UNIT : III

FINANCIAL STATEMENT ANALYSIS

INTRODUCTION
WHAT IS ACCOUNTING?
Accounting is the art of recording, classifying and summarizing the financial transactions and interpreting the results thereof. Thus involves the following four major phases: Recording of transactions: This is done in book called journal Classifying the transactions: This is done in a book called ledger. Summarizing the transactions: This includes preparation of trial balance, profit and loss account and balance sheet of the business. Interpreting the results: This involves computation of various accounting ratios etc. to know about the liquidity, solvency and profitability of the business

FINANCIAL STATEMENT

Financial Statement
Financial statement refers to formal and original statements prepared by business concern to disclose its financial information. The following reasons the financial statement is prepared: Presenting periodical review or report on the progress by the management Deal with status of investments in the business The result achieved during the period.

Which all are called Financial Statement?

The statement disclose the status of investments is known as balance sheet Statement showing result means that is P&L a/c or income statement. Another statement also being prepared called surplus statement or retained earnings statement Schedule of fixed assets, schedule of investments, schedule of creditors, schedule of debtor. supplementary schedules. All of the above is called package of financial statement

BALANCE SHEET
The balance sheet comprises of a list of assets, liabilities and capital fund at a given date. It sets forth the financial conditions of a business concern as revealed by the accounting records. It reflects the assets owned by the concern and the sources of fund (from creditors & owners) used in acquisition of those assets

Profit and Loss a/c (or) Income statement

The earnings capacity and potential of a firm are reflected by the income statement. The P&L a/c is the score board of the firms performance during a particular period of time. Net Income Income exceeds Expenses Net Loss Expenses exceeds Income

Surplus statement (or) Retained earnings statement

It refers to accumulated excess profit over losses and dividends. Such retained earnings are taken to Balance sheet from the retained earning statement The statement starts with accumulated profits at beginning of the current year, brought down from previous years net profit and any profit on revaluation of assets increase retained earnings. Any appropriation like dividend and transfer to specific reserves reduce retained earnings. Link between balance sheet and Income Statement.

Functions and Uses Importance of Financial Statement

For Management: Legal requirement, Decision making For Creditors: Creditor Extension For Investor: Investing prospective For Owners: Their capital is properly used or not For Employees: Remuneration , Bonus For Consumers: Product price is reasonable or justified Government: Formulate tax policies, Export Import policies For tax authorities: levied and collected tax For Researchers and academicians: ?

Limitations of Financial Statements

1. Financial statements do not always disclose the correct financial position of business concerns as they are influenced by the personal opinions, judgment subjective views and of accountants of each concern. Balance sheet of a concern is a static document as it discloses the financial position of a concern on particular date. But the values shown and composition of items keep changing day-by-day. There fore, the data and information does not disclose the current realities. Information disclosed by profit and loss account may not be real profit as many items shown in the profit and loss account are not real but estimated. Financial statements are dumb because they cannot speak themselves. The statement require further detailed analysis and interpretation.

2.

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Window Dressing
The practice of manipulating the financial statements of a firm to present an untrue or exaggerated, position termed as windows dressing. Window dressing is practiced in corporate world also for different purposes, as motioned below, (a) Mergers or Amalgamations: (b) Issue of Shares and Debentures (c) Control Needs Methods of Window Dressing: (a) Valuation of stocks (b) Depreciation (c) Under valuation of assets (d) Provisioning (e) Tampering sales and purchases

FINANCIAL STATEMENT ANALYSIS

Understanding the financial statement Analysis and Interpretation

Analysis and interpretation of financial statements are an attempt to determine the significance and meaning of the financial statement data so that forecast may be of the prospects for future earnings, ability to pay, interest and debt maturities (both current and long term ) and profitability of a sound dividend policy Financial statement analysis is undertaken by creditors, investors, and other financial statement users in order to determine the credit worthiness of an entity

Objectives of Analysis and Interpretation

1. To interpret the profitability and efficiency of various business activities with the help of profit and loss account 2. To measure managerial efficiency of the firm 3. To measure short-term and long-term solvency of the business 4. To ascertain the earning capacity of the concern 5. To measure utilization of various assets during the period. 6. To compare operational efficiency of similar concern engaged in the same industry

Types of Analysis
External Analysis Internal Analysis Vertical Analysis : common size Horizontal Analysis : comparative statement

Techniques or Tools of financial statement analysis

The most important techniques of analysis and interpretation of financial statements are listed below: 1. Ratio Analysis 2. Comparative financial statements 3. Common measurement or size statements 4. Cash flow analysis 5. Fund flow analysis 6. Net working capital analysis 7. Trend analysis

Ratio Analysis
A ratio is a mathematical relationship between two or more items taken from the financial statements. Ratio analysis is helpful to management and outsiders to diagnose the financial health of a business concern. It helps in measuring the profitability, solvency, and activity of a firm.

Classification Of Ratios
Classification by statements 1. Balance Sheet Ratios 2. Profit and loss a/c ratios 3. Balance sheet and p&l a/c ratios (or) Mixed or composite ratios Classification by users 1. Ratios for Management 2. Ratios for creditors 3. Ratios for Shareholders Classification of ratios by purpose/ Function 1. Financial Ratios or Solvency ratios or liquidity ratio 2. Turnover Ratios 3. Profitability Ratios

Liquidity Ratio Or solvency Ratio Or Financial Ratio

Short term solvency Ratios: Current Assets Liquid Ratio Cash Position Ratio or absolute liquidity ratio Long term solvency Ratios: Fixed Assets Ratio Debt Equity Ratio Proprietary Ratio Capital gearing ratio Over all Solvency Ratios (or) Total debt (or) Debt Ratio

Liquidity Ratio or Short Term Solvency Ratios or Financial Ratios

Current Ratio = current assets / current liabilities The ratio of current assets to current liabilities is called current ratio. In order to measure the short-term liquidity or solvency of a concern, comparison of current assets and current liabilities is inevitable. Standard expected current ratio: Internationally accepted current ratio is 2:1, current assets shall be 2 times to current liabilities.

Current Ratio
Current assets: Debtors, stock, Bills Receivables, bank and cash balances, prepaid expenses, income due and short term investment Current liability: Creditors, Bank OD, Bills payable, outstanding expenses, income received in advance.

Liquid Ratio
Liquid Ratio also called Quick or Acid Test ratio. It is calculated by comparing the quick assets with current liabilities. Liquid Ratio = Quick Assets or Liquid Assets Current Liabilities Liquid assets = current assets stock + prepaid expenses The ideal liquid ratio or generally accepted norm for liquidity ratio is 1

Cash position ratio OR Absolute liquidity ratio

This ratio is called Absolute Liquidity ratio or super quick ratio. This ratio is calculated when liquidity is highly restricted in terms of cash and cash equivalents. Cash Position Ratio= Cash and Bank Balance + Marketable Securities Current Liabilities An ideal cash position ratio is 0.75:1. This ratio is a more rigorous measure of a firms liquidity position . It is not widely used ratio.

Problem in Short Term Solvency Ratio

You are given the following information: Calculate (a) Current Ratio (b) Liquidity Ratio C)Absolute Liquidity Ratio
CASH DEBTORS CLOSING STOCK BILLS PAYABLE 18,000 1,42,000 1,80,000 27,000

CREDITORS
OUTSTANDING EXPENSES TAX PAYABLE

50,000
15,000 70,000

Problem No:2
Find the current Ratio and Quick Ratio and comment on the financial condition of the company. Find the current ratio and quick ratio and comment on the financial condition of the company

Equity Capital Revenue Reserves

1,50,000 30,000

Fixed Assets Current Assets: Stock Debtors Bills Receivable Bank

1,62,000 22,000 51,000 2,000 12,000

Current Liabilities: Sundry Creditors TOTAL

49,000

2,49,000

2,49,000

Long-Term Solvency Ratio

Fixed asset Ratio Debt Equity Ratio Proprietary Ratio Capital gearing Ratio

Fixed Assets Ratio

The ratio establishes the relationship between fixed assets and long term funds. The objective of calculating this ratio is to ascertain the proportion of long term funds invested in fixed assets. Fixed asset ratio = fixed assets/ long term funds Fixed asset means = Fixed assets-Depreciation Long Term funds = Share capital + Reserves and Surplus+ Long term funds Fictitious assets assets An Ideal fixed asset ratio is 0.67 . More than 1 means it implies that fixed assets are purchased with short term funds, which is not a prudent policy

Debt Equity Ratio

The debt equity ratio establishes the relation ship between establishes shareholders funds and outsiders funds. Outsiders fund include all long term and short term debts. Share holders funds consists of preference share capital, equity share capital and reserves and surplus Debt equity ratio = Debt/Equity (or) Outsiders funds /share holders funds Ideal ratio is 1

Proprietary Ratio
This ratio compares