3.

1 Financial Statements
3.2 Financial Analysis
3.3 Analyses and Interpretation
3.4 Types of Analysis
3.5 Techniques of Financial Statement Analysis
3.6 Industrial Background
 THEORETICAL BACKGROUND OF THE
STUDY

3.1 FINANCIAL STATEMENTS

An organization communicates its financial information to the users

through financial statements and reports. Financial statements contain
summarized information of the organization’s financial affairs, organized
systematically. These statements comprise the income statements or profit
and loss account and the position statement or the balance sheet.

To give a full view of the financial affairs of the undertaking it is also

necessary to include a statement of retained earnings, a statement of changes
in the financial position and a few schedules such as schedule of fixed assets
and schedule of debtors.

 Income Statement – the profit and loss account sets out income as
well as expenses of the same period and after matching the two, the
difference being the net profit or net loss, is shown as the difference
between the two sides of the account. Thus, the earning capacity and
the potential of an organization are reflected by its profit and loss
account.
 Position Statement – otherwise know as the balance sheet displays
the total resources of a business and the owners and creditor’s equity
in these resources. It indicates a statement of affair of a business at a
particular moment of time and thus it is static in nature.

 Statement of Retained Earning – also known, as the profit and loss

appropriation account, is generally a part of the profit and loss
account. It shows how the profit of the business for the accounting
period is appropriated towards reserve and dividend and how much of
the same is carried forwarded as retained earnings.

 Statement of Changes in Financial Position – also known as the

fund flow statement, summarizes the changes in assets, liabilities and
the owner’s equity between two balance sheet dates. Thus, it is a
statement of flows, i.e., it measures the changes that have been taken
place in the financial position of a firm between two balance sheet
dates. It summarizes the sources and uses of the funds obtained.
 CHART SHOWING ANATOMY OF FINANCIAL STATEMENTS

FINANCIAL

STATEMENT

Position Statement Income Statements Statement of Changes Statement of

Or Or in Owner’s Equity Or changes in
Balance Sheet Profit & loss A/c Retained Earnings Financial Position

Fund Flow Cash Flow

Statement Statement
3.2 FINANCIAL ANALYSIS

Financial analysis is the process of identifying the financial

strengths and weakness of the firm by properly establishing relationships
between the items of the balance sheet and profit and loss account. The
purpose of financial analysis is to disclose the information contained in the
financial statements so as to judge the profitability and financial soundness
of the organization.

The first task of the financial analyst is to select the information

relevant to the decision under consideration from the total information
contained in the financial statement.

Secondly, to arrange the information in a way to highlight the

significant relationships.

Finally, to interpret and draw inferences and conclusions. In brief,

financial analysis is the process of selection, relation and evaluation.
3.3 ANALYSES AND INTERPRETATION

Analysis of Financial statements is a process of scanning them with

a view to get the necessary information. Accordingly, there are a large
number of persons who are interested in the analysis of financial statements.
However, even with the accompanying schedules, the layman does not
understand the statements. Except an expert analyst, others including the
management cannot follow and digest the information contained in the
statements. Hence, the need for analysis.

Interpretation is drawing conclusions with regard to the nature of the

inter-relationship between figures analyzed.

It is necessary to note in the context, that analysis and interpretation

are complementary and one cannot be stressed or favored as against the
other. In fact, the very object of the analysis is to interpret the significant
relationship between figures, and there cannot be any interpretation without
first analyzing the data. Thus, analysis and interpretation go hand in hand.
3.4 TYPES OF ANALYSIS

When we use the term financial analysis, we do distinguish between

horizontal analysis and vertical whether the analysis and vertical analysis
whether the analysis is for those external to the business or the managerial
personnel.

 Horizontal Analysis- also known as dynamic analysis portrays

figures for a number of years and change in these figures from the
figure of a particular year is chosen as the standard or the base year.
Changes from the figures of the base year, represented as percentage,
gives us a clear idea of the trend, during the year, i.e. whether there is
an increasing trend, decreasing trend or violent fluctuations so that it
is possible to analyze the reasons for the same.

 Vertical Analysis- aims at making a static analysis of financial

statements for one year only. This method of analysis is useful in
studying the inter-relationship of different figures, as for instance, the
relationship of gross or net profit to total deposits and also for inter-
firm comparison.
3.5 TECHNIQUES OF FINANCIAL
STATEMENT ANALYSIS

A financial analyst analyzes the financial statements by selecting

the appropriate techniques according to the purpose of analysis.
Financial statements may be analyzed by means of any of the following
techniques.

 Comparative Statements

 Common-size Statements

 Trend Analysis

 Ratio Analysis

 Fund Flow Statements

 Cash Flow Statements

 Cost-Volume-Profit Analysis
Ratio Analysis
A ratio is defined as ‘the indicated quotient of two mathematical
expressions’ and as ‘the relationship between two quantitative terms
between figures which have a cause and effect relationship or which are
connected with each other in some manner or the other. A noticeable point
is that a ratio reflecting a quantitative relationship helps to perform a
qualitative judgment. Such is the nature of all financial ratios.

Ratio analysis is a widely used technique in financial analysis. It is

defined as systematic use of ratio to interpret the financial statements so that
the strengths and weaknesses of the organization, its historical performance
and current financial condition, can be determined.

Classification of Ratios

The use of ratio analysis is not confined to the financial manager only.
There are different parties interested in the ratio analysis for knowing the
financial position of the firm for different purpose. In view of the various
users of ratios, there are many types of ratios, which can be calculated for
the given information in the financial statements.

Following is the classification of ratios:

1. Liquidity Ratio
2. Leverage Ratio
3. Profitability Ratio
4. Activity Ratio
Liquidity Ratios

Liquidity refers to the ability of the concern to meet its current

obligations as and when they, become due. These ratios are calculated to
comment upon the short term paying capacity of the concern or the firm’s
ability to meet its current obligations. Much insight could be obtained into
the present cash solvency of the firm and its ability to remain solvent in the
event of emergent: i.e. the firm should ensure that it does not suffer from any
lack of liquidity and also that it is necessary to strike a proper balance
between high liquidity and lack of liquidity.

Leverage Ratios

The short-term creditors like the bankers and the suppliers of raw
materials are more concerned with the firm’s current debt paying ability. On
the other hand, long terms creditors like debenture holders, financial
institutions, etc, are more concerned with the firm’s long-term financial
position. To judge the long-term financial position of the firm, financial
leverage or capital structure ratio is used. The shareholders, debenture
holders and other long-termed creditors like financial institutions are more
interested in the long term financial position or long term solvency of the
firm. Leverage or solvency ratios are used for such an analysis. These ratios
are also used to analyze the capital structure of a company. That is only
these are also called capital-structure ratios. The term solvency generally
refers to the firm ability to pay the interest regularly and repay the principal
amount of debt on due date.
There are two aspects of long-term solvency of a firm. They are:

1. Ability to repay the principal amount of loan on the due date.

2. Regular payment of interest.

Accordingly, there are two types of leverage ratios. The first type of
leverage ratio is based on the relationship between owned-capital and
borrowed capital. These ratios are calculated from the balance items. The
second type of leverage ratio is coverage ratios. These are computed from
the profit and loss account.

Profitability ratio

Profit reflects the final result of the business operations. There is two
types of profitability ratios namely margin ratio and ratio on returns rates.
Profit margin ratios show the relation between sales and profits.

The ultimate aim of any business enterprise is to earn maximum

profit. Lord keens remarked, “Profit is the engine that drive the business
enterprise”, a firm should earn profit to survive and grow for a long period
of time. To the management profit is a measurement of efficiency and
control. To the owners it is to measure the worth of their investment. To the
creditors it is the margin of safety.
 The management of the company should know how efficiently they
carry out business operation. In other words, the management of the
company is very much interested in the profitability of the company. Beside
management, creditors and owners are also interested in the profitability of
the co-creditors, as they want to get interest and repayment of principal
amount regularly. Owners want to get a reasonable return on their
investment.

The profitability ratio measures the ability of the firm to earn and on
sales, total assets and invested capital. Profitability ratios are generally
calculated either in relation to sales or in relation to investment. The
profitability ratios in relation to sales are gross profit ratio. Net profit ratio,
operating ratio, expenses ratio, and etc. the profitability ratios in relation to
investment are return on assets, return on investment, return on equity
capital.

The important profit margin ratios are gross profit margin and net
profit margin .the rate of return ratio reflects the relationship between rate
and profit and investment. The important rate of return ratio is return on
equity and return on investment, etc.
Activity ratio

Funds of the owners and creditors are invested in various assets to

generate sales and profits. The better the management of assets, the larger
the amount of sales. Activity ratios are employed to evaluate the efficiency
with which the firm’s managers utilize their assets.

These ratios are also called turnover ratio because they indicate the
speed with the assets are being converted or turn over into sales.
3.6 INDUSTRIAL BACKGROUND

Meaning of Bank

According to banking regulation act of 1949 defines the term banking

as accepting for the purpose of lending or investment of deposits of money
from the public, repay on demand or otherwise and withdraw by cheques,
draft or otherwise.

Kinds or types of bank: -

 Commercial bank
 Industrial bank
 Foreign exchange bank
 Co-operative bank
 Agricultural bank
 Land and development bank
 Saving bank
 Central bank
Commercial bank

These banks are also called as deposit banks as they accept deposits
from the public and lend them for short period. Commercial banks
encourage savings among general public and supply financial needs of
modern business. These banks are purely meant to finance traders and
others. Thus commercial bank accept deposits and lend to needy customers
from short terms.

Function of commercial banks

There are two functions namely primary and secondary function:

 Primary function includes acceptance of deposits, advancing of loans.

 Secondary function includes agency function General, utility services.

PRIMARY FUNCTIONS

Acceptance of deposits

Banks accept deposits from the public. People keep deposit of money
for safety, interest, easy to transfer cheques. So they accept following types
of deposit.

Current Account Deposits

These deposits constitute major portion of banks circulating medium of

exchange. Normally business people keep money in his accounts as they can
withdraw and issues cheques any number of times. Banks does not pay any
interest for these deposits.

Saving Bank Account Deposits

People with steady and monthly income save their excess earning
through this account. There are certain restrictions in the withdrawals. Bank
pays interest at a nominal rate. Small savings are encouraged in this account.

Fixed Deposit Account

Money is accepted foe a fixed period it cannot be withdrawn before

expiry of fixed period. The interest rate is higher than other accounts. The
longer the period is the rate of interest.
Advancing of Loans

The deposits received are invested by advancing loans to needy

borrowers for higher rate of interest. This function is source of profit for
banks.

Overdrafts

This facility is extended to current account holders where they are

allowed to overdraw more than the credit standing in their account. Since the
facility is only for respectable and reliable customers, bank may not insist on
security. The security will also be taken in the form of fixed deposits,
NSC’S, shares, LIC policy and so on.

Cash Credit

Under this account bank gives loans to borrowers against certain

security. The entire loan amount will not be given at one time. It will allow
the borrower to withdraw from time to time depending on the values of
stocks debt in the go-down. The interest rate is charged on the amount
withdrawn.
Discounting of the Bills of Exchange

This is a popular type of lending. If the holder of an exchange of bills

needs money immediately he can get it discounted by the bank.

The bank pays the present price of bills after deducting commission and
when the bills mature the banks can receive the payment form the party who
accepted the bill.

Direct/Term Loans

Bank also gives loans to individuals or firms against collateral

security. The amount sanctioned will be credited to his requirements.
Normally, industrialists, agriculturists and others borrow these loans to start
industries and for his working capital.
SECONDARY FUNCTIONS

Agency function

Transfer of Funds

 Banks help customers in transferring of funds from one place to the

other through drafts and other instruments, collect cheques, bills,
salaries, pensions, dividends, and rents on behalf of customers form
other agencies.

 Undertake the payments of subscription, insurance, premiums, rents,

etc.

 Undertake to buy and sell securities, acts as representative for

customers in other banks or financial institutions, acts as a trustee,
execute and administrator to manage trust.

 Carry out deceased customers desire, signs, transfer forms and

documents.

 Banks give advice to customers on income tax matters.

General Utility Service

The banks will safe keep valuables and documents. It collects credit
information regarding customers, transfer of foreign exchange, providing
advisory services to industry, commerce, trade, project, prospectus, order
writing the issue of shares and debentures of companies.