FINANCIAL STATEMENTS

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

INTRODUCTION
Accounting is the recording and reporting of all activities of an entity. The business activities covers actual Business (selling goods or services), Investment (purchasing assets) and Financing (raising money for investment).
Business Investment Financing

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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 called Balance sheet.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

SUMMARY OF MANAGEMENT ACTIVITIES

Management
Sell Goods / Services

Income P & L A/c

Business Activity

Buy Goods / Services

Expenses

Requires Assets Long Term : Fixed Assets Investment Activity Short Term : Current Assets Assets

Surplus : Investment
Requires Money BALANCE SHEET

From Owner : Capital Financing Activity From Outsiders Long Term: Loans Short Term: Liabilities Liabilities

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

According to the American Institute of Certified Public Accountants (AICPA), Financial Statements are prepared for the purpose of presenting a periodical review or report on the progress 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 which shows the position of the assets and the liabilities of the business on a particular date and the Profit & Loss Account which shows the profit or loss during a particular year. AICPA has summed up the nature of financial statements in the following words- Financial Statements reflects a combination of recorded facts, accounting principles and personal judgment.
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ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Need for Analysis and Interpretation Meaning of Analysis
A typical Financial Statement of a company may run into several pages. It normally contains a huge mass of data and figures. 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.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

Types of Analysis
Horizontal analysis moves over a number of years or across many firms, it is called Dynamic Analysis Vertical analysis, on the other hand involves finding out the relationship between two items in respect of the same firm and in the same year. Vertical analysis is, therefore, called Static Analysis

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

Vertical balance sheet

The horizontal format of Balance Sheet is designed from the point of view of the owner of firm. It enables the owner to know at a glance the amount of Total Funds Owned (total assets) and the amount of Total Funds Owed (total liabilities). It also enables the owner to know which assets will take time to sell (fixed assets) and which assets can be realized quickly (current assets). The order of payment of liabilities in the event of liquidation can also be ascertained from such a balance sheet in conventional form. However, the Conventional Form of Balance Sheet is not suitable for financial analysis, precisely because

It is designed for the owner. It does not serve the purpose of the other users such as a potential investor or lender. Its presentation and sequence or order of items is relevant only in the event of liquidation; it is unsuitable for financial analysis of a going firm.
Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

Vertical profit and loss statement

The conventional form of Profit and Loss Statement is not suitable for financial 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 be classified into operating expenses, Administrative expenses etc. Such classification enables the financial analysis to find out the relationship between the expenses and sales, whether the expenses are variable or fixed and 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 disclosed step 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 is useful in financial analysis, especially in Ratio Analysis. This is done through the Vertical or Multi-step Form of Profit and Loss Account

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

COMPARATIVE FINANCIAL STATEMENTS

INTER-FIRM AND INTER-PERIOD COMPARISONS
A business firm does not exist in isolation. It co-exists with other competing firms in the same industry. It has to therefore constantly compare its performance with such competing firms to find out where it scores over its rivals and where it lags behind them. Such comparison is called inter-firm comparison. It also needs to compare its own past performance with its current performance to ascertain its progress or decline over the years. This is known as Inter Period Comparison

FORMAT OF COMPARATIVE STATEMENTS

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

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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COMPARATIVE FINANCIAL STATEMENTS

Limitations:
Inflation Common Size Comparisons Trend Comparisons Only Horizontal Comparisons Different Accounting Policies

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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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.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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TREND ANALYSIS
LIMITATIONS : Choice of Base Year & No. of years Different Accounting Policies

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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13
Notes to the Accounts and Significant Accounting Policies

Financial Accounting for Management

Note 5Contribution to gratuity fund Note 6Debenture Redemption Reserve Note 7Capital commitments

Note 8Auditors remuneration Note 9Managerial remuneration Note 10Exchange difference

Note 15Expenditure in foreign currency

Note 18Amount of dividend remitted in foreign currency

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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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.
Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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For m s
There are three different forms in which an accounting ratio can be expressed: Proportion: A proportion is a simple division of one number by another. The relationship between Current Assets & Current Liabilities is expressed in 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 a certain 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 that the stock is converted into sales for 8 times in 12 months.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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Classification
BASED ON FINANCIAL STATEMENT
Balance Sheet Ratios Revenue Statement Ratios Composite Ratios Liquidity ratios Leverage ratios
Activity Ratios

BASED ON FUNCTION
These are also known as Solvency ratios

Profitability ratios Coverage ratios

Also known as Turnover ratios or Productivity ratios

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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Classification
BASED ON USER
Ratios for Short Term Creditors Ratios for Shareholder Ratios for Management Ratios for Long Term Creditors

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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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 decisions appropriate 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

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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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.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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Investor use of ratio analysis

Profitability ratios: Shareholders are interested in the profits earned by the company as well as the profits accrued on their own investment. Profitability ratio which is of interest to shareholders can be divided into following firms:

Profitability of total investment i.e, gross profits earned on total funds invested in the company irrespective of the capital structure. Profits as percentage of sales i.e. profits earned from normal business activity. This indicates shareholders proportion of profits earned from normal business. Profits after payment of interest as a ratio of shareholders equity. This indicates the actual earnings per share for investors. Dividend per share or dividend as percentage of profits. Dividend ratios can be computed to develop a trend over a number of years.
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Investor use of ratio analysis

Risk ratios: Investors while making investment in a company undertake (i) Risk of capital loss due to decline in share price which may be due to lower profitability of the company or on account of general economic depression; (ii) Risk of bankruptcy of the company; and (iii) Risk of non payment of dividend causing suffering to investors.
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Investor use of ratio analysis

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 the firms 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 companys financial position with reference to its capacity to repay the loan and service the interest charges. Where creditors execute conversion rights they remain interested in the capital gains like ordinary shareholders through appreciation in market price for share as well as enhanced 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 that may 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 the financial statements. Ratios are no doubt useful but one should also be aware of its limitations. Interpretations of the ratios after understanding these limitations would be more meaningful. Some of the important limitations of accounting ratios are as follows:
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 ratios and conclusions drawn from them. For example, a high ratio of debt to net worth can be expected of a public utility operating with large fixed assets with social benefit considerations. Seasonal characters of the business affect ratios for a particular type of industry or business enterprise. For example, inventory to sales ratio for a grains merchant during the peak season has a different meaning and is supposed to be much higher than during other period of the same year.
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Related Concepts
Quality of assets also affects the ratio analysis and gives different interpretation to different business enterprises. Current assets to current liabilities ratio mostly 2 : 1 is considered more satisfactory for a liquid position of the company but if with same proportion of assets acid test ratio is calculated it may give a different result and may depict the unsatisfactory position of availability of liquid funds with the company to meet its most urgent and pressing obligations. Adequacy of data is another consideration for comparison of particular factors with each other. For example, average collection period for bill receivables for a particular month may differ to those with other months or the average of the year. Another consideration would be whether bill receivables have been properly valued for a particular period as over valuation may render the ratio incomparable.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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Related Concepts
Modification of ratios reflects only the past performance and must be modified by future trends of business. Interpretation of ratios should not be relied upon in isolation and should be considered with accounting documents for interpretations. Non-financial data ratios based on financial data of firms should be considered with non-financial data to supplement the financial ratios and give better interpretation.
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Du Pont Analysis
The financial ratios in themselves are meaningless to assess the performance of a company in a given year. To interpret the financial health of a company it is crucial to analysis and compare the ratios for a given year viz a viz the previous financial years and 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 overall picture of the performance of a firm and enable the management to identify the factors which have a bearing on its profitability.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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CHAPTER 14
CASH FLOW STATEMENT
Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press 37

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 and cash equipments, and the needs of the enterprise to utilize those cash flows.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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INTRODUCTION
Cash Cash equivalents Cash flows Cash management

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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CASH FLOWS
Cash flows from operating activities: Operating activities are the principal revenueproducing activities of the enterprise, and other activities that are not investing and financing activities. Operating activities include cash effects of those transactions and events that enter in to the determination of net profit or loss.
Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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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.

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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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

Basic Financial Accounting For Management by Dr. Paresh Shah, Oxford University Press

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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.

Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in Reported Earnings
Financial Accounting for Management

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 Longterm Investments

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

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

2. Window Dressing: Financial statements are said to be window dressed when the management tries to portray a rosier performance and financial position of a company than 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 term investments (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.