Financial Statement

Concept
Financial statements are the summary reports of a company's financial transactions. They
report the end results of accounting activities during a given period of time. Financial
statements are end of the period accounts prepared to show the profit or loss situation for a
period of time and to assess the financial position and cash flow situation on a particular date.
Financial statements report the result of past activities. Therefore, the are also called as the
historical record of a company.

It includes
1)Income Statements:

The income statement, sometimes called as the trading and profit and loss account or an
earning statement, reports the profitability of a business organization for a stated period of
time.

2)Statement of Retained Earnings

The statement of retained earnings is also called as profit and loss appropriation account.
The statement of retained earnings explains the changes in retained earnings between two
balance sheet date. These changes usually consist of the addition of net income and the
deduction of dividends.

3) Balance Sheet
The balance sheet, sometimes called statements of financial position, lists the company's assets,
liabilities and stockholder's equity as on a particular date. A balance sheet is like a snap shot
that captures the financial position of a company at a particular point of time.

4.Statement Of Cash Flows

Management is interested in the cash inflows to the company and the cash outflows from the
company, because they determine the company's liquidity, its ability to pay its bills when due.
The statement of cash flows shows the cash inflows and outflows from operating, investing and
financing activities.

  Objectives of Financial Statements

Financial statements of a company are the result of management's past actions and decisions.
They are the end products of the accounting process. They give a picture of solvency and
profitability of a company. The major objectives of the financial statements are as follows:

1. To provide the financial information to the internal and external users.

2. To provide the information, which are useful in the decision making process.
3. To reveal the profitability and solvency of the company.

4. To help to evaluate the financial position and efficiency of the management.

5. To show the financial health of the company.

Importance of Financial Statement

1) Provide information about the financial status and financial position of the organization
(or other entities).

2) Provide information about the financial status and financial position of the organization
(or other entities).

3) Provide information to analyze and assess the economic and business performance of
the organization (or other entities).

4) Serve as an accounting database for future references.

5) Facilitate effective, accurate and well-thought-out policies and strategies for the
organization (or other economic entities).

6) Serve as an important tool to promote effective decision making.

7) Act as an important source of crucial business information.

8) Ascertain the results of various business operations such as income, expenditure,

debtors, payables, receivables, profits, losses, etc.

Financial Statement Analysis

Financial statement analysis is the process of analyzing and reviewing firm’s balance sheet
(Statement of financial position), income statement (Profit and loss report) and other
statements. It allows estimating company’s overall performance by calculating and comparing a
complex of indicators, building the trend lines and making the conclusions on business health
and sustainability. The users of financial statement analysis may be different: creditors, willing
to find out more about the creditworthiness of firm; investors, who want to measure firm’s
ability to issue dividends and company’s management.

Techniques Of Financial Statement Analysis

Analyzing financial statements helps company leaders determine the opportunities and
problems the company faces financially. At its core, the financial statement is a pulse of the
financial health of the company, defining whether it is capable of paying expenditures,
overburdened with debt or flush with capital to expand. There are two primary methods of
financial statement analysis:

1) Horizontal Financial Data Analysis

2) Vertical Financial Data Analysis.

1) Horizontal Financial Data Analysis

Horizontal financial data analysis covers thefinancial information as it changes from reporting
period to reporting period. Comparing line items on the financial statement such as cost of
goods sold or net income from one quarter to another helps the business leader define progress.
The analysis may span over several defined reporting periods, such as months, quarters or
years.

The critical things a business leader looks for in horizontal financial analysis is whether a
specific line item changed significantly. For example, if the cost of goods sold rose by 20 percent
but revenues didn't reflect an increase in sales, something is costing the company more money.
Likewise, if the gross profit rises but the net profit drops, the business leader must determine if
cost-cutting measured are needed.

2)Vertical Financial Data Analysis

Vertical financial data analysis takes a look at the financial statement independent of time. This
means the statement is reviewed on its own without comparing it to other months or quarters.
The goal of vertical analysis is to find the correlations of various line items to each other in the
financial statement. Business leaders are looking for overall efficiency in the flow of revenues
and expenses. All information is reviewed as a ratio, comparing one line in the vertical to
another line.
For example, the business might want to see how significant expenses are to total revenues. If
total revenues are $100,000 and the cost of goods sold is $25,000, the ratio is 0.25 or 25
percent. The corresponding ratio then is net income after cost of goods is equated, or 75
percent. Looking at ratios helps determine how well the company takes hard costs to produce
goods to selling and delivering them to consumers.

Trends and Ratios in Financial Analysis

Because the horizontal analysis is looking at the same line items over time, it is specifically
designed to recognize trends in the company's financial status. The ratios defined in vertical
analysis help clearly show upward and downward trends in gross and net profits. A business
leader is looking for specific metrics over time for the company to meet. For example, a
manufacturer might want to see a 10 percent increase in cost of goods sold, representing more
products on the market annually. He would then want to see the correlating net profit increase
by 20 percent to show that manufacturing growth is resulting in net revenue growth.

Understanding how the various line items on the financial statement work with each other and
compare over time gives business leaders the information to make strategic plans. If overhead
such as rents and administrative labor start to overwhelm the ability of the company to
improve net profits, it might be time to strategize cost-cutting measures. Executives would need
to determine what roles are necessary to fulfill the company vision and where they can reduce
costs. They might actually choose to relocate the office to a less expensive location.

Ratio Analysis

Ratio analysis is the process of determining and interpreting numerical relationships based on
financial statements. A ratio is a statistical yardstick that provides a measure of the relationship
between two variables or figures.
This relationship can be expressed as a percent or as a quotient. Ratios are simple to
calculate and easy to understand. The persons interested in the analysis of financial statements
can be grouped under three heads,
i) Owners or investors
ii) Creditors and
iii) Financial executives.
Classification of Ratios:
Financial ratios can be classified under the following five groups:
1)Liquidity Ratio
2) Activity Ratio
3) Capital Structure Ratio
4) Market Strength Ratio
5) Profitability and Growth Ratio

1) Liquidity Ratios
Liquidity represents one's ability to pay its current obligations or short-term debts within a period less
than one year. Liquidity ratios, therefore, measures a company's liquidity position. The ratios are
important from the viewpoint of its creditors as well as management. The liquidity position of the
company can be measured mainly by using two liquidity ratios such as follows.

a. Current Ratio

b. Quick Ratio

a. Current Ratio

Current ratio is also known as short-term solvency ratio or working capital ratio. Current ratio is used to
assess the short-term financial position of the business. In other words, it is an indicator of the firm's
ability to meet its short-term obligations.

Current ratio is calculated by using following formula:

Current Assets
Current Ratio =
Current Liabilities

Where,

Current assets are cash and those cash equivalent of a business which can be converted into cash
within a short period of time not exceeding a year. Cash in hand, cash at bank, bills receivables, sundry
debtors, accrued incomes, prepaid expenses, inventory, short term loans provided , advance given etc
are the examples of current assets

Current liabilities are those obligations of a business, which are to be paid within in a short period of
time not exceeding a year. Bills payable ,sundry creditors, short term loan taken, income tax payable,
dividend payable, advance incomes, accrued expenses are the examples of current liabilities.

b. Quick Ratio
Quick ratio is another measure of a company's liquidity. Quick ratio is also known as liquid ratio or acid
test ratio. However, although it is used to test the short-term solvency or liquidity position of the firm, it
is a more stringent measure of liquidity than the current ratio. This ratio is calculated by dividing liquid
assets by current liabilities. Liquid assets are cash and other assets which are either equivalent to cash
or convertible into cash within a very short period of time.

The following formula is used to calculate quick ratio:

Quick Assets
Quick Ratio =
Current Liabilities

Liquid assets = Total current assets - stock- prepaid expenses

2) Activity Ratios/Turnover Ratio/Efficiency Ratio

2)Activity ratios measure company sales per another asset account—the most common asset
accounts used are accounts receivable, inventory, and total assets. Activity ratios measure the
efficiency of the company in using its resources..
The various ratios calculated under it are
a)Account Receivable/Debtors Turnover Ratio
b)Inventory/Stock Turnover Ratio.
c) Total Assets Turnover Ratio
a)Accounts receivable Turnover Ratio
Account Receivable is the total amount of money due to a company for products or services
sold on an open credit account. The accounts receivable turnover shows how quickly a
company collects what is owed to it and indicates the liquidity of the receivables.

Total Credit Sales

Accounts Receivable Turnover =
Accounts Receivable

Closely related to the accounts receivable turnover rate is the average collection period in
days, equal to 365 days divided by the accounts receivable turnover:

Average Collection Period = 365 Days

 Accounts Receivable Turnover

Analysts frequently use the average collection period to measure the effectiveness of a company's
ability to collect payments from its credit customers. Generally, the average collection period should
not exceed the credit terms that the company extends to its customers.

b)Inventory Turnover Ratio

For a company to be profitable, it must be able to manage its inventory, because it is money invested
that does not earn a return until the product is sold. A higher inventory turnover ratio indicates more
effective cash management and reduces the incidence of inventory obsolescence.
Mathematically.

Total Annual Sales or Cost of Goods Sold

Inventory Turnover =
Inventory Cost

or

Net Sales
Inventory Turnover =
Closing Inventory

Closely related to inventory turnover is the days in inventory, equal to 365 days divided by the
inventory turnover:

365 Days
Days in Inventory =
Inventory Turnover

c) Total Assets Turnover Ratio

The total asset turnover measures the return on each rupee invested in assets and is equal
to the net sales.
Net Sales = Total Sales – Cash Sales – Returns and Allowances

If there are no pronounced seasonal variations, then average total sales can be calculated by adding
the total assets at the beginning of the year to the total assets at year-end, then dividing by 2:

Assets at Beginning of Year

+ Assets at End of Year
Average Total Assets =

Net Sales
Total Asset Turnover =
Average Total Assets

It shows how much revenue is generated for each rupee invested in assets.

3) Capital Structure/Long Term Solvency Ratio

It is a type of Financial ratio that indicates the level of debt incurred by a business entity.It provides
an indication of how the company's assets and business operationsare financed(using debt or equity).
The various types of ratios are:
a)Debt Equity Ratio
b)Debt –Total Assets Ratio
c)Dividend Coverage Ratio
d) Interest Coverage Ratio
a) Debt Equity Ratio

The Debt-Equity ratio indicates the relative contribution of total debt and owners equity
in the capital structure of the company; the relative contribution of each to finance the
company's assets. It is computed as:

Mathematically

Long Term Debt Or Total Debt

Debt Equity Ratio =
Shareholder's Equity
 The debt component includes all liabilities including current liabilities. The equity
component consists to net worth and preference capital.

In general, the lower the debt to equity ratio, the higher the degree of protection felt by the
lenders. A high debt to equity ratio means that the company has been aggressively using debt to
finance its assets.

b)Debt To Total Assets Ratio

This ratio indicates the proportion of debt used in financing the total assets of a firm.

Long Term Debt Or Total Debt

Debt Assets Ratio =
Total Assets

c) Dividend Coverage Ratio

It measures the ability of a firm to pay dividend on preference shares which carries a
fixed stated dividend rate.

  EAT  
Dividend coverage
= Preference
ratio
Dividend

EAT = Earnings after tax

d) Interest Coverage Ratio

Interest Coverage ratio is one of the measures of a firm's ability to handle financial
burdens. It is also referred to as times interest coverage ratio. The ratio tells us how many times
the firm can cover or meet the interest payments associated with debt. It indicates the firm's
ability to meet or honor interest obligations on debt. It is computed as:
 EBIT
Interest Coverage Ratio =
Interest Expenses

EBIT stands for 'Earnings Before Interest and Taxes'

The higher the coverage ratio, the greater is the ability of the firm to meet its interest
obligations. An interest coverage ratio of three times indicates that the firm is able to generate
earning three times greater than its interest payments.

4) Market Strength Ratio

a) PE Ratio(Price- Earning Ratio)

Price/earnings (P/E) ratio measures investors’ confidence in a company. It is the ratio of
the market price per share to earnings per share. The P/E ratio is useful in comparing
the earnings of different companies and the value of a company’s shares in relation to
values in the overall market
Mathematically,

Current Market Price

Price Earning Ratio =
Earning Per Share

b)Book Value Per Share (BVPS)

Book value per share is the amount each share would receive if the company were liquidated
on the basis of amounts reported on the balance sheet. It helps to determine the net worth o the
Concern.

Mathematically,

Common Stockholder's Equity

Book Value Per Share =
Outstanding Common Shares
c)Book to Market Ratio:

It is also called the book-to market value ratio and is frequently used in investment analysis.
The book-to-market ratio reflects the difference between a company’s balance sheet value and
the company’s actual market value. A company’s book-to-market ratio is almost always less
than 1.0.
Mathematically,

Company's Balance Sheet Value

Book to Market Ratio =
Company's Actual Market Value

d)Dividend Ratios

Two ratios are used to evaluate a company’s dividend policies: the dividend payout ratio and
the dividend yield ratio. Dividends per share measures the extent to which earnings are being
distributed to common shareholders. It is computed as follows:

Dividend Distributed to Common Shareholders

Dividend Per Share =
No.of Common Shares Outstanding

1)Dividend Payout Ratio

It shows the percentage or ratio o earning being distributed as dividend.

Companies that have high growth rates generally have low payout ratios because they reinvest
most of their net income into the business.
Mathematically,

Dividend Per Share(DPS)

Dividend Payout Ratio =
Earning Per Share(EPS)

2) Dividend Yield Ratio

It shows the rate of return of equity shareholders on the basis of market price o
the stock

Dividend Yield Ratio = Dividend Per Share(DPS)

 Market Price Per Share(MPS)

5)Profitabilty and Growth ratios

Management effectiveness has many dimensions and without standardized points of reference,
it can be difficult to evaluate. These ratios can be used to compare management performance
against peers and competitors. They can also be used to benchmark company performance over
time and in different economic environments.

a)Return on assets
Return on assets (ROA) is a financial ratio that shows the percentage of profit a company earns
in relation to its overall resources. It is calculated by dividing net income by total assets. ROA is
a key profitability ratio that measures the amount of profit made by a company per rupee of its
assets. Generally, the higher the ROA, the better the management.

Mathematically,

Net Income Or Net Profit After Tax(NPAT)

Return On Assets(ROA) =
Total Assets

b)Return on equity
Return on equity (ROE) is an important measure of the profitability of a company. It is the ratio
of net income of a business during a year to its stockholders' equity during that year.. Higher
values are generally favorable, meaning that the company is efficient in generating income on
new investment. But note that a higher ROE does not necessarily mean better financial
performance of the company.

Mathematically,

Earning Available to Shareholders(EAS)

Return On Equity(ROE) =
Common Shareholder Equity
c)Gross profit margin
Gross profit margin is a profitability ratio that measures how much of every rupee of revenue is
left over after paying cost of goods sold.

Gross Profit
Gross Profit Margin =
Net Sales

Where,

Gross Profit= Sales-Cost of Goods Sold

d)Return on investment
Return on investment (ROI) conceptually is the net amount of money one earns from an
investment, expressed as a percentage of the total cost of making that investment.

Earning Available to Shareholders(EAS)

Return On Equity(ROE) =
Common Shareholder Equity

e) Operating margin
Operating margin is the percentage that results when operating profit is divided by sales
revenue. Operating profit reflects only that portion of earnings that results from primary
business activities. It does not reflect gains or losses on any incidental investment securities or
comparable assets that might also be owned by the company.

Operating Profit
Operating Margin =
Net Sales

f) Return on Sales
Return on sales is the percentage that results when the reported net income before interest and
taxes is divided by sales revenue. It can be useful when used to analyze a company's
performance and efficiency over time.
 Net Income Or Net Profit After Tax(NPAT)
Return On Sales(ROS) =
Net Sales

Cash Flow Statement

Cash Flow Statement refers to an Analytical Reconciliation Statement, which shows the
changes in the position of cash and cash equivalents between two periods. In addition to this, it
emphasizes the reasons for such movement of cash.
From a financial point of view, the cash flow statement is an important part of the financial
statement, along with the Balance Sheet and Income Statement. It is concerned with the inflow
and outflow of cash to/from the business. It specifies the sources of cash to the firm, from
various activities and the uses of cash during a time interval.

Classification of Cash Flow Statement By Activity

The classification of cash flows, allows the users to evaluate the affect of such activities on the
company’s financial position. The link between these activities can also be assessed with the
help of the information provided by the statement.

1. Operating Activities:

These activities take into consideration, the firm’s core revenue producing activities. It includes
the production or purchase and sale of goods and services, receipt of royalty, fee, commission,
etc., payment of insurance premium and receipt of claims, payment to suppliers, payment to or
on behalf of employees and so on.The reporting of cash flow from operating activities can be
done in two ways, i.e. by using a direct method or indirect method. Both the methods are
used for converting net profit into net cash flows.

2. Investing Activities:

The activities which involve the procurement and disposal of long-term fixed assets, buying
and selling of investments such as shares, warrants, and debentures, etc. and disbursement and
collection of advances and loans are investing activities.

3. Financing Activities:

The activities that can change the size and composition of the shareholder’s equity and
borrowed funds of the firm are financing activities. Such activities include payment/receipt of
interest and dividend, raising funds from lenders and shareholders, repayment of loans and
redemption preference share capital.
These three sections present the net change in the balance of cash in hand and at the bank of
the firm. It is an important tool for short term analysis especially, its ability to pay bills. It is a
summary, which helps the users of financial statement to know the firm’s performance in
generation and utilization of cash. It also helps managers in budgeting and business planning.

Objectives Of Cash Flow Statement

The primary objective of cash flow statement is to help management in taking a decision
and making a plan by providing current information on cash inflow and outflow of any
accounting period.It presents the investment and financial activities of a concern for a
particular period. It also fulfills the following objectives;
a)To ensure future positive cash flow of particular concern.
b)To ensure capacity of an organization to pay a dividend.
c) To identify non-cash items ensuring cash income and expenses of a concern.
d)To compare various items of the current year with those of last year.
e) To Know cash and cash equivalent and outsource inflow of a concern for a particular
period.

Advantages of Cash flow statement

Cash flow statement is recognized as an indispensable part of the financial statements for
its characteristics.The three main elements of the financial statements – balance sheet,
income statement, and cash flow statements represent a financial position, trend and
business activities of business concern respectively.

The main advantages arising out of the cash flow statement are as follows;

 It provides information relating to cash flow, net assets difference, and liquidity
of a business concern.
 It provides information relating to size and kind of cash and cash equivalent.
 It helps a company in getting an idea of future cash position.
 In preparing reports, it presents events and transactions from different angles by
which management can take multipurpose decisions.
 Cash flow statement prepared by historical information helps in determining the
future cash flow of the company.
 Primarily prepared cash flow statement can be compared to the cash flow
statement prepared considering the present rise and fall of price.
 Three-part cash flow statement presents the true financial picture of concern.

Importance of cash flow statement

Cash flow statement is an important and necessary example of cash management. Since
the cash flow statement is prepared by cash record, it is very important in the evaluation of
the cash position of a business concern.

The importance and necessity of the cash flow statement are stated below;
a) Evaluation of cash position
Since the cash flow statement is prepared by cash records, it is very much useful in
evaluating the cash position of a business concern.The expected amount of cash helps the
management in deciding for short-term investment.Contrarily, if the shortage of cash
arises, the management can find out the possible sources of cash for meeting various
expenditure.

b)Getting an idea of future cash position

By various information, a probable cash flow statement is prepared so that a clear idea
regarding future cash position can be achieved by making a plan and adjustment regarding
financial activities.With the help of this statement, a business concern can find out sources
of cash needed and the amount of cash to be spent on different heads.

c)Correction of decision

The comparison is made between the historical cash flow statement and a projected cash
flow statement. If any deviation is marked, the management can take corrective measures.
d)Picture of liquidity position
Every business organization should possess the required liquidity. In the light of it, cash
flow statement is prepared and compared with those of similar business organizations and
concerned departments of the organization.

e)Framing long term-planning

In the case of investment and financing, both cash quantity and time are significant to the
management. Projected cash flow statement helps the management in this respect.It helps
largely in respect of loan payment, preference share capital payment, replacement of fixed
asset and other long-term plans.

F) Searching for solutions to various problems

Answers to various questions can be known from the cash flow statement.

For example,how the net profit has been earned, where that profit has gone, why dividend
could not be paid despite sufficient profit, how tax will be paid, what types of fixed assets
have been purchased in a particular financial year, whether any fixed assets have been
sold, if sold how that cash has been utilized etc.
g)Useful to interested outside parties

Cash flow statement is not less important to those who use published financial statements
of a company. Potential creditors always remain eager to know about the liquidity position
of concern before making any transaction.They also like to be aware of the profit earning
capacity of the concern.