Complied By: Prof.

Puja Salunke

Unit 2

Financial Statements and Financial Analysis

2.1 Concept of Financial Statement

2.2 Importance and Objectives of Financial Statements

2.3 Types of Financial Statements – For Public and For Management

2.4 Statutory Provisions Regarding Financial Statements

2.5 Technique of Financial Statement Analysis

2.1 Concept of Financial Statement

A Financial Statement is a collection of data organized according to logical and

consistent accounting procedures, which indicate the financial position of the firm.

Financial Statement is prepared primarily for decision accounting. On other words,

“Financial Statement provide a summary of the accounts of business enterprise,

the balance sheet reflecting the assets, liabilities and capital as on a certain date

and the income statement showing the results of operation during a certain period”.

It is prepared as an end result of financial accounting and it is the major sources of

financial information of an enterprise.

Financial Statements are written records that convey the business activities and

the financial performance of a company. The balance sheet provides an overview

of assets, liabilities, and stockholders’ equity as a snapshot in time.

The income statement primarily focuses on a company’s revenues and expenses

during a particular period. Once expenses are subtracted from revenues, the

statement produces a company’s profit figure called net income. The cash flow

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statement (CFS) measures how well a company generated cash to pay its debt

obligations, fund its operating expenses, and fund investments.

Financial statements are basically reports that depict financial and accounting

information relating to businesses. A company’s management uses it to

communicate with external stakeholders. These include shareholders, tax authorities,

regulatory bodies, investors, creditors, etc.

These statements basically include the following reports:

1. Balance sheet

2. Profit and Loss statement

3. Statement of cash flow

4. Income sheet

2.2 Importance and Objectives of Financial Statements

Importance of Financial Statements:

The importance of financial statements lies in their utility to satisfy the varied

interest of different categories of parties such as management, creditors, public,

etc.

1. Importance to Management:

Increase in size and complexities of factors affecting the business operations

necessitate a scientific and analytical approach in the management of modern

business enterprises.

The management team requires up to date, accurate and systematic financial

information for the purposes. Financial statements help the management to

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understand the position, progress and prospects of business vis-a-vis the

industry.

By providing the management with the causes of business results, they enable

them to formulate appropriate policies and courses of action for the future. The

management communicates only through these financial statements, their

performance to various parties and justify their activities and thereby their

existence.

A comparative analysis of financial statements reveals the trend in the progress

and position of enterprise and enables the management to make suitable

changes in the policies to avert unfavorable situations.

2. Importance to the Shareholders:

Management is separated from ownership in the case of companies.

Shareholders cannot, directly, take part in the day-to-day activities of business.

However, the results of these activities should be reported to shareholders at

the annual general body meeting in the form of financial statements.

These statements enable the shareholders to know about the efficiency and

effectiveness of the management and also the earning capacity and financial

strength of the company.

By analyzing the financial statements, the prospective shareholders could

ascertain the profit earning capacity, present position and future prospects of

the company and decide about making their investments in this company.

Published financial statements are the main source of information for the

prospective investors.

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3. Importance to Lenders/Creditors:

The financial statements serve as a useful guide for the present and future

suppliers and probable lenders of a company.

It is through a critical examination of the financial statements that these groups

can come to know about the liquidity, profitability and long-term solvency

position of a company. This would help them to decide about their future course

of action.

4. Importance to Labour:

Workers are entitled to bonus depending upon the size of profit as disclosed by

audited profit and loss account. Thus, P & L a/c becomes greatly important to

the workers. In wages negotiations also, the size of profits and profitability

achieved are greatly relevant.

5. Importance to the Public:

Business is a social entity. Various groups of society, though directly not

connected with business, are interested in knowing the position, progress and

prospects of a business enterprise.

They are financial analysts, lawyers, trade associations, trade unions, financial

press, research scholars and teachers, etc. It is only through these published

financial statements these people can analyze, judge and comment upon

business enterprise.

6. Importance to National Economy:

The rise and growth of corporate sector, to a great extent, influence the

economic progress of a country. Unscrupulous and fraudulent corporate

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managements shatter the confidence of the general public in joint stock

companies, which is essential for economic progress and retard the economic

growth of the country.

Financial Statements come to the rescue of general public by providing

information by which they can examine and assess the real worth of the

company and avoid being cheated by unscrupulous persons.

The law endeavors to raise the level of business morality by compelling the

companies to prepare financial statements in a clear and systematic form and

disclose material information.

This has increased the confidence of the public in companies. Financial

statements are also essential for the various regulatory bodies such as tax

authorities, Registrar of companies, etc. They can judge whether the

regulations are being strictly followed and also whether the regulations are

producing the desired effect or not, by evaluating the financial statements.

Objectives of Financial Statements:

Stakeholders of a company heavily rely on financial statements to understand its

functioning. They portray the true state of affairs of the company. Here are some

objectives of financial statements:

 These statements show an accurate state of a company’s economic assets

and liabilities. External stakeholders like investors and authorities generally

do not possess this information otherwise.

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 They help in predicting the extent of a company’s capacity to earn profits.

Shareholders and investors can use this data to make their financial

decisions.

 These statements depict the effectiveness of a company’s management.

How well a company is performing depends on its profitability, which these

statements show.

 They even help readers of these statements know the accounting

policies used in them. This helps in understanding statements more

comprehensively.

 These statements also provide information relating to the company’s cash

flows. Investors and creditors can use this data to predict the company’s

liquidity and cash requirements.

 Finally, they explain the social impact of businesses. This is because it

shows how the company’s external factors affect its functioning.

2.3 Types of Financial Statements – For Public and For Management

There are generally just two types of financial statements:

1. Balance sheet

2. Statement of profit and loss

Apart from these two, accountants also create some other reports to understand

the movement of funds. For example, cash flow statements show how liquid a

business is.

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1. Balance Sheet

Let us see in detail the types of financial statements. A balance sheet is basically

an accurate representation of assets and liabilities of a business. They contain all

details pertaining to the long-term and short-term assets, debts, and capital of

a firm. It is one of the most important tools stakeholders use to understand a

particular business.

Every company has to annually prepare and present a balance sheet according

to the (Revised) Schedule VI of Companies Act, 1956. Companies generally

cannot deviate from this format. Apart from this, they even have to follow

the relevant Accounting Standards of ICAI.

Contents of a Balance Sheet

According to Schedule VI, a balance sheet must comprise the following contents

and requirements. Every balance sheet basically contains these parts: share

capital, reserve and surplus, current & non-current assets and liabilities,

borrowings, etc.

a) Share capital

Balance sheets must state disclosures relating to share capital in notes to

accounts. Further, they must contain the following modifications and additions:

All rights, preference and restrictions associated with each class of share

have to be specified.

Specific disclosures pertaining to the identity of certain shareholders.

Details regarding the number of shares issued, subscribed, paid, reserved

and bought back.

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b) Reserve and surplus

The balance sheet must classify reserves and surplus funds in the following

manner:

 Capital reserve

 Capital redemption reserve

 Debenture redemption reserve

 Securities premium reserve

 Surplus funds

c) Current & non-current assets

Every balance sheet has to classify assets in categories of current and non-

current. A current item has typical features like these: it is used for less than

12 months, it is mainly held for trading, etc. This distinction is important

because it helps make the details of assets more comprehensive.

d) Borrowings

Similar to assets, borrowings and liabilities can also be current or non-current.

Loans are debts that have a repayment period of more than 12 months are

non-current borrowings. For example, large bank loans are generally non-

current in nature. On the contrary, those with shorter repayment periods are

current liabilities.

e) Investments

Even investments come under categories of current and non-current. Investments

which can be realized within 12 months are current investments, while others are

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non-current. Every balance sheet must reflect the business’s investments in this

format.

Apart from these basic contents, a typical balance sheet also contains some other

information. This includes trade receivables, trade payables, cash and cash

equivalent, inventories, etc.

2. Statement of Profit and Loss

Apart from the balance sheet, a statement of profit and loss is the second

important financial statement. It basically shows revenues and expenses of a

business. Deduction of taxes from this depicts the final profit or loss amount. The

format of a profit and loss statement is also given in Schedule VI (Part II) of

Companies Act, 1956.

Contents of a Statement of Profit and Loss

a) Revenue from operations, including sales and other operating revenue.

Furthermore, finance companies have to state revenue from interest,

dividend and other services.

b) Other income, including income from interest, dividend, non-operating

income and income from the sale of investments.

c) Expenses, including costs of materials, stock-in-trade, finance costs,

depreciation, employee’s benefits and all other expenses.

Treatment of these three items will finally result in a statement of profit and loss.

Accountants also have to deduct taxes and extraordinary items from the profit to

ascertain the final profit or loss amount.

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2.4 Statutory Provisions Regarding Financial Statements

1) Section 215 of Companies Act, 1956 – Authentication of Balance Sheet & Profit

and Loss Account as per the provisions of Section 215: (1), the balance sheet

& profit and loss account of a company.

Shall be signed on behalf in the case of a banking company by the persons

specified in clause (a) or clause (b) of sub-section (2) of section 29 of Banking

Companies Act, 1949 (now the Banking Regulations Act, 1949) i.e. (a) in the

case of a banking company incorporated in India, by the manager or the

principal officer of the company and where there are not more than three

directors of the company, by at least three of these directors, or where there

are not more than three directors, by the directors, and (b) in the case of a

banking company incorporated (outside India) by the manager or agent of the

principal office of the company in India.

In the case of any other company, shall be signed by manager or secretary and

not less than 2 directors of the company one of whom shall be managing

director if there is one.

In the case of non-banking company shall be signed by the director who is in

India if only he is in India, but shall attach a statement explaining the reason for

non-compliance of the above. [215(2)]

Shall be approved by the Board before they are signed on their behalf and

before submission to the auditors for their report 215(3).

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2) Section 229 of Companies Act, 1956 – Signature of audit report etc.

The auditor’s report shall be signed only by the

 The auditor appointed by the firm

 Partner in the firm practicing in India the Appointment of the auditor shall

be in keeping with the Provisions of Section 226(1) of the Companies

Act, 1956.

3) Section 223 of Companies Act, 1956 – Penalty for non-compliance by auditor

with section 277 and Section 229. This Section provides that if any auditor’s

report is made or if any company document is signed or authenticated

otherwise than in conformity with Section 227 (Powers and Duties of Auditors)

or Section 229 (Signature of audit report), then the auditor and the other person

(other than the auditor) who wilfully defaults by wrongly signing shall be

punishable with fine which may extend to ten thousand rupees (prior to

31.12.2000 the penalty was up to Rs.1000).

2.5 Technique of Financial Statement Analysis

There are several techniques used by analysts to develop a fair understanding of a

company’s financial performance over a period. The three most commonly

practiced methods of financial analysis are – horizontal analysis, vertical analysis,

and ratio and trend analysis.

 Horizontal Analysis

Performance of two or more periods are compared to understand company’s

progress over a period. Each component of a ledger is compared with the

previous period to gather a general understanding of trends.

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For example, if the cost of final goods rises by 20 percent in a year, but it is not

reflected in the revenue earned, then there may be some components which

are costing the company more.

 Vertical Analysis

Vertical analysis helps to establish a correlation between different line items in

a ledger. It gives analysts an understanding of overall performance in terms of

revenue and expenses. The results are reviewed as a ratio.

 Ratio analysis

Ratio Methods of financial analysis is used to compare one financial component

against another and reveal a general upward or downward trend. Once the ratio

is calculated, it can be compared against the previous period to analyse if the

company’s performance is in accord with set expectations. It helps

management highlight any deviation from set expectations and take corrective

measures.

 Trend analysis

It helps to analyse trends over three or more periods. It takes into account

incremental change patterns, considering the earliest year as the base period.

A change in a financial statement will either reveal a positive or negative trend.

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