Prof.

Muhammad Amanullah Khan

Dean, Faculty of Management Sciences
Riphah International University, Islamabad
Pakistan
Tel. 92-51-5469641-47
Cell 92-323-5666671
deanaman@riphah.edu.pk
deanaman@hotmail.com
Facebook: Prof. Amanullah Khan
Blog: http://profamanullah.blogspot.com

FINANCIAL MANAGEMENT
Financial management is one of the most important functions of any business. Finance
in broader terms and cash flow in specific terms is the life line of any business. There
are numerous example of companies producing products of excellent quality and of
great demand, failing miserably just because of inefficient financial management.
A business organization or even the individuals, keeps on making three types of
decisions to keep the life running on a sustainable basis. These are:
1. investing,
2. financing and
3. operating decisions.
The investing decisions are concerned with the Asset Portfolio of the organization. The
financing decisions are about the Capital Structure and operating decisions are about
generating Revenues, managing Expenses and managing Working Capital. It can be
said that financial management is all about managing the Balance sheet equation which
is as follows:
Assets = Liabilities + Capital/Equity
Lets understand the balance sheet with a simple example.

The Story

Business Entity Concept

The business is treated as a separate entity apart from its owners. The accounting records are
maintained for the business entity. An entity is assumed to own its assets and incur liabilities.

Historical Cost Principle

The cost principle states that acquired assets and services should be recorded at their
exchange price (called historical cost) agreed by the parties.

Stable Currency Principle

Accountants assume that the moneys purchasing power is relatively stable and this concept is
the basis for ignoring the effect of inflation in the accounting records. It allows accountants to
add and subtract rupee amounts as though each rupee has the same purchasing power as any
other rupee at any other time.

The Reliability (or Objectivity) Principle

The primary objective of financial reporting is to provide information useful for making
investments and lending decisions. To be useful, this information must be relevant, reliable and
comparable.

The Going-Concern Assumption

Another reason for measuring assets at historical cost is the going-concern assumption. It
means that an entity is supposed to remain in operation for the foreseeable future.

What do we know about

ASSETS

LIABILITIES

CAPITAL

EXPENSES

REVENUE

Accounting Equation Illustrated

Investment by Owner
Mr. Khan started a business by establishing a workshop by the name of Khan Autoes.
During the month of January 2007 following transactions occurred.
Mr. Khan invested. Rs.1,000,000 of his personal funds in the new business. It resulted
in an increase of an asset, Cash, for the business and corresponding change in owners
claim in the business.

Assets
Bank
1,000,000

Khans claim
1,000,000

Purchase of Rights
Khan Autos hired premises for workshop at a monthly rent of Rs.5,000. The landlord
asked for two-year advance of Rs.120,000.
Assets
1
2

Bank
1,000,000
(120,000)
880,000

Khans claim

Prepaid rent
1,000,000
120,000
120,000

1,000,000

Purchase of an asset
Purchased furniture for Rs.80,000 paying by cheque.
Bank
2

880,000
(80,000)
800,000

Prepaid
rent
120,000
120,000

Furniture

Khans claim
1,000,000

80,000
80,000

1,000,000

Purchase of an asset
Purchased tools for Rs.1000,000 paying by cheque
Bank
3

800,000

Prepaid
rent
120,000

Furniture
80,000

Tools

Khans claim
1,000,000

(100,000)
700,000

120,000

80,000

100,000
100,000

1,000,000

Purchase of an asset
Purchased Equipment worth Rs.900,000/-. Paid Rs.600,000 by cheque and remaining
to be paid within a year.
A decision is required for the value at which the equipment should be recorded. Should
it be Rs.600,000/- or Rs.900,000/-? It also requires another decision as to when should
it be recorded. Should it be recorded when the order was placed, the equipment was
received or when the full payment was made? In accounting we keep on haggling with
three types of issues.
1. Recognition
2. Classification
3. Valuation
Right now its recognition issue. To solve it we need to understand the nature of sale
and purchase transaction. Sale and purchase transaction requires the following to be
eligible for recognition.
1. A contract between seller and purchaser to this effect
2. Transfer of major chunk of risk from the seller to the purchaser which implies the
transfer of title of owner ship.
Bank
4
5

700,000
(600,000)
700,000

Prepaid
rent
120,000

Furniture

Tools

80,000

100,000

120,000

80,000

100,000

Uses of Finance

Khans claim

Plant &
Machinery

Raja Autos
claim

1,000,000
900,000
900,000

1,000,000

300,000
300,000

Sources of Finance

Notice that assets are equal to the claims.

Assets = Claims
The owners claim is known as capital and creditors/lenders claim is known as liabilities. The
above equation becomes as follows
Assets = Liabilities + capital
This equation is called Accounting equation or Balance Sheet equation.

Balance Sheet
The accounting equation, also known as balance sheet equation, provides the following
information at any point of time:

Sources of funds, i.e. creditors and owners claims

Composition of funds provided by different sources, i.e. the percentage of total amount
provided each by creditors and by owners

The use of those funds, i.e. the composition of assets acquired

It portrays the financial position of an organisation at a particular point of time.

Following is the balance sheet of Khan Autoes as at January 31, 2013
KHAN AUTOS

Balance Sheet
as at January 31, 2013
Assets
Bank
Advance Rent
Furniture and Fixture
Tools
Plant and Equipment

100,000
120,000
80,000
100,000
900,000
1,300,000

Liabilities and Capital

Liabilities
Loan- RA
3,000,000
Capital
Khan's Capital
1,000,000
1,300,000

Assets
Assets are the economic resources of a business which are expected to benefit in future. The
future benefit embodied in an asset is the potential to contribute directly or indirectly to the flow
of cash and cash equivalents to the enterprise.

Tangible and Intangible Assets

Assets having physical form like furniture and fixture, plant and machinery, building, land, etc.
are known as tangible assets. The assets, which do not have physical form, like copyrights,
patents, etc. are called intangible assets.

Current and Fixed Assets

The assets are also classified with reference to time span of their utility. The assets that are
supposed to be consumed or converted into cash within one operating cycle, generally less than
a year are called current assets. The assets, which are supposed to generate benefits for a

longer period, are called non-current or long term assets. The long term tangible assets are
called fixed assets.

Liabilities (current and long term liabilities)

Liabilities are creditors claims on the assets of the business. An essential characteristic of a
liability is that the enterprise has an obligation. An obligation is a duty or responsibility to act or
perform in a certain way. They are classified into current liabilities and long-term liabilities.

Equity/Capital
Capital is the claim of owners on the assets of the business i.e. owners interest in the business.
The claim may arise through investment by owners or by earning of profit by the business. The
owners claim is defined as the residual interest in the assets of the enterprise after deducting all
its liabilities.

Income Statement / Profit and Loss Account

Revenue
Revenue is the gross inflow of economic benefits during the period arising in course of
ordinary activities of an enterprise when these inflows result in increase in equity other
than increases relating to contributions from equity participants (IAS-18).
Expenses
The decreases in owners equity as a result of costs incurred to generate revenue are
defined as expenses. An expense may be incurred by payment of cash, promise to pay
or consumption of an asset (IAS-18).

Losses
Decrease in owners equity as a result of incidental transactions which are not expenses or
withdrawals by owners, e.g. loss on sale of an asset.

Cash Flow Statement

The financial statements are the basic source of financial information for stakeholders
particularly investors, lenders and management. The term financial statements was
originally used to describe profit and loss account and balance sheet. Initially profit and
loss account was considered to be the most important source of information. The
emphasis, however, changed over time from profit and loss account to balance sheet.
Later on it was realized that information regarding cash flows is equally important. The
sources and uses of cash during a particular period provide information on operating
efficiency, investing policies and financing policies. The information about cash flow is
necessary to answer many vital questions like:

Is the company generating sufficient cash from its operations?

Will the company be able to pay its liabilities?
What will be the dividend policy?
What are the causes for difference between the net profit and net cash flows?
How the company is financing its investing activities?

Important
The basic and very important lesson to remember is that the right side of the equation
tells the sources of funds and left side tells about the uses of funds. The asset side tells
about what is available with the organization for its future prospect. The right side, i.e.
liabilities and capital side simply tells the past history of financing decisions. It cannot be
used as predictor of future except in a very indirect way. Dont get confused with the
terminologies used on this side like Reserves, Provisions etc. They are simply sources
of funds and already invested in assets unless they are supported by cash and bank
balances on the asset side. Marketable securities or short term investments on asset
side may in certain cases partially support these reserves.
Essentials of Financial Management

First of all we need to understand the basics of investing decisions. By now we

have learnt about different classifications of assets. The very first lesson to learn
is that different assets have different productive capacity. From a manufacturing
organization perspective, the long term assets, mainly fixed assets, are more
productive than current assets. Within long term assets there are operating

assets and non-operating assets. As the terminology itself suggests that

operating assets are naturally more productive than non-operating assets.
The investing strategy must become obvious. The major chunk of investment,
under normal circumstances, must go to operating assets and minimum to nonoperating assets. The current assets must claim a bare minimum investment.
The bare minimum means that it should not result in lost sales or interrupted
production. There are classic example of Dell and HP for pulling out investment
from current assets and reinvesting it in operating assets. This could be made
possible by adopting Just-in-Time (JIT) technique for inventory, both raw material
and finished goods, management and rationalizing credit policy. To evaluate
investing policies from this perspective we can use the following ratios.
Current Assets
Total Assets

Other Long term Assets

Total Assets

Fixed Assets
Total Assets

Operating Assets
Fixed Assets
Operating Assets
Total Long term Assets

Lets discuss the following example

CA/TA
FA/TA
Company A
Company B

CA/TA

OLTA/TA

OA/FA

OA/TLTA

FA/TA

Company A
OLTA/TA
OA/FA

OA/TLTA

FA/TA

Company B
OLTA/TA
OA/FA

OA/TLTA

Year 1
Year 2

CA/TA
Year 1
Year 2

Financing Decisions
Lets discuss the right side of the equation i.e. liabilities and capital. The managing of
this side involves financing decisions. It sounds simple but it is the most misunderstood
part of the balance sheet and hence the financial management. There are two major

sources of finance i.e. debt and equity. Debt comprises of short term (current liabilities)
and long term funds. The equity is long term fund and is acquired by external and
internal sources. The external source is shareholders who purchase shares at the time
of issuance of shares by the company. The internal source is the retained earnings i.e.
the profit reinvested in the business. Therefore, it can be said that there are three
sources of long term funds. So simple but the devil lies in the details.
1. Loans: They may include institutional loans and public loans acquired by issuing
bonds or debentures. In addition there could be long term liabilities created as
provisions based on different estimates for those expenses which has
supposedly (as it depends on estimates and judgment) been incurred but the
payment will be made in future. They may also include contingent liabilities.
2. Contributed Equity: The funds raised by issuing shares. The amount includes
share capital and premium if any. The shares may be of different kinds. The two
major categories are ordinary and preference shares. Preference shares are
hybrid in nature i.e. they possess some characteristics of loan and some of
equity. So they are treated as loan or equity depending on their nature and
purpose of analysis.
3. Retained Earnings: This is the profit generated by the business and reinvested in
it rather than distributing to shareholders as dividend. The retained earnings is
the area where host of complicated terminology is used. The terms like revenue
reserves, capital reserves, unappropriated profit etc. have of capacity to create
confusion not only for finance illiterate but for qualified accountants also.
First we need to understand the terminology and its implication and then understand the
concept of Cost of Capital. The basic objective of managing this side is to minimize the
weighted average cost of capital and solvency risk.
The Terminology
Reserves or appropriated profit:
The term reserve gives a feeling as if some money has been kept in some safe account
and will be used as and when needed. A big misunderstanding! Its not that non-finance
people think like this, interestingly finance literate persons with professional
qualifications generally think on the same lines. It is the linguistic side of accounting.
Remember, we learnt that right side of balance sheet equation comprises of the history
of the sources of funds and does not indicate any resources available with the
company. If the amount indicated as reserves does not match with the cash and bank
on asset side, which is generally the case, it means the retained profit has already been
invested in other assets and it is not available for future. Interestingly, a company may
have negative balance in Reserve account (see Dewan Salman balance sheet).

Types of Reserves
The investors put their money in a business to earn a return on their investment. The
return to equity investors is provided in the form of dividends. They also earn capital
gains when the share prices increase. However, for present discussion we are going to
discuss the dividends only. Dividends could be in the form of cash or bonus shares
(scrip dividend). The cash dividend can only be paid out of business profit i.e. profit
earned from ordinary/regular activities. A reserve created out of any other reason does
not qualify for cash dividends. The phrase created again has a linguistic aspect. It
sound sounds as if something tangible existed out there and a part or whole of it has
been kept as reserve. A big misunderstanding! Remember the financial statements are
not written in English. They are rather written in accounting language which has its own
vocabulary, grammar, phrases, proverbs etc. As we proceed in our discussion this point
will become clear. The items in the equity portion of balance sheet, other than share
capital, can be classified into two main categories.
Revenue Reserves: These are items against which cash dividend can be paid if
cash is available. They generally comprise of General Reserve and
Unappropriated Profit. In addition there could be host of other names like
Reserve for foreign exchange fluctuations, Reserve for dividend equilisation etc.
Capital Reserves: These are the items against which cash dividends cannot be
given even if the cash is available. They generally comprise of Share premium,
Revaluation Reserve, Debenture redemption Reserve etc.
Accounting Profit
In order to properly understand the preceding discussion we need to know the nature of
accounting profit. We start with a very simple example.
Mr. Zahid has recently completed his MBA and has set up a small business with
the name of Zahid Computers. His transactions for the month of January, 2013 were as
follows.
Date
Jan01
Jan 10
Jan 25

Purchases
10 units
10 units

Sales

20

Price/unit
50,000
60,000
80,000

Total Amount
500,000
600,000
1,600,000

Let us calculate the profit of Zahid Computers for the month January. Assume that all
transactions were on cash. The investment by Mr. Zahid became Rs.1,100,000. The
profit and Loss Account will be as follows.

Zahid Computers
Profit and Loss Account
For the period ending January 31, 2013
Sales
Less Cost of goods sold
Gross profit

Assets
Cash/bank

Total Assets

Rs. 1,600,000
1,100,000
Rs.
500,000

Zahid Computers
Balance sheet as at Jan.31, 2013
Liabilities and Capital
Rs.1,600,000 Trade creditors
Zahid Capital
as at Jan. 1
add profit
as at Jan. 31
Rs.1,600,000 Total Liabilities and Capital

Rs.

1,100,000
500,000
1,600,000
Rs.1,600,000

It is so simple. However, take the following scenario.

Date
Jan01
Jan 10
Jan 25

Purchases
10 units
10 units

Sales

15

Price/unit
50,000
60,000
80,000

Total Amount
500,000
600,000
1,200,000

Now the calculation of profit becomes a subjective matter. We need to determine the
composition of 15 units sold. Should we assume that 10 units of first lot and 5 units from
the second lot were sold or the other way round? Or should we take an average? The
amount of profit calculated will depend on our assumption. The actual flow may entirely
be different than the assumed flow. As a result just from three transactions we end up
with three different profit figures. The value of remaining five computers (Stock in trade)
will also depend on our assumption.

Sales
Less Cost of Goods Sold
Opening Stock
Add Purchases
Less Closing Stock
Cost of goods sold

First in
First out
1,200,000

Last in
First out
1,200,000

Weighted
Average
1,200,000

0
1,100,000
1,100,000
300,000
800,000

0
1,100,000
1,100,000
250,000
850,000

0
1,100,000
1,100,000
275,000
825,000

Profit

400,000

350,000

375,000

Value of Closing Stock

300,000

250,000

275,000

Which profit figure and which value of stock is the right one? The answer is all the three
are right and comply with all the legal and academic requirements. Then what are these
accounting figures, reality or a social construct. A reality, or to be more precise a brute
reality, is one that is not open to interpretation. It does not depend on human decisions.
A mountain is a reality. It does not require any assumptions or arrangements by
humans for its existence. The social reality on the other hand is open to interpretations
and people will interpret in different way. For example, to most of us Revenue is a
simple reality and that it should not be open to interpretations. The fact, however, is that
Revenue recognition is the most complicated and controversial thing in accounting.
The FASB (Financial Accounting Standard Board of USA) has to issue more than 200
explanations in response to the quarries about revenue recognition standard they
issued. The IASB (International Accounting Standard Board) has issued more than 20
announcements to explain IAS 18 (standard for revenue recognition).
The complexity of the issue becomes evident by Just looking at the list of
pronouncements (USA GAAP) on revenue recognition. Among them are FASB
Concept Statements No. 5 and 6; 25 FASB and Technical Bulletins; 44 EITFs
and Statements of Position (particularly SOP 97-2 re: software revenue
recognition); Two Accounting Research Bulletins; Six Accounting Principle Board
Opinions;18 Technical Practice Aids; and The SEC's Staff Accounting Bulletin
(SAB) No. 101 and related FAQs, and various accounting and auditing
enforcement releases (California CPA, September 2003)
Thus revenue is not a reality but a social construct. Therefore, when and in what
amount revenue should be recognized is a complex issue.
It has its implications for decision making. The question is how to base ones decision
on a figure which one knows has been constructed on the basis of judgement.

Lee (2006) argues that income and capital accounts refer, not to any
intrinsic, brute reality of economic substance, but rather to the socially
constructed abstract notion of economic reality.
A social reality exists as an objective linguistic thing, independently of the
subjectivity of any one individual but inter-subjectivity of many agents in
which they collectivity treat it as if it does exist.
Accounting exists as a social reality rather than a brute physical reality.

Ambiguous terms like fair value, reserves, substance over form make
financial reporting incomprehensible not only for non-finance people but
for qualified accountants also.

Taking the same example of Profit and Loss Account of Zahid Computers, let us change
the scenario. Mr. Zahid purchased and sold the computers on credit. No cash flow took
place. The very first question to be asked is that whether the firm still earned profit. The
answer is, yes. Earning of profit is a phenomenon quite independent of cash flow. You
may earn revenue without receiving cash at that point of time or receive cash and dont
earn revenue. It is called accrual based accounting. According to accrual concept the
revenue is to be recognized when it is earned and similarly an expense must be
recognized when it is incurred. The summary of IAS 18 (Revenue recognition) is as
follows.
Revenue: the gross inflow of economic benefits (cash, receivables, other assets)
arising from the ordinary operating activities of an entity (such as sales of goods,
sales of services, interest, royalties, and dividends). [IAS 18.7]
Recognition of revenue
Recognition, as defined in the IASB Framework, means incorporating an item
that meets the definition of revenue (above) in the income statement when it
meets the following criteria:
is probable that any future economic benefit associated with the item of revenue
will flow to the entity, and
the amount of revenue can be measured with reliability
IAS 18 provides guidance for recognising the following specific categories of
revenue:
Sale of goods
Revenue arising from the sale of goods should be recognised when all of the
following criteria have been satisfied: [IAS 18.14]
1. the seller has transferred to the buyer the significant risks and rewards of
ownership
2. the seller retains neither continuing managerial involvement to the degree
usually associated with ownership nor effective control over the goods
sold
3. the amount of revenue can be measured reliably
4. it is probable that the economic benefits associated with the transaction
will flow to the seller, and
5. the costs incurred or to be incurred in respect of the transaction can be
measured reliably
Rendering of services
For revenue arising from the rendering of services, provided that all of the
following criteria are met, revenue should be recognised by reference to the
stage of completion of the transaction at the balance sheet date (the percentageof-completion method): [IAS 18.20]

1. the amount of revenue can be measured reliably;

2. it is probable that the economic benefits will flow to the seller;
3. the stage of completion at the balance sheet date can be measured
reliably; and
4. the costs incurred, or to be incurred, in respect of the transaction can be
measured reliably.
Now referring back to our example, we know that there has been no cash flow but profit
has been earned as per the accounting standards. Profit is an accounting concept
rather than a reality. However; you will find that a portion of it is transferred to General
Reserve or some other reserve.

Sales
Less Cost of Goods Sold
Opening Stock
Add Purchases
Less Closing Stock
Cost of goods sold
Profit
Transferred to General Reserve
Un-appropriated Profit

First in
First out
1,200,000

Last in
First out
1,200,000

Weighted
Average
1,200,000

0
1,100,000
1,100,000
300,000
800,000
400,000
300,000
100,000

0
1,100,000
1,100,000
250,000
850,000
350,000
300,000
50,000

0
1,100,000
1,100,000
275,000
825,000
375,000
300,000
75,000

The sentence used is, Transferred to General Reserve. What has been transferred? A
person with no understanding of accounting language will not be able to comprehend it
properly. The balance sheet of Zahid Computers on Jauary 31,2013 will be as follows.

Assets
Trade Debtors
Stock in Trade

Total Assets

Zahid Computers
Balance sheet as at January 31, 2013
(FIFO Method)
Liabilities and Capital
Rs.1,200,000 Trade Creditors
300,000 Zahids Capital
as of Jan. 1
add Profit
as at Jan. 31
Rs. 1,500,000 Total Liabilities and Capital

Rs. 1,100,000
0
400,000
400,000
Rs.1,500,000

Assets
Trade Debtors
Stock in Trade

Total Assets

Assets
Trade Debtors
Stock in Trade

Total Assets

Zahid Computers
Balance sheet as at January 31, 2013
(LIFO Method)
Liabilities and Capital
Rs.1,200,000 Trade Creditors
250,000 Zahids Capital
as of Jan. 1
add Profit
as at Jan. 31
Rs. 1,450,000 Total Liabilities and Capital

Zahid Computers
Balance sheet as at January 31, 2013
(WA Method)
Liabilities and Capital
Rs.1,200,000 Trade Creditors
275,000 Zahids Capital
as of Jan. 1
add Profit
as at Jan. 31
Rs. 1,475,000 Total Liabilities and Capital

Rs. 1,100,000
0
350,000
350,000
Rs.1,450,000

Rs. 1,100,000
0
375,000
375,000
Rs.1,475,000

Language affects what people see, how they see it, and the social categories
and descriptors they use to interpret their reality. It shapes what people notice
and ignore and what they believe is and is not important (e.g., Pondy, 1978;
Weick, 1979).
Language plays a dominant role in the creation of meaning and the construction
of knowledge. Words can and do take on different meanings in the context of
different language games. Think of the word love. It signifies differently in a
marriage ceremony, a game of tennis, and in accepting an invitation to dinner.
Love shifts its meaning depending on the rules of the language game in which
it is put into play. The scientific method and economic theory are simply language
games that get elevated to a game-of games status by those academics who
currently seem to rule over the accounting and finance academies. (Wittgenstein)

Social Construction of Reality is based on the concept that events are open to
interpretation. Because interpretations differ, a common base of communication
must be found. This common base is known as social reality and is developed
based on the most common interpretation of physical reality within a society.
Physical Reality refers to the concrete. For example, on September 11 th 2002
two planes flew into the World Trade Center. This fact is concrete. It can be
proven. It is not open to interpretation.
Social Reality is not concrete. It deals with an interpretation of the physical reality
and is not necessarily shared between societies.
For example, the US sees the events of Sept. 11th as a horrible terrorist attack.
The terrorists however, see this as a major success in their battle against the
United States.
Social Construction of Reality is vital for communication. Without a common base
of knowledge, communication is impossible. If aliens came to Earth and thought
a smile was a way of declaring war, then an obvious miscommunication would
occur.
While this example may be extreme, it serves to show why social reality is
necessary. Social Reality provides a way to simplify communication and provides
a point of reference for both the sender and receiver or receivers of a
communication.

FASB and IASB to form joint transition resource group for revenue
recognition
26 July 2013

Norwalk, CT and London, UKThe International Accounting Standards Board (IASB)

and the Financial Accounting Standards Board (FASB) today formally announced plans
to create a joint transition resource group focused on the upcoming final converged
standard on revenue recognition.
The transition group will be responsible for informing the IASB and the FASB about
interpretive issues that could arise when companies, institutions, and other
organisations implement the revenue recognition standard. It will solicit, analyse, and
discuss stakeholder issues that apply to common transactions that could reasonably
create diversity in practice. In addition to providing a forum to discuss the application of
the requirements, the transition group will provide information that will help the Boards
determine what, if any, action will be needed to resolve that diversity. The group itself
will not issue guidance.
The resource group will convene following the final issuance of the revenue recognition
standard later this year. The group is intended to have a limited life and the primary
activities of the group are planned to occur before the standard takes effect in 2017.
Russell G. Golden, Chairman of the FASB commented:
Effective implementation of the revenue recognition standard is critical to its success in
providing financial statement users with the information they need to make the right

decisions about how to allocate their capital. The Boards are committed to ensuring a
smooth transition to the new standard, and the transition resource group is an important
tool for determining any areas that will need additional guidance before the standard
becomes effective in 2017.
Hans Hoogervorst, Chairman of the IASB commented:
Revenue is a key performance indicator and is important to every business. Our joint
transition group will help to ensure that stakeholders are reading the words in the new
revenue standard in the way that we intend that they be read.
The transition group will consist of 10 to 15 specialists representing financial statement
preparers, auditors, regulators, users, and other stakeholders as well as members of
the IASB and FASB. Transition group members will be announced shortly after the final
standard is issued.
Stakeholders will be encouraged to submit implementation issues to the transition
group. Submissions that meet the Boards minimum guidelinessuch as broad
applicability, potential to create diversity in practice, if industry specific broad
applicability to industry, etc.will be presented by IASB and FASB staff at public
transition group meetings. Guidelines for submitting issues will be posted to the Boards
respective websites after issuance of the final standard.
More information about the activities of the revenue recognition transition resource
group will be available at www.ifrs.org and www.fasb.org.

After understanding the nature of Revenue, Accounting Profit and Reserves lets get
back to the discussion on financing decisions. To understand the financing policies of a
company the following ratios are useful.
1. Debt / Equity
2. Retained Earnings / Total capital Employed
3. Gearing
4. Current Liabilities / Total Assets
To evaluate the operating activities three areas are important. These are
1. Asset Management
2. Profitability
3. Market performance
The next section explains the analysis of financial statement.
Analysis of Financial Statements
FINANCIAL RATIOS
Stake holders
Share holders

Area of Interest
Focus on profitability and long term health of the firm. Hence they
are interested to know about the investing, financing and
operating activities of the firm. It means they need to evaluate the

Lenders
Trade Creditors

asset utilization, capital structure and its implication of long term

business financial risk
Focus on long term cash flows. They are also interested in the
long term health of the firm.
Focus on the short term liquidity of the firm.

Liquidity Ratios

Liquidity ratios attempt to measure the ability to pay obligations such as current liabilities
and the pool of assets available to cover the obligations. Liquidity is the ability of an asset to be
converted to cash quickly at low cost. Converting an asset to cash occurs in one of two ways.
Sell the asset, hoping it has reasonable liquidity, or in the case of a financial asset, like accounts
receivable or Treasury bill, maturity brings cash. Working capital circulates from inventory to
accounts receivable to cash, etc. Accounting value estimates of liquid assets are reasonable
estimates of their value.

Current assets (the pool of circulating cash assets available to be allocated to pay bills)
minus current liabilities(the pool of obligations the business must pay in the near future) is an
analytical amount called net working capital (NWC). NWC is a rough measure of the current
assets left over if the current liabilities were paid. The NWC to total assets ratio estimates the
proportion of assets in net current assets, another name for NWC:
NWC/total asset ratio
The current ratio is the classic liquidity ratio, but is merely a variation of the idea above--what

pool of circulating assets is available relative to the pool of current obligations:

Current ratio
Continuing the theme of assets available to pay obligations, the quick or acid-test ratio
eliminates inventories, the least liquid current asset, from current assets:
Quick ratio
The cash ratio eliminates inventories and receivables from current assets to review the cash
assets relative to the current liabilities:
Leverage Ratios

The use of fixed cost financing, either debt or preferred stock, is called financial
leverage. Financial leverage presents a risk/return opportunity. Shareholders may magnify their
earnings/returns by the use of fixed cost financing but, on the other hand, debt is a fixed cost,
contractual commitment to pay regardless of the asset earning rate.

Creditors, owners, and suppliers are interested in the extent to which a firm has sought
the tax shielded benefits from financial leverage producing debt.

Leverage ratios are of two types: balance sheet ratios comparing leverage capital to total
capitalization (long-term debt and equity) or total assets, and coverage ratios which measure
the earnings or cash-flow times coverage of fixed cost obligations.

The long-term debt ratio measures the proportion of the capital structure that is made up
of debt and lease obligations:
Long-term debt ratio
The higher the ratio the greater the use of financial leverage, posing an increased risk/return
situation for investors.
The debt to equity ratio measures the amount of long-term debt to equity or the amount of
leverage capital in relation to the equity cushion under the debt:
Debt-equity ratio
The total debt ratio measures total liabilities, current and long-term, relative to total assets or the
proportion of assets financed by debt:
Total debt ratio
A coverage ratio, such as the times interest earned ratio, measures an amount available relative
to amount owed. How many times is the obligation covered?
Times interest earned
One may include principal payments necessary per period in the denominator to review the
ability of operating earnings to cover the total debt obligation of principal and interest.
Gearing Ratios

Fixed return capital to Total capital employed, fixed return capital to risk capital and
Times Interest Earned.

Fixed Return Capital/ Risk Capital

Fixed return capital is the total of interest bearing loan and preference shares. The risk
capital is the equity capital i.e. ordinary share capital plus reserves and retained
earnings.
Gearing is measured by the following two ratios:
I)
Fixed return capital/Total capital employed
II)
Fixed return capital / risk capital
Efficiency Ratios

Another area of financial analysis, efficiency ratios, measures how effectively the
business is using its assets. "Using" relates to liquidity or profitability or performance. The
numerators used in efficiency ratios are activity-based items, such as sales, cost of sales, etc.,
while the denominators are generally some average balance sheet amount. Turnover ratios are
often converted to a time-line focus by dividing turnovers ratios into 365 days.

The asset turnover ratio measures the sales activity derived from total assets, or the
revenue generated per dollar of total assets. The asset turnover is also an important component
of asset profitability studied later, measuring the revenue per dollar invested:
Asset turnover ratio
Sales, a measure of activity, may be compared to a variety of balance sheet accounts (e.g. fixed
assets, net working capital, stockholders equity, etc.) to measure the revenue generating
efficiency of the account.
NWC Turnover
The inventory turnover ratio, using the cost of goods sold representing the cumulative amount of
inventory sold in a period as the numerator and average inventory (beginning plus ending
divided by two) as the denominator, measures the number of times the value of inventory turns
over in a period:
Inventory turnover
The inventory turnover may be converted to a time line concept, the number of day sales in
inventories, by finding the reciprocal (1/) of the inventory turnover times 365 or:
Days' sales in inventories
The average collection period applies the same concept above to accounts receivables. The
average collection period is the estimated number of days it takes to collect receivables:
Average collection period
The more days' sales outstanding, the greater amount of capital is tied up in accounts
receivables relative to sales.
Profitability Ratios
Profitability refers to some measure of profit relative to revenue or an amount invested. The net
profit margin measures the proportion of sales revenue that is profit available for sources of
funds (EBIT - tax). Net profits after taxes is commonly used in this ratio, but net profits is biased
by the relative amount of leveraging or debt financing in the business:
Net profit margin

A good performance ratio is the return on total assets (current and fixed), or the EBIT - tax
earned per dollar of average assets. This ratio is featured later in the Du Pont analysis:
Return on assets
The return on equity measures the profitability of the common stockholder's equity or return per
dollar of invested equity capital:
Return on equity
The earnings available for common (EAC) is the net income less any preferred dividends, if
applicable.
The proportion of earnings that is paid out as dividends is called the payout ratio:
Payout ratio
The complement of the payout ratio is the plowback ratio studied earlier, or the proportion of
earnings retained in the period:
Plowback Ratio
The plowback ratio times the return on equity (ROE) is an estimate of the growth rate in
common equity from internally generated earnings, or the sustainable growth rate in assets that
the business can support from internal earnings without changing the total debt/total asset ratio: