BACHELOR OF COMMERCE SEMESTER-VI FINANCIAL ANALYSIS AND BUSINESS VALUATION
First Published in 2022 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the event the Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action. 2 CU IDOL SELF LEARNING MATERIAL (SLM)
CONTENT UNIT – 1 Types Of Financial Statements.....................................................................................4 UNIT – 2 Analysis Of Financial Statements ..............................................................................40 UNIT 3Analysis Of Financial Statement Ii...............................................................................61 UNIT 4 Analysis Of Financial Statement Iii ............................................................................83 UNIT – 5 Liquidity Ratio...........................................................................................................100 UNIT – 6 Solvency Ratio...........................................................................................................113 UNIT - 7Profitability Ratios ......................................................................................................124 UNIT - 8 Turnover Ratio ...........................................................................................................141 UNIT – 9 Cash Flow Statements ...............................................................................................159 UNIT – 10 Business Valuation I................................................................................................178 UNIT - 11 Business Valuation II ...............................................................................................191 UNIT – 12 Present Value Method .............................................................................................204 UNIT - 13Valuation Of Shares I................................................................................................215 UNIT – 14 Valuation Of Shares II ............................................................................................230 3 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 1 TYPES OF FINANCIAL STATEMENTS STRUCTURE 1.0 Learning Objectives 1.1 Introduction 1.2 Meaning of financial statements 1.3 Nature and significance of financial statements 1.4 Objectives of financial statements 1.5 Types of financial statements 1.6 Summary 1.7 Keywords 1.8 Practical Problems 1.9 Learning Activity 1.10 Unit End Questions 1.11 References 1.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Understand meaning of financial statements. Describe nature and significance of financial statements Prepare types of financial statements 1.1 INTRODUCTION Financial statements are documents that describe a company's operations and financial performance. Government organisations, accounting companies, etc. frequently audit financial statements to guarantee accuracy and for tax, financing, or investing purposes. The balance sheet, income statement, statement of cash flow, and statement of changes in equity 4 CU IDOL SELF LEARNING MATERIAL (SLM)
are the four basic financial statements for for-profit entities. A similar but distinct set of financial statements is used by nonprofit organisations. The financial statements are used to prepare a company's final accounts, and they show the net outcomes for the year. They are essential in helping a user of a financial statement comprehend a company's results for a specific year. Let's learn more about the definition of a financial statement and its importance. An official record of a company, individual, or other entity's financial transactions and standing is called a financial statement. It is provided in a methodical and simple to comprehend format. An organization's financial summaries reflect an accurate representation of its financial standing. They show assets and liabilities in addition to profits and losses. We can only make these claims if all bookkeeping procedures have been completed. The financial statements include information about the presentation, activities, income, and general conditions of an organisation as well as a picture of its financial health at a certain point in time. Investors need them to settle on informed choices about their value predictions, particularly when it comes time to decide on company difficulties. Investors can perform these value assessments using a variety of tools at their disposal. They should assess their stocks using a variety of estimations rather than just a few in order to make better decisions. Liquidity ratios, debt ratios, efficiency ratios, pricing ratios, and profitability ratios are some of the measurements that are available. 1.2 MEANING OF FINANCIAL STATEMENTS Fundamentally, financial statements and budget summaries are papers that show financial and bookkeeping information specific to organisations. The administration of an organisation uses it to communicate with outside parties, such as tax authorities, regulatory agencies, investors, creditors, shareholders, etc. Financial information is used by investors and financial analysts to assess a company's performance and forecast where the stock price will go in the future. The annual report, which includes the company's financial statements, is one of the most significant sources of trustworthy and audited financial information. Investors, market analysts, and creditors assess a company's financial status and profits potential using its financial statements. The balance sheet, income statement, and statement of cash flows are the three main financial statement reports. 5 CU IDOL SELF LEARNING MATERIAL (SLM)
1.3 NATURE AND SIGNIFICANCE OF FINANCIAL STATEMENTS Nature of financial statements Financial reports are prepared using information about occasions and events that are consecutively recorded. The next step is to first categorise this wealth of information in monetary terms. Then, at that point, we need to deal with them utilising every single material guideline and process. Finally, we would be in a position to use this data to generate budget summaries. Due to this arrangement, the concept of financial statements or budget summaries depends on the following focuses: 1.Recorded realities: In order to support our assertions, we need to first record the facts in a financial context. We wish to represent data from records like fixed assets, cash, exchange receivables, and so on for this. 2.Accounting conventions: Specific conventions and notions applicable during the time spent bookkeeping are recommended by accounting standards. When setting up these claims or statements, we must follow certain conventions. For instance, the market price or cost of a stock, depending on which is cheaper. 3.Postulates: In addition to accounting practises, hypothesis also plays a significant role in the preparation of these assertions. In bookkeeping, assumptions are essentially what hypotheses are. For instance, the going concern notion is predicated on the idea that a company would last for a long time. In light of this, we must treat resources as true expenses. 4.Individual choices: Even personal views and choices play a significant role in the preparation of these claims or declarations. Therefore, while calculating things like devaluation, amortisation, and depreciation, one must rely on their own evaluations. Significance of Financial Statements: Financial statements have importance because they can be used to satisfy the shifting interests of many types of organisations, including management, lenders, the general public, and others. 1.Significance to Management: The complexity and scale of the factors influencing current company activities necessitate the use of a rational and perceptive management strategy. For these reasons, the manager or 6 CU IDOL SELF LEARNING MATERIAL (SLM)
management team requires modern, precise, and organised financial data. The administration benefits from financial reports in understanding the status, trajectory, and future possibilities of competing businesses. The administration is empowered to design appropriate strategies and game plans for the future by providing them with the reasons behind business results. The administration only communicates through the presentation of these budget summaries to various groups, legitimising their activities and, as a result, their reality. A similar analysis of budget summaries reveals a pattern in the effort's progress and position, enabling the government to implement the proper improvements in its methods for avoiding unfavourable scenarios. 2. Significance to the shareholders: Due to organisations, the board is a distinct entity from proprietorship. Directly speaking, investors are unable to take part in the operations of the business. However, at the annual general meeting, investors should be given financial reports detailing the results of these activities. These claims give investors the capacity to understand the administration's efficiency and viability, as well as the organization's purchasing power and financial stability.By dissecting the budget summary, potential investors might learn about the organization's benefit procuring cap, current standing, and future prospects and decide whether to invest in it.The main data sources for prospective financial backers are distributed budget summaries. 3.Significance to labour: Workers are eligible for compensation based on the profit level shown by the assessed profit and loss statement. As a result, P and L A/c are crucial for the workers in compensation exchanges. Additionally, it's crucial to consider how much productivity and profit were generated. 4.Significance to lenders/Creditors: The financial reports serve as a valuable resource for an organization's potential lenders, both present and prospective. These groups can become familiar with an organization's liquidity, productivity, and long- term dissolvability status by performing a rudimentary analysis of its financial records. They could then make decisions about their future strategy with the help of this. 5.Significance to public: 7 CU IDOL SELF LEARNING MATERIAL (SLM)
A social substance is business. Even though they are clearly unrelated to the business, various social groups are interested in the status, development, and future possibilities of an enterprise. They include financial examiners, lawyers, exchange affiliations, labour unions, the financial press, researchers, and educators, among others. 6. Significance to National economy: A country's economic development is typically impacted by the rise and development of the corporate sector. Corrupt and dishonest corporate managements undermine public confidence in commercial enterprises, which is essential for financial progress, and thus impede the country's economic growth. 1.4 OBJECTIVES OF FINANCIAL STATEMENTS Financial statements are documents created by a company's management to outline its current financial situation and performance. Financial statements' most fundamental goal is to give consumers of all types the data they need to make informed decisions about their financial situation, performance, and cash flows. The Financial Statements are created to accommodate the majority of users' common needs. Financial statements, however, may not offer all the data that customers might require to make economic decisions because They essentially depict the financial repercussions of earlier actions. You don't have to give non-financial information. The results of management's stewardship or its accountability for the assets entrusted to it are also displayed in the statement of financial accounts. The internal and external stakeholders can make a variety of decisions with the use of financial statements. Financial statements are generated to determine a business concern's profits or losses throughout a given period as well as its financial status at the end of that given period. Following are the objectives of preparing financial statements: - 1. Evaluating business activities' outcomes: Every businessman is interested in learning how his company's operations performed during a specific time period in terms of earnings realised or losses suffered. Income statement serves this purpose. 8 CU IDOL SELF LEARNING MATERIAL (SLM)
2. Determining the fiscal situation: Financial statements depict the state of the company's finances as of a specific date, which is often the end of the accounting quarter. For this, a position statement, or balance sheet, is created 3. Information's source: Financial statements are a crucial source of data on a business unit's finances, assisting the finance manager in planning the company's financial activities and optimising the use of available funds. 4. Helps in managerial decision making: By comparing the results of the current year with those of the previous years, the manager can conduct a comparative analysis of the profitability of the company and adjust his or her managerial decisions as necessary. 5. A measure of the company's financial health: Financial statements also demonstrate the company's long- and short-term viability. This enables the business company to obtain credit for purchases of products or services from banks and other financial institution. To provide us with a true image of the company, the financial consequences of transactions and other events are categorised into broad groups based on their economic features, as shown in the table below. 1.5 TYPES OF FINANCIAL STATEMENTS Following are the types of financial statements: 1. Balance Sheet A company's assets, liabilities, and shareholders' equity are outlined in the balance sheet as a snapshot in time. You may find out when the snapshot was taken by looking at the date at the top of the balance sheet, which is often the conclusion of the reporting period. A financial statement that lists a company's assets, liabilities, and shareholder equity at a certain point in time is referred to as a balance sheet. Balance sheets offer the basis for estimating rates of return for investors and evaluating a company's capital structure. The balance sheet is a financial statement that gives a quick overview of the assets and liabilities of a firm as well as the amount of shareholder investment. When doing basic analysis or calculating financial ratios, balance sheets can be utilised in conjunction with other crucial financial data. Why Is a Balance Sheet Important? 9 CU IDOL SELF LEARNING MATERIAL (SLM)
Executives, investors, analysts, and regulators utilise the balance sheet as a crucial tool to comprehend the current financial condition of a corporation. It frequently coexists with the income statement and the cash flow statement, the other two categories of financial statements. The user may quickly see the company's assets and liabilities thanks to balance sheets. Users can use the balance sheet to determine things like whether a firm has a positive net worth, if it has enough cash and short-term assets to pay its debts, and whether it is heavily indebted in comparison to its competitors. What Is Included in the Balance Sheet? The assets and liabilities of a corporation are disclosed in the balance sheet. This could include long-term assets like property, plant, and equipment or short-term assets like cash and accounts receivable, depending on the business (PP&E). Similar to its assets, its liabilities could consist of long-term debts like bank loans and other debt commitments or short-term debts like accounts payable and salaries payable. Who Prepares the Balance Sheet? The balance sheet may be created by a variety of parties, depending on the business. The proprietor or a company bookkeeper may construct the balance statement for small privately held firms. They may be prepared internally for mid-sized private businesses and then reviewed by an outside accountant. Public firms, on the other hand, must ensure that their accounts are kept to a far higher standard and obtain external audits by public accountants. These businesses are required to prepare their balance sheets and other financial statements in line with generally accepted accounting principles (GAAP) and submit them on a regular basis to the Securities and Exchange Commission (SEC). What Are the Uses of a Balance Sheet? A balance sheet details a company's financial situation at a certain time. A balance sheet is used to assess the position of a business on a particular day, as opposed to an income statement, which presents financial data across time. 10 CU IDOL SELF LEARNING MATERIAL (SLM)
Parties outside of a firm frequently examine a bank statement to determine the situation of the organisation. Banks, lenders, and other institutions may compute financial ratios based on balance sheet balances to assess a firm's level of risk, the liquidity of its assets, and the likelihood that the company will continue to operate. Even though the data on a balance sheet is typically less useful than that on an income statement, a business can nevertheless utilise it to make internal decisions. A business may use its balance sheet to assess risk, check that it has adequate cash on hand, and determine how to raise further capital (through debt or equity). What Is the Balance Sheet Formula? A company's assets, liabilities, and equity are balanced to create a balance sheet. Total assets are equal to total liabilities plus total equity. The aggregate of all short-term, long-term, and other assets is referred to as total assets. The sum of all current, future, and other liabilities is used to compute total liabilities. Net income, retained earnings, owner contributions, and shares of issued stock are added together to determine total equity. General instructions for preparation of Balance sheet: 1.When a change in treatment or disclosure is necessary to comply with the Act's requirements, including the Accounting Standards that apply to companies, such as an addition, modification, substitution, or deletion of a head or sub-head or any changes, per se, to financial statements or statements that form part of them, the necessary changes must be made, and the requirements of this Schedule must be modified as a result. 2. The disclosure obligations outlined in this Schedule are in addition to, not a replacement for, those outlined in the accounting standards established by the 2013 Companies Act. Unless required to be declared on the face of the Financial Statements, additional disclosures stipulated in the Accounting Standards must be made in the notes to accounts or by way of an additional statement. In addition to the requirements outlined in this Schedule, all other disclosures mandated by the Companies Act must be made in the notes to accounts. 11 CU IDOL SELF LEARNING MATERIAL (SLM)
3. The terminology used herein shall have the meanings assigned by the applicable Accounting Standards for the purposes of this Schedule. Note: This section of the schedule outlines the minimal information that must be shown on the face of the balance sheet, the statement of profit and loss (together referred to as \"Financial Statements\" for the purposes of this schedule), and the Notes. When necessary for compliance with changes to the Companies Act or under the Accounting Standards, line items, sub-line items, and sub-totals must be presented as an addition to or a replacement of other information on the face of the financial statements in order to aid in understanding the company's financial position or performance. Format of Balance Sheet as per schedule III of Companies Act, 2013, PART I — BALANCE SHEET Name of the Company……………………. Balance Sheet as at ……………………… (Rupees in…………) Particulars Note no Figures as at Figures as at the the end of end of the current previous reporting reporting period period Table 1.1 Balance Sheet 12 I. EQUITY AND LIABILITIES (1) Shareholders’ funds (a) Share capital (b) Reserves and surplus (c) Money received against share warrants (2) Share application money pending allotment (3) Non-current liabilities CU IDOL SELF LEARNING MATERIAL (SLM)
(a) Long-term borrowings 13 (b) Deferred tax liabilities (Net) (c) Other Long term liabilities (d) Long-term provisions (4) Current liabilities (a) Short-term borrowings (b) Trade payables (c) Other current liabilities (d) Short-term provisions TOTAL II. ASSETS Non-current assets (1) ( a) Fixed assets I. Tangible assets II. Intangible assets III. Capital work-in-progress IV. Intangible assets under development a. Non-current investments b. Deferred tax assets (net) c. Long-term loans and advances d. Other non-current assets (2) Current assets a. Current investments b. Inventories c. Trade receivables d. Cash and cash equivalents e. Short-term loans and advances f. Other current assets TOTAL CU IDOL SELF LEARNING MATERIAL (SLM)
Notes GENERAL INSTRUCTIONS FOR PREPARATION OF BALANCE SHEET A. Share Capital The following information is required for each class of share capital (different classes of preference shares to be treated separately): (a) the number and amount of authorised shares (b) the number of issued shares (c) the number of shares subscribed and fully paid; (d) the par value per share; and (e) a reconciliation of the number of outstanding shares at the start and end of the reporting period. B. Reserves and Surplus (i) Reserves and Surplus shall be classified as: (a) Capital Reserves; (b) Capital Redemption Reserve; (c) Securities Premium Reserve; (d) Debenture Redemption Reserve (e) Revaluation Reserve; (f) Share Options Outstanding Account; (g) Other Reserves–(specify the nature and purpose of each reserve and the amount in respect thereof); (h) Surplus i.e., balance in Statement of Profit and Loss disclosing allocations and appropriations such as dividend, bonus shares and transfer to/ from reserves, etc.; (Additions and deductions since last balance sheet to be shown under each of the specified heads); (ii) A reserve specifically represented by earmarked investments shall be termed as a “fund”. (iii) Debit balance of statement of profit and loss shall be shown as a negative figure under the head “Surplus”. Similarly, the balance of “Reserves and Surplus”, after adjusting negative balance of surplus, if any, shall be shown under the head “Reserves and Surplus” even if the resulting figure is in the negative C. Long-term borrowings (i) Long-term borrowings shall be classified as: (a) Bonds/debentures; (b) Term loans: (A) from banks. (B) from other parties. 14 CU IDOL SELF LEARNING MATERIAL (SLM)
(c) Deferred payment liabilities; (d) Deposits (e) Loans and advances from related parties; (f) Long term maturities of finance lease obligations; (g) Other loans and advances (specify nature). (ii) Borrowings shall further be sub-classified as secured and unsecured. Nature of security shall be specified separately in each case. (iii) Where loans have been guaranteed by directors or others, the aggregate amount of such loans under each head shall be disclosed. (iv) Bonds/debentures D. Other Long-term Liabilities Other Long-term Liabilities shall be classified as: (a) Trade payables; (b) Others. E. Long-term provisions The amounts shall be classified as: (a) Provision for employee benefits; (b) Others (specify nature). F. Short-term borrowings (i) Short-term borrowings shall be classified as: (a) Loans repayable on demand; (A) from banks. (B) from other parties. (b) Loans and advances from related parties; (c) Deposits; (d) Other loans and advances (specify nature). (ii) Borrowings shall further be sub-classified as secured and unsecured. Nature of security shall be specified separately in each case. G. Other current liabilities The amounts shall be classified as: (a) Current maturities of long-term debt; 15 (b) Current maturities of finance lease obligations; CU IDOL SELF LEARNING MATERIAL (SLM)
(c) Interest accrued but not due on borrowings; (d) Interest accrued and due on borrowings (e) Income received in advance; (f) Unpaid dividends; (g) Application money received for allotment of securities and due for refund and interest accrued thereon.Share application money includes advances towards allotment of share capital. (h) Share application money not exceeding the issued capital and to the extent not refundable shall be shown under the head Equity and share application money to the extent refundable, i.e., the amount in excess of subscription or in case the requirements of minimum subscription are not met, shall be separately shown under “Óther current liabilities”; (i) Unpaid matured deposits and interest accrued thereon; (j) Unpaid matured debentures and interest accrued thereon; (k) Other payables (specify nature) H. Short-term provisions The amounts shall be classified as: (a) Provision for employee benefits. (b) Others (specify nature). I. Tangible assets (i) Classification shall be given as: (a) Land; (b) Buildings; (c) Plant and Equipment; (d) Furniture and Fixtures; (e) Vehicles; (f) Office equipment; (g) Others (specify nature). (ii) Assets under lease shall be separately specified under each class of asset. J. Intangible assets (i) Classification shall be given as: (a) Goodwill; (b) Brands /trademarks; (c) Computer (d) Mastheads and publishing title; (e) Mining rights; (f) Copyrights, and patents and other intellectual property rights, services and operating rights; (g) Recipes, formulae, models, designs and prototypes; 16 CU IDOL SELF LEARNING MATERIAL (SLM)
(h) Licences and franchise ( i) Others (specify nature). K. Non-current investments (i) Non-current investments shall be classified as trade investments and other investments and further classified as (a) Investment in property (b) Investments in Equity Instruments; (c) Investments in preference shares; (d) Investments in Government or trust securities; (e) Investments in debentures or bonds; (f) Investments in Mutual Funds; (g) Investments in partnership firms; (h) Other non-current investments (specify nature) L. Long-term loans and advances (i) Long-term loans and advances shall be classified as: (a) Capital Advances; (b) Security Deposits; (c) Loans and advances to related parties (giving details thereof); (d) Other loans and advances (specify nature). (ii) The above shall also be separately sub-classified as: (a) Secured, considered good; (b) Unsecured, considered good; (c) Doubtful. (iii) Allowance for bad and doubtful loans and advances shall be disclosed under the relevant heads separately. (iv) Loans and advances due by directors or other officers of the company or any of them either severally or jointly with any other persons or amounts due by firms or private companies respectively in which any director is a partner or a director or a member should be separately stated. M. Other non-current assets Other non-current assets shall be classified as: 17 CU IDOL SELF LEARNING MATERIAL (SLM)
(i)Long-term Trade Receivables (including trade receivables on deferred credit terms); (ii) Others (specify nature); (iii) Long term Trade Receivables, shall be sub-classified as: (A) (a) Secured, considered good; (B) Unsecured, considered good; (C) Doubtful. (b) Allowance for bad and doubtful debts shall be disclosed under the relevant heads separately. (c) Debts due by directors or other officers of the company or any of them either severally or jointly with any other person or debts due by firms or private companies respectively in which any director is a partner or a director or a member should be separately stated. N. Current Investments (i) Current investments shall be classified as: (a) Investments in Equity instruments (b) Investment in Preference Shares; (c) Investments in Government or trust securities; (d) Investments in debentures or bonds (e) Investments in Mutual Funds; (f) Investments in partnership firms; (g) Other investments (specify nature) O. Inventories (i) Inventories shall be classified as: (a) Raw materials; (b) Work-in-progress; (c) Finished goods; (d) Stock-in-trade (in respect of goods acquired for trading); (e) Stores and spares; (f) Loose tools; (g) Others (specify nature). (ii) Goods-in-transit shall be disclosed under the relevant sub-head of inventories. (iii) Mode of valuation shall be stated. P. Trade Receivables (i) Aggregate amount of Trade Receivables outstanding for a period exceeding six months from the date they are due for payment should be separately stated. (ii) Trade receivables shall be sub-classified as: 18 CU IDOL SELF LEARNING MATERIAL (SLM)
(a) Secured, considered good; (b) Unsecured, considered good; (c) Doubtful. (iii) Allowance for bad and doubtful debts shall be disclosed under the relevant heads separately. Q. Cash and cash equivalents (i) Cash and cash equivalents shall be classified as: (a) Balances with banks; (b) Cheques, drafts on hand; (c) Cash on hand; (d) Others (specify nature). R. Short-term loans and advances (i) Short-term loans and advances shall be classified as: (a) Loans and advances to related parties (giving details thereof); (b) Others (specify nature). (ii) The above shall also be sub-classified as: (a) Secured, considered good; (b) Unsecured, considered good; (c) Doubtful. (iii) Allowance for bad and doubtful loans and advances shall be disclosed under the relevant heads separately. (iv) Loans and advances due by directors or other officers of the company or any of them either severally or jointly with any other person or amounts due by firms or private companies respectively in which any director is a partner or a director or a member shall be separately stated. S. Other current assets (specify nature) This is an all-inclusive heading, which incorporates current assets that do not fit into any other asset categories. T. Contingent liabilities and commitments (to the extent not provided for) (i) Contingent liabilities shall be classified as: (a) Claims against the company not acknowledged as debt; (b) Guarantees; (c) Other money for which the company is contingently liable. (ii) Commitments shall be classified as: 19 CU IDOL SELF LEARNING MATERIAL (SLM)
(a) Estimated amount of contracts remaining to be executed on capital account and not provided for; (b) Uncalled liability on shares and other investments partly paid; (c) Other commitments (specify nature). U.The amount of dividends proposed to be distributed to equity and preference shareholders for the period and the related amount per share shall be disclosed separately. Arrears of fixed cumulative dividends on preference shares shall also be disclosed separately. V. Where in respect of an issue of securities made for a specific purpose, the whole or part of the amount has not been used for the specific purpose at the balance sheet date, there shall be indicated by way of note how such unutilised amounts have been used or invested. W. If, in the opinion of the Board, any of the assets other than fixed assets and non-current investments do not have a value on realisation in the ordinary course of business at least equal to the amount at which they are stated, the fact that the Board is of that opinion, shall be stated. 2. Statement of Profit and Loss What Is a Profit and Loss (P&L) Statement? A financial statement that outlines the sales, expenditures, and expenses incurred during a specific time period—typically a quarter or fiscal year—is referred to as a profit and loss (P&L) statement. These documents reveal if a business can produce profit by raising sales, cutting expenses, or doing both. P&L statements are frequently displayed using the cash or accrual method. P&L statements are used by investors and corporate managers to assess a company's financial condition. Types of Profit and Loss (P&L) Statements 1. Cash Method Only when cash enters and exits the business is the cash method, also known as the cash accounting method, used. This is a fairly straightforward system that merely tracks money that has been paid or received. When money is received in a transaction, it is recorded as income; when it is spent on obligations, it is recorded as a liability. Smaller businesses and consumers who want to manage their own money frequently employ this technique. 20 CU IDOL SELF LEARNING MATERIAL (SLM)
2. Accrual Method Revenue is recorded using the accrual accounting method as it is earned. This indicates that a business utilising the accrual technique records the amount of money it anticipates receiving in the future. For instance, even when it hasn't yet received payment, a business that delivers a good or service to a customer records the revenue on its P&L statement. Similar to assets, liabilities are recorded even if no expenses have yet been paid by the business. Why Are Profit and Loss Statements Important? One of the three types of financial statements that businesses prepare is a P&L statement. The balance sheet and the cash flow statement make up the other two. The P&L statement's goal is to display a company's earnings and expenses for a given time period, typically one fiscal year. By integrating this data with insights from the other two financial statements, investors and analysts can utilise this information to evaluate the profitability of the business. To determine a company's return on equity (ROE), an investor could, for instance, compare its net income (as displayed on the P&L) to the amount of shareholder equity (as shown on the balance sheet). 21 CU IDOL SELF LEARNING MATERIAL (SLM)
Format of Profit and loss statement as per schedule III of Table no 1.2 Format of Profit and loss statement as per schedule III 22 CU IDOL SELF LEARNING MATERIAL (SLM)
Companies Act, 2013 GENERAL INSTRUCTIONS FOR PREPARATION OF STATEMENT OF PROFIT AND LOSS 1. The provisions of this Part shall apply to the income and expenditure account referred to in sub-clause (ii) of clause (40) of section 2 in like manner as they apply to a statement of profit and loss. 2. (A) In respect of a company other than a finance company revenue from operations shall disclose separately in the notes revenue from— a) Sale of products; b) Sale of services; c) Other operating revenues; Less: d) Excise duty. (B) In respect of a finance company, revenue from operations shall include revenue from— (a) Interest; and (b) Other financial services. Revenue under each of the above heads shall be disclosed separately by way of notes to accounts to the extent applicable. 3. Finance Costs Finance costs shall be classified as: (a) Interest expense; (b) Other borrowing costs; (c) Applicable net gain/loss on foreign currency transactions and translation. 4. Other income Other income shall be classified as: (a) Interest Income (in case of a company other than a finance company); (b) Dividend Income; (c) Net gain/loss on sale of investments; (d) Other non-operating income (net of expenses directly attributable to such income). 23 CU IDOL SELF LEARNING MATERIAL (SLM)
5. Additional Information A Company shall disclose by way of notes additional information regarding aggregate expenditure and income on the following items:— (i) (a) Employee Benefits Expense [showing separately (i) salaries and wages, (ii) contribution to provident and other funds, (iii) expense on Employee Stock Option Scheme (ESOP) and Employee Stock Purchase Plan (ESPP), (iv) staff welfare expenses] (b) Depreciation and amortisation expense; (c) Any item of income or expenditure which exceeds one per cent. of the revenue from operations or Rs.1,00,000, whichever is higher; (d) Interest Income; (e) Interest expense; (f) Dividend income; (g) Net gain/loss on sale of investments; (h) Adjustments to the carrying amount of investments; (i) Net gain or loss on foreign currency transaction and translation (other than considered as finance cost); (j) Payments to the auditor as (a) auditor; (b) for taxation matters; (c) for company law matters; (d) for management services; (e) for other services; and (f) for reimbursement of expenses; (k) In case of Companies covered under section 135, amount of expenditure incurred on corporate social responsibility activities; (l) Details of items of exceptional and extraordinary nature; (m) Prior period items; (ii) (a) In the case of manufacturing companies,— (1) Raw materials under broad heads. (2) goods purchased under broad heads. (b) In the case of trading companies, purchases in respect of goods traded in by the company under broad heads. (c) In the case of companies rendering or supplying services, gross income derived from services rendered or supplied under broad heads. (d) In the case of a company, which falls under more than one of the categories mentioned in (a), (b) and (c) above, it shall be sufficient compliance with the requirements herein if purchases, sales and consumption of raw material and the gross income from services rendered is shown under broad heads. (e) In the case of other companies, gross income derived under broad heads. (iii) In the case of all concerns having works in progress, works-in-progress under broad heads. (iv) (a) The aggregate, if material, of any amounts set aside or proposed to be set aside, to reserve, but not including provisions made to meet any specific liability, contingency or 24 CU IDOL SELF LEARNING MATERIAL (SLM)
commitment known to exist at the date as to which the balance sheet is made up. (b) The aggregate, if material, of any amounts withdrawn from such reserves. (v) (a) The aggregate, if material, of the amounts set aside to provisions made for meeting specific liabilities, contingencies or commitments. (b) The aggregate, if material, of the amounts withdrawn from such provisions, as no longer required. (vi) Expenditure incurred on each of the following items, separately for each item:— (a) Consumption of stores and spare parts; (b) Power and fuel; (c) Rent; (d) Repairs to buildings; (e) Repairs to machinery; (f) Insurance; (g) Rates and taxes, excluding, taxes on income; (h) Miscellaneous expenses, (vii) (a) Dividends from subsidiary companies. (b) Provisions for losses of subsidiary companies. (viii) The profit and loss account shall also contain by way of a note the following information, namely:— (a) Value of imports calculated on C.I.F basis by the company during the financial year in respect of— I. Raw materials; II. Components and spare parts; III. Capital goods; (b) Expenditure in foreign currency during the financial year on account of royalty, know-how, professional and consultation fees, interest, and other matters; (c) Total value if all imported raw materials, spare parts and components consumed during the financial year and the total value of all indigenous raw materials, spare parts and components similarly consumed and the percentage of each to the total consumption; (d) The amount remitted during the year in foreign currencies on account of dividends with a specific mention of the total number of non-resident shareholders, the total number of shares held by them on which the dividends were due and the year to which the dividends related; (e) Earnings in foreign exchange classified under the following heads, namely:— I. Export of goods calculated on F.O.B. basis; II. Royalty, know-how, professional and consultation fees; III. Interest and dividend; IV. Other income, indicating the nature thereof. Note:— Broad heads shall be decided taking into account the concept of materiality and presentation of true and fair view of financial statements. 1.6 SUMMARY A financial statement that outlines the sales, expenditures, and expenses incurred during a specific time period—typically a quarter or fiscal year—is referred to as a profit and loss (P&L) statement. These documents reveal if a business can produce 25 CU IDOL SELF LEARNING MATERIAL (SLM)
profit by raising sales, cutting expenses, or doing both. P&L statements are frequently displayed using the cash or accrual method. P&L statements are used by investors and corporate managers to assess a company's financial condition. The balance sheet may be created by a variety of parties, depending on the business. The proprietor or a company bookkeeper may construct the balance statement for small privately held firms. They may be prepared internally for mid-sized private businesses and then reviewed by an outside accountant Financial statements have importance because they can be used to satisfy the shifting interests of many types of organisations, including management, lenders, the general public, and others. Investors, market analysts, and creditors assess a company's financial status and profits potential using its financial statements. The balance sheet, income statement, and statement of cash flows are the three main financial statement reports. Financial information is used by investors and financial analysts to assess a company's performance and forecast where the stock price will go in the future. The annual report, which includes the company's financial statements, is one of the most significant sources of trustworthy and audited financial information. Only when cash enters and exits the business is the cash method, also known as the cash accounting method, used. This is a fairly straightforward system that merely tracks money that has been paid or received. When money is received in a transaction, it is recorded as income; when it is spent on obligations, it is recorded as a liability. Smaller businesses and consumers who want to manage their own money frequently employ this technique. Parties outside of a firm frequently examine a bank statement to determine the situation of the organisation. Banks, lenders, and other institutions may compute financial ratios based on balance sheet balances to assess a firm's level of risk, the liquidity of its assets, and the likelihood that the company will continue to operate. 26 CU IDOL SELF LEARNING MATERIAL (SLM)
1.7 KEYWORDS Balance sheet : A company's assets, liabilities, and shareholders' equity are outlined in the balance sheet as a snapshot in time. You may find out when the snapshot was taken by looking at the date at the top of the balance sheet, which is often the conclusion of the reporting period. Financial statement: The balance sheet is a picture of a company's assets, liabilities, and shareholders' equity. By glancing at the date at the top of the balance sheet, which is frequently the end of the reporting period, you may determine when the snapshot was taken. Assets: All the things a company has are its assets. On a balance sheet, they are located on the left side. Current assets and fixed assets are the two categories of assets. Assets that can be swiftly turned into cash are known as current assets. They consist of inventory, cash, and accounts receivable. Fixed assets are tangible possessions that have a shelf life of more than a year and have monetary value to a business, such as tools and computer hardware. Liabilities: Everything a company owes, both now and in the future, is considered a liability. On a balance sheet, they are located on the right side. Accounts payable, or money owing to vendors, is a typical small business liability. Reserves: Financial accounting reserves always have a credit balance. It also refers to a portion of the equity held by the shareholders, including their contra-asset for past-due accounts and responsibility for future claims. Additionally, it can exist in any portion of the shareholders' equity other than the basic share or contributed capital. Surplus: It is regarded as the remaining portion of the resources after a particular usage time. In addition, a surplus in accounting refers to the amount of retained earnings that is shown on a company's balance sheet. A surplus, however, benefits the company because it has extra resources that may come in handy in the future. Dividend: A dividend is a payment made by a corporation to its shareholders that is decided by the board of directors. Dividend payments are frequently made quarterly and might take the form of cash payments or stock reinvestments. 1.8 PRACTICAL PROBLEMS 1. 27 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 1.3 Practical Problems Adjustments: (a) Closing stock Rs, 35,000. (b) Provision for doubtful debts at 5% of sundry debtors. (c) Depreciation furniture and machinery by 10%. (d) Commission of Rs. 3,600 has been earned but not received till the closing of accounts. Solution: 28 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 1.4 Solution 29 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 1.5 Solution 30 CU IDOL SELF LEARNING MATERIAL (SLM)
5. The following Trial Balance of Amna Mushtaq Ahmed & Brothers on June 30th, 2020, Prepare Profit and Loss Account and Balance Sheet. Table 1.6 Prepare Profit and Loss Account and Balance Sheet. 31 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 1.7 Solution 32 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 1.8 balance sheet 33 CU IDOL SELF LEARNING MATERIAL (SLM)
6. Table 1.9 prepare the tables below Additional Information 1. Depreciation furniture by 10% by written down method (WDM). 2. A provision for doubtful debts is to be created to the extent of 5% on sundry debtors. 3. Salaries for the month of June, 2019 amounting to Rs. 3,000 were unpaid which must be provided for. However, salaries included Rs. 2,000 paid in advance. Office expenses outstanding Rs. 8,000. 4. Insurance amounting to Rs. 2,000 is prepaid. 5. Stock use for private purpose Rs. 6,000 and closing stock Rs. 60,000. 34 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 1.10Trading And P&L Account 35 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 1.11 Balance Sheet 1.9LEARNING ACTIVITY 1. Uses of Balance Sheet. ___________________________________________________________________________ ________________________________________________________________ ___________ _______________________________________________________________________ 2. Preparation of Balance Sheet. ___________________________________________________________________________ ___________________________________________________________________________ _______________________________________________________________________ 36 CU IDOL SELF LEARNING MATERIAL (SLM)
3. Preparation of Profit and Loss Account. ___________________________________________________________________________ ___________________________________________________________________________ _______________________________________________________________________ 4. Meaning and importance of financial statements. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 1.10UNIT END QUESTIONS A. Descriptive Questions Short Answers 1. Give Meaning of financial statements 2. Give information about Nature and objective of financial statements. 3. Explain in short about Balance sheet and profit and loss statement. Long Answers 1. Explain two types of financial statements. 2. Format of balance sheet . 3. Format of profit and loss account. 4. Explain Current assets and current liabilities. B. Multiple Choice Questions. 1. The balance sheet, income statement, and statement of cash flows are the three main _____________ a. Financial statement reports 37 b. Notes to accounts c. Profit and loss account statement d. Cash flow statement CU IDOL SELF LEARNING MATERIAL (SLM)
2. A _______details a company's financial situation at a certain time. a. Balance sheet b. P/l account c. Trading account d. Cash flow statement 3. The balance sheet is a financial statement that gives a quick overview of the________ of a firm as well as the amount of shareholder investment. a. Profit and loss b. Depreciation c. Revenue and expenditure d. Assets and Liabilities 4.The Financial Statements are created to accommodate the majority of users' ___________ a. Desires b. Common needs c. Wishes d. Savings 5. Specific __________applicable during the time spent bookkeeping are recommended by accounting standards a. Conventions and notions b. Formalities c. Beliefs d. Ideas/methods Answers 1-a, 2-a, 3-d. 4-b, 5-a 1.11 REFERENCES References book 38 CU IDOL SELF LEARNING MATERIAL (SLM)
Financial Statement Analysis - Martin Fridson. ... International Financial Statement Analysis - Thomas Robinson. ... The Finance Book - Stuart Warner & Si Hussain. ... Financial Statements: Step by Step - Thomas Ittelson. Website https://www.investopedia.com/terms/f/financial-analysis.asp https://corporatefinanceinstitute.com/resources/knowledge/finance/types-of-financial- analysis/ https://en.wikipedia.org/wiki/Financial_analysis 39 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 2 ANALYSIS OF FINANCIAL STATEMENTS STRUCTURE 2.0 Learning Objectives 2.1 Introduction 2.2 Objectives & significance of Financial Analysis 2.3 Parties Interested in Financial Analysis 2.4 Types , process and limitations of financial statement analysis 2.5 Horizontal vs. vertical analysis 2.6 Inter firm vs. Intra firm analysis 2.7 Summary 2.8 Keywords 2.9 Learning Activity 2.10 Unit End Questions 2.11 References 2.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Define financial statement analysis. Give information about Parties interested in financial analysis. State the difference between horizontal and vertical analysis. Explain Inter firm Vs. Intra firm. 2.1 INTRODUCTION You have learned about the income statement and balance sheet of firms' financial statements. These are essentially condensed financial reports that give an overview of a company's operating performance and financial status. The specific information provided can be used to evaluate a company's operational effectiveness and financial stability. This necessitates accurate information analysis and interpretation, for which a variety of methodologies (tools) have been created by financial specialists. 40 CU IDOL SELF LEARNING MATERIAL (SLM)
Financial statements are the end result of the accounting cycle and provide reliable, timely, and relevant financial information for making informed economic decisions. A company's main goal is to make money. It is a matter that every company must take seriously. The difference between an organization's total revenues and its total expenses for a certain time period is its profit. The owner is also curious about their financial standing. The process of creating a trading, profit and loss, and balance sheet is referred to as \"final accounts preparation.\" Meaning and Definition: Financial statement analysis is the act of evaluating the financial data present in the financial statements critically in order to comprehend and make judgments regarding the firm's operations. It consists primarily of an analysis of the relationships between various financial facts and figures as presented in a set of financial statements, as well as their interpretation in order to gain knowledge of the firm's profitability and operational effectiveness and to evaluate the firm's financial condition and future prospects Financial analysis is a broad word that encompasses both analysis and interpretation. The term \"analysis\" refers to the methodical classification of financial data that is used to simplify it for the financial statements. Interpretation entails describing the importance and meaning of the facts. These two complement one another well. Analyses are pointless , difficult or impossible without interpretation, while interpretation is impossible without analysis. Understanding Analysis and Interpretation It is essential to comprehending the significance of Analysis of financial statements cannot be done in isolation because they complement one another without any interpretation. Financial Analysis: It focuses on the right classification of given data to simplify financial data in the monetary statement. Interpretation: It focuses on elucidating the relevance and meaning of the financial data. Definition of Financial Statement Analysis As per Myer: Financial Statement Analysis is largely a study of relationships among the various financial factors in a business, as disclosed by a single set of statements, and a study of trends of these factors, as shown in a series of statements. 41 CU IDOL SELF LEARNING MATERIAL (SLM)
The financial statements provide a summary of the accounts of a business enterprise , the balance sheet reflecting the assets , liabilities and capital as on a certain data and the income statements showing the results of operations during a certain period ―. (John N. Meyer 2009). The end product of financial accounting is a set of financial statements prepared by the accountant of a business enterprise that purport to reveal the financial position of the enterprise the result of its recent activities, and an analysis of what has been done with earnings''. (Smith and Ashburn 2017). 2.2 OBJECTIVES & SIGNIFICANCE OF FINANCIAL ANALYSIS: Following are the Purposes (Objectives) and of Financial Analysis: i. To Evaluate the Earning Capacity or Profitability: The financial statement analysis can be used to evaluate the enterprise's earning capacity and profitability. Additionally, it makes it easier to predict the same for subsequent years. Since earnings are of interest to external users, this is their main goal while analysing financial statements. ii. To evaluate managerial effectiveness: This evaluation is made feasible by financial statement analysis, which shows where managers have been effective and where they have not. It is possible to locate the managerial inefficiency by identifying favourable and unfavourable variants. iii. To determine the enterprise's long- and short-term solvency: By carefully analysing the financial statements, this judgement is feasible. Debentureholders and lenders are interested to know the long- and short-term solvency of the firm to assess the ability of the company to repay the principle and interest thereon. Creditors or suppliers are interested to know the ability of the entity to satisfy the short-term responsibilities. iv. To permit inter-firm comparison: If mergers and acquisitions are to be considered, inter- firm comparison enables an organisation to evaluate both its own performance and that of others. v. To Project and Prepare Budgets: Examining historical data in the financial statements enables one to predict future trends. It makes it easier to estimate and create budgets for upcoming years. 42 CU IDOL SELF LEARNING MATERIAL (SLM)
vi. To Understand Complicated Matter: The study of financial statements aids users in comprehending complex issues. This can be aided by the use of clear and understandable charts, graphs, and diagrams. Significance of Analysis of Financial Statements Financial analysis is the act of correctly creating correlations between the various elements of the balance sheet and the statement of profit and loss in order to determine the firm's financial strengths and weaknesses. Management of the company may conduct financial analysis, or parties outside the company, such as owners, trade creditors, lenders, investors, labour unions, analysts, and others, may do so. Depending on the analyst's goal, the type of analysis will vary. Because the interests of the analysts varied, a strategy that one analyst uses regularly may not always be useful to other analysts. For many users, financial analysis is significant and beneficial in the following ways: (a) Finance manager: The facts and connections connected to management performance, corporate effectiveness, financial strengths and weaknesses, and the company's creditworthiness are the main subjects of financial analysis. A financial manager needs to be well-versed in the various analytical tools in order to make wise judgments for the company. The analysis tools assist in examining accounting data to assess the viability of operating strategies, the investment potential of the company, credit ratings, and operational effectiveness. The procedures are similarly important in the field of financial control because they allow the finance manager to continuously evaluate the firm's actual financial operations in order to identify the root causes of significant deviations and, if appropriate, take corrective action. (b) Top management: Financial analysis is important for all levels of management, not just the finance manager. Its extensive scope covers senior management in general as well as other functional managers. Every part of the financial analysis would be of interest to the company's management. They have a general duty to ensure that the company's resources are utilised as effectively as possible and that its financial standing is stable. Financial analysis assists management in gauging the effectiveness of the business' operations, assessing employee performance, and assessing the internal control system. (c) Trade payables: By analysing financial accounts, trade payables assesses the company's ability to meet both its immediate financial obligations and the likelihood that it will continue to be able to do so in the future. The firm's capacity to settle claims within a very short time 43 CU IDOL SELF LEARNING MATERIAL (SLM)
frame is of special significance to trade payables. Therefore, their study will assess the firm's liquidity status. (d)Lenders : The company's long-term viability and existence is a worry for long-term financing providers. They evaluate the company's long-term profitability, cash flow, ability to cover principle and interest payments, and the relationship between various funding sources. Long-term lenders examine previous financial data to evaluate the company's future profitability and solvency. (e) Investors: People who have invested money in the company's stock are curious about its financial performance. As a result, they focus on the examination of the company's current and potential profitability. They are also curious about the capital structure of the company and how it affects risk and earnings. They also assess the management's effectiveness and decide whether or not a change is required. The shareholders' options to buy, sell, or keep shares may be limited in some major corporations. (f) Labor unions: To determine if an organisation can currently afford a wage rise and whether it can absorb a wage increase through greater productivity or by raising prices, labour unions examine the financial statements. (g) Others: To understand the current company and economic situations, economists, academics, etc. analyse financial accounts. The government agencies require it for taxation, pricing regulation, and other related uses. 2.3 PARTIES INTERESTED IN FINANCIAL ANALYSIS: i. Management: Financial analysis aids management in determining the overall and segmental effectiveness of the company. Additionally, it aids in self-evaluation, control, and decision- making. ii. Employees and Trade Unions: By analysing the profitability, sustainability, and financial position of the enterprise from its financial statements, financial analysis is thought to be helpful for employees to get a clear idea of the emoluments, bonus, working conditions, and security of their jobs. Trade unions also analyse financial documents to evaluate the level of profitability of the firm on the basis of which they can further negotiate in order to make wise judgments and engage into advantageous wage agreements. 44 CU IDOL SELF LEARNING MATERIAL (SLM)
iii. Shareholders, owners, or investors: These are the investors who put their money to work by contributing it as capital. They are therefore interested in the business's returns, which may be determined by looking at its profitability. Additionally, growth potential aids in the growth of investments. iv. Potential Investors: These are people who are considering investing in a business concern and are curious about the current profitability, financial situation, and future possibilities. v. Suppliers or Creditors: This group of interested users is concerned about the company's ability to make timely payments of the sums due on account of credit transactions made with them as well as whether to grant the company further credit. Such a choice is based on the company's short-term viability, which may be assessed by looking at its financial accounts. vi. Bankers and Lenders: These are the parties that contribute money to an enterprise in the form of loans that must be repaid at the end of a predetermined time. Such parties should have a good understanding of the enterprise's long-term solvency in order to determine its repayment capabilities. The analysis of the relevant enterprise's financial accounts is how this information is obtained. vii. Researchers: People who are actively conducting research and want to do the same for commercial entities in order to evaluate an enterprise's financial health, growth, and profitability. They are interested in analysing the relevant parts of these fields, including data on corporate operations, finances, human resources, etc., to acquire knowledge on these topics. viii. Tax authorities: These are concerned with ensuring that the enterprise's tax liabilities are properly assessed in accordance with the tax rules that are currently in effect. ix. Customers: Customers are interested in learning about an enterprise's future. This is especially true if they are dependent on the company or have a long-term relationship with it. 2.4 TYPES , PROCESS AND LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS Types of financial statement analysis: Financial statement analysis can be categorised into the following four categories: 45 CU IDOL SELF LEARNING MATERIAL (SLM)
i. External Analysis: This type of analysis is carried out by investors, credit agencies, researchers, etc. who do not have access to the private and complete records of an enterprise. Investors, credit agencies, researchers, etc. who do not have access to the private and complete records of an enterprise must rely on information published in various statements or reports, which may include the Statement of Profit and Loss, Balance Sheet, Auditor's Reports, etc. ii. Internal Analysis: The management of the business conducts this thorough and comprehensive sort of analysis to ascertain the organization's financial status and operational effectiveness. Since management has access to all information, they do thorough analysis that is more precise and detailed. iii. Horizontal analysis: Dynamic Analysis is another name for horizontal analysis. It is also referred to as time series analysis because it involves reviewing and analysing financial statements for a number of years. It makes it easier to compare financial data from various years to a particular base year. iv. Vertical Analysis: Vertical Analysis, also referred to as Static Analysis Only one year's worth of financial statements are reviewed and analysed. It is helpful for comparing the results of many businesses of the same type, or divisions or departments within one compa ny. Differences between Horizontal Analysis and Vertical Analysis: Following are the points of differences between Horizontal Analysis and Vertical Analysis: Table no 2.1 Differences between Horizontal Analysis and Vertical Analysis: Inter- and intra-firm analysis: understanding 46 CU IDOL SELF LEARNING MATERIAL (SLM)
i. Inter-firm analysis: It makes it possible to compare two or more firms based on the many financial aspects or variables that determine how competitive each firm is. Cross-sectional analysis refers to a comparison of one set of financial statements from two or more firms. ii. Intra-firm Analysis : It is often referred to as Time Series Analysis or Trend Analysis since it makes it possible to compare the different financial variables of an organisation across time. It aids in analysing an enterprise's performance over time. Process of Financial Statement Analysis: Following are the main functions that are used in the process of analysis and interpretation of Financial Statement. i. Reorganization of Financial Statements: In order to extract the most needed information from each set of data for analysis, it is important to reorganise the complicated data in financial statements into purposeful classes. ii. Comparison: If the analysis is a time series, once the complex data has been classified, comparable data from the same company's earlier eras must be gathered. If the analysis is cross-sectional, it is required to get comparative information from businesses that are equivalent or similar and that have the same accounting period. iii. Analysis: Financial parameters including profitability, solvency, and liquidity are used to analyse the comparative financial data. iv. Interpretation: The fourth and final element of the financial statement analysis is the interpretation. The interpretation needs to be accurate and focused on showing the evolution of different financial features. Limitations of Financial Statement Analysis Following are the limitations of Financial Statement Analysis: i. Historical Analysis: Financial Statements are created utilising historical data from previous financial transactions. This is known as a historical analysis. Financial statements are therefore appropriately referred to as historical records of financial transactions. Therefore, analysing such transactions involves doing a historical study. Because the statement refers to the utilisation of future data, it is false. 47 CU IDOL SELF LEARNING MATERIAL (SLM)
ii.Price Level Changes are not considered: Analysis of financial accounts from different accounting years is invalidated by price level changes since accounting records overlook changes in the purchasing power of money. iii. Qualitative Aspect Ignored: Financial Statements solely include quantitative financial transactions. Other significant qualitative factors that have an impact on the financial accounts are not taken into account. iv. Limitations on Financial Statements: Financial Statements have some restrictions and aren't always accurate. These restrictions will thus have an effect on the judgments made based on the analysis of the information given by such financial statements since analysis is based on the information provided by financial statements. v. Not free from bias: Financial statements are the result of accounting principles, practises, and estimates, hence they are not impartial. Estimates are not totally reliable because there is a potential that the numbers will change and are therefore subject to bias. The financial statements are therefore not entirely trustworthy. vi. Accounting Procedures: It is essential that all businesses use the same accounting procedures in order to compare their profitability and financial standing. Inter-firm comparison is impossible if various accounting practises are used. vii. Window dressing: This is the practise of changing the books of accounts to reflect a better financial state than what it truly is. Such erroneous representations will give analysts misleading data, which will lead to poor decision-making. viii. Symptoms: Financial statements analysis makes it easier to spot symptoms or problems, but it is unable to offer a fix or remedy. The management must handle the correction of the error or problem based on their individual analyses. 2.5 HORIZONTAL VS. VERTICAL ANALYSIS I. Horizontal analysis When analysing financial statements, horizontal analysis is used to analyse historical data from various accounting periods, such as ratios or line items. In horizontal analysis, comparisons can be made using either absolute comparisons or percentage comparisons, where each subsequent period's figures are expressed as a share of the baseline year's total, with 100% as the baseline value. The base-year analysis is another name for this. 48 CU IDOL SELF LEARNING MATERIAL (SLM)
A horizontal analysis, also known as \"trend analysis,\" is a step in financial analysis where financial data quantities over a given time period are compared line by line to help with decision-making. E.g. HGY Company’s income statement for the year ended 2016 is shown below along with the financial results for the year 2015. Table No 2.2 Income Statement 49 CU IDOL SELF LEARNING MATERIAL (SLM)
Table No 2.3 Assets And Liabilities Comparing financial outcomes horizontally, line by line, is known as horizontal analysis. Understanding how the results have changed from one financial period to another is made easier by this. Both an absolute value and a percentage value can be used to determine this. In the case above, HGY's income grew by $1,254 million ($6,854 million – $5,600 million). This increase is a 22.4% percentage increase ($1,254m/$5,600m* 100). Every organisation should strive to expand over time in order to increase shareholder value. In order to comprehend how successfully this has been accomplished over a period of time, horizontal analysis is helpful. How Horizontal Analysis Works Investors and analysts can identify trends and growth patterns by using horizontal analysis to understand what has been influencing a company's financial performance over a number of years. Analysts can evaluate relative changes in various line items over time and project them into the future using this sort of analysis. A thorough picture of operational outcomes is provided by a time-series analysis of the income statement, balance sheet, and cash flow statement, which exposes what motivates a company's success and if it is profitable and functioning efficiently. 50 CU IDOL SELF LEARNING MATERIAL (SLM)
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