Bikaner Technical University

Managerial Economics and Financial Accounting

Business Organization and Business Cycles
Unit V

Business Cycle

A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural
growth rate. It explains the expansion and contraction in economic activity that an economy experiences
over time.

Stages of the Business Cycle

In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves
about the line. Below is a more detailed description of each stage in the business cycle:

1. Expansion

The first stage in the business cycle is expansion. In this stage, there is an increase in positive economic
indicators such as employment, income, output, wages, profits, demand, and supply of goods and services.
Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment
is high. This process continues as long as economic conditions are favourable for expansion.

2. Peak

The economy then reaches a saturation point, or peak, which is the second stage of the business cycle. The
maximum limit of growth is attained. The economic indicators do not grow further and are at their highest.
Prices are at their peak. This stage marks the reversal point in the trend of economic growth. Consumers
tend to restructure their budgets at this point.

3. Recession

The recession is the stage that follows the peak phase. The demand for goods and services starts declining
rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on
producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive
economic indicators such as income, output, wages, etc., consequently start to fall.

4. Depression

There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as
this falls below the steady growth line, the stage is called a depression.

5. Trough
In the depression stage, the economy’s growth rate becomes negative. There is further decline until the
prices of factors, as well as the demand and supply of goods and services, contract to reach their lowest
point. The economy eventually reaches the trough. It is the negative saturation point for an economy. There
is extensive depletion of national income and expenditure.

6. Recovery

After the trough, the economy moves to the stage of recovery. In this phase, there is a turnaround in the
economy, and it begins to recover from the negative growth rate. Demand starts to pick up due to low
prices and, consequently, supply begins to increase. The population develops a positive attitude towards
investment and employment and production starts increasing.

Business Organisation
Sole Proprietorship, Partnership Firm, Limited Liability Partnership, Joint Stock Company

Sole Proprietorship

Sole proprietorship or individual entrepreneurship is a business concern owned and operated by one person.
The sole proprietor is a person who carries on business exclusively by and for himself. He alone contributes
the capital and skills and is solely responsible for the results of the enterprise. In fact, sole proprietor is the
supreme judge of all matters pertaining to his business subject only to the general laws of the land and to
such special legislation as may affect his particular business.

salient features of the proprietorship are as follows

Single ownership
One man control
Undivided risk
Unlimited liability
No separate entity of the business
No Government regulations.

Advantages:

(a) Simplicity – It is very easy to establish and dissolve a sole proprietorship. No documents are required and
no legal, formalities are involved. Any person competent to enter into a contract can start it. However, in
some cases, i.e., of a chemist shop, a municipal license has to be obtained. You can start business from your
own home.

(b) Quick Decisions – The entrepreneur need not consult anybody in deciding his business affairs. Therefore,
he can take on the spot decisions to exploit opportunities from time to time. He is his own boss.

(c) High Secrecy – The proprietor has not to publish his accounts and the business secrets are known to him
alone. Maintenance of secrets guards him from competitors.

(d) Direct Motivation – There is a direct relationship between efforts and rewards. Nobody shares the profits
of business. Therefore, the entrepreneur has sufficient incentive to work hard.

(e) Personal Touch – The proprietor can maintain personal contacts with his employees and clients. Such
contacts help in the growth of the enterprise.

(f) Flexibility – In the absence of Government control, there is complete freedom of action. There is no scope
for difference of opinion and no problem of co-ordination.

Disadvantages:

(a) Limited Funds – A proprietor can raise limited financial resources. As a result, the size of business remains
small. There is limited scope for growth and expansion. Economies of scale are not available.
(b) Limited Skills – Proprietorship is a one man show and one man cannot be an expert in all areas
(production, marketing, financing, personnel etc.) of business. There is no scope for specialisation and the
decisions may not be balanced.

(c) Unlimited Liability – The liability of the proprietor is unlimited. In case of loss his private assets can also
be used to pay off creditors. This discourages expansion of the enterprise.

(d) Uncertain Life – The life of proprietorship depends upon the life of the owner. The enterprise may die
premature death due to the incapacity or death of the proprietor. The proprietor has a low status and can be
lonely.

Therefore, sole proprietorship is suitable in the following cases:

i. Where small amount of capital is required e.g., sweet shops, bakery, newsstand, etc.

ii. Where quick decisions are very important, e.g., share brokers, bullion dealers, etc.

iii. Where limited risk is involved, e.g., automobile repair shop, confectionery, small retail store, etc.

iv. Where personal attention to individual tastes and fashions of customers is required, e.g., beauty parlour,
tailoring shops, lawyers, painters, etc.

v. Where the demand is local, seasonal or temporary, e.g., retail trade, laundry, fruit sellers, etc.

vi. Where fashions change quickly, e.g., artistic furniture, etc.

vii. Where the operation is simple and does not require skilled management.

Thus, sole proprietorship is a common form of organisation in retail trade, professional firms, household and
personal services. This form of organization is quite popular in our country. It accounts for the largest
number of business establishments in India, in spite of its limitations.

Partnership Firm

As a business enterprise expands beyond the capacity of a single person, a group of persons have to join
hands together and supply the necessary capital and skills. Partnership firm thus grew out of the limitations
of one-man business. Need to arrange more capital, provide better skills and avail of specialisation led to the
growth to partnership form of organisation.

According to Section 4 of the Partnership Act, 1932 partnership is “the relation between persons who have
agreed to share the profits of a business carried on by all or anyone of them acting for all”. In other words, a
partnership is an agreement among two or more persons to carry on jointly a lawful business and to share
the profits arising there from. Persons who enter into such agreement are known individually as ‘partners’
and collectively as ‘firm’.

Characteristics of Partnership:

i. Association of two or more persons — maximum 10 in banking business and 20 in non-banking business

ii. Contractual relationship—written or oral agreement among the partners

iii. Existence of a lawful business

iv. Sharing of profits and losses

v. Mutual agency among partners

vi. No separate legal entity of the firm

vii. Unlimited liability

viii. Restriction on transfer of interest

ix. Utmost good faith.

Merits of Partnership:
The partnership form of business ownership enjoys the following advantages:

1. Ease of Formation:

A partnership is easy to form as no cumbersome legal formalities are involved. An agreement is necessary
and the procedure for registration is very simple. Similarly, a partnership can be dissolved easily at any time
without undergoing legal formalities. Registration of the firm is not essential and the partnership agreement
need not essentially be in writing.

2. Larger Financial Resources:

As a number of persons or partners contribute to the capital of the firm, it is possible to collect larger
financial resources than is possible in sole proprietorship. Creditworthiness of the firm is also higher because
every partner is personally and jointly liable for the debts of the business. There is greater scope for
expansion or growth of business.

3. Specialisation and Balanced Approach:

The partnership form enables the pooling of abilities and judgment of several persons. Combined abilities
and judgment result in more efficient management of the business. Partners with complementary skills may
be chosen to avail of the benefits of specialisation. Judicious choice of partners with diversified skills ensures
balanced decisions. Partners meet and discuss the problems of business frequently so that decisions can be
taken quickly.

4. Flexibility of Operations:

Though not as versatile as proprietorship, a partnership firm enjoys sufficient flexibility in its day-to-day
operations. The nature and place of business can be changed whenever the partners desire. The agreement
can be altered and new partners can be admitted whenever necessary. Partnership is free from statutory
control by the Government except the general law of the land.

5. Protection of Minority Interest:

No basic changes in the rights and obligations of partners can be made without the unanimous consent of all
the partners. In case a partner feels dissatisfied, he can easily retire from or he may apply for the dissolution
of partnership.

6. Personal Incentive and Direct Supervision:

There is no divorce between ownership and management. Partners share in the profits and losses of the firm
and there is motivation to improve the efficiency of the business. Personal control by the partners increases
the possibility of success. Unlimited liability encourages caution and care on the part of partners. Fear of
unlimited liability discourages reckless and hasty action and motivates the partners to put in their best
efforts.

7. Capacity for Survival:

The survival capacity of the partnership firm is higher than that of sole proprietorship. The partnership firm
can continue after the death or insolvency of a partner if the remaining partners so desire. Risk of loss is
diffused among two or more persons. In case one line of business is not successful, the firm may undertake
another line of business to compensate its losses.

8. Better Human and Public Relations:

Due to number of representatives (partners) of the firm, it is possible to develop personal touch with
employees, customers, government and the general public. Healthy relations with the public help to enhance
the goodwill of the firm and pave the way for steady progress of the business.

9. Business Secrecy:

It is not compulsory for a partnership firm to publish and file its accounts and reports. Important secrets of
business remain confined to the partners and are unknown to the outside world.
Demerits of Partnership:

1. Unlimited Liability:

Every partner is jointly and severally liable for the entire debts of the firm. He has to suffer not only for his
own mistakes but also for the lapses and dishonesty of other partners. This may curb entrepreneurial spirit
as partners may hesitate to venture into new lines of business for fear of losses. Private property of partners
is not safe against the risks of business.

2. Limited Resources:

The amount of financial resources in partnership is limited to the contributions made by the partners. The
number of partners cannot exceed 10 in banking business and 20 in other types of business. Therefore,
partnership form of ownership is not suited to undertake business involving huge investment of capital.

3. Risk of Implied Agency:

The acts of a partner are binding on the firm as well as on other partners. An incompetent or dishonest
partner may bring disaster for all due to his acts of commission or omission. That is why the saying is that
choosing a business partner is as important as choosing a partner in life.

4. Lack of Harmony:

The success of partnership depends upon mutual understanding and cooperation among the partners.
Continued disagreement and bickering among the partners may paralyse the business or may result in its
untimely death. Lack of a central authority may affect the efficiency of the firm. Decisions may get delayed.

5. Lack of Continuity:

A partnership comes to an end with the retirement, incapacity, insolvency and death of a partner. The firm
may be carried on by the remaining partners by admitting new partners. But it is not always possible to
replace a partner enjoying trust and confidence of all. Therefore, the life of a partnership firm is uncertain,
though it has longer life than sole proprietorship.

6. Non-Transferability of Interest:

No partner can transfer his share in the firm to an outsider without the unanimous consent of all the
partners. This makes investment in a partnership firm non-liquid and fixed. An individual’s capital is blocked.

7. Public Distrust:

A partnership firm lacks the confidence of public because it is not subject to detailed rules and regulations.
Lack of publicity of its affairs undermines public confidence in the firm.

Joint Stock Company

A joint stock company is an incorporated and voluntary association of individuals with a distinctive name,
perpetual succession, limited liability and common seal, and usually having a joint capital divided into
transferable shares of a fixed value.

With the growing needs of modern business, collection of vast financial and managerial resources became
necessary. Proprietorship and partnership forms of ownership failed to meet these needs due to their
limitations, e.g., unlimited liability, lack of continuity and limited resources.

The company form of business organisation was evolved to overcome these limitations. Joint stock company
has become the dominant form of ownership for large scale enterprises because it enables collection of vast
financial and managerial resources with provision for limited liability and continuity of operations.

Merits of Company Organisation:

The company form of business ownership has become very popular in modern business on account of its
several advantages:

1. Limited Liability:
Shareholders of a company are liable only to the extent of the face value of shares held by them. Their
private property cannot be attached to pay the debts of the company. Thus, the risk is limited and known.
This encourages people to invest their money in corporate securities and, therefore, contributes to the
growth of the company form of ownership.

2. Large Financial Resources:

Company form of ownership enables the collection of huge financial resources. The capital of a company is
divided into shares of small denominations so that people with small means can also buy them. Benefits of
limited liability and transferability of shares attract investors. Different types of securities may be issued to
attract various types of investors. There is no limit on the number of members in a public company.

3. Continuity:

A company enjoys uninterrupted business life. As a body corporate, it continues to exist even if all its
members die or desert it. On account of its stable nature, a company is best suited for such types of business
which require long periods of time to mature and develop.

4. Transferability of Shares:

A member of a public limited company can freely transfer his shares without the consent of other members.
Shares of public companies are generally listed on a stock exchange so that people can easily buy and sell
them. Facility of transfer of shares makes investment in company liquid and encourages investment of public
savings into the corporate sector.

5. Professional Management:

Due to its large financial resources and continuity, a company can avail of the services of expert professional
managers. Employment of professional managers having managerial skills and little financial stake results in
higher efficiency and more adventurous management. Benefits of specialisation and bold management can
be secured.

6. Scope for Growth and Expansion:

There is considerable scope for the expansion of business in a company. On account of its vast financial and
managerial resources and limited liability, company form has immense potential for growth. With continuous
expansion and growth, a company can reap various economies of large scale operations, which help to
improve efficiency and reduce costs.

7. Public Confidence:

A public company enjoys the confidence of public because its activities are regulated by the government
under the Companies Act. Its affairs are known to public through publication of accounts and reports. It can
always keep itself in tune with the needs and aspirations of people through continuous research and
development.

8. Diffused Risk:

The risk of loss in a company is spread over a large number of members. Therefore, the risk of an individual
investor is reduced.

9. Social Benefits:

The company organisation helps to mobilise savings of the community and invest them in industry. It
facilitates the growth of financial institutions and provides employment to a large number of persons. It
provides huge revenues to the Government through direct and indirect taxes.

Demerits of Company:

A company suffers from the following limitations:

1. Difficulty of Formation:
It is very difficult and expensive to form a company. A number of documents have to be prepared and filed
with the Registrar of Companies. Services of experts are required to prepare these documents. It is very
time-consuming and inconvenient to obtain approvals and sanctions from different authorities for the
establishment of a company. The time and cost involved in fulfilling legal formalities discourage many people
from adopting the company form of ownership. It is also difficult to wind up a company.

2. Excessive Government Control:

A company is subject to elaborate statutory regulations in its day-to-day operations. It has to submit
periodical reports. Audit and publication of accounts is obligatory. The objects and capital of the company
can be changed only after fulfilling the prescribed legal formalities. These rules and regulations reduce the
efficiency and flexibility of operations. A lot of precious time, effort and money have to be spent in complying
with the innumerable legal formalities and irksome statutory regulations.

3. Lack of Motivation and Personal Touch:

There is divorce between ownership and management in a large public company. The affairs of the company
are managed by the professional and salaried managers who do not have personal involvement and stake in
the company. Absentee ownership and impersonal management result in lack of initiative and responsibility.
Incentive for hard work and efficiency is low. Personal contact with employees and customers is not possible.

4. Oligarchic Management:

In theory the management of a company is supposed to be democratic but in actual practice company
becomes an oligarchy (rule by a few). A company is managed by a small number of people who are able to
perpetuate their reign year after year due to lack of interest, information and unity on the part of
shareholders. The interests of small and minority shareholders are not well protected. They never get
representation on the Board of Directors and feel oppressed.

5. Delay in Decisions:

Too many levels of management in a company result in red-tape and bureaucracy. A lot of time is wasted in
calling and holding meetings and in passing resolutions. It becomes difficult to take quick decisions and
prompt action with the consequence that business opportunities may be lost.

6. Conflict of Interests:

Company is the only form of business where in a permanent conflict of interests may exist. In proprietorship
there is no scope for conflict and in a partnership continuous conflict results in dissolution of the firm. But in
a company conflict may continue between shareholders and board of directors or between shareholders and
creditors or between management and workers.

7. Frauds in Promotion and Management:

There is a possibility that unscrupulous promoters may float a company to dupe innocent and ignorant
investors. They may collect huge sums of money and, later on, misappropriate the money for their personal
benefit. The case of South Sea Bubble Company is the leading example of such malpractices by promoters.

Moreover, the directors of a company may manipulate the prices of the company’s shares and debentures
on the stock exchange on the basis of inside information and accounting manipulations. This may result in
reckless speculation in shares and even a sound company may be put into financial difficulties.

8. Lack of Secrecy:

Under the Companies Act, a company is required to disclose and publish a variety of information on its
working. Widespread publicity of affairs makes it almost impossible for the company to retain its business
secrets. The accounts of a public company are open for inspection to public.

9. Social Evils:
Giant companies may give rise to monopolies, concentration of economic power in a few hands, interference
in the political system, lack of industrial peace, etc.

Suitability:

Despite its drawbacks, the company form of organisation has become very popular, particularly for large
business concerns. This is because its merits far outweigh the demerits. Many of the drawbacks of a company
are mainly due to the weaknesses of the people who promote and manage companies and not because of
the company system as such. The company organisation has made it possible to accumulate large amounts of
capital required for large scale operations.

Due to its unique characteristics, the company form of ownership is ideally suited to the following types of
business:

(i) Heavy or basic industries like ship-building, coach-making factory, engineering firms, etc., requiring huge
investment of capital.

(ii) Large scale operations are very crucial because of economies of scale, departmental stores, chain stores
and enterprises engaged in the construction of bridges, dams, multi-storeyed buildings, etc.

(iii) The line of business involves great uncertainty or heavy risk, e.g., shipping and airline concerns.

(iv) The law makes the company organisation obligatory, e.g., banking business can be run only in the form of
company.

(v) The owners of the business want to enjoy limited liability.

State/ Public Enterprises and their Forms

Private Company

Section 2 (68) of Companies Amendment Act, 2013 defines a Private Company as follows:

“private company” means a company having a minimum paid-up share capital of one lakh rupees or such
higher paid-up share capital as may be prescribed, and which by its articles—

i. Restricts the right to transfer its shares;

ii. Except in case of One Person Company, limits the number of its members to two hundred-

Provided that where two or more persons hold one or more shares in a company jointly, they shall, for the
purposes of this clause, be treated as a single member-

Provided further that:

a. Persons who are in the employment of the company; and

b. Persons who, having been formerly in the employment of the company, were members of the company
while in that employment and have continued to be members after the employment ceased, shall not be
included in the number of members; and

iii. Prohibits any invitation to the public to subscribe for any securities of the company.

Benefits of a Private Company:

A private company offers the following benefits:

i. Stability – being a separate legal entity, the existence of a private company is independent of the existence
of its members.

ii. Limited liability – the liability of members is limited only to the extent of the unpaid capital on the shares
held by them.

iii. Comparative flexibility of operations – a private company enjoys lesser compliance and more privileges as
compared with a public company, making it a suitable choice for entrepreneurs.
iv. Improved credibility – due to incorporation, a private company enjoys an improved credibility in doing
transactions with various stakeholders.

v. Team building – private company offers stock ownership and ESOP schemes to attract talented pool of
workforce for the company.

vi. Expansion – In private companies, scope of expansion is large as fund raising can easily be done by
receiving funds from its members, directors. Bank also give high value to private companies and sanction
loans accordingly.

Limitation of Private Company:

i. Process and Formalities:

As the registration of the company requires many formalities, one needs assistance from professionals like
C.As or C.S, w.r.t. registration and other compliances with the relevant laws.

ii. Limited Availability of Funds:

Due to restrictions on seeking public funding, the prospects of growth and expansion are limited to the
personal financing capacities of members of a private company.

iii. Exit Strategy:

Though it is easy for a shareholder to exit from a company, the procedures to wind up a private limited
company is complicated and involves cumbersome procedures and substantial liquidation cost.

Public Limited Company

Public company is a separate legal entity incorporated under companies act, allowing the members to
transfer their shares, while having a larger number of shareholder base.

Definition of Public Company:

u/s2 (71) of Companies Act Amendment 2013, public company means a company which:

i. Is not a private company;

ii. Has a minimum paid-up share capital of five lakh rupees or such higher paid-up capital, as may be
prescribed

Provided that a company which is a subsidiary of a company, not being a private company, shall be deemed
to be public company for the purposes of this Act even where such subsidiary company continues to be a
private company in its articles.

Public companies are able to attract large funding through issue of equity, debt and other forms of financing
domestically as well as internationally. Due to too much legal constraints and compliances, a public company
is not a very suitable form of business especially for small scale businesses and small entrepreneurs.

However once a business is well established in the industry, then riding on the prestige and credibility of the
business, at a later stage, a business can unravel the option of being formed as a public company.

Advantages of a Public Limited Company (PLC):

Following are the prominent advantages of having a public limited company:

i. Limited Liability of shareholders – The business is viewed as a separate legal entity. This means that even if
a shareholder leaves the PLC or dies, the business can continue.

ii. Ability to raise large amount of capital – Public limited companies are able to raise large sums of money
because there is no limit on the maximum number of members.

iii. Transferability of shares – the shares of a PLC can be freely transferable. This provides liquidity for
shareholders.
iv. Exit strategy – due to transferability of shares and being widely recognizable in the public domain, a public
company magnifies its chances of easily seeking future suitors for the company.

v. Limited liability of shareholders – The liability of shareholders is limited to the extent of unpaid capital on
the shares held by them.

vi. Separate legal entity – The public company due to incorporation is distinct legal person different from its
shareholders.

Disadvantages of a Public Limited Company:

Despite having several benefits, a public limited company suffers from the following disadvantages:

i. There are many legal formalities and regulatory compliances to be adhered to by a company during the
stage of formation as well as carrying of day to day operations.

ii. Ownership and control woes – due to larger shareholder base, at times it’s difficult to take speedy and
timely business decisions especially if the shareholders are geographically scattered.

iii. Vulnerable to takeovers – With shares being freely transferable, a potential bidder can secretly stock up
the shareholding of the company even from open market, to stage a hostile takeover bid.

iv. Larger possibility of conflicts between management and owners

v. Lack of secrecy – due to open access of books of accounts to public, as well as inspection by the relevant
authorities, it is difficult to maintain secrets of business within the confined walls of business.

vi. In order to protect the interest of investors, a public company is required to follow many controls and
regulations.

vii. There is a possibility that the original owners can lose control of the public limited company in the issue
of a dispute or violation.

viii. Some public limited companies can grow very large. As a result, many can suffer from mismanagement
and slow decision making.

ix. Owing to higher degree of transparency and accountability, public companies suffer from slow decision
making woes.

Finally it can be concluded that no particular form of business is perfect for organizing a startup. The specific
choice of business form inter-alia depends upon combination of various factors like control over the
business, ease of doing the business, legal compliances, flexibility, taxation as well as the nature of the
business. An entrepreneur should cautiously choose a form of business after considering all the relevant
factors.

Forms of public enterprises

Public enterprises can be classified into three forms:

(a) Departmental undertaking

(b) Public corporation

(c) Government company

These are explained below

Departmental Undertaking

This is the earliest from of public enterprise. Under this form, the affairs of the public enterprise are carried
out under the overall control of one of the departments of the government. The government department
appoints a managing director (normally a civil servant) for the departmental undertaking. He will be given
the executive authority to take necessary decisions. The departmental undertaking does not have a budget
of its own. As and when it wants, it draws money from the government exchequer and when it has surplus
money, it deposits it in the government exchequer. However, it is subject to budget, accounting and audit
controls.

Examples for departmental undertakings are Railways, Department of Posts, All India Radio, Doordarshan,
Defence undertakings like DRDL, DLRL, ordinance factories, and such.

Features

1. Under the control of a government department: The departmental undertaking is not an independent
organization. It has no separate existence. It is designed to work under close control of a government
department. It is subject to direct ministerial control.

2. More financial freedom: The departmental undertaking can draw funds from government account as per
the needs and deposit back when convenient.

3. Like any other government department: The departmental undertaking is almost similar to any other
government department

4. Budget, accounting and audit controls: The departmental undertaking has to follow guidelines (as
applicable to the other government departments) underlying the budget preparation, maintenance of
accounts, and getting the accounts audited internally and by external auditors.

5. More a government organization, less a business organization . The set up of a departmental undertaking
is more rigid, less flexible, slow in responding to market needs.

Advantages

1. Effective control: Control is likely to be effective because it is directly under the Ministry.

2. Responsible Executives: Normally the administration is entrusted to a senior civil servant. The
administration will be organized and effective.

3. Less scope for mystification of funds: Departmental undertaking does not draw any money more than is
needed, that too subject to ministerial sanction and other controls. So chances for mis-utilisation are low.

4. Adds to Government revenue: The revenue of the government is on the rise when the revenue of the
departmental undertaking is deposited in the government account.

Disadvantages

1. Decisions delayed: Control is centralized. This results in lower degree of flexibility. Officials in the lower
levels cannot take initiative. Decisions cannot be fast and actions cannot be prompt.

2. No incentive to maximize earnings: The departmental undertaking does not retain any surplus with it. So
there is no inventive for maximizing the efficiency or earnings.

3. Slow response to market conditions: Since there is no competition, there is no profit motive; there is no
incentive to move swiftly to market needs.

4. Redtapism and bureaucracy: The departmental undertakings are in the control of a civil servant and under
the immediate supervision of a government department. Administration gets delayed substantially.

5. Incidence of more taxes: At times, in case of losses, these are made up by the government funds only. To
make up these, there may be a need for fresh taxes, which is undesirable.

Any business organization to be more successful needs to be more dynamic, flexible, and responsive to
market conditions, fast in decision marking and prompt in actions. None of these qualities figure in the
features of a departmental undertaking. It is true that departmental undertaking operates as a extension to
the government. With the result, the government may miss certain business opportunities. So as not to miss
business opportunities, the government has thought of another form of public enterprise, that is, Public
corporation.
 PUBLIC CORPORATION

Having released that the routing government administration would not be able to cope up with the demand
of its business enterprises, the Government of India, in 1948, decided to organize some of its enterprises as
statutory corporations. In pursuance of this, Industrial Finance Corporation, Employees’ State Insurance
Corporation was set up in 1948.

Public corporation is a ‘right mix of public ownership, public accountability and business management for
public ends’. The public corporation provides machinery, which is flexible, while at the same time retaining
public control.

Definition

A public corporation is defined as a ‘body corporate create by an Act of Parliament or Legislature and notified
by the name in the official gazette of the central or state government. It is a corporate entity having
perpetual succession, and common seal with power to acquire, hold, dispose off property, sue and be sued
by its name”.

Examples of a public corporation are Life Insurance Corporation of India, Unit Trust of India, Industrial
Finance Corporation of India, Damodar Valley Corporation and others.

Features

1. A body corporate: It has a separate legal existence. It is a separate company by itself. If can raise
resources, buy and sell properties, by name sue and be sued.

2. More freedom and day-to-day affairs: It is relatively free from any type of political interference. It enjoys
administrative autonomy.

3. Freedom regarding personnel: The employees of public corporation are not government civil servants.
The corporation has absolute freedom to formulate its own personnel policies and procedures, and these are
applicable to all the employees including directors.

4. Perpetual succession: A statute in parliament or state legislature creates it. It continues forever and till a
statue is passed to wind it up.

5. Financial autonomy: Through the public corporation is fully owned government organization, and the
initial finance are provided by the Government, it enjoys total financial autonomy, Its income and
expenditure are not shown in the annual budget of the government, it enjoys total financial autonomy. Its
income and expenditure are not shown in the annual budget of the government. However, for its freedom it
is restricted regarding capital expenditure beyond the laid down limits, and raising the capital through capital
market.

6. Commercial audit: Except in the case of banks and other financial institutions where chartered
accountants are auditors, in all corporations, the audit is entrusted to the comptroller and auditor general of
India.

7. Run on commercial principles: As far as the discharge of functions, the corporation shall act as far as
possible on sound business principles.

Advantages

1. Independence, initiative and flexibility: The corporation has an autonomous set up. So it is independent,
take necessary initiative to realize its goals, and it can be flexible in its decisions as required.

2. Scope for Redtapism and bureaucracy minimized: The Corporation has its own policies and procedures. If
necessary they can be simplified to eliminate redtapism and bureaucracy, if any.

3. Public interest protected: The Corporation can protect the public interest by making its policies more
public friendly, Public interests are protected because every policy of the corporation is subject to ministerial
directives and board parliamentary control.
4. Employee friendly work environment: Corporation can design its own work culture and train its
employees accordingly. It can provide better amenities and better terms of service to the employees and
thereby secure greater productivity.

5. Competitive prices: the corporation is a government organization and hence can afford with minimum
margins of profit, It can offer its products and services at competitive prices.

6. Economics of scale: By increasing the size of its operations, it can achieve economics of large-scale
production.

7. Public accountability: It is accountable to the Parliament or legislature; it has to submit its annual report
on its working results.

Disadvantages

1. Continued political interference: the autonomy is on paper only and in reality, the continued.

2. Misuse of Power: In some cases, the greater autonomy leads to misuse of power. It takes time to unearth
the impact of such misuse on the resources of the corporation. Cases of misuse of power defeat the very
purpose of the public corporation.

3. Burden for the government: Where the public corporation ignores the commercial principles and suffers
losses, it is burdensome for the government to provide subsidies to make up the losses.

Government Company

Section 617 of the Indian Companies Act defines a government company as “any company in which not less
than 51 percent of the paid up share capital” is held by the Central Government or by any State Government
or Governments or partly by Central Government and partly by one or more of the state Governments and
includes and company which is subsidiary of government company as thus defined”.

A government company is the right combination of operating flexibility of privately organized companies
with the advantages of state regulation and control in public interest.

Government companies differ in the degree of control and their motive also.

Some government companies are promoted as

• industrial undertakings (such as Hindustan Machine Tools, Indian Telephone Industries, and so on)

• Promotional agencies (such as National Industrial Development Corporation, National Small

Industries Corporation, and so on) to prepare feasibility reports for promoters who want to set up public or
private companies.

• Agency to promote trade or commerce. For example, state trading corporation, Export Credit
Guarantee Corporation and so such like.

• A company to take over the existing sick companies under private management (E.g. Hindustan
Shipyard)

• A company established as a totally state enterprise to safeguard national interests such as Hindustan
Aeronautics Ltd. And so on.

• Mixed ownership company in collaboration with a private consult to obtain technical know-how and
guidance for the management of its enterprises, e.g. Hindustan Cables)

Features

The following are the features of a government company:

1. Like any other registered company: It is incorporated as a registered company under the Indian
companies Act. 1956. Like any other company, the government company has separate legal existence.
Common seal, perpetual succession, limited liability, and so on. The provisions of the Indian Companies Act
apply for all matters relating to formation, administration and winding up. However, the government has a
right to exempt the application of any provisions of the government companies.

2. Shareholding: The majority of the share are held by the Government, Central or State, partly by the
Central and State Government(s), in the name of the President of India, It is also common that the
collaborators and allotted some shares for providing the transfer of technology.

3. Directors are nominated: As the government is the owner of the entire or majority of the share capital of
the company, it has freedom to nominate the directors to the Board. Government may consider the
requirements of the company in terms of necessary specialization and appoints the directors accordingly.

4. Administrative autonomy and financial freedom: A government company functions independently with
full discretion and in the normal administration of affairs of the undertaking.

5. Subject to ministerial control: Concerned minister may act as the immediate boss. It is because it is the
government that nominates the directors, the minister issue directions for a company and he can call for
information related to the progress and affairs of the company any time.

Advantages

1. Formation is easy: There is no need for an Act in legislature or parliament to promote a government
company. A Government company can be promoted as per the provisions of the companies Act. Which is
relatively easier?

2. Separate legal entity: It retains the advantages of public corporation such as autonomy, legal entity.

3. Ability to compete: It is free from the rigid rules and regulations. It can smoothly function with all the
necessary initiative and drive necessary to complete with any other private organization. It retains its
independence in respect of large financial resources, recruitment of personnel, management of its affairs,
and so on.

4. Flexibility: A Government company is more flexible than a departmental undertaking or public

corporation. Necessary changes can be initiated, which the framework of the company law. Government can,
if necessary, change the provisions of the Companies Act. If found restricting the freedom of the government
company. The form of Government Company is so flexible that it can be used for taking over sick units
promoting strategic industries in the context of national security and interest.

5. Quick decision and prompt actions: In view of the autonomy, the government company take decision
quickly and ensure that the actions and initiated promptly.

6. Private participation facilitated: Government company is the only from providing scope for private
participation in the ownership. The facilities to take the best, necessary to conduct the affairs of business,
from the private sector and also from the public sector.

Disadvantages

1. Continued political and government interference: Government seldom leaves the government company
to function on its own. Government is the major shareholder and it dictates its decisions to the Board. The
Board of Directors gets these approved in the general body. There were a number of cases where the
operational polices were influenced by the whims and fancies of the civil servants and the ministers.

2. Higher degree of government control: The degree of government control is so high that the government
company is reduced to mere adjuncts to the ministry and is, in majority of the cases, not treated better than
the subordinate organization or offices of the government.

3. Evades constitutional responsibility: A government company is creating by executive action of the

government without the specific approval of the parliament or Legislature.

4. Poor sense of attachment or commitment: The members of the Board of Management of government
companies and from the ministerial departments in their ex-officio capacity. The lack the sense of
attachment and do not reflect any degree of commitment to lead the company in a competitive
environment.
5. Divided loyalties: The employees are mostly drawn from the regular government departments for a
defined period. After this period, they go back to their government departments and hence their divided
loyalty dilutes their interest towards their job in the government company.

6. Flexibility on paper: The powers of the directors are to be approved by the concerned Ministry,
particularly the power relating to borrowing, increase in the capital, appointment of top officials, entering
into contracts for large orders and restrictions on capital expenditure. The government companies are rarely
allowed to exercise their flexibility and independence.

Introduction to Double Entry Systems

The double-entry system is the foundational accounting principle used to record financial transactions in a
systematic and comprehensive manner. It is a method that ensures the accounting equation remains
balanced and accurate. The double-entry system is based on the concept that every transaction has two
equal and opposite effects, which are recorded in at least two accounts.

Here's an introduction to the double-entry system:

1. Basic Principle: The double-entry accounting system is built on the accounting equation, which states that
assets equal liabilities plus equity. This equation must always be in balance. In a double-entry system, each
transaction affects at least two accounts, with one account debited and another credited.

2. Debits and Credits: In the double-entry system, debits and credits are used to record changes in accounts.
These terms can be a bit confusing at first because they don't always align with common language. However,
they are fundamental to understanding the system.

• Debit: Increases assets and expenses, decreases liabilities and income.

• Credit: Increases liabilities and income, decreases assets and expenses.

3. Dual Aspect: The principle of dual aspect is the essence of the double-entry system. It recognizes that
every business transaction involves a give-and-take relationship. For every debit made, there must be an
equal and opposite credit, ensuring that the accounting equation stays balanced.

4. Recording Transactions: When a business transaction occurs, the accountant identifies which accounts are
affected and applies the appropriate debits and credits to keep the accounting equation in balance. For
example, when a company makes a sale, it will debit the cash or accounts receivable account (increasing
assets) and credit the sales account (increasing income).

The double-entry system provides a robust framework for accurately recording and reporting financial
transactions. It enhances transparency, accountability, and the ability to analyze a company's financial
position. By adhering to this system, businesses can produce reliable financial statements that serve as a
foundation for informed decision-making.

What Is the Disadvantage of the Double-Entry Accounting System?

The primary disadvantage of the double-entry accounting system is that it is more complex. It requires two
entries to be recorded when one transaction takes place. It also requires that mathematically, debits and
credits always equal each other. This complexity can be time-consuming as well as more costly; however, in
the long run, it is more beneficial to a company than single-entry accounting.
 Preparation of final accounts

Introduction

The most important function of an accounting system is to provide information about the profitability of the
business. A sole trader furnishes a Trading and Profit and loss Account which depicts the result of the
business transactions of the sole trader. Along with the Trading and Profit and Loss Account he also prepares
a Balance Sheet which shows the financial position of the business.

Steps in the Process of Finalization of Accounts

A. For Trading Concerns:

1. Trading Account.

2. Profit and Loss Account.

3. Balance Sheet.

B. For Manufacturing and Trading Concerns:

1. Manufacturing Account.

2. Trading Account.

3. Profit and Loss Account.

4. Balance Sheet.

Preparation of Financial Statements

Profitability Statement – This statement is related to a complete accounting period. It shows the outcome of
business activities during that period in a summarized form. The activities of any business will include
purchase, manufacture, and sell.

Balance Sheet – Business needs some resources which have longer life (say more than a year). Such
resources are, therefore, not related to any particular accounting period, but are to be used over the useful
life thereof. The resources do not come free. One requires finance to acquire them. This funding is provided
by owners through their investment, bank & other through loans, suppliers by way of credit terms. The
Balance Sheet shows the list of resources and the funding of the resources i.e. assets and liabilities (towards
owners and outsiders). It is also referred as sources of funds (i.e. liabilities & capital) and application of funds
(i.e. assets). Let us discuss these statements in depth.

Trading Account: It is an account which is prepared by a merchandising concern which purchases goods and
sells the same during a particular period. The purpose of it to find out the gross profit or gross loss which is
an important indicator of business efficiency.

The following items will appear in the debit side of the Trading Account:

(i) Opening Stock: In case of trading concern, the opening stock means the finished goods only. The amount
of opening stock should be taken from Trial Balance.

(ii) Purchases: The amount of purchases made during the year. Purchases include cash as well as credit
purchase. The deductions can be made from purchases, such as, purchase return, goods withdrawn by the
proprietor, goods distributed as free sample etc.

(iii) Direct expenses: it means all those expenses which are incurred from the time of purchases to making
the goods in suitable condition. This expenses includes freight inward, octroi, wages etc.

(iv) Gross profit: If the credit side of trading A/c is greater than debit side of trading A/c gross profit will arise.

The following items will appear in the credit side of Trading Account:

(i) Sales Revenue: The sales revenue denotes income earned from the main business activity or activities.
The income is earned when goods or services are sold to customers. If there is any return, it should be
deducted from the sales value. As per the accrual concept, income should be recognized as soon as it is
accrued and not necessarily only when the cash is paid for. The Accounting standard 7 (in case of contracting
business) and Accounting standard 9 (in other cases) define the guidelines for revenue recognition. The
essence of the provisions of both standards is that revenue should be recognized only when significant risks
and rewards (vaguely referred to as ownership in goods) are transferred to the customer. For example, if an
invoice is made for sale of goods and the term of sale is door delivery; then sale can be recognized only on
getting the proof of delivery of goods at the door of customer. If such proof is pending at the end of
accounting period, then this transaction cannot be taken as sales, but will be treated as unearned income.

(ii) Closing Stocks: In case of trading business, there will be closing stocks of finished goods only. According to
convention of conservatism, stock is valued at cost or net realizable value whichever is lower.

(iii) Gross Loss: When debit side of trading account is greater than credit side of trading account, gross loss
will appear.

Profit and Loss Account:

The following items will appear in the debit side of the Profit & Loss A/c:

(i) Cost of Sales: This term refers to the cost of goods sold. The goods could be manufactured and sold or can
be directly identified with goods.

(ii) Other Expenses: All expenses which are not directly related to main business activity will be reflected in
the P & L component. These are mainly the Administrative, Selling and distribution expenses. Examples are
salary to office staff, salesmen commission, insurance, legal charges, audit fees, advertising, free samples,
bad debts etc. It will also include items like loss on sale of fixed assets, interest and provisions.

(iii) Abnormal Losses: All abnormal losses are charged against Profit & Loss Account. It includes stock
destroyed by fire, goods lost in transit etc.

The following items will appear in the credit side of Profit & Loss A/c:

(i) Revenue Incomes: These incomes arise in the ordinary course of business, which includes commission
received, discount received etc.

(ii) Other Incomes: The business will generate incomes other than from its main activity. These are purely
incidental. It will include items like interest received, dividend received, etc .The end result of one
component of the P & L A/c is transferred over to the next component and the net result will be transferred
to the balance sheet as addition in owners’ equity. The profits actually belong to owners of business. In case
of company organizations, where ownership is widely distributed, the profit figure is separately shown in
balance sheet.

Ratio Analysis

Meaning of Accounting Ratios

As stated earlier, accounting ratios are an important tool of financial statements analysis. A ratio is a
mathematical number calculated as a reference to relationship of two or more numbers and can be
expressed as a fraction, proportion, percentage and a number of times. When the number is calculated by
referring to two accounting numbers derived from the financial statements, it is termed as accounting ratio.
‘Revenue from Operations’ . This ratio is termed as gross profit ratio. Similarly, inventory turnover ratio may
be 6 which implies that inventory turns into ‘Revenue from Operations’ six times in a year. It needs to be
observed that accounting ratios exhibit relationship, if any, between accounting numbers extracted from
financial statements. Ratios are essentially derived numbers and their efficacy depends a great deal upon the
basic numbers from which they are calculated. Hence, if the financial statements contain some errors, the
derived numbers in terms of ratio analysis would also present an erroneous scenario. Further, a ratio must
be calculated using numbers which are meaningfully correlated. A ratio calculated by using two unrelated
numbers would hardly serve any purpose. For example, the furniture of the business is Rs. 1,00,000 and
Purchases
are Rs. 3,00,000. The ratio of purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance.
The reason is that there is no relationship between these two aspects.

Objectives of Ratio Analysis

Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It
provides users with crucial financial information and points out the areas which require investigation. Ratio
analysis is a technique which involves regrouping of data by application of arithmetical relationships, though
its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for
preparing financial statements. Once done effectively, it provides a lot of information which helps the
analyst:

1. To know the areas of the business which need more attention;

2. To know about the potential areas which can be improved with the effort in the desired direction;

3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;

4. To provide information for making cross-sectional analysis by comparing the performance with the best
industry standards; and

5. To provide information derived from financial statements useful for making projections and estimates for
the future.

Types of Ratios

There is a two way classification of ratios: (1) traditional classification, and (2) functional classification. The
traditional classification has been on the basis of financial statements to which the determinants of ratios
belong. On this basis the ratios are classified as follows:

1. ‘Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is
known as statement of profit and loss ratio. For example, ratio of gross profit to revenue from operations is
known as gross profit ratio. It is calculated using both figures from the statement of profit and loss.

2. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet
ratios. For example, ratio of current assets to current liabilities known as current ratio. It is calculated using
both figures from balance sheet.

3. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and
another variable from the balance sheet, it is called composite ratio. For example, ratio of credit revenue
from operations to trade receivables (known as trade receivables turnover ratio) is calculated using one
figure from the statement of profit and loss (credit revenue from operations) and another figure (trade
receivables) from the balance sheet.

Although accounting ratios are calculated by taking data from financial statements but classification of ratios
on the basis of financial statements is rarely used in practice. It must be recalled that basic purpose of
accounting is to throw light on the financial performance

(profitability) and financial position (its capacity to raise money and invest them wisely) as well as changes
occurring in financial position (possible explanation of changes in the activity level). As such, the alternative
classification (functional classification) based on the purpose for which a ratio is computed, is the most
commonly used classification which is as follows:

1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business to pay
the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to
measure it are known as ‘Liquidity Ratios’. These are essentially short-term in nature.

2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations
towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure
solvency position are known as ‘Solvency Ratios’. These are essentially long-term in nature.
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of
operations of business based on effective utilisation of resources. Hence, these are also known as ‘Efficiency
Ratios’.

4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from operations or funds (or
assets) employed in the business and the ratios calculated to meet this objective are known as ‘Profitability
Ratios’.

Liquidity Ratios

Liquidity ratios are calculated to measure the short-term solvency of the business,

i.e. the firm’s ability to meet its current obligations. These are analysed by looking

at the amounts of current assets and current liabilities in the balance sheet. The

two ratios included in this category are current ratio and liquidity ratio.

1.Current Ratio:

Current ratio is the proportion of current assets to current liabilities. It is

expressed as follows:

Current assets include current investments, inventories, trade receivables (debtors and bills receivables),
cash and cash equivalents, short-term loans and advances and other current assets such as prepaid
expenses, advance tax and accrued income, etc.

Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current
liabilities and short-term provisions.

Significance: It provides a measure of degree to which current assets cover current liabilities. The excess of
current assets over current liabilities provides a measure of safety margin

available against uncertainty in realisation of current assets and flow of funds. The ratio should be
reasonable. It should neither be very high or very low. Both the situations have their inherent disadvantages.
A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects
under utilisation or improper utilisation of resources. A low ratio endangers the business and puts it at risk of
facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it may
affect firms credit worthiness adversely. Normally, it is safe to have this ratio within the range of 2:1.

2. Quick Ratio

It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as

The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick
assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax,
etc., from the current assets. Because of exclusion of non-liquid current assets it is considered better than
current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary
check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’.

Significance: The ratio provides a measure of the capacity of the business to meet its short-term obligations
without any flaw. Normally, it is advocated to be safe to have a ratio of 1:1 as unnecessarily low ratio will be
very risky and a high ratio suggests unnecessarily deployment of resources in otherwise less profitable short-
term investments.
 Solvency Ratios

The persons who have advanced money to the business on long-term basis are interested in safety of their
periodic payment of interest as well as the repayment of principal amount at the end of the loan period.
Solvency ratios are calculated to determine the ability of the business to service its debt in the long run. The
following ratios are normally computed for evaluating solvency of the business.

1. Debt-Equity Ratio;

2. Debt to Capital Employed Ratio;

3. Proprietary Ratio;

4. Total Assets to Debt Ratio;

5. Interest Coverage Ratio.

1. Debt-Equity Ratio

Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt component of the
total long-term funds employed is small, outsiders feel more secure. From security point of view, capital
structure with less debt and more equity is considered favorable as it reduces the chances of bankruptcy.
Normally, it is considered to be safe if debt equity ratio is 2 : 1. However, it may vary from industry to
industry. It is computed as follows:

Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-
term lender regarding extent of security of the debt. As indicated earlier, a low debt equity ratio reflects
more security. A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in
meeting its obligations to outsiders. However, from the perspective of the owners, greater use of debt
(trading on equity) may help in ensuring higher returns for them if the rate of earnings on capital employed is
higher than the rate of interest payable.

2. Debt to Capital Employed Ratio

The Debt to capital employed ratio refers to the ratio of long-term debt to the total of external and internal
funds (capital employed or net assets). It is computed as follows:

Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)

Significance: Like debt-equity ratio, it shows proportion of long-term debts in capital employed. Low ratio
provides security to lenders and high ratio helps management in trading on equity. In the above case, the
debt to Capital Employed ratio is less than half which indicates reasonable funding by debt and adequate
security of debt.

3. Proprietary Ratio

Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets and is calculated as
follows :

Proprietary Ratio = Shareholders, Funds/Capital employed (or net assets)

Significance: Higher proportion of shareholders funds in financing the assets is a positive feature as it
provides security to creditors. This ratio can also be computed in relation to total assets instead of net assets
(capital employed). It may be noted that the total of debt to capital employed ratio and proprietary ratio is
equal to 1.

4. Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by assets. It is

calculated as

Total assets to Debt Ratio = Total assets/Long-term debts

Significance: This ratio primarily indicates the rate of external funds in financing the assets and the extent of
coverage of their debts are covered by assets.

Interest Coverage Ratio

It is a ratio which deals with the servicing of interest on loan. It is a measure of security of interest payable on
long-term debts. It expresses the relationship between profits available for payment of interest and the
amount of interest payable. It is calculated as follows:

Interest Coverage Ratio = Net Profit before Interest and Tax

Interest on long-term debts

Significance: It reveals the number of times interest on long-term debts is covered by the profits available for
interest. A higher ratio ensures safety of interest on debts.

Activity (or Turnover) Ratio

These ratios indicate the speed at which, activities of the business are being performed. The activity ratios
express the number of times assets employed, or, for that matter, any constituent of assets, is turned into
sales during an accounting period. Higher turnover ratio means better utilisation of assets and signifies
improved efficiency and profitability, and as such are known as efficiency ratios.

The important activity ratios calculated under this category are

1. Inventory Turnover;

2. Trade receivable Turnover;

3. Trade payable Turnover;

4. Investment (Net assets) Turnover

5. Fixed assets Turnover; and

6. Working capital Turnover.

1. Inventory Turnover Ratio

It determines the number of times inventory is converted into revenue from operations during the
accounting period under consideration. It expresses the relationship between the cost of revenue from
operations and average inventory.

The formula for its calculation is as follows:

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory

Where average inventory refers to arithmetic average of opening and closing

inventory, and the cost of revenue from operations means revenue from operations less gross profit.

Significance : It studies the frequency of conversion of inventory of finished goods into revenue from
operations. It is also a measure of liquidity. It determines how many times inventory is purchased or replaced
during a year. Low turnover of inventory may be due to bad buying, obsolete inventory, etc., and is a danger
signal. High turnover is good but it must be carefully interpreted as it may be due to buying in small lots or
selling quickly at low margin to realise cash.
Trade Receivables Turnover Ratio

It expresses the relationship between credit revenue from operations and trade

receivable. It is calculated as follows :

Trade Receivable Turnover ratio = Net Credit Revenue from Operations/Average

Trade Receivable

Where Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing

Debtors and Bills Receivable)/2

It needs to be noted that debtors should be taken before making any provision for doubtful debts.

Significance: The liquidity position of the firm depends upon the speed with which trade receivables are
realised. This ratio indicates the number of times the receivables are turned over and converted into cash in
an accounting period. Higher turnover means speedy collection from trade receivable. This ratio also helps in
working out the average collection period. The ratio is calculated by dividing the days or months in a year by
trade receivables turnover ratio.

Trade Payable Turnover Ratio

Trade payables turnover ratio indicates the pattern of payment of trade payable.

As trade payable arise on account of credit purchases, it expresses relationship

between credit purchases and trade payable. It is calculated as follows:

Significance : It reveals average payment period. Lower ratio means credit allowed by the supplier is for a
long period or it may reflect delayed payment to suppliers which is not a very good policy as it may affect the
reputation of the business. The average period of payment can be worked out by days/months in a year by
the Trade Payable Turnover Ratio.

Profitability Ratios

The profitability or financial performance is mainly summarised in the statement of profit and loss.
Profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of
utilisation of resources employed in the business. There is a close relationship between the profit and the
efficiency with which the resources employed in the business are utilised. The various ratios which are
commonly used to analyse the profitability of the business are:

1. Gross profit ratio

2. Operating ratio

3. Operating profit ratio

4. Net profit ratio

5. Return on Investment (ROI) or Return on Capital Employed (ROCE)

6. Return on Net Worth (RONW)

7. Earnings per share

8. Book value per share

9. Dividend payout ratio

10. Price earning ratio.

1.Gross Profit Ratio

Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross
margin. It is computed as follows:

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

Significance: It indicates gross margin on products sold. It also indicates the margin available to cover
operating expenses, non-operating expenses, etc. Change in gross profit ratio may be due to change in selling
price or cost of revenue from operations or a combination of both. A low ratio may indicate unfavourable
purchase and sales policy. Higher gross profit ratio is always a good sign.

2. Operating Ratio

It is computed to analyse cost of operation in relation to revenue from operations.

It is calculated as follows:

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/

Net Revenue from Operations × 100

Operating expenses include office expenses, administrative expenses, selling expenses, distribution
expenses, depreciation and employee benefit expenses etc.

Cost of operation is determined by excluding non-operating incomes and expenses such as loss on sale of
assets, interest paid, dividend received, loss by fire, speculation gain and so on.

Operating Profit Ratio

It is calculated to reveal operating margin. It may be computed directly or as a residual of operating ratio.

Significance: Operating ratio is computed to express cost of operations excluding financial charges in relation
to revenue from operations. A corollary of it is ‘Operating Profit Ratio’. It helps to analyse the performance of
business and throws light on the operational efficiency of the business. It is very useful for inter-firm as well
as intra-firm comparisons. Lower operating ratio is a very healthy sign.

Net Profit Ratio

Net profit ratio is based on all inclusive concept of profit. It relates revenue from operations to net profit
after operational as well as non-operational expenses and incomes. It is calculated as under:

Net Profit Ratio = Net profit/Revenue from Operations × 100

Generally, net profit refers to profit after tax (PAT). Significance: It is a measure of net profit margin in
relation to revenue from operations. Besides revealing profitability, it is the main variable in computation of
Return on Investment. It reflects the overall efficiency of the business, assumes great significance from the
point of view of investors.