FINANCIAL

STATEMENTS

IBS Bangalore
23 October 2010
Faculty : Aparna Hawaldar
Forms of Business Organization
 Sole Proprietorship
 Partnership
 Company
• Private Limited Company
• Joint Stock/Public Limited Company
 Users of Financial Statements
 Accounting system is the information
system that identifies, records and
communicates the economic events of
an organization to the interested users
 Internal Users and External Users
Internal Users External Users
 Resource providers
(investors &
 People who work
creditors)
for the business
 Recipients of goods
and services
(customers)
 Parties performing a
review or a oversight
function (Regulatory
agencies)
Generally Accepted Accounting
Principles (GAAP)
Assumptions:
Accounting Entity
Going Concern
Monetary
Period Principles:
Historical Cost
Full Disclosure
Accounting Entity Assumption
 The business is separate and distinct
from its owners.
 Entity’s assets and other financial
elements are not commingled with
those of the owners.
 The economic entity assumption is an
accounting concept, and not a legal
construct.
Going Concern Assumption
• The business is assumed to continue
indefinitely unless terminated by
owners.

• The basis of recording financial

elements is historical accounting.
 Monetary Unit Assumption
• Money is the common unit of measure of
economic transactions.

• Use of a monetary unit is relevant, simple

to understand and universally available.

• Price level changes are ignored in

accounting, leading to the assumption that
the rupee remains relatively stable.
Periodicity Assumption

• Economic activity of an entity may be

artificially divided into time periods
for reporting purposes.

• Shorter time periods are subject to

revisions but may be more timely.
 Historical Cost Principle
 Transaction is recorded at its acquisition
price.

 It is not changed to reflect market price.

 The principle applies to most assets and

liabilities.
The Matching Principle
 Expenses are matched to the revenues
they help generate.

 There should be a logical, rational

association of revenues and expenses.

 If a cost does not benefit future periods,

it is recorded in the current period as an
expense.
Full Disclosure Principle
 Financial statements must report what
a reasonable person would need to
know to make an informed decision.
 Disclosure may be made:
• within the body of the financial
statements,
• as notes to those statements, or
• as supplementary information.
Constraints: Cost Benefit Rule
Cost-Benefit Relationship : The cost of
providing information should not
outweigh the benefit derived
.
• Costs and benefits are not always
obvious or measurable.

• Sound judgment must be used in

providing information.
Constraints: Materiality
Materiality refers to an item’s importance to
a firm’s overall financial operations.
• An item must make a difference to be
material and be disclosed.
• It is a matter of the relative significance of
the element.
• Both quantitative and qualitative factors
are to be considered in determining
relative significance.
 Constraints: Conservatism
 Conservatism suggests that the preparer,
when in doubt, choose a conservative solution.

 This solution will be least likely to overstate

assets and income.

 Conservatism does not suggest that net assets

or net income be deliberately understated.
 Qualitative Characteristics
 Relevance - Information that is capable of
making a difference in a decision context
 Reliability - Can be relied on to represent
the true, underlying situation.
 Comparability - measured & reported in a
similar manner for different businesses
 Understandability
Elements of Financial Statements

Liabilities

Assets Equity

Financial
Statements
Revenues Gains

Expense Losses
 Balance Sheet Income Statement
 Assets: Probable future  Comprehensive Income:
economic benefits All changes in equity
resulting from past from non-owner sources
transactions
 Revenues: Inflows from
 Liabilities: Probable
future sacrifices of entity’s ongoing
economic benefits operations
resulting from past  Expenses: Outflows from
transactions entity’s ongoing
 Equity: Residual or operations
ownership interest  Gains:
 Investment by Owners:  Losses:
 Distributions to
Owners:
Principal Financial Statements

Cash Flow Income

Statement Statement

Balance
Sheet
FINANCIAL RATIOS
 Objectives of Ratio Analysis
 Standardize financial information for
comparisons
 Evaluate current operations
 Compare performance with past
performance
 Compare performance against other firms or
industry standards
 Study the efficiency of operations
 Study the risk of operations
 Rationale Behind Ratio Analysis
 A firm has resources
 It converts resources into profits through
• production of goods and services
• sales of goods and services
 Ratios
• Measure relationships between resources and
financial flows
• Show ways in which firm’s situation deviates from
• Its own past
• Other firms
• The industry
 Types of Ratios
 Financial Ratios:
• Liquidity Ratios
• Leverage Ratios : Structural & Coverage
• Operational Ratios:
• Activity (Turnover) Ratios
• Profitability Ratios
 Valuation Ratios
 Liquidity Ratios
Assess the firm’ ability to cover current
obligations to maintain sound liquidity

 Current Ratio: Current Assets

Current Liabilities

 Quick (Acid Test) Ratio:

Current Assets – Inventories
Current Liabilities
 Leverage Ratios – Structural
Assess ability to cover long term debt obligations
 Debt Equity Ratio: Debt
Shareholders funds
 Capital Gearing Ratio :
Fixed interest bearing securities
Equity Shareholders funds
 Fixed Asset Ratio : Fixed Assets
Capital Employed
 Leverage Ratios - Coverage
Ability of the firm to service the debt

Interest Coverage Ratio: EBIT

Interest Expense

Debt Service Coverage Ratio :

 Profitability Ratios
Assess profits relative to amount of resources used
 Gross Profit Margin Ratio
 Net Profit Margin Ratio

 Return on Capital Employed (ROCE):

EBIT
(Average total Debt + shareholders equity)

 Return on Equity (ROE): Net Income

Average Equity
 Activity (Turnover) Ratios
Assess amount of activity relative to amount of resources
used
 Total Asset Turnover Ratio:
Sales
Average total assets

 Debtors Turnover Ratio

Net Credit Sales
Average Debtors

 Inventory Turnover Ratio:

Cost of goods sold
Average Inventory
 Valuation Ratios
Assess market price relative to assets or earnings

 Earnings Per Share (EPS)

Net Income (PAT)
Number of shares
 Price-Earnings Ratio (PE Ratio)
Market price of the share
Earnings Per Share
 Capitalization ratio : 1/PE Ratio
 The DuPont Analysis
 Method to breakdown ROE into:
• ROA and Equity Multiplier
 ROA is further broken down as:
• Profit Margin and Asset Turnover
 Helps to identify sources of strength and
weakness in current performance
 Helps to focus attention on value drivers
The DuPont Analysis
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r
The DuPont Analysis

ROE  ROA  Equity Multiplier

Net Income Total Assets
 
Total Assets Common Equity

ROA  Profit Margin  Total Asset Turnover

Net Income Sales
 
Sales Total Assets
 Summary of Financial Ratios
 Ratios help to:
• Evaluate performance
• Structure analysis
• Show the connection between activities and
performance
 Benchmark with
• Past for the company
• Industry
 Ratios adjust for size differences
 Limitations of Ratio Analysis
 A firm’s industry category is often difficult
to identify
 Published industry averages are only
guidelines
 Accounting practices differ across firms
 Sometimes difficult to interpret deviations
in ratios
 Industry ratios may not be desirable
targets
 Seasonality affects ratios