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## Sunday, February 01, 2015

### IGNOU SOLVED ASSIGNMENT: ECO - 14 (2013 - 2014)

Ratio analysis is one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern. Simply, ratio means the comparison of one figure to other relevant figure or figures.
According to Myers, “Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements."
There are various groups of people who are interested in analysis of financial position of a company used the ratio analysis to work out a particular financial characteristic of the company in which they are interested.
Following are the various classes of ratio used by various users to assess the financial soundness and efficiency of a company:
(A) Liquidity Ratios:
(i) Short term solvency ratio
(ii) Long term solvency ratio
(B) Profitability Ratios
(C) Activity Ratios/ Turnover Ratios
(D) Financial Ratios

The above groups are further classified into following parts:
(i) Short term solvency ratio:
(a) Current ratio
(b) Liquid ratio/Acid Test ratio
(c) Absolute liquid ratio
(ii) Long term solvency ratio:
(a)  Equity ratio
(b)  Debt ratio
(c)  Equity ratio
(d)  Net income to debt service ratio
(iii) Profitability ratio:
(a)  Gross Profit Ratio
(b)  Net Profit Ratio
(c)  Operating Net Profit Ratio
(d)  Operating Ratio
(e)  Return on Investment or Return on Capital Employed
(f)   Return on Equity
(g)  Earning Per Share
(iv) Activity Ratios/ Turnover Ratios:
(a)  Capital Turnover Ratio
(b)  Fixed Assets Turnover Ratio
(c)  Working Capital Turnover Ratio
(d)  Stock Turnover Ratio
(e)  Debtors Turnover Ratio
(f)   Creditors turnover ratio
(v) Financial Ratios:
(a)    Debt-Equity Ratio
(b)   Proprietary Ratio
(a)  Capital Gearing Ratio
(c)    Debt to Total Funds Ratio
(d)   Fixed Assets Ratio
(e)   Interest Coverage Ratio

Meaning, Objective and Method of Calculation of some of the important ratios are as follows:
Current Ratio: Current ratio is calculated in order to work out firm’s ability to pay off its short-term liabilities. This ratio is also called working capital ratio. This ratio explains the relationship between current assets and current liabilities of a business. It is calculated by applying the following formula:
Current Ratio = Current Assets/Current Liabilities
Current Assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Stock of Goods, Short-term Investments, Prepaid Expenses, Accrued Incomes etc.
Current Liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Current ratio shows the short-term financial position of the business. This ratio measures the ability of the business to pay its current liabilities. The ideal current ratio is supposed to be 2:1. In case, if this ratio is less than 2:1, the short-term financial position is not supposed to be very sound and in case, if it is more than 2:1, it indicates idleness of working capital.
Liquid Ratio: Liquid ratio shows short-term solvency of a business. It is also called acid-test ratio and quick ratio. It is calculated in order to know whether or not current liabilities can be paid with the help of quick assets quickly. Quick assets mean those assets, which are quickly convertible into cash.
Liquid Ratio = Liquid Assets/Current Liabilities
Liquid assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Short-term investments etc. In other words, all current assets are liquid assets except stock and prepaid expenses.
Current liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Liquid ratio is calculated to work out the liquidity of a business. This ratio measures the ability of the business to pay its current liabilities in a real way. The ideal liquid ratio is supposed to be 1:1. In case, this ratio is less than 1:1, it shows a very weak short-term financial position and in case, it is more than 1:1, it shows a better short-term financial position.
Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner: -
Gross Profit Ratio = Gross Profit/Net Sales x 100
Where Gross Profit = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
And Net Sales = Total Sales – Sales Return
Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. This ratio can also be used in stock-inventory control. Maintenance of steady gross profit ratio is important .Any fall in this ratio would put the management in difficulty in the realisation of fixed overheads of the business.
Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner: -
Net Profit Ratio = Net Profit/Net Sales x 100
Where, Net Profit = Gross Profit – Selling and Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non Operating Incomes.
And Net Sales = Total Sales – Sales Return
Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern.
Operating Profit Ratio: Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: -
Operating Profit Ratio = (Operating Profit/Net Sales) x 100
Where Operating Profit = Gross Profit – Operating Expenses
Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales Return
Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.
Operating Ratio: Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses.
Operating Ratio = Operating Cost/Net Sales x 100
Where Operating Cost = Cost of goods sold + Operating Expenses
(Operating Expenses = Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance.)
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Or Cost of Goods Sold = Net sales – Gross Profit
Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.
Debt-Equity Ratio: Debt equity ratio shows the relationship between long-term debts and shareholders funds’. It is also known as ‘External-Internal’ equity ratio.
Debt Equity Ratio = Debt/Equity
Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.
Equity (Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets
Objective and Significance: This ratio is a measure of owner’s stock in the business. Proprietors are always keen to have more funds from borrowings because:
(i) Their stake in the business is reduced and subsequently their risk too
(ii) Interest on loans or borrowings is a deductible expenditure while computing taxable profits. Dividend on shares is not so allowed by Income Tax Authorities.
The normally acceptable debt-equity ratio is 2:1.
Proprietary Ratio: Proprietary Ratio establishes the relationship between proprietors’ funds and total tangible assets. This ratio is also termed as ‘Net Worth to Total Assets’ or ‘Equity-Assets Ratio’.
Proprietary Ratio = Proprietors’ Funds/Total Assets
Where Proprietors’ Funds = Shareholders’ Funds = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets
Total Assets include only Fixed Assets and Current Assets. Any intangible assets without any market value and fictitious assets are not included.
Objective and Significance: This ratio indicates the general financial position of the business concern. This ratio has a particular importance for the creditors who can ascertain the proportion of shareholder’s funds in the total assets of the business. Higher the ratio, greater the satisfaction for creditors of all types.
indicates that how many times the profit covers the interest. It measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of periodical interest.
Stock Turnover Ratio: Stock turnover ratio is a ratio between cost of goods sold and average stock. This ratio is also known as stock velocity or inventory turnover ratio.
Stock Turnover Ratio = Cost of Goods Sold/Average Stock
Where Average Stock = [Opening Stock + Closing Stock]/2
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Objective and Significance: Stock is a most important component of working capital. This ratio provides guidelines to the management while framing stock policy. It measures how fast the stock is moving through the firm and generating sales. It helps to maintain a proper amount of stock to fulfill the requirements of the concern. A proper inventory turnover makes the business to earn a reasonable margin of profit.
Debtors’ Turnover Ratio: Debtors turnover ratio indicates the relation between net credit sales and average accounts receivables of the year. This ratio is also known as Debtors’ Velocity.
Debtors Turnover Ratio = Net Credit Sales/Average Accounts Receivables
Where Average Accounts Receivables = [Opening Debtors and B/R + Closing Debtors and B/R]/2
Credit Sales = Total Sales – Cash Sales-Return Inward
Objective and Significance: This ratio indicates the efficiency of the concern to collect the amount due from debtors. It determines the efficiency with which the trade debtors are managed. Higher the ratio, better it is as it proves that the debts are being collected very quickly.
Debt Collection Period: Debt collection period is the period over which the debtors are collected on an average basis. It indicates the rapidity or slowness with which the money is collected from debtors.
Debt Collection Period = 12 Months or 365 Days/Debtors Turnover Ratio
Or
Debt Collection Period = Average Trade Debtors/Average Net Credit Sales per day
Or
365 days or 12 months x Average Debtors/Credit Sales
(360 days can also be used instead of 365 days)
Objective and Significance: This ratio indicates how quickly and efficiently the debts are collected. The shorter the period the better it is and longer the period more the chances of bad debts. Although no standard period is prescribed anywhere, it depends on the nature of the industry.

Journal Entries in the Books of Sanjay Ltd.
 Particulars L.F. Amount (Dr.) Amount (Cr.) Bank Account                                                                                                  Dr. To Equity Share Application Account (Being the application money received on 15000 equity shares @ Rs. 3 each) 45000 45000 Equity Share Application Account                                                                       Dr. To Equity Share Capital Account To Equity Share Allotment Account (Being the application money transferred to share capital and excess money transferred to share allotment account) 45000 30000 15000 Equity Share Allotment Account                                                                       Dr. To Equity Share Capital Account To Securities Premium Account (Being the allotment money due on 10000 shares @ Rs. 5 each including premium of Rs. 2) 50000 30000 20000 Bank Account                                                                                                  Dr. To Equity Share Allotment Account (Being the allotment money received on 10000 equity shares @ Rs. 5 each after adjusting excess application money) 35000 35000 Equity Share 1st Call Account                                                                       Dr. To Equity Share Capital Account (Being the 1st call money due on 10000 shares @ Rs. 2 each) 20000 20000 Bank Account                                                                                                  Dr. To Equity Share 1st Call Account (Being the 1st call money received on 10000 equity shares @ Rs. 2 each) 20000 20000 Equity Share Final Call Account                                                                       Dr. To Equity Share Capital Account (Being the 1st call money due on 10000 shares @ Rs. 2 each) 20000 20000 Bank Account                                                                                                  Dr. To Equity Share Final Call Account (Being the final call money received on 10000 equity shares @ Rs. 2 each) 20000 20000

Balance Sheet of Sanjay Ltd.
 Liabilities Amount Assets Amount Called up and Paid up capital: 10000 equity shares @ Rs. 10 each Securities Premium 100000 20000 Cash At Bank 120000 Total 120000 Total 120000

Dissolution of Partnership:
Dissolution of a partnership means the termination of connections with the firm by some of the partners of the firm, and remaining partners of the firm continuing the business of the firm under the same firm’s name under an agreement. Hence, admission, retirement and a death of a partner are considered dissolution of partnership. The dissolution of partnership may take place in any of the following ways:
(a)    Change in existing profit sharing ratio among partners;
(b)   Admission of a new partner;
(c)    Retirement of a partner;
(d)   Death of a partner;
(e)   Insolvency of a partner;
(f)     Completion of the venture, if partnership is formed for that; and
(g)    Expiry of the period of partnership, if partnership is for a specific period of time;
In case of dissolution of firm a new partnership agreement is formed, this is why the old partnership comes to an end and a new partnership begins.

Modes of Dissolution of a Partnership Firm:
The dissolution of partnership between all the partners of a firm is called the "dissolution of the firm". A firm may be dissolved with the consent of all the partners or in accordance with a contract between the partners. The Indian Partnership Act, 1932 provides that a partnership firm may be dissolved in any of the following modes:
(a)    Compulsory dissolution;
(b)   Dissolution on the happening of certain contingencies;
(c)    Dissolution by notice of partnership at will;
(d)   Dissolution by the court.
i) Compulsory Dissolution: A firm is dissolved by the adjudication of all the partners or of all the partners but one as insolvent, or by the happening of any event which makes it unlawful for the business of the firm to be carried on or for the partners to carry it on in partnership.
However, where more than one separate venture or business or undertaking is carried on by the firm, the illegality of one or more ventures or businesses or undertakings shall not by itself cause the dissolution of the firm in respect of its lawful ventures, businesses and undertakings.
ii) Dissolution on the Happening of Certain Contingencies: Subject to contract between the partners, a firm is dissolved:
(a)    if constituted for a fixed term, by the expiry of that term;
(b)   if constituted to carry out one or more adventures or undertakings, by the completion thereof;
(c)    by the death of a partner; and
(d)   By the adjudication of a partner as an insolvent.
iii) Dissolution by Notice of Partnership at Will: Where the partnership is at will, the firm may be dissolved by any partner giving notice in writing to all the other partners of his intention to dissolve the firm.
The firm is dissolved as from the date mentioned in the notice as the date of dissolution or, if no date is so mentioned, as from the date of the communication of the notice.
iv) Dissolution by Court: A court may order a partnership firm to be dissolved in the following cases:
(a)    When a partner becomes of unsound mind
(b)   When a partner becomes permanently incapable of performing his/her duties as a partner,
(c)    When partner deliberately and consistently commits breach of agreements relating to the management of the firm;
(d)   when a partner’s conduct is likely to adversely affect the business of the firm;
(e)   when a partner transfers his/her interest in the firm to a third party;
(f)     When the court regards dissolution to be just and equitable.

The capital of a joint stock company is divided into shares which are collectively called ‘Share Capital’. Share capital refers to the amount that a company can raise or has raised by the issue of shares.
The share capital may be classified as below:
(a)    Nominal/Authorized/Registered Capital: This is the amount of the capital which is stated in Memorandum of Association and with which the company is registered. Nominal capital is the maximum amount which the company is authorised to raise from the public.
(b)   Issued Capital: Issued capital is that part of the nominal capital, which is offered to the public for subscription. The balance of the nominal capital, which is not offered to the public for subscription, is called unissued capital.
(c)    Subscribed Capital: Subscribed capital is that part of the issued capital, which is applied for by the public. The balance of the issued capital, which is not subscribed for by the public is called, unsubscribe capital.
(d)   Called up Capital: This is the amount of the capital that the shareholders have been called to pay on the shares subscribed for by them. The amount of the subscribed capital, which is not called, is known as uncalled capital.
(e)   Paid up Capital: This represents that part of the called up capital, which is actually received by the company. The amount of the called-up capital, which not paid by the shareholders, is called as unpaid capital or calls in arrears.
(f)     Reserve Capital: A company may by special resolution determine that any portion of its share capital which has not been already called up shall not be capable of being called-up, except in the event of winding up of the company. Such type of share capital is known as reserve-capital.

(a)    Difference between Departmental Accounts and Branch Accounts
The main distinctions between Departmental Accounts and Branch Accounts are given below:
 Basis of Distinction Departmental Accounts Branch Accounts Maintenance of Accounts All accounts are maintained at one place & departmental trading and profit and loss account is prepared accordingly In case of branch, all branch accounts are kept at Head Office except cash, customers and stock registers are maintained at branch. But in case of independent branch all accounts are kept at branch and a branch prepares its own trading and Profit & Loss Account. Allocation of Common Expenses Departments are not geographically separated from each other, so problem of allocation of common expenses among different departments arises. As branches are geographically separated from each other so the problem of allocation of common expenses among different branches does not arises. Adjustments &  Reconciliation of Accounts The question of adjustments and reconciliation of accounts does not arise in departmental accounts In case of independent branch some adjustments and reconciliation of head office and the branch accounts are required to be done at the end of the year. Problem of foreign currency The problem of conversion of foreign currency into home currency does not arise. The problem of conversion of foreign branch figures may arise at the time of finalization of accounts of head office.

(b)   Differences Between Hire Purchase System and Installment Purchase System:

(c)    Difference between Reserve Capital and Capital Reserve
 Basis of Difference Reserve Capital Capital Reserve Meaning Reserve Capital is the part of uncalled capital, which shall not be called except in the event of winding up of the company. It is that part of the reserves which is not free for distribution as dividend. Creation It is created out of uncalled capital. It is created out of capital profits. Optional/ Mandatory It is not mandatory to create Reserve Capital. Capital Reserve is mandatory to be created in case of profit on reissue of forfeited shares. Disclosure It is not to be disclosed in the Balance Sheet of the company. Capital Reserve is to be shown in liability side of the balance sheet of the company under the heading of ’Reserve and Surplus.’ Writing of Capital Losses Reserve Capital cannot be used to write off capital losses. Capital Reserve is used to write off capital losses and to issue bonus shares to shareholder.

(d)   Difference Between Average Profit method and Super Profit method
Average Profits Method: In this method, normal past business profits of a number of years are taken into account. Such profits are totaled up and their average is arrived at. The average profits are multiplied by the number year’s purchases to arrive at the value of goodwill.
Super Profit Method: Super Profits means profits earned in excess of the normal Profit, i.e., Actual Profit –Normal. Normal profits mean the profit which the firms could normally earns in a particular business.
Difference between Average Profits and Super Profits
 Basis Average Profits Super Profits 1. Meaning It is the average of the profits of the past few years. It is the excess of average profits over normal profits. 2. Normal Rate of Return Normal rate of return is not relevant in the calculation of average profits. Normal rate of return is considered while calculating super profit. 3. Relevance of Valuing Goodwill It is relevant for average profits method, super profits method and capitalization methods of valuation of goodwill Super profit is relevant for super profit method and capitalization of super profit method of valuation of goodwill.

(a)    Inter-Branch Transactions
Where there are numbers of branches, inter-branch transactions are likely to take place, e.g., cash or goods sent by one branch to another or expenses incurred by one branch on behalf of another.  Such transactions are usually adjusted assuming that they were entered into under the instructions from the H.O.  Suppose Kolkata branch transfers some goods to Mumbai branch under the directions of the H.O.  The entries will be as follows:

 1 In the books of Kolkata Branch: Head Office A/c                        Dr                                To Goods Supplied to Branch A/c XXX XXX 2 In the books of Mumbai Branch: Goods received from Branches A/c        Dr                   To Head Office A/c XXX XXX 3 In the books of Head Office: Mumbai Branch A/c                      Dr                          To Kolkata Branch a/c XXX XXX
Note:     Inter-branch transactions without the knowledge of head office may be passed as between the branches only in the usual manner.

(b)   Partnership Deed
Partnership deed:
A partnership is formed by an agreement. This agreement may be oral or in writing. Though the law does not expressly require that the partnership agreement should be in writing, it is desirable to have it in writing. A document, which contains the terms of partnership, as agreed to by the partners is called ‘Partnership Deed.’
Contents of the Deed:
a)      Name of the firm and its permanent address.
b)      Names and addresses of the partners.
d)      Methods of evaluating of assets and liabilities.
e)      Date of commencement of partnership.
f)       Amount of capital to be contributed by each partner.
g)      Interest of Capital, if provided the rate of interest must be specified.
h)      Drawings by the partners, Interest on Drawings, if charged, the rate of interest should also be specified.
i)        Accounting Period of the Firm: -The period after which the final accounts of the firm are to be prepared. Whether yearly or half-yearly and the date on which accounts are to be closed every year.
j)        Profit and loss sharing ratio: Partners must agree as to the ratio in which they will be distributing profit or loss. In the absence of any agreed ratio profit or loss will be shared equally
k)      Partner’s salary: If any partner is allowed salary, it should be mentioned in the partnership deed and the amount of salary should also be specified.
l)        Duration of partnership: The period for which the partnership has established and the mode of dissolution of partnership.

(c)    Issue of Share at Premium
If Shares are issued at a price, which is more than the face value of shares, it is said that the shares have been issued at a premium. The Company Act 1956 does not place any restriction on issue of shares at a premium but the amount received, as premium has to be placed in a separate account called Securities Premium Account.
Under Section 78 of the Company Act 1956, the amount of security premium may be used only for the following purposes:
(a)    To write off the preliminary expenses of the company.
(b)   To write off the expenses, commission or discount allowed on issued of shares or debentures of the company.
(c)    To provide for the premium payable on redemption of redeemable preference shares or debentures of the company.
(d)   To issue fully paid bonus shares to the shareholders of the company.