Financial Statements & Analysis – Quick Review for the day-before

exams
Financial statements are the end products of the accounting process. The last but not the least leg of the
accounting process is summarizing the accounting data in the form of balance sheet, income statement and
statement of changes in the financial position which help in analysis and interpretation of the accounting data.

Financial statements to be filed by the board with the Registrar of Companies (ROC)  Laying down of
Balance Sheet and income statement before the Annual General Body Meeting of the shareholders along with
Auditor’s Report and Director’s Report in discharge of the stewardship responsibility of the management
towards the shareholders.

Meaning of Financial Statements :

Financial statements are the final product of accounting work done during the accounting period – quarterly/
half-yearly/annually. Financial statements are prepared in monetary terms. Some refer to them as ‘Annual
Accounts’ , when they are prepared on a yearly basis. However, interim financial statements are prepared for a
shorter period, usually a quarter, and hence called ‘Quarterly Financial Statements’.

The financial statements are prepared by the board of directors for reporting to shareholders in discharge of
their stewardship function and hence corporate law enjoins upon them the responsibility of laying down them
before annual general meeting of the shareholders so as to give a ‘true and fair view’ of the affairs of the
company. The profit and loss account shall be annexed to the balance sheet and auditor’s report (including the
auditor’s separate, special or supplementary report, if any) shall be attached thereto.

Financial statements normally include

• Balance Sheet
• Profit and Loss Account (also called Income Statement)

Imp : Publicly available financial statements do not contain Manufacturing Account and Trading Account.

The annual accounts also contain fund-flow and cash flow statements. The financial statements are historical
documents and relate to the past period.

Balance Sheet  is a sheet of balances of assets, liabilities and capital indicating the financial position of the
enterprise at a point in time. A Balance Sheet gives the statement of shareholders’ equity (paid-up share
capital and reserves and surplus), loans, current liabilities and provisions, fixed assets net of depreciation,
investments, loans and advances, and current assets.

Briefly stated, a balance sheet is a listing of investing and financing activities at a point in time. Every
accounting transaction related to cash flows, income, and shareholders’ equity affects the balance sheet. For
example, difference of revenues and expenses affects reserves and surplus, which in turn affect shareholders’
equity. However, it is to be noted that the values shown in the balance sheet are historical in nature and do not
indicate their current market value unless otherwise specified in a particular case.

The format of the Balance Sheet is prescribed in Schedule VI of the Companies Act.
Profit and Loss Account  An income statement is a measure of financial performance between two points
in time - is a report of business activities for a given period, say a quarter or a year, and is prepared to ascertain
profit (or loss), earned (or sustained) by the enterprise for that period. It lists revenues (sales and other
incomes), gains, expenses and losses over a period of time. Usually this period is a financial year. The profit is
shown before and after tax by making due adjustments for prior period transactions. The net profit so arrived at
is used for appropriation in various reserves mandated by the law or decided upon by the Board of Directors.
Surplus if any, is carried forward to the next year.

The statement of changes in financial position explains the inflow and outflow of working capital and cash
flow statement portrays the movement of cash.

Cash Flow Statement  A cash flow statement indicates inflows and outflows of cash during an accounting
period. Under accrual system of accounting, the net profit shown by Profit & Loss Account does not equal to
net cash flow except over the lifetime of the company. Since, Profit & Loss Account relates to the time
segment, and is based on certain accounting policies, it is necessary for periodic reporting of cash inflows and
outflows.

A cash flow statement is required to be published pursuant to Clause 32 of the listing agreement and should be
based on and be in agreement with corresponding Profit & Loss Account and balance sheet of the company.
The Institute of Chartered Accountants of India has issued accounting standard related to cash flow statement
— AS3.

Notes and Annexure to Financial Statements  Formal financial statements are not sufficient to give a
true and fair view of the financial affairs of the business enterprise; hence these statements are accompanied
with schedules, annexure and notes forming part of balance sheet and Profit & Loss Account. These are quite
important for they provide additional information and clarifications with regard to the numbers arrived.
One must read these notes very carefully to understand the application of different accounting policies over a
period of time concerning the recognition of revenues and matching of different expenses.

Financial analysis forms an important part of business analysis, which is preceded by accounting analysis
and followed by prospective analysis.

Accounting analysis  involves examining how generally accepted accounting principles and conventions
have been applied in arriving at the values of assets liabilities revenues and expenses. An appreciation of the
changes in accounting rules and conventions significantly impact the values of assets and liabilities, so also the
net income/loss. The rules governing the valuation of assets, matching of cost and revenue should be carefully
examined so as to effectively evaluate a company’s accounting choices and accrual estimates.

Financial analysis  involves how analytical tools and techniques such as Ratios, Cash Flow measures can
be used to evaluate the operating, financing and investment performance of a business enterprise with a focus
on effectiveness and efficiency in the conduct of business affairs by the management. Financial Analysis based
on publicly available financial statements is seriously handicapped by the quality and quantity of information
disclosed. The disclosed financial information reveals less than it conceals. Therefore it is the experience and
expertise of the financial analyst that comes to his/her aid in carrying out sound, systematic scientific, and
logical analysis to permit informed decision making by the users of that information. It is for this reason that
all financial analysts and auditors use indirect statement of disclaimer by stating, “According to the
information made available”. Financial analysis can also be carried out by comparing balance sheets and Profit
& Loss Account over a period of time either by preparing a common size statement or comparative statements.

Prospective Analysis  The next extension of financial analysis - involves developing forecasted financial
statements keeping in view the changes that are likely to shape and affect the business given the assumptions
about these changes and the limitations of the forecasting techniques used. This is quite complicated and
requires good professional expertise.

(b) Contents of Financial Statements :

Following are the contents of financial statements:

(a) Board’s Report
(b) Director’s Responsibility Statement
(c) Management Discussion and Analysis
(d) Auditor’s Report
(e) Report on Corporate Governance
(f) Accounting Policies
(g) Balance Sheet
(h) Profit and Loss Account
(i) Cash Flow Statement
(j) Segment Report

The above stated statement, account, reports are statutory requirements to be complied with by the
management. In some cases non-statutory disclosures are also made which are voluntary in nature, such as,
Human Resource Accounting, Accounting for Changing Prices, Value Added Statement, Social Accounting
Report etc.

Types of financial statements

Companies have been presenting annual financial statements until the Securities and Exchange Board of India
(SEBI) made it mandatory in case of listed public companies to submit halfyearly unaudited reports and later
on required them to submit quarterly reports.

On the basis of periodicity of publication of financial statements, we have two types of financial statements :
1. Annual financial statements
2. Quarterly financial statements.

Annual Financial Statements  statements and accounts that are required to be presented in the Annual
General Body Meeting of members of the company who in turn are required to adopt them. These statements
include
• Balance Sheet,
• Profit & Loss Account,
• Cash Flow Statement,
• Statement of Material Changes in the Financial Position of the subsidiary company, if the date of
closure of financial year of subsidiary company is different from that of the parent company and
• Consolidated financial statement in case of holding company.

Apart from these, there are disclosures with respect to corporate governance, energy consumption,
export earnings, related party transactions, balance sheet, Profit & Loss Account, director’s report and auditor’s
report of subsidiary company(ies).

Quarterly Financial Reports  Companies issue these reports at the end of each quarter – also known as
Interim Financial Reports. Quarterly Financial Reports have been mandated by SEBI and are required to be
submitted to the stock exchanges where the securities are listed. These reports are helpful in understanding the
current financial performance of the companies and help in the evaluation and forecasting objectives. The
quarterly reports added together should usually lead to the portrayal of annual performance but this may not be
true owing to the seasonal, random, scheduled, cyclical and non-random factors. Theoretically, it is believed
that each interim period accounting results of business operation should be determined in essentially the same
manner as results of annual accounting period. From this standpoint, the same principles employed for annual
reports should be used to report deferrals, accruals, and estimations at the end of each interim period.

While the other viewpoint is that each interim period is in integral part of the annual period and hence
deferrals, accruals, and estimations at the end of each interim period depend on judgments made at each
interim date about the results of operations for the entire annual period.

The Accounting Standard (AS) — 25 requires at a minimum, the following components

(a) condensed balance sheet;
(b) condensed statement of profit and loss;
(c) condensed cash flow statement; and
(d) selected explanatory notes.

If an enterprise prepares and presents a complete set of financial statements in its interim financial report, the
form and content of those statements should conform to the requirements as applicable to the annual complete
set of financial statements.

If an enterprise prepares and presents a set of condensed financial statements in its interim financial report,
those condensed statements should include all the headings and sub-headings that were included in its most
recent annual financial statements. Additional notes should be included if their omission would make the
condensed interim financial statements misleading.

An enterprise should include the following information in notes to its financial

statements, if material and if not disclosed elsewhere in the interim financial
report:
(a) a statement that same accounting policies are followed in the interim financial statement as those followed
in the most recent annual financial statements or, if those policies have been changed, a description of the
nature and effect of the change;
(b) explanatory comments about the seasonality of interim operations;
(c) the nature and amount of items affecting assets, liabilities, equity, net income or cash flows that are unusual
because of their nature, size or incidence;
(d) nature and amount of changes in the estimates of amounts reported in prior interim periods of current
financial year or changes in estimates of amount reported in prior financial years,
(e) issuance, buy-backs, repayments and restructuring of debt, equity and potential equity shares;
(f) dividend, aggregate or per share, separately for equity shares and others;
(g) segment revenue, capital employed and results for each segment;
(h) the effect of changes in the composition of the enterprise such as amalgamation, acquisition or disposal of
subsidiaries and long-term investments, restructurings and discontinuance of operations; and
(i) material changes in contingent liabilities since the last balance sheet.

Segment reports

Of lately, the business enterprises have been required to publish segment information with a view to helping
the users of financial statements in better understanding the performance of the enterprise, better assessment of
risk and returns of the enterprise, and enable informed judgement about the enterprise as a whole. Many
enterprises provide multiple groups of products and services or operate in geographical areas that are subject to
differential rates of profitability, opportunities for growth, future prospects and growth.

For example, Hindustan Lever Ltd. is a multi-product company while Infosys Technologies Ltd. is a multi-
market company because its products are sold in different overseas markets having diverse characteristics. The
information about different types of products and services of an enterprise and its operations in different
geographical areas is called segment information. The segment information is relevant to assessing the risk and
returns of a diversified or multi-locational enterprise. Therefore, reporting of segment information is widely
regarded as necessary for meeting the needs of users of financial statements.

Accounting Standard (AS– 17) issued by the Council of the Institute of Chartered Accountants of India
applicable for accounting periods commencing on or after 1st April, 2001 is mandatory in nature and is to be
observed in quarterly and annual reporting.

Concept of Financial Analysis

The analysis includes establishing relationship, comparisons and ascertaining trends. Financial analysis deals
with the use of financial data in the evaluation of current and past performance of an enterprise and to assess
its sustainability in future. This implies that the person attempting to make financial analysis should not only
be in command of the appropriate financial analysis tools and techniques, but must be a master craftsman to
make creative and imaginative use of such tools and techniques. Besides, he should also be endowed with the
sound statistical knowledge to relate the current performance with the future of the business, keeping in view
the changes that are shaping in the business environment of the firm.

To sum up, it requires two-fold exercise — (a) analysis of past performance, and (b) prospective analysis to
predict the likely future. In order to make analysis of the financial data, one must know about the different
techniques such as horizontal and vertical analysis and tools of analysis such as accounting ratios, Statement of
Changes in Financial Position (SCFP).

Uses of Financial Analysis  Used for a variety of decision contexts such as security analysis, analysis of
credit worthiness, credit analysis, debt analysis, dividend decision, mergers, take-overs, acquisitions and
general business analysis.

Security Analysis An investor would like to know whether the firm is fulfilling his expectations with regard
to payment of dividend, capital appreciation and security of money. He would like to know whether his
investment in a particular firm is enhancing his wealth or not. If not, what are the reasons thereof ? If Yes, how
well is he being served in comparision to other firms in the same industry. Should he continue to hold his
investment or sell the same? In accounting terms, the security analyst is interested in cash-generating ability,
dividend payout policy and the behaviour of share prices.

Credit Analysis  The manager of the firm may have to offer credit to a prospective dealer and therefore he
would like to know whether to extend credit to him or not. What is the risk associated in extending credit to the
new customer/dealer. The same type of questions can be raised by a banker when we approach for a loan.

Debt Analysis The manager of the firm may be interested in knowing the borrowing capacity of the firm
which in turn requires analysis of the relationship of debt and equity, capacity to repay and the capacity to
borrow further.

Dividend Decisions The management have to reward the shareholders of the company by paying dividends
(returns on equity) periodically. For this, management needs to assure the sustainability of the rate of dividends
in the future years as also the past performance of the company and the practice of the industry. Dividend
income provides cash inflows to the shareholders to meet their consumption needs as also it indicates the
profitability of the firm and hence to some extent affects the behaviour of share prices.

Mergers & Acquisitions If the company is doing well in relation to its competitors and is generating surplus
cash flows, the management may be tempted to expand the business by acquiring other companies or brands to
expand the market and make the profitable investment. This would require analysis of the
ompeting/supporting brands and products for horizontally or vertically linking the operations. For example,
Reliance Industries has acquired strategic stake in Indian Petrochemicals Corporation Ltd. for horizontal
expansion of the petrochemical business. In the same way Hindustan Lever Ltd. has acquired products of
Lakme India Ltd.
General Business Analysis The general business analysis aims at identifying the key profit drivers and
business risks in order to assess the profit potential of the firm. This analysis is required to create sustainable
competitive advantage. This analysis also helps in developing future growth scenarios for the firm.

Regulatory Compliance  The regulators include the Registrar of Companies, Department of Company
Affairs, Stock Exchanges, SEBI use these reports for analyzing the contents to ensure compliance with
different rules and regulations enforced from time to time.

TOOLS FOR FINANCIAL ANALYSIS

The end products of the accounting process are balance sheet, profit and loss account, and statement of cash
flows. These are supplemented by detailed explanation in the Director’s Report, annexures and schedules. The
information contained in the financial statements are arranged in such a manner that enables analyst to make
inferences about the working and financial health of the enterprise.

The numbers given in the financial statements are not of much use to the decision maker. These numbers are to
be analysed over a period of time or in relation to other numbers so that significant conclusions could be drawn
regarding the strengths and weaknesses of a business enterprise. The tools of financial analysis help in this
regard. These tools include
• Comparative statements,
• common-size statements,
• ratio analysis,
• funds flow analysis,
• cash flow analysis and
• statement of changes in financial position

Comparative statement  compares financial numbers at two point of time and helps in deriving meaningful
conclusions regarding the changes in financial position and operating results. The purpose of focusing at
change in the financial numbers over a period of time is to get an insight into the reasons for changes in
financial position and operating results. This analysis is also known as ‘horizontal analysis’. This change in
accounting numbers over a period of time may also change because of change in accounting policies. So this
analysis recommends that consistency be maintained with regard to use of accounting principles and policies.

Common-size statement  expresses all items of a financial statement as a percentage of some common base
and then permits the analyst to infer changes in financial numbers. For example, in case of profit and loss
account, each item is expressed as a percentage of sales. Thus, the common-size profit and loss account
captures the relationship between sales and expenses. One can draw conclusion regarding the behaviour of
expenses over period of time by examining these percentages. An analysis of common size statement will help
better understand the important changes which have occured in the enterprise over a period of time. This
analysis is also known as ‘vertical analysis’.

Ratio analysis  is one of the most widely used tools of financial analysis. This is so because accounting
numbers do not explain any phenomenon on their own. However, when a relationship is established between
two numbers figuring in the three financial statements, i.e., balance sheet, profit and loss account and
cash flow statement, one can make an assessment regarding the phenomenon. Ratio analysis involves
calculation and interpretion of financial numbers by relating them in a logical manner in order to assess the
strengths and weaknesses underlying the performance of an enterprise. Ratio analysis involves the method of
calculating and interpreting financial ratios in order to assess the strengths and weaknesses underlying the
performance of an enterprise.

We calculate ratios because in this way that we get a comparison that may prove more useful. In order to
comment on the quality of a ratio one has to make a comparison with some standard or benchmark. These
benchmarks could be :
i)Past ratio : A ratio could be benchmarked with the last year’s ratio. This type of process was discussed under
time-series analysis;
ii) Ratio of similar firms or industry average : A ratio could be compared with the ratio of firms in the same
industry or by industry average at the same point of time. This type of process has already been discussed
under crosssectional analysis; and
iii) Rule of thumb : 'Rule of thumb' have evolved over a period of time. For example, rule of thumb for current
ratio is 2:1, meaning thereby current assets should be two times the current liabilities. However, these rule of
thumb are to be cautiously used.

Financial ratios can be grouped into four types:

(i) liquidity ratios,
(ii) solvency ratios,
(iii) activity ratios,
(iv) profitability ratios.

Liquidity Ratios
1.Current Ratio Current ratio is the relationship between current assets and current liabilities. Current
assets are assets held on a short-term basis. These assets include cash and bank balances,
prepaid expenses, debtors, bills receivables, inventory (finished goods, work-in-progress
and raw material), short term investment in treasury accounts and accrued income.
Normally short-term refers to an accounting period.
Current liabilities are obligations that are payable within an accounting period. Current
liabilities include, creditors, bills payable, cash credit and overdraft from a bank for a
short period and liability for expenses, income recorded in advance, and any other
liability due for payment during the current accounting period.
Current ratio is calculated by dividing current assets by current liabilities.

Current Ratio = Current Liabilities/ Current Assets.

2. Liquid Ratio Also referred to as 'acid-test ratio' or 'quick-ratio'. The ratio seeks to ascertain the
liquidity position of a business enterprise. Liquidity implies the ability to convert current
assets into cash. Liquid ratio is expressed as follows :

Liquid Ratio = Liquid Assets/ Current Assets

The term 'liquid assets' implies current assets minus inventory. The current liabilities have
already been explained in the context of current ratio.

Generally, a quick ratio of 1:1 or more is considered to be good for the reason that it
indicates availability of funds to meet the liabilities 100%.
 Solvency Ratios
Solvency implies the ability of the enterprise to meet its obligations on the due date. Some payments have
short-term maturity and some have longterm maturity. The firm has to plan for both short-term and long-term
obligations.

1. Debt-equity Debt-equity ratio refers to the relationship of the long-term debt and the equity of the
Ratio enterprise. The degree of indebtedness of an enterprise is captured by this ratio. Long-
term lender wants to know about the status of outsiders’ long- term funds being used by a
business enterprise vis-a-vis owner’s funds.
Debts are long-term liabilities having maturity after one year. It includes debenture, long-
term loans from banks and financial institutions and public deposits. Equity (also called
shareholder’s funds) includes equity share capital, preference share capital, general
reserves, capital reserves, securities premium account balance and all other reserves and
surplus available for equity share holders.

Debt-Equity Ratio is expressed as Debt/Equity

2.Total Assets to Measures the proportion of total assets funded by longterm debt. The lower the ratio, the
Debt Ratio role of loaned funds in financing the assets engaged in profit generating activities of the
organization.
The ratio is calculated as Total Assets/Debt

3.Proprietary Variant of debt-equity ratio. It captures relationship between equity and total assets. It
Ratio attempts to indicate the part of total assets funded through equity.

Proprietary Ratio = Equity/Total Assets

Activity Ratios
1. Inventory Inventory is needed for smooth flow of production and sales. Inventory is of three types,
Turnover Ratio i.e., raw material, work-in-progress and finished goods. Inventory turnover ratio
measures the efficiency with which inventory has been converted into sales.
Inventory Turnover Ratio = Sales/Av Inventory
Inventory is generally valued at cost. In order to have a logical relationship with the
denominator, the numerator should also be a cost variable. Sales include an element of
profit. By eliminating this element, cost of goods sold is calculated and then inventory
turnover ratio will be
Inventory Turnover Ratio = Cost of goods Sold/ Av Inventory

Av Inventory = (Opening Stock+ Closing Stock)/2

Inventory Turnover Ratio = Sales Net Of Excise Duty / ((Opening Stock+ Closing
Stock)/2)

The figure of cost of goods sold is not separately available in the published accounts of
Indian companies. The external analysts do not have an access to cost of goods sold data.
So, they use sales in the numerator. However, management should use cost of goods sold
data in order to calculate this ratio. Higher the ratio, the better it is. This is subject to one
condition that the inventory turnover ratio should not turn so high that it results into a
situation of stock out.Inventory turnover ratio can also be converted into number of days,
in the following manner. Av Age of Inventory = Days in a year/ Inventory Turnover
Ratio.

2. Debtors Measures the efficiency with which the debtors are converted into cash. This ratio
Turnover Ratio indicates both the quality of debtors and the collection efforts of the business enterprise.
Inventory Turnover Ratio = Cost of goods Sold/ Av Inventory
Debtor Turnover Ratio = Sales/ Av Debtors
Av Debtors = (Opening Debtors + Closing Debtors)/2
The numerator of this ratio should preferably be credit sales. However, as the information
related to credit sales is not separately available in corporate accounts, so total sales
could be taken in the numerator.
Higher a turnover ratio, better it is. However, a too high debtor's turnover ratio generally
means tight credit policy and hence denial of opportunity to increase sales by offering
liberal credit facility to the customers.Conversally the nature of product and industing
customers may warrantee no credit, or very limited credit.
Av Collection Period = Days in a year/ Debtor Turnover Ratio.
3. Payable This ratio reflects the efficiency in making payment to the creditors. Prudence
Turnover Ratio demands that one should not make payment to creditors at a pace which is faster than the
pace of receiving payments from debtors.
Payable Turnover Ratio = Purchases/ Av Creditors
Av Creditors = (Opening Creditors + Closing Creditors)/2
Av Payment Period = Days in a year/ Creditors Turnover Ratio

4. Working Working capital refers to investment in current assets. This is also known as gross
Capital Turnover concept of working capital. There is another concept of working capital known as net
working capital. Net working capital is the difference between current assets and current
liabilities.
Working Capital Turnover Ratio = Sales/ Net Working Capital
 Profitability Ratios
1. Gross Profit Gross Profit Ratio = Gross Profit / Sales x 100
Ratio
In case of a trading concern
Cost of Goods Sold = Opening Stock + Purchases + Expenses directly related to Purchases* – Closing
Stock
In case of a manufacturing concern
Cost of Goods Sold = Opening Stock of Finished Goods + Cost of Goods Manufactured – Closing Stock
of Finished Goods
It is to be noted that gross profit ratio cannot be calculated from the publicly available
from published accounts because of its high sensitivity competitiveness of the firm.
Hence, it is calculated by management for internal decision-making, sales pricing, etc.

2. Operating Operating Ratio = Operating Expenses / Sales x 100

Ratio
Operating Expenses = Cost of Raw Material, Finished Goods and Semi-finished Goods + operating,
administrative, selling and distribution expenses – Finance charges + Depreciation
The lower the ratio, better it is. As a higher operating ratio will leave a small amount of
operating income to meet interest, tax and dividends.