FINANCIAL STATEMENTS / FINANCIAL REPORTS



FINANCIAL ANALYSISA RIGHT WAY FOR?FINANCIAL?DECISIONAnalysis?means to put?the meaning of?a?statement?in to simple terms for?the benefit?of?a person.?analysis?comprises resolving the statements by breaking them in to simpler statements by a process of rearranging, regrouping and collection of information broadly the term is applied to almost any kind of detailed enquiry in to?financial?data. A?financial?manager has to evaluate the past performance, present?financial?position, liquidity situation, enquire in to profitability of the firm and to plan for future operations. for all this, they have to study the relationship among various?financial?variables in a business as disclosed in various?financial?statements.written by Dr. Malik Mohummed K. Shahzad Awan?orFinancial statement analysis?(or?financial analysis) is the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports.Financial statement analysis consists of 1) reformulating reported financial statements, 2) analysis and adjustments of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted financial statements.FINANCIAL STATEMENTS / FINANCIAL REPORTSFinancial?statements?(financial?reports) are formal records of a business?financial activities. these statements provide an overview of a business profitability and?financial condition?in both?short and long?term. There are five basic?financial?statements:Balance SheetBalance?sheet?also referred to as?statement?of?financial?position?or?condition, reports on a company assets, liabilities and net equity as of a given point in time.Income StatementIncome?statement?also referred to as profit or loss statement. reports on a company results of operations over a period of time.Cash Flow StatementStatement?of cash flows?reports on a company cash flow activities, particularly its operating, investing and financing activities.Statement of Changes in EquityStatement?of?retained earnings?explains the changes in a company retained earnings over the reporting period.Notes to the Financial StatementsNotes to the?financial?statements?explain the necessary details and calculations about the key figures nominated at the face of?balance?sheet?and income?statement. Commonly this section is called footnotes but it’s a comprehensive part of?financial statements that describe the accounting?procedures and policies.USER OF FINANCIAL STATEMENTSAnalysis of financial statements?is linked with the objective and interest of the?individual agency involved. some of?the agencies?interested include management, investors, creditors, bankers, workers, government and public at large.MANAGEMENTManagement is interested in the?financial?performance and?financial?condition?of the enterprise. it would like to know about its viability as an ongoing concern, management of cash, debtors, inventory and?fixed asset?and adequacy of?capital structure. Management would also be interested in the overall?financial?position and profitability of the enterprise as a whole and its various departments and divisions.INVESTORSAn investor is interested in the profitability and safety of his investment and would like to know whether the business is profitable, has growth potential and is progressing on sound lines. The present investors want to decide whether they should hold thesecurities?of the company or sell them. potential investors, on the other hand, want to know whether they should invest in the shares of the company or not. investors (Shareholders or owners) and potential investors, thus, make use of the?financialstatements to judge the present and future earning capacity of the business, to judge the operational efficiency of the business and to know the safety of investment and growth prospects.BANKERS AND LENDERSBankers and lenders are interested in serving of their loans by the enterprise, i.e. regular payment of interest and repayment of principal amount on?schedule?dates. They also like to know the safety of their investment and reliability of returns.SUPPLIERS / CREDITORSCreditors dealing with the enterprise are interested in receiving their payments as and when fall due and would like to know its ability to honor its ?short-term commitments.EMPLOYEESEmployees interested in better emoluments, bonus and continuance of the business, would like to know its?financial?performance and ERNMENTGovernment?and regulatory authorities would like to ensure that the?financial?statements prepared areas per the specified laws and rules and are to safe guard the interest of various concerned agencies. e.g.:?Taxation?authorities would be interested in?ensuring?proper assessment of tax liability of the enterprise as per the laws.STOCK EXCHANGEStock exchange uses the?financial?statements to?analyse?and thereafter,?inform?its members about the performance,?financial?health? etc,?of?the company, to see whether financial?statements prepared are in conformity with the specified laws and rules and to see whether they safeguard the interest of various concerned agencies.Other regulatory authorities ?(such as, company law board, SEBI, stock exchanges, tax authorities etc) would like that the?financial?statements prepared are in conformity with the specified laws and rules and are to safeguard the?interest?of various concerned agencies, For example, taxation authorities would be interested in ensuring proper assessment of tax liability of the enterprise as per the laws in force from time to time.CUSTOMERCustomer are interested to ascertain continuance of an enterprise. for example, an enterprise may be supplier of a particular type of consumer goods and in case it appears that the enterprise may not continue for a long time, the customer has to find an alternate source.PUBLICEnterprises affect?members?of the public in a?variety?of ways. for example, enterprises may make a substantial?contribution?to the local economy in many ways including the number of people, they employ and their patronage of local suppliers,?Financial?statements may assist the public by providing information about trends and recent developments in the prosperity?of?the?enterprise?and the range of its activities.Different agencies thus look at the enterprise from?their?respective?viewpoint?and are interested in knowing about its?profitability?and?financial?condition. In short a detailed cause and effect study of profitability and?financial?condition?is the overall?objective?of financial?statement?analysis.TYPES OF FINANCIAL ANALYSISFollowing are the various?types of?financial?analysis.A. On the basis of material used.1. External?AnalysisAnalysis of?financial?statements may be carried out on the basis of published information.?i.e..,?information made?available?in the?annual?report of the enterprise. Such analysis?are usually carried out by those who do not have access to the detailed accounting records of the Co.?i.e., Banks, Creditors?etc.2. Internal?AnalysisAnalysis may also be based on detailed information available within the Co. which is not available to?the outsiders. Such analysis is called internal analysis. This type of analysis is of a detailed one and is carried out on behalf of?the management?for the purpose of providing necessary?information?for?decision?making, such analysis emphasizes on the performance appraisal and assessing the?profitability?of different activities.B. According to objectives of?analysis1. Short Term AnalysisShort term?analysis?is mainly concerned with the?working capital?analysis.in the short run, a Co. must have ample funds?readily?available to meet its current needs and sufficient borrowing capacity to meet the contingencies. in short term?analysis?the current assets?and current?liabilities?are?analyzed?and liquidity is determined.2. Long Term?AnalysisIn the long term a Co. must earn a minimum amount sufficient to maintain a reasonable rate of return?on the investment to provide for the necessary growth and development of the Co., and to meet the cost of capital.Financial?planning is also desirable for the continued success of a Co. Thus in the long term?analysis?the stability and the earning potentiality of the C. is?analyzed? i.e., fixed assets, long term debt structure and the ownership interest is?analyzed.C. According to the Modus Operandi of?analysis1. Horizontal AnalysisAnalysis?of?financial?statements?involves?making comparisons and establishing relationship among related items. such comparison or establishing of relationship may be based on?financial?statements of a Co. For a number of years and the financial?statements?of different Co's for the same year. such?analysis?is called horizontal?analysis. It may take the following two forms.a. comparative?financial?statement?analysisb. trend analysis.2. Vertical?Analysis.Analysis?of?financial?data based on relationship among items in a single period of financial?statement?is called vertical?analysis. from a single balance sheet or P&L A/C relationships of various items may be established.e.g. various assets can be expressed as percentage of total assets. Statements containing such?analysis?are also called as common size statements. The common size?P&L A/C?is more useful in?analyzing?the operating results and costs during the year. It shows each element of cost as a percentage of sales. Similarly common size balance sheet show?fixed?assets as a percentage to total assets.TOOLS OF FINANCIAL ANALYSIS (METHODS)The analysis of?financial?statements?consists of a study of relationship and trends to determine whether or not the?financial?position?of the concern and its?operating efficiency?have been satisfactory. In the process of this analysis various tools or methods are used by?financial?analyst.these?tools are:1. comparative statements2. common size statements3. Trend analysis4. Average analysis?5.?Statement?of changes in working capital6. Fund flow analysis7. Cash flow analysis8. Ratio analysisRATIO ANALYSISA company's?financial?information is contained in 3 basic?financial?statements the balance sheet,?the trading?and?profit and loss account?and?profit and loss?appropriation?account. These statements are very useful to different?parties?concerned such as management, creditors, investors and so on. These statements may be more fruitfully used if they are analysed an interpreted to have an insight into the strengths and weakness of the firm.Analysis of statements means such a treatment of the information contained in the two statements as to afford a diagnosis of the profitability and?financial?position of the firm concerned. In the analysis of?financial?statements, the analyst has variety of tools available from which he can choose those best suited to his specific purpose.The most important tools used now days are ratio analysis, fund flow analysis and comparative and common size statements.Ratio AnalysisRatios are well known?and?most widely used tools of?financial?analysis, A ratio gives the mathematical relationship between one variable and another, Accounting ratios are relationships, expressed in quantitative terms between figures which have a?cause and effect?relationship or which are connected with each other in some manner or the other. The analysis of a ratio can disclose the relationships as well as bass of comparison?that?reveals conditions and trends that can’t be detected by going through the individual components of the ratio.The usefulness of ratios is ultimately dependent on their intelligent and?skillful?interpretation.CLASSIFICATION OF RATIO ANALYSIS"Ratios" can be grouped into various?classes?according to "financial" activity or function to be evaluated. In view of the?requirements?of the various users of "ratios", we can classify then into the following categories.Liquidity?"Ratios"Profitability?"Ratios"Solvency?"Ratios""Financial"?statement?"analysis" is a?judgemental?process. One of the?primary?objectives?is identification of major changes in trends and relationships andthe investigation?of the reasons underlying those changes, The?judgement?process can be improved?by experience?and the use of analytical tools. Probably the most widely used "financial" "analysis: technique is "ratio" "analysis" the "analysis" of relationships between two or more line items on the "financial"?statement. "Financial" "ratios" are usually expressed in percentage or times. Generally, "financial" "ratios" are calculated for?the?purpose of evaluating aspects of company's operations and fall into the following categories:Liquidity ratios:?measure a firm's ability to meet?its?current obligations.Profitability ratios:?measure management's ability to control expenses and to earn a return on the resources committed to the business.Leverage ratios:?measure the degree of protection of suppliers of long-term funds and can?also?aid in judging a firm's ability to raise additional debt and its capacity to pay its ?liabilities on time.efficiency, activity or turnover ratios:?provide information about management's ability to control expenses and to earn a return on the resources committed to the business.A "ratio" can be?computed?from any pair of numbers. Given the large quantity of variables?included?in "financial" statements, a very long list of meaningful ratios can be derived. A standard list of "ratios" or standard computation of them does not exist, The following ratio presentation includes "ratios" that are most often used when evaluating the credit worthiness of customer. "Ratio" "analysis" becomes a very personal or company driven procedure. Analysts are drawn to and use the ones they are comfortable with and understand.LIQUIDITY RATIOSWORKING CAPITAL:Working capital compares?current assets?to?current liabilities?and serves as the liquid reserve?available?to satisfy contingencies and uncertainties, A high working capitalbalance?is mandated if the entity is unable?to borrow?on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its?current liabilities?when due.Formula:?? ??Current assets?-?Current liabilitiesACID TEST OR?QUICK RATIO:A measurement of the liquidity?position?of the business.?The quick?ratio compares the cash plus cash?equivalents?and accounts receivable to the?current liabilities. the primary?difference?between the?current ratio?and?the quick?ratio is?the quick?ratio does not include inventory and prepaid expenses in the calculation. Consequently, a business's?quick ratio?will be lower than its?current?ratio. It is a stringent test of liquidity.Formula:?? ? ?Cash+Marketable securities+Account Receivable? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??Current LiabilitiesCURRENT RATIO:Provides an indication of the liquidity of the business by comparing the amount ofcurrent assets?to?current liabilities. A business's?current assets?generally consist of cash, marketable securities, accounts receivable and?inventories??Current liabilitiesinclude accounts payable current maturities of long-term debt, accrued income taxes and other accrued expenses that are due within one year, In general businesses prefer to have at least one dollar of?current assets?for every dollar of?current liabilities. However, the normal?current ratio?fluctuates from industry to industry. A?current ratio?significantly higher than the industry average could indicate the existence of redundant?assets? Conversely a?current ratio?significantly lowers than the industry average could indicate a lack of liquidity.Formula:?? ? ? ? ??Current Assets? ? ? ? ? ? ? ? ? ? ? ? ?Current LiabilitiesCASH RATIO:Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the?analyst?suspect's severe liquidity problems with inventory and receivables.Formula:?? ? ? ? ??Cash Equivalents + Marketable Securities? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??Current LiabilitiesPROFITABILITY RATIOSNet?Profit Margin?(Return on Sales):A measure of?net income?dollars?generated?by each dollar of sales.Formula: ? ? ??Net Income? ? ? ? ? ? ? ? ? ? ??Net SalesRefinements to the?net income?figure can make it more accurate than this ratio computation. They could include removal of equity earnings from?investments? Other income and other expense items as well as minority share of earnings and?non-recurring?items.Formula: ? ? ?Net income? ? ? ? ? ? ? ? ? ? ?(beginning + Ending Total Assets)/2Operating Income Margin:A measure of the operating income generated by each dollar of salesFormula: ? ? ?Operating Income? ? ? ? ? ? ? ? ? ? ?Net SalesReturn on Investment:Measures the income earned on the invested capital.Formula: ? ??Net Income? ? ? ? ? ? ? ? ? ? Long-term Liabilities + EquityReturn on Equity:Measures?the income earned on the?shareholder's?investment in the business.Formula: ? ??Net Income? ? ? ? ? ? ? ? ? ? EquityDu Point Return on Assets:A combination of financial ratios in a series to evaluate?investment return. The?benefit?of the method id that it provides an understanding of how the company generates its return.Formula: ? ?Net Income?? ?x ??Sales?? ? x ? ?Assets? ? ? ? ? ? ? ? ? ?Sales ? ? ? ? ? ? ? ? ? Assets ? ? ? ? ?EquityGross?Profit Margin:Indicates the relationship between?net sales?revenue and the?cost of goods sold. This ratio should be?compared?with industry data as it may indicate insufficient volume and?excessive?purchasing or?labour?costs.Formula: ? ??Gross Profit? ? ? ? ? ? ? ? ? ??Net SalesFINANCIAL LEVERAGE RATIOTotal Debts to Assets:Provides information about the company's ability to absorb asset?reductions?arising from losses?without?jeopardizing the interest of creditors.Formula ? ? ? ? ? ? ? ? ? ??Total Liabilities? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?Total AssetsCapitalization Ratio:Indicates long-term debt usage.Formula ? ? ? ? ? ? ? ??Long-Term Debit? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?Long-Term + Owners EquityDebt to Equity:Indicates how well creditors are protected in case of the company's insolvency.Formula ? ? ? ? ? ? ? ??Total Debt? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?Total EquityInterest Coverage Ratio?(Times Interest Earned):Indicates a compaany's capacity to meet interest payments. Uses EBIT (Earnings before interest and taxes)Formula ? ? ? ? ? ? ? ? ?EBIT? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Interest ExpenseLong-term Debt to Net?Working Capital:Provides insight into the ability to pay long term debt from?current assets?after paying current liabilities.Formula ? ? ? ? ? ? ? ? ?Long-term Debt? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??Current Assets?- Current LiabilitiesEFFICIENCY RATIOSCash TurnoverMeasures how effective a company is utilizing its cash.Formula ? ? ? ??Net Sales? ? ? ? ? ? ? ? ? ? ? ?CashSales to?Working Capital?(Net Working Capital?Turnover)Indicates the turnover in?working capital?per year. A low ratio indicates inefficiency, while a high level implies that the company's?working capital?is working too hard.Formula ? ? ? ? ?Net Sales? ? ? ? ? ? ? ? ? ? ? ?Average?Working CapitalTotal Asset TurnoverMeasures the activity of the assets and the ability of the business to generate sales through the use of the assets.Formula ? ? ? ? ?Net Sales? ? ? ? ? ? ? ? ? ? ? ? Average Total AssetsFixed Assets?TurnoverMeasures the capacity utilization and the quality of?fixed assets.Formula ? ? ? ? ??Net Sales? ? ? ? ? ? ? ? ? ? ? ? ?Net?Fixed AssetsDay's Sales in ReceivablesIndicates the average time in days, those receivables are outstanding (DSO). It helps determine if a change in receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might compare the days sales in receivables with the company's credit terms as an indication of how efficiently the company manages its receivables.Formula ? ? ??Gross Receivables?? ? ? ? ? ? ? ? ? ? ?Annual?Net Sales/365Accounts Receivable TurnoverIndicates the liquidity of the company's receivables.Formula ? ? ??Net Sales? ? ? ? ? ? ? ? ? ? ?Average Gross ReceivablesAccounts Receivable Turnover?in DaysIndicates the liquidity of the company's receivable in days.Formula ? ? ? ??Average Gross Receivables? ? ? ? ? ? ? ? ? ? ? ?Annual?Net Sales/365Inventory TurnoverIndicates the liquidity of the inventory.Formula ? ? ? ? ? ??Cost of Goods Sold? ? ? ? ? ? ? ? ? ? ? ? ? ?Average InventoryInventory Turnover?in DaysIndicates the liquidity of the inventory in days.Formula ? ? ? ? ? ?Average Inventory? ? ? ? ? ? ? ? ? ? ? ? ??Cost of Goods Sold?/ 365Operating CycleIndicates the time between the acquisition of inventory and the realization of cash from sales of ?inventory. For most companies the operating cycle is less than one year, but in some industries it is longer.Formula ? ? ? ? ?Accounts Receivable turnover?in Days +?Inventory Turnover?in DayDays Payables OutstandingIndicates how the firm handles obligations of its suppliers.Formula ? ? ? ? ?Ending Accounts Payable? ? ? ? ? ? ? ? ? ? ? ? Purchases / 365Payables TurnoverIndicates the liquidity of the firm's payables.Formula ? ? ?Purchases? ? ? ? ? ? ? ? ? ?Average AccountsPayables Turnover in DaysIndicates the liquidity of the firm's Payables in days.Formula ? ??Average Accounts Payable? ? ? ? ? ? ? ? ? ?Purchases / 365Balance SheetThe principal financial statements are the balance sheet, income statement, and statement of cash flows. This chapter will review the balance sheet in detail. Other titles used for the balance sheet are statement of financial position and statement of financial condition. The title balance sheet is the predominant title used.1Another statement, called the statement of stockholders’ equity, reconciles the changes in stockholders’ equity, a section of the balance sheet. This statement will also be reviewed in this chapter. Many alternative titles are used for the statement of stockholders’ equity. The title most frequently used is the statement of stockholders’ ................
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