Financial Management - Chapter 8

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Subject: Financial Management

Chapter no. 8: Financial statements analysis

Chapter No. 8 – Financial statements analysis

ContentsIntroduction to financial statements and their differing objectivesSchedule VI of The Companies’ Act format for Balance Sheet and Profit and Loss statementsLimitations on Schedule VI balance sheet format and need for regrouping in the “Analytical”form of balance sheet to overcome these limitationsFinancial ratios and their usefulnessInter-firm and intra-firm analysisLimitations to financial statement analysis and study of financial ratiosFunds flow statement and its construction from balance sheet as on two successive annualdates with additional informationNumerical exercises on:Financial statement analysis and calculation of ratiosInterpretation of these ratiosFunds flow statement preparationAt the end of the chapter the student will be able toRegroup the assets and liabilities in the “Analytical form” of balance sheetCalculate the financial ratios relating both to Profit and Loss and Balance SheetInterpret the financial ratios for their impact on business enterpriseAppreciate the limitations to the study of financial statements and ratiosPrepare funds flow statement given two successive dates balance sheets

Punjab Technical University, Online Virtual Campus1

Subject: Financial Management

Chapter no. 8: Financial statements analysis

Introduction to Financial Statements and their differing objectives: What are financial statements in a business enterprise?

The financial statements are:Profit and Loss statementBalance SheetCash flow statement andFunds flow statementObjectives are:Profit and Loss statement – to know whether the enterprise is in profit or loss at the end of a given period ornot. The period would usually be one year. It could be as short a period as one month even. Howeverpreparing the Profit and Loss Account every year is a must.Balance Sheet – it is also referred to as statement of assets and liabilities. This is as on a particular date. Theobjective is to know the financial position of the enterprise, how much it owes to outsiders in the form ofliabilities and how much it owns in the form of various assets. Although it could be prepared on a monthlybasis as at the end of every month, it is prepared as at the end of every year – again a statutory requirementbesides being a business necessity.Cash flow statement – as explained in the chapter on working capital management, cash flow statement isprimarily to know the cash from operations, investments and finance obtained and manage the liquidity inthe short-run. In the short-run, the objective could be financial planning. It lists all the cash inflows and cashoutflows to verify as to whether the system has the required liquidity or not. The business should not havetoo little or too much cash. The frequency of preparing it depends upon the business needs – it could evenbe on a weekly basis. The minimum frequency is one month.Funds flow statement – this is the fundamental statement used for financial planning. The minimum periodis one year. It talks of all resources, be it short-term or medium-term/long-term and the uses to which theseare put to. The objective is to ensure that proper funding takes place in the business enterprise and thatthere is no diversion of working capital to acquiring fixed assets.Out of the above we have seen cash flow statement in the chapter on “working capital management”. Hencethe same is not repeated here. The students should take “funds flow” statement as summary statement ofsources and application for a given period; they would realise that the format for the statement as given inthe annexure to this chapter is different from the one they are used to under “Management Accounting”.

Example no. 1 - A sample of “Profit and Loss” Account (R upees in Lacs )

Income from operations 100Operating expenses:Salaries 30Repairs and maintenance 3Depreciation 10Office and general expenses 10Marketing expenses includingCommission, if any 7Interest and otherCharges 10

Punjab Technical University, Online Virtual Campus2

Subject: Financial Management

Chapter no. 8: Financial statements analysis

Total expenses 70Profit before tax 30Tax at 35% 10.5Profit after tax 19.5Dividend 7.5Profit retained inBusiness [Retained Earnings] 12Learning points:

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Interest is charged to income before determining the profit of the organisation. Once the profit of theorganisation is determined, tax is paid at the stipulated rate and the dividend is paid only after this. Thus,dividend is profit allocation.

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This difference between “interest” and “dividend” gives opportunity to business enterprises, to have a mix ofcapital of the owners and loans taken from outside, so that they can save on tax, through the interest charged asexpense on the income. The amount of tax so saved is called “tax shield” on the interest.

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In the case of profit distributed among the partners as well in the case of dividend distributed among theshareholders, these are not taxed again in the hands of the owners.Linkage between balance sheet and profit and loss accountsThe above statement is known as the “Profit and Loss Account”. This records the income and expenditure for agiven period and is closed as soon as the period is over. The residual profit, as it belongs to the owners, getstransferred to the capital account in another statement, called “Balance Sheet”.

The balance sheet tells us about the following:

How much money has the business enterprise raised?Which are the sources for the money?What is the use for this money?

Example no. 2

The balance sheet is also known as “Assets and Liability” statement. A sample balance sheet is shown below:(Rupees in lacs)

LiabilitiesAssets

Share capital: 100Fixed Assets 60Reserves: 150Less: Depreciation 30(Retained profits Net Fixed Assets: 30over a period ofInvestments:80time)Current Assets:Net worth250Bills Receivable 100Bank overdraft 30Cash and Bank 35Creditors for expenses 10Other current assets 60

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