UNIT 5

FINANCIAL STATEMENT ANALYSIS: BALANCE SHEET AND RELATED CONCEPTS, PROFIT AND LOSS STATEMENT AND
RELATED CONCEPTS, FINANCIAL RATIO ANALYSIS, CASH FLOW ANALYSIS, FUND FLOW ANALYSIS, COMPARATIVE
FINANCIAL STATEMENT, ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS, CAPITAL BUDGETING
TECHNIQUES

FINANCIAL STATEMENT ANALYSIS: BALANCE SHEET AND RELATED CONCEPTS

• The financial statements comprise of the accounts that are prepared by a firm to analyse its current position
and identify the transactions done in the entire year. It comprises of three statements, viz; Trading, profit and
loss and balance sheet.
• A business needs to prepare a trading and profit and loss account first before moving on to the balance
sheet. Trading and profit and loss accounts are useful in identifying the gross profit and net profits that a
business earns.
• The motive of preparing trading and profit and loss account is to determine the revenue earned or the losses
incurred during the accounting period.
The trading and profit and loss account are two different accounts that are formed within the general ledger. The two
parts of the account are:
1. Trading Account
2. Profit and Loss Account
Trading account is the first part of this account, and it is used to determine the gross profit that is earned by the
business while the profit and loss account is the second part of the account, which is used to determine the net profit
of the business.
1. Trading Account

Trading account is used to determine the gross profit or gross loss of a business which results from trading activities.
Trading activities are mostly related to the buying and selling activities involved in a business. Trading account is
useful for businesses that are dealing in the trading business. This account helps them to easily determine the overall
gross profit or gross loss of the business. The amount thus determined is an indicator of the efficiency of the business
in buying and selling.
The formulae for calculating gross profit is as follows:
Gross profit = Net sales – Cost of goods sold

Where

Net sales = Gross sales of the business minus sales returns, discounts and allowances.

The trading account considers only the direct expenses and direct revenues while calculating gross profit. This
account is mainly prepared to understand the profit earned by the business on the purchase of goods.
Items that are seen in the debit side include purchases, opening stock and direct expenses while credit side includes
closing stock and sales.
2. Profit and Loss Account

• Profit and loss account shows the net profit and net loss of the business for the accounting period. This
account is prepared in order to determine the net profit or net loss that occurs during an accounting period
for a business concern.
• Profit and loss account get initiated by entering the gross loss on the debit side or gross profit on the credit
side. This value is obtained from the balance which is carried down from the Trading account.
• A business will incur many other expenses in addition to the direct expenses. These expenses are deducted
from the profit or are added to gross loss and the resulting value thus obtained will be net profit or net loss.
The examples of expenses that can be included in a Profit and Loss Account are:

1. Sales Tax
2. Maintenance
3. Depreciation
4. Administrative Expense
5. Selling and Distribution Expense
6. Provisions
7. Freight and carriage on sales
8. Wages and Salaries
• These appear in the debit side of Profit and Loss Account while Commission received, Discount received,
profit obtained on sale of assets appear on the credit side.
• Net profit can be determined by deducting business expenses from the gross profit and adding other
incomes obtained
Net profit = Gross profit – Expenses + Other income

3. Balance Sheet: The term balance sheet refers to a financial statement that reports a company's assets, liabilities,
and shareholder equity at a specific point in time. Balance sheets provide the basis for computing rates of return
for investors and evaluating a company's capital structure.

In short, the balance sheet is a financial statement that provides a snapshot of what a company owns and owes, as
well as the amount invested by shareholders. Balance sheets can be used with other important financial statements
to conduct fundamental analysis or calculate financial ratios.

The balance sheet provides an overview of the state of a company's finances at a moment in time. It cannot give a
sense of the trends playing out over a longer period on its own. For this reason, the balance sheet should be
compared with those of previous periods.
FINANCIAL RATIO ANALYSIS

• Ratio analysis is referred to as the study or analysis of the line items present in the financial statements of
the company. It can be used to check various factors of a business such as profitability, liquidity, solvency and
efficiency of the company or the business.
• Ratio analysis is mainly performed by external analysts as financial statements are the primary source of
information for external analysts.
• The analysts very much rely on the current and past financial statements in order to obtain important data
for analysing financial performance of the company. The data or information thus obtained during the
analysis is helpful in determining whether the financial position of a company is improving or deteriorating.

Categories of Ratio Analysis

The following groups of ratios are considered in this article, which are as foll:

1. Liquidity Ratios: Liquidity ratios are helpful in determining the ability of the company to meet its debt obligations
by using the current assets. At times of financial crisis, the company can utilise the assets and sell them for obtaining
cash, which can be used for paying off the debts.
Some of the most commonly used liquidity ratios are quick ratio, current ratio, cash ratio, etc. The liquidity ratios are
used mostly by creditors, suppliers and any kind of financial institutions such as banks, money lending firms, etc for
determining the capacity of the company to pay off its obligations as and when they become due in the current
accounting period.
 Liquidity Ratios Formula

Current Ratio Current Assets / Current Liabilities

Quick Ratio (Cash + Marketable securities + Accounts receivable) / Current liabilities

Cash Ratio Cash and equivalent / Current liabilities

Net Working Capital Ratio Current Assets – Current Liabilities

• 2. Solvency Ratios: Solvency ratios are used for determining the viability of a company in the long term or in
other words, it is used to determine the long term viability of an organisation.
• Solvency ratios calculate the debt levels of a company in relation to its assets, annual earnings and equity.
Some of the important solvency ratios that are used in accounting are debt ratio, debt to capital ratio,
interest coverage ratio, etc.
• Solvency ratios are used by government agencies, institutional investors, banks, etc to determine the
solvency of a company.

3. Activity Ratio: Activity ratios are used to measure the efficiency of the business activities. It determines how the
business is using its available resources to generate maximum possible revenue.
These ratios are also known as efficiency ratios. These ratios hold special significance for business in a way that
whenever there is an improvement in these ratios, the company is able to generate revenue and profits much
efficiently.
Some of the examples of activity or efficiency ratios are asset turnover ratio, inventory turnover ratio, etc.

• 4. Profitability ratios: The purpose of profitability ratios is to determine the ability of a company to earn
profits when compared to their expenses. A better profitability ratio shown by a business as compared to its
previous accounting period shows that business is performing well.
• The profitability ratio can also be used to compare the financial performance of a similar firm, i.e it can be
used for analysing competitor performance.
• Some of the most used profitability ratios are return on capital employed, gross profit ratio, net profit ratio,
etc.
Use of Ratio Analysis
Ratio analysis is useful in the following ways:
1. Comparing Financial Performance: One of the most important things about ratio analysis is that it helps in
comparing the financial performance of two companies.
2. Trend Line: Companies tend to use the activity ratio in order to find any kind of trend in the performance.
Companies use data from financial statements that is collected from financial statements over many accounting
periods. The trend that is obtained can be used for predicting the future financial performance.
3. Operational Efficiency: Financial ratio analysis can also be used to determine the efficiency of managing the asset
and liabilities. It helps in understanding and determining whether the resources of the business is over utilised or
under-utilised.

CASH FLOW ANALYSIS

• Cash flow analysis refers to the evaluation of inflows and outflows of cash in an organisation obtained from
financing, operating and investing activities. In other words, we can say that it determines the ways in which
cash is earned by the company.
• It measures how much cash is generated and spent on the business during a given accounting period.
• While performing a cash flow analysis, the business needs to check all the line items that come under the
three cash flow categories to find out if the flow of capital is coming in or going out.
• Cash flow analysis can be performed by analysing the following activities:

1. Cash flow from operations or operating activities: In this type of cash flow the cash inflow is generated from the
internal activities. In other words, the cash flow is generated from the normal business operations. The examples of
such activities are rent, salaries for the employees.

2. Cash flow from investing activities: Cash flow from investing activities are mostly focused on purchase (outflow) or
sale of fixed assets (inflow), or on capital investments like purchase (outflow) or sales of stocks and securities of
another company (inflow).

3. Cash flow from financing activities: Cash flow from financing activities include buying back of shares, issuing of
stock. The activities of borrowing or repaying of loans is also a part of the cash inflow and outflow from the business.
Dividend payments can also be considered as a part of the cash flow from the financing activities.

Importance of Cash Flow Analysis

• Cash flow analysis is important due to the following reasons:
• Cash flow analysis helps in determining the working capital of a firm which is very essential for running the
business. Working capital is referred to as the money available to run the business and is calculated by
subtracting the current liabilities from the current assets.
• It provides a view of the liquidity position of the business and its capability to maintain its operations.
FUND FLOW ANALYSIS

Fund flow statement is a statement that compares the two balance sheets by analyzing the sources of funds (debt
and equity capital) and the application of funds (assets) and its reasons for any differences. It helps the company see
through where their money has been spent and from where they have received the money (long-term funds raised
by issues of shares, debentures, and sale of non-current assets).
 • The company prepares this statement to analyze the changes in working capital between two balance
sheets. It is based on historical data. It helps the management make future decisions, but management
cannot take the entire decision based on only the fund flow statement because it considers only fund-based
items.
• Last, management should prepare this statement because it considers all sources, i.e., from where the funds
are coming, and all applications, i.e., where the funds are going. This summarized statement helps
management to move further.

Limitations: The fund flow statement does not consider other features from the balance sheet and profit and loss
account. Therefore, it must be checked alongside the balance sheet and profit and loss account, and it also does not
display a company’s cash position.

COMPARATIVE FINANCIAL STATEMENT

• Comparative statements or comparative financial statements are statements of financial position of a

business at different periods. These statements help in determining the profitability of the business by
comparing financial data from two or more accounting periods.
• The data from two or more periods are updated side by side, which is why it is also known as Horizontal
Analysis. The advantage of such an analysis is that it helps investors to identify the trends of business, check
a company’s progress and also compare it with that of its competitors.
• The financial data will be considered to be comparative only when the same set of accounting principles are
being used for preparing the statements.
Types of Comparative Statements
There are two types of comparative statements which are as follows
1. Comparative income statement
2. Comparative balance sheet

Comparative Income Statement

• Income statements provide the details about the results of the operations of the business, and comparative
income statements provide the progress made by the business over a period of a few years. This statement
also helps in ascertaining the changes that occur in each line item of the income statement over different
periods.
• The comparative income statement not only shows the operational efficiency of the business but also helps
in comparing the results with the competitors, over different time periods. This is possible by comparing the
operational data spanning multiple periods of accounting.
The following points should be studied when analysing a comparative income statement
1. Compare the increase or decrease in sales with a relative increase in the cost of goods sold
2. Studying the operational profits of the business
3. Overall profitability of the business can be analysed by an increase or decrease in the net profit

Comparative Balance Sheet

• Comparative balance sheet analyses the assets and liabilities of business for the current year and also
compares the increase or decrease in them in relative as well as absolute parameters.

• A comparative balance sheet not only provides the state of assets and liabilities in different time periods, but
it also provides the changes that have taken place in individual assets and liabilities over different accounting
periods.

The following points should be studied when analysing a comparative balance sheet

1. The present financial and liquidity position (study working capital)

2. The financial position of the business in the long term

3. The profitability of the business

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Analysis and Interpretation refers to a systematic and critical examination of the financial statements. It not only
establishes cause and effect relationship among the various items of the financial statements but also presents the
financial data in a proper manner.

The main purpose of Analysis and Interpretation is to present the financial data in such a manner that is easily
understandable and self explanatory. This not only helps the accounting users to assess the financial performance of
the business over a period of time but also enables them in decision making and policy and financial designing
process. The main function of financial analysis is the pinpointing of the strength and weaknesses of a business
undertaking by regrouping and analysis of figures contained in financial statements, by making comparisons of
various components and by examining their content.

Analysis and interpretation of financial statements are an attempt to determine the significance and meaning
of the financial statement data so that a forecast may be made of the prospects for future earni ngs, ability to
pay interest, debt maturities, both current as well as long term, and profitability of sound dividend policy.

The main function of financial analysis is the pinpointing of the strength and weaknesses of a business undertaking
by regrouping and analysis of figures contained in financial statements, by making comparisons of various
components and by examining their content. The analysis and interpretation of financial statements represent the
last of the four major steps of accounting.
The first three steps involving the work of the accountant in the accumulation and summarisation of financial and
operating data as well as in the construction of financial statements are:

(i) Analysis of each transaction to determine the accounts to be debited and credited and the measurement and
variation of each transaction to determine the amounts involved.
(ii) Recording of the information in the journals, summarisation in ledgers and preparation of a worksheet.
(iii) Preparation of financial statements.
The fourth step of accounting, the analysis and interpretation of financial statements, results in the presentation of
information that aids the business managers, investors and creditors.
Interpretation of financial statements involves many processes like arrangement, analysis, establishing relationship
between available facts and drawing conclusions on that basis.

CAPITAL BUDGETING TECHNIQUES

Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or
equipment. The process involves analyzing a project's cash inflows and outflows to determine whether the expected
return meets a set benchmark.

There are different methods adopted for capital budgeting. The traditional methods or non-discount methods
include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV
method, profitability index method and IRR.

• Payback period method:

As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial
investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in
the project, with no consideration to time value of money. Through this method selection of a proposal is based on
the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with
results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider
the importance of time value of money and so the relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow

• Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as
a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having
ARR higher than the minimum rate established by the management will be considered and those below the
predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better means of comparison. It also
ensures compensation of expected profitability of projects through the concept of net earnings. However, this
method also ignores time value of money and doesn’t consider the length of life of the projects. Also it is not
consistent with the firm’s objective of maximizing the market value of shares.
ARR= Average income/Average Investment

• Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are
then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This
technique takes into account the interest factor and the return after the payback period.

• Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow
that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow
are compared to the original investment. If the difference between them is positive (+) then it is accepted or
otherwise rejected. This method considers the time value of money and is consistent with the objective of
maximizing profits for the owners.

• Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is
equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of
interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR
is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not
any rate determined outside the investment.
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IR < k = reject

• Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of
the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index
(PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term investments which involve more financial
risks. That is why proper planning through capital budgeting is needed.
2) Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning
through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e.
once a permanent asset is purchased its disposal shall incur losses.
3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the
company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long
run.