One of the main important of accounting is to
ascertain or calculate the profit or loss of the businessenterprise. Income statements are prepared with the
help of trial balance (prepared with the balances of ledger accounts). At the end of the accounting period,
we prepare trading account and ascertain gross profit or gross loss. Afterwards profit and loss account is
prepared to ascertain net profit or net loss.

To ascertain financial position or financial health of the business: At the end of the accounting
period, we prepare position statement. Balance sheet is a statement of assets and liabilities of the business
on a particular date and serves as a parameter to measure the financial health of the business.

To help in decision making: Accounting serves as an information system for helping to arrive at
rational decisions. American Accounting Association also stresses upon this point while defining the
term Accounting as “the process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by the users of the information. Accounting keeps systematic
record of all transactions and events which are used to assist the management in its function of decision
making and control.

Providing Effective Control over the Business: Accounting reveals the actual performance of the
business in terms of production, sales, profit, loss, cost ofproduction and the book value of the sundry
assets. The actual performance can be compared with the planned and or desired performance of the
business. It can also becompared with the previous performance. Comparison reveals deviation in
terms ofweaknesses and plus points.
Making Information to various groups: Accounting makes information available to all these interested
parties. Proprietors have interest in profit or dividend, debenture holders, lenders and investors are
concerned with the safety of money advanced by them to the business and interest thereon. The object of
the accounting is to provide meaningful information to all these interested parties.
Advantages of Accounting:

Replacement of memory: In a large business it is very difficult for a business- man to remember all
the transactions. Accounting provides records which will furnishinformation as and when desired
and thus it replaces human memory. All financial transactions are recorded in a systematic manner
in books of accounts so that there is no need to relay on memory.

Evidence in court: Properly maintained accounts are often treated as good evidence in the
court to settle a dispute.

Settlement of taxation liability: If accounts are properly maintained, it will be of great assistance
to the businessman in settling the income tax and sale tax liabilityotherwise tax authorities may
impose any amount of tax which the businessman will have to pay.

Comparative study: Accounting provides the facility of comparative study of the various aspects
of the business such as profits, sales, expenses etc. with that of previous year and helps the business
man to locate significant factor leading to the change, if any. Systematic maintenance of business
records enables the accountant to compare the profit of one year with those of earlier year‟s profits
and to know the significant facts about the changes. This helps the business to plan its future affairs
accordingly.

Sale of the business: If accounts are properly maintained, it helps to ascertain the proper
purchase price in case the businessman is interested to sell his business.
Assistance to the insolvent person: If a person is maintaining proper accounts and unfortunately he
becomes insolvent (i.e., when he is unable to pay to his creditors), he can explain many things about
the past with the help of accounts and can start a fresh life.

Assistance to various interested parties: It provides information to various interested parties, i.e.,
owners, creditors, investors, government, managers, research scholars, public and employees and
financial position of a business enterprise from their own view point. Various interested parties or
groups are interested in accounting information related to various aspects viz., sales, production, profit
etc. Accounting provides suitable information to such interested parties.

Preparation of Financial Statements: Systematic records enable the accountant to prepare financial
statements. Trading and Profit and Loss account is prepared for calculating profit or loss during a
particular period and Balance sheet is prepared to state the financial position of the business on a
particular date.

Decision Making: The accountant helps the management by providing the relevant information for
solving the day to day problems of the business.

Planning and Control of Operations: Planning operations like sales, production, cash requirements for
the next account period are achieved with the help ofaccounting information and estimates can be
prepared based on that information.
 Value of Business: Accounting records kept in a proper way enables a business unit to determine the
purchase or sale value of the business in a simple manner.

Limitations or disadvantages of Accounting:

Records only monetary transactions: Accounting records only those transactions which can be
measured in monetary terms. Those transactions which cannot be measured in monetary terms as
conflict between production manager and marketing manager, office management etc., may be
very important for concern but not recordedin the business books.

Effect of price level changes not considered: Accounting transactions are recorded at cost in the
books. The effect of price level changes is not brought into the books with the result that
comparison of various years becomes difficult. For example, the sales to total assets in 2007 would
be much higher than in 2003 due to rising prices, fixed assets being shown at cost and not at market
price.

No realistic information: Accounting information may not be realistic as accounting statements

are properly prepared by following basic concepts and conventions. Forexample, going
concern concept gives us an idea that the business will continue and assets are to be recorded at
cost but the book value which the asset is showing may not be actually realizable. Similarly, by
following the principles of conservation the financial statements will not reflect the true position of
the business.

No real test of managerial performance: Profit earned during an accounting period is the test of
managerial performance. Profit may be shown in excess by manipulation of accounts by
suppressing such costs as depreciation, advertisement and research and development or taking
excess value of closing stock.

Historical in nature: Usually accounting supplies information in the form of Profit and Loss
Account and Balance Sheet at the end of the year. So, the information provided is of historical
interest and only gives post-mortem analysis of the past accounting information. For control and
planning purposes management is interested in quick and timely information which is not provided
by financial accounting.

Personal bias / judgment of Accountant affects the accounting Statements: Accounting

statements are influenced by the personal judgment of the accountant. He may select any method of
depreciation, valuation of stock, amortization of fixed assets and treatment of deferred revenue
expenditure. Such judgment based on integrity and competency of the accountant will definitely
affect the preparation of accounting statements.

Permits alternative treatments: Accounting permits alternative treatments within generally

accepted accounting concepts and conventions. For example, method of charging depreciation may
be straight line method or diminishing balance method or some other method. Similarly, closing
stock may be valued by FIFO(First-in-First Out) or LIFO(Last in First Out) or Average Price
Method. Application of different methods may give different results and results may not be
comparable.

Process of Accounting:
Accounting Process consists of the following stages:
 1. Recording of entries for all business transactions in Journal.
2. Posting of entries into Ledger.
3. Balancing of accounts.
4. Preparing of Trial Balance with the help of different accounts to know the
arithmetical accuracy.
5. Preparing final accounts with the help of Trial Balance.
- Trading and Profit and Loss Account is prepared to know the Profit or Loss.
- Balance Sheet is prepared to know the financial position of the Business concern.
Accounting Process is also known as accounting cycle.

Accounting Cycle:

An Accounting cycle is a complete sequence beginning with the recording of the transactions
and ending with the preparation of the final accounts. The sequential steps involved in an
accounting cycle are as follows:

Journalizing

Balance Posting
Sheet

ACCOUNTING CYCLE

Income Balancing
Statement
Trial Balance

Accounting Cycle Chart:

Step 1: Journalizing: Record the transactions and events in the Journal.

Step 2: Posting: Transfer the transactions in the respective accounts opened in the ledger.

Step 3: Balancing: Ascertain the difference between the total of debit amount column and
the total of credit amount column of a ledger account.

Step 4: Trial Balance: Prepare a list showing the balance of each and every account to
verify whether the sum of the debit balances is equal to the sum of the credit balances.

Step 5: Income Statement: Prepare Trading and Profit and Loss account to ascertain the
profit or loss for accounting period.

Step 6: Balance Sheet: Prepare the Balance Sheet toascertain the financial position
as at the end of accounting period.
Double Entry System
Double entry system is a scientific way of presenting accounts. As such all the business concerns
feel it convenient to prepare the accounts under double entry system. The taxation authorities also
compel the businessmen to prepare the accounts under Double Entry System. Under dual
aspect the Account deals with the two aspects of business transaction i.e., (1) Receiving
Aspect and (2) Giving Aspect. Receiving Aspect is known as Debit aspect and Giving Aspect is
known as Credit aspect. Under which system these two aspects of transactions are recorded in
chronological manner in the books of the business concern is known as Double Entry System. In
Double Entry System these two aspects are recorded facilitating the preparation of Trial Balance
and the Final Accountsthere from.

Principle of Double Entry System

Every business transaction has got two accounts, where one account is debited and the other
account is credited. If one account receives a benefit, there should be another account to
impart/give the benefit. The principle of Double Entry is based on the fact that there can be no
giving without receiving nor can there be receiving without something giving. The receiving
account is debited (i.e., entered on the debit side of the account) and the giving account is
credited (i.e., entered on the credit side of the account).

The principle under which both debit and credit aspects are recorded is known asthe principle
of double entry. According to this principle every debit must necessarily have a corresponding
credit and vice versa.

Advantages of Double Entry System:

1. Scientific system: Double entry system records, classifies and summarizes business
transactions in a systematic manner and, thus, produces useful information for decision makers.
It is more scientific as compared to single entry of book-keeping.

2. Full Information: Full and authentic information can be had about all transactions as the trader
maintains the ledger with all types of accounts.

3. Assessment of Profit and Loss: The businessman/trader will be able to know correctly whether
he had earned profit or sustained loss. It facilitates the trader to take such steps so as to increase
the efficiency of the firm.

4. Knowledge of Debtors: The trader will be able to know exactly what amounts are owed by
different customers to the firm. If any amount is pending for a long time from any customer, he
may stop credit facility to that customer.

5. Knowledge of Creditors: The trader is also knows the exact amounts owed by the firm to
others and he will be able to arrange prompt payment to obtain cash discount.

6. Arithmetical Accuracy: The arithmetical accuracy of the books can be proved by the trial
balance.
7. Assessment of Financial Position: The trader will be able to prepare the Balance Sheet which
will help the interested parties to know fully about the financial position of the firm.

8. Comparison of Results: It facilitates the comparison of current year results with those of
previous years.

9. Maintenance according to Income Tax Rules: Proper maintenance of books willsatisfy

the tax authorities and facilitates accurate assessment. In India Joint stock companies should
maintain accounts under double entry system.

10. Detection of Frauds: The systematic and scientific recording of business transactions on the
basis of this system minimizes the chances of embezzlement and frauds or errors. The frauds or
errors can be easily detected by vouching, verification and auditing of accounts .

Limitations / Disadvantages of Double Entry System:

The Double Entry System however may not provide any solution to the following errors.

1. Not Practical to All Concerns: This system requires the maintenance of a number of books of
accounts which is not practical in small concerns.

2. Costly system: This system is costly because of a number of records are to be maintained.

3. No guarantee of Absolute Accuracy of the Books of Account: There is no guarantee of

absolute accuracy of the books of account inspite of agreement of the trial balance because of there
are some errors like errors of principles, errors of omission, compensating errors etc., which remain
understand inspite of agreement of trial balance.

4. Errors of Omission: In case the entire transaction is not recorded in the books of accounts, the
mistake cannot be detected by accounting. The Trial Balance will tally inspite of the
mistakes.

5. Errors of Principle: Double entry is based upon the fact that every debit has its
corresponding credit and vice versa. It will not be able to detect the mistake such as debiting Ram‟s
account instead of Rao‟s account or Building account in place of Repairs account.

6. Compensating Errors: If Rahim‟s account is by mistake debited with Rs. 15 lesser and
Mohan‟s account is also by mistake credited with Rs.15 lesser, the Trial Balance will tally but
mistake will remain in accounts.
 Accounting Principles:
Account is a system evolves to achieve a set of objectives. In order to achieve the goals, we need a
set of rules or guide lines. These guide lines are termed as “Accounting Principles”

Accounting Principles are of 2 types:-

1. Accounting Concepts
2. Accounting Conventions.

Accounting Principles

Accounting Concepts Accounting Conventions

1. Business Entity Concept 1. Convention of full Disclosure
2. Going Concern Concept 2. Convention of Consistency
3. Money Measurement Concept 3. Convention of Conservation
4. Cost Concept 4. Convention of Materiality
5. Accounting Period Concept
6. Dual Aspect Concept
7. Matching Concept
8. Realization Concept

Different types of Accounting Concepts:

The term concept means an idea or thought. Basic accounting concepts are the fundamental ideas or
basic assumptions underlying theory and practice of financial accounting. These are broad working
rules of accounting activity. They are evolved over a period in response to changing business
environment. They are developed and accepted by accounting profession. The concepts guide the
identification of events and transactions to be accounted for.

The concepts help in bringing about uniformity in the practice in accounting. In accountancy
following concepts are quite popular.

1. Business Entity Concept: Business is treated separate from the proprietor. All the transactions
are recorded in the books of the proprietor. The proprietor is also treated as a creditor for the
business. When he contributes capital, he is treated as a person who has invested his amount in the
business. Therefore, capital appears in the liabilities of balance sheet of the proprietor.

2. Going Concern Concept: This concept relates with the long life of the business. The assumption is
that business will continue to exist unlimited period unless it is dissolved due to some reason or the other.
When final accounts are prepared, record is made for outstanding expenses and prepaid expenses because of
the assumption that business will continue. Going concern concept helps other business undertaking to
make contracts withspecific business unit for business dealing in future.

3. Money Measurement Concept: Only those transactions are recorded in accounting which can be
expressed in terms of money. The transactions which cannot be expressed in money fall beyond the scope
of accounting. One serious short coming of this concept is that the money value of that date is recorded on
 which transaction has taken place. It does not recognize the changes in the purchasing power of monitory
unit.

4. Cost Concept: According to this concept, an asset is recorded at its cost in the books of account, i.e.,
the price, which is paid at the time of acquiring it. In balance sheet, these assets appear not at cost price
every year, but depreciation is deducted and they appear at the amount, which is cost less depreciation.
Under this concept, all such events are ignored which affect the business but have no cost. For example, if
an important and influential director dies, then the earning capacity and position of the business will be
affected. But this event has nocost. Hence it will not be recorded in account books.

5. Account Period Concept: Every businessman wants to know the result of his investment and
efforts after a certain period. Usually one-year period is regarded as an ideal for this purpose. The
life of the business is considered to be indefinite, but the measurement of income cannot be
postponed for a very long period of time. Therefore, it is necessary to have a period for which the
operational results are assessed for external reporting. Hence a period of one year i.e., twelve
months is considered as accounting period. It may be a calendar year (January to December or any
period of one year.) In India, the accounting period begins on 1st April every year and ends on 31st
March every year. This concept implies that at the end of each accounting period, financial
statements i.e., profit & loss account and balance sheet are to be prepared. It is mandatory under
Income Tax Act to assess profit of the business every year and determine tax liability.

6. Dual Aspect Concept: Under this concept, every transaction has got a twofold aspects i.e., (i)
receiving aspect/ receiving benefit and (ii) giving aspect/ giving of benefit. For instance, when a firm
acquires an asset (receiving of the benefit), it must have to pay cash (giving of benefit). Therefore, two
accounts are to be passed in the books of accounts. One for the receiving benefit and the other for the giving
of benefit. Thus, there will be a double entry for every transaction – debit for receiving the benefit and credit
for giving the benefit.

7. Matching Concept: Every businessman is eager to make maximum profit at minimum cost. Hence,
he tries to find out revenue and cost during the accounting period. An accountant records all expenses of a
year (whether they are paid in cash or are outstanding) and all revenues of a year (whether they are received
in cash or accrued).

Expenses, which are incurred during a particular accounting period forearning the revenue of the related
period, are to be considered. All expenses incurred during the accounting period must not be taken. Only
relevant cost should be deducted from the revenue of a period for periodic income statement. The process of
relating coststo revenue is called “Matching process”. While ascertaining profit, other appropriatecost
which are not directly related to cost of goods sold are to be taken into consideration. Example, rent paid,
interest paid, depreciation etc., Thus appropriate costs have to be matched against the appropriate revenues
for the accounting period.

8. Realization Concept: This concept is also known as “revenue recognition concept”. Revenue
results out of sale of goods and services. According to this concept revenue is realized when a sale
is made. Sale is considered to be made at the point when the property in goods passes to the buyer
and he becomes legally liable to pay. No profit or income will arise without the realization of sales.
Likely sales and anticipated revenues are not to be recorded in account books. The realization
concept is important in ascertaining the exact profit earned during a period in a business concern.
According to this concept, the revenue should be considered only when it is realized. Any business
transaction should be recorded only after it actually taken place. Production of goods does not mean that the
total production is sold, it should be recorded only when they are sold and cash realized or obligation
created.
Different types of Accounting Conventions:
In accounting, convention means a custom or tradition, used as a guide for thepreparation of
accounting statement. The following are the accounting conventions:
 1. Convention of Full Disclosure: Accounting to this convention, accounts should be prepared honestly
and they should disclose all materials and significant information. Every company shall keep proper books of
accounts. Auditor records expenses, incomes, profits, losses, assets and liabilities. The essential items to be
disclosed in the Profit and Loss Account are given. There is legal form for the balance sheet.

2. Convention of Consistency: In every business, the management draws important conclusion from the
financial statements, regarding working of the concern, for this purpose in preparing the final accounts. The
same principle and practices should be followed from year to year.

3. Convention of Conservation: This is very important in preparing final accounts. This term suggests
caution. All prospective profits should be ignored. All outstanding expenses should be taken into account.
Adequate reserves or provisions should be provided for. This means that there should be no window dressing
and secret reserves.

4. Convention of Materiality: This is also called the convention of reasonable degree of accuracy.
According to this, the information given in the accounts should bereasonable accurate. All the entries should
be exact. Fraction of a rupee is avoided.

Classification of Accounts:

Classification of Accounts

Personal Accounts Impersonal Accounts

Real Accounts Nominal Accounts

Broadly speaking accounts are classified into two types. They are
I. Personal Accounts
II. Impersonal Accounts. Impersonal accounts are again divided into RealAccounts and Nominal
Accounts. Thus accounts are of Two types.
1. Real Accounts
2. Nominal Accounts

1. Personal Accounts: Personal Accounts are those which are opened in the names of
persons. These are accounts of persons and institutions with whom the business deals. A
separate account is kept for each person. Personal accounts can be also sub classified into
three categories:
They are i) Natural personal accounts ii) Artificial Personal accounts iii) Representative
Personal accounts.
i) Natural Personal Accounts: The term Natural Persons means who are creations
of Gods. For example Ravi Account, Rani Account, Raghu account Nagarjuna
Account etc., are called as Natural Personal Accounts.
ii) Artificial Personal Accounts: These accounts include accounts of corporate
 bodies or institutions which are recognized as persons in business dealings. The
account of a Limited Company, the accounts of co-operative society, the accounts
of clubs, the account of Government, the account of insurance company, the
account of Colleges, Schools, Universities and Hotels etc., are examples of
Artificial Personal Accounts.
iii) Representative Personal Accounts: These are accounts which
represent a certain person or group of persons. For example, Outstanding
expenses A/c, Prepaid expenses A/c, Income Receivable A/c and Income received
in advance A/c, Drawings A/c and Capital A/c are termed as Representative
Accounts.

Principle/ Rule of Personal Account:

1. Debit the receiver and
2. Credit the giver.
For example, if cash has been paid to Raja, the account of Raja will have to be debited since Raja
is the receiver of cash.
Similarly, if cash received from Krishna, the account of Krishna will have to be credited since
Krishna is the giver of cash.

2. Real Account: Real Accounts are those which are relating to Properties and Asset of the
business concern. Accounts relating to properties or assets or possessions of the firm are called Real
Accounts. Every business firm needs Fixed Assets such as Land and Buildings, Plant and
Machinery, Furniture and Fixtures etc for running its business. A separate account is maintained for
each asset. There are Four types of Assets. They are

Fixed Assets: Those assets which are acquired for long term use by the business concern are known
as Fixed assets. For example Land and Buildings, Plant and Machinery, Furniture and Fixtures etc
are called as Fixed Assets.

Current Assets: Those assets which are possible to convert into cash are known as known as
Current assets. For example cash in hand, cash at Bank, Stock in trade, Debtors, Bills Receivable
etc., are called as current assets.

Tangible Assets: Tangible assets are those which relate to such things which can be touched, felt,
measured etc., Tangible assets have physical existence. Hence these assets may be transferred from
one place to another place. Fixed assets and Current assets are the examples of Tangible assets.

Intangible Assets: These accounts represent such things which cannot be touched. Of course, they
can be measured interms of money. Intangible assets haven’t any physical existence. Goodwill, copy
rights, patents and trademarks are the examples of Intangible assets.
Principle/Rule of Real Account:

1. Debit what comes into the business and

2. Credit what goes out of the business.
For example, if machinery has been purchased for cash, machinery account should be debited since
 Machinery is coming into the business, while cash account should be credited since cash is going
out of the business.

If furniture is sold for cash, cash account should be debited since cash is coming into the business,
while Furniture account should be credited since furniture is going out of the business.
3. Nominal Accounts: Nominal accounts include accounts of all Expenses, Losses, Incomes and
Profits or Gains.

The examples of Expenses and Losses are salaries, wages, rent, taxes, lighting charges, transport
charges, travelling charges, coolie charges, warehouse rent, insurance, advertisement paid, Bad
debts, commission paid, Discount allowed, interest paid, interest paid on capital,

The examples of Incomes and Profits are rent received, interest received, commission received,
discount received, dividend received, interest on investment received, bad debts recovered etc.,

These accounts are opened in the books to simply explain the nature of the transactions. They do
not really exist. For example, in a business when salary is paid to the manager, commission is paid
to the salesmen, rent is paid to landlord, cash goes out of the business and it is something real, while
salary, commission, or rent as such does not exist. The accounts of these items are opened simply to
explain how the cash has been spent. In the absence of such information, it may be difficult for the
cashier to explain how the cash at his disposal was utilized. Nominal accounts are also called
Fictitious Accounts.

Principle or Rule of Nominal Account:

1. Debit all Expenses and Losses and

2. Credit all Incomes and Profits/Gains.
For example when salaries paid in cash, salaries account should be debited since Salaries is an
expenditure to the business, while cash account should be credited since cash is going out of the
business.

For example If Rent received in cash, Cash account should be debited since cash is coming into the
business, while rent account should be credited since Rent Received is an income to the business.

The principle of Nominal account is quite opposite to the principles of personal account
and real account. As per the principle of Nominal account receiving aspects (Incomes and profits)
are credited and giving aspects (expenses and losses) are debited. But as per the principles of
personal account and real account, receiving aspect is debited and giving aspect is credited. Hence
the rule of Nominal account is different from the principles of Real account and Nominal account.
JOURNAL:
The word Journal is derived from the French word „Jour‟ which means a day. Journal, therefore,
means a daily record of business transactions. Journal is a book of original entry/prime entry
because transaction is first written in the journal from which it is posted to the ledger at any
convenient time. The journal is a complete and chronological record of business transactions. It is
recorded in a systematic manner. The process of recording a transaction in the journal is called
Journalising. The entries made in the book are called Journal Entries.
 Proforma of Journal

Journal Entries in the books of-------------------

Date Particulars L.F Debit (Rs.) Credit (Rs.)

Advantages of Journal/ Importance of Journal

The main advantages of Journal are given below:

1. Availability of Full information/Complete Record: All business transactions date-wise will be

recorded in the Journal As such the total information for every transaction can be obtained very
easily without late. So Journal serves as a complete record. It provides a chronological record of all
transactions and hence provides permanent record.

2. Posting becomes easy: When once the transactions are entered in the Journal, recording the same
in the relevant accounts in the ledger can be made easily. The businessman can have an
understanding on debit and credit principles in the beginning itself. It provides information of debit
and credit in an entry and an explanation to make it understandable properly.

3. Explanation of the transaction: Every Journal entry will be briefly explained with a
narration. Narration helps in proper understanding of the entry.

4. Location of the errors easy: Journal helps to locate the errors easily. Both debit and credit
aspects of a transaction are recorded in the journal. Since the amount recorded in debit amount
column and credit amount column must be equal. Therefore, the possibility of committing
errors is reduced and the detection of errors, if any, committed becomes easy.

5. Chronological order: Transactions are recorded in a chronological order in the Journal. Hence,
when any information is required, the information can be traced out quickly and easily.
6. Eliminates the need for reliance on memory: It eliminates the need for a reliance on memory of
the accounts keeper. Some transactions are of a complicated nature and without the journal, the
entries may be difficult, if not impossible.

LIMITATIONS / DISADVANTAGES OF JOURNAL:

The following are the main limitations of the journal.

1. The Journal will be too long and becomes unwieldy if all transactions are recorded in
the journal.
2. The Journal is unable to ascertain daily cash balance. That is why cash transactions are
directly recorded in a separate cash book so that daily cash balances may be available.
 3. It becomes difficult in practice to post each and every transaction from the Journal to the ledger.
Hence in order to make the accounting easier and systematic, transactions are recordedin total in
different books.

LEDGER:

Ledger means posting transactions entered in the journal into their respective accounts in the ledger.
It is the book of final entry. The Ledger is designed to accommodate the various accounts maintained
by a trader. It contains the final and permanent record of all transactions in duly classified form. A
ledger is a book which contains various accounts. The process of transferring the entries from the
journal intothe ledger is called posting.

 It is vertically divided into two halves/parts.

 It is prepared in the form of Alphabet T.
 The left side of this account is known as Debit side and right side of the account is
known as Credit side.
 Debit is the Receiving Aspect / Benefit and Credit is the Giving Aspect / Benefit.
 The word Dr should be written at the top left hand corner side of the account. The
word Cr should be written at the top right hand corner side of the account.
 The title or name of the account should be written at the top in the middle of the account.
 The word “To‟ should be written on the debit side of an account in the particulars
column.
 The word “By‟ should be written on the credit side in the particulars column of an
account.

 All the Receiving Aspects are entered on the debit side and all the Giving Aspects are
entered on the credit side of the account in the particulars column.
 All accounts are maintained in Ledger. So they are called “Ledger accounts”.

Performa of an Account: An account contains the following columns on the following columns on
either side. 1) Date column 2) Particulars column 3) Journal Folio column 4) Amount column.
The format or ruling of an account is as follows:
Date Particulars J.F Amount Date Particulars J.F Amount
Rs. Rs.
To Particulars of Xxxxxx By Particulars of xxxxxx
benefits received benefits given

Features of a Ledger:
i. Ledger contains all the accounts-personal, real and nominal accounts.

ii. It is a permanent record of business transactions.

 iii. It provides a means of easy reference.

iv. It provides final balance of the accounts.

Ledger is the principal book of accounts because it helps us in achieving the objectives of
accounting. It gives answers to the following pertinent questions.

 How much amount is due from others to the business?

 How much amount is owed to others?
 What are the total sales to an individual customer and
 What are the totalpurchases from an individual supplier?
 What is the amount of profit or loss made during a particular period?
 What is the financial position of the firm on a particular date?

Advantages/ Utilities/Importance of Ledger

The following are the main utilities of Ledger

1. It provides complete information about all accounts in one book.
2. It is easy to ascertain how much money is due to suppliers (trade creditors from creditors‟
ledger) and how much money is due from customers (trade debtors from debtors‟ ledger).
3. It enables to ascertain, what are the main items of revenues/incomes (Nominal
accounts).
4. It enables to ascertain, What are the main items of expenses(Nominal accounts)
5. It enables to know the kind of assets the enterprise holds and their respective
values(Real Accounts)
6. It facilitates preparation of trial balance and thereafter preparation of financial
statements i.e., profit and loss account and balance sheet.

Differences between Journal and Ledger

Point of
Journal Ledger
difference
The book in which all the transactions are The book which enables to transfer all
Meaning recorded, as and when they arise is the transactions into separate accounts is
known as Journal. known as Ledger.
What is it? It is a subsidiary book. It is a principal book.

Also known as Book of original entry. Book of second entry.

Record Chronological record Analytical record

The process of recording transactions The process of transferring entries from
Process
into Journal is known as Journalizing. the journal to ledger is known as Posting.
How transactions
Sequentially Account-wise
are recorded?
Debit and Credit Columns Sides
Narration Must Not necessary.
Balancing Need not to be balanced. Must be balanced.
TRIAL BALANCE:

Trial balance is a bookkeeping worksheet in which the balances of all ledgers are compiled into debit
and credit account column totals that are equal. A company prepares a trial balance periodically,
usually at the end of every reporting period.

Definitions of Trial Balance:

According to [Link], “A Trial Balance is a statement of Debit and Credit balances
extracted from the various accounts in the ledger with a view to test the arithmetical accuracy of the
books.”

According to Spicer and Pegler, “A Trial Balance is a list of all the balances standing on
the ledger accounts and cash book of a concern at any given date.”

Features of a Trial Balance:

1. It is not an account., it is only a statement which is prepared to veryfy the arithmetical
accuracy of ledger accounts.

2. It contains debit and credit balances of ledger account.

3. It is prepared on a particular date generally at the end o f business year.

4. Trial Balance helps in preparing final accounts.

5. As it is prepared by taking up the ledger account balances, both debit and credit side of a Trial
Balance are always equal.

6. The preparation of Trial Balance is not compulsory. There is no hard fast rule in this
regard.
Importance / Merits /Advantages of Trial Balance:

1. Proof of Arithmetical accuracy: It helps in checking the arithmetical accuracy of

books of accounts.

2. Preparation of financial statements: It helps in the preparation of final accounts i.e.,

Trading Account, Profit & Loss Account and Balance Sheet.

3. Detection of Errors: It will help in detection of errors in the books of accounts and in their
rectification.

4. Rectification of Errors: It serves as instrument for carrying out the job of rectification of
errors.

5. Easy Checking: It is possible to find out the balances of various accounts at one place.
Limitations of Trial Balance:
1. Trial balance can be prepared only in those concerns where double entry system of
accounting is adopted. This system is very costly and time consuming. It cannot be adopted
 by the small business concerns.

2. Though Trial Balance gives arithmetical accuracy of the books of accounts but there are
certain errors which are not disclosed by Trial Balance. That is why it is said that Trial
balance is not a conclusive proof of the accuracy of the books of accounts.

3. If Trial Balance is not prepared correctly then the final accounts prepared will not reflect the
true and fair view of the state of the affairs/financial position of the business.
Whatever conclusions and decisions are made by the various groups of persons will not be
correct and will mislead such persons.

4. Trial Balance tallies even though errors are existing in the books of accounts.

5. Even some transactions are omitted the Trial Balance tallies.

Objectives of Trial Balance:

The following are the main objectives of preparing the Trial Balance.

1. To have balances of all the accounts of the ledger in order to avoid the necessity of
going through the pages of the ledger to find it out.
2. To have a proof that the double entry of each transaction has been recorded because ofits
agreement.
3. To have arithmetical accuracy of the books of accounts because of the agreement of the Trial
Balance.
4. To have material for preparing the profit or loss account and balance sheet of the
business.

Specimen of Trial Balance

[Link] DEBIT [Link] CREDIT

1 Opening Stock Asset 1 Sales Gain
2 Provision for discount on Creditors Asset 2 Creditors Liability
3 Debtors Asset 3 Cash in Hand Liability
4 Goodwill Asset 4 General Reserve Liability
5 Plant & Machinery Asset 5 Provision for Depreciation Liability
6 Land & Buildings Asset 6 Bills Payable Liability
7 Furniture & Fittings Asset 7 Bank Overdraft Liability
8 Investments Asset 8 Outstanding Salaries Liability
9 Loan Advances Asset 9 Capital Loan
10 Horse & Carts Asset 10 Loan Taken Loan
11 Bills Receivables Asset 11 Discount Received Revenue
12 Prepaid Insurance Asset 12 Commission Received Revenue
13 Patents & Trademarks Asset 13 Interest Received Revenue
14 Motor Cycle Asset 14 Petty Receipts Revenue
15 Income Tax Drawings 15 Bad Debts Reserve Revenue
16 Purchases Expenses 16 Outstanding Rent Revenue
17 Wages Expenses
18 Freight Expenses
19 Transport Expenses Expenses
 20 Royalties on Production Expenses
21 Gas & Fuel Expenses
22 Repairs Expenses
23 Rent Expenses
24 Salaries Expenses
25 Interest Paid Expenses
26 Insurance Expenses
27 Carriage Outwards Expenses
28 Advt. Expenses
29 Petty Expenses Expenses
30 Trade Expenses Expenses
31 Office Expenses Expenses
32 Customs Duty Expenses
33 Sales Tax Expenses
34 Excise Duty Expenses
35 Returns Outwards Gain
36 Provision for discount on Debtors Liability
37 Returns Inwards Loss
38 Discount Allowed Loss
39 Bad Debts Loss
40 Depreciation Loss

TRADING ACCOUNT:
This account is prepared to know the trading results or gross margin on trading ofbusiness, i.e., how
much gross profit the business has earned from buying and selling during a particular period. The
difference between the sales and cost of goods sold is gross profit. This is a nominal account in its
nature hence all the trading expenses should be debited where as all the trading incomes should be
credited to Trading Account. The balance of trading account will be considered as Gross Profit
(credit balance) or Gross Loss (debit balance) and will be transferred to profit and loss A/c. While
preparing the trading A/c the following equations also can be used.

Sales less returns – Cost of goods sold = Gross Profit or

Gross LossSales = Total cash sales + credit sales.

Cost of goods sold = Opening stock + purchases less purchase returns + Direct expenses–Closing stock

Advantages / Importance of Trading A/c:

Trading Account has the following advantages.

 Information of Gross profit or Gross Loss:

Trading Account provides information regarding gross profit and sets the upper limit within
which indirect expenses are to be incurred. Indirect expenses should be much less than the
gross profit so that a good amount of profit may be earned. If trading account discloses gross
loss , it is better to close the business rather than running at a gross loss because gross loss will
further increase when indirect expenses are added to it.
  Gross Profit Ratio: This ratio is calculated as follows:

Gross profit Ratio = Gross Profit / Sales X 100

Higher the ratio, it is better condition. Gross profit ratio can be calculated with the help the
Trading account year after year and comparison of performance of year after year can be
made. A low ratio indicates unfavorable trend in the form of reduction in selling prices not
accompanied by the proportionate decrease in cost of goods purchased or increase in cost of
production.

 Comparison of Closing Stock with Opening Stock:

Comparison of stock figures of one period with another period will be helpful in avoiding
overstocking. Investment in stock should be reasonable so that production and sales go on
smoothly.

 Fixation of selling price: In case of a new product, the selling price can be easily fixed by
adding in the cost of purchases or cost of goods manufactured the desired percentage of gross
profit.

 It enables the comparison of sales, purchases and direct expenses of one period with
another period. The comparative study helps the management to control the affairs of the
business and take sound decisions.
 It helps to check the direct expenses.
 It gives us the information about the proportion of gross profit or gross loss to the direct
expenses. This study helps the management in arresting the unnecessary expenditure on any
time.
Dr Trading A/C of MR…………………………for the year ended………………… Cr
Particulars Amount Particulars Amount
To Opening stock xxx By Sales xxx
To Purchases xxx Less: Returns xxx xxx
Less: Returns xxx xxx By Closing Stock xxx
To Carriage Inwards xxx
To Wages xxx By Gross Loss c/d xxx
xxx
To Freight xxx
To Customs Duty xxx
xxx
To Gas, Fuel, Coal & Water xxx
To Factory Expenses xxx
To Productive Expenses xxx

To Gross Profit c/d xxx

xxx xxx
PROFIT AND LOSS ACCOUNT:

This account is prepared to calculate the net profit or net loss of the business concern. There are certain
items of incomes and expenses of the business which must be taken into consideration for calculating
net profit or net loss of the business concern. These are of indirect nature i.e., the whole business and
relating to various activities which are done by the business for the purpose of making the goods
available to the customers. Indirect expenses may be administrative expenses or management expenses,
selling and distribution expenses, financial expenses and extra-ordinary losses and expenses to maintain
the assets into working order. This account is prepared from nominal accounts and its balance is
transferred to capital account asthe whole the profit or loss will be that of the owner and it will increase
or decrease the capital.

Importance of Profit and Loss Account:

Information of Net profit or Net loss: One of the important objectives of maintains the accounts are
to see whether the business has earned profit of suffered loss during the accounting period. Profit and Loss
A/c provides information regarding this important objective because it gives information about the
profitability or otherwise of the business.

Comparison of current profit with the last year profit: Profit and
Loss A/c affords comparison of the current year’s net profit with those of the past years. With this
comparison it can be ascertained whether net profit of the business is showing a rising trend or
down ward trend.

Comparison of expenses: Comparison of various expenses included in the profit and loss
account with expenses of the previous period helps in taking effective steps for control of
unnecessary expenses.

Helpful in preparation of Balance Sheet: Net profit or Net loss disclosed by the profit and loss
A/c is transferred to capital Account and Capital Account appears on the liabilities side of the Balance
Sheet. Without taking net profit or net loss, the balance sheet cannot be completed. Thus, the profit and loss
account helpsin the preparation of the balance sheet.

Helpful in future Growth of business: On the basis of their profit figures of the current and previous
period, estimates about the profits in the years to come canbe made and projections about the expansion of
the business can be made.
 Dr Profit & Loss A/C of MR…………………………for the year ended………………… Cr
Particulars Amount Particulars Amount
To Gross Loss b/d xxx By Gross Profit b/d xxx
To Office Salaries xxx By Interest Received xxx
xxx xxx
To Rent, Rates & Taxes By Discount Received
xxx xxx
To Printing & Stationary xxx
By commission Received xxx
To Legal Charges, Audit fee xxx By Income from Investments xxx
To Insurance xxx By Dividend on Shares xxx
To General Expenses xxx By Rent Received xxx
xxx xxx
To Advt. By Miscellaneous Investments xxx
xxx
To Bad Debts xxx By Net Loss…
To Carriage Outwards xxx (Transfer to Capital A/C)
To Repairs xxx
To Depreciation xxx
xxx
To Interest Paid xxx
To Interest On Capital xxx
To Interest on Loans xxx
To Discount Allowed xxx
xxx
To Commission xxx
To Net Profit….
(Transferred to Capital A/C) xxx xxx

BALANCE SHEET:
A Balance Sheet a statement prepared with a view to measure the financial position of a business on
a certain fixed date. The financial position of a concern is indicated by its assets on a given date and
its liabilities on that date. Excess of assets over liabilities represent the capitaland is indicative of
the financial soundness of a company.
A Balance sheet is also described as a “statement showing the sources and application of
the capital”. It is a statement and not an account and prepared from real and personal accounts.
Sources or liabilities are shown on the left hand side of the Balance Sheet. Application of funds
(Assets) is shown on the right hand side of the Balance Sheet.

Characteristics of Balance Sheet:

1. It is prepared on a particular date and not for a particular period.
2. It is prepared after preparation of the Trading and Profit & Loss A/c.

3. As assets must be equal to the total liabilities. The two sides of the Balance must have the
same total.
4. It shows the financial position of a business as a going concern.
5. It is a statement of assets and liabilities and not an account.
 Information that Balance Sheet convey to Outsiders (Importance):

1. The nature and the value of assets.

2. It shows the nature and extent of liabilities.
3. It shows the owner’s equity (i.e., assets-liabilities = capital)
4. It tells about the creditworthiness and solvency of the firm.
5. It reflects the liquidity of a firm.
6. It reveals other information required to changes in economic reserves and
obligations.

Balance Sheet of MR…………………………as on…………………

Liabilities Amount Assets Amount
Creditors xxx Cash in Hand xxx
Bills Payable xxx Cash at Bank xxx
xxx xxx
Outstanding Income Bills Receivables
xxx xxx
Loans xxx
Debtors xxx
Mortgage xxx Closing stock xxx
Reserve Funds xxx Investments xxx
Capital xxx Furniture & fittings xxx
xxx
Add: Net Profit xxx Plant & Machinery xxx
xxx Land & Buildings xxx
Less: Drawings xxx xxx
xxx Patents, Goodwill, Copyrights
Prepaid Expenses xxx

xxx xxx
RATIO ANALYSIS:

Meaning of Ratio

Definition of Ratio
A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship
between two or more things.” Here ratio means financial ratio or accounting ratio which is a
mathematical expression of the relationship between accounting figures.

Ratio Analysis

The term financial ratio can be explained by defining how it is calculated and what the objective of
this calculation is
a. Calculation Basis (Basis of Calculation)
 A relationship expressed in mathematical terms;
 Between two individual figures or group of figures;
 Connected with each other in some logical manner; and
 Selected from financial statements of the concern

b. Objective for financial ratios is that all stakeholders (owners, investors, lenders, employees
etc.) can draw conclusions about the
 Performance (past, present and future)
 Strengths & weaknesses of a firm; and
 Can take decisions in relation to the firm

Ratio analysis is based on the fact that a single accounting figure by itself may not communicate
any meaningful information but when expressed relative to some other figure, it may definitely
provide some significant information. Ratio analysis is not just comparing different numbers from
the balance sheet, income statement, and cash flow statement. It is comparing the number against
previous years, other companies, the industry, or even the economy in general for the purpose of
financial analysis.

Sources of Financial Data for Analysis

The sources of information for financial statement analysis are:
1. Annual Reports
2. Interim financial statements
3. Notes to Accounts
4. Statement of cash flows
5. Business periodicals.
6. Credit and investment advisory services

ADVANTAGES OF RATIO ANALYSIS

Ratio Analysis is an important technique of financial analysis.
It is used as a device to analyze and interpret the financial health of enterprises. Its
usefulness is not only confined to business managers but also extends to various interested
parties like government, creditors, employees, investors, consumers etc.
1. Helps in Decision making:

Though Financial Statements provide necessary data for decision making. It is not possible
to take appropriate decisions merely on the basis of each data. Ratio Analysis provides a
meaningful analysis and interpretation to the data contained in Financial Statements. This
ratio analysis facilitates the managers to take correct decisions.

2. Helps in Financial Forecasting and Planning

Ratios calculated for a number of years reveal the trends in the phenomenon. As
such, it is possible to make predictions for a future period. Thus, ratio analysis helps
in financial forecasting and planning
3. Helps in assessing the operational efficiency:

Ratio Analysis helps in analyzing the strengths and weaknesses of a concern. It helps
in diagnosing the financial health of a concern in terms of liquidity, solvency,
profitability etc

4. Helps in controlling business:

With the help of ratio analysis, it is possible to identify the weak spots with regard to
the performance of the managers.
Weakness in financial structure due to incorrect policies in the past and present is revealed
by the ratios. These weaknesses may be communicated to the people concerned and as such
ratio analysis helps in better communication, Coordination and control of unfavorable
situations.

5. Helps in comparison of performance:

Through accounting ratios comparison can be made between one departments ofa firm
with another of the same firm in order to evaluate the performance of various departments
in the firm. This is needed for the smooth functioning of the departments.

6. Ratio analysis simplifies the complex financial data. It reveal the change in
thefinancial position.
7. Ratio analysis may be used as instruments of management control, particularly in
the area of sales and control.

8. Ratios facilitates the function of communication and enhance the value

offinancial statements.

9. Ratios are helpful in assessing the financial position and profitability of a concern.

10. Ratio Analysis also helps in effective control of business measuring performance, control of
costs etc., Effective control is a keystone ofbetter management.

11. Ratio analysis helps the investors in making investment decisions to make a
profitable investment
Limitations of Ratio Analysis
1. Limited use of a Single Ratio:

A single ratio does not convey meaningful message. As such, a number of ratios will
have to be calculated for a better understanding of particular situation.
Thus, a series of ratios computed may create confusion.
Ratios can be useful only when they are computed in a sufficient large number. calculation of
more ratios sometimes confuses the analysts than help him.

[Link] of Adequate Standards:

Expecting a few situations, in majority cases, universally accepted standards

for ratios are not available.
It renders interpretation of ratios difficult.

3. Lack of comparability:

The results of two firms are comparable with the help of accounting ratios only if they
follow the same accounting methods. Comparison becomes difficult if they follow different
methods. Similarly, utilization of facilities , availability of facilities and scale of operation
affects the Financial Statements of different firms.
Comparison of such firms would be misleading.

4. Inherent Limitations of Accounting:

Accounting records contain historical data. As such, ratios based on data drawn from
accounting records also suffer from the inherent weaknesses ofaccounting records. Thus,
accounting ratios of the past may not be true indicators of the future.
5. Changes in Accounting Procedures:

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 LIFIO Increase the
cost of sales and reduces the value of the closing stock which makes inventory turnover
ratio to be impressive and an unfavorable gross profit ratio.

6. Window Dressing: Financial statements 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. However, it may be
difficult for an outsider to learn about the window dressing made by a firm.

7. Price-Level Changes:
Since ratios are computed for historical data, no consideration is made to the changes
in price levels and this makes the interpretation of ratios invalid

8. Personal Bias:

Ratios are only means of financial analysis and not an end in itself. They have to be interpreted
and different people may interpret the same ratio indifferent ways.
 9. Ignoring qualitative factors:
Ratio analysis ignores the qualitative factors which generally influence the conclusions derived.
10. Reliability of data:
The accuracy and correctness of ratios are totally dependent upon reliability of data contained in
financial statements. If there are any mistakes or omissions in the financial statements, ratio
analysis presents a wrong picture about the concern.

CLASSIFICATION OF RATIOS AND THEIR FORMULAS

CLASSIFICATION OF RATIOS

Ratios may be classified into four categories. They are

1. Liquidity Ratios
2. Capital structure/ gearing Ratios.(Leverage / Solvency Ratios)
3. Turnover Ratios
4. Profitability Ratios
1. LIQUIDIDTY RATIOS

Liquidity ratios are helpful in determining the ability of the company to meet its debt obligations by using
the current assets. At times of financial crisis, the company can utilise the assets and sell them for
obtaining cash, which can be used for paying off the debts.
Some of the most commonly used liquidity ratios are quick ratio, current ratio, cash ratio, etc.
The liquidity ratios are used mostly by creditors, suppliers and any kind of financial institutions such as
banks, money lending firms, etc for determining the capacity of the company to pay off its obligations as
and when they become due in the current accounting period.

FORMULAE:

1. Current Ratio = Current Assets/ Current Liabilities.

The Standard Current Ratio is 2:1
2. Quick Ratio/ Liquid Ratio = Liquid Assets / Quick Liabilities
The Standard Quick Ratio is 1:1
2. CAPITAL STRUCTURE/ SOLVENCY / LEVERAGE RATIOS

Solvency ratios are used for determining the viability of a company in the long term or in other
words, it is used to determine the long term viability of an organization. Solvency ratios calculate
the debt levels of a company in relation to its assets, annual earnings and equity. Some of the
important solvency ratios that are used in accounting are debt ratio, debt to capital ratio, interest
coverage ratio, etc.
Solvency ratios are used by government agencies, institutional investors, banks, etc to determine the
solvency of a company.

FORMULAE:

1. Debt- Equity Ratio = Long-Term Debts/ Shareholders Funds orExternal Equity / Internal Equity
2. Proprietary Ratio = Shareholders’ Funds / Total Assets
3. Interest Coverage Ratio= Earnings before Interest and Taxes (EBIT) / Fixed Interest
Charges.
4. Debts to Total Funds Ratio = Debts
Total Funds

3. TURNOVER/ ACTIVITY RATIOS

Activity ratios are used to measure the efficiency of the business activities. It determines how the
business is using its available resources to generate maximum possible revenue.
These ratios are also known as efficiency ratios. These ratios hold special significance for business
in a way that whenever there is an improvement in these ratios, the company is able to generate
revenue and profits much efficiently.
Some of the examples of activity or efficiency ratios are asset turnover ratio, inventory turnover
ratio, etc.

FORMULAE:

1. Stock / Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

2. Debtor/Receivable Turnover Ratio = Credit sales / Average Debtors + Bills Receivables
3. Average Collection Period = 365 days or 12 Months / Debtor or Receivable Turnover Ratio
4. Creditors Turnover Ratio = Net Credit purchases/ Average Creditors
5. Average Payment Period (in terms of days) = 365 DAYS / Creditors Turnover Ratio
6. Working Capital Turnover Ratio = Cost of Sales / Net Working Capital
7. Fixed Assets Turnover Ratio= Cost of sales / Fixed Assets at cost Less Accumulated
Depreciation.
8. Capital Turnover Ratio= Cost of sales / Capital Employed
4. PROFITABILITY RATIOS
The purpose of profitability ratios is to determine the ability of a company to earn profits when
compared to their expenses. A better profitability ratio shown by a business as compared to its
previous accounting period shows that business is performing well.
The profitability ratio can also be used to compare the financial performance of a similar firm, i.e it
can be used for analysing competitor performance. Some of the most used profitability ratios are
return on capital employed, gross profit ratio, net profit ratio, etc.

FORMULAE:

1. Gross Profit Ratio= (Gross Profit / Net Sales) x 100

Or
=(Net Sales- cost of goods sold / net sales)x 100
2. Net Profit Ratio=(Net Profit / Net Sales) x 100
3. Operating Ratio= (Cost of goods sold + operating expenses )/ Net Sales.
4. Operating Profit Ratio= (Operating Net profit / Net Sales) x 100
OR
=100% - Operating Ratio
5. Expenses Ratios:
6. For cost of Materials =(Materials consumed / Net sales ) x 100
7. For SellingExpenses= (Selling Expenses / Net Sales) x 100

8. Return on Investment Ratio (ROI)=(Net profit before interest and Taxes / Total Capital
Employed)x 100
9. Returns on Shareholders Funds= (Net Profit after Interest and Taxes/Shareholders Funds)
x100
10. Return on Equity Share Capital= (Net profit after interest, Taxes and Dividend / Equity
Shareholders Funds) x100
11. Earnings Per Share (EPS)= (Net Profit after Taxes- Preference Dividend)/ Number of Equity
Shares
12. Dividend Payout Ratio= Dividend per Share / Earning per share.
13. Price Earnings Ratio (P/E Ratio)= Market Price per Equity Share / Earning per share