Financial Accounting and Analysis

Financial Accounting and Analysis
Prof. Padmini Srinivasan

Week 1 Handout
READING MATERIAL FOR WEEK 1
Introduction to Financial Accounting
1.1 Introduction
All organizations, irrespective of the legal status – proprietorship, partnership, incorporated
company, statutory corporation or trust and whether they exist for profit or not for profit, are
formed with a view to achieve certain goals (objective, purpose or vision as you may choose).
In order to impart direction and greater certitude to achieving the result, organizations prepare
plans. It is said that all plans, in order to succeed, have to be controlled and all controls, in order
to be effective, have to be planned. This implies that the actual performance should be
measured, compared with the plans and deviation suitably dealt with. The action taken may
involve either correcting the performance or modifying plans or both. Further, there are several
stakeholders of business who will need financial information for decision making. For this
purpose, organizations have to measure the performance and this is achieved through the
accounting system. The objective of financial accounting is to provide relevant, reliable and
timely information for decision making.
1.2 What is accounting?

Accounting is a systematic process that is concerned with measurement and reporting of
transactions and events occurring in an organization. Financial reports that are generated
provide information that will enable the stakeholders to take decisions.
1.3 Users of Accounting Information

Who are the users of accounting information? What information will the stakeholders look for?
Let us understand through a small situation.
John, a young graduate, wants to start a laundry service. He needs $100,000 to buy the
equipment. He has $50000. For the remaining capital, he decides to take a loan from a bank
and approaches ABV Bank. When approached by John, the bank manager says that in order to
process the application, he needs details of the project and the return expected at the end of
every year during the life of the car. Why did the bank manager ask John for the project details?
The bank manager will sanction the loan only if he is convinced of the financial viability of the
project. These stakeholders need information about the firm in order to decide whether to deal
with it and if so, to what extent.
There are several users of accounting information. Let us briefly discuss them.
• Investors: They provide capital to the firm. Hence, they need information to assess the
inherent risk of loss of capital and the return their investment in the firm is likely to
yield. They also need information to buy, sell or hold these investments.
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Financial
Accounting and Analysis" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
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Week 1 Handout
• Lenders: They are interested in ascertaining the ability of the firm to service their loans
over the entire term of the loan by paying interest and repaying installments on the due
dates.
• Suppliers and other creditors: They would like to assess the ability of the firm to pay
amounts owed to them within the credit period allowed to the firm. Normally, the
interest of the trade creditors is over shorter periods as compared to lenders.
• Customers and employees: They would like to know if the firm represents a stable
source of supply/employment.
• Government: The government is interested in information that will help it to assess the
taxes that can be collected from the firm, regulate the businesses in general, draft tax
and economic policies, and prepare national income statistics.
• Public: Members of the public are interested in assessing the economic benefits and
costs arising from factors such as employment of people from the locality, patronage to
local suppliers and hazards to environment.
1.4 Accounting System

Is there a formal process or a system to do accounting? Let us explain.
Accounting System is similar to any other information system and has three components,
namely input, process and output as outlined below.
The Accounting System
INPUT PROCESS OUTPUT
DOUBLE ENTRY Financial

MONETARY
SYSTEM OF Reports
TRANSACTION
AND EVENTS ACCOUNTING
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The accounting system in detail:

Input
All business phenomena, which can be expressed in monetary terms, constitute the input for
the accounting system. Certain non-monetary data is used as additional information.
When a cash sale is made, monetary events such as the cash received and the value of the sale
involved constitute the input for the accounting system.
Non-monetary events such as the description of the item and the units sold are also considered
by the system since this input is required for additional information. Particulars regarding the
customer such as name, address and profile may or may not be treated as an input. However,
if the sale is on credit basis, the name and address will be treated as a needed input. The non-
monetary phenomena can vary from simple events as stated above to highly involved data on
employee performance and customer preferences.
The monetary phenomena or transactions which constitute the input can arise either from
transactions with third parties such as purchase/sale of goods/services or from other monetary
events not involving third parties such as depreciation/amortization/depletion.
Process
As a rule, the double entry book-keeping mechanism can process an event only after the event
becomes eligible for processing. Rather than attempting to answer the above questions, we will
make out a case here for establishing rules of measurement and reporting for carrying out the
double entry book-keeping process. We do not cover the double entry process in this course.
More important are the rules we should follow.
Rules for measurement and reporting

Accounting rules or Accounting standards are a set of rules, guidance or principles governing
the way the elements of financial statements should be recorded and reported in the financial
statements. They provide the principles for recognition, measurement and disclosures in the
financial statements. They set the rules the way specific transactions should be reported and
disclosed in the financial statements.
Financial statements are prepared in accordance with the accounting standards make them
uniform and comparable. Accounting standards impart consistency to financial reports. The
investors and analysts can compare the financial statements across different companies and
countries if they are prepared as per the same accounting standards.
• Accounting standards improve the quality of reporting.

• These standards bring out the most appropriate, fair and legitimate way of recording and
disclosing the complexities of any transaction.
• Accounting standards play a key role in removing the number of alternatives available to
present a particular item in the financial statements. Though there are still different ways
of reporting transactions depending on the circumstances, to a great extent, these
ambiguities have been resolved to present a clean and clear picture of the organization.
• The standards ensure that the materiality of the transaction remains intact.
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• They ensure that the companies resort to the fair practice of recording and
reporting/disclosures.
Generally, every country has its own set of accounting standards. This authority is vested in a
professional accounting body – private, government or a combination of the two. Some of the
renowned accounting standards across the world are US GAAP and IFRS.
In the United States, the responsibility of setting accounting standards are with SEC, this
function is delegated to FASB (The Financial Accounting Standard Board”). The accounting
rules in the United States are called as US GAAP.
Internationally, the accounting standards are formulated by an independent body called the
IASB (The International Accounting Standard Board). The standards are referred to as IFRS
or the International Financial Reporting Standards. More than 100 countries across the
world have adopted or converged IFRS. The usage of accounting standards enables business
organizations to bring in the best accounting practices for preparing and reporting financial
statements.
Output
The basic accounting system produces financial reports. The reports are categorized into two
kinds, depending upon the intended user – internal or external. For the external users, there are
3 important financial statements.
• Income Statement or the Statement of Profit and Loss, giving information on the
performance of the firm
• Balance Sheet, giving information on the financial position of the firm
• Cash Flow Statement, giving information on the cash generated/used by the firm
➢ Balance Sheet
A balance sheet is a statement prepared at a particular point in time that tells us what the
business owns as assets and how these have been funded.
Understanding the balance sheet through an example:

‘Mr. Von has been working for the last 15 years. What is your wealth as on date?’ Mr. Von
gives you information about his cash in bank and investments in other long-term saving
instruments. He also tells you that he owns a car and another house. Will this information be
enough to gauge the wealth held by Mr. Von? Think again, what has he left out? Loans or
Borrowings? Isn’t it important for you to know if he has taken any loan for buying the car and
the house? Isn’t it important for you to know if he has any other borrowings or liabilities? Yes,
in order to evaluate the wealth, or more specifically, the financial position of Mr. Von, you
must consider both the assets (car and house) and the money that he owes to others (liability)
and the balance contributed by him to buy the assets (equity).
What information does the Balance Sheet provide?
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A balance sheet provides information about the assets (cash, investment in shares, vehicles,
machinery, land, etc.) held by a firm and the ways in which the acquisition of these assets were
financed by the owners and others. The balance sheet is measured with reference to a point of
time and this point of time normally coincides with the end of the period with reference to
which the performance is measured (quarter, half, or financial year).
Since every transaction alters the financial position of the firm, the balance sheet, which is
measured with reference to a point of time, can be said to give a ‘snap shot view of a
continuously changing scene.
➢ Income Statement or Statement of Profit and Loss
The income statement depicts the incomes and expenses for a period of time, i.e., it depicts the
financial performance of the firm.
Let us come back to Mr. Von. You ask Mr Von about his income. Mr. Von tells you that he
earned $200,000 per year. What will be your next question to Mr. Von? You are bound to have
several questions, but what is the next most important question that you will ask? You may
also want to know his expenses and thus the net savings from his income.
Since incomes are earned and expenses are incurred over a period of time, performance of a
firm is measured with reference to a period of time. This is very similar to the flow of water
into and out of a dam – measured with reference to a period of time.
➢ Cash Flow Statement, provides this information.
The cash flow statement provides details of the cash inflows and outflows during the year. This
statement would give information on how and where the cash was generated and how it was
spent.
1.5 Preparation of financial statements using the accounting equation

Preparation of financial statements is not a difficult task. We are not going to record the
transaction using the traditional method, rather we are going to use the accounting equation,
which is more simple to capture the transactions. The accounting equation is the foundation of
the accounting system and is captured through the equation.
Assets = Liabilities + Shareholder Equity
Let us illustrate how accounting statements can be prepared with the help of a few transactions.
1. John starts ABC Corporation for trading widgets. John starts the business with
$300,000 in cash.
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Our accounting equation now is as follows. figures in $ 000’

Assets = Liabilities + Equity
Cash ($300 ) = 0 + Equity share capital $(300 )
2. We approach a bank for a loan and the bank, based on their assessment gives a loan of
$200,000. Interest rate is 1% per month.
Assets = Liabilities + Shareholders' Equity
Cash (500 ) = Borrowings (200 ) + Equity share capital (300 )
3. Rented an office space at $1000 per month payable on the last day of the month.
No transaction as we will record the transaction at the end of the month.

Cash (500 ) = Borrowings (200 ) + Equity capital (300 )
4. Bought furniture for $5000 for the office and paid cash. Furniture is an asset. Our
Cash (500 ) = Borrowings (200 ) + Equity share capital (300 )
accounting equation now is as follows.

Furniture (5) + Cash (495) = Borrowings (200) + Equity capital (300)
Note that cash comes down as we spend money.
5. Purchased widgets for $60000. Paid cash for $40000 and agreed to pay the balance in
60 days. Our accounting equation now is as follows.
Furniture (5) + Cash (455) +Inventory (60) = Borrowings (200) + Trade

Payables (20)+ Equity capital (300)
6. Sold goods costing $40000 for $ 50000 in cash.

This is the first time we have encountered items that do not appear directly in the
accounting equation. To answer this, let us understand and answer the following
questions:
What is the profit made in the transaction? Answer: $10000
Whom does the profit belong to? Answer: Equity capital (Shareholders)
So, rightfully this has to be added to the equity capital.
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We now modify the basic equation into:

Assets = Liabilities + Equity (Contributed + Retained Earnings)
Assets = Liabilities + Equity (Contributed + Income - Expenses)
The accounting equation would be depicted as:

Furniture (5) + Inventory (20) + Cash (505) = Borrowings (200) + Trade
Payables (20) + Equity share capital (300) + (Revenue (50) - Cost of goods
sold expense (40))
The equation has undergone a few changes. Inventory stock has come down from 60
to 20 on account of inventory being sold. Cash is increased by $50,000 because we
made cash sale. Revenue/sales increased by $50,000 along with an expense of $40,000
resulting in a profit of $10,000.
7. Since we have borrowed money to invest in the business, we have to pay the interest
which is 1% of the borrowings, i.e. $2000. Our cash holding declines by $2000 and
expenses increase by $2000. Our accounting equation is as follows:
Furniture (5) + Inventory (20) + Cash (503) = Borrowings (200) + Trade

Payables (20) + Equity share capital (300) + (Revenue (50) - Cost of goods sold
expense (40) –Interest Expense (2)
1.6 Accounting Equation to Financial Statements

We can now prepare the financial statements with the help of our accounting equations. The
income statement would be reported as follows:
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Income statement for the month ending 31 January xx

Income $
Revenue 50,000
Other Income -
Total Income 50,000
Expenditure
Cost of Goods Sold 40,000
Interest Expenses 2,000
42,000
Net Income / Profit 8000
Notice that this is the expanded version of the retained earnings.
Balance Sheet as on 31 January xx

Equity + Liability $
Shareholders' Fund
Equity Share Capital 300,000
Retained Earnings 8,000 308,000
Liabilities
Borrowings 200,000
Trade Payables 20,000
Total 528,000
ASSETS
Property Plant & Equipment (Furniture)1 5,000
Current Assets, Loans and Advances

Inventory 20,000
Cash 503,000
523,000 523,000
Total 528,000
The purpose of the above illustration is not to teach accounting process or preparation of
financial statement but to demonstrate that they are simple and easy to follow. Many of you
will find it exciting to see that your balance sheet is 'balanced' at the end.
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To Summarize
ASSETS MATCH WITH SOURCE OF FINANCING THE ASSET

ie
ASSETS = LIABILITIES + EQUITY
Expanding
ASSETS = LIABILITIES + EQUITY CAPITAL + RETAINED EARNING
Expanding to next level

ASSETS = LIABILITIES + EQUITY CAPITAL + RETAINED EARNING (Income –
Expenses)*
*Note that we have not adjusted the equation for any dividend payment
1.5 Accounting concepts
Accounting concepts provide a basis to record the transactions in a particular way. These are
the basic assumptions and conventions which have to be followed while recording any
transaction. Some of the concepts are discussed next.
Entity Concept
The entity concept states that the business and its owner(s) are viewed as entities, separate from
each other. The transactions of business are to be recorded separately and the personal
transactions of the owner should not be mixed with business transactions.
It is because of the entity concept that the capital contributed by the owner is treated like a
liability owed to the owner. Based on this logic, capital or equity is shown on the same side of
the balance sheet as liabilities.
Going Concern Concept

The going concern concept assumes that the business is going to continue its operations in the
foreseeable future. In other words, the business is going to exist for an indefinite period of time.
For example, depreciating assets is an example of the going concern concept. If the assumption
fails to hold, then all expenses including expenses incurred for purchased of property plant and
equipment (which are assets in the balance sheet), will be shown as expenses.
Cost Concept
Under the cost concept, all expenses, assets or liabilities should be recorded at their purchase
or acquisition price initially. Cost concept offers a sense of reliability to the accounting records.
The cost or purchase is reliable since it has proper evidence. For example, the company
purchased a piece of land on May 1, for $50,000. The same will be recorded at $50,000
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Money measurement concept:

Money measurement concept requires the accounting system to record transactions only if such
transactions can be measured on a monetary basis. In other words, events that cannot be
measured in money terms cannot be entered in the books. There is no way to measure
customers' satisfaction or production excellence or human resources value in accounting. In
that sense, accounting is not integrating itself with other functions and a typical performance
measurement includes several other non-monetary measurements. However, it can be counter
argued that if a firm’s production facility is excellent or customer satisfaction levels are high,
then they will be reflected in the form of additional revenue. Though it is true that ultimately
they will be reflected in incremental revenue or profit, there could be a considerable time gap.
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Week 2: Handout
Handout for week 2

Understanding Balance sheet
The purpose of financial accounting is generating status and performance reports in the
form of Balance Sheet and Statement of Profit & Loss (Income Statement). We can proceed
to the next step of understanding the form, content and the manner of determining the values
that appear in these two reports. The format and content (items to be disclosed) of the
Balance Sheet and the Income statement is usually mandated by the regulators in a country.
See a few illustrations in the Appendix.
BALANCE SHEET
The balance sheet provides a snapshot view of the assets, liabilities and equity of an
enterprise at a given point of time. In short we can say what the company owns and what
the company owes to others. An asset is a resource controlled by an enterprise as a result
of events and from which future economic benefits are expected to flow to the enterprise
and the assets are arising from a past identifiable event and are objectively measurable.
Liability is a present obligation of the enterprise arising from past events, the settlement of
which is expected to result in an outflow from the enterprise of resources embodying
economic benefits. Equity is the residual interest in the assets of the enterprise deducting
all its other liabilities (or simply liabilities).
How do these assets, liabilities and owners’ equity arise? All enterprises (also referred to
as 'firms') make financial decisions, investment decisions and operating decisions. These
decisions when implemented give rise to assets, liabilities and equity. Please note that
every investment decision has to be matched, in terms of value with the financing decision
involving raising money from outsiders or owners or both. As you have understood, the
balance sheet can be represented as follows.
Most countries around the world require Consolidated Financial Statements. Some countries
such as India prepare both the Consolidated and Standalone Financial statements. More about
this is provided in the next module.
Let us now briefly discuss the various elements of the balance sheet.
I. ASSETS
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Assets are resources which are expected to provide a firm with future economic benefits, by
way of cash flows or by their use. Resources are recognized as assets in accounting when (a)
the firm acquires rights over them as a result of a past transaction and (b) the firm can quantify
future economic benefits with a reasonable degree of accuracy.
As you can observe from the definition, assets give us future benefits either by use or through
generation of cash flows. Things that constitute assets are Plant and Machinery, Cash and Bank
Balances, Goods for sale, etc.
Assets are classified as follows:
• Non-current assets
• Current assets
1.1 Non-current Assets:
Non-current assets are relatively long-lived assets. They consist of fixed assets, non-current
investments, other non-current items such as long-term loans and advances, and other non-
current assets. Sometimes, you may find other classifications such as property plant and
equipment, intangible assets, available for sale securities and other non-current assets. These
act as the backbone of the business or help perform the operations of the business . These are
important resources to the business as they help in performing the business operations
effectively and smoothly.
Let us elaborate each of the following.
Fixed assets
These are assets meant to be used for producing/providing goods or services and not intended
to be sold in the ordinary course of business. These have a useful life of more than one year
and are of material value. Fixed assets comprise tangible fixed assets and intangible assets.
Tangible fixed assets also called as Property Plant and Equipment include items such as land,
buildings, plant, machinery used in the manufacturing process, furniture & fixtures, computers
etc. Fixed Assets are disclosed as Net fixed assets. Net fixed assets represents the gross book
value less accumulated depreciation. The gross book value is normally the historical cost
though this can be substituted with a revalued figure.
Historical cost of a fixed asset is all costs incurred to bring the asset to its working condition
for its intended use. The cost of an item of fixed asset comprises its purchase price, including
import duties and other taxes and any other costs directly attributable to the fixed asset. The
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cost also includes installation cost such as special foundations for plant; and professional fees,
for example, fees of architects, etc.
Depreciation is the systematic allocation of the depreciable amount of the asset over its useful
life. Accumulated depreciation is all depreciation charged to the profit and loss account till the
end of the current financial year in respect of the assets. Net block is gross block less
accumulated depreciation. More on depreciation in the next module.
Intangible Assets
Intangible asset is an identifiable non-monetary asset, without physical substance. Intangible

assets include items such as patents, copyrights, trademarks, and software etc. These include
the rights which give the business a competitive advantage. Intangible assets are reported at
their net book value, which is simply the gross value less accumulated amortization. Self-
generated intangible assets cannot be recorded in the books. Only acquired intangible assets
can be recorded.
A special category of intangible asset is goodwill. Goodwill is not good name in the business.
Goodwill represents the excess amount paid over the fair value of net assets taken over in case
of merger of companies and is found only in the acquirers books. Goodwill is also disclosed in
the consolidated financial statements on consolidation.
Non-current investments (also referred to as available for sale securities) generally

comprises financial securities such as equity shares, bonds or other financial securities that
are intended to be held for more than 12 months from the date of the balance shee
Other non-current assets consist of items such as long term advances (receivables) given to
others including employees, suppliers etc. that are due for repayment /adjustment for a beyond
a period of more than one year
1.2 Current Assets
Current Assets An asset is classified as a current asset when it satisfies any of the following
criteria: (a) It is expected to be realized in, or is intended for sale or consumption in, the
company’s normal operating cycle;.(b) It is held primarily for the purpose of being traded. (c)
It is expected to be realized within 12 months after the reporting date. (d) It is cash or cash
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equivalent unless it is restricted from being exchanged or used to settle a liability for at least
12 months after the reporting date.
Current assets include current investments (Marketable securities), inventories, trade

receivables, cash and cash equivalents, short-term loans and advances, and other currents
assets.
Current investments (Marketable securities) mainly represent short-term holdings of units or

shares of mutual fund schemes. These investments are made primarily to deploy idle funds to
generate an income. Also referred as securities that are held at fair value through the income
statement.
Inventories comprise raw materials, work-in-process, finished goods, packing materials, and
stores and spares. Inventories are generally valued at cost or net realizable value, whichever is
lower.
The cost of inventories includes purchase cost, conversion cost, and other cost incurred to bring
them to their respective present location and condition. The cost of raw materials, stores and
spares, packing materials, trading and other products is generally determined on weighted
average basis.
The cost of work-in-process and finished goods is generally determined on absorption costing
basis – this means that the cost figure includes allocation of manufacturing overheads.
Cost Flow vs. Physical flow of goods:
Inventory is purchased and sold at different points in time and at different prices. This results
in difficulty in identification of the items that were purchased or sold. If each and every item
is identifiable, then a firm can find the exact rate at which they are held in the inventory.
However, this practice may not be feasible for a company to maintain such efficient tracking
systems, particularly if the items are standardized, small and too many. Hence, the company
tracks the cost flow of goods instead of the physical flow of goods.
There are three methods used for identifying the cost of inventory on hand.
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First-in-first-out method or FIFO assumes that goods received first are consumed or sold first
and hence the closing inventory consists of goods recently purchased.
Last-in-first-out method or LIFO assumes exactly the opposite. Here, we assume that the goods
last received are used or sold first and the closing inventory consists of units purchased earlier.
Accordingly, consumption or sales is valued at the last invoice price and closing inventory is
computed by deducting the cost of consumption or sales from total purchase cost. LIFO is not
permitted under IFRS. US GAAP has elaborate provisions to be complied if a company is
following the LIFO method.
The weighted average cost method updates the inventory value every time a purchase is made
taking into account the value of inventory available at that point of time on a continuous
averaging basis.
The process of updating the value of the inventory continues and closing inventorys are valued
at this weighted average rate. Among the three methods, weighted average cost method is
widely used by most companies.
Trade receivables (also called accounts receivable) Business practice requires companies to
sell goods or provide services on credit. Receivables represent the amounts owed to the firm
by its customers (who have bought goods and services on credit). The period of credit given is
based on the negotiating power, the liquidity position and the “risk” profile of the customer.
They are part of current assets since these dues are normally collected within one year.
Trade receivables are the disclosed net of any provision (allowance ) for bad and doubtful
debts. Generally, firms make a provision for doubtful debts which is equal to debts considered
doubtful. The net figure of trade receivables is arrived at after deducting the provision for
doubtful debts.
Cash and cash equivalents consist of cash on hand and bank balances. Cash and bank
balances are required to meet the day-to-day operations of the company. However, any excess
holding will of cash would result in assets being idle. Companies have to hold a certain level
of cash to meet the day-to-day expenses and any other contingencies.
Other current assets include loans and advances given to suppliers, employees, and other
companies that are recoverable within a year.
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Current Investments are financial assets which the company plans to sell/dispose within 12
months. These include investment in securities such as Mutual fund etc. They are also referred
as marketable securities
2. Equity and Liabilities
Equity and liabilities represent what the firm owes to its financers.
2.1 Equity
Equity (also shareholders’ funds/Stockholders equity): Shareholders’ funds represent the

contribution made by shareholders in some form or the other. They include share capital (also
termed as common stock) and retained earnings (reserves and surplus).
Share capital (Common Stock): Equity capital represents the contribution of equity
shareholders to finance the business. The share capital is usually divided into a face value (par
value) and number of shares. The share capital is initially brought in at the time of registering
a company. When the company first raises capital from the public after its formation, it is called
'Initial Public Offer' (IPO). Subsequently, the company can raise additional capital. Shares are
issued to investors at more than the face value; these are termed as ‘share (securities) premium’
or ‘additional paid in capital’.
Equity share capital or common stock carries high risk. The equity holders get a dividend only
if there is profit. Further, if a company is in liquidation, it will receive capital only after meeting
the claims of all other fund providers such as bank borrowings and other liabilities. A great
advantage of equity is that the liability of the shareholders is limited (i.e. on winding up, their
personal wealth will not be used). The concept of limited liability enabled formation of large
companies with several million shareholders which will help build a strong capital market.
Subsequent to the initial offering, companies may have 2 other events related to equity; Stock
Split and Buy back of shares and Bonus Issue.
Stock split
Stock split is a process by which the companies split their existing shares into multiple shares
of lower par value or face value. Stock splits result in an increase in the number of issued
shares of the company. For example, a company is having 10,000 shares outstanding with a
par value of $10 each. The company decides to split the face value or par value to half say of
$5 each. After stock split, the number of shares will increase to 20,000 with a par value of $5
each. Although the number of shares increases after stock split, the total amount of
shareholder’s funds or common equity remains unchanged. A reasons for splitting the stock of
the company may be its high stock market price. Splitting into smaller face value splits the
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market price as well, thus enable access to small investors. Companies also sometime split
stocks par value to compensate for not declaring cash dividends.
Buyback of shares
Buyback of shares or stocks refers to a process by which a company buys backs or re-acquires
its own shares. It is also known as share repurchases in some countries. Share buyback leads
to a reduction in the number of outstanding shares. In some countries, these shares have to be
cancelled. However, in some countries, these shares can be resold (subject to certain rules
specific to that country). The shares which are repurchased and are not immediately retired or
reissued are called as treasury stocks
Treasury Stock. Treasury stocks do not carry any voting right nor do they receive dividends.
As per IFRS guidance, treasury stocks are required to be reported as deduction from equity.
The cost of an entity's own equity instruments that it has reacquired ('treasury shares') is
deducted from equity. The gain or loss is not recognized on the purchase, sale, issue, or
cancellation of treasury shares. Treasury shares may be acquired and held by the entity or
by other members of the consolidated group. Consideration paid or received is recognized
directly in equity. [IAS 32.33]
Why do companies buy back their own stock? There are many reasons for a business to buy
back its own issued stock. Some of the common reasons for a buyback are as follows.
• The company’s stock is undervalued which prompts the management to opt for buy-
back of shares. This has an immediate impact on the stock price.
• Company has excess cash with no immediate use for the cash.
• To reduce dilution of shares and strengthen majority shareholders (promoter’s)
control over business.
• To improve key financial ratios such as earnings per share, and return on equity
Companies reacquire shares usually through the open market although there are other ways to
buyback such as entering into private negotiations or making a fixed price offer to its
shareholders. Many of the top US companies such as Apple and Microsoft have ongoing stock
repurchase plans.
Bonus Shares
Bonus shares are the shares which are issued to the shareholders without any consideration in
cash. Bonus issues can be called as the distribution of a company’s earnings in the form of
Week 2: Handout
stocks or shares. Bonus issue is also known a scrip issue, capitalization issue or stock dividends
as known in the USA. It is a free issue of shares or stocks to its existing shareholders or
stockholders in a certain proportion to their shareholding. For example, if a company makes
1:1 bonus issue; a shareholder gets 1 share for every 1 share held. There is no transfer of cash
to the shareholders in the case of bonus issue. Bonus issue involves a transfer of amounts from
the retained earnings. It is a convenient way of providing shareholders their return on
investments when the company is having huge reserves and surplus but not adequate cash.
There are several reasons why a company opts for bonus issue:
• Bonus shares are a signaling mechanism for future growth potential (as in future they
have to pay a dividend on the higher share capital), thus raising the company’s overall
market value.
• High stock market price may discourage potential investors from buying shares in the
stock market. Issue of bonus reduces the market price in the same proportion as that of
the bonus (on that date) and consequent to increase in the number of shares. Thus, bonus
issue helps in reducing the price to a more realistic level. For example, a company with
a share price of $20 may decide to issue bonus shares in the ratio of 1 share for every 1
share. On the date of bonus issue, the share price will split to $10 (subsequent to the
issue, the price may move either way depending on other factors). Market price of the
share is impacted in the same way as that of the stock split.
Retained Earnings /Reserves and surplus/Other Equity
Retained earnings often is the most significant item on the balance sheet, represents profits
retained in the business as well as non-earnings items such as reserves.
Retained earnings is the amount of accumulated profits owed by the business entity to the
equity shareholders. It is the profits remaining after distributing dividends to the shareholders.
Retained earnings are reinvestment of profits in the business.
Companies create certain reserves for meeting any future liability or contingencies. Reserves
are the amount set side from the profits of the company before paying dividends. Reserves
comprise statutory reserves required to be created by law), and general reserves. Apart from
the statutory reserves, companies create certain general reserves out of the profits of the
business. These reserves are not held for any specific reason. These are also called revenue
reserves since they are created out of the normal profits of the company.
Statement of shareholders equity is discussed in the next module.
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2.2 Liabilities
Liabilities are present obligations that a firm owes to the outsiders. The can be borrowings, or
amounts payables to suppliers of goods and services etc.
Liabilities are broadly classified into:
• Non-Current liabilities
• Current Liabilities
Non-current Liabilities
Non-current liabilities are liabilities which are expected to be settled after one year of the
reporting date. They include long-term borrowings, deferred tax liabilities, long-term
provisions, and other long-term liabilities.
Long-term borrowings are borrowings which have a tenor of more than one year. They
generally comprise term loans from financial institutions and banks. They could be in the form
of bonds and foreign currency bonds, and public deposits and many other forms of borrowings.
Term loans and bonds are typically secured by a charge on the assets of the firm, whereas
public deposits represent unsecured borrowings.
Other long-term liabilities: This includes provisions for employee benefits such as retirement
benefits and other liabilities that are due beyond a year.
2.2 Current Liabilities
Current liabilities are those which are due to be settled within 12 months after the reporting
date. They include short-term borrowings, trade payables (amount that you need to pay the
suppliers of goods and services), short-term provisions, and other current liabilities.
Short-term borrowings are borrowings which have a tenor of less than one year. They
comprise mainly working capital loans, inter-corporate deposits, commercial paper, and public
deposits maturing in less than one year.
Trade payables are amounts owed to suppliers who have sold goods and services on credit.
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Other current liabilities are items such as current maturities of long-term borrowings,
advance payments from customers, and so on.
Appendix
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Ginger Co.
Balance Sheet as at 31st December
$ million $ million
Note 2016 2015
Assets
Non-current assets
Property, plant and equipment 9 14,500 13,970
Intangible assets 10 1,750 1,660
Financial Assets (Available for sale investments) 11 347 381
Other non-current assets 11 B 1,103 849
Total non-current assets 17,700 16,860
Current assets
Inventories 12 681 745
Trade receivables less provision for doubtful debt 13 5,460 5,790
Other current assets 14 2,445 3,657
Marketable securities 14A 1,122 1,125
Cash and cash equivalents 14B 1,954 1,923
Total current assets 11,662 13,240
Total Assets 29,362 30,100
Liabilities and Equity
Non-current liabilities
Financial Liabilities 15A 935 1,680
Deferred tax liabilities 1,690 1,760
Other non-current liabilities 19 390 620
Total non-current liabilities 3,015 4,060
Current liabilities
Financial Liabilities 15B 1,750 1,930
Short-term provisions for liabilities 220 310
Trade payables 3,040 3,000
Total current liabilities 5,010 5,240
Total Liabilities 8,025 9,300
Equity
Share capital 70 70
Share premium 240 240
Other reserves 9,320 9,850
Retained earnings 11,707 10,640
Total equity 21,337 20,800
Total Liabilities & Equity 29,362 30,100
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Balance Sheet
Please see some of the additional links below for your reference.
Week 2: Handout
Few additional links for reference:
http://www.globalsuzuki.com/ir/library/annualreport/pdf/2016/2016-2.pdf
http://www.picknpay-ir.co.za/downloads/2016/PnP_IAR_2016.pdf
https://www.sap.com/docs/download/investors/2016/sap-2016-annual-report-form-20f.pdf
https://www.hul.co.in/Images/annual-report-2016-17_tcm1255-507593_en.pdf
https://s2.q4cdn.com/056532643/files/doc_financials/2016/annual/2016-Annual-Report-PDF.pdf
Week 3: Handout
HANDOUT FOR WEEK 3

UNDERSTANDING THE INCOME STATEMENT
(Profit and loss statement)
Introduction
The financial account system generates and important report that captures the financial
performance of the company called as the “Income statement” or the Statement of profit and
loss.
Income statement is measured with reference to a period of time. This period of time is
usually for a year. Performance reports are also prepared for periods less than a year when
firms provide interim reports for quarters or half years. For internal purpose this statement
can be prepared every month as well.
It depicts the financial performance of the firm in terms of incomes earned and expenses
incurred. This is very similar to the flow of water into and out of a dam measured with
reference to a period of time.
An income statement presents the revenue earned during the period and the expenses
incurred in generating that revenue.
Net Income represents the excess of revenue over expenses over a period of time.
Net Income = Revenue – Expenses
The income statement presents a summary of the operating and financial transactions, which
have contributed to the change in the owners' equity during the accounting period. Revenues
are transactions that augment owners' equity and expenses are transactions that diminish
owners' equity.
Income:
Income is defined in the standards as: Income is the 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 (Retained earnings) other than those relating to
contributions from equity participants.
Income comprises both the operating income as well as the non-operating income. Operating
income constitutes the revenue generated from the core activities of the business, i.e. it can be
either sale of goods or rendering of services. Apart from the primary income, a company can
generate income from other sources like generating income from sale of assets, interest
income and other income from non-operating activities.
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Operating expenses are incurred to run the core business of the firm. It comprises of items
like the cost value of goods or services sold and general administrative, selling and
distribution expenses.
Non-operating income /gain comprises of income generated from sources other than the core
activities of the firm and can be further broken down into income and gains. For example, for
a firm engaged in tourist taxi service, income earned from investment will be considered as a
non-operating income (other income) and profit earned on sale of cars will be non-operating
gains. Non-operating expense/loss comprises of the losses or and expenses are relatable to
sources other than the core business. For a tourist taxi firm, examples of non-operating
expenses will be loss on sale of equity shares held as investment will be a non-operating loss.
Revenue: The term Revenue means the price charged to customers for goods sold or
services rendered. It is the inflow of economic benefits (cash, receivables, other assets)
arising from the ordinary operating activities of an entity
To illustrate, a retail store generates revenue by selling the goods. A service enterprise gets
revenue by charging fees for the services provided. When goods are sold or services
performed, the resulting revenue is in the form of cash or accounts receivable. Revenue is not
necessarily “cash” flowing into a business within same Accounting year. Rather, it is the
amount “earned” during the period. It can be in cash or kind.
Expenses: Expenses in general terms mean the costs incurred for generating revenue. They
are the cost incurred in the normal course of business operations. The expenses can range
from acquiring raw materials, production costs, administrative expenses like employee
salaries, utilities expenses; other overhead expenses used are the common examples of
business expenses.
There are 3 important concepts related to the income statement. These are Realisation,
Accrual and Matching Concept.
The Realization Concept

An important concept, the realization concept, indicates the amount of revenue that
should be recognized from a given sale. Revenue should be recognised only when the goods
are sold and when the services are provided. According to the realisation principle, a
revenue is recognised when the transaction generating the revenue takes place and not when
the cash for the transaction is received. To illustrate this principle, let us consider an
example. Suppose a firm sells goods worth $10,000 on credit to a customer. The revenue is
recognised when the sale takes place even though cash may be received later. When the firm
receives cash, it will adjust its balance sheet by decreasing the receivables and increasing the
cash.
The Matching Concept
As noted earlier, the sale of merchandise has two aspects: (1) a revenue aspect, reflecting the
revenue realized, and (2) an expense aspect, that is incurred to earn the revenue
This principle requires that all the costs and expenses incurred should be identified and
matched against the related revenue earned during a time period. To summarise, all the
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expenses incurred to generate revenue should be recognised in the same accounting period as
the related revenue. There has to be a clear matching of the revenue with expenses incurred.
For example, if a particular sale has been recorded, then all the costs associated to that sale
should also be recorded in the same time period. If a firm sells 10 pens the cost incurred to
sell the 10 pens should be included as expenses in the same period.
The Accrual concept

Accounting transactions generally end up with cash. That is, revenue is ultimately realised
and expenses are generally paid. The question is should accounting system wait for the cash
part to complete before recording the same. It is not normally treated that way. Accounting
transactions are recorded without waiting for cash part to complete. The reason is accrual
concept. When it comes to revenue or expenses, accrual concept is consistent with matching
concept. If a sale is made, whether expenses on account of sale is paid or not, they are to be
recognised. For instance, an advertisement was released on December 25 but the amount was
paid on 4th April. Since the expenses have been accrued, they need to be recognised in the
accounts. Similarly, if a loan is taken in January and next interest has to be paid at the end of
June, interest expenses for the period of January to March are to be recognised when closing
the books of accounts in the month of March.
Some Major issues related to the Income Statement

1. Revenue Recognition
Most of the activities of the business can be broadly classified into

Operating activities
Investing activities
Financing Activities
The main objective of any business is to generate revenue. Businesses generate revenue either
by selling goods or services. For example; Retail Store sells food and other household goods,
Pharmaceutical companies sells pharma products, banks lend money and sell financial
services etc., We can see that the sale of product or service is at the heart of any business,
same way correct accounting of revenue is the key to correct disclosure of revenue in
financial statements.
A number of questions get raised in this regard: When should revenue be recognised? Is it
when:
 The customer places the order, or

 The goods are manufactured or
 The invoice is prepared or
 The goods are delivered or
 When cash is collected or
 Maybe later when there is no chance of return of goods by the customer.
How do we assign revenue to a particular period? This is really an important issue, which has
to be dealt with utmost care and caution.
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As per IFRS guidelines, there are set number of conditions that have to fulfil in order to
recognize revenue. In simple terms, revenue should be recognised:
 When the goods or services have been provided or delivered to the customer (i.e.
when the risk and reward of ownership is transferred) and
 There is no uncertainty in collection of consideration from the customers.
If these two conditions are met, revenue can be recorded for such items.
Revenue recognition can get quite complex for services industry. For example: A company
in the IT services gets a contract for development, installation, customer support and
providing hardware. The issue arise as to at what point in time, the company should recognise
its revenue?
Learners can examine the “accounting Policy” section of the annual report of companies to
understand the “Revenue Recognition” of Companies.
Expenses
There are several expenses a company incurs to earn the income. For example a
manufacturing firm incurs expenses such as: Raw Material expenses, wages,
manufacturing overheads, administration expenses such as rent, depreciation interest and
other expenses.
Tax expense consists of current tax and deferred tax. Current tax is computed by
multiplying the taxable income, as reported to the tax authorities, by the appropriate tax rate.
Deferred tax, also called future income tax, is an accounting concept that arises on account
of temporary difference (also called timing difference) caused by items which are included
for calculating taxable income and accounting profit but in a different manner over time. For
example, depreciation is charged as per the written down value for the taxable income but as
per the straight-line method for calculating the accounting profit. As a result, there are
differences in the year-to-year depreciation charges under the two methods, but the total
depreciation charges over the life of the asset would be the same under both the methods.
Some companies have extraordinary items reported in the income statement.
Extraordinary items are material items, which are both infrequent and unusual, and they
have to be disclosed separately by virtue of their size and incidence. Examples of
extraordinary items are the discontinuance of a business segment, either through termination
or disposal, the sale of investments in subsidiary and associated companies etc.
One of the important expenses in the income statement is Depreciation. We discuss the same
in the next section.
Depreciation
As we have seen that all the expenses have to be recorded in the Income Statement.
Depreciation is one such non-cash expense, which is reported in the Income Statement.
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One of the issues in accounting for plant & equipment is the allocation of an asset’s cost over
its useful life. The matching principle requires that this costs be recorded as expense in the
period when the benefits from the use of asset have been enjoyed. This allocation procedure
is depreciation and the allocated amount recorded in the closing entry is an expense.
Depreciation is the systematic process of allocating the depreciable cost of the asset over the
useful life of the asset. Accounting for depreciation is often confusing. People think that
depreciation reflects the decline in an asset’s value. The concept of depreciation is nothing
more than a systematic write off or allocation of the cost of an asset over its useful life.
To calculate depreciation for an asset, you need to know:

Original cost of the asset
Useful life
Estimated Salvage value
Salvage value is the amount expected to be received when the asset is sold at the end of its
useful life. There are several methods for depreciating the costs of assets for financial
reporting.
Most commonly used method of depreciation is the Straight Line method of depreciation.
This method assumes that an asset will benefit all periods equally and the cost of the asset
should be assigned equally for all the accounting periods.
The formula for calculating straight-line depreciation is;
Cost - Salvage Value

Expected useful life ( years ) = Annual Depreciation expense
For example, ABC purchased a vehicle for $100,000 for its own use. The expected useful life
of the asset is 10 years. The estimated salvage value is $20,000. What would be the annual
depreciation expense for the vehicle?
Annual Depreciation expense will be
$100,000 - $20,000 = $8,000

10
There is one exception here. For example land. Land doesn’t get depreciated because its
assumed to have unlimited useful life. For assets having unlimited life, there is no
depreciation charged because they are going to provide future economic benefits to the
business forever.
Week 3: Handout
There are other methods of depreciation like accelerated method of depreciation, units of
production method of depreciation. Under the accelerated depreciation method, the
depreciation expense is higher in the early years of the asset’s useful life and lower in the
later years.
Associated terms in the income statement are amortisation and impairment.
Amortisation term is depreciation but associated with certain intangible assets.
Impairment of asset
An impaired asset is a company's asset that has a “recoverable value or future benefits” less
than the value listed on the company's balance sheet. Accounts that are likely to be written
down are the company's goodwill, accounts receivable and long-term assets because the
carrying value has a longer span of time for impairment.
As per IFRS guidance, Impairment loss is the amount by which the carrying amount (net
book value) of an asset exceeds its recoverable amount (its future benefits)
The Recoverable amount is measured by the higher of
a) The asset's fair value less costs of disposal* (sometimes called net selling price)
b) Its value in use
How do we measure the value in use? The value in uses is a difficult concept to measure. A
running business or a useful asset gives future benefits through production and sale of
products. This has to be quantified to measure the value in use.
If, and only if, the recoverable amount of an asset is less than its carrying amount, the
carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an
impairment loss.
Statement of Changes in equity
It is a detailed statement showing the changes in share capital, retained earnings and reserves
during a period of time.
Shareholders’ Equity can increase or decrease as a result of several things, for example:
• If new shares are issued

• If the company buys back its shares
• The company makes a profit or loss during the period
• It pays out dividends to its shareholders
This statement comprises of broad categories, which together make the shareholder’s
equity for a company. That is:
• Share Capital
• Securities Premium or Additional paid in capital
• Retained earnings
• Reserves
Week 3: Handout
Statement of comprehensive income
Comprehensive income reflects the overall change in a company’s wealth during a period.
This statement includes items that are not related to the business operations of the company
but arise from change in certain market conditions and resulting fair value changes.
Therefore these items are excluded from the Income Statement and included in the
comprehensive income.
Examples of the types of changes captured by other comprehensive income include:
• Foreign currency transaction adjustments
• Unrealized gains and losses on Available-for-sale securities.
• Unrealized gains or losses on derivative instruments
• Unrealized gains or losses on defined benefit Pension plans.
Revenues, expenses, gains and losses appear in other comprehensive income when they have
not yet been realized.
Thus, if the company has invested in Available for sale securities and the fair value of those
changes in the year-end, recognize the difference as a gain or loss in other comprehensive
income. On selling them, the gain or loss on sale is realised and it moves to the income
Cash Flow Statement
The Cash Flow Statement gives information about the cash generated or used by the firm
during a financial year. Consider the Balance Sheet of a firm. The status depicted is different
in the beginning and end of the year. Can the change in status be attributed entirely to the
performance of the company, incomes earned and expenses incurred during the financial
year? Not quite. Performance always affects the status of a firm. But all changes in the status
cannot be attributed only to performance. The changes in status may also arise due to other
activities of a firm such as equity raised, loans repaid and equipment purchased. We need a
statement, which explains why the status changed during a period.
The causes for the change in the status can be attributed to 3 sources:-
 Performance (operating) activities
 Investing activities (i.e., acquisition and disposal of long term assets)
 Financing activities (i.e., raising and settlement of loans and share capital)
The cash generated or used by the firm during a period is categorized under the above three
broad activities as given in the following format:-
A. Cash generated/(used) from Operating Activities
B. Cash generated /(used) from Investing Activities
C. Cash Generated/(used) from Financing Activities
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D. Net Cash generated during the period

E. Opening cash balance
F. Closing cash
Cash normally means currency (coins, bank notes). But it also includes cheques, drafts, and
traveller’s cheque.
Accountant defines cash to include cash on hand as well as cash at banks and cash
equivalents. Cash at banks means money lying in bank accounts, money on deposits in bank,
and some cases bank overdrafts also.
Companies maintain several bank accounts as well as keep a small amount of cash on hand.
Cash equivalents: These are highly liquid investments. These are short-term investments
that are readily convertible to known amounts of cash and which have insignificant risk of
changes in value. These securities have a low-risk, low-return profile.
It presents a summarised view of the cash transactions of the business during a period.
Cash flow statement provides relevant information in assessing a company's liquidity and
solvency position.
It helps in answering questions like:
• How was cash generated from the main business activity or from its operations
• How were the assets financed
• Was there any dividend distribution done by the firm
• How much money was borrowed during the year
• Has the company raised further funds by issue of shares etc?
Cash Flow Statement helps the users of financial statements to assess various aspects of
firm’s financial position like
• The entity’s ability to generate future cash flows

• The entity’s ability to pay dividends and meet financial obligations
• The reason for the difference between the net income and net cash generated from
operations
• The investing and financing transactions of the business
• Managers in evaluating past operations and in planning future investing and financing
activities use the cash flow statement.
• Others also use it like creditors, investors to assess the company’s cash generating
potential and ability to pay off its debts.
The statement of cash flows report three types of cash flow activities:
• Cash flow from operating activities
• Cash flow from investing activities
Week 3: Handout
• Cash flow from financing activities
Cash flows from operating activities:
Cash flows from operating activities are the cash inflow or outflow from a company’s
day-to-day operations.
• These consist of the cash flows generated by the company’s main or core business
activity. The operating activities section shows the cash effects of revenue and
expense transactions.
• This can be cash flow arising from buying and selling of goods for a manufacturing or
trading company or it can be from rendering services for a service company.
• Cash from operating activities doesn’t include cash spent on capital expenditures like
buying new equipment, buying long-term investments.
• Since these are not related to the main operations of the company, they are disclosed
under the other heads.
Example of Cash from operating activities:
• Cash received from customers
• Cash paid to suppliers
• Cash paid for other operating expenses of the business including payment to
employees
• Cash payments for income taxes
The operating activities section includes the cash effects of those transactions reported
in the income statement.
Let us consider the effects of credit sales.
Credit sales are reported in the income statement in the period when the sales occur.
But the cash effects occur later- when the receivables are collected in cash. If these
events occur in different accounting periods, the income statement and the operating
activities section of the cash flow statement will differ.
In a similar way, it happens for the expenses accounted in the income statement but
for which cash has not been paid in the current period. There are again certain
expenses, which are non-, cash in nature and which don’t involve any cash outflow.
Cash flow from operating activities can be made following either direct method or
indirect methods
The direct method shows each major class of gross cash receipts and gross cash
payments.
Week 3: Handout
The operating cash flows section of the statement of cash flows under the direct
method would appear something like this:
Direct Method
Cash receipts from customers xx,xxx
Cash paid to suppliers xx,xxx
Cash paid to employees xx,xxx
Cash paid for other operating expenses xx,xxx
Interest paid xx,xxx
Income taxes paid xx,xxx
Net cash from operating activities xx,xxx
The indirect method adjusts accrual basis net profit or loss for the effects of non-cash
transactions. The operating cash flows section of the statement of cash flows under
the indirect method would appear something like this:
Earnings before interest and income xx,xxx

taxes (some companies use earnings
after tax)
1. Add: Non Cash, Non operating xx,xxx

items such as depreciation and
impairment losses
2. Add/Less: Interest Income /Interest xx,xxx

Expenses and other non operating
income and expenses
3. Working capital changes xx,xxx
Increase / Decrease in receivables, xx,xxx

inventories, payables and other items of
operating working capital. xx,xxx
xx,xxx
Cash flow from Operations
Less: Direct taxes paid
Net cash from operating activities xx,xxx
Week 3: Handout
Cash flows from investing activities
Cash flow from investing activities shows the cash inflows and outflows related to changes in
a company’s long-term assets. Cash flows from investing activities include cash used in
acquiring fixed assets and making investments and cash generated from selling these assets
and investments
Cash flow from investing activities is related to activities that are intended to generate income
and cash flows in future.
Examples: Cash from investing activities are “Cash paid for purchasing fixed assets, Cash
received from sale of fixed assets; Cash invested in financial assets of investments; Cash
received by way of dividends, interest
Cash flow from financing activities
Cash flows from financing activities show the cash inflows and outflows related to changes in
long-term liabilities and shareholder’s equity. It helps in understanding how the financing
structure of the business.
Cash flows from financing activities: Cash received form issue of shares, Cash received from
borrowings, Cash paid for buy back of shares, Cash paid for repayments of debts or
borrowings, Cash paid as dividends.
Interest paid ( Some differences as per US GAAP and IFRS )
IFRS: interest and dividends received and paid may be classified as operating, investing, or
financing cash flows, provided that they are classified consistently from period to period [IAS
7.31] Interest received or interest paid is usually classifies as cash flow from investing
activities except for financial institutions where it is classified as cash flow from operating
activities.
US GAAPS: Interest paid or received are classified as cash flow under operating activities
Week 4 and Week 5 Handout

Financial Statement Analysis
Introduction
After understanding the basic financial statements, one may be interested in analysing the financial
statements to understand the performance of the business. Financial statement analysis helps
answer basic questions such as
• How has the business performed during the year

• What is the financial condition of the company
• How investment activities have performed during the year
• Does the company have enough liquidity to meet its day - today operations and
many more
Let us examine the sequence of accounting and analysis as depicted below
Evaluating the Forecasting

Preparation of performance about the Taking steps to
Analyzing the
Finanacial and position of future period address the
Financial
Statements the business and diagnosing problems areas
Statements
using certain the present if any
tools situation
1.What does analysis involve ?
Financial statement analysis is a set of tools and techniques used to assess the financial performance
of the business. Here one must understand that business does not operate in vacuum and therefore
understanding the business context, the industry, the company’s own strategy are important before
we start the analysis.
Apart from financial statements there are several additional inputs in the annual report that aid in
analyzing the financial statements. These are Directors report/Chairman’s statement, Segment
Accounting and Analysis” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
Reporting, Companies Risks and mitigation measures, Notes and explanations in the annual report.
Using the additional parts of the annual report the numbers can be interpreted in a better manner.
2. Tools to analysis
Once you develop the basic understanding. We can go to number crunching ie analysis
We start with the following basic tools
• Horizontal Analysis
• Vertical or Common sizing statements and
• Ratio analysis
Let’s elaborate each one:
2.1 Horizontal Analysis & Trend Analysis
The trend analysis is a technique of studying several financial statements over a series of years. In
this analysis the trend percentages are calculated for each item by taking the figure of that item for
the base year taken as 100. Generally, the first year is taken as a base year. This analysis helps in
understanding the trend of figures, whether moving upward or downward. Trend analysis shows
the level of growth that the company has achieved over the years on each component of financial
statements. Suppose the growth rate of sales is 20% but its cost has increased by 26%, then its
profitability is affected. One can perform such analysis by observing the trends on each element in
the balance sheet as well as the income statement.
2.2 Common Sizing
The common size statements (Balance Sheet and Income Statement) are shown in analytical
percentages. The figures of these statements are shown as percentages of total assets, total liabilities
and total income respectively. Take the example of Balance Sheet. The total assets are taken as 100
and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken
as a percentage of total liabilities. In the income statement, the total income is taken as 100 and all
other elements (such as different type of expenses) of the income statement are worked out as a
percentage to the revenue.
Common size statement analysis if performed across several years helps understand the structure of
the company and track the changes in the allocation of assets or liabilities. In the income statement
one can also observe the movement in the various expenses and identify which of the expense
contributed to the change in the net profit compared to the previous year.
2.3 Ratio analysis
A ratio is a mathematical relationship between two numbers. Financial ratio analysis is a

study of ratios between various items or groups of items in financial statements. This can be
related to only the income statement or the balance sheet or a combination of both the
financial statements.
Ratio analysis is among the most popular and widely used tools of financial analysis. Ratios may be
expressed as percentages or fractions or as a stated comparison between simple numbers. A ratio
simply presents information regarding a single financial relationship but it is not an end in itself.
Ratios help in the judging the efficiency of the business. There are various ratios that are used for
evaluating the performance and the financial condition of the company. Broadly, ratios help
determine the Operational efficiency, Investment efficiency, Financing Efficiency
Remember ratios cannot tell the complete story. Ratios properly interpreted help in identifying
areas which require further examination.
Financial ratios can be mainly classified into the broad categories as follows:
• Profitability ratios
• Asset management or Turnover ratios
• Liquidity ratios and
• Leverage ratios
• Other Ratios
2.3.1 Profitability ratios
Profit represents the excess of revenue over expenses for a period. Profit is a number but is that
number a good number or an ideal number for the business considering the scale and size of
business? Here arises the concept of profitability. Profitability is the ability of the firm to generate
earnings. Profitability denotes the efficiency of the business in generating profits. Analysis of profit is
of vital importance to all the stakeholders.
hey can be divided as margin ratios and return ratios. Margin ratios indicates the relationship
between profit and revenue. Since profit can be measured at different stages, there are several
measures of profit margin.
Some of them are as follows:
Gross Profit Margin Ratio The gross profit margin ratio is defined as:
Gross profit
Revenues from operations
Gross profit is defined as the difference between revenues from operations and cost of goods sold.
Cost of goods sold is the sum of manufacturing costs relating to the revenues of the period. This ratio
shows the margin left after meeting manufacturing costs. It measures the efficiency of production as
well as pricing. More importantly, this can act as a bargaining tool. A higher or an adequate gross
margin is always advantageous. Higher GP represents better ability to absorb the fixed costs. A
company should have a stable gross profit margin unless there have been changes to the company's
business model.
To analyze the factors underlying the variation in gross profit margin the proportion of various
elements of cost (labor, materials, and manufacturing overheads) to sales may be studied in detail.
Net Profit Margin Ratio The net profit margin ratio is defined as:
Net profit
Total revenues
This ratio shows the net earnings or net profit after all expense as a percentage of total revenues. It
measures the overall efficiency of production, administration, selling, financing and tax management.
The ratio provides a valuable understanding of the cost and profit structure of the firm and enable the
analyst to identify the sources of business efficiency/inefficiency.
Return on Assets The return on assets (ROA) is defined as:
ROA = Profit after tax
Average total assets
The ratio helps understand the return generated from the use of assets. It captures both the cost
management and efficient utilization of assets.
Note: The generic term used is return on investment. Many organizations use variants of the above
equation. For example: Return on capital employed or Return on net assets etc.
Investors always look for companies which generate good returns on investments in assets. Higher
ROA represents a firm’s return generating ability.
Return on Equity A measure of great interest to equity shareholders, the return on equity is defined
as:
Net profit
Average equity
The numerator of this ratio is equal to profit after tax. The denominator includes all contributions
made by shareholders (capital + retained earnings). This ratio is also referred as return on net worth
or return on shareholders’ funds.
This ratio is very important measure because as it reflects the efficiency of the using the shareholder
funds employed in the firm. It is influenced by several factors: profit, debt-equity ratio, average cost
of debt funds, and tax rate.
In judging all the profitability measures it should be borne in mind that the historical valuation of
assets imparts an upward bias to profitability measures during an inflationary period. This happens
because the numerator of these measures represents current values, whereas the denominator
represents historical values.
2.3.2 Turnover Ratios/Asset Management Ratio
Turnover ratios, also referred to as activity ratios or asset management ratios, measure how efficiently
the assets are employed by a firm. These ratios are based on the relationship between the level of
activity, represented by revenues or cost of goods sold, and levels of various assets. The important
turnover ratios are: inventory turnover, average collection period, receivables turnover, fixed assets
turnover, and total assets turnover.
Total Assets Turnover Akin to the output-capital ratio in economic analysis, the total assets turnover
is defined as:
Total revenues
Average total assets
This ratio measures how efficiently assets are employed, overall.
Property Plant and Equipment (Fixed Assets) Turnover This ratio measures revenue per dollar of
investment in property plant and equipment. It is defined as:
Revenues
Average net fixed assets
This ratio measures the efficiency with which property plant and equipment are employed - a
high ratio indicates a high degree of efficiency in asset utilization and a low ratio reflects inefficient
use of assets. However, in interpreting this ratio, one caution should be borne in mind. When the fixed
assets of the firm are old and substantially depreciated, the fixed assets turnover ratio tends to be
high because the denominator of the ratio is very low.
Inventory Turnover The inventory turnover, measures how fast the inventory is moving through the
firm and generating sales. It is defined as:
Revenues from operations
Average inventory
The inventory turnover reflects the efficiency of inventory management. The higher the ratio, the
more efficient the management of inventories and vice versa. However, this may not always be true.
A high inventory turnover may be caused by a low level of inventory which may result in frequent
stock outs and loss of sales.
Receivables' Turnover This ratio shows how many times trade receivables turn over during the year.
It is defined as:
Revenue
Average trade receivables
The ratio indicates the efficiency of credit management ie collection from its customers.
Average Collection Period The average collection period represents the number of days' of credit
sales. It is defined as:
Average trade receivables
Average daily credit sales
The average collection period may be compared with the firm's credit terms to gauge the efficiency
of credit management. Please note that this is an average figure and managers must monitor the
receivables due based on each customer.
2.3.3 Liquidity Ratios
Liquidity Ratios: Liquidity refers to the ability of a firm to meet its short-term obligations. Liquidity
ratios are generally based on the relationship between current assets (the sources for meeting short-
term obligations) and current liabilities. The important liquidity ratios are: current ratio and acid-test
ratio.
Current Ratio A very popular ratio, the current ratio is defined as:
Current assets
Current liabilities
Current assets include current investments, inventories, trade receivables, cash and cash equivalents,
and other current assets. Current liabilities represent liabilities that are expected to mature in the next
twelve months. These comprise of short-term borrowings, trade payables, other current liabilities,
and short-term provisions.
The current ratio measures the ability of the firm to meet its current liabilities - current assets get
converted into cash during the operating cycle of the firm and provide the funds needed to pay
current liabilities. Apparently, the higher the current ratio, the greater the short-term solvency.
However, in interpreting the current ratio the composition of current assets must not be overlooked.
A firm with a high proportion of current assets in the form of cash and receivables is more liquid
than one with a high proportion of current assets in the form of inventories even though both the
firms have the same current ratio.
Acid-test Ratio Also called the quick ratio, the acid-test ratio is defined as:
Current Asset – Inventory

Current liabilities
The acid-test ratio is a fairly stringent measure of liquidity. It is based on those current assets which
are highly liquid - inventories are excluded from the numerator of this ratio because inventories are
deemed to be the least liquid component of current assets.
Solvency ratios
Solvency of a business is important in the long run as well. A set of ratios to track the long term
financial position is called solvency ratios. Lenders are usually interested in this ratio. While debt
capital is a cheaper source of finance, it is also a riskier source of finance. Leverage ratios help in
assessing the risk arising from the use of borrowings or debt.
Two types of ratios are commonly used to analyze financial leverage: structural ratios and coverage
ratios. The most important structural ratio is the debt-equity ratio.
Debt-equity Ratio The debt-equity ratio shows the relative contributions of creditors and owners. It
is defined as:
Total liabilities
Shareholders’ funds
The numerator of this ratio consists of all liabilities1, non-current and current, and the denominator
consists of share capital and retained earnings2.
Sometimes also calculated as :
Long Term Debt
Shareholders’ funds
In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed by the
creditors. The ratio also captures the leverage in the business.
1
Alternatively, the ratio of non-current liabilities to equity may be calculated. What is important is that the same ratio
is used consistently when comparisons are made.
2
For the sake of simplicity, preference capital is subsumed under equity. Since preference capital is usually a very minor
source of finance, its inclusion or exclusion hardly makes any difference.
Coverage ratios show the relationship between debt servicing commitments and the sources for
meeting these burdens. The important coverage ratios are: interest coverage ratio, and debt service
coverage ratio.
Interest Coverage Ratio Also called the times interest earned, the interest coverage ratio is defined
as:
Profit before interest and taxes
Interest (Finance Cost)
Note that profit before interest and taxes are used in the numerator of this ratio because the
ability of a firm to pay interest is not affected by tax payment, as interest (or finance costs) oan debt
funds is a tax-deductible expense. A high interest coverage ratio means that the firm can easily meet
its interest burden even if earnings before interest and taxes suffer a considerable decline. This ratio
is widely used by lenders to assess a firm's debt capacity. There are several modifications of this ratio
Other ratios
There are several other ratios that can be computed by the firm. For example valuation ratios such as
earnings per share etc.
A Word of caution. Ratios are not an end in itself. It has to be used judiciously along with other
information.

Financial Accounting and Analysis

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Financial Accounting and Analysis

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Financial Accounting and Analysis

Prof. Padmini Srinivasan

READING MATERIAL FOR WEEK 1

Introduction to Financial Accounting

1.2 What is accounting?

1.3 Users of Accounting Information

1.4 Accounting System

The Accounting System

INPUT PROCESS OUTPUT

DOUBLE ENTRY Financial

The accounting system in detail:

Rules for measurement and reporting

• Accounting standards improve the quality of reporting.

Understanding the balance sheet through an example:

➢ Income Statement or Statement of Profit and Loss

➢ Cash Flow Statement, provides this information.

1.5 Preparation of financial statements using the accounting equation

Assets = Liabilities + Shareholder Equity

Our accounting equation now is as follows. figures in $ 000’

No transaction as we will record the transaction at the end of the month.

Assets = Liabilities + Shareholders' Equity

Assets = Liabilities + Shareholders' Equity

Note that cash comes down as we spend money.

Furniture (5) + Cash (455) +Inventory (60) = Borrowings (200) + Trade

6. Sold goods costing $40000 for $ 50000 in cash.

We now modify the basic equation into:

Assets = Liabilities + Equity

Assets = Liabilities + Equity (Contributed + Income - Expenses)

The accounting equation would be depicted as:

Furniture (5) + Inventory (20) + Cash (503) = Borrowings (200) + Trade

1.6 Accounting Equation to Financial Statements

Income statement for the month ending 31 January xx

Notice that this is the expanded version of the retained earnings.

Balance Sheet as on 31 January xx

Property Plant & Equipment (Furniture)1 5,000

Current Assets, Loans and Advances

ASSETS MATCH WITH SOURCE OF FINANCING THE ASSET

Expanding to next level

1.5 Accounting concepts

Going Concern Concept

Money measurement concept:

Handout for week 2

Assets = Liabilities + Equity

Assets are classified as follows:

1.1 Non-current Assets:

Let us elaborate each of the following.

Intangible asset is an identifiable non-monetary asset, without physical substance. Intangible

Non-current investments (also referred to as available for sale securities) generally

1.2 Current Assets

Current assets include current investments (Marketable securities), inventories, trade

Current investments (Marketable securities) mainly represent short-term holdings of units or

Cost Flow vs. Physical flow of goods:

2. Equity and Liabilities

Equity (also shareholders’ funds/Stockholders equity): Shareholders’ funds represent the

Retained Earnings /Reserves and surplus/Other Equity

Liabilities are broadly classified into:

2.2 Current Liabilities

Few additional links for reference:

HANDOUT FOR WEEK 3

Net Income = Revenue – Expenses

The Realization Concept

The Accrual concept

Some Major issues related to the Income Statement