FINANCIAL STATEMENTS

  INTRODUCTION
A financial statement is an official document of the firm, which explores the entire financial
information of the firm. The main aim of the financial statement is to provide information
and understand the financial aspects of the firm. Hence, preparation of the financial
statement is important as much as the financial decisions.
MEANING AND DEFINITION
According to Hamptors John, the financial statement is an organized collection of data
according to logical and consistent accounting procedures. Its purpose is to convey an
understanding of financial aspects of a business firm. It may show a position at a moment
of time as in the case of a balance-sheet or may reveal a service of activities over a given
period of time, as in the case of an income statement.
Financial statements are the summary of the accounting process, which, provides
useful information to both internal and external parties. John N. Nyer also defines it
“Financial statements provide a summary of the accounting of a business enterprise, the
balance-sheet reflecting the assets, liabilities and capital as on a certain data and the income
statement showing the results of operations during a certain period”.
Financial statements generally consist of two important statements:
(i) The income statement or profit and loss account.
(ii) Balance sheet or the position statement.
A part from that, the business concern also prepares some of the other parts of
statements, which are very useful to the internal purpose such as:
(i) Statement of changes in owner’s equity.
(ii) Statement of changes in financial position.
12 Financial Management
Financial Statement
Income Statement Position Statement
Statement of changes
in Owner's Equity
Statement of changes
in Financial Position
Fig. 2.1 Financial Statement
Income Statement
Income statement is also called as profit and loss account, which reflects the operational
position of the firm during a particular period. Normally it consists of one accounting year.
It determines the entire operational performance of the concern like total revenue generated
and expenses incurred for earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern.
Gross profit is determined by preparation of trading or manufacturing a/c and net profit is
determined by preparation of profit and loss account.
Position Statement
Position statement is also called as balance sheet, which reflects the financial position of
the firm at the end of the financial year.
Position statement helps to ascertain and understand the total assets, liabilities and
capital of the firm. One can understand the strength and weakness of the concern with
the help of the position statement.
Statement of Changes in Owner’s Equity
It is also called as statement of retained earnings. This statement provides information
about the changes or position of owner’s equity in the company. How the retained earnings
are employed in the business concern. Nowadays, preparation of this statement is not
popular and nobody is going to prepare the separate statement of changes in owner’s equity.
Statement of Changes in Financial Position
Income statement and position statement shows only about the position of the finance,
hence it can’t measure the actual position of the financial statement. Statement of changes
in financial position helps to understand the changes in financial position from one period
to another period.
Financial Statement Analysis 13
Statement of changes in financial position involves two important areas such as fund
flow statement which involves the changes in working capital position and cash flow
statement which involves the changes in cash position.
TYPES OF FINANCIAL STATEMENT ANALYSIS
Analysis of Financial Statement is also necessary to understand the financial positions during
a particular period. According to Myres, “Financial statement analysis is largely a study of
the relationship among the various financial factors in a business as disclosed by a single set
of statements and a study of the trend of these factors as shown in a series of statements”.
Analysis of financial statement may be broadly classified into two important types on
the basis of material used and methods of operations.
Types of Financial
Analysis
On the basis of
Materials Used
On the basis of
Methods of Operations
External
Analysis
Internal
Analysis
Horizontal
Analysis
Vertical
Analysis
Fig. 2.2 Types of Financial Statement Analysis
1. Based on Material Used
Based on the material used, financial statement analysis may be classified into two
major types such as External analysis and internal analysis.
A. External Analysis
Outsiders of the business concern do normally external analyses but they
are indirectly involved in the business concern such as investors, creditors,
government organizations and other credit agencies. External analysis is
very much useful to understand the financial and operational position of
the business concern. External analysis mainly depends on the published
financial statement of the concern. This analysis provides only limited
information about the business concern.
B. Internal Analysis
The company itself does disclose some of the valuable informations to the
business concern in this type of analysis. This analysis is used to understand
14 Financial Management
the operational performances of each and every department and unit of the
business concern. Internal analysis helps to take decisions regarding achieving
the goals of the business concern.
2. Based on Method of Operation
Based on the methods of operation, financial statement analysis may be classified
into two major types such as horizontal analysis and vertical analysis.
A. Horizontal Analysis
Under the horizontal analysis, financial statements are compared with several
years and based on that, a firm may take decisions. Normally, the current
year’s figures are compared with the base year (base year is consider as 100)
and how the financial information are changed from one year to another.
This analysis is also called as dynamic analysis.
B. Vertical Analysis
Under the vertical analysis, financial statements measure the quantities
relationship of the various items in the financial statement on a particular period.
It is also called as static analysis, because, this analysis helps to determine the
relationship with various items appeared in the financial statement. For example,
a sale is assumed as 100 and other items are converted into sales figures.
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is interpreted mainly to determine the financial and operational
performance of the business concern. A number of methods or techniques are used to
analyse the financial statement of the business concern. The following are the common
methods or techniques, which are widely used by the business concern.
Techniques
Ratio
Analysis
Comparative
Statement
Trend
Analysis
Cash Flow
Statement
Funds Flow
Statement
Common
Size
Analysis
Fig. 2.3 Techniques of Financial Statement Analysis
1. Comparative Statement Analysis
A. Comparative Income Statement Analysis
B. Comparative Position Statement Analysis
Financial Statement Analysis 15
2. Trend Analysis
3. Common Size Analysis
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis
Comparative Statement Analysis
Comparative statement analysis is an analysis of financial statement at different period of
time. This statement helps to understand the comparative position of financial and
operational performance at different period of time.
Comparative financial statements again classified into two major parts such as
comparative balance sheet analysis and comparative profit and loss account analysis.
Comparative Balance Sheet Analysis
Comparative balance sheet analysis concentrates only the balance sheet of the concern at
different period of time. Under this analysis the balance sheets are compared with previous
year’s figures or one-year balance sheet figures are compared with other years. Comparative
balance sheet analysis may be horizontal or vertical basis. This type of analysis helps to
understand the real financial position of the concern as well as how the assets, liabilities
and capitals are placed during a particular period.
Exercise 1
The following are the balance sheets of Tamil Nadu Mercantile Bank Ltd., for the years
2003 and 2004 as on 31st March. Prepare a comparative balance sheet and discuss the
operational performance of the business concern.
Balance Sheet of Tamil Nadu Mercantile Bank Limited
As on 31st March (Rs. in thousands)
Liabilities 2003 2004 Assets 2003 2004
Rs. Rs. Rs. Rs.
Capital 2,845 2,845 Cash and Balance
Reserve and with RBI 27,06,808 22,37,601
Surplus 39,66,009 47,65,406 Balance with Banks
Deposits 4,08,45,783 4,40,42,730 and Money at call &
Borrowings and short notice 11,36,781 16,07,975
Other Liabilities 7,27,671 2,84,690 Investments 2,14,21,060 2,35,37,098
Provisions 16,74,165 17,99,197 Advances 1,95,99,764 2,11,29,869
Fixed Assets 4,93,996 5,36,442
Other Assets 18,58,064 18,35,883
4,72,16,473 5,08,94,868 4,72,16,473 5,08,94,868
16 Financial Management
Solution
Comparative Balance Sheet Analysis
Increased/ Increased/
Particulars Year ending 31st March Decreased Decreased
(Amount) (Percentage)
2003 2004
Rs. Rs. Rs. Rs.
Assets
Current Assets
Cash and Balance with
RBI 27,06,808 22,37,601 (+) 4,69,207 (+) 17.33
Balance with Banks and
money at call and short notice 11,36,781 16,07,975 (–) 4,71,194 (–) 41.45
Total Current Assets 38,43,589 38,45,576 1987 0.052
Fixed Assets
Investments 2,14,21,060 2,35,37,098 (-) 21,16,038 (-) 9.88
Advances 1,95,99,764 2,11,39,869 (-) 15,40,105 (-) 7.86
Fixed Assets 4,93,996 5,36,442 (-) 42,446 (-) 8.59
Other Assets 18,58,064 18,35,883 (+) 22,181 (+) 1.19
Total Fixed Assets 4,33,72,884 4,70,49,292 (+) 36,76,408 8.48
Total Assets 4,72,16,473 5,08,94,868 36,78,395 7.79
Current Liabilities
Borrowings 7,27,671 2,84,690 (+) 4,42,981 60.88
Other Liability and
Provisions 16,74,165 17,99,197 (–) 1,25,032 7.47
Total Current Liability 24,01,836 20,83,887 3,17,949 13.24
Fixed Liability Capital 2,845 2,845 — —
Reserves surplus 39,66,009 47,65,406 (+) 7,99,397 20.16
Deposit 4,08,45,783 4,40,42,730 (+) 31,96,947 7.83
Total Fixed Liability 4,48,14,637 4,88,10,981 (+) 39,96,344 8.92
Total Liability 4,72,16,473 5,08,94,868 36,78,395 7.79
Comparative Profit and Loss Account Analysis
Another comparative financial statement analysis is comparative profit and loss account
analysis. Under this analysis, only profit and loss account is taken to compare with previous
year’s figure or compare within the statement. This analysis helps to understand the
operational performance of the business concern in a given period. It may be analyzed on
horizontal basis or vertical basis.
Financial Statement Analysis 17
Trend Analysis
The financial statements may be analysed by computing trends of series of information. It
may be upward or downward directions which involve the percentage relationship of each
and every item of the statement with the common value of 100%. Trend analysis helps to
understand the trend relationship with various items, which appear in the financial
statements. These percentages may also be taken as index number showing relative changes
in the financial information resulting with the various period of time. In this analysis, only
major items are considered for calculating the trend percentage.
Exercise 2
Calculate the Trend Analysis from the following information of Tamilnadu Mercantile
Bank Ltd., taking 1999 as a base year and interpret them (in thousands).
Year Deposits Advances Profit
1999 2,05,59,498 97,14,728 3,50,311
2000 2,66,45,251 1,25,50,440 4,06,287
2001 3,19,80,696 1,58,83,495 5,04,020
2002 3,72,99,877 1,77,26,607 5,53,525
2003 4,08,45,783 1,95,99,764 6,37,634
2004 4,40,42,730 2,11,39,869 8,06,755
Solution
Trend Analysis (Base year 1999=100)
(Rs. in thousands)
Deposits Advances Profits
Year Amount Trend Amount Trend Amount Trend
Rs. Percentage Rs. Percentage Rs. Percentage
1999 2,05,59,498 100.0 97,14,728 100.0 3,50,311 100.0
2000 2,66,45,251 129.6 1,25,50,440 129.2 4,06,287 115.9
2001 3,19,80,696 155.5 1,58,83,495 163.5 5,04,020 143.9
2002 3,72,99,877 181.4 1,77,26,607 182.5 5,53,525 150.0
2003 4,08,45,783 198.7 1,95,99,764 201.8 6,37,634 182.0
2004 4,40,42,730 214.2 2,11,39,869 217.6 8,06,755 230.3
Common Size Analysis
Another important financial statement analysis techniques are common size analysis in
which figures reported are converted into percentage to some common base. In the balance
sheet the total assets figures is assumed to be 100 and all figures are expressed as a percentage
of this total. It is one of the simplest methods of financial statement analysis, which reflects
the relationship of each and every item with the base value of 100%.
18 Financial Management
Exercise 3
Common size balance sheet of Tamilnadu Mercantile Bank Ltd., as on 31st March 2003
and 2004.
Particulars 31st March 2003 31st March 2004
Amount Percentage Amount Percentage
Fixed Assets
Investments 2,14,21,060 45.37 2,35,37,098 46.25
Advances 1,95,99,764 41.51 2,11,39,869 41.54
Fixed Assets 4,93,996 1.05 5,36,442 1.05
Other Assets 18,58,064 3.94 18,35,883 3.61
Total Fixed Assets 4,33,72,884 91.86 4,70,49,292 94.44
Current Assets
Cash and Balance with
RBI 27,06,808 5.73 22,37,601 4.40
Balance with banks
and money at call
and short notice 11,36,781 2.41 16,07,975 3.20
Total Current Assets 38,43,589 8.14 38,45,576 7.60
Total Assets 4,72,16,473 100.00 5,08,94,868 100.00
Fixed Liabilities
Capital 2,845 0.01 2,845 0.01
Reserve and Surplus 39,66,009 8.40 47,65,406 9.36
Deposits 4,08,45,783 86.50 4,40,42,730 86.54
Total Fixed Liabilities 4,48,14,637 94.91 4,88,10,981 95.91
Current Liability
Borrowings 7,27,671 1.54 2,84,690 0.56
Other Liabilities
Provisions 16,74,165 3.55 17,99,197 3.53
Total Current Liability 24,01,836 5.09 20,83,887 4.09
Total Liabilities 4,72,16,473 100.00 5,08,94,868 100.00
FUNDS FLOW STATEMENT
Funds flow statement is one of the important tools, which is used in many ways. It helps to
understand the changes in the financial position of a business enterprise between the
beginning and ending financial statement dates. It is also called as statement of sources and
uses of funds.
Institute of Cost and Works Accounts of India, funds flow statement is defined as “a
statement prospective or retrospective, setting out the sources and application of the funds
of an enterprise. The purpose of the statement is to indicate clearly the requirement of
funds and how they are proposed to be raised and the efficient utilization and application
of the same”.
Financial Statement Analysis 19
CASH FLOW STATEMENT
Cash flow statement is a statement which shows the sources of cash inflow and uses of
cash out-flow of the business concern during a particular period of time. It is the statement,
which involves only short-term financial position of the business concern. Cash flow
statement provides a summary of operating, investment and financing cash flows and
reconciles them with changes in its cash and cash equivalents such as marketable securities.
Institute of Chartered Accountants of India issued the Accounting Standard (AS-3) related
to the preparation of cash flow statement in 1998.
Difference Between Funds Flow and Cash Flow Statement
Funds Flow Statement Cash Flow Statement
1. Funds flow statement is the report on the 1. Cash flow statement is the report showing
movement of funds or working capital sources and uses of cash.
2. Funds flow statement explains how working 2. Cash flow statement explains the inflow and
capital is raised and used during the particular out flow of cash during the particular period.
3. The main objective of fund flow statement is 3. The main objective of the cash flow statement
to show the how the resources have been is to show the causes of changes in cash
balanced mobilized and used. between two balance sheet dates.
4. Funds flow statement indicates the results of 4. Cash flow statement indicates the factors
current financial management. contributing to the reduction of cash balance
in spite of increase in profit and vice-versa.
5. In a funds flow statement increase or decrease 5. In a cash flow statement only cash receipt and
in working capital is recorded. payments are recorded.
6. In funds flow statement there is no opening 6. Cash flow statement starts with opening cash
and closing balances. balance and ends with closing cash balance.
Exercise 4
From the following balance sheet of A Company Ltd. you are required to prepare a schedule
of changes in working capital and statement of flow of funds.
Balance Sheet of A Company Ltd., as on 31st March
Liabilities 2004 2005 Assets 2004 2005
Share Capital 1,00,000 1,10,000 Land and Building 60,000 60,000
Profit and Loss a/c 20,000 23,000 Plant and Machinery 35,000 45,000
Loans — 10,000 Stock 20,000 25,000
Creditors 15,000 18,000 Debtors 18,000 28,000
Bills payable 5,000 4,000 Bills receivable 2,000 1,000
Cash 5,000 6,000
1,40,000 1,65,000 1,40,000 1,65,000
20 Financial Management
Solution
Schedule of Changes in Working Capital
Particulars 2004 2005 Incharge Decharge
Rs. Rs. Rs. Rs.
Current Assets
Stock 20,000 25,000 5,000 —
Debtors 18,000 28,000 10,000 —
Bills Receivable 2,000 1,000 — 1,000
Cash 5,000 6,000 1,000
A 45,000 60,000
Less Current Liabilities
Creditors 15,000 18,000 3,000
Bills Payable 5,000 4,000 1,000
B 20,000 22,000 17,000 4,000
A-B 25,000 38,000 — 13,000
Increase in W.C. 38,000 38,000 17,000 17,000
Fund Flow Statement
Sources Rs. Application Rs.
Issued Share Capital 10,000 Purchase of Plant and Machinery 10,000
Loan 10,000 Increase in Working Capital 13,000
Funds From Operations 3,000
23,000 23,000
Exercise 5
From the above example 4 prepare a Cash Flow Statement.
Solution
Cash Flow Statement
Inflow Rs. Outflow Rs.
Balance b/d 5,000 Purchase of plant 10,000
Issued Share Capital 10,000 Increase Current Assets
Loan 10,000 Stock
Cash Opening Profit 3,000 Decrease in Bills Payable 5,000
Decrease in Bills 1,000 Balance c/d 10,000
Receivable 3,000 1,000
Increase in Creditors 6,000
32,000 32,000
RATIO ANALYSIS
Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a mathematical
relationship between one number to another number. Ratio is used as an index for
evaluating the financial performance of the business concern. An accounting ratio shows
Financial Statement Analysis 21
the mathematical relationship between two figures, which have meaningful relation with
each other. Ratio can be classified into various types. Classification from the point of view
of financial management is as follows:
● Liquidity Ratio
● Activity Ratio
● Solvency Ratio
● Profitability Ratio
Liquidity Ratio
It is also called as short-term ratio. This ratio helps to understand the liquidity in a business
which is the potential ability to meet current obligations. This ratio expresses the relationship
between current assets and current assets of the business concern during a particular
period. The following are the major liquidity ratio:
S. No. Ratio Formula Significant Ratio
1. Current Ratio = Current Assets
Current Liability 2 : 1
2. Quick Ratio = Quick Assets
Quick /Current 1 : 1
Liability
Activity Ratio
It is also called as turnover ratio. This ratio measures the efficiency of the current assets
and liabilities in the business concern during a particular period. This ratio is helpful to
understand the performance of the business concern. Some of the activity ratios are given
below:
S. No. Ratio Formula
1. Stock Turnover Ratio
Costof Sales
Average Inventory
2. Debtors Turnover Ratio
CreditSales
AverageDebtors
3. Creditors Turnover Ratio
Credit Purchase
AverageCredit
4. Working Capital Turnover Ratio
Sales
NetWorkingCapital
22 Financial Management
Solvency Ratio
It is also called as leverage ratio, which measures the long-term obligation of the business
concern. This ratio helps to understand, how the long-term funds are used in the business
concern. Some of the solvency ratios are given below:
S. No Ratio Formula
1. Debt-Equity Ratio External Equity
Internal Equity
2. Proprietary Ratio
Shareholder / Shareholder ' s Fund
Total Assets
3. Interest Coverage Ratio
EBIT
Fixed Interest Charges
Profitability Ratio
Profitability ratio helps to measure the profitability position of the business concern. Some
of the major profitability ratios are given below.
S. No Ratio Formula
1. Gross Profit Ratio Gross Profit × 100
NetSales
2. Net Profit Ratio × Net Profit after tax 100
Net Sales
3. Operating Profit Ratio × Operating Net Profit 100
Sales
4. Return in Investment × Net Profit after tax 100
Shareholder Fund
Exercise 6
From the following balance sheet of Mr. Arvind Industries Ltd., as 31st March 2007.
Liabilities Rs. Assets Rs.
Equity Share Capital 10,000 Fixed assets (less 26,000
7% Preference Share Capital 2,000 depreciation Rs. 10,000)
Reserves and Surplus 8,000 Current Assets:
6% Mortgage Debentures 14,000 Cash 1,000
Current Liabilities: Investments (10%) 3,000
Creditors 1,200 Sundry debtors 4,000
Bills payable 2,000 Stock 6,000
Outstanding expenses 200
Tax Provision 2,600
40,000 40,000
Financial Statement Analysis 23
Other information:
1. Net sales Rs. 60,000
2. Cost of goods sold Rs. 51,600
3. Net income before tax Rs. 4,000
4. Net income after tax Rs. 2,000
Calculate appropriate ratios.
Solution
Short-term solvency ratios
Current Ratio = = = Current Assets 14,000
2.33 :1
Current Liability 6,000
Liquid Ratio = = = LiquidRatio 8,000
1.33 : 1
Current Liability 6,000
Long-term solvency ratios
Proprietary ratio =
′
= = Proprietor s funds 20,000
0.5 :1
Total Assets 40,000
Proprietor’s fund or Shareholder’s fund=Equity share capital+Preference share
capital+Reserve and surplus
= 10,000+2,000+8,000=20,000
Debt-Equity ratio = = = Externalequities 20,000
1:1
Internalequities 20,000
Interest coverage ratio =
EBIT 4,000+840
= =5.7times
Fixed interest charges 840
Fixed interest charges = 6% on debentures of Rs.14,000
= Rs. 840
Activity Ratio
Stock Turnover Ratio =
Cost of Sales 51,600
= =8.6times
AverageInventory 6,000
As there is no opening stock, closing stock is taken as average stock.
24 Financial Management
Debtors Turnover Ratio =
Credit Sales 60,000
= =10times
AverageDebtors 6,000
In the absence of credit sales and opening debtors, total sales is considered as credit
sales and closing debtors as average debtors.
Creditors turn over ratio = = = Credit Purchases 43,200
36times
AverageCreditors 1,200
In absence of purchases, cost of goods sold – gross profit treated as credit purchases
and in the absence of opening creditors, closing creditors are treated as average creditors.
Working Capital Turnover Ratio = = = Sales 60,000
7.5times
NetWorkingCapital 8,000
Profitability Ratios
Gross profit ratio = × × GrossProfit 8,400
100= 100=14%
Sales 60,000
Net profit ratio = × × Net Profit 2,000
100= 100=3.33%
Sales 60,000
In the absence of non-operating income, operating profit ratio is equal to net profit
ratio.
Return of Investment = × ×
′
Net Profit afterTax 2,000
100= 100=10%
Shareholder sFund 20,000