Analysis of Financial

Statements
Muhammad Sarwar
Definition of Analysis
To study or examine something in detail, in order to
discover more about it.
Examining or tending to examine things very carefully.
The process of separating something into its
constituent elements.
Definition of Financial Analysis
Financial analysis refers to an assessment of the
liquidity, solvency, stability and profitability of
a Business.
Importance of Financial Analysis
Financial statements are mainly prepared for decision
making purposes.
Analysis of financial statements is an attempt to assess
the efficiency and performance of an enterprise
Importance of Financial Analysis
Financial analysis also serves the following purposes
Measuring the profitability
Indicating the trend of achievements
Assessing the growth potential of the business
Comparative position in relation to other firms
Assess overall financial strengths
Assess solvency of the firm
Financial Reporting
The disclosure of financial information to the various
stakeholders about the financial performance and
financial position of the organization over a specified
period of time.
Stakeholders
Investors
Management
Trade unions
Lenders
Suppliers and trade creditors
Tax authorities
Researchers
Employees
Govt. and their agencies
Stock exchange
Statutory Financial Reports
Annual Reports
Qualitative Information
Quantitative Information
Quarterly reports
Tax returns
Prospectus
Other SECP filings
Factors affecting Statutory Reports
Generally Accepted Accounting Principles
Securities and Exchange Commission of Pakistan
(SECP)
International Financial Reporting Standards
Managerial Discretion
Qualities of Accounting Information
Reliability
Accounting information must be reliable. Reliability
of information can be explained with the following
points:
Verifiability
Neutrality
Representational Truthfulness
Qualities of Accounting Information
(Cont…)
Relevance
Information must relevant for the purpose for which
manager needs this information. To the point
information must be provided.
Example
In a company’s annual report only relevant
information is provided which the stakeholders need.
Qualities of Accounting Information
(Cont…)
Timing of Information
Timing of information is very much important.
Information must be available at the time of decision
making.
Accuracy
Information must be correct and accurate because the
inaccurate information can lead towards serious
financial constraints
Important Accounting Principles
Business Entity
The business entity means that business for which
financial statements are prepared is separate from its
owners.
Going Concern Concept
The business will remain in business for indefinite
period of time. It means that life of business will be
indefinite and it is assumed that it will not be
liquidated.
Important Accounting Principles (Cont…)
Time period
The life of business is divided into different periods to
assess the performance of the company.
Example:
Companies prepare the financial statements mostly on
annual basis.
Important Accounting Principles (Cont…)
Monetary Unit
To present the accounting information some standard of
measure is used.
Every country has different monetary unit.
Examples:
Pakistan: PKR
England: Pound
Important Accounting Principles (Cont…)
Historical Cost
Historical cost means the cost of an item on which it was
originally purchased. Historical cost is used in practice
as it is objective and determinable. A deviation from
historical cost is accepted only when it becomes
obvious that historical can not be recovered.
Important Accounting Principles (Cont…)
Conservatism
Conservatism principle means the accountant must
select measurement of a financial event which has
least favorable impact on financial statements in
recent period.
Important Accounting Principles (Cont…)
Realization
The revenue will be realized at a point in time when it
can be reasonably determined. But different methods
of revenue recognition can be used. These are as
follow:
Point of sale
End of production
Cost recovery
Important Accounting Principles (Cont…)
Matching
Matching means when to offset the costs associated with
the revenues earned.
Consistency
It means to give the same treatment to comparable
transactions from period to period. This means that
the same accounting principles must be applied
throughout the business life unless they are changed
by authorities concerned.
Important Accounting Principles (Cont…)
Full Disclosure
The accounting reports must disclose all the facts that
may influence the judgment of any stakeholder.
Materiality
It refers to the relative size and importance of an item to
a firm. An item that is material for one firm may not be
material for other one.
Important Accounting Principles (Cont…)
Transaction Approach:
The accountant records only events that affect the
financial position of the business.
Event must influence the financial position of the
business
Event must be measured in monetary terms.
Forms of Business Entities
Sole Proprietorship
In eyes of Law single owner business is not a legal entity
separate from its owner
but the accountant treats the business as a separate
accounting entity.
The profit or loss of the proprietorship goes on the
income tax return of the owner
The owner is responsible for the debts of the sole
proprietorship.
Forms of Business Entities
Partnership:
Each partner is personally responsible for the debts of
the partnership
 The accountant treats the partners and the business
as separate accounting entities
The profit or loss of the partnership goes on the
individual income tax return of the partners.
Forms of Business Entities
Company
is a legal entity incorporated under Companies Act 2017
in Pakistan
Ownership is evidenced by shares of stock
A corporation is considered to be separate and distinct
from the stockholders
The stockholders risk only their investment
They are not responsible for the debts of the
corporation.
The Financial Statements
Accounting for corporations, sole proprietorships, and
partnerships is the same
Except for the owners’ equity section of the balance
sheet
The owners’ equity section for a sole proprietorship
consists of the owners’ capital account
Owners’ equity section for a partnership has a capital
account for each partner
The more complicated owners’ equity section for a
corporation will be described in detail
The Financial Statements
Balance Sheet (Statement of Financial Position)
A balance sheet shows the financial condition of an
accounting entity as of a particular date
The balance sheet consists of three major sections:
I. Assets, the resources of the firm
II. Liabilities, the debts of the firm
III. Stockholders’ equity, the owners’ interest in the firm.
The Financial Statements
The income statement summarizes revenues and
expenses and gains and losses, ending with net income
It summarizes the results of operations for a particular
period of time
Net income is included in retained earnings in the
stockholders’ equity section of the balance sheet
The Financial Statements
The statement of cash flows details the inflows and
outflows of cash during a specified period of time
The same period that is used for the income statement
The statement of cash flows consists of three sections:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities.
The Financial Statements
Notes to the Accounts
The notes to the financial statements are used to
present additional information about items included
in the financial statements to present additional
financial information.
Notes are an integral part of financial statements
A detailed review of notes is essential to
understanding the financial statements.
Auditors’ Opinion on Financial Statement
Unqualified Opinion
Qualified Opinion
Adverse Opinion
Disclaimer of Opinion
Auditors’ Opinion on Financial Statement
Unqualified opinion. This opinion states that the
financial statements present fairly, in all material
respects
Qualified opinion. A qualified opinion states that,
except for the effects of the matter(s) to which the
qualification relates, the financial statements present
fairly, in all material respects,
Auditors’ Opinion on Financial Statement
Adverse opinion. This opinion states that the
financial statements do not present fairly the financial
position
Disclaimer of opinion. A disclaimer of opinion
states that the auditor does not express an opinion on
the financial statements.
A disclaimer of opinion is rendered when the auditor
has not performed an audit sufficient in scope to form an
opinion.
AUDITOR’S REPORT ON THE FIRM’S
INTERNAL CONTROLS
The internal control report is usually much longer
than the audit report
For some firms, the audit opinion and the report on
the firm’s internal controls have been combined
This results in one audit report that can be very long
Proxy
The proxy, the solicitation sent to stockholders for
the election of directors and for the approval of other
corporation actions, represents the shareholder
authorization regarding the casting of that
shareholder’s vote.
Consolidated Statements
Financial statements of legally separate entities may
be issued to show financial position, income, and cash
flow as they would appear if the companies were a
single entity
Basic Elements of the Balance Sheet
Assets = Liabilities + Stockholders’ Equity
ASSETS
Assets are probable future economic benefits
obtained or controlled by an entity as a result of
past transactions or events.
Assets may be physical, such as land, buildings,
inventory of supplies, material, or finished products
Assets may also be intangible, such as patents and
trademarks
Basic Elements of the Balance Sheet
Assets are normally divided into two major categories:
current and noncurrent (long-term).
Current assets are assets:
 (1) in the form of cash, (2) that will normally be
realized in cash, or
(3) that conserve the use of cash during the operating
cycle of a firm or for one year, whichever is longer
The operating cycle covers the time between the
acquisition of inventory and the realization of cash
from selling the inventory
Current Assets
Cash is the most liquid asset, includes negotiable
checks and unrestricted balances in current accounts,
Cash on hand.
Savings accounts are classified as cash even though the
bank may not release the money for a specific period
of time.
Current Assets
Marketable securities (also labeled short-term
investments) are characterized by their marketability
at a readily determinable market price.
A firm holds marketable securities to earn a return on
near-cash resources.
Management must intend to convert these assets to
cash during the current period for them to be
classified as marketable securities.
The carrying basis of debt and equity marketable
securities is fair value
Current Assets
Accounts receivable are amount that arise from
credit sales or services rendered to customers.
Accounts receivable are shown net of allowances to
reflect their realizable value
This amount is expected to be collected.
The most typical allowances are for bad debts
(uncollectible accounts).
Other allowances may account for expected sales
discounts, which are given for prompt payment or for
sales returns.
Current Assets
Inventories are the balance of goods on hand. In a
manufacturing firm, they include raw materials, work
in process, and finished goods.
Inventories will be carried at cost, expressed in terms
of lower-of-cost-or-market
Raw Materials
Work in Process
Finished Goods
Noncurrent or long-term assets take longer than
a year or an operating cycle to be converted to cash or to
conserve cash.

Note: Some industries, such as banking (financial

institutions), insurance, and real estate, do not divide
assets (or liabilities) into current and noncurrent.
Chapter 12 reviews specialized industries.