ToTCOOP+i O3 o4 unit-4_final_version_en

STRATEGIC PARTNERSHIP FOR INNOVATING THE TRAINING
OF TRAINERS OF THE EUROPEAN AGRI-FOOD COOPERATIVES
ToTCOOP+i PROJECT
Competence Unit 4 / Training Unit 4 :
Financial reporting

Index
- Activity 1: balance sheet
- Activity 2: income statement
- Activity 3: equity statement
- Activity 4: cash flow statement
- Activity 5: management discussion and analysis -
MD&A
- Activity 6: the case of the application to the
cooperatives of the IAS 32
- Activity 7: the IAS 41 Agriculture
- Activity 8: financial statement analysis

Activity 1 - Balance Sheet
A financial statement that summarizes a company's assets, liabilities and
shareholders' equity at a specific point in time.
The accounting balance sheet is one of the major financial statements
used by accountants and business owners.
It is also referred to as the statement of financial position.

Assets – Its anything tangible or intangible which is owned or
leased by a business.
Liability – Its any obligation which a company owes to another
business entity
Owner’s equity - all claims of the proprietor, partners, or
stockholders against the assets of a firm, equal to the excess of
assets over liabilities.
Basic accounting equation - relationship that states that assets
equal liabilities plus owners’ equity.
Components of Balance sheet

Assets
Current Assets
Cash
Accounts receivable
Inventories
Prepaid Expenses
Fixed Assets
Land & Building
Equipments
Investments
Goodwill
Liabilities
Current Liabilities
Accounts payable
Accrued Expenses
IT Payable
Short Term debt
Non Current Liabilities
Bonds Payable
Long Term Borrowings
Owner's Equity
Common Stock
Retained earnings
Reading a Balance sheet

• A balance sheet offers a way to look inside your business and outline what it is
really worth. A balance sheet is different from a measure of profit and loss.
• It’s a list of assets and liabilities. Any good balance sheet includes some
basics:
• 1) What the business owns (real estate, vehicles, office equipment, etc.)
• 2) Revenue you expect to take in (accounts receivable)
• 3) Expenses you expect to pay out (accounts payable)
Why Balance sheet

• The balance sheet is used to assess the value of your
business at any given point
• It helps to keep track of finances
• It helps for showing it to investors & Bank Managers
• It is also useful for annual accounts too.

1. What Is Financial Statement ?
2. Overview Financial Statement
3. What Is Income Statement?
4. Why Income Statement ?
5. Usefulness
6. Limitation
7. Proforma of income statement
8. Contents of income statement
9. Sum solving
Activity 2 - Income statement

 Income Statement - It presents financial record of a company’s revenues and
expenses, and profits over a period of time.
 It also gives firm’s financial performance in terms of revenues, expenses, and
profits over a given time period.
 It focus on revenues and costs associated with revenues.
 Financial Statement is a group of reports that tell a company’s financial status
 From company owners to potential investors everyone in between are interested
 People are interested because they want to know how much money they made or
how much money they spent
 Some want to know how much money was reinvested in the company
 There are three financial reports that are created during the accounting cycle
1. What Is Financial Statement ?

Reading an Income Statement
Sales
(-) Cost of goods sold
Gross Profit
Operating Expenses
Operating Income
Interest Expenses
Income Before Tax
(-) Taxes
Net Income Available to Shareholders
+ General & Administrative Expenses
+ Selling & Marketing Expenses
+ Research & Development
Expenses
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX

 Income Statement is the member of Financial Statement that tell us whether
or not a company made a profit or incurred a loss.
 It is something refers to Profit & Loss statement, Statement of Income
 Important because it shows the profitability of a company during the time
interval
 It varies from company to company:
Three months
Four weeks
Fiscal years (1st April – 31st March)
3. What Is Income Statement?

 In income statement all you have to know are two simple things:
 1. Revenue (Money that company takes in)
 2. Expenses (Money that company pays out)
 Use this simple formula:
Revenue – Expenses = Net Income
(Amount of money that is left)

 The Income Statement is one of the major financial statement used by
accountants and business owners
 It shows the Profitability of a company during the time interval specified in its
heading
 It helps in Identifying Risk And Opportunities and forecast future performance
for:
◦ Owners
◦ Creditors
◦ Competitors
◦ Investors
4. Why Income Statement ?

 Income statement should help investors and creditors of financial statement
predict future cash flow in numbers of ways
 Evaluate the past performance of the enterprise
 Provide a basis for predicting future performance
 Help assess the risk of uncertainty of achieving future cash flows
5. Usefulness

 Its is based on various assumptions & estimates. Therefore the net income
measured by preparing an income statement is not absolutely accurate
 Items that might be relevant but cannot be easily measure
 Income numbers are affected by accounting methods
 Income measurement involves judgments
 While preparing income statement we take into account only those activities
whose value can be objectively measured
 A manipulation in net income is possible by using a particular inventory
valuation method
6. Limitations

Activity 3 – Equity Statement
Purpose:
To reconcile the owner equity amount stated at the beginning of
the time period, with the owner equity amount determined at
the end of the time period.
OWNER Equity
 Term used to describe value of the business after the total
claims of creditors are subtracted from the value of the assets.
 The term “owner equity” refers only to a business and this
statement includes no information for an individual person.

Net Worth
 The term “net worth” is used to describe value of
business plus personal valuation after the total claims of
creditors are subtracted from the value of assets.
 The term “net worth” refers to a statement for an
individual person or a statement for a business which
also contains data for an individual person.

Statement of Owner Equity
 Components should include:
1. Beginning owner equity
2. Plus net income amount
3. Minus owner withdrawals
4. Plus contributions received by business
5. Minus contributions distributed to others
6. Equals Change in Retained Earnings/Contributed Capital
7. Ending Owner Equity (Cost Value Basis)

 Components should include:
7. Ending Owner Equity (Cost Value Basis)
8. Adjustment for change in Asset Values (Ending market value -
cost value) -
(Beginning market value - cost value)
from beginning to end of time period
and adjustment for change in Deferred Debt
(+Beginning - Ending Deferred Liabilities)
9. Equals change in market valuation equity
10. Ending Owner Equity (Market Value Basis)

CONTENTS OF PROFIT AND LOSS / INCOME STATEMENT
1) Revenue From Operation :
Note :
In respect of company other than a financial finance company revenue from
operation shall disclose separately in the notes revenue from
 Sale of products
 Sale of services
 Other operating revenues
Less:
Excise duty
PARTICULARS AMT AMT
Gross Sale (If Sale Not Given Then Gross Profit)
Less : Returns

while, in respect of a finance company revenue from operation shall include from
 Interest and
 Other financial services
Revenue under each of above heads shall be disclosed separately by way of notes
to accounts to extent applicable
2) Other Income
PARTICULARS AMT AMT
Rest Income
Dividend Received
Rent Received
Transfer fees
Profit on sale of fixed assets

3) Cost Of Material Consumed , Purchase Of Stock In Trade :
4) Changes In The Inventories of Finished Goods , Stock In Trade,
Work-in-progress :
5) Employee Benefits Expenses:
PARTICULARS AMT AMT
Opening Stock
Add: Purchase
Less: Closing Stock
PARTICULARS AMT AMT
Opening Stock
Less: Closing Stock
PARTICULARS AMT AMT
Salaries And Wages
Staff Welfare Expenses
Contribution To Provident Fund
Managing Directors Remuneration

6) Finance Cost:
7) Depreciation And Amortization Expense:
Amortization and depreciation are non-cash expenses on a
company's income statement. Depreciation represents the cost of capital
assets on the balance sheet being used over time, and amortization is the
similar cost of using intangible assets like goodwill over time.
PARTICULARS AMT AMT
Interest On Debentures
Interest From Borrowings From Banks/Financial Institution
Interest By Tax Department
Discount on issue of debentures w/off
PARTICULARS AMT AMT
Depreciation Of Plant And Machinery
Depreciation On Furniture, Building

Other Expenses:
PARTICULARS AMT AMT
Rates
Payment To Auditor
Consumables
Bad Debts
Discount
Commission
Advertisement
Trade Expenses
Transit Expenses
Transit Insurance
Directors Sitting Fees
Printing And Stationery
Provision For Bad Debts
Maintenance Of Motor Car
General Expenses
Loss No Sale Of Asset
Establishment Expenses
Selling Expenses

Power and fuel
Rent
Repairs to building
Repairs to machinery
Insurance
Travelling expenses
Freight and carriage outward
Delivery expenses
Preliminary expenses w/off

Exceptional items:
When items of income and expenses from ordinary activities are of
such size , nature or incidence that their disclosure are relevant to
explain the performance of the enterprise for the period ,the nature and
amount of such items should be disclosed separately . Eg , the
disposal of items of fixed asset, provision for the costs of
reconstruction.
Extra ordinary items:
These are those incomes or expenses that arises from event or
transaction that are clearly distinct from ordinary activities of the
enterprise and therefore are not expected to recur frequently or
regularly E.g. loss from earthquake.

 A cash flow presents information about the cash flow with the
oganisation’s main activity and those associated with its investing
and financing activities of the period.It shows both inflow and out
flow of the cash during the period
 IAS 7 Cash Flow Statements
Activity 4 - Cash flow statement

 This statement shows the dynamics of short-term liquidity and long-
term solvency
 Cash flow information is an essential input for economic decision
models
 It shows how much cash onlow or outflow is made during the period
by operating,investing or financing activity
Usage

Cash conversion cycles
 Cash flows through the company continuously in a series of short-
term and long-term conversion cycles
 The ST - cash conversion cycle (operating cycle) relates to the main
business operations
= OPERATING ACTIVITIES

Format and structure of the cash flow statement
 Cash flows from operating activities
 + Cash flows from investing activities
 + Cash flows from financing activities
 Net change in cash during period
 + Beginning cash balance
 Ending cash balance

Cash flows from operating activities
 Operating activities are primarily the revenue-generating activities of
a organisation
 “Operating cash flow” is conceptually most near to “net profit”
Following iteams are added or deducted:
1. Non-cash expenses and non-cash revenues (f.i. depreciation
expense)
2. Non-operating items (f.i. gain on disposal of tangible fixed
assets)
3. Timing differences between net profit and underlying cash flow
(f.i. changes in the level of inventories, receivables, creditors,
etc.)`

Operating cash flows: Examples
 Receipts from sale of goods and rendering of services (cashing in of
receivables included)
 Receipts from taxes on sales and VAT
 Receipts from royalties, fees, commissions,…
 Payments to suppliers (payment of creditors included)
 Payments to employees
 Payments of taxes, VAT, fines

Operating cash flows – Direct versus indirect method
2 methods for identifying and presenting the operating
cash flow:
 Direct method: engenders the presentation of the most important
categories of gross operating cash inflows and cash outflows
 Indirect method: net operating cash flow is determined by adjusting
the (net) profit figure for the 3 types of differences

Direct method - Example
 Cash receipts from customers 20250
 Cash paid to suppliers and employees -17300
 Cash generated from main operations 2950
 Income taxes paid -1050
 Net cash flow from operating activities 1900

Cash flows from investing activities
 This shows item on the cash flow statement that reports the
aggregate change in a company's cash position resulting from any
gains (or losses) from investments in the financial markets and
operating subsidiaries and changes resulting from amounts spent
on investments in capital assets
 Examples:
◦ Payments for newly acquired equipment
◦ Receipts from the disposal of a building

Cash flows from financing activities
 This catagory shows accounts for external activities that allow a firm
to raise capital and repay investors, such as issuing stok, devidend
etc.
Examples:
◦ Inflow from issuing stock
◦ Inflow from new bank loan
◦ Outflow from buy-back of shares
◦ Outflow of loans

Constructing a cash flow statement
1. First determine under which method cash flow is made
2. Now begin with cash flow from operating activies then Investing and
financing activities
3. Identify all transactions of the period leading operating,Investing
and Financing activities
4. Construct a cash flow statement according to the formal rules

Classifying balance sheet movements as inflows or
outflows of cash

 What do internal users use it for?
Planning, evaluating and controlling company operations
 What do external users use it for?
Assessing past performance and current financial position and
making predictions about the future profitability and solvency of
the company as well as evaluating the effectiveness of
management
Activity 5 – Management discussion and analysis

Information is available from
◦ Published annual reports
 (1) Financial statements
 (2) Notes to financial statements
 (3) Letters to stockholders
 (4) Auditor’s report (Independent accountants)
 (5) Management’s discussion and analysis
627 628

Information is available from
◦ Other sources
 (1) Newspapers (e.g., Wall Street Journal )
 (2) Periodicals (e.g. Forbes, Fortune)
 (3) Financial information organizations such
as: Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc.,
and Robert Morris Associates
 (4) Other business publications
627 628

 Horizontal Analysis
 Vertical Analysis
 Common-Size Statements
 Trend Percentages
 Ratio Analysis
Methods of Financial Statement Analysis

Horizontal Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next

Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales

Common-Size Statements
Financial statements that show
only percentages and no
absolute dollar amounts

Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)

Ratio Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)

Activity 6 - IAS 32
What is a financial instrument-1?
 It can be a financial liability or an equity instrument
 If it is an equity instrument then :
 A) it does not any contractual obligations (deliver cash or exchange
asset / liability)
 B) it is either a non derivative (with no contractual obligations)
alternatively
 C) if it is a derivative then it is to be settled in either cash or by an
asset for a fixed number of the entity’s own equity instruments

 When an entity is obligated to buy back its own shares (treasury
shares) a liability exists
 In a situation where an entity can exchange its own equity instruments
to receive or deliver shares ( with a fixed amount) then this
arrangement / contract is not an equity instrument but a financial asset
or a financial liability

 An instrument that gives right to the holder to sell it to the issuer for
either cash or another financial asset is a liability to the issuer
 An instrument is a liability when settlement depends on some
uncertain events
 A derivative financial instrument is either an asset or a liability when
there is a choice for settlement.

 While measuring a financial instrument, the asset and liability
components are first separated & then the residual is considered as
equity component.
 Treasury shares- when an entity acquires or resells its own shares,
this transaction represents a change of ownership and consequently
no gain or loss arises.
 The treasury share transaction costs are equity related and are
deducted from equity.

Scope within IAS 32- 1
 This standard is applicable to all financial instruments except:
 Subsidiaries, joint ventures, associates etc.
 Employees’ benefits
 Insurance contracts. However, where such contracts are embedded
derivatives (IAS 39) then apply IFRS 4 (recognition and measurement
of financial instruments)
 Instruments where share based payments are involved, apply IFRS 2

Scope within IAS 32- 2
 The standard applies to contracts to buy or sell non financial
instruments which can be settled in cash by some other financial
instruments
 When settlement can be in cash / other financial instruments then
watch for these: a) the contracts demand this type of settlements, b)
when contract is not explicit then the traditional settlements like cash
or other instruments will be in order, c) when it is the usual practice
of the entity to quickly buy/sell to make short term gains or losses
 When a contract is readily convertible in cash
 A written option that can be settled in cash, cannot be settled in any
other way.

Definitions- 1
 A financial instrument is a contract that gives rise to a financial asset
and a liability in two different entities
 A financial asset is cash, equities in another entity, a contractual right
to receive cash or exchange with another asset or liability that is
potentially favorable to the entity.
 A financial asset is also a contract that may be settled by the entity’s
own equity if it is a non derivative. If it is a derivative, then it may be
settled for either cash or another asset. An entity’s own equity
instruments will not be included in these transactions.

Definitions- 2
 A financial liability can be a contractual obligation to deliver cash or
another asset or exchange financial assets / liabilities under
unfavorable conditions to the entity.
 A liability can also be a contract which can be settled with the entity’s
own equity instrument which is when a non derivative can be settled
by a certain number of the entity’s own equity instrument and if a
derivative then settlement can be by means other than cash

Definitions- 3
 An equity instrument is a contract that has a residual interest after
deducting all liabilities
 Fair value could be defined as a value that could be exchanged or
liabilities settled between settled between willing and knowledgeable
parties in an arm’s length transaction.
 A puttable instrument is sellable for cash or any other financial asset
or it is automatically transferred to the issuers on the occurrence of an
uncertain event.
 Contracts usually have clear economic consequences and the related
parties have little discretionary power to avoid.
 Entities include individuals, partnerships, incorporated bodies etc.

Presentation
 The issuer of a financial instrument will classify the instrument either
as an asset or an equity instrument,
 Under certain conditions, an issuer will define an equity instrument if it
has no contractual obligations to deliver cash or financial asset of
another entity or to exchange any assets / liabilities under
unfavorable conditions. If the instrument is to be settled with the
issuer’s own equity instrument then if it is a non-derivative that
includes no contractual obligations to deliver the entity’s own equity or
if it is a derivative that would require settlement with a fixed amount of
cash or a fixed number of shares of the entity.

Puttable instruments
 These include contractual obligations for the issuer to repurchase or
redeem instruments for cash or another financial asset when sold.
 What is an equity instrument?- if an instrument entitles the holder to a
pro-rata share after payment of all liabilities on liquidation. A pro-rata
share is determined on dividing an entity’s assets into equal units of
amounts and multiply the units held by the holder with the unit amount.
The instrument is subordinate to all other instruments. A subordinate
instrument has no priority over other claims to the assets. All subordinate
instruments are puttable and the formula to calculate the redemption price
is the same in that class.
 Puttable instruments do not have any obligations apart from the
contractual obligations by the issuer.

Obligations on liquidation
 Some financial instruments hold conditions to transfer pro rata share
of net assets to the holder on liquidation. Obligation arises when it is
beyond control of the entity or it is uncertain to occur.
 An equity instrument has features such as the holder is entitled to pro
rata share on liquidation. The share is determined by unit rates
multiplied by the number of units held. These are subordinate
instruments. All subordinate instruments have identical obligations.

Reclassification of puttable instruments
 An entity will reclassify a financial instrument as an equity instrument
when it has all the necessary features. Reclassification will be done
when an equity instrument ceases to have the specific features. The
difference between the carrying amount of an equity instrument and
the fair value of a financial instrument will be recognized in equity at
the date of reclassification. To reclassify a financial liability as equity
when it has all the requisite features. It is to be re-measured at
carrying value at reclassification.

Absence of contractual obligations
 With some exceptions, a financial liability differs from equity as it has
contractual liabilities to deliver either cash or another financial asset.
Substance rather the legal form governs the financial liability’s
classification. Such as a preference share has a mandatory financial
liability for redemption. When a holder of a financial instrument has the
right to sell it back to the issuer for cash or another financial asset
then it is a financial liability. If an entity does not have the right to avoid
a liability by payment of cash or another asset then the obligation is a
financial liability.

Settlement with the entity’s own shares
 Even if it is contractual to settle an instrument with an entity’s own
shares, this situation does not necessarily make it an equity
instrument.
 In a settlement, if an entity receives its own shares, then it is financial
asset or a financial liability contract.
 It is a financial liability when the entity has to buy back its own shares
for cash.
 A contract that requires delivery of an entity’s own shares in exchange
for cash or another asset is a financial asset or a financial liability.

Contingent settlement provisions
 A contingent settlement requires a financial instrument to deliver cash
or another financial asset on the happening of a certain event in
future which will render the instrument as a financial liability. Such
events are beyond control of an entity.

Settlement options
 When an instrument holder has a choice of settlement such as by net
cash or by exchanging shares then the instrument is either a financial
asset or a financial liability unless all the settlement alternatives point
to the instrument being an equity instrument.
 Financial instruments are either settled in cash or by exchanging
shares. These are not equity instruments.

Compound financial instruments
 The issuer of a non derivative financial instrument will examine the
terms to determine whether the instrument contains both liability and
equity elements in which case such different components will be
separately displayed.
 The instrument holders may have the option to convert financial
instruments into equity ones at a later date. Example: convertible
bonds converted into a fixed number of ordinary shares.

Treasury shares
 If an entity acquires its own shares or equity instruments then these
are termed as treasury shares and these are then deducted from
entity’s shareholders equity.
 No gain or loss arise on an entity’s own equity transactions.
 All the treasury share related payments and receipts are accounted
for under equity.
 The details of all the treasury shares held are to be disclosed in the
financial statements.

Interest, dividends, gains and losses
 Interests, dividends, gains and losses relating to a financial instrument or a
component that is a financial liability, shall be recognized in the profit and loss
accounts.
 Any dividend distributions to holders of financial instruments along with any
transaction costs shall be directly debited to equity net of any income tax
benefits.
 The classification of any instrument such as whether it is a financial liability or
an equity instrument will determine whether the related costs such as interests
etc. will be recognized in the profit and loss.
 The issue costs of equities should be deducted from equity. These costs are
typically legal, accounting etc.
 If dividends are classified as an expense then they should be presented in the
statement of comprehensive income.
 The requirements of IAS 1 and IFRS 7 are to be complied with.

Offsetting a financial asset and a financial liability
 a financial asset and a financial liability shall be offset and the net
amount shall be presented in the financial statements under the
following circumstances:
 A) there is a legal enforceable right of setoff
 B) the entity wants to settle on a net basis or wants to realize asset
and settle liability simultaneously
 When transfer of an asset does not qualify for de-recognition, asset
and liability set offs do not take place.
 This standard requires a set off when doing so presents the future
cash flows after settling two or three instruments. Net presentation
has to reflect more meaningful expected cash flows.

Offsetting a financial asset and a financial liability
(continued)
 Offsetting assets with liabilities is generally inappropriate when:
 A) several instruments are used to emulate one instrument
 B) financial assets and liabilities have the same primary risk
exposure (example: assets and liabilities of a portfolio involve
different counterparties)
 C) financial assets are pledged
 D) assets are set aside in trust
 E) obligations arising under an insurance contract
 An entity may enter into a multiple instrumental transaction with a
single counterparty with a master netting arrangement.

… the management by an entity of the biological transformation of living
animals or plants (biological assets) for sale, into
agricultural produce, or into additional biological assets.
Activity 7 - The IAS 41 Agriculture
Agricultural activity is…
living animals
plants
TRANSFORMING
INTO
PRODUCE
ASSETS

Harvesting from unmanaged
sources
(such as ocean fishing and
deforestation) is not agricultural
activity.
81
Agricultural activity?
Biological transformation …
… comprises the processes of growth,
degeneration,
production, and procreation that cause
qualitative or quantitative changes in
a biological asset.

… the incremental costs directly attributable
to the disposal of an asset, excluding
finance costs and income taxes.
82
Costs to sell are …
Measure the biological assets at…
… fair value less costs to sell from initial recognition of
biological assets up to the point of harvest, other than
when fair value cannot be
measured reliably on initial recognition.

However, IAS 41 does not deal with
processing of agricultural produce after
harvest; for example, processing grapes
into wine and wool into yarn.
83
IAS 41 for processing?

There is a presumption that fair value
can be measured reliably for a biological
asset.
However, that presumption can be
rebutted only on initial recognition for
a biological asset for which quoted
market prices are not available and for
which
alternative fair value measurements are
determined to be clearly unreliable.
In such a case, IAS 41 requires an entity
to measure that biological asset at its
cost
less any accumulated depreciation and
any accumulated impairment losses.
84
Always fair value?

In all cases, an entity should measure
agricultural produce at the point of
harvest at its fair value less costs to
sell.
85
But, always!

IAS 41 requires that a change in fair value
less costs to sell of a biological asset be
included in profit or loss for the period in
which it arises.
86
Where include?
No income?
Under a transaction-based, historical cost accounting model,
a plantation forestry entity
might report no income until first harvest and sale, perhaps 30 years after
planting.
On the other hand, an accounting model that recognises and
measures biological growth using current fair values reports changes in fair
value throughout the period between planting and harvest.

Biological assets that are physically
attached to land (for example, trees in a
plantation forest) are measured at their
fair value
less costs to sell separately from the
land.
87
Separately or jointly?

IAS 41 requires an unconditional
government grant related to a biological
asset
measured at its fair value less costs to
sell to be recognised in profit or loss
when,
and only when, the government grant
becomes receivable.
88
Unconditional government grant.

If a government grant is conditional, including when a government
grant requires an entity not
to engage in specified agricultural activity, an entity should
recognise the
government grant in profit or loss when, and only when, the
conditions
attaching to the government grant are met.
89
Unconditional government grant.

Activity 8 - Financial statement analysis

Business Survival:
There are two key factors for business survival:
 Profitability
 Solvency
 Profitability is important if the business is to generate revenue
(income) in excess of the expenses incurred in operating that
business.
 The solvency of a business is important because it looks at the
ability of the business in meeting its financial obligations.

Financial Statement Analysis
 Financial Statement Analysis will help business owners and other
interested people to analyse the data in financial statements to
provide them with better information about such key factors for
decision making and ultimate business survival.

 Financial Statement Analysis is the collective name for the tools and
techniques that are intended to provide relevant information to the
decision makers. The purpose of the FSA is to assess the financial
health and performance of the company.
 FSA consist of the comparisons for the same company over the
period of time and comparisons of different companies either in the
same industry or in different industries.

Financial Statement Analysis
Purpose:
 To use financial statements to evaluate an organisation’s
◦ Financial performance
◦ Financial position
◦ Prediction of future performance
 To have a means of comparative analysis across time in terms of:
◦ Intracompany basis (within the company itself)
◦ Intercompany basis (between companies)
◦ Industry Averages (against that particular industry’s averages)
 To apply analytical tools and techniques to financial statements to
obtain useful information to aid decision making.

Financial statement analysis involves analysing the information provided in
the financial statements to:
◦ Provide information about the organisation’s:
 Past performance
 Present condition
 Future performance
◦ Assess the organisation’s:
 Earnings in terms of power, persistence, quality and growth
 Solvency

Financial Statements…
 1. The Income Statement
 2. The Balance Sheet
 3. The Statement of Retained Earnings
 4. The Statement of Changes in Financial Position
 Changes in Working Capital Position
 Changes in Cash Position
 Changes in Overall Financial Position

Effective Financial Statement Analysis
 To perform an effective financial statement analysis, you need to be
aware of the organisation’s:
◦ business strategy
◦ objectives
◦ annual report and other documents like articles about the
organisation in newspapers and business reviews.
These are called individual organisational factors.

Requires that you:
 Understand the nature of the industry in which the organisation
works. This is an industry factor.
 Understand that the overall state of the economy may also have an
impact on the performance of the organisation.
→ Financial statement analysis is more than just “crunching numbers”; it
involves obtaining a broader picture of the organisation in order to
evaluate appropriately how that organisation is performing

Standards of Comparision…
 1. Rule-of-thumb Indicators
Financial analyst and Bankers use rule-of thumb or benchmark
financial ratios.
 2. Past performance of the Company
 3.Industry Standards…

Tools of Financial Statement Analysis:
The commonly used tools for financial statement analysis are:
 Financial Ratio Analysis
 Comparative financial statements analysis:
◦ Horizontal analysis/Trend analysis
◦ Vertical analysis/Common size analysis/ Component
Percentages

Financial Ratio Analysis
 Financial ratio analysis involves calculating and analysing ratios that
use data from one, two or more financial statements.
 Ratio analysis also expresses relationships between different financial
statements.
 Financial Ratios can be classified into 5 main categories:
◦ Profitability Ratios
◦ Liquidity or Short-Term Solvency ratios
◦ Asset Management or Activity Ratios
◦ Financial Structure or Capitalisation Ratios
◦ Market Test Ratios

Profitability Ratios
3 elements of the profitability analysis:
 Analysing on sales and trading margin
◦ focus on gross profit
 Analysing on the control of expenses
◦ focus on net profit
 Assessing the return on assets and return on equity

 Gross Profit % = Gross Profit * 100
Net Sales
 Net Profit % = Net Profit after tax * 100
Net Sales
Or in some cases, firms use the net profit before tax figure.
Firms have no control over tax expense as they would have
over other expenses.
Net Profit % = Net Profit before tax *100
Net Sales
 Return on Assets = Net Profit * 100
Average Total Assets
 Return on Equity = Net Profit *100
Average Total Equity

Liquidity or Short-Term Solvency ratios
Short-term funds management
 Working capital management is important as it signals the firm’s ability
to meet short term debt obligations.
For example: Current ratio
 The ideal benchmark for the current ratio is $2:$1 where there are two
dollars of current assets (CA) to cover $1 of current liabilities (CL). The
acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL
represents liquidity riskiness as there is insufficient current assets to
cover $1 of current liabilities.

 Working Capital = Current assets – Current Liabilities
 Current Ratio = Current Assets
Current Liabilities
 Quick Ratio = Current Assets – Inventory – Prepayments
Current Liabilities – Bank Overdraft

Asset Management or Activity Ratios
 Efficiency of asset usage
◦ How well assets are used to generate revenues (income) will
impact on the overall profitability of the business.
For example: Asset Turnover
 This ratio represents the efficiency of asset usage to generate
sales revenue

Asset Management or Activity Ratios
 Asset Turnover = Net Sales
Average Total Assets
 Inventory Turnover = Cost of Goods Sold
Average Ending Inventory
 Average Collection Period = Average accounts Receivable
Average daily net credit sales*
* Average daily net credit sales = net credit sales / 365

Financial Structure or Capitalisation Ratios
Long term funds management
 Measures the riskiness of business in terms of debt gearing.
For example: Debt/Equity
 This ratio measures the relationship between debt and equity. A ratio
of 1 indicates that debt and equity funding are equal (i.e. there is $1 of
debt to $1 of equity) whereas a ratio of 1.5 indicates that there is
higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of
equity). This higher debt gearing is usually interpreted as bringing in
more financial risk for the business particularly if the business has
profitability or cash flow problems.

 Debt/Equity ratio = Debt / Equity
 Debt/Total Assets ratio = Debt *100
Total Assets
 Equity ratio = Equity *100
Total Assets
 Times Interest Earned = Earnings before Interest and Tax
Interest

Market Test Ratios
 Based on the share market's perception of the company.
For example: Price/Earnings ratio
 The higher the ratio, the higher the perceived quality of the earnings
by the share market.

 Earnings per share = Net Profit after tax
Number of issued ordinary shares
 Dividends per share = Dividends
Number of issued ordinary shares
 Dividend payout ratio = Dividends per share *100
Earnings per share
 Price Earnings ratio = Market price per share
Earnings per share

Horizontal analysis/Trend analysis
 Trend percentage
 Line-by-line item analysis
 Items are expressed as a percentage of a base year
 This is a time series analysis
 For example, a line item could look at increase in sales turnover
over a period of 5 years to identify what the growth in sales is over
this period.

Vertical analysis/Common size analysis/ Component
Percentages
 All items are expressed as a percentage of a common base item
within a financial statement
 e.g. Financial Performance – sales is the base
 e.g. Financial Position – total assets is the base
 Important analysis for comparative purposes
◦ Over time and
◦ For different sized enterprises

Limitations of Financial Statement Analysis
 We must be careful with financial statement analysis.
◦ Strong financial statement analysis does not necessarily mean
that the organisation has a strong financial future.
◦ Financial statement analysis might look good but there may be
other factors that can cause an organisation to collapse.

Limitations of FSA…..
1. Financial Analysis is only a Means
2. Ignores the Price Level Changes
3. Financial Statements are essentially Interim Reports
4. Accounting Concepts and Conventions
5. Influence of Personal Judgments
6. Disclose only Monetary Facts

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