1. Accounting for Managers Unit 2 –Depreciation & Ratio Analysis
Session No :2
Padma. R

2. Deprecations
Straight Line Method
Diminishing Balance Method
Annuity Method
Ratio Analysis
Classification of Ratios – Liquidity, Profitability, Financial and Turnover Ratios

3. Meaning of Depreciation
Depreciation means a fall in the quality or value of an asset.
The concept of depreciation refers to the process of allocating the initial or restated input valuation of fixed assets to the several periods expected to benefit from their acquisitions and use.

4. Depreciation accounting
Is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation and not of valuation.

5. Methods Of Depreciation
The amount of depreciation of a fixed asset is determined taking into account the following three factors :
Its original cost
Its recoverable cost at the time it is retired from service
The length of its life
There a three methods of depreciation
1.Straight line method,
2.Diminishing balance method
3.Annuity method

6. Straight Line Method Of Depreciation
Also known as “fixed installment system”
Equal amount of depreciation every year.
This depreciation method is appropriate where economic benefits from an asset are expected to be realized evenly over its useful life.
In other words, this method writes off a fixed percentage
Cost of acquisition + installment chargers – scrap value
Annual charges =
Estimated life

7. Annual value = ---------------------------------- = 14,000
Example
Machinery A was purchased at Rs 1,00,000. The installment cost was Rs 50,000. scrap value is estimated at Rs 10,000. The estimated life machinery is 10 years . Calculate the Depreciation. Sol:
1,00,000+50,000-10,000
Annual value = = 14,000 10

8. Diminishing Balance Method
Also known as the, `reducing installment system’ or `written down value method’,
Depreciation as a fixed percentage to the balance of the net cost of the asset not yet allocated at the end of the previous accounting period.

9. On 1-1-2012, machinery was purchased for Rs. 3,00,000
On , machinery was purchased for Rs.3,00,000. Depreciation at the rate of 10% has to be written off. Write up the machinery account for three years under:
1. Straight line method (SLM) and
2. Written down value method (WDV)

10. Straight line method On 1st jan 2012 3,00,000*10/100= 30,000 Year
Value of machinery (minus) Deprecation amount = Annual value
1st jan 2012
3,00,000
30,000
2,70,000
1st jan 2013
30,0000
2,40,000
1st jan 2014
2,10,000
1st jan 2015
1,80,000

11. Written down value method (WDV)
Year
Value of machinery Deprecation amount = Annual value
(10%)
1st jan 2012
3,00,000
3,00,000*10% =30,000
2,70,000
1st jan 2013
2,70,000*10%= 27,000
2,43,000
1st jan 2014
2,43,000*10= 24,300
2,18,700
1st jan 2015
2,18,700*10= 21,870
1,96,830

12. writing off depreciation under any method
Depreciation a/c ….. Dr To asset a/c

13. writing off depreciation under any method
Date
Particulars
SLM
WDV
2012
2013
2014
2015
To Bank A/C
To Balance B/D
3,00,000
2,70,000
2,40,000
2,10,000
2,43,000
2,18,700
31-12
31-12-
By Depreciation
By Balance C/D
30,000
27,000
24,300
writing off depreciation under any method
Depreciation a/c ….. Dr To asset a/c

14. Annuity Method Of Depreciation
The amount spent on the acquisition of an asset is regarded as investment which is assumed to earn interest at a certain rate.
Every year the asset is debited with the amount of interest and credited with the amount of depreciation.
This interest is calculated on the debit balance of the asset account at the beginning of the year.
The amount to be written off as depreciation is calculated from the annuity table.

16. Year
3`%
3.5% 4%
4.5% 5% 3 4 5
A lease is purchased for a term of 4 years by payment of rs.1,00,000. It is proposed to depreciate the lease by annuity method charging 4% interest. If annuity of re.1 for 4 years at 4% is , show the lease account for the full period.
Amount of annual depreciation =rs.1,00,000 x re
= rs.27,549

17. Lease account Date Particulars Amount amount 1st Year 2nd Year
3rd Year
To Bank
To Interest At 4%
To Balance B/D
1st
3rd
By Depreciation
By Balance C/D

18. Ratio Analysis
Analysis and interpretation of financial statements full diagnosis of the profitability and financial soundness of the business is made possible.
The term `analysis of financial statements’ means methodical classification of the data given in the financial statements.
The term `interpretation of financial statements’ means explaining the meaning and significance of the data so classified

19. Financial Analysis
“Analyzing financial statements is a process of evaluating the relationship between the component parts of the financial statements to obtain a better understanding of a firm’s position and performance”. The purpose of evaluation of financial statements differs among various groups: creditors, shareholders, potential investors, management and so on.

20. Meaning of Ratio Analysis
“The relationship of one item to another expressed in simple mathematical form is known as a ratio”
The main objectives of ratio analysis are:
To simplify the comparative picture of financial statements.
To assist the management in decision making.
To guage the profitability, solvency and efficiency of an enterprise, and
To ascertain the rate and direction of change and future potentiality

21. Classification of Ratios
The ratios have been categorized under the following headings:- (i) ratios for analysis of capital structure or leverage. (ii) ratios for fixed assets analysis. (iii) ratios for analysis of turnover. (iv) ratios for analysis of liquidity position. (v) ratios for analysis of profitability. (vi) ratios for analysis of operational efficiency.

22. Capital Structure or Leverage Ratios
Financial strength indicates the soundness of the financial resources of an organization to perform its operations in the long run
Financial strength is directly associated with the operational ability of the organisation and its efficient management of resources. The financial strength analysis can be made with the help of the following ratios:
(1) Debt-equity ratio
(2) Capital gearing ratio
(3) Financial leverage
(4) Proprietary ratio and
(5) Interest coverage.

23. Debt-Equity Ratio
The debt-equity ratio is determined to ascertain the soundness of the long-term financial policies of the company.
This ratio indicates the proportion between the shareholders’ funds (i.e. Tangible net worth) and the total borrowed funds.
Ideal ratio is 1.
Debt
Debt-equity ratio =
Equity
A high ratio indicates that the claims of creditors are higher as compared to owners’ funds and a low debt-equity ratio may result in a higher claim of equity.

24. Capital Gearing Ratio
This ratio establishes the relationship between the fixed interest-bearing securities and equity shares of a company. It is calculated as follows: Fixed interest-bearing securities Capital gearing ratio = Equity shareholders’ funds If this ratio is less than one, it is said to be low geared. If it is exactly one, it is evenly geared.

25. Financial Leverage Ratio
Financial leverage results from the presence of fixed financial charges in the firm’s income stream.
Financial leverage is concerned with the effects of changes in earnings before interest and taxes on the earnings available to equity holders. It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in ebit on the firm’s earning per share.

26. Proprietary Ratio
This ratio establishes the relationship between the proprietors’ funds and the total tangible assets.
The general financial strength of a firm can be understood from this ratio.
The ratio is of particular importance to the creditors who can find out the proportion of shareholders’ funds in the capital assets employed in the business.
A high ratio shows that a concern is less dependent on outside funds for capital .
Net Worth
Proprietary Ratio =
Total Assets

27. Interest Coverage
This ratio measures the debt servicing capacity of a firm in so far as fixed interest on long-term loan is concerned. It is determined by dividing the operating profits or earnings before interest and taxes (ebit) by the fixed interest charges on loans.
EBIT
Interest Coverage =
Interest

28. II. Fixed Assets Analysis
Analysis of fixed assets is very important from investors’ point of view because investors are more concerned with long term assets. Fixed assets are properties of non-current nature which are acquired to provide facilities to carry on business .
Fixed assets are generally financed by owners’ equity and long-term borrowings.
Fixed assets has been done with the help of the following ratios:-
(a) Fixed Assets To Net Worth
(b) Fixed Assets To Long-Term Funds

29. Fixed Assets To Net Worth
“this ratio indicates the relationship between net worth (i.e. Shareholders’ funds) and investments in net fixed assets (i.e. Gross block minus depreciation)”. The higher the ratio the lesser would be the protection to creditors. If the ratio is less than 1, it indicates that the net worth exceeds fixed assets. Net Fixed Assets Fixed Assets To Net Worth Ratio = Net Worth

30. Fixed Assets To Long-Term Funds
This ratio establishes the relationship between the fixed assets and long-term funds and it is obtained by the formula: Fixed Assets FIXED ASSET RATIO = Long-Term Funds The ratio should be less than one. If it is less than one, it shows that a part of the working capital has been financed through long-term funds. This is desirable because a part of working capital termed as “core working capital” is more or less of a fixed nature. The ideal ratio is 0.67.

31. III. Analysis Of Turnover (Or) Analysis Of Efficiency
Turnover ratios also referred to as activity ratios are concerned with measuring the efficiency in asset management.
These ratios are also called as efficiency ratios or asset utilisation ratios.
The greater the rate of turnover or conversion, the more efficient the utilisation/management, other things being equal.
Some of the more widely used turnover ratios are:-
Fixed Assets Turnover Ratio
Current Assets Turnover Ratio
Working Assets Turnover Ratio
Inventory (Or Stock) Turnover Ratio
Debtors Turnover Ratio
Creditors Turnover Ratio

32. Fixed Assets Turnover Ratio
The fixed assets turnover ratio measures the efficiency with which the firm is utilising its investment in fixed assets, such as land, building, plant and machinery, furniture, etc.
Sales
Fixed Assets Turnover Ratio =
Net Fixed Assets
A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generating operating revenue.

33. Current Assets Turnover Ratio
The current assets turnover ratio ascertains the efficiency with which current assets are used in a business .
This ratio is strongly associated with efficient utilisation of costs, receivables and inventory .
A higher value of this ratio indicates greater circulation of current assets while a low ratio indicates a stagnation of the flow of current assets.
Sales
Current Assets Turnover Ratio =
Current Assets

34. Working Capital Turnover Ratio
this ratio shows the number of times working capital is turned-over in a stated period. Working capital turnover ratio reflects the extent to which a business is operating on a small amount of working capital in relation to sales.
Sales
Working Capital Turnover Ratio =
Net Working Capital
The higher the ratio, the lower is the investment in working capital and greater are the profits.

35. Inventory Turnover Ratio
The inventory turnover ratio, also known as stock turnover ratio normally establishes the relationship between cost of goods sold and average inventory. This ratio indicates whether investment in inventory is within proper limit or not.
Cost Of Goods Sold
Inventory Turnover Ratio =
Average Inventory
High inventory turnover ratio is better than a low ratio. A high ratio implies good inventory management.

36. Debtors Turnover Ratio And Collection Period
The debtors turnover ratio is a test of the liquidity of the debtors of a firm. The liquidity of a firm’s receivables can be examined in two ways: (i) debtors/receivables turnover and (ii) average collection period.
Net Credit Sales
Debtors Turnover Ratio =
Average Debtors
Net credit sales consists of gross credit sales minus returns if any, from the customers. Average debtors is the simple average of debtors at the beginning and at the end of the year.

37. The second type of ratio measuring the liquidity of a firm’s debtors is the average collection period.
This ratio is, in fact, interrelated with and dependent upon, the receivables turnover ratio. It is calculated by dividing the days in a year by the debtors turnover. Thus,
Days In Year
Average Collection Period =
Debtors Turnover

38. Creditors’ Turnover Ratio And Debt Payment Period
Creditors’ turnover ratio indicates the speed with which the payments for credit purchases are made to the creditors. This ratio can be computed as follows:-
Average Accounts Payable
Creditors’ Turnover Ratio =
Net Credit Purchases
A high ratio indicates that creditors are not paid in time while a low ratio gives an idea that the business is not taking full advantage of credit period allowed by the creditors.

39. IV Analysis Of Liquidity Position
The liquidity ratios measure the ability of a firm to meet its short- term obligations and reflect the short-term financial strength/solvency of a firm.
The term liquidity is described as convertibility of assets ultimately into cash in the course of normal business operations and the maintenance of a regular cash flow.
Ratios are used to measure the liquidity position:-
current ratio
liquid (or) quick ratio
cash to current assets ratio
cash to working capital ratio

40. Current Ratio
the ratio of the firm’s current assets to current liabilities. It is calculated by dividing current assets by current liabilities:
Current Assets
Current Ratio =
Current Liabilities

41. Liquid (Or) Quick Ratio
Liquid (or) quick ratio is a measurement of a firm’s ability to convert its current assets quickly into cash in order to meet its current liabilities. It is a measure of judging the immediate ability of the firm to pay-off its current obligations.
Quick Assets
Liquid Ratio =
Current Liabilities

42. Cash To Current Assets Ratio
Efficient management of the inflow and outflow of cash plays a crucial role in the overall performance of a business. Cash is the most liquid form of assets which safeguards the security interest of a business. Cash Cash To Working Capital Ratio = Working Capital

43. Analysis Of Profitability
Profitability is a measure of efficiency and control. It indicates the efficiency or effectiveness with which the operations of the business are carried on.
Gross Profit Ratio
Net Profit Ratio
Return On Capital Employed
Operating Ratio
Operating Profit Ratio
Return On Owners’ Equity
Earnings Per Share
Dividend Pay Out Ratio

44. The gross profit ratio or gross profit margin ratio expresses the relationship of gross profit on sales / net sales.
Gross Profit
Gross Profit Ratio = X 100
Sales
Net profit is a good indicator of the efficiency of a firm. Net profit ratio or net profit margin ratio is determined by relating net income after taxes to net sales.
Net Profit
Net Profit Ratio = X 100

45. Return On Capital Employed
the return on capital employed is used as a measure of success of a business in realising this objective.
Operating Profit
Return On Capital Employed = X 100
Capital Employed
Operating Ratio:
This ratio establishes the relationship between total operating expenses and sales. Total operating expenses includes cost of goods sold plus other operating expenses.

46. Cost Of Goods Sold + Operating Experience Operating Ratio = X 100 Sales Operating Profit Ratio: this ratio indicates net-margin earned on a sale of rs.100. It is calculated as follows: Net Operating Profit Operating Profit Ratio = X 100

47. Return On Owners’ Equity (Or) Shareholders’ Fund (Or) The Net Worth The ratio of return on owners’ equity is a valuable measure for judging the profitability of an organisation. This ratio helps the shareholders of a firm to know the return on investment in terms of profits. Net Profit After Interest And Tax Return On Owners’ Equity = X 100 Owners’ Equity (Net Worth)

48. Earnings Per Share (EPS) Net Profit After Tax – Preference Dividend Earnings Per Share = Number Of Equity Shares Dividend Pay Out Ratio Dividend Per Equity Share Dividend Payout Ratio = Earnings Per Share

49. Summary
Depreciation is fall in the value of the assets.
Three methods of calculating deprection.
Straight line method/ fixed installment method
Diminishing balance method/ reducing installment system/ written down value method
Annuity method

50. Summary Ratio Indicates Higher/ more than 1 Lower / less than 1
Debt-equity
Share holder’s fund and total borrowed fund
Clams of creditors higher than owners
Higher claim of equity
‘K’ gearing
Fixed interest bearing & equity share
High geared
Low geared
Financial leverage
Fixed charges do not vary Earning before interest and tax
Neither high
Nor low
Proprietary ratio
Proprietor’s fund and total tangible assets
Less dependent on outside fund
More dependent
Interest coverage
Debt servicing capacity and fixed interest on long team loan
Unused debt capacity
Using excessive debt
Fixed assets to net worth
Net worth and investment in fixed assets
More than one part of FA has been provided by creditors
Less than 1, net worth is more than fixed assets
FA to long term fund
FA and long term funds
Current liability is invested in long term assets
Working capital is financed by long term fund

51. Ratio
Indicates
Higher/ more than 1
Lower / less than 1
Fixed turn over
Efficiency for utilizing investment
Efficient utilizing of assets for earing revenue
Inefficient utilization
Current assets turnover
Use of current assets
Great circulation of current assets
Stagnation
Inventory turnover
Cost od goods sold n average inventory
Good inventory management
Dangerous
Current ratio
Liquid position ideal 2:1
More than 2 very comfortable in payment
Difficult
Liquid ratio
Current asset quickly to cash 1:1

52. Ratio
Indicates
Higher/ more than 1
Lower / less than 1
Gross profit
Gross profit and sale.
Good effective mgt
Decline in business
Net ratio
Efficiency of a firm
Better position
Operating ratio
Total operating expenses and sale
Operation expenses are high
Lower is better
EPS
Profit available to equity shareholders
Dividend payout ratio
Earnings belonging to the ordinary shareholder and dividend paid to them

53. THANK YOU
Padma..R