FINANCIAL STATEMENT ANALYSIS:

Abstract

♦ The quality of financial information determines the value of analysis.

♦ Financial information must be accurate, timely and comprehensive to be useful in
the financial management
♦ Financial statements compares the company against itself to evaluate strengths and
weakness
♦ Requires at least three years of historical financial information to identify operating
records
♦ Use industry standards as one of the measures but not the only measure of
performance
♦ Financial analysis raises the questions to be answered and the issues to be
addressed

INTRODUCTION

The conceptual framework sets out the concepts underlying the preparation and presentation of
general-purpose financial reports. The accounting standards, rules and guidance applicable
under Presentation of Financial Statements’ and AASB 108 ‘Accounting Policies, Changes in
Accounting Estimates and Errors’ are based on that framework.

If there is a conflict between the ‘Framework’ and an Australian equivalent to an International

Financial Reporting Standard (IFRS), the requirements of the IFRS prevail.

The International Accounting Standards Board (IASB) ‘Framework for the Preparation and
Presentation of Financial Statements’ has been adopted in the Australian context as follows:

OVERVIEW

The conceptual framework applicable on adoption of International Financial Reporting Standards

(IFRS) will be:

• Definition of the Reporting Entity’;

• Objective of General Purpose Financial Reporting’; and

• ‘Framework’ - Framework for the Preparation and Presentation of Financial Statements.

The existing conceptual framework is provided in:

• Definition of the Reporting Entity’;

• Objective of General Purpose Financial Reporting’;

 • Qualitative Characteristics of Financial Information’; and

• Definition and Recognition of the Elements of Financial Statements’.

will continue to apply in order to provide guidance for the IFRS application paragraphs.

The ‘Framework’ will replace which will be withdrawn. Although the ‘Framework’ is brief in
comparison the concepts are similar with the key differences being that the ‘Framework’:

• includes prudence as a qualitative characteristic; and

• identifies two components to both income and expenses

Another Financial Ratios:

Working Capital:
 Current Assets-Current Liabilities
 Measures of liquidity: excess of current assets over current liabilities
 Lenders look for a positive and growing amount of the working capital as
a sign that a company can handle its short-term obligation
Current Ratios:

 Current Assets/Current Liabilities

 A variation on the working capital measure of liquidity
 Lenders look for a 2:1 ratio which indicates that there are twice as many
current liabilities to satisfy current short-term obligations
Debt and Equity

 Short term and Long term debt/Net worth

 Measures the percent of the company financed by lenders relative to
owner
 Fact: Most private sector lender won’t finance companies with more than
2:1 ratio: public lenders may go up to 5:1

Definition of the Reporting Entity

Objective of General Purpose Financial Reports

will continue to apply in order to provide guidance for the IFRS application paragraphs. The
‘Framework’ also addresses issues discussed

reporting entity concept is embedded in the reporting structure and implemented through the
IFRS application paragraphs. Similarly, the general purpose financial report concept is essential
to the operation of the application paragraphs.
Qualitative Characteristics of Financial Information
Definition and Recognition of the Elements of Financial Statements

The ‘Framework’ will replace which will be withdrawn. Although the ‘Framework’ is brief in
comparison the concepts are similar with the key differences being that the ‘Framework’
includes prudence as a qualitative characteristic and identifies two components to both income
and expenses.

APPLICATION DATE

The Framework is applicable to annual reporting periods.

KEY DIFFERENCES FROM THE EXISTING CONCEPTUAL FRAMEWORK

Public sector application

The IASB framework focuses on for-profit entities and lacks commentary specific to the
circumstances of not-for-profit entities. The is responsible for setting standards for all types of
reporting entities and satisfies that responsibility by providing sector neutral pronouncements
with additional commentary for not-for-profit entities.

The existing explanatory references and examples relevant to the public sector and not-for-profit
entities that will be lost on transition.

Income and Revenue

Under the ‘Framework’ some inflows are shown on a gross basis and others on a net basis
whereas inflows are shown on a gross basis.

definition of “income” encompasses “both revenue and gains” where:

• revenue “arises in the course of the ordinary activities of an entity”; and

• “gains” are determined on a net basis (proceeds less the carrying amount and/or costs of
achieving the proceeds) and “may, or may not, arise in the course of the ordinary activities
of an entity”.

defines “revenue” as “inflows or other enhancements, or savings in outflows, of future economic

benefits in the form of increases in assets or reductions in liabilities of the entity”.

For example, under the net gain on a disposal will be recognised and reported as income (gain).
Under the current arrangements the gross proceeds of the disposal are recognised as revenue and
the carrying amount is expensed.
 Gains may occur under standards including Non-Current Assets Held for Sale and Discontinued
Operations’, ‘Property, Plant and Equipment’, Financial Instruments: Recognition and
Measurement’ Investment Property’ and Agriculture’.

Expenses and Losses

Under the ‘Framework’ some outflows are shown on a gross basis and others on a net basis
whereas outflows are shown on a gross basis.

The ‘Framework’ notes that the definition of expenses “encompasses losses as well as those
expenses that arise in the course of the ordinary activities of the entity”. “Losses” are determined
on a net basis (carrying amount and/or costs of achieving the proceeds less the proceeds); and
“may, or may not, arise in the course of the ordinary activities of an entity”.

as “consumptions or losses of future economic benefits in the form of reductions in assets or

increases in liabilities of the entity, other than those relating to distributions to owners, that result
in a decrease in equity during the reporting period”.

Prudence

The ‘Framework’ introduces prudence as a qualitative characteristic. This raises the potential
for judgements to be made that result in assets or income being understated and liabilities or
expenses being overstated.

IMPACT OF DIFFERENCES

Effect on general reporting in the public sector

The different recognition criteria for components of income and expense may require amended
presentation and, while the change does not affect the net result, it may affect the income/expense
split. For example, recognition of a net gain from the disposal of an asset as income, rather than the
gross proceeds, can result in lower income and expense than would occur under the existing
arrangements.

The inclusion of prudence as a qualitative characteristic may have some financial impact but it would
be difficult to quantify at this stage and is likely to

Pro-forma profit and loss account and balance sheet of a sole trader

(Name of business)
Trading and Profit and Loss Account for the year ended (date)

Sales
Less Cost of Goods Sold
Opening stock
Add Purchases

Less Closing stock

Gross Profit
Less Expenses
(list here)

Net Profit

Balance Sheet as at (date)

Cost Accumulated Net Book
Depreciation Value
Fixed Assets

Current Assets
Stock
Debtors
Prepayments
Bank balance
Cash

Less Current Liabilities

Creditors
Accruals

Net current assets

Total net assets

Capital
Opening balance
Add Net Profit
Less Drawings

Questionare ;

Analyzing The Profit and Loss Statement: Four Credit

♦ Is the Business Growing?

ANS
a) Quality Indicator: % of sales growth/decline
b) Are sales increasing at a growth greater than the inflation rate?

♦ Does the business control its Direct Cost?

ANS
a) Quality Indicator: COGS/Sales
b) Beware of sudden changes in relationship of COGS to Sales

♦ Does the Business Control Overhead Cost

ANS
a) Quality Indicator: Operating and Administrative Exp./Sales
b) Is the relationship of operating and administrative exp to sales stable or falling
over time?
♦ Is the Business Truly Profitable?

ANS
a) Quality indicator: i) EBT (Earnings before taxes)/Sales ii) Operating
Profit/Sales
b) Is the percentage of OP/Sales and EBT/Sales increasing with growth?

Analyzing The Balance Sheet: The Six Credit

♦ Does the Business Collect its Bills?

ANS
a) Quality indicator: Account Receivables/Sales*360dys
b) Measures the average number of days it takes to collect bills
c) Compare the term a company offers to customers to day’s receivables to measure
quality

♦ Does the business control its inventory?

ANS
 a) Quality Indicator: Inventory/COGS*360 days
b) Measures the average number of days worth of inventory on hand
c) Compare the company’s inventory cycle: ordering time, production time,
warehousing
♦ Does the Business Pay its Bills?

ANS
a) Quality indicator: Accounts Payables/COGS*360
b) Measures the average number of days its takes to pay suppliers

♦ Have the owners invested in the business?

ANS
a) Reinvested profits, investment in common stock, deferred officers’ salary
b)
♦ Has the business produced a positive net worth?

ANS
a) Positive retained earnings indicate that the company has been profitable and has
reinvested profits into operations
b) Negative retained earnings indicates the company has experienced losses

References

1. www.India-report.com
2. www.rbi.com
3. www.accuntingreviews.com
4. www.icfai.in