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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.

Paramasivan, C.. Financial Management, New Age International Ltd, 2009. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/apus/detail.action?docID=437705. Created from apus on 2022-01-10 21:44:53.

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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.

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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

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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

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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

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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.

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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%.

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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”.

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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

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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

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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 Credit Sales

Average Debtors

3. Creditors Turnover Ratio Credit Purchase AverageCredit

4. Working Capital Turnover Ratio Sales

Net WorkingCapital

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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 Net Sales

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

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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 = = = Liquid Ratio 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 = = = External equities 20,000

1 : 1 Internal equities 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

= =8.6 times Average Inventory 6,000

As there is no opening stock, closing stock is taken as average stock.

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24 Financial Management

Debtors Turnover Ratio = Credit Sales 60,000

= =10 times Average Debtors 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

36 times Average Creditors 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 Net Working Capital 8,000

Profitability Ratios

Gross profit ratio = × × Gross Profit 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 after Tax 2,000 100= 100=10%

Shareholder s Fund 20,000

MODEL QUESTIONS

1. What is financial statement? 2. What is financial statement analysis? 3. Discuss various types of financial statement analysis. 4. Explain various methods of financial statement analysis. 5. What are the differences between fund flow and cash flow? 6. What is ratio analysis? Explain its types.

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