FINANCIAL STATEMENTANALSIS

1. UNDERSTANDING THE ROLE OF FINANCIAL STATEMENTS

2. RELEVANCE OF NOTES TO ACCOUNTS AND SCHEDULES TO FINANCIAL STATEMENT3. NUANCES OF ACCOUNTING: INVENTORIES, DEPRECIATION, EPS, INTANGIBLE ASSETS4. INTRODUCTION TO RATIO ANALYSIS

5. FINANCIAL MODELING

6. NUANCES OF LEASES, HIRE PURCHASE, PENSION LIABILITIES AND CLASSIFICATION OF INVESTMENTS IN FINANCIAL ASSETS7. NUANCES OF ACCOUNTING: FOREIGN EXCHANGE GAIN / LOSS

8. RED FLAGS

CONTENTS

ROLE OF FINANCIAL STATEMENTS

FINANCIAL STATEMENTS?

A company carries out numerous activities that have a bearing on its financial performance over time.

Financial statements are a systematic record/presentation of all such activities, summarized on a yearly basis, that give a glimpse into the working and performance of a company.

This information is widely used by a range of stakeholders for economic decision making.

USE OF FINANCIAL STATEMENTS1. Management• to assess the financial performance and position of the company and accordingly take business decisions

2. Shareholders• to take investment decisions by assessing the risk and return of their investment in the company

3. Prospective Investors• to gauge the risks associated with, and viability of investing in the company

4. Banks• to assess the financial health of the company, thereby facilitating decision-making with respect to extension of credit to a business

5. Suppliers• to assess the credit worthiness of a business

6. Competitors• compare their performance with rival companies to learn and develop strategies to improve their competitiveness

7. Government• to determine the correctness of tax declared in the tax returns

8. General Public• they may be interested in the effects of a company on the economy, environment and the local community

MANAGEMENT DISCUSSION AND ANALYSIS Certain companies also provide an overview of the accounting period from the

management’s perspective.

The principal objective of this report is to supplement the financial information with other information considered necessary for a full appreciation of the companies’ activities.

It may cover a formalized and structured explanation of the operating and financial performance.

The operating review covers item such as operating results, profit and dividend while the financial review may cover items such as capital structure and treasury policy.

AUDITORS REPORT Financial statements are supplemented by other reports like Auditors’ Report, Notes to accounts, management discussion, etc.

Auditors are independent accountants who are registered to carry out the work of auditing the accounts of the company. Auditors must make a brief report to confirm that the accounts give a true and fair view of the company’s financial position.

Depending on the opinion of the auditor about the conformity and genuineness of accounts, the audit report could be described as unqualified, qualified, adverse or disclaimer.1. An unqualified report is the clean report wherein the auditor concludes that the Financial

Statements give a true and fair view of the financial position of the company and are in conformity with the generally accepted accounting principles (GAAP) as specified by ICAI.

2. A qualified opinion report can result from a limitation on the scope of the audit or failure to follow generally accepted accounting principles.

3. Adverse Report is used only when the auditor believes that the overall financial statements are so materially misstated or misleading that they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP.

4. A disclaimer is issued when the auditor is unable to be satisfied that the overall financial statements are fairly presented.

GENERALLY ACCEPTED FUNDAMENTAL ACCOUNTING ASSUMPTIONS

GOING CONCERN

• The enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future.• It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the operations.

CONSISTENCY

• It is assumed that accounting policies are consistent from one period to another.

ACCRUAL

• Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate.

ACCRUAL ACCOUNTING CONCEPT According to the Accruals Concept of accounting, income and expense are recognized in

the accounting periods to which they relate, rather than on cash basis. This essentially means that income must be recorded in the accounting period in which

it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are matched with the revenue earned in an accounting period.

FEW ACCOUNTING CONCEPTSBusiness

Entity Concept

•Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from its owners.•The business entity is therefore considered to be distinct from its owners for the purpose of accounting.

Limited Liability Concept

•The companies in India are generally limited by shares. It means that the liability of a shareholder is limited to the face value of share contributed by the shareholder.•So in case of insolvency, shareholders will not have to contribute their personal assets for any payments due to creditors.

ACCOUNTING EQUATIONA Balance Sheet derives its name from the fact that a company’s financial structure always balances accordingly to the following equation, known as the accounting equation:

The left hand side of the equation represents the assets or the things that a company owns and which have value.

The right hand side of the equation represents the sources of funds used to fund the assets of the company.

Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from internal sources of finance such as share capital and retained profits (i.e. Equity).

Therefore, assets of an entity will always equal to the sum of its liabilities and equity.

Assets = Liabilities + Shareholders’ Equity

UNDERSTANDING A FINANCIAL STATEMENTSPart 1 :- BALANCE SHEET

• It details the financial position of the company at a given point of time. It is a snapshot of all the assets owned by the company and the liabilities it owes to others.

• Assets include tangible assets like plants & equipment, vehicles, etc. and intangible assets like trademarks and patents.

• Liabilities are amounts of money that a company owes to others. • Shareholders’ equity, also known as capital or net worth, is the money owed to the owners of the company.

Part 2 :- STATEMENT OF PROFIT AND LOSS

• It is also referred to as Income statement.• It summaries the financial performance of a company for a given period of time.• It details the revenue earned and the associated expenses incurred by the company over a given period and the

profit (or loss) generated as a result of the business operations.

Part 3 :- CASH-FLOW STATEMENT

• Cash flow statements report a company’s inflows and outflows of cash during a given period.• It is different from a profit and loss account as unlike profit and loss account, it records actual movement of cash

and not any credit sales or purchases and is therefore, reflective of genuine cash generated by a company.• Divided into three parts :

• a) Operating cash flow• b) Cash from investing• c) Cash from financing

NOTES TO ACCOUNTS Notes to the accounts provides a more detailed analysis of some of the entries

in the accounts including Disclosure of accounting policies used (e.g. method adopted for charging

depreciation i.e. straight-line method or written down method ) and any changes to these policies

An explanation for any deviation from accounting standards Sources of turnover from different geographical areas Details of fixed assets, investments, share capital, debentures and reserves Directors’ emoluments Earnings per share

ACCOUNTING POLICIES The companies inform about the accounting policies used in the preparation of financial

statements.

They have a choice of accounting policies in many areas such as foreign currencies, goodwill, pensions, sales and inventories.

As different accounting policies will result in different figures, it is necessary to state the policy that was used so that readers of the accounts can make an informed judgment about the performance of the company.

Companies also state the effect of any changes in accounting policies by restating prior year numbers where they are materially significant.

UNDERSTANDING RELATIONSHIP BETWEEN CONSTITUENTS OF FINANCIAL STATEMENTS

Balance Sheet (Format as per Revised Schedule VI of the Companies Act, 1956)

SHAREHOLDERS FUNDA company sources funds from shareholders by the issue of shares. It is the difference between the total assets and total liabilities of the company. It is thus, the investment made by the owners of the company and the return thereof.

Shareholders fund consist of two types:(a) Share Capital:- face value of the shares issued to the shareholders in any of the following ways:

Private Placement –shares offered to select group of individuals or institutions.

Public Issue –shares offered to public.

Rights issues –Companies may also issue shares to their shareholders as a matter of right in proportion to their holding. Rights issues come at a price which the investors must pay by subscribing to the rights offer.

Bonus shares –When a company has accumulated a large reserve out of profits, the company may distribute a part of it amongst the shareholders in the form of bonus. Bonus can be paid either in cash or in the form of shares.

Shareholders can be divided into two. One, Equity Shareholders who are the real shareholders as they bear maximum risk and rewards related to a company. The others are preference shareholders. As name suggests they have preference in certain matters. Preference Shares generally carry a fixed rate of dividend which is paid to them before any dividends are paid to equity shareholders. In case of liquidation as well, preference shareholders get preference over equity shareholders.

SHAREHOLDERS FUND(b) Reserves –Reserves are profits or gains which are retained and not distributed. Companies have two kinds of reserves:

Capital Reserves

Capital reserves are gains that have resulted from an increase in the value of assets and they are not freely distributable to the shareholders.

The most common capital reserves are the share premium account arising from the issue of shares at a premium and the capital revaluation reserve, i.e. unrealized gain on the value of assets.

BORROWINGSThe company also sources funds from external sources in form of borrowings. These may be taken for long term (when repayable after a year) or short term (repayable within a year). Moreover these could be secured or unsecured.

Secured Loans

• These loans are taken by a company by pledging some of its assets or by a ceding charge (hypothecation or mortgage)in respective assets.

• The usual long term secured loans a company has are debentures and term loans (having first charge on fixed assets) while short term secured loans include working capital borrowings (having first charge on current assets).

Unsecured loans

• Good name and creditworthiness may sometimes allow companies to raise loans without offering any hypothecation or mortgage to the lender.

• Fixed deposits and unsecured loans from relatives and friends are examples of unsecured loans.• In case a company is dissolved, unsecured lenders are usually paid after the secured lenders have been paid.

CURRENT LIABILITIESCurrent liabilities are amounts due that are payable within the next twelve months. These also include provisions which are amounts set aside for an expense incurred for which the bill has not been received as yet or whose cost has not been fully estimated.

CreditorsTrade creditors are those to whom the company owes money for raw materials and other articles used in the manufacture of its products.

Companies usually purchase these on credit – the credit period depending on the demand for the item, the standing of the company and market practice.

Accrued ExpensesCertain expenses such as interest on bank overdrafts, telephone costs, electricity and overtime are paid after they have been incurred.

Such expenses are estimated based on past trends and reported in balance sheet as accrued expenses.

ProvisionsProvisions are amounts set aside from profits for an estimated expense or loss.

Certain provisions such as depreciation and provisions for bad debts are deducted from the concerned asset itself.

Other current liabilitiesAny other amounts due like unclaimed dividends and dues payable to third parties are reflected under this head.

FIXED ASSETSFixed assets are assets that a company owns for use in its business and to produce goods. They are not for resale in normal course of business and comprises of land, buildings i.e. offices, warehouses and factories, vehicles, machinery, furniture, equipment, etc.

Fixed assets are shown in the Balance Sheet at cost less the accumulated depreciation. Depreciation is based on the concept that an asset has a useful life and that after years of toil it wears down. The common methods of calculating depreciation are:

Straight line method• The cost of the asset is written off equally over its life.

Consequently, at the end of its useful life, the cost will equal the accumulated depreciation.

• Under this method, depreciation is calculated on the written down value, i.e. cost less depreciation.

• Consequently, depreciation is higher in the beginning and lower in the later years. An asset is never fully written off as the depreciation is always calculated on a reducing balance.

INVESTMENTSMany companies purchase investments in the form of shares or debentures to earn income or to utilize cash surpluses profitably. Investments could be in form of:

Trade investments – these are investments made in shares or debentures of other companies for capital appreciation and dividend.

Subsidiary and associate companies –These are shares held in subsidiary or associate companies in which the company has business interest.

Investments are also classified as quoted and unquoted investments. Quoted investments are shares and debentures that are quoted in a recognized stock exchange and can be freely traded while unquoted investments are not listed or quoted in a stock exchange. Consequently, they are not liquid and are difficult to dispose of.

CURRENT ASSETS Current assets are assets owned by a company which are used in the normal course of business or are generated by the company in the course of business such as debtors or finished stock or cash.

The rule of thumb is that any asset that is turned into cash within twelve months is a current asset. The current assets a company has are:

Inventories Debtors Other Current assets

CURRENT ASSETSA. INVENTORIES –These are arguably the most important current assets that a company has as it is by the sale of its stocks that a company makes its profits. Stocks, in turn, consist of: Raw materials –The primary purchase which is utilized to manufacture the products a

company makes. Work in progress –Goods that are in the process of manufacture but are yet to be completed. Finished goods –The finished products manufactured by the company that are ready for sale.

Stocks are valued at the lower of cost or net realizable value. This is to ensure that there will be no loss at the time of sale as that would have been accounted for. The common methods of valuing stocks are:

FIFO or first in first out –This method assumes that the first inventories bought are the first ones to be sold, and that inventories bought later are sold later.

LIFO or last in last out –The premise on which this method is based is the opposite of FIFO. It is assumed that the goods that arrive last will be sold first. The reasoning is that customers prefer newer materials or products.

Weighted Average–This method assumes that all inventories are sold simultaneously. The method specifically involves working out an average cost per unit at each point in time after a purchase.

CURRENT ASSETSB. DEBTORS – Most companies do not sell their products for cash but on credit and purchasers are expected to pay for the goods they have bought within an agreed period of time – 30 days or 60 days. Often customers may not pay within the agreed credit period. This may be due to laxity in credit administration or the inability of the customers to pay. Consequently, debts are classified as:

Those over six months, and Others

These are further subdivided into;

Debts considered good, and Debts considered bad and doubtful

If debts are likely to be bad, they must be provided for or written off, absence of which would result in assets being overstated to the extent of the bad debt. A write off is made only when there is no hope of recovery while a provision (general or specific) is made to cover for any probability of default by a debtor.

CURRENT ASSETSC. Prepaid Expenses –All payments are not made when due. Many payments, such as insurance premium, rent and service costs, are made in advance. The portion of such expenses that relates to the next accounting period are shown as prepaid expenses in the Balance Sheet.

D. Cash & Bank Balances and Cash equivalents –Cash in hand in petty cash boxes, safes and balances in bank accounts are shown under this heading in the Balance Sheet.

E. Loans & Advances –These are loans that have been given to other corporations, individuals and employees and are repayable within a certain period of time. This also includes amounts paid in advance for the supply of goods, materials and services.

F. Other Current Assets –Other current assets are all amounts due that are recoverable within the next twelve months. These include claims receivable, interest due on investments and the like.

OFF-BALANCE SHEET ITEMS : CONTINGENT LIABILITIES

Contingent liabilities are liabilities that may arise up on the happening of an event. It is uncertain however whether the event itself may happen. This is why these are not provided for and shown as an actual liability in the balance sheet.

Contingent liabilities are detailed in the Financial Statements as a note to inform the readers of possible future liabilities while arriving at an opinion about the company.

The contingent liabilities one normally encounters are:

Bills discounted with banks – These may crystallize into active liabilities if the bills are dishonored.

Corporate Guarantee given for Group companies Claims against a company not acknowledged or accepted Excise claims against the company etc.

Profit and Loss Statement (Format as per Revised Schedule VI of the Companies Act, 1956)

REVENUE FROM OPERATIONS It includes revenue from sales i.e. the amount received or receivable from customers arising from the sales of goods and the provision of services by a company, net of any excise duty or other levies.

A sale occurs when the ownership of goods and the consequent risk relating to these goods are passed to the customer in return for consideration, usually cash.

In normal circumstances the physical possession of the goods is also transferred at the same time.

OTHER INCOME Companies may also receive income from sources other than from the sale of their products or the provision of services. This may include:

Profit from the sale of assets –Profit from the sale of investments or assets. Dividends –Dividends earned from investments made by the company in the shares

of other companies. Rent –Rent received from commercial buildings and apartments leased from the

company. Interest –Interest received on deposits made and loans given to corporate and

other bodies. Miscellaneous Income: Such income comprises Liquidated damages, sale of scrap,

foreign exchange gain, etc.

OPERATING EXPENSES Raw Materials –The raw materials and other items used in the manufacture of a company’s products. It is also sometimes called the cost of goods sold.

Employee Costs –The costs of employment are accounted for under this head and would include wages, salaries, bonus, gratuity, contributions made to provident and other funds, welfare expenses, and other employee related expenditure.

Operating & Other Expenses –All other costs incurred in running a company are called operating and other expenses, and include.

Selling expenses –The cost of advertising, sales commissions, sales promotion expenses and other sales related expenses.

Administration expenses –Rent of offices and factories, municipal taxes, stationery, telephone and telex costs, electricity charges, insurance, repairs, motor maintenance, and all other expenses incurred to run a company.

Others –These include costs that are not strictly administration or selling expenses, such as donations made, losses on the sale of fixed assets or investments, miscellaneous expenditure, etc.

FINANCE CHARGES A company has to pay interest on money it borrows. This is normally shown separately as it is a cost distinct from the normal costs incurred in running a business and would vary from company to company.

The normal borrowings that a company pays interest on are: Bank overdrafts Term loans taken for the purchase of machinery or construction of a factory Fixed deposits from the public Debentures Inter-corporate loans

DEPRECIATION Depreciation represents the wear and tear incurred by the fixed assets of a company.

TAX It refers to the tax payable to the Government as per the Income tax Act, 1961.

Taxes are payable on the taxable income or profit and this can differ from the accounting income or profit.

Taxable income is what income is according to tax law; some income and expenditure items are excluded for tax purposes (i.e. they are not assessable or not deductible) but are considered legitimate income or expenditure for accounting purposes.

DIVIDENDS Dividends are profits distributed to shareholders.

The total profits after tax are not always distributed – a portion is often ploughed back into the company for its future growth and expansion.

TRANSFER TO RESERVES The transfer to reserves is the profit ploughed back into the company.

This may be done to finance working capital, expansion, fixed assets or for some other purpose.

CASH FLOW STATEMENTSCash flow is determined by looking at three components by which cash enters and leaves a company, its core operations, investing activities and financing activities. (a) Cash Flow from Operations:-

Generally, changes made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses and credit transactions (appearing on the balance sheet and profit and loss statement) resulting from transactions that occur from one period to the next.

Certain adjustments made to net profit to arrive at cash from operations are:i. Depreciation – depreciation is a non-cash expense; it is an amount that is deducted from the total value of an

asset that has previously been accounted for. That is why it is added back into net sales for calculating cash flow. ii. Changes in accounts receivable on the balance sheet from one accounting period to the next must also be

reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts – the amount by which accounts receivable has decreased is then added to net sales and vice-versa.

iii. An increase in inventory, on the other hand, signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales. and vice-versa.

iv. The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.

CASH FLOW STATEMENTS(b) Cash Flow from Investing:-

Changes in equipment, assets or investments relate to cash from investing.

Usually cash changes from investing are a “cash out” item, because cash is used to buy new equipment, buildings or short-term assets such as marketable securities.

However, when a company divests of an asset, the transaction is considered “cash in” for calculating cash from investing.

(c) Cash Flow from Financing:-

Changes in debt, loans or dividends are accounted for in cash from financing.

Changes in cash from financing are “cash in” when capital is raised, and they are “cash out” when dividends are paid.

Thus, if a company issues a bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the company is reducing its cash.

FREE CASH FLOW (FCF) Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures.

Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating.

FCF is majorly used for valuation purposes by investors.

The FCF measure gives investors an idea of a company’s ability to pay down debt, increase savings and increase shareholder value.