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FINANCIAL
STATEMENTS
Unit III
Syllabus
Analysis of Financial
Statements
Financial Ratio Analysis
Cash Flow
(as per Accounting Standard 3)
Funds Flow Statement Analysis.
Analysis of Financial
Statements
Financial Statement
Analysis
American Institute of certified public accounts
says financial statements are prepared for
the purpose of presenting a periodical review
or report on the progress by the management
and dealt with
The status of investment in the business and
The result achieved during the period under
review.
A financial statement is an organized
collection of data.
Financial Statement
Types of Financial Statements
Financial Statement
Schedules to financial statements
Financial Statement
Profit and Loss account or Income statement
It matches the revenue and costs incurred in the
process of earning revenues and shows the net profit
earned or loss suffered during a particular period.
Balance Sheet
It is the statement which shows the assets and
liabilities of the business. It reflects the financial
condition of a business concern as revealed by the
accounting records. It shows the assets owned by the
concern and the source of funds used in the
acquisition of those assets.
Financial Statement
Surplus or Retained earnings statement
It reflects to excess of profit over losses. Such
retained earnings are taken to balance sheet from
the retained earnings statement. It is a link between
the balance sheet and the income statement.
Supplementary schedules
Lists of schedules are used to supplement the data
and details contained in the balance sheet and profit
and loss account. The schedules re considered to be
part and parcel of the financial statements for the
benefit of analysis and interpretation.
Nature of financial
statements
Financial statements are prepared to
check the nature of investment in a
business and result achieved during the
specific time period. Financial statements
shows :Based on recorded facts
Accounting conventions
Postulates (assumptions/suggestions)
Personal judgment
Financial Statement
Limitations
Information shown in financial statements are not
accurate.
It is based on practical experience and
conventions
Do not disclose correct position of the business
Do not disclose the contribution of human
resource towards the efficiency of the business
It is prepared by way of comparing two different
periods
Record only monetary facts
Objectives
To interpret the profitability and efficiency of
various business activities with the help of profit
and loss account.
To determine the managerial efficiency of the
firm.
To measure short-term and long-term solvency of
the business.
To ascertain earning capacity in future period.
To compare operational efficiency.
To determine profitability of the concern.
To measure the financial stability of the business.
Financial Statement
Analysis
Financial
Statement
Analysis
is
classified below:On the basis of information used
External Analysis
Internal Analysis
On the basis of modus operandi of
analysis
Horizontal Analysis
Vertical Analysis
On the basis of objectives of analysis
Long-term Analysis
Short-term
Financial Statement
Analysis
On the basis of information used
External Analysis
It is made by those who do not have access to
detailed record and depend on published
statements. Such type of analysis is made by
investors, credit agencies, government agencies
and research scholars.
Internal Analysis
It is done on the basis of unpublished records by
the executives. It is very much useful and
significant to employees and management.
Financial Statement
Analysis
On the basis of modus operandi of analysis
Horizontal Analysis
This is made to review and verify the financial
statements of a number of years. This is very useful for
long-term trend analysis and planning. This analysis is
also called as dynamic or trend analysis.
Vertical Analysis
This is made to review and analyze the financial
statements of one particular year only. It is also called
as static analysis or structural analysis. Quantitative
relationship is established between different items
shown in a particular statement.
Financial Statement
Analysis
On the basis of objectives of analysis
Long-term Analysis
This analysis is used for understanding the longterm financial stability, solvency and liquidity as
well as profitability and earning capacity of a
organization.
Short-term Analysis
This analysis is used to determine the short-term
solvency of the business concern. Stability,
liquidity and earning capacity of the business is
also analyzed.
Techniques of
Analysis and Interpretation.
Comparative statements
Common size statements
Fund flow analysis
Cash flow analysis
Ratio analysis
Net working capital analysis
Trend analysis
Comparative
statement analysis
Comparative statement analysis
It is a technique used to analyze the financial
statement. This statement summarizes and presents
related data for a number of years.
These statements are prepared in a way so as to
provide time prospective to the consideration of
various elements of financial position embodied in such
statements.
These statements normally contains comparative
balance sheet and comparative income statement.
Comparative balance sheet is a statement which shows
changes in total capital and changes in working capital
2010
Current Assets
(a)
Fixed Assets
(b)
Total Assets
+ b)
(a
Current Liabilities
(a)
Long Term Liabilities
(b)
Total Liabilities
+ b)
(a
2011
Increase
Decrease
2010
2011
Ratio Analysis
Ratio analysis refers to the numerical relationship
between two numbers.
An accounting ratio shows the relationship
between the two inter-related accounting figures
as
gross profit to sales, current assets to
current liabilities, loaned capital to owned capital.
Ratio analysis is the process of computing,
determining and presenting the relationship of
items.
It
also
includes
comparison
and
interpretation of ratios and using them as basis
for the figure projection.
Trend Analysis
Trend analysis is an important tool of horizontal
financial analysis. This method plays a vital role
to making a comparative study of the financial
statements of several periods.
Trend analysis is carried out by calculating trend
ratio (%) and plotting the accounting data on
graph sheet or paper.
Trend analysis is significant for forecasting and
budgeting. Trend analysis discloses the changes
in financial and operating data between specific
periods.
Limitations of
Financial Statement Analysis
Historical
nature
of
financial
statements
Reliability of figures
Based on past records
Different interpretation
Change in accounting methods
Single year analysis is not much useful
Price level changes
Ratio Analysis
Ratio Analysis
Accounting ratios are relationships expressed in
mathematical terms between figures which are
connected with each other in some manner.
Accounting ratios can be expressed as
A pure ratio
A rate
A percentage
Ratio analysis stands for the process of determining
and presenting the relationship of items and group
of items in the financial statements. It is an
important method of financial analysis.
Ratio Analysis
Merits
Useful in financial position analysis
Useful in simplifying accounting figures
Useful in assessing the operational
efficiency
Useful in forecasting purposes
Useful in locating the working of the
business
Useful in comparison of performance
Ratio Analysis
Limitations
Practical knowledge and experience
Inter-relationship
Non-availability of standards or norms
Accuracy of financial information
Consistency in preparation of financial
statement
Time delay
Change in price level
Ratio Analysis
Classification of Ratios
Classification by Statements
Balance Sheet, Profit and Loss A/c and Composite
ratios
Classification by users
Ratios for Management, Creditors and Shareholders
Classification by relative importance
Primary, Secondary, Creditors and Growth ratios
Classification of ratios by purpose
Profitability, Turnover and Solvency ratios
Classification of Ratios by
Statements
From Balance Sheet
Liquid Ratio, Current Ratio, Adequate Liquid Ratio,
Proprietary Ratio, Fixed Assets Ratio, Debt Equity Ratio
and Capita Gearing Ratio.
From Profit & Loss
Gross Profit Ratio, Operating Profit Ratio, Net Profit
Ratio and Expenses Ratio.
Composite Ratios
Return on investment, Return on net worth, Stock
Turnover Ratio, Debtors Turnover Ratio, Creditors
Turnover Ratio, Fixed Assets Turnover Ratio, Earning per
Share Ratio and Payout Ratio.
Classification by Users
Ratios for Management
Operating Ratio, Stock Turnover Ratio, Debtors
Turnover Ratio, Fixed Assets Turnover Ratio, Creditors
Turnover Ratio, Working Capital Turnover Ratio, Net
Profit Ratio, Gross Profit Ratio, Operating Profit Ratio,
Short term Solvency Ratio and Long term Solvency
Ratio.
Ratios for Creditors
Fixed charges cover Ratio, Debt Service cover Ratio,
Liquid Ratio, Current Ratio, Debt Equity Ratio, Capital
Gearing Ratio, Solvency Ratio and Creditors Turnover
Ratio.
Ratio for Shareholders
Return on Shareholders fund, Shareholders fund,
Payout ratio, Dividend yield ratio, Dividend cover ratio
Detailed Formulae
for Calculating Ratios
Profitability Ratios
Return on Investment
Operating Profit x 100
Capital Employed
Return on Shareholders fund
Net Profit after tax and interest x 100
Shareholders fund
Return on Equity Shareholders fund
Net Profit after tax and Pref. dividend x 100
Equity Shareholders fund
Detailed Formulae
for Calculating Ratios
Return on Total Assets
Net Profit after tax and interestx 100
Shareholders fund
Gross Profit Ratio
Gross Profit x 100
Net Sales
Operating Profit Ratio
Operating Profit x 100
Net Sales
Detailed Formulae
for Calculating Ratios
Expenses Ratio
Specific expensesx 100
Net Sales
Net Profit Ratio
Net Profit x 100
Net Sales
Earning per share (EPS)
Net Profit after tax and Pref. dividend x 100
No. of equity shares
Detailed Formulae
for Calculating Ratios
Price Earning Ratio
Market price per equity share
Earning per equity share
Payout Ratio
Equity Dividend x 100
Net Profit after tax and Pref. dividend
Retaining Earnings Ratio
Retained Earnings x 100
Net Profit after tax and Pref. dividend
Detailed Formulae
for Calculating Ratios
Interest Cover Ratio
Profit before interest and tax
Fixed interest charges
Fixed Dividend Cover Ratio
Profit after tax
Pref. Dividend
Dividend Yield Ratio
Dividend per share x 100
Market price per share
Detailed Formulae
for Calculating Ratios
Turnover Ratios
Inventory Turnover Ratio
Cost of goods sold
Average Stock
Debtors Turnover Ratio
Net Credit Sales
Average receivable
Detailed Formulae
for Calculating Ratios
Creditors Turnover Ratio
Net credit purchase
Average accounts payable
Working Capital Turnover Ratio
Cost of Sales
Net Working Capital
(Working Capital = Current Assets Current
Liabilities)
Detailed Formulae
for Calculating Ratios
Fixed Assets Turnover Ratio
Cost of Sales
Net Fixed Assets
Capital Turnover Ratio
Cost of Sales
Capital Employed
Owned Capital Turnover Ratio
Cost of Sales
Shareholders Fund
Detailed Formulae
for Calculating Ratios
Solvency Ratios
Current Ratio
Current Assets
Current Liabilities
Liquid Ratio
Liquid Assets
Current Liabilities
Detailed Formulae
for Calculating Ratios
Absolute Liquid Ratio
Cash + Bank + Marketable securities
Current Liabilities
Fixed Assets Ratio
Fixed Assets
Long term funds
Detailed Formulae
for Calculating Ratios
Debt Equity Ratio
Total long term debt
Shareholders funds
Proprietary Ratio
Shareholders fund
Total tangible assets
Capital Gearing Ratio
Long term loan + Debentures + Pref. Capital
Equity Shareholders funds
Profitability Ratios
Profitability refers to the ability to make more
profit from optimum utilization of resources
by a business concern.
Profitability involves study of sales, cost of
goods sold, analysis of gross margin on
sales, analysis of operating expenses,
operating profit and analysis of profit in
relation to capital employed.
Profits are the goals of every business firm.
They indicate a firms progress.
Profitability Ratios
Profitability Ratios are in two models:Profit Margin Ratio
It shows the difference between profits
and sales.
Rate of Return Ratio
It explains the relationship between
profit and capital.
Profitability Ratios
Gross Profit Ratio
Refers to the relationship between gross profit and net sales.
A higher ratio is preferable for showing higher profitability.
Operating Ratio
Reflects the difference between total operating expenses and
net sales. Operating expenses includes cost of goods sold,
administrative expenses and selling expenses but excludes
finance expenses. Net sales means sales sales returns.
Operating Profit Ratio
Explains the operating efficiency of the firm and is a measure
of the managements efficiency in running the business
operations.
Operating profit ratio = Gross profit operating expenses
Profitability Ratios
Expenses Ratio
Useful to support operating ratio and indicates the
effectiveness of the business. Guides management to
ascertain the savings or wastages in different items of
expenses.
Net Profit Ratio
Also called as net profit to sale ratio. Higher the ratio
better is the operational efficiency of the business.
Earning per share (EPS)
Highlights the overall success of the business from
owners. It is calculated by dividing the net profit after
tax and pref. dividend by number of equity shares.
Profitability Ratios
Price Earnings Ratio
P/E ratio is important to prospective investors to decide
whether to invest in the equity shares of a company at
a specific market price or not. Shows earnings per
share reflected by the market price.
Interest cover or Fixed Charges cover Ratio
Reflects the relationship between profit before interest
and tax and fixed interest charges.
Dividend Yield Ratio
Dividend yield ratio based on market value of shares.
The calculation of this ratio related with dividend per
share and market price per share.
Turnover Ratios
Inventory Turnover or Stock Turnover Ratio
Also known as stock velocity ratio. It is effective to determine
the efficiency of the inventory. Shows relationship between
the cost of goods sold and average inventory.
Cost of goods sold means Sales Gross profit
Debtors Turnover ratio
Also called as Account receivable ratio or Debtors velocity
ratio. This ratio indicates the number of times the receivable
are rotated in a year in terms of sales. It shows the efficiency
of credit collection and credit policy.
Creditors Turnover Ratio
Also called as Account payable or Creditors velocity.
Indicates the number of times the payable rotate in a year.
Turnover Ratios
Working Capital Turnover Ratio
Working capital means the relationship between current assets
and current liabilities. This ratio measures the effective
utilization of working capital and the relationship between cost
of sales and
net working capital.
Fixed Assets Turnover Ratio
Determines the efficiency of utilization of fixed assets and
profitability of business concern. Higher ratio indicates efficiency
in utilization and lower ratio indicates under utilization of fixed
assets.
Capital Turnover Ratio
Managerial efficiency is calculated with the help of capital
turnover ratio. It is the relationship between cost of sales and
amount of capital invested in the business.
Solvency Ratios
Current Ratio
The ratio of current assets to current liabilities. This ratio
indicates the ability of a concern to meet its current
obligations as and when they are due for payments.
Current ratio = 2 : 1
Liquid Ratio
Also known as Quick ratio or acid test ratio. It is calculated
by comparison of quick assets and current liabilities.
Absolute Ratio
Also called cash position ratio or super quick ratio.
It measures liquidity in terms of cash and cash
equivalents.
Solvency Ratios
Fixed Assets Ratio
Express the relationship between fixed assets
and long term funds. The benefit of calculating
this ratio is to ascertain the proportion of long
term funds invested in fixed assets.
Debt Equity Ratio
Determining long term solvency position of a
company. Debt equity ratio is calculated in
relationship between external debt and internal
debt. Also called external internal ratio.
Solvency Ratios
Proprietary Ratio
Expresses
the
relationship
between
the
proprietors funds and the total tangible assets. It
shows the soundness of the company. A high ratio
indicates safety to creditors and a low rate shows
greater risk to the creditors.
Capital Gearing Ratio
It is used to analyze the capital structure of the
firm. Establishes relationship between fixed
interest and dividend bearing funds and equity
shareholders fund.
Sources of Cash
Cash from Operations
Refers to a business generating cash inflow
through its normal business operations which
is usually the most important and routine
source of cash.
Computation of Cash from Operations
When all transactions are cash transactions
When all transactions are not cash
transactions
Sources of Cash
When all transactions are cash
transactions
When all expenses, incomes and
revenues are received or paid in cash,
the net profit ascertained by profit and
loss account represents cash from
operations.
Net loss represents cash out flow on
account of operations.
Sources of Cash
When all transactions are not cash transactions
Basically income statements are prepared on accrual
basis, several non-cash items are duly accounted in
the statements.
In such situations, cash from operations is ascertained
in two stages: Calculation of funds from operations
This is be dealt in the next topic Fund Flow
Analysis
Calculation of cash from operations
Will be discussed in detail in this topic
Rs.
Rs.
Rs.
Particulars
Rs.
To depreciation on fixed
assets
By Balance B/d
To loss on sale of
investment
By profit on sale of
investment
By Cash from
Operations
To preliminary expenses
To Balance C/d
Total
Total
Rs.
Rs.
Cash
Bank
Rs.
Rs.
Cash
Bank
Rs.
Rs.
Amou
nt
Opening balance of
Cash and Bank
XX
XX
Issue of shares
XX
Repayment of Debenture
XX
Issue of debentures
XX
Repayment of loans
XX
Raising of loans
XX
XX
XX
Dividend paid
XX
Dividends received
XX
XX
Share Premium
received
XX
XX
XX
XX
XX
XX
Extraordinary Items
Foreign Currency cash flow
Unrealized gains and losses arising from changes in
foreign exchange rates are not cash flows.
Interest and Dividend
Cash flow arising from interest paid and interest and
dividend received in the case of financial firm should
classify as cash flows arising from operating activities.
Non-cash transactions
Financing and investing transactions that do not use
cash or cash equivalents should be excluded from a
cash flow statement. E.g., conversion of debt to equity.
Statement of changes
in working capital - specimen
Changes in Working Capital
Particulars
Current Assets
Cash Balance
Bank Balance
Stock
Sundry Debtors
Trading Investment
Prepaid expenses
Bills Receivable
Total (A)
Year
Year
Increas
e
Decrea
se
Statement of changes
in working capital - specimen
Changes in Working Capital
Particulars
Year
Year
Increas
e
Decreas
e
Sources of funds
Issue of shares
Issue of debentures
Sale of fixed assets
Investment sold
Funds from operations
Total Sources (A)
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.