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FINANCIAL STATEMENTS

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Basic Financial Accounting For

Management by Dr. Paresh Shah,Oxford University Press


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INTRODUCTION

Accounting is the recording and reporting of allactivities of an entity.

The business activities covers actual Business

(selling goods or services), Investment (purchasingassets) and Financing (raising money forinvestment).

Business

Investment

Financing

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TYPES OF FINANCIAL STATEMENTS

Profit and loss account

At the year end, the balances of all revenue accounts i.e.

income and expense accounts are summarized and

reported in a statement called the Profit and loss account Balance sheet

The balances of all capital receipts and capital payments

i.e. assets, liabilities and capital accounts as at the year

end are summarized and reported in a statement calledBalance sheet.

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Management

Business Activity

Requires Assets

Investment Activity

Requires Money

Financing Activity

Sell Goods / Services

Buy Goods / Services

Long Term : Fixed Assets

Short Term : Current Assets

Surplus : Investment

From Owner : Capital

From Outsiders

Long Term: Loans

Short Term: Liabilities

Liabilities

Assets

Income

Expenses

P & L A/c

BALANCE

SHEET

SUMMARY OF MANAGEMENT ACTIVITIES

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ANALYSIS AND INTERPRETATION OF


According to theAmerican Institute of Certified PublicAccountants (AICPA), Financial Statements are prepared forthe purpose of presenting a periodical review or report on theprogress by the management and deal with- The status of the investments in business, and

The results achieved during the period under review.

Thus, Financial Statements mean the Balance Sheet whichshows the position of the assets and the liabilities of thebusiness on a particular date and the Profit & Loss Accountwhich shows the profit or loss during a particular year.

AICPA has summed up the nature of financial statements inthe following words- Financial Statements reflects acombination of recorded facts, accounting principles andpersonal judgment.

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ANALYSIS AND INTERPRETATION OF


Need for Analysis and Interpretation A typical Financial Statement of a company may run into several

pages. It normally contains a huge mass of data and figures.

Meaning of Analysis Analysis means to resolve something into its elements or

components The process of breaking up a large mass of raw data into manageable

form is called analysis of the Financial Statements.

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Types of Analysis

Horizontal analysis moves over a number ofyears or across many firms, it is calledDynamic Analysis

Vertical analysis, on the other hand involvesfinding out the relationship between twoitems in respect of the same firm and in thesame year. Vertical analysis is, therefore,

called Static Analysis


Management by Dr. Paresh Shah,Oxford University Press 7


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Vertical balance sheet

The horizontal format of Balance Sheet is designed from the point of viewof the owner of firm.

It enables the owner to know at a glance the amount of Total FundsOwned (total assets) and the amount of Total Funds Owed (totalliabilities).

It also enables the owner to know which assets will take time to sell (fixedassets) and which assets can be realized quickly (current assets).

The order of payment of liabilities in the event of liquidation can also beascertained from such a balance sheet in conventional form.

However, the Conventional Form of Balance Sheet is not suitable forfinancial analysis, precisely because

It is designed for the owner. It does not serve the purpose of the other userssuch as a potential investor or lender.

Its presentation and sequence or order of items is relevant only in the event ofliquidation; it is unsuitable for financial analysis of a going firm.

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Vertical profit and loss statement

The conventional form of Profit and Loss Statement is not suitable forfinancial analysis because It does not show the gross profit. Hence, it is not possible to ascertain

whether the goods are being sold above cost or not.

It does not classify expenses. Financial analysis requires that expenses beclassified into operating expenses, Administrative expenses etc. Such

classification enables the financial analysis to find out the relationshipbetween the expenses and sales, whether the expenses are variable or fixedand so on.

The T form does not separately reveal the net non-operating income.

Thus, a proper financial analysis is possible only if the profit is disclosedstep by step i.e., Gross profit, then Net Operating Profit, followed by net

profit before tax and after tax and profits distributed and retained. This isuseful in financial analysis, especially in Ratio Analysis. This is donethrough the Vertical or Multi-step Form of Profit and Loss Account

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COMPARATIVE FINANCIAL STATEMENTS

INTER-FIRM AND INTER-PERIOD COMPARISONS

A business firm does not exist in isolation. It co-exists with othercompeting firms in the same industry. It has to therefore constantlycompare its performance with such competing firms to find out whereit scores over its rivals and where it lags behind them. Such

comparison is called inter-firm comparison. It also needs to compareits own past performance with its current performance to ascertain itsprogress or decline over the years. This is known as Inter PeriodComparison

FORMAT OF COMPARATIVE STATEMENTS

The usual Financial Statements have to be presented in a differentmanner to facilitate such Inter-firm and Inter-period Comparisons

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COMPARATIVE FINANCIAL

STATEMENTS

Limitations:

Inflation

Common Size Comparisons

Trend Comparisons

Only Horizontal Comparisons

Different Accounting Policies

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COMMON SIZE STATEMENTS

Features:

Quick comparison of odd amounts

Base of sales Base of total assets or total liabilities

Both horizontal and vertical analysis

Restricted scope Combined analysis not possible

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TREND ANALYSIS

The Comparative Statements and Common- size

Statements compare the figures of year 2 with those

of year 1, the figure of year 3 with those of year 2,

and so on. Trend Analysis, on the other hand, treats year 1 as

the base year and compares the figures of all the

years (year 2, year 3) with those of the base year to

ascertain the trend in figures.

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TREND ANALYSIS

LIMITATIONS :

Choice of Base Year & No. of years

Different Accounting Policies

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Financial Accounting for Management

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Notes to the Accounts andSignificant Accounting

Policies


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Note 5Contribution to gratuity fund

Note 6Debenture Redemption Reserve

Note 7Capital commitments


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Note 8Auditors remuneration

Note 9Managerial remuneration

Note 10Exchange difference

Note 15Expenditure in foreign currency


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Note 18Amount of dividend remitted in foreigncurrency


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RATIO ANALYSIS

Financial ratios as tools of analysis

The analysis of financial statements aims to

study the relationship amongst various factors

in a business as disclosed in the financial

statements for a particular period.

Trend of these factors can be studied through

the examination of such financial statements

over a period of time

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Management by Dr. Paresh Shah,

Oxford University Press


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RATIO ANALYSIS

A ratio shows the relationship between two

numbers.

Accounting ratio shows the relationship

between two accounting figures.

Ratio analysis is the process of computing and

presenting the relationship between the items

in the financial statements.

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For m s

There are three different forms in which an accounting ratio can beexpressed:

Proportion: A proportion is a simple division of one number by another.The relationship between Current Assets & Current Liabilities is expressedin this way. If the current assets are Rs. 2,00,000 and current liabilities Rs.1,00,000 the ratio is derived by dividing Rs. 2,00,000 by Rs. 1,00,000. It will

be expressed as 2:1. Percentage: The relationship between profit and sales is expressed as

percentage. For example, if sales are Rs. 4,00,000 and Gross profit is Rs.2,00,000 then it is expressed as gross profit being 50% of sales.

Rate: Ratios are also expressed as rates i.e. number of times over acertain period. Relationship between stock and sales is expressed in this

way. If stock turnover rate is said to be 8 times in a year, it means thatthe stock is converted into sales for 8 times in 12 months.

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Classification

BASED ON FINANCIAL STATEMENT Balance Sheet Ratios

Revenue Statement Ratios

Composite Ratios

BASED ON FUNCTION Liquidity ratios

Leverage ratios These are also known as Solvency ratios

Activity Ratios Also known as Turnover ratios or Productivity ratios

Profitability ratios

Coverage ratios

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Classification

BASED ON USER

Ratios for Short Term Creditors

Ratios for Shareholder

Ratios for Management

Ratios for Long Term Creditors

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Management use of ratio analysis

Management in a company at all levels, top

to middle and at operations level makes use

of ratio analysis for evaluating their own

achievements and making decisionsappropriate to their levels. For example,

Production Manager

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Management use of ratio analysis

Sales Manager

Financial Manager

Executive Manager or General Manager

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Investor use of ratio analysis

Investors in a company mean the shareholder.

Creditors are to be differentiated with investors.

The interests of the two are contradiction.

Shareholders major interest in the company is not

the day-to-day management of its affairs but in the

net results of its functioning in terms of profitability

and reduction of the degree of risk.

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Profitability ratios:

Shareholders are interested in the profits earned by thecompany as well as the profits accrued on their owninvestment. Profitability ratio which is of interest toshareholders can be divided into following firms:

Profitability of total investment i.e, gross profits earned on total fundsinvested in the company irrespective of the capital structure.

Profits as percentage of sales i.e. profits earned from normal businessactivity. This indicates shareholders proportion of profits earned fromnormal business.

Profits after payment of interest as a ratio of shareholders equity. Thisindicates the actual earnings per share for investors.

Dividend per share or dividend as percentage of profits. Dividendratios can be computed to develop a trend over a number of years.

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Risk ratios:

Investors while making investment in acompany undertake (i) Risk of capital loss due

to decline in share price which may be due tolower profitability of the company or onaccount of general economic depression; (ii)Risk of bankruptcy of the company; and (iii)Risk of non payment of dividend causingsuffering to investors.

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Share performance:

Shareholders main view remains the market

performance of the shares with the sole

objective of capital gains realization.

Earnings per share and market price per share

can be compared for over the year for inter

firm comparison of the performance in an

industry.

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Creditors use of ratio analysis

Creditors frequently make use of ratio analysis to assess thefirms financial position and standing.

These creditors include financial institutions, banks,debenture holders, as well as investment institutions.

The main firm of the creditors is in assessing companysfinancial position with reference to its capacity to repay theloan and service the interest charges.

Where creditors execute conversion rights they remaininterested in the capital gains like ordinary shareholders

through appreciation in market price for share as well asenhanced dividend rate through earnings per share.

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Utility of Ratios

For Inter Company Comparisons / Inter firm

Comparisons:

Accounting ratios are extensively used for evaluating the

financial performance. Important accounting ratios thatmay be used for inter-company comparisons are as

follows

R.O.I (Return On Investments)

Debt-Equity Ratio

Current Ratio

For Inter Period Comparison

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Limitations of ratio analysis

Ratio analysis is widely used these days due to interpret thefinancial statements.

Ratios are no doubt useful but one should also be aware of itslimitations. Interpretations of the ratios after understandingthese limitations would be more meaningful.

Some of the important limitations of accounting ratios are asfollows: Unreliable Accounts

Inter firm Comparisons, Difficult

Changing Prices

Different Terms/ Formulas

Different Standard Ratios

Deeper Analysis

Year-end Data

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Related Concepts

Care in Use of Ratios

Type of the business under consideration affects the ratiosand conclusions drawn from them. For example, a highratio of debt to net worth can be expected of a publicutility operating with large fixed assets with social benefitconsiderations.

Seasonal characters of the business affect ratios for aparticular type of industry or business enterprise. Forexample, inventory to sales ratio for a grains merchantduring the peak season has a different meaning and is

supposed to be much higher than during other period ofthe same year.

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Related Concepts

Quality of assets also affects the ratio analysis and gives differentinterpretation to different business enterprises. Current assets tocurrent liabilities ratio mostly 2 : 1 is considered more satisfactory fora liquid position of the company but if with same proportion of assetsacid test ratio is calculated it may give a different result and maydepict the unsatisfactory position of availability of liquid funds withthe company to meet its most urgent and pressing obligations.

Adequacy of data is another consideration for comparison ofparticular factors with each other. For example, average collectionperiod for bill receivables for a particular month may differ to thosewith other months or the average of the year. Another consideration

would be whether bill receivables have been properly valued for aparticular period as over valuation may render the ratio incomparable.

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Related Concepts

Modification of ratios reflects only the pastperformance and must be modified by futuretrends of business.

Interpretation of ratios should not be relied uponin isolation and should be considered withaccounting documents for interpretations.

Non-financial data ratios based on financial dataof firms should be considered with non-financialdata to supplement the financial ratios and givebetter interpretation.

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Du Pont Analysis

The financial ratios in themselves are meaningless to assess theperformance of a company in a given year.

To interpret the financial health of a company it is crucial to analysis andcompare the ratios for a given year viz a viz the previous financial yearsand the industry ratios.

The DU PONT company of USA pioneered a system of financial analysis

which has received widespread recognition and acceptance. The analysis takes into account important inter-relationship on the basis of

information available in the financial statements.

The usefulness of Dupont chart lies in the fact that it presents the overallpicture of the performance of a firm and enable the management toidentify the factors which have a bearing on its profitability.

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CHAPTER 14CASH FLOW

STATEMENT

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INTRODUCTION

Information about the cash flows of an

enterprise is useful in providing users of

financial statements with a basis to assess the

ability of the enterprise to generate cash andcash equipments, and the needs of the

enterprise to utilize those cash flows.

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INTRODUCTION

Cash

Cash equivalents

Cash flows

Cash management

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CASH FLOWS

Cash flows from operating activities:

Operating activities are the principal revenue-producing activities of the enterprise, and

other activities that are not investing andfinancing activities.

Operating activities include cash effects ofthose transactions and events that enter in tothe determination of net profit or loss.

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CASH FLOWS

Cash flows from investing activities:

Investing activities are the acquisition and

disposal of long-term assets (not held for

resale) and other investments not included in

cash equivalents.

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CASH FLOW S

Cash flows from financing activities:

Financing activities are activities that result in

changes in the size and composition of the

owners capital (including preference share

capital in case of a company) and borrowings

of the enterprise

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Difference between Cash Flow and Funds Flow Statement

Cash Flow Statement:

1. Shows inflows and outflows of cash and cash equivalents.

2. While preparing a cash flow statement, cash refers to cash in hand, cash at

bank (demand deposits) and short term investments (i.e. cash & cash

equivalents only).3. It is prepared on cash basis of accounting.

4. Shows cash changes from different types of activities: Operating, Investing

and Financing.

5. It is an important tool for short-term financial analysis.

Fund Flow Statement:

Shows inflow and outflow of funds (i.e. working capital).It is prepared on accrual basis of accounting.

It is an important tool for long-term financial analysis.

It identifies movement of working capital.

Net fund flow from the different activities are not separately exhibited through

the fund flow statement.


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Financial Accounting for Management

Quality of Earnings: Window

Dressing, Creative FinancialPractices and Issues

Related to Quality of

Disclosures in ReportedEarnings


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Introduction

Quality of Earnings

Limitations of Financial Statements

Leverage Provided by GAAPS Window Dressing

Creative Accounting/creative Financial

Practices Non-provision of Diminution in the Value of Long-

term Investments


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Quality of earnings - implies

Derived from core business operations

Recognized and measured as per GAAP

Accounting policies consistently followed, where GAAP allow

choice

Close to reality, neither overstated nor understated

High chances of continuation of past earnings in future

A fair prediction of future profitability and cash flows

Principal qualitative characteristics of financial statements

preparation have been followed


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Limitations of Financial Statements

1. Leverage Provided by GAAPS

(i) Different accounting policies as per AS-1 Valuation of fixed assets

Methods of charging depreciation

Treatment of intangible assets

Valuation of inventories

Valuation of investments

Treatment of Contingent Liabilities

Impairment loss on assets

Cash Flow Statements etc.

(ii) Change in accounting policies as per AS-5


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2. Window Dressing: Financial statements are said to bewindow dressed when the management tries to portray a

rosier performance and financial position of a companythan is true, to suit its motives.

(i) Non operational income being major source of income

(ii) Non provision of diminution in the value of long terminvestments

(iii) Capitalization of revenue expenses

(iv) Revaluation of fixed assets to show better position

(v) Extension of accounting year

(vi) Inadequate or no provision for doubtful debts

(vii) Increasing the life of assets(viii) No separate disclosure of extraordinary items.

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