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FINANCIAL STATEMENTS

IBS Bangalore23 October 2010

Faculty : Aparna Hawaldar



Forms of Business Organization

Sole Proprietorship

Partnership

Company

Private Limited Company

Joint Stock/Public Limited Company



Users of Financial Statements

Accounting system is the information

system that identifies, records and

communicates the economic events of an organization to the interested users

Internal Users and External Users



People who work

for the business

Resource providers

(investors &

creditors)

Recipients of goods

and services

(customers)

Parties performing a

review or a oversight

function (Regulatory

agencies)

Internal Users External Users



Generally Accepted Accounting

Principles (GAAP)Assumptions:

Accounting Entity

Going Concern

Monetary

Period Principles:

Historical Cost

Full Disclosure



Accounting Entity AssumptionAccounting Entity Assumption The business is separate and distinct

from its owners.

Entity·s assets and other financialelements are not commingled with

those of the owners.

The economic entity assumption is an

accounting concept, and not a legal

construct.



The business is assumed to continue

indefinitely unless terminated by

owners.

The basis of recording financial

elements is historical accounting .

Going Concern AssumptionGoing Concern Assumption



Money is the common unit of measure of economic transactions.

Use of a monetary unit is relevant, simpleto understand and universally available.

Price level changes are ignored inaccounting, leading to the assumption thatthe rupee remains relatively stable.

Monetary Unit AssumptionMonetary Unit Assumption



Economic activity of an entity may be

artificially divided into time periodsfor reporting purposes.

Shorter time periods are subject torevisions but may be more timely.

Periodicity AssumptionPeriodicity Assumption



Historical Cost Principle

Transaction is recorded at its acquisition pr ice .

It is not changed to reflect market price.

The principle applies to most assets and

liabilities.



The Matching Principle

Expenses are matched to the revenuesthey help generate.

There should be a logical, rational association of revenues and expenses.

If a cost does not benefit future periods,it is recorded in the current period as anexpense.



Full Disclosure Principle Financial statements must report what

a reasonable person would need to

know to make an informed decision. Disclosure may be made:

within the body of the financial

statements,

as notes to those statements, or

as supplementary information.



Constraints: Cost Benefit Rule

Cost-Benefit Relationship :: The cost of

providing information should not

outweigh the benefit derived.

Costs and benefits are not always

obvious or measurable.

Sound judgment must be used in

providing information.



Constraints: Materiality Materiality refers to an item·s importance

to a firm·s overall financial operations.

An item must make a difference to bematerial and be disclosed.

It is a matter of the relative significance

of the element.

Both quantitative and qualitative factors

are to be considered in determining

relative significance.



Constraints: Industry PracticesConstraints: Industry Practices The nature of some industries sometimes

require departures from basic accounting

theory.

If application of accounting theory results

in statements that are not comparable or

consistent, then industry practices must

be examined for possible explanations.



Constraints: ConservatismConstraints: Conservatism Conservatism suggests that the preparer,

when in doubt, choose a conservative solution .

This solution will be least likely to overstate

assets and income.

Conservatism does not suggest that net assetsor net income be deliberately understated.



Qualitative Characteristics

R elevance - Information that is capable of nformation that is capable of

making a difference in a decision contextmaking a difference in a decision context

R eliability - Can be relied on to representthe true, underlying situation.

C omparability - measured & reported in a

similar manner for different businesses

U nderstandability



Elements of Financial Statements

Assets

Revenues

Expense Losses

Gains

Equity

Liabilities

Financial

Statements



Assets: Probable future

economic benefitsresulting from pasttransactions

Liabilities: Probablefuture sacrifices of

economic benefitsresulting from pasttransactions

Equity: Residual orownership interest

Investment by Owners: Distributions to

Owners:

Comprehensive Income:

All changes in equity from non-owner sources

Revenues: Inflows from

entity·s ongoing

operations Expenses: Outflows from

entity·s ongoing

operations

Gains:

Losses:

Balance SheetBalance Sheet IncomeIncome StatementStatement




Assets

Revenues

Expense Losses

Gains

Equity

Liabilities

Financial

Statements

Result fromResult from

delivering or delivering or producing goods,producing goods,

rendering services,rendering services,

or other activitiesor other activities

that constitute thethat constitute the

entity¶s major or entity¶s major or

central operationscentral operations




Assets

Revenues

Expense Losses

Gains

Equity

Liabilities

Financial

Statements

Result fromResult from

delivering or delivering or

producing goods,producing goods,

rendering services,rendering services,

or other activitiesor other activities

that constitute thethat constitute theentity¶s major or entity¶s major or

central operationscentral operations




Assets

Revenues

Expense Losses

Gains

Equity

Liabilities

Financial

Statements

Revenues

-

Expenses



Principal Financial Statements

IncomeStatement

Balance

Sheet

Cash FlowStatement



Balance Sheet

CapitalShare Capital

Retained Earnings

Reserves

Non current liabilities

Debentures

Long term Loans

Current LiabilitiesAccount payables

Outstanding

payments

Non Current/ FixedAssets

Land & Building

Plant & Machinery

Investments Intangible Assets

Current Assets

Inventories

Account Receivables

Prepaid Expenses

Cash



FIN A NCI AL R AT IOS



Objectives of Ratio Analysis Standardize financial information for

comparisons

Evaluate current operations Compare performance with past

performance

Compare performance against other firms or

industry standards

Study the efficiency of operations

Study the risk of operations



Rationale Behind Ratio Analysis A firm has resources

It converts resources into profits through production of goods and services

sales of goods and services

Ratios Measure relationships between resources and

financial flows

Show ways in which firm·s situation deviates fromIts own past

Other firms

The industry



Types of Ratios Financial Ratios:

Liquidity Ratios

Leverage Ratios : Structural & CoverageOperational Ratios:

Activity (Turnover) Ratios

Profitability Ratios

Valuation Ratios



Liquidity RatiosAssess the firm· ability to cover current

obligations to maintain sound liquidity

Current Ratio: Current Assets

Current Liabilities

Quick (Acid Test) Ratio:

Current Assets ² Inventories

Current Liabilities



Assess ability to cover long term debt obligations

Debt Equity Ratio: Debt

Shareholders funds Capital Gearing Ratio :

Fixed interest bearing securities

Equity Shareholders funds Fixed Asset Ratio : Fixed Assets

Capital Employed

Leverage Ratios ² Structural



Ability of the firm to service the debt

Interest Coverage Ratio: EBIT

Interest Expense

Debt Service Coverage Ratio :

Leverage Ratios - Coverage



Gross Profit Margin Ratio

Net Profit Margin Ratio

Return on Capital Employed (ROCE):

EBIT

(Average total Debt + shareholders equity)

Return on Equity (ROE): Net Income

Average Equity

Profitability Ratios

Assess profits relative to amount of resources used



Total Asset Turnover Ratio:

Sales

Average total assets

Debtors Turnover Ratio

Net Credit Sales

Average Debtors

Inventory Turnover Ratio:Cost of goods sold

Average Inventory

Activity (Turnover) RatiosAssess amount of activity relative to amount of resources

used



Valuation RatiosAssess market price relative to assets or earnings

Earnings Per Share (EPS)

Net Income (PAT)

Number of shares

Price-Earnings Ratio (PE Ratio)

Market price of the share

Earnings Per Share

Capitalization ratio : 1/PE Ratio



The DuPont Analysis Method to breakdown ROE into:

ROA and Equity Multiplier

ROA is further broken down as:Profit Margin and Asset Turnover

Helps to identify sources of strength andweakness in current performance

Helps to focus attention on value drivers



The DuPont Analysis

Profit Margin Total Asset Turnover

ROA Equity Multiplier

ROE



The DuPont Analysis

EquityCommon

AssetsTotal

AssetsTotal

Income Net

Multiplier EquityROAROE

v!

v!

AssetsTotalSales

SalesIncome Net

Turnover AssetTotalMarginProfitROA

v!

v!



Summary of Financial Ratios Ratios help to:

Evaluate performance

Structure analysisShow the connection between activities andperformance

Benchmark with

Past for the company Industry

Ratios adjust for size differences



Limitations of Ratio Analysis A firm·s industry category is often difficult

to identify

Published industry averages are only guidelines

Accounting practices differ across firms Sometimes difficult to interpret deviations

in ratios Industry ratios may not be desirable

targets

Seasonality affects ratios

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