Qualitative characteristics of financial statements

Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users. The four principal qualitative characteristics are understandability,
relevance, reliability and comparability.

1.) Understandability
An essential quality of the information provided in financial statements is that it is readily
understandable by users. For this purpose, users are assumed to have a reasonable knowledge
of business and economic activities and accounting and a willingness to study the information
with reasonable diligence. However, information about complex matters that should be included
in the financial statements because of its relevance to the economic decision-making needs of
users should not be excluded merely on the grounds that it may be too difficult for certain users
to understand.

2.) Relevance
Information about financial position and past performance are interrelated and has the quality of
relevance when it influences the decision-making needs of the users such as dividend and wage
payments, security price movements and the ability to meet its commitments as they fall due. It
helps them evaluate past, present or future events or confirming, or correcting, their past
evaluations.

3.) Materiality
The relevance of information is affected by its nature and materiality, for example, the amounts
of inventories held in each of the main categories are appropriate to the business. Information is
material, if its omission or misstatement could influence the economic decisions of users and
provides a threshold or cut-off point rather than being a primary qualitative characteristic.

4.) Reliability
Information has the quality of reliability when it is free from material error and bias and can be
depended upon by users to represent faithfully that which it either purports to represent or could
reasonably be expected to represent.

 Faithful representation
To be reliable, information must represent faithfully the transactions and other events it
either purports to represent or could reasonably be expected to represent. Thus, for
example, a balance sheet should represent faithfully the transactions and other events that
result in assets, liabilities and equity of the entity at the reporting date which meet the
recognition criteria.

 Substance over form

The substance of transactions or other events is not always consistent with that which is
apparent from their legal or contrived form. For example, an entity may dispose of an asset
to another party in such a way that the documentation purports to pass legal ownership to
that party; nevertheless, agreements may exist that ensure that the entity continues to enjoy
the future economic benefits embodied in the asset.

 Neutrality
To be reliable, the information contained in financial statements must be neutral, that is,
free from bias. Financial statements are not neutral if, by the selection or presentation of
information, they influence the making of a decision or judgement in order to achieve a
predetermined result or outcome.
 Prudence

Prudence is the inclusion of a degree of caution in the exercise of the judgements needed
in making the estimates required under conditions of uncertainty, such that assets or
income are not overstated and liabilities or expenses are not understated.

 Completeness
To be reliable, the information in financial statements must be complete within the bounds
of materiality and cost. An omission can cause information to be false or misleading and
thus unreliable and deficient in terms of its relevance.

 Comparability
Users must also be able to compare the financial statements of different entities in order to
evaluate their relative financial position, performance and changes in financial position. An
important implication of the qualitative characteristic of comparability is that users be
informed of the accounting policies employed in the preparation of the financial statements,
any changes in those policies and the effects of such changes. Compliance with
International Accounting Standards, including the disclosure of the accounting policies used
by the entity, helps to achieve comparability.

Constraints on relevant and reliable information

 Timeliness
To provide information on a timely basis it may often be necessary to report before all
aspects of a transaction or other event are known, thus impairing reliability. Conversely, if
reporting is delayed until all aspects are known, the information may be highly reliable but
of little use to users who have had to make decisions in the interim. In achieving a balance
between relevance and reliability, the overriding consideration is how best to satisfy the
economic decision-making needs of users.

 Balance between benefit and cost

The evaluation of benefits and costs is, however, substantially a judgmental process.
Furthermore, the costs do not necessarily fall on those users who enjoy the benefits.
Benefits may also be enjoyed by users other than those for whom the information is
prepared; for example, the provision of further information to lenders may reduce the
borrowing costs of an entity. For these reasons, it is difficult to apply a cost-benefit test in
any particular case.

 Balance between qualitative characteristics

In practice a balancing, or trade-off, between qualitative characteristics is often necessary.
Generally the aim is to achieve an appropriate balance among the characteristics in order
to meet the objective of financial statements. The relative importance of the characteristics
in different cases is a matter of professional judgement.

True and fair view/fair presentation

 Financial statements are frequently described as showing a true and fair view of, or as
presenting fairly, the financial position, performance and changes in financial position of an
entity. Although this Framework does not deal directly with such concepts, the application
of the principal qualitative characteristics and of appropriate accounting standards normally
results in financial statements that convey what is generally understood as a true and fair
view of, or as presenting fairly such information.
The elements of financial statements
The elements directly related to the measurement of financial position in the balance sheet are
assets, liabilities and equity.

The elements directly related to the measurement of performance in the income statement are
income and expenses.

The statement of changes in financial position usually reflects income statement elements and
changes in balance sheet elements; accordingly, this Framework identifies no elements that
are unique to this statement.

The presentation of these elements in the balance sheet and the income statement involves a
process of sub-classification, by their nature or function in the business of the entity in order to
display information in the manner most useful to users for purposes of making economic
decisions.

Financial position
The elements directly related to the measurement of financial position are assets, liabilities and
equity. These are defined as follows:

Assets
An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity. The future economic benefit embodied in an
asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents
to the entity. The potential may be a productive one that is part of the operating activities of the
entity. It may also take the form of convertibility into cash or cash equivalents or a capability to
reduce cash outflows, such as when an alternative manufacturing process lowers the costs of
production.

Many assets, for example, property, plant and equipment, receivables and property, are
associated with legal rights, including the right of ownership. In determining the existence of an
asset, the right of ownership is not essential; thus, for example, property held on a lease is an
asset if the entity controls the benefits which are expected to flow from the property.

The future economic benefits embodied in an asset may flow to the entity in a number of ways;

(a) used singly or in combination with other assets in the production of goods or services to be
sold by the entity;

(b) exchanged for other assets;

(c) used to settle a liability; or

(d) distributed to the owners of the entity.

(b) A liability is a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying economic
benefits.

(c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Liabilities
An essential characteristic of a liability is that the entity has a present obligation. Obligations may
be legally enforceable as a consequence of a binding contract or statutory requirement. This is
normally the case, for example, with amounts payable for goods and services received.
Obligations also arise, however, from normal business practice, custom and a desire to maintain
good business relations or act in an equitable manner. If, for example, an entity decides as a
matter of policy to rectify faults in its products even when these become apparent after the
warranty period has expired, the amounts that are expected to be expended in respect of goods
already sold are liabilities.
The settlement of a present obligation usually involves the entity giving up resources embodying
economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation
may occur in a number of ways, for example, by:

(a) payment of cash;

(b) transfer of other assets;

(c) provision of services;

(d) replacement of that obligation with another obligation; or

(e) conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting
its rights.

Liabilities result from past transactions or other past events. Thus, for example, the acquisition of
goods and the use of services give rise to trade payables (unless paid for in advance or on
delivery) and the receipt of a bank loan results in an obligation to repay the loan. An entity may
also recognize future rebates based on annual purchases by customers as liabilities; in this case,
the sale of the goods in the past is the transaction that gives rise to the liability.

Equity
In a corporate entity, funds contributed by shareholders, retained earnings, reserves representing
appropriations of retained earnings and reserves representing capital maintenance adjustments
may be shown separately. Such classifications can be relevant to the decision-making needs of
the users of financial statements when they indicate legal or other restrictions on the ability of the
entity to distribute or otherwise apply its equity. They may also reflect the fact that parties with
ownership interests in an entity have differing rights in relation to the receipt of dividends or the
repayment of contributed equity.

The amount at which equity is shown in the balance sheet is dependent on the measurement of
assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds
with the aggregate market value of the shares of the entity or the sum that could be raised by
disposing of either the net assets on a piecemeal basis or the entity as a whole on a going concern
basis.

Performance
Profit is frequently used as a measure of performance or as the basis for other measures, such
as return on investment or earnings per share. The elements directly related to the measurement
of profit are income and expenses depends in part on the concepts of capital and capital
maintenance used by the entity in preparing its financial statements

The elements of income and expenses are defined as follows:

(a ) Income is increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants.

(b) Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.

Distinguishing between items of income and expense and combining them in different ways also
permits several measures of entity performance. These have differing degrees of inclusiveness.
For example, the income statement could display gross margin, profit or loss from ordinary
activities before taxation, profit or loss from ordinary activities after taxation, and profit or loss.

Income
The definition of income encompasses both revenue and gains. Revenue arises in the course
of the ordinary activities of an entity and is referred to by a variety of different names including
sales, fees, interest, dividends, royalties and rent.
Gains represent increases in economic benefits and as such are no different in nature from
revenue. Gains include, for example, those arising on the disposal of non-current assets. The
definition of income also includes unrealized gains; for example, those arising on the revaluation
of marketable securities and those resulting from increases in the carrying amount of long-term
assets. When gains are recognized in the income statement, they are usually displayed
separately because knowledge of them is useful for the purpose of making economic decisions.
Gains are often reported net of related expenses.

Expenses
Expenses that arise in the course of the ordinary activities of the entity include, for example, cost
of sales, wages and depreciation also includes unrealized losses, for example, those arising from
the effects of increases in the rate of exchange for a foreign currency in respect of the borrowings
of an entity.

Losses represent decreases in economic benefits and as such they are no different in nature
from other expenses. For example, those resulting from disasters such as fire and flood, as well
as those arising on the disposal of non-current assets.

The definition of expenses, when losses are recognized in the income statement, they are often
reported net of related income.

Capital maintenance adjustments

The revaluation or restatement of assets and liabilities gives rise to increases or decreases in
equity. While these increases or decreases meet the definition of income and expenses, they are
not included in the income statement under certain concepts of capital maintenance. Instead
these items are included in equity as capital maintenance adjustments or revaluation reserves.

Recognition of the elements of financial statements

It involves the depiction of the item in words and by a monetary amount and the inclusion of that
amount in the balance sheet or income statement totals. The failure to recognize such items is
not rectified by disclosure of the accounting policies used nor by notes or explanatory material.

An item that meets the definition of an element should be recognized if:

1.) The probability of future economic benefit

Assessments of the degree of uncertainty attaching to the flow of future economic benefits
are made on the basis of the evidence available when the financial statements are
prepared. For example, when it is probable that a receivable owed to an entity will be paid,
it is then justifiable, in the absence of any evidence to the contrary, to recognize the
receivable as an asset. For a large population of receivables, however, some degree of
non-payment is normally considered probable; hence an expense representing the
expected reduction in economic benefits is recognized.

2.) Reliability of measurement

In many cases, cost or value must be estimated; the use of reasonable estimates is an
essential part of the preparation of financial statements and does not undermine their
reliability. When, however, a reasonable estimate cannot be made the item is not
recognized in the balance sheet or income statement. For example, the expected
proceeds from a lawsuit may meet the definitions of both an asset and income as well as
the probability criterion for recognition; however, if it is not possible for the claim to be
measured reliably, it should not be recognized as an asset or as income; the existence of
the claim, however, would be disclosed in the notes, explanatory material or
supplementary schedules.

Recognition of assets
An asset is recognized in the balance sheet when it is probable that the future economic benefits
will flow to the entity and the asset has a cost or value that can be measured reliably. An asset is
not recognized in the balance sheet when expenditure has been incurred for which it is
considered improbable that economic benefits will flow to the entity beyond the current accounting
period. Instead such a transaction results in the recognition of an expense in the income
statement.

Recognition of liabilities
A liability is recognized in the balance sheet when it is probable that an outflow of resources
embodying economic benefits will result from the settlement of a present obligation and the
amount at which the settlement will take place can be measured reliably. In practice, obligations
under contracts that are equally proportionately unperformed (for example, liabilities for inventory
ordered but not yet received) are generally not recognized as liabilities in the financial statements.

Recognition of income
Income is recognized in the income statement when an increase in future economic benefits
related to an increase in an asset or a decrease of a liability has arisen that can be measured
reliably. This means, in effect, that recognition of income occurs simultaneously with the
recognition of increases in assets or decreases in liabilities (for example, the net increase in
assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver
of a debt payable).

Recognition of expenses
Expenses are recognized in the income statement when a decrease in future economic benefits
related to a decrease in an asset or an increase of a liability has arisen that can be measured
reliably. This means, in effect, that recognition of expenses occurs simultaneously with the
recognition of an increase in liabilities or a decrease in assets (for example, the accrual of
employee entitlements or the depreciation of equipment). An expense is also recognized in the
income statement in those cases when a liability is incurred without the recognition of an asset,
as when a liability under a product warranty arises.

Measurement of the elements of financial statements

Measurement is the process of determining the monetary amounts at which the elements of the
financial statements are to be recognized and carried in the balance sheet and income statement.
This involves the selection of the particular basis of measurement.

A number of different measurement bases are employed to different degrees and in varying
combinations in financial statements. They include the following:

(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the
fair value of the consideration given to acquire them at the time of their acquisition. Liabilities
are recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents
expected to be paid to satisfy the liability in the normal course of business.

(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have
to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at
the undiscounted amount of cash or cash equivalents that would be required to settle the
obligation currently.

(c) Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents
that could currently be obtained by selling the asset in an orderly disposal. Liabilities are
carried at their settlement values; that is, the undiscounted amounts of cash or cash
equivalents expected to be paid to satisfy the liabilities in the normal course of business.

(d) Present value. Assets are carried at the present discounted value of the future net cash
inflows that the item is expected to generate in the normal course of business. Liabilities are
carried at the present discounted value of the future net cash outflows that are expected to
be required to settle the liabilities in the normal course of business.
Concepts of capital and capital maintenance

Concepts of capital
A financial concept of capital is adopted by most entities in preparing their
financial statements. Under a financial concept of capital, such as invested
money or invested purchasing power, capital is synonymous with the net
assets or equity of the entity. Under a physical concept of capital, such as
operating capability, capital is regarded as the productive capacity of the
entity based on, for example, units of output per day.

Concepts of capital maintenance and the determination of profit

(a) Financial capital maintenance. Under this concept a profit is earned
only if the financial (or money) amount of the net assets at the end of the
period exceeds the financial (or money) amount of net assets at the
beginning of the period, after excluding any distributions to, and
contributions from, owners during the period. Financial capital
maintenance can be measured in either nominal monetary units or units
of constant purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned
only if the physical productive capacity (or operating capability) of the
entity (or the resources or funds needed to achieve that capacity) at the
end of the period exceeds the physical productive capacity at the
beginning of the period, after excluding any distributions to, and
contributions from, owners during the period.
It is a prerequisite for distinguishing between an entity's return on capital
and its return of capital; only inflows of assets in excess of amounts
needed to maintain capital may be regarded as profit and therefore as
a return on capital. Hence, profit is the residual amount that remains
after expenses (including capital maintenance adjustments, where
appropriate) have been deducted from income. If expenses exceed
income the residual amount is a loss.
The Vertical Balance Sheet Format
Statement of Changes in Equity
Statement of Changes in Equity, often referred to as Statement of Retained
Earnings, details the change in owners' equity over an accounting period by
presenting the movement in reserves comprising the shareholders' equity.

Movement in shareholders' equity over an accounting period comprises the

following elements:

 Net profit or loss during the accounting period attributable to shareholders

 Increase or decrease in share capital reserves
 Dividend payments to shareholders
 Gains and losses recognized directly in equity
 Effect of changes in accounting policies
 Effect of correction of prior period error
Example
Following is an illustrative example of a Statement of Changes in Equity

ABC Plc
Statement of changes in equity for the
year ended 31st December 2012

Share Retained Revaluation Total

Capital Earnings Surplus Equity

USD USD USD USD

Balance at 1 January 2011 100,000 30,000 - 130,000

Changes in accounting policy - - - -

Correction of prior period error - - - -

Restated balance 100,000 30,000 - 130,000

Changes in equity for the year 2011

Issue of share capital - - - -

Income for the year - 25,000 - 25,000
Revaluation gain - - 10,000 10,000
Dividends - (15,000) - (15,000)

Balance at 31 December 2011 100,000 40,000 10,000 150,000

Changes in equity for the year 2012

Issue of share capital - - - -

Income for the year - 30,000 - 30,000
Revaluation gain - - 5,000 5,000
Dividends - (20,000) - (20,000)

Balance at 31 December 2012 100,000 50,000 15,000 165,000

Opening Balance

This represents the balance of shareholders' equity reserves at the start of the
comparative reporting period as reflected in the prior period's statement of
financial position. The opening balance is unadjusted in respect of the
correction of prior period errors rectified in the current period and also the effect
of changes in accounting policy implemented during the year as these are
presented separately in the statement of changes in equity (see below).

Effect of Changes in Accounting Policies

Since changes in accounting policies are applied retrospectively, an adjustment

is required in stockholders' reserves at the start of the comparative reporting
period to restate the opening equity to the amount that would be arrived if the
new accounting policy had always been applied.

Effect of Correction of Prior Period Error

The effect of correction of prior period errors must be presented separately in

the statement of changes in equity as an adjustment to opening reserves. The
effect of the corrections may not be netted off against the opening balance of
the equity reserves so that the amounts presented in current period statement
might be easily reconciled and traced from prior period financial statements.

Restated Balance

This represents the equity attributable to stockholders at the start of the

comparative period after the adjustments in respect of changes in accounting
policies and correction of prior period errors as explained above.

Changes in Share Capital

Issue of further share capital during the period must be added in the statement
of changes in equity whereas redemption of shares must be deducted
therefrom. The effects of issue and redemption of shares must be presented
separately for share capital reserve and share premium reserve.

Dividends

Dividend payments issued or announced during the period must be deducted

from shareholders equity as they represent distribution of wealth attributable to
stockholders.

Income / Loss for the period

This represents the profit or loss attributable to shareholders during the period
as reported in the income statement.

Changes in Revaluation Reserve

Revaluation gains and losses recognized during the period must be presented
in the statement of changes in equity to the extent that they are recognized
outside the income statement. Revaluation gains recognized in income
statement due to reversal of previous impairment losses however shall not be
presented separately in the statement of changes in equity as they would
already be incorporated in the profit or loss for the period.

Other Gains & Losses

Any other gains and losses not recognized in the income statement may be
presented in the statement of changes in equity.

Closing Balance

This represents the balance of shareholders' equity reserves at the end of the
reporting period as reflected in the statement of financial position.

Purpose & Importance

Statement of changes in equity helps users of financial statement to identify the
factors that cause a change in the owners' equity over the accounting periods.
Whereas movement in shareholder reserves can be observed from the balance
sheet. Statement of changes in equity discloses significant information about
equity reserves that is not presented separately elsewhere in the financial
statements which may be useful in understanding the nature of change in equity
reserves.

Examples of such information include share capital issue and redemption

during the period, the effects of changes in accounting policies and correction
of prior period errors, gains and losses recognized outside income statement,
dividends declared and bonus shares issued during the period.

Statement of Cash Flows

Statement of Cash Flows, also known as Cash Flow Statement, presents
the movement in cash flows over the period as classified under operating,
investing and financing activities.

Example (presented according to the indirect method)

ABC PLC
Statement of Cash Flows for the year ended 31 December 2013
2013 2012
Notes

Cash flows from operating activities

Profit before tax 40,000 35,000

Adjustments for:
Depreciation 4 10,000 8,000
 Amortization 4 8,000 7,500
Impairment losses 5 12,000 3,000
Bad debts written off 14 500 -
Interest expense 16 800 1,000
Gain on revaluation of investments (21,000) -
Interest income 15 (11,000) (9,500)
Dividend income (3,000) (2,500)
Gain on disposal of fixed assets (1,200) (1,850)

35,100 40,650

Working Capital Changes:

Movement in current assets:

(Increase) / Decrease in inventory (1,000) 550
Decrease in trade receivables 3,000 1,400

Movement in current liabilities:

Increase / (Decrease) in trade payables 2,500 (1,300)

Cash generated from operations 39,600 41,300

Dividend paid (8,000) (6,000)

Income tax paid (12,000) (10,000)

Net cash from operating activities (A) 19,600 25,300

Cash flows from investing activities

Capital expenditure 4 (100,000) (85,000)

Purchase of investments 11 (25,000) -
Dividend received 5,000 3,000
Interest received 3,500 1,000
Proceeds from disposal of fixed assets 18,000 5,500
Proceeds from disposal of investments 2,500 2,200

Net cash used in investing activities (B) (96,000) (73,300)

Cash flows from financing activities

Issuance of share capital 6 1000,000 -

Bank loan received - 100,000
Repayment of bank loan (100,000) -
Interest expense (3,600) (7,400)

Net cash from financing activities (C) 896,400 92,600

Net increase in cash & cash equivalents (A+B+C) 820,000 44,600

Cash and cash equivalents at start of the year 77,600 33,000
Cash and cash equivalents at end of the year 24 897,600 77,600

Basis of Preparation

Statement of Cash Flows presents the movement in cash and cash equivalents
over the period.

Cash and cash equivalents generally consist of the following:

1. Cash on hand
2. Cash in bank
3. Short term investments that are highly liquid and involve very low risk of
change in value (therefore usually excludes investments in equity
instruments)
4. Bank overdrafts in cases where they comprise an integral element of the
organization's treasury management (e.g. where bank account is allowed to
float between a positive and negative balance (i.e. overdraft) as opposed to a
bank overdraft facility specifically negotiated for financing a shortfall in funds
(in which case the related cash flows will be classified under financing
activities).

As income statement and balance sheet are prepared under the accrual basis
of accounting, it is necessary to adjust the amounts extracted from these
financial statements (e.g. in respect of non cash expenses) in order to present
only the movement in cash inflows and outflows during a period.

All cash flows are classified under operating, investing and financing activities
as discussed below.

Operating Activities
Cash flow from operating activities presents the movement in cash during an
accounting period from the primary revenue generating activities of the
entity.
For example, operating activities of a hotel will include cash inflows and
outflows from the hotel business (e.g. receipts from sales revenue, salaries paid
during the year, etc), but interest income on a bank deposit shall not be
classified as such (i.e. the hotel's interest income shall be presented in investing
activities).

Profit before tax as presented in the income statement could be used as a

starting point to calculate the cash flows from operating activities.

Following adjustments are required to be made to the profit before tax to arrive
at the cash flow from operations:

1. Elimination of non - cash expenses (e.g. depreciation, amortization,

impairment losses, bad debts written off, etc)
2. Removal of expenses to be classified elsewhere in the cash flow statement
(e.g. interest expense should be classified under financing activities)
3. Elimination of non - cash income (e.g. gain on revaluation of investments)
4. Removal of income to be presented elsewhere in the cash flow statement
(e.g. dividend income and interest income should be classified under
investing activities unless in case of for example an investment bank)
5. Working capital changes (e.g. an increase in trade receivables must be
deducted to arrive at sales revenue that actually resulted in cash inflow
during the period)

Investing Activities
Cash flow from investing activities includes the movement in cash flow as a
result of the purchase and sale of assets other than those which the entity
primarily trades in (e.g. inventory).

For example, in case of a manufacturer of cars, proceeds from the sale of

factory plant shall be classified as cash flow from investing activities whereas
the cash inflow from the sale of cars shall be presented under the operating
activities.

Cash flow from investing activities consists primarily of the following:

 Cash outflow expended on the purchase of investments and fixed assets

 Cash inflow from income from investments
 Cash inflow from disposal of investments and fixed assets

Financing activities
Cash flow from financing activities includes the movement in cash flow resulting
from the following:

 Proceeds from issuance of share capital, debentures & bank loans

 Cash outflow expended on the cost of finance (i.e. dividends and interest
expense)
 Cash outflow on the repurchase of share capital and repayment of
debentures & loans
Purpose & Importance
Statement of cash flows provides important insights about the liquidity and
solvency of a company which are vital for survival and growth of any
organization. It also enables analysts to use the information about historic cash
flows to form projections of future cash flows of an entity. Cash flow statement
serves to highlight priorities of management.

For example, increase in capital expenditure and development costs may

indicate a higher increase in future revenue streams whereas a trend of
excessive investment in short term investments may suggest lack of viable long
term investment opportunities. Furthermore, comparison of the cash flows of
different entities may better reveal the relative quality of their earnings since
cash flow information is more objective as opposed to the financial
performance reflected in income statement which is susceptible to significant
variations caused by the adoption of different accounting policies.

Link between Financial Statements

FINANCIAL STATEMENTS
Financial statements reveal data about a company’s incoming earnings from
sales and outgoing funds from paying expenses, rent and payroll, for
example. However, these statements do not show how well the company is
doing on the given market and the exact worth of the company. In other
words, financial statements should not be the primary documents to analyze
a company’s performance, as it is limited in information.

Financial Standing
Financial statements do not reveal how much the company is worth,
meaning readers will not be able to determine whether the company is
wealthy or owes money from the financial statements. Cash-flow charts and
income statements only show how much the company is spending and
earning on a monthly basis. All of these statements are combined for a single
fiscal period in an annual report, but these documents do not show how
many assets or unpaid liabilities are currently in the company’s name.

Market Trends
These documents are limited when analyzing company performance, as
they do not reveal what is in-demand with the given target market. Income
statements show how much the company earns from service and product
sales, but these figures may not be reflective of the market trends or
demands. Although a company’s income is higher than the year before, a
competitor may earn three times as much. In relation to other companies,
the given business may not be performing as well as it could be.

Analysis and Interpretation of Financial Statements:

Analysis and interpretation of financial statements are an attempt to

determine the significance and meaning of the financial statement data so
that a forecast may be made of the prospects for future earnings, ability to
pay interest, debt maturities, both current as well as long term, and
profitability of sound dividend policy.

The main function of financial analysis is the pinpointing of the strength

and weaknesses of a business undertaking by regrouping and analysis of
figures contained in financial statements, by making comparisons of
various components and by examining their content.
Four major steps of accounting in the analysis and interpretation of
financial statements. (The first three steps involving the work of the accountant)

(i) Analysis of each transaction to determine the accounts to be debited

and credited and the measurement and variation of each
transaction to determine the amounts involved.

(ii) Recording of the information in the journals, summary in ledgers

and preparation of a worksheet.

(iii) Preparation of financial statements.

(IV) The fourth step of accounting, the analysis and interpretation of

financial statements, results in the presentation of information
that aids the business managers, investors and creditors.

Interpretation of financial statements involves many processes like

arrangement, analysis, establishing relationship between available facts and
drawing conclusions on that basis.

Types of Financial Analysis:

The process of analysis may partake the varying types. Normally, it is

classified into different categories on the basis of information used and
on the basis of modus operandi.

1.) On the basis of Information Used:

(i) External analysis - is an analysis based on information easily available

to outsiders (externals) for the business. Outsiders include creditors,
suppliers, investors, and government agencies regulating the business
in a normal way. These parties do not have access to the internal
records (information) usually obtain data for analysis from the
published financial statements.

(ii) Internal analysis - is done on the basis of information obtained

from the internal and unpublished records and books. While
conducting this analysis, the analyst is a part of the enterprise he is
analyzing. This analysis is for managerial purposes is conducted
by executives and employees of the enterprise as well as
governmental and court agencies which may have major regulatory
and other jurisdiction over the business.

2. ) On the basis of Modus Operandi:

(i) Horizontal analysis - is also known as ‘dynamic analysis’ or ‘trend

analysis’ consists of a study of the behavior of each of the entities
and done by analyzing the statements over a period of time. Under
this analysis, we try to examine as to what has been the periodical
trend of various items shown in the statement.
(ii) Vertical analysis - is also known as ‘static analysis’ or ‘structural
analysis’. It is made by analyzing a single set of financial statement
prepared at a particular date. Under such a type of analysis,
quantitative relationship is established between the different items
shown in a particular statement. Common size statements are the
form of vertical analysis.

Preliminaries Required for Analysis and Interpretation of Financial Statements:

(i) Data should be presented in some logical way.

(ii) Data should be analyzed for preparing comparative statements.

(iii) All data shown in financial statements should be studied just to

understand their significance.

(iv) The objective and extent of analysis and interpretation should be

determined.

(v) Facts disclosed by the analysis should be interpreted taking into account
economic facts.

(vi) Interpreted data and information should be in a report form.

Objectives of Analysis and Interpretation of Financial Statements:

(i) To investigate the future potential of the concern.

(ii) To determine the profitability and future prospects of the concern.

(iii) To make comparative study of operational efficiency of similar

concerns.

(iv) To examine the earning capacity and efficiency of various business

activities with the help of income statements.

(v) To estimate about the performance efficiency and managerial

ability.

(vi) To determine short term and long term solvency of the business
concerns.

(vii) To enquire about the financial position and ability to pay of the
concerns.

The following factors have increased the importance of the

analysis and interpretation of financial statements:

(i) Decision taken are based on some logical and scientific methods and
hence decisions taken on that basis seldom prove to be misleading
and wrong.
(ii) The user as individual has a very limited personal experience. He
can only understand the complexities of business and mutual
relationship by observation and external experience. Thus it
becomes necessary that financial statements in an implicit form
should be analyzed in an intelligible way.

(iii) Decision or conclusions based on scientific analysis and

interpretation are relative and easily to be read and understood by
other people.

(iv) Even to verify and examine the correctness and accuracy of the
decisions already taken on the basis of intuition, analysis and
interpretation are essential.

The most important techniques of analysis and interpretation are:

1. Ratio Analysis:

Ratios are computed for items on the same financial statement or on

different statements. These ratios are compared with those of prior
years and with those of other companies to make them more
meaningful.

Ratio may be expressed by a number of ways. It is a number

expressed in terms of another number. It i s a statistical yard stick
that provides a measure of relationship between two figures.

2. Fund Flow Analysis:

Funds Flow Analysis has been the salient feature of the evolution of
accounting theory and practice. The financial statement of a
business provides only some information about financial activities
of a business in a limited manner. The income statement deals solely
with operations and the balance sheet shows the changes in the
assets and liabilities.

In fact, these statements are substantially an analysis of static

aspects of financial statements. Under this context, it is imperative
to study and to analyze the fund movements in the business concern.
Such a study or analysis may be undertaken by using another tool of
financial analysis, which is called ‘Statement of Sources, and Uses of
Funds’ or simply ‘Fund Statement’ or Fund Flow Analysis.

This statement is also called by other several names and they are:

(a) Application of Funds Statement.

(b) Statement of Sources and Applications of Funds.

(c) Statement of Funds Supplied and Applied.

(d) Where Got and Where Gone Statement.

(e) Statement of Resources Provided and Applied.

(f) Fund Movement Statement.

(g) Inflow-Outflow of Fund Statement.

3. Cash Flow Analysis:

Cash flow statement is a statement of cash flow and signify the

movements of cash in and out of a business concern. Inflow of cash
is known as sources of cash and outflow of cash is called uses of
cash. This statement also depicts factors for such inflow and outflow
of cash.

This is particularly useful to the management, credit grantors,

investors and others. As regards the management, it is helpful in
budgeting cash requirements.

Definition of Financial Statement Analysis :

Financial Statement analysis embraces the methods used in assessing

and interpreting the results of past performance and current financial
position and in forecasting and planning future performance as they
relate to particular factors of interest in investment decisions such as
the portfolio selection model, bank lending decision models, and
corporate financial management models.”

Objectives of Financial Statement Analysis:

The major objectives of financial statement analysis is to provide

decision makers information about a business enterprise for use in
decision-making. Users of financial statement information are the
decision makers concerned with evaluating the economic situation of
the firm and predicting its future course.

Financial statement analysis can be used by the different users and

decision makers to achieve the following objectives:

1. Assessment of Past Performance and Current Position:

Past performance is often a good indicator of future performance.

Therefore, an investor or creditor is interested in the trend of past
 sales, expenses, net income, cast flow and return on investment. It
will tell what the cash position is, how much debt the company has
in relation to equity and how reasonable the inventories and
receivables are.

Similarly, the analysis of current position indicates where the

business stands today. For instance, the current position analysis
will show the types of assets owned by a business enterprise and
the different liabilities due against the enterprise.

2. Prediction of Net Income and Growth Prospects:

The financial statement analysis helps in predicting the earning

prospects and growth rates in the earnings which are used by investors
while comparing investment alternatives and other users interested in
judging the earning potential of business enterprises.

3. Prediction of Bankruptcy and Failure:

Financial statement analysis is a significant tool in predicting the

bankruptcy and failure probability of business enterprises. After
being aware about probable failure, both managers and investors
can take preventive measures to avoid/minimize losses. Corporate
managements can effect changes in operating policy, reorganize
financial structure or even go for voluntary liquidation to shorten
the length of time losses.

4. Loan Decision by Financial Institutions and Banks

Financial statement analysis is used by financial institutions, loaning

agencies, banks and others to make sound loan or credit decision. In
this way, they can make proper allocation of credit among the different
borrowers. Financial statement analysis helps in determining credit risk,
deciding terms and conditions of loan if sanctioned, interest rate,
maturity date etc.
Three Key Areas to effectively analyze the financial statements

1. The structure of the financial statements;

2. The economic characteristics of the industry in which the firm
operates;
3. The strategies the firm pursues to differentiate itself from its
competitors.

Six steps to developing an effective analysis of financial statements.

1. Identify the industry economic characteristics.

First, determine a value chain analysis for the industry—the chain of activities involved
in the creation, manufacture and distribution of the firm’s products and/or services.
Techniques such as Porter’s Five Forces or analysis of economic attributes are typically
used in this step.

2. Identify company strategies.

Next, look at the nature of the product/service being offered by the firm, including the
uniqueness of product, level of profit margins, creation of brand loyalty and control of
costs. Additionally, factors such as supply chain integration, geographic diversification
and industry diversification should be considered.

3. Assess the quality of the firm’s financial statements.

Review the key financial statements within the context of the relevant accounting
standards. In examining balance sheet accounts, issues such as recognition, valuation
and classification are keys to proper evaluation. Evaluation of the statement of cash
flows helps in understanding the impact of the firm’s liquidity position from its
operations, investments and financial activities over the period—in essence, where
funds came from, where they went, and how the overall liquidity of the firm was
affected.

4. Analyze current profitability and risk.

This is the step where financial professionals can really add value in the evaluation of
the firm and its financial statements. The most common analysis tools are key financial
statement ratios relating to liquidity, asset management, profitability, debt
management/coverage and risk/market valuation.
5. Prepare forecasted financial statements.

Although often challenging, financial professionals must make reasonable assumptions

about the future of the firm (and its industry) and determine how these assumptions will
impact both the cash flows and the funding. This often takes the form of pro-forma
financial statements, based on techniques such as the percent of sales approach.

6. Value the firm.

The cash flows could be in the form of projected dividends, or more detailed
techniques such as free cash flows to either the equity holders or on enterprise basis.
Other approaches may include using relative valuation or accounting-based measures
such as economic value added.

The next steps

Once the analysis of the firm and its financial statements are completed, there are
further questions that must be answered. One of the most critical is: “Can we really trust
the numbers that are being provided?” There are many reported instances of
accounting irregularities. Whether it is called aggressive accounting, earnings
management, or outright fraudulent financial reporting, it is important for the financial
professional to understand how these types of manipulations are perpetrated and more
importantly, how to detect them.

Identifying significant matters

A significant matter is a finding or issue that, in the auditor’s judgment, is significant to
the procedures performed, evidence obtained, or conclusions reached. Significant
matters either are, or could be, important to our audit opinion/report, or to the support for
the assurance engagement opinion/conclusion(s). These matters frequently require
consultation. Significant matters require appropriate resolution and documentation by the
audit team, and timely review by the engagement leader and quality reviewer (where
appointed).
Determining which issues during an audit are to be recorded and resolved as significant
matters depends on their significance, complexity, and degree of judgment required, as
evaluated by team members in consultation with more senior members of the audit team,
the engagement leader or others, as appropriate. Whether a matter is treated as a
significant matter will also depend on factors such as whether the involvement of the
quality reviewer, where appointed, or consultation with others, is necessary.
What is Comparative Income Statement?
A Comparative Income Statement shows the operating results for a number of

accounting periods and helps the reader of such statement to compare the

results over the different periods for better understanding and also for detailed

analysis of variation of line wise items of Income Statement.

 Comparative Income Statement format combines several Income

Statements as columns in a Single Statement which helps the reader in

analyzing trends and measure the performance over different reporting

periods.

 It can also be used to compare two different companies operating metrics

as well. Such Analysis helps in comparing the performance with another

business which can be used to analyze how companies react to market

conditions affecting the companies belonging to the same Industry.

 Thus Comparative Income Statement is an important tool through which

the result of operations of a business (or say operation of the business of

different companies) over multiple accounting periods can be analyzed to

understand the various factors contributing to the change over the period

for better interpretation and analysis.

 It helps various stakeholders of business and also Analyst community to

analyze the impact of business decisions over the company’s top line and

bottom line and helps in identifying various trends over the period which

otherwise would have been difficult and time-consuming.

 Comparative Income Statement shows absolute figures, changes in

absolute figures, absolute data in terms of percentages and also as an

increase (or decrease) in terms of percentages over the different periods.

With the help of a Comparative Income Statement format in one snapshot,

the performance of a company over different periods can be compared

and changes in expense items and Sales can be easily ascertained.

Comparative Income Statement format of ABC Limited for the period ended

2016 and 2017

Based on the above Comparative Income Statement of ABC Limited it can be

analyzed how an increase in sales (25% over the previous year = Absolute

change/previous year) has impacted the Net profit (increased by 100% in

absolute terms over the previous year) and how various line items have

contributed. Basic Analysis includes the following:

 Net Sales increased by 25% over the period.

 Gross Profit Ratio increased from 25% to 28% over the period.

 Net Profit Ratio increased from 6% to 9% over the period.

 Tax Expense doubled from $8000 to $16000 and Interest expense increased by 5.88%.

Thus we can see how Comparative Income Statement helps to ascertain the

changes of various components of expenses and identify the reason for

changes which help the management in decision making in the future.

Income Statement Analysis

#1 – Horizontal Analysis
One of the popular technique of Comparative Income Statement which shows

the change in amount both in absolute and percentage terms over a period of

time. It helps in easy analysis of trends and as such also known as Trend

Analysis. One can easily observe growth patterns and seasonality using

the Horizontal Analysis Technique.

We note the following –

 In 2014 and 2015, Colgate saw negative revenue growth.

 Cost of Sales has also decreased during the corresponding period.

 Net Income decreased the most in 2015 with a 36.5% decline in 2015.

#2 – Vertical Analysis

Another technique which exhibits Comparative Income Statement in terms of relative size

of line items is the Vertical Analysis. This technique enables easy comparison of Income

Statement of companies of different size as well. It shows each item on the Income
Statement as a percentage of Base figures (which is usually the Sales figure) with the

statement. Under this, all components of Income Statement are shown as a percentage

of Sales such as Gross Profit, Net Profit, and Cost of Sales etc which makes it very handy

to use even when comparing of different as it removes the Size biases and makes

analysis more easy and understandable. It is mostly used for individual statement for a

reporting period but can also be used for timeline analysis.

An Illustration showing Vertical Analysis is depicted below

Vertical Analysis of Colgate’s Income Statement

Below is the snapshot of Colgate’s Comparative Income Statement

 In Colgate, Gross profit has been in the range of the range of 56%-59%.

 SG&A expenses decreased from 36.1% in 2007 to 34.1% in the year ending 2015.

 Operating income has dropped significantly in 2015.

 Net income decreased substantially to less than 10%.

 Between 2008 to 2014, the tax rate was in the range of 32-33%.

 It makes analyses simple and fast as past figures can easily be compared with the

current figures without the need for referring to separate past Income Statements

 It makes comparison across different companies also easy and helps in analyzing

the efficiency both at Gross Profit Level and Net Profit Level.

 It shows percentage changes in all line items of the Income Statement which makes

analysis and Interpretation of Top Line (Sales) and Bottom Line (Net Profit) easy

and more informative.

Financial Data reported in Comparative Income Statement is useful only if

same accounting principles are followed in the preparation of such statements. In the
case where deviation is observed such Comparative Income Statement will not serve the
intended purpose.
  Comparative Income Statement is not of much use in cases where the company

has diversified into new business lines which have impacted the Sales and

Profitability drastically.

Horizontal or trend analysis of financial statements

Financial statement analysis (explanations)
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Horizontal analysis (also known as trend analysis) is a financial statement analysis

technique that shows changes in the amounts of corresponding financial statement items
over a period of time. It is a useful tool to evaluate the trend situations.

The statements for two or more periods are used in horizontal analysis. The earliest
period is usually used as the base period and the items on the statements for all later
periods are compared with items on the statements of the base period. The changes are
generally shown both in dollars and percentage.

Dollar and percentage changes are computed by using the following formulas:

Horizontal analysis may be conducted for balance sheet, income statement, schedules
of current and fixed assets and statement of retained earnings.
Example:

An example of the horizontal analysis of balance sheet, schedule of current assets

, income statement and statement of retained earnings is given below:

Comparative balance sheet with horizontal analysis:

Comparative schedule of current assets:

Comparative income statement with horizontal analysis:

Comparative retained earnings statement with horizontal analysis:

In above analysis, 2007 is the base year and 2008 is the comparison year. All items on the
balance sheet and income statement for the year 2008 have been compared with the items
of balance sheet and income statement for the year 2007.

The actual changes in items are compared with the expected changes. For example, if
management expects a 30% increase in sales revenue but actual increase is only 10%, it
needs to be investigated.

What are common-size financial statements?

Common-size financial statements present the financial statement amounts as

a percentage of a base number. For example, the common-size income statement will
report the revenue and expense amounts as percentages of net sales. The common-size
balance sheet will report each asset, liability, and owner equity amount as a percentage
of total assets.
Common-size financial statements allow you to compare the financial statements of large
companies with the financial statements of smaller companies, because you are
comparing percentages instead of dollars. For example, a small retailer can compare her
cost of goods sold (perhaps 78%) to a much larger retailer's cost of goods sold (perhaps 80%).
Similarly, one company's inventory might be 33% (of total assets) while a competitor's might be
28%.
Common-size financial statements are related to a technique known as vertical analysis.

Common size income statement analysis makes it easier to see what is driving a

company’s profits, and compare that performance to its peers. By looking at how that

performance has been changing over time, common size financial statements help

investors spot trends that a raw financial statement may not uncover. Large changes in

the percentage of revenue used by different expense categories over a given period of

time could be a sign that the business model is changing, or that manufacturing costs are

changing.

The common figure for an income statement is total sales revenue, so the analysis is the
same as calculating a company’s margins. The net profit margin is simply net income
divided by sales, which happens to be a common-size analysis. The same goes for
calculating the gross margin (sales revenue minus cost of goods sold, divided by sales
revenue) and operating margin (gross profit minus selling & general administrative
expenses, divided by sales revenue).

For example, Company A has an income statement with five different line items,
revenue, cost of goods sold (COGS), selling & general administrative
expenses(S&GA), taxes and net income. Net income is calculated by subtracting
COGS, S&GA expenses and taxes from revenue. If revenue is $100,000, COGS
is $50,000 and S&GA is $10,000, then gross profit is $50,000, operating profit is
$40,000 and net income is $31,600 (less taxes at 21%). The common size version
of this income statement is to divide each line item by revenue, or $100,000.
Revenue divided by $100,000 is 100%. COGS divided by $100,000 is 50%,
operating profit divided by $100,000 is 40% and net income divided by $100,000
is 32%. As we can see, gross margin is 50%, operating margin is 40% and the net
profit margin is 32% - the common size statement figures.

Common-Size Analysis of Financial Statements

1. Perform common-size analysis to evaluate financial statement information.

Question: How is common-size analysis used to evaluate the financial health of an

organization?

Answer: Common-size analysis (also called vertical analysis) converts each line of
financial statement data to an easily comparable, or common-size, amount measured as
a percent. This is done by stating income statement items as a percent of net sales and
balance sheet items as a percent of total assets (or total liabilities and shareholders’
equity). For example, Coca-Cola had net income of $11,809,000,000 and net sales of
$35,119,000,000 for 2010. The common-size percent is simply net income divided by net
sales, or 33.6 percent (= $11,809 ÷ $35,119).

There are two reasons to use common-size analysis: (1) to evaluate information from one
period to the next within a company and (2) to evaluate a company relative to its
competitors. Common-size analysis answers such questions as “how do our current
assets as a percent of total assets compare with last year?” and “how does our net
income as a percent of net sales compare with that of our competitors?”

Using Common-Size Analysis to Evaluate Trends within a Company

Question: How is a formal common-size analysis prepared, and what does it tell us
for Coca-Cola?

Answer: "Common-Size Income Statement Analysis for " presents the common-size
analysis for Coca-Cola’s income statement, and "Common-Size Balance Sheet Analysis
for " shows the common-size analysis for Coca-Cola’s balance sheet. As you look at
these figures, notice that net sales are used as the base for the income statement, and
total assets (or total liabilities and shareholders’ equity) are used as the base for the
balance sheet. That is, for the income statement, each item is measured as a percent of
net sales, and for the balance sheet, each item is measured as a percent of total assets
(or total liabilities and shareholders’ equity).

Common-Size Income Statement Analysis for Coca-Cola

Note: All percentages use net sales as the base. For example, 2010 cost of goods sold
percent of 36.1 percent equals $12,693 cost of goods sold ÷ $35,119 net sales. Note that
rounding issues sometimes cause subtotals in the percent column to be off by a small
amount.
In general, managers prefer expenses as a percent of net sales to decrease over time,
and profit figures as a percent of net sales to increase over time. As you can see
in "Common-Size Income Statement Analysis for ", Coca-Cola’s gross margin as a
percent of net sales decreased from 2009 to 2010 (64.2 percent versus 63.9 percent).
Operating income declined as well (26.6 percent versus 24.1 percent). Income before
taxes increased significantly from 28.6 percent in 2009 to 40.4 percent in 2010, again
mainly due to a one-time gain of $4,978,000,000 in 2010. This caused net income to
increase as well, from 22.0 percent in 2009 to 33.6 percent in 2010. In the expense
category, cost of goods sold as a percent of net sales increased, as did other operating
expenses, interest expense, and income tax expense. Selling and administrative
expenses increased from 36.7 percent in 2009 to 37.5 percent in 2010.

Common-Size Balance Sheet Analysis for Coca-Cola

As you can see from "Common-Size Balance Sheet Analysis for ", the composition of
assets, liabilities, and shareholders’ equity accounts changed from 2009 to 2010.
Notable changes occurred for intangible assets (26.4 percent in 2009 versus 36.9
percent in 2010), long-term debt (10.4 percent in 2009 versus 19.3 percent in 2010),
retained earnings (86.5 percent in 2009 versus 68.0 percent in 2010), and treasury
stock (52.2 percent in 2009 versus 38.1 percent in 2010).

Using Common-Size Analysis to Evaluate Competitors

Question: To this point, we have used common-size analysis to evaluate just one
company, Coca-Cola. Common-size analysis is, however, also an effective way of
comparing two companies with different levels of revenues and assets. For example,
suppose one company has operating income of $100,000, and a competing company
has operating income of $2,000,000. If both companies have similar levels of net sales
and total assets, it is reasonable to assume that the more profitable company is the
better performer. However, most companies are not the same size. How do we compare
companies of different sizes?
Answer: This is where common-size analysis can help. "Common-Size Income Statement
Analysis for " shows an income statement comparison for Coca-
Cola and PepsiCo using common-size analysis.
Common-Size Income Statement Analysis for Coca-Cola and PepsiCo

Note that rounding issues sometimes cause subtotals in the percent column to be off by a small
amount.

Notice that PepsiCo has the highest net sales at $57,838,000,000 versus Coca-Cola at
$35,119,000,000. Once converted to common-size percentages, however, we see
that Coca-Colaoutperforms PepsiCo in virtually every income statement
category. Coca-Cola’s cost of goods sold is 36.1 percent of net sales compared to 45.9
percent at PepsiCo. Coca-Cola’s gross margin is 63.9 percent of net sales compared to
54.1 percent at PepsiCo. Coca-Cola’s operating income is 24.1 percent of sales
compared to 14.4 percent at PepsiCo. Figure 13.8 "Comparison of Common-Size Gross
Margin and Operating Income for " compares common-size gross margin and operating
income for Coca-Cola and PepsiCo.

Comparison of Common-Size Gross Margin and Operating Income for Coca-

Cola and PepsiCo

Common-size analysis enables us to compare companies on equal ground, and as this

analysis shows, Coca-Cola is outperforming PepsiCo in terms of income statement
information. However, as you will learn in this chapter, there are many other measures
to consider before concluding that Coca-Cola is winning the financial performance
battle.

Common-size analysis is obviously crucial to comparative analysis. In fact, some sources

of industry data present the information exclusively in a common-size format, and most
of the accounting software available today has been engineered to facilitate this type of
analysis.
Cash flow from Operations
Cash flow from the operation means taking into account cash inflows generated from the

normal business operations and its corresponding cash outflows.

There are two ways to compute cash flow from operations –

1) Direct method

2) Indirect method

Computation of Cash Flow from Operations:

 Before you start thinking about cash flow statement analysis, have a look at the

income statement, start with net income.

 You need to add back non-cash expenses like depreciation, amortization etc. The

reason behind adding back non-cash expenses is they are not actually expensed in

cash (but in the record).

 This is the same with any sort of sale of assets. If there is any loss on sale of assets,

we need to add back and if there is any gain on sale of assets, we need to deduct.

 And then we need to take into account any changes in non-current assets.

 Finally, we need to include changes in current assets and in current liabilities

(in current liabilities we shouldn’t include dividend payable & notes payable.
 Even though Colgate’s Net Income of 2015 is $1,548 million, its cash flow from

Operation seems to be in line with the past.

 If you look closely to 2015 Cash Flow from operations, there is a charge for

Venezuela accounting change that has contributed $1,084 million in 2015. This was

absent in 2013 and 2014. If you remove this charge, Colgate’s Cash Flow From

Operations will not look too exciting.

Cash Flow from Investment Activities

Other than operations, the company also invests in assets which can provide

them with greater returns. We need to find out how many cashless (loss or gain)

activities are done during the period so that we can take them into account

while ascertaining the net cash inflow. Cash Inflow from investing activities

would include the activities like purchasing long-term assets or securities or

selling them (except cash) and also providing and taking loans.

Though there is nothing much to be talked about here; there are two things

to be taken into account.

 First, we need to add back losses (if any) while selling any long term assets

or marketable securities. These losses should be added back as there is no

cash outflow for the losses.

 Second, we need to deduct profits (if any) while selling any long term

assets or marketable securities. These profits should be deducted because

there is no cash inflow for the profits the company has made.
Cash flow from Investments

 Colgate’s Cash Flow Analysis from Investing Activities was at -685

million in 2015 and -859 million in 2014.

 Colgate’s core capital expenditure was -691 million in 2015 as compared

to -757 million in 2014.

 In 2015, Colgate got proceeds of $599 million from the sale of

marketable securities and investments

 Additionally, Colgate received $221 million from proceeds from the sale

of South Pacific laundry detergent business.

Cash Flow from Financing Activities

 First, if there is any buying back or issuing stocks, it will come under financing

activities in cash flow analysis.

 Borrowing and repaying loans on short term or long term issuing notes and bonds

etc.) will also be included under financing activities.

 We also need to include dividend paid (if any). However, we need to make sure that

we don’t include accounts payable or accrued liabilities (because they would be

taken into account in net cash flow from operating activities).

 Colgate’s Financing activities have been pretty stable for the years of 2015, 2014

and 2013.

 Colgate principal repayment on debt was -9,181 million in 2015 and its issuances

stood at $9,602 million

 Colgate has a stable dividend policy. They paid -1,493 million in 2015 and -1446

million in 2014.

 As a part of its Share repurchase program, Colgate buys back shares at regular

intervals. In 2015, Colgate purchase

Cash Flow Analysis Financing Example – IronMount vs BronzeMetal

Let go back to the earlier cash flow analysis example that we started with –

IronMount Corp and BronzeMetal Corp had identical cash positions at the

beginning and end of 2007. Each company also reported a net income of

$225,000 for 2007.

 Cash Flow Analysis.

IronMount and Bronze Metal, both companies have the same end of the year cash of

$365,900. Additionally, changes in cash during the year is the same at $315,900. Which

company is displaying elements of cash flow stress?

 We note that Cash Flow from Operations is negative for IronMount at -

21,450. Gain on sale of equipment is deducted as this is not an operating

cash flow. IronMount sale of equipment adds 307,350 which contributes

to the increase in the cash.

 On the other hand, when we look at BronzeMetal, we note that its cash flow

from operations are strong at $374,250 and seems to be doing great in its

business. They are not relying on the one-time sale of equipment to

generate cash flows.

  With this, we conclude that IronMount is showing signs of stress due to low

core operating income and its reliance on other one-time items to generate

cash.

Cash Flow Analysis Example – Alphabet

(Google)

 Cash Flow From Operations – Google’s Cash Flow from Operations are

generated from advertising revenues by Google properties and Google

Network Members’ properties. Additionally, Google generates cash

through sales of apps, in-app purchases and digital content, hardware

products, licensing arrangements, and service fees received for Google

Cloud offerings. Google’s Cash flow from operation shows an increasing

trend primarily due to an increase in Net Income. Google’s Net Income was

$14.14 billion in 2014, $16.35 billion in 2015 and $19.48 billion in 2016.
 Cash Flow From Investing Activities – Google’s investing activities

primarily include the purchases of marketable securities, cash collateral paid

related to securities lending and spends related to acquisitions.

 Cash Flow from Financing Activities – Cash Flow from Financing is driven

by proceeds from the issuance of debt, debt repayments, repurchases of

capital stock and net payments related to stock-based award activities.

Google’s Cash Flows from Financing activities are decreasing each year due

to the increase in shares repurchased. In 2016, Google repurchased shares

worth $3.304 billion as compared to $2.422 billion in 2015.

Cash Flow Analysis Example – Amazon

 Cash Flow from Operations – Amazon’s Cash Flow from Operations is derived from

cash received from consumer, seller, developer, enterprise, and content creator

customers, advertising agreements, and co-branded credit card agreements. We

note that Cash Flow from Operations has been increasing steadily. This is primarily
 due to the increase in net income. Amazon’s Net Income was -$241 million in 2014,

$596 million in 2015 and $2,371 million in 2016.

 Cash Flow from Investing – Cash Flow from Investment for Amazon comes from

cash capital expenditures, including leasehold improvements, internal-use software

and website development costs, cash outlays for acquisitions, investments in other

companies and intellectual property rights, and purchases, sales, and maturities of

marketable securities. Cash Flow from Investing was -$9.9 billion in 2016 as

compared to -6.5 billion in 2015.

 Cash Flow from Financing Activities – Amazon’s Cash Flow from Financing

activities comes from cash outflows resulting from the Principal repayment of long-

term debt and obligations related to capital and financial leases. Amazon’s cash

flow from Financing Activities was -$2.91 billion in 2016 and -$3.76 billion in 2015.

Cash Flow Analysis Example – Box Inc

Cash Flow from Operations – Box generates in Cash Flow from operations by providing

its Software-as-a-Service (SaaS) cloud content management platform to organizations to

manage their content along with secure and easy access and sharing of this content.

Unlike the other two examples of Amazon and Google, Box Cash Flow from
 Operations and weak due to continued losses over the years. Box CFO was -

$1.21 million in 2016 as compared to -$66.32 million in 2015.

 Cash Flow from Investing Activities – Box Cash Flow from Investing activities was

at -$7.57 million in 2016 as compared to -$80.86 million in 2015. This was primarily

due to reduced capital expenditure in the core business.

 Cash flow from Financing Activities – Box Cash Flow from Financing Activities has

shown a variable trend. In 2015, Box came up with its IPO and therefore its Cash

Flow from Financing increased to $345.45 million in 2015. Prior to its IPO, Box was

financed by Private Equity Investors.

Limitations of financial statements

The limitations of financial statements are those factors that a user should be aware
of before relying on them to an excessive extent. Knowledge of these factors could
result in a reduction of invested funds in a business, or actions taken to investigate
further. The following are all limitations of financial statements:

 Dependence on historical costs. Transactions are initially recorded at their cost. This
is a concern when reviewing the balance sheet, where the values of assets and
liabilities may change over time. Some items, such as marketable securities, are
altered to match changes in their market values, but other items, such as fixed
assets, do not change. Thus, the balance sheet could be misleading if a large part of
the amount presented is based on historical costs.
 Inflationary effects. If the inflation rate is relatively high, the amounts associated with
assets and liabilities in the balance sheet will appear inordinately low, since they are
not being adjusted for inflation. This mostly applies to long-term assets.
 Intangible assets not recorded. Many intangible assets are not recorded as assets.
Instead, any expenditures made to create an intangible asset are immediately
charged to expense. This policy can drastically underestimate the value of a
business, especially one that has spent a large amount to build up a brand image or
to develop new products. It is a particular problem for startup companies that have
created intellectual property, but which have so far generated minimal sales.
 Based on specific time period. A user of financial statements can gain an incorrect
view of the financial results or cash flows of a business by only looking at
one reporting period. Any one period may vary from the normal operating results of
a business, perhaps due to a sudden spike in sales or seasonality effects. It is better
to view a large number of consecutive financial statements to gain a better view of
ongoing results.
 Not always comparable across companies. If a user wants to compare the results of
different companies, their financial statements are not always comparable, because
 the entities use different accounting practices. These issues can be located by
examining the disclosures that accompany the financial statements.
 Subject to fraud. The management team of a company may deliberately skew the
results presented. This situation can arise when there is undue pressure to report
excellent results, such as when a bonus plan calls for payouts only if the reported
sales level increases. One might suspect the presence of this issue when the reported
results spike to a level exceeding the industry norm.
 No discussion of non-financial issues. The financial statements do not address non-
financial issues, such as the environmental attentiveness of a company's operations,
or how well it works with the local community. A business reporting excellent financial
results might be a failure in these other areas.
 Not verified. If the financial statements have not been audited, this means that no
one has examined the accounting policies, practices, and controls of the issuer to
ensure that it has created accurate financial statements. An audit opinion that
accompanies the financial statements is evidence of such a review.
 No predictive value. The information in a set of financial statements provides
information about either historical results or the financial status of a business as of a
specific date. The statements do not necessarily provide any value in predicting what
will happen in the future. For example, a business could report excellent results in
one month, and no sales at all in the next month, because a contract on which it was
relying has ended.

Financial statements are normally quite useful documents, but it can pay to be aware
of the preceding issues before relying on them too much .

Limitations
Even if cash flow analysis is one of the best tools for investors to find out whether a

company is doing well or not, cash flow analysis also has few disadvantages.

 One of the most significant things about cash flow analysis is that it doesn’t take into

account any growth in the cash flow statement. The cash flow statement always

shows what happened in the past. But past information may not be able to portray

the right information about a company for investors who are interested in

investing in the company. For example, if the company has invested a large

amount of cash into R&D and would generate a huge amount of cash through its

ground-breaking idea, these should come in the cash flow statement (but they don’t

get included in the cash flow).

 Another disadvantage of cash flow statement is this – it can’t be easily interpreted. If

you ask any investor to interpret the cash flow statement, he wouldn’t be able to
 understand much without the help of the income statement and the other information

about transactions occurred throughout the period. For example, it’s difficult to

understand from a cash flow statement whether a company is paying off its debt or

investing more in assets.

 Cash Flow Statement is inappropriate if you want to understand the profitability of the

firm because, in the cash flow statement, non-cash items are not taken into account.

Thus, all the profits are deducted and all the losses are added back to get the actual

cash inflow or outflow.

 Cash Flow Statement is articulated on the basis of cash basis of accounting and it

completely ignores the accrual concept of accounting.

Summary
Line Item Comments

Cash flow from Operating activities

Net Income From the Net Income line on the inc

Adjustments for

From the corresponding line item in

Depreciation & Amortization
Statement

From the change in the allowance fo

Provision for losses on accounts receivables
accounts in period

Gains / Loss on sale of facility From gain/loss accounts in the Incom

 Change in trade receivables during t
Increase/Decrease in trade receivables
balance sheet

Change in inventory during the perio

Increase/Decrease in inventories
balance sheet

Change in trade payable during the

Increase/Decrease in trade payables
balance sheet

Cash generated from Operations Summary of preceding items in the S

Cash Flow from Investing Activities

Purchase of Fixed Assets Itemized in the fixed asset accounts

Proceeds from sale of Fixed Assets Itemized in the fixed asset accounts

Net Cash used in Investing Activities Summary of preceding items in the S

Cash Flow from Financing Activities

Net Increase in Common Stock & ad

Proceed from issuance of common stock
Capital accounts during the period

Itemized in the Long Term Debt acco

Proceeds from issuance of Long Term Debt
period
 Itemized in the Retained Earnings ac
Dividends Paid
period

Net Cash Used in Financing Activities Summary of preceding items in the S

Net Change in Cash & Cash Equivalents Summary of All the Preceding Sub

Conclusion
If you want to understand a company and its financial affairs, you need to look

at all three statements and all the ratios. Only cash flow analysis would not be

able to give you the right picture of a company. Look for net cash inflow, but

also make sure that you have checked how profitable the company is over the

years.

Also, cash flow analysis is not an easy thing to compute. If you want to compute cash

flow analysis, you need to understand more than the basic level of finance. And you also

need to understand financial terms, how they are captured in the statements and how

they reflect the income statement. Thus, if you want to do a cash flow analysis, first know

how to see the income statement and understand what to include and what to exclude in

the cash flow statement.

Definition and explanation

Before talking about gross profit analysis, we need to briefly explain what is gross profit.
Gross profit is the difference between net sales and cost of goods sold and is computed
as a part of income statement or profit and loss account of a business. It is computed for
a specific period by deducting the cost of goods sold (COGS) from net sales revenue
realized during that period. In equation form, it can be presented as follows:

Gross profit = Nets sales revenue – Cost of goods sold

For example, if the annual net sales revenue of a company is $1,000,000 and its cost of
goods sold is $600,000, the gross profit would be $400,000 (= $1000,000 – $600,000).
The gross profit figure is very important for any business because it is used to cover all
operating expenses and provide for operating profit. The higher the gross profit, the better
it is.

A company or firm may experience a significant positive or negative change in gross

profit. In order to maintain profitability and avoid operating losses, any unexpected or
significant change in gross profit for a period must be timely investigated.

Gross profit analysis is the procedure of finding the causes of changes in gross profit
percentage from budgeted to actual or from one period to another period. The major
purpose of gross profit analysis is to reveal the unexpected changes in gross profit and
their causes so that they can be brought to the attention of management in a timely
manner. A change in gross profit usually occurs due to one or more of the following
reasons:

1. Changes in total revenue for the period due to changes in selling prices of goods and
services.
2. Changes in total revenue for the period due to changes in quantity of goods and
services sold during the period.
3. Changes in proportion in which a multi-product company sells its products (usually
termed as shift in sales mix or product mix).
4. Changes in basic manufacturing cost elements i.e., direct materials, direct labor and
manufacturing overhead.

Procedure of gross profit analysis

The procedure of determining the gross profit variation is identical to the computation of
variances in a standard costing system. However, the gross profit analysis is possible
without the use of budgets or standard costs. In that case, the prices and costs data of
any year may be used as the basis for the computations of variances involved in gross
profit analysis. The usual approach is to use the prices and costs of any previous year as
the basis to find the variations. However, to achieve a greater degree of accuracy and
better results, it is always recommended to employ standard costs and budgeted figures
to carry out the analysis.

Variances involved in gross profit analysis

For performing a gross profit analysis, the standard sales and cost figures (or a previous
year’s sales and cost figures) are used as the basis. The analysis is performed in three
steps. In first step, the sales price variance and the sales volume variance are computed.
In second step, the cost price variance and cost volume variance are computed. In third
step, the sales volume variance and cost volume variance are further analyzed by
computing sales mix variance and a final sales volume variance.

Example

The Steward Company manufactures to products – product A and product B. The

budgeted and actual data for the last month is provided below:

Accounting has been done manually till the 1980s, when the advent of fast computers
and easy-to-use, accurate and reliable software started.
An accounting system is a collection of processes, procedures and controls designed to
collect, record, classify and summarize financial data for interpretation and management
decision-making.

Computerized Accounting involves making use of computers and accounting software to

record, store and analyze financial data. A computerized accounting system brings with
it many advantages that are unavailable to analog accounting systems.
This article does not tackle the use of spreadsheets that are often used instead of proper
accounting software to process financial data. It is common knowledge that spreadsheets
do not provide a scalable solution for accounting purposes and therefore are a dangerous
solution to invest in.
 Gross profit analysis is designed to pick apart the reasons why the gross profit
margin changes from period to period, so that management can take steps to bring
the gross margin in line with expectations. A decline in gross profits can be an
indicator of serious problems, so the figure is closely watched. Gross profit is
calculated as:

Gross profit = Sales - direct materials - direct labor - manufacturing overhead

A change in gross profit can be caused by any of the following events:

 Sales prices have changed

 The unit volume of items sold have changed
 The mix of products sold has changed (which alters the gross profit if different
products have different gross margins)
 The purchase price of direct materials have changed
 The amount of direct materials required has changed, which in turn can be due to:
o Altered scrap levels
o Altered spoilage levels
o Altered amounts of rework
o Changes in the design of the product
 The amount of direct labor has changed, due to altered efficiency levels
 The cost of direct labor has changed, which in turn can be due to:
o Altered overtime levels
o Changes in the mix of employees having different pay rates
o Changes in the amount of shift differentials paid
o Changes in the equipment used
o Changes in the design of the product
 The amount of fixed overhead incurred has changed
 The amount of variable overhead incurred has changed

The preceding list is not comprehensive, since gross profit analysis may also uncover
problems in such as areas as late or double-counted inventory, incorrect units of
measure, and theft. Also, the broad scope of this list of events should make it clear
that controlling gross margin requires the input of many parts of a business, including
the engineering, materials management, sales, and production departments.

A gross profit analysis involves comparing the gross profit for the period being
reviewed to either the budgeted level or the historical average. If you are
using standard costing, then you can use any of the standard cost variance formulas
for gross profit analysis, which are:

 Purchase price variance. The actual price paid for materials used in the production
process, minus the standard cost, multiplied by the number of units used
 Labor rate variance. The actual price paid for the direct labor used in the production
process, minus its standard cost, multiplied by the number of units used.
 Variable overhead spending variance. Subtract the standard variable overhead cost
per unit from the actual cost incurred and multiply the remainder by the total unit
quantity of output.
 Fixed overhead spending variance. The total amount by which fixed overhead costs
exceed their total standard cost for the reporting period.
 Selling price variance. The actual selling price, minus the standard selling price,
multiplied by the number of units sold.
 Sales volume variance. The actual unit quantity sold, minus the budgeted quantity to
be sold, multiplied by the standard selling price.
 Material yield variance. Subtract the total standard quantity of materials that are
supposed to be used from the actual level of use and multiply the remainder by the
standard price per unit.
 Labor efficiency variance. Subtract the standard quantity of labor consumed from the
actual amount and multiply the remainder by the standard labor rate per hour.
 Variable overhead efficiency variance. Subtract the budgeted units of activity on
which the variable overhead is charged from the actual units of activity, multiplied by
the standard variable overhead cost per unit.

If you are not using standard costs, you can still use the preceding variances, except
that you use budgeted or historical cost information as the baseline, rather than
standard costs.

The gross profit analysis reported to management should describe the total variance
from expectations, and then itemize the exact reasons for the differences. The report
should contain actionable items, so that management can identify specifically what is
wrong and proceed to fix it. An even better gross profit analysis is one that clusters
identified problems into categories and shows the frequency of occurrence of the
categories over time. Doing so shows management which problems are causing the
most trouble on a repetitive basis, and which are therefore most worthy of attention.

While gross profit analysis is important, it only covers product-related costs. Thus, if
you want a comprehensive review of all aspects of a company's financial results, you
must also evaluate all costs of selling and administration, as well as all financing and
other non-operational expenses.

Gross profit analysis also ignores the amount of investment in working

capital and fixed assets in proportion to sales. That is, it does not account for the
efficiency of asset usage in creating gross profits.

Here are the advantages of using computerized accounting software

· Automation: Since all the calculations are handled by the software, computerized
accounting eliminates many of the mundane and time-consuming processes associated
with manual accounting. For example, once issued, invoices are processed automatically
making accounting less time-consuming.
· Accuracy: This accounting system is designed to be accurate to the minutest detail.
Once the data is entered into the system, all the calculations, including additions and
subtractions, are done automatically by software.
· Data Access: Using accounting software it becomes much easier for different
individuals to access accounting data outside of the office, securely. This is particularly
true if an online accounting solution is being used.
· Reliability: Because the calculations are so accurate, the financial statements prepared
by computers are highly reliable.
· Scalable: When your company grows, the amount of accounting necessary not only
increases but becomes more complex. With computerized accounting, everything is kept
straightforward because sifting through data using software is easier than sifting through
a bunch of papers.
· Speed: Using accounting software, the entire process of preparing accounts becomes
faster. Furthermore, statements and reports can be generated instantly at the click of a
button. Managers do not have to wait for hours, even days, to lay their hands on an
important report.
· Security: The latest data can be saved and stored in offsite locations so it is safe from
natural and man-made disasters like earthquakes, fires, floods, arson and terrorist
attacks. In case of a disasters, the system can be quickly restored on other computers.
This level of precaution is taken by Clever Accounting.
· Cost-effective: Since using computerized accounting is more efficient than paper-
based accounting, than naturally, work will be done faster and time will be saved. When
one considers that Clever Accounting, one of the latest online accounting solutions, starts
at a low monthly subscription (check out pricing here), then computerized accounting
really becomes a no-brainer.
· Visuals: Viewing your accounts using a computer allows you to take advantage of the
option to view your data in different formats. You can view data in tables and using
different types of charts.
Computerized Accounting represents a technological advancement in the field of
business accounting

Required: Using the data of Steward Company given above, compute:

1. sales price variance and sales volume variance

2. cost price variance and cost volume variance
3. sales mix variance and final sales volume variance
Solution
1. Sales price variance and sales volume variance

2. Cost price variance and cost volume variance

Interim recapitulation:
3. Sales mix variance and final sales volume variance

Final recapitulation:

Usefulness of gross profit analysis

The gross profit figure is very important for any business and must be closely watched.
The gross profit analysis uncovers inefficiencies in company’s performance during the
period and enables management to take remedial actions to correct the situation. The
manufacturing and marketing departments of business are mostly responsible to meet or
exceed the planned gross profit. In case the business fails to achieve the desired gross
profit, the manufacturing department must explain the changes in manufacturing costs
and marketing department must explain the changes in prices, decrease in number of
units of each product sold and/or shift in sales mix during the period. This way, the gross
profit analysis brings together the two major functional areas of the business and focuses
on the need of more study by these two departments.

The limitations of financial statements are those factors that a user should be
aware of before relying on them to an excessive extent. Knowledge of these factors
could result in a reduction of invested funds in a business, or actions taken to
investigate further. The following are all limitations of financial statements:
 Dependence on historical costs. Transactions are initially recorded at their cost. This
is a concern when reviewing the balance sheet, where the values of assets and
liabilities may change over time. Some items, such as marketable securities, are
altered to match changes in their market values, but other items, such as fixed
assets, do not change. Thus, the balance sheet could be misleading if a large part of
the amount presented is based on historical costs.
 Inflationary effects. If the inflation rate is relatively high, the amounts associated with
assets and liabilities in the balance sheet will appear inordinately low, since they are
not being adjusted for inflation. This mostly applies to long-term assets.
 Intangible assets not recorded. Many intangible assets are not recorded as assets.
Instead, any expenditures made to create an intangible asset are immediately
charged to expense. This policy can drastically underestimate the value of a
business, especially one that has spent a large amount to build up a brand image or
to develop new products. It is a particular problem for startup companies that have
created intellectual property, but which have so far generated minimal sales.
 Based on specific time period. A user of financial statements can gain an incorrect
view of the financial results or cash flows of a business by only looking at
one reporting period. Any one period may vary from the normal operating results of
a business, perhaps due to a sudden spike in sales or seasonality effects. It is better
to view a large number of consecutive financial statements to gain a better view of
ongoing results.
 Not always comparable across companies. If a user wants to compare the results of
different companies, their financial statements are not always comparable, because
the entities use different accounting practices. These issues can be located by
examining the disclosures that accompany the financial statements.
 Subject to fraud. The management team of a company may deliberately skew the
results presented. This situation can arise when there is undue pressure to report
excellent results, such as when a bonus plan calls for payouts only if the reported
sales level increases. One might suspect the presence of this issue when the reported
results spike to a level exceeding the industry norm.
 No discussion of non-financial issues. The financial statements do not address non-
financial issues, such as the environmental attentiveness of a company's operations,
or how well it works with the local community. A business reporting excellent financial
results might be a failure in these other areas.
 Not verified. If the financial statements have not been audited, this means that no
one has examined the accounting policies, practices, and controls of the issuer to
ensure that it has created accurate financial statements. An audit opinion that
accompanies the financial statements is evidence of such a review.
 No predictive value. The information in a set of financial statements provides
information about either historical results or the financial status of a business as of a
specific date. The statements do not necessarily provide any value in predicting what
will happen in the future. For example, a business could report excellent results in
one month, and no sales at all in the next month, because a contract on which it was
relying has ended.
Financial statements are normally quite useful documents, but it can pay to be aware
of the preceding issues before relying on them too much.

What is business valuation?

Quite simply, business valuation is a process and a set of procedures used to determine
what a business is worth. Sounds straightforward? But the devil is in the details – to
create a credible business valuation you need knowledge, preparation, and a good deal
of thought.
Assumptions drive your business valuation results

To make things interesting, there are a number of ways to measure business value.
Business value is seen differently by different people.
For example, a business owner may believe that the business value is defined by its
contribution to the local community it serves. On the other hand, a financially minded
investor may gauge a business solely based on its ability to generate desired returns.
Business value does not stand still. Market conditions change all the time and business
people may see greater value in companies as their fortunes shift. It is common
knowledge that competition for private businesses increases when jobs are scarce as
more people enter the business buying market in search of income. This tends to drive
up the business selling prices based on supply and demand.
Market is the ultimate test of business value. It does make a big difference how the
company is marketed. The selling price for a business presented to a well-funded group
of strategic investors is likely to be much higher than even the highest bid at an auction
for used equipment.

Are business value and expected selling price the same?

In theory the reason to figure out business value is to estimate what it would sell for. In
practice, the business value could vary quite a bit depending on who wants to know.
For example, a highly motivated business buyer seeking to replace lost income may pay
a premium to get that dream business. A financial buyer is the type who plays the low-
cost acquisition game.
Market exposure also plays a role. Getting the business in front of the right buyers is half
the battle in fetching the top selling price.

Three approaches to business valuation

Asset approach

Under the asset approach you adopt the view of a business as a set
of assets and liabilities. The balance sheet elements serve as building blocks to create
the picture of business value. A finance professor would tell you that the asset approach
is based on the economic principle of substitution. It answers this question:
What will it cost to create another business like this one that will produce the same
economic benefits for its owners?
The cost here is a bit tricky. Sure, the costs include coming up with the actual business
equipment and machinery, office furniture, and the like. But don't forget that costs also
include lost income as you are staking out the company's position in the market, while an
established competitor is busy raking in the dough.
Plus, you need to account for functional and economic obsolescence of business assets.
Things have a tendency to wear out and need to be replaced at some point.
Intangible assets, such as technology, may be getting a bit long in the tooth. A company
still using vacuum tubes in its products while the competitors are pushing nanotech is
behind the times. Not cool.
So if the company's financial condition is defined by its assets and liabilities, why not just
figure out the values of these and calculate business value as the difference, much like
on the balance sheet?

Market approach

Under the market approach, you look for signs from the real market place to figure out
what a business is worth. The market is a competitive place, so the economic principle
of competition applies.The market approach to business valuation is a great way to
determine the company's fair market value – a monetary value exchanged in an arms-
length transaction with the buyer and seller each acting in their best interest.

Income approach

The income approach cuts at the core of why people go into business – making money.
Unsurprisingly, the economic principle of expectation prevails. The income valuation
approach helps you to figure what kind of money the business is likely to bring as well as
to assess the risk.
The real power of the income valuation is that it lets you calculate business value in the
present. To do so, the expected income and risk must be translated to today.

There are two ways you can do this translation:

1.) Business valuation - by income capitalization

The capitalization valuation method is essentially the result of dividing the

expected business earnings by what is known as the capitalization rate. The idea
is that the business value is defined by business earnings and the capitalization
rate is used to relate the two. Capitalization uses a single income figure such as
the average of the earnings over several years or the most recent number.
For example, if the capitalization rate is 33%, then the business is worth about 3
times its annual earnings. An alternative is a capitalization factor that is used to
multiply the income. Either way, the result is what the business value is today.
The capitalization method works really well for businesses with steady, predictable
earnings.

2.) Business valuation - by discounting its cash flow

The discounting valuation method: a.) you forecast the business income some time
into the future, usually a number of years. b), you figure out the discount rate which
captures the risk of getting this income on time and in full measure. c.) you estimate what
the business is likely to be worth at the end of your forecast period. If you expect the
company to keep running, there is some residual value, also known as the terminal
value. Discounting the forecast earnings and the terminal value together gives you
the present value of the business, or what it is worth today. The discounting is run on a
sequence of income numbers, one for each year in your forecast.

Business valuation: how discount and cap rates are related

Since both income valuation methods do the same thing, you would expect similar
results. You would be right, the capitalization and discount rates are related:
CR = DR - K
where CR is the capitalization rate, DR is the discount rate, and K is the expected
average growth rate in the income stream.

As an example, let's say that the discount rate is 25% and your forecast suggests that
the business profits would be growing at a steady 5% per year. Then your capitalization
rate is 25 - 5 = 20%.
What is the real difference between capitalization and discounting?
If your business shows smooth, steady profits year after year, the capitalization valuation
is a good way to go. For a young start-up or businesses with rapidly changing earnings,
discounting gives the most accurate results.

Can business valuation methods produce different results?

You may wonder: is it possible to run income business valuations and come up with
different results? You bet. Your assumptions drive the results.
Consider two business buyers doing earnings forecasts and sizing up the risk of owning
a given business. Each buyer may see business risk differently so their capitalization and
discount rates will differ. In addition, the two buyers may have different ideas of where to
take the company. This will affect their income stream projections.
So even if they use the same valuation methods, the business valuation results may differ
quite a bit. The financial gurus call it the investment value standard of valuing a
business. Each business buyer acts as an investor and measures the business value
differently, based on their unique investment.

Types of Costs and their Basis of Classification

Cost classification can be done in various ways depending on its nature and a specific
purpose. Classifications of costs make the cost information meaningful. It is of utmost
importance to the management of a manufacturing concern. It is the first step towards
their decision-making process relating to costs and costing.

For example, if we know total expenses are of $500 Million against $550 Million revenue.
What insight can we derive? Nothing. Now if we add one more information say $350
Million is direct material cost and $100 Million is a direct labor and other overheads. Now,
the management can focus on direct material cost because that forms the major part of
the total cost as far as cost control initiatives are concerned.

BASIS OF CLASSIFICATION OF COST

There can be various bases on which classification of costs can be done.

1. Nature of Expense: By nature of expenses, costs are classified into material, labor and
expenses.
2. Relation to Cost Object – Trace-ability: This classification is based on the relation of
cost element with the cost object. The classification is done into direct and indirect
costs. The basis is cause and effect relationship between cost element and cost object
or trace-ability of costs to its cost object.
3. Functions / Activities: Costs can also be classified into various functions / activities.
Common functional classification of costs are done into following:

 Production
 Administration
 Finance
 Selling
 Distribution
 Research and Development
 Quality Check etc.
4. The behavior of Costs: The behavior of costs is seen with respect to the change in
volume. On this basis, costs are classified into Fixed Costs, Variable Costs, and Semi-
variable Costs. Fixed costs do not change with the change in volume, variable costs do
change. Semi-variable costs does not change up to a particular level of activity, beyond
that it will change.
5. The purpose of Decision Making by Management: For decision-making purpose of
management, costs can be classified into various types such as opportunity
cost, marginal cost, differential cost, relevant cost, imputed cost, replacement cost,
sunk cost, normal/ abnormal cost, avoidable/ unavoidable costs, etc.
6. Production Process: It’s an important classification for cost accounting of different
manufacturing industries. Based on the production process of the industry, costs can
be classified into following:

What is cost behavior?

Cost behavior is an indicator of how a cost will change in total when there is a change in
some activity. In cost accounting and managerial accounting, three types of cost behavior
are usually discussed:

 Variable costs. The total amount of a variable cost increases in proportion to the
increase in an activity. The total amount of a variable cost will also decrease in
proportion to the decrease in an activity.
 Fixed costs. The total amount of a fixed cost will not change when an activity increases
or decreases.
 Mixed or semi-variable costs. These costs are partially fixed and partially variable.
Understanding how costs behave is important for management's planning and
controlling of its organization's costs, and for cost-volume-profit analyses (including
the calculation of a company's break-even point).

Examples of Cost Behavior

An example of a variable cost is the cost of flour for a bakery that produces artisan
breads. The greater the number of loaves produced, the greater the total cost of the flour
used by the bakery.

An example of a fixed cost is the depreciation and insurance on the bakery facility and
equipment. Regardless of the quantity of artisan breads produced in a month, the total
amount of depreciation and insurance cost for the month will remain the same.

An example of a mixed cost or semi-variable cost is the bakery's cost of natural gas.
Some of the monthly gas bill is a flat fee charged by the utility and some of the gas bill is
the cost of heating the building. These two components of the gas bill are fixed since they
will not change when the bakery produces more or less loaves of its bread. However, a
third component of the gas bill is the cost of operating the ovens. This component is a
variable cost since it will increase when the ovens must operate for a longer time in order
to produce additional loaves of bread.

Cost Classifications

In managerial accounting, costs are classified into fixed costs, variable costs or mixed
costs (based on behavior); product costs or period costs (for external reporting); direct
costs or indirect costs (based on traceability); and sunk costs, opportunity costs or
incremental costs (for decision-making).

Classification of costs based on behavior helps in cost-volume-profit analysis.

Classification based on traceability is important for accurate costing of jobs and units
produced. Classification for the purpose of decision-making is important to help
management identify costs which are relevant for a decision.
Cost Classification Diagram

The following diagram summarizes the different categories into which costs are classified
for different purposes:

Product Costs vs Period Costs

Product costs (also called inventory costs) are costs assigned to the manufacture of
products and recognized for financial reporting when sold. They include direct materials,
direct labor, factory wages, factory depreciation, etc.

Period costs are on the other hand are all costs other than product costs. They include
marketing costs and administrative costs, etc.

Breakup of Product Costs

The product costs are further classified into direct materials, direct labor
and manufacturing overhead costs:

 Direct materials: Represents the cost of the materials that can be identified directly
with the product at reasonable cost. For example, cost of paper in newspaper
printing, etc.
 Direct labor: Represents the cost of the labor time spent on that product, for example
cost of the time spent by a petroleum engineer on an oil rig, etc.
 Manufacturing overhead costs: Represents all production costs except those for
direct labor and direct materials, for example the cost of an accountant's time in an
organization, depreciation on equipment, electricity, fuel, etc.

Direct Costs vs Indirect Costs

The product costs that can be specifically identified with each unit of a product are called
direct product costs. Whereas those which cannot be traced to a specific unit are
indirect product costs. Thus direct material cost and direct labor cost are direct product
costs whereas manufacturing overhead cost is indirect product cost.

Prime Costs vs Conversion Costs

Prime costs are the sum of all direct costs such as direct materials, direct labor and any
other direct costs.

Conversion costs are all costs incurred to convert the raw materials to finished products
and they equal the sum of direct labor, other direct costs (other than materials) and
manufacturing overheads.

Fixed Costs vs Variable Costs

Fixed costs are costs which remain constant within a certain level of output or sales.
This certain limit where fixed costs remain constant regardless of the level of activity is
called relevant range. For example, depreciation on fixed assets, etc.

Variable costs are costs which change with a change in the level of activity. Examples
include direct materials, direct labor, etc.

Mixed costs (also called semi-variable costs) are costs which have both a fixed and a
variable component.

Sunk Costs vs Opportunity Costs

The costs discussed so far are historical costs which means they have been incurred in
past and cannot be avoided by our current decisions. Relevant in this regard is another
cost classification, called sunk costs. Sunk costs are those costs that have been
irreversibly incurred or committed; they may also be termed unrecoverable costs.

In contrast to sunk costs are opportunity costs which are costs of a potential benefit
foregone. For example the opportunity cost of going on a picnic is the money that you
would have earned in that time.

Flow of costs

The flow of costs is the path taken by costs as they move through a business. The
concept is most applicable to a manufacturing firm, where costs are first incurred
when raw materials are purchased. The flow of costs then moves to work-in-process
inventory, where labor, machining, and overhead costs are added to the cost of
the raw materials. Once the production process is complete, the costs move to
the finished goods inventory classification, where the goods are stored prior to sale.
When the goods are eventually sold, the costs move to the cost of goods sold. During
this process flow, the costs are initially recorded in the balance sheet as assets, and
are eventually flushed out at the point of sale and shifted to the cost of goods sold
section of the income statement.
The flow of costs concept also applies to the cost layering system being used to
record inventory. In the first in first out (FIFO) system, the cost of those inventory
items that were acquired first are charged to expense when goods are sold; this
means that only the cost of the most recently-acquired goods are still recorded in
inventory. In the last in first out (LIFO) system, the cost of those inventory items that
were acquired last are charged to expense when goods are sold; this means that only
the cost of the oldest goods are still recorded in inventory.

The flow of costs concept is less applicable in a services firm, where most costs are
incurred and charged to expense at the same time.

Financial system
The main task of the financial system is to channel funding from savers to investors.

The financial system performs the essential economic function of channeling funds from
those who are net savers (i.e. who spend less than their income) to those who are net
spenders (i.e. who wish to spend or invest more than their income). In other words, the
financial system allows net savers to lend funds to net spenders.

Funds are intermediated by banks and other credit institutions, and directly via financial
markets through the issuance of securities. An efficient allocation of funds, together with
financial stability, contribute to economic growth and prosperity.

The most important lenders are normally households, but firms, public entities and non-
residents may also lend out excess funds. The principal borrowers are typically non-
financial corporations and government, but households and non-residents also
sometimes borrow to finance their purchases.

Funds flow from lenders to borrowers via two routes. In direct or market-based finance,
debtors borrow funds directly from investors operating on the financial markets by selling
them financial instruments, also called securities (such as debt securities and shares),
which are claims on the borrower’s future income or assets. If financial intermediaries
play an additional role in the channeling of funds, one refers to indirect finance. Financial
intermediaries can be classified into credit institutions, other monetary financial
institutions and other financial intermediaries, and they are part of the financial system.

One of the key features of a well-functioning financial system is that it fosters an allocation
of capital that is most beneficial to economic growth. Well-functioning financial systems
do not easily drift into financial crises and can perform their basic tasks even under
difficult financial conditions.

The infrastructure of the financial system refers to payment and settlement systems,
through which financial market operations are concretely carried out. A smooth and
reliable functioning of payment and settlement systems promotes effective capital
movements in the economy and thereby supports financial stability.
FINANCIAL INTERMEDIATION

Sources of Funds

Business simply cannot function without money, and the money required to make a
business function is known as business funds. Throughout the life of business, money is
required continuously. Sources of funds are used in activities of the business. They are
classified based on time period, ownership and control, and their source of generation.
Cost of Goods Sold, (COGS), can also be referred to as cost of sales (COS), cost of
revenue, or product cost, depending on if it is a product or service. It includes all
the costs directly involved in producing a product or delivering a service.
These costs can include labor, material, and shipping.
ifference between Service, Trading, & Manufacturing
Service Organization Trading Organization Manufacturing
Organization

An Organization which Goods are Purchases Raw materials are

Provides Services to & Sold without purchased and
others as an occupation Further Processing. converted into a new
or business. final product for sales.

The major business The major business

The major business
process of a service processes of
process of Trading
organization is to manufacturing concerns
concerns are
provide service at the are procurement,
Procurements &
point of consumption by production and sales.
Sales.
the customers.

The time required from

There is no
Procurements of
Products involved for
service organization.
procurement to sales will
be relatively more for
The time required from manufacturing
procurement to sales organizations since the
will be relatively less manufacture requires
for trading conversion time for
Organization. processing the goods.

The cost of goods sold for

The cost of services
provided depends on
the demand for such a
service as there is no
inventory.
the
manufacturer=(opening
finishing goods + cost of
goods manufactured –
The Cost of Goods sold
closing finished goods).
for the trader=(opening
trading goods +
purchases of trading
goods – closing trading
goods).

Cost of Goods Sold & Cost of Services

Definition:
Cost of Goods Sold, (COGS), can also be referred to as cost of sales (COS), cost of
revenue, or product cost, depending on if it is a product or service. It includes all the
costs directly involved in producing a product or delivering a service. These costs can
include labor, material, and shipping. The idea behind COGS is to measure all costs
(which are variable) directly associated with making the product or delivering the service.

Example:

Let’s assume you start a delivery company and line up a few customers. In the first full
month of operation you do $10,000 worth of business (this becomes our revenue line).
For that month we also had expenses, including the cost of gas for the delivery truck in
the amount of $2,000, and the salary of the driver at $3,000. These costs are directly
related to our service and fall into the Cost of Goods Sold (COGS) line. There are more
line items that would be included in COGS, but you get the idea. All other expenses not
directly related to the product or service goes under a category called Operating
Expenses such as your receptionists’ or accountants’ salary. The top part of our income
statement (with our COGS line) would look like this:

Some of these decisions are easy. In a manufacturing company, for instance, the
following costs are definitely in:

 The wages of the people on the manufacturing line

 The cost of the materials that are used to make the product\

And plenty of costs are definitely out, such as:

 The cost of supplies used by the accounting department (paper, etc.)

 The salary of the human resources manager in the corporate office

Ah, but then there’s the gray area—and it’s enormous. For example:

 What about the salary of the person who manages the plant where the product is
manufactured?

 What about the wages of the plant supervisor?

 What about sales commissions?

Are all of these directly related to the manufacturing of the product? Or are they operating
expenses, like the cost of the HR manager? There’s the same ambiguity in the service
environment. COS in a service company typically includes labor associated with
delivering the service.