FINANCIAL STATEMENT ANALYSIS

Financial statements are summarized reports of accounting transactions. The Financial

Statement contains the financial information of an enterprise. It is the result of the accounting process
which begins with the recording of transactions . And the accounting process involves recording,
classifying and summarizing business transactions. The basic objective of financial statement is to
help in decision making. The Generally Accepted Accounting Principles and procedures are followed
to prepare the financial statements .

The following are the financial statements which are prepared from the accounting records
maintained by the enterprises.

Balance Sheet : Balance sheet is usually prepared at the end of financial year or at the end of every
quarter. It indicates the financial position of the enterprise at that particular moment . (For more details
about Balance Sheet the students may refer to earlier parts of this book).

Profit and Loss Account or Income Statement : Profit & Loss account or Income statement is
prepared to know the earning of the enterprise. In this statement all incomes received and due but not
received and all revenue expenses made and due but not made are entered. If the credit side or income
is more than that of debit side cir expenditure then the enterprise makes a net profit and if vice-versa
then net loss. Income Statement may be made in the form of manufacturing account , trading account
and profit & loss account to know the cost of production, gross profit or gross loss and net profit or
net loss respectively.

Reserve and Surplus Account : The Undistributed Profit is transferred to reserve and surplus account.
In case of partnership firms the profit is added in the capital account and the drawings are deducted.
But in case of joint stock companies the reserve and surplus is created to transfer the undistributed
profit and this can be used for the expansion of business or for distribution of dividend .in future.
Total Assets - Liabilities = Capital + Reserves

Funds Flow Statement : The working capital of an enterprise at the end of two periods can not be same
and this statement is designed to analyse the changes in the financial position of the enterprise. This
statement will show the sources of funds received and their expenditure.

Cash Flow Statement : This statement shows the different sources of cash receipts and its uses. The
cash balance at the end of two periods will not be the same.

Meaning of Financial Analysis : There are two significant factors of Financial Statements, viz . the
Income Statement or the Profit and Loss Account and the Position Statement or the Balance Sheet and
the company would like to know Profitability and Financial Soundness
 Techniques of Financial Analysis :
In simple words the data provided in the financial statements should be methodically
classified, analysed and compared with figures of previous periods or other similar firms or with
budgeted figures. The further questions between the two companies can be answered by further and
deeper study and analysis. To compare the figures of two companies; arrange the cost and revenue of
both the companies and relate the income to the capital employed and compare the result. On this
basis, we may come to know whether the first company is more profitable or the second company.
These questions will require further analysis and study of the underlying situation.

The analysis of financial statements requires :

1. Methodical classification of the data

2. Comparison of the given data in the firiancial statements with each other by different tools of financial
analysis.

Types of Financial Analysis :

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1. External Analysis : The outsiders means the public at large who might be already share holders or
debt holders or might like to invest in the company and the government and financial institutions
analyse the companies statements published in the newspapers. prospectus or brochure.

2. Internal Analysis : The executives and employees who have an access to the internal accounting
records of a company analyse the financial statements. The certain government agencies, under rules,
are also authorized to inspect the financial statements and can analyse them .

3. Horizontal Analysis :The figures of company 's financial affairs are written side by side, horizontally, for
two or more then two years . These different years' financial statements are analysed to know the changes
in the performance of the company.

4. Vertical Analysis : Under this type. the various figures of one accounting year are studied / compared
with a base selected from some year's statement.

Advantages for preparing Financial Statement :

1. Management : Management wants to analyse the financial statement to know the deviation from the
budgeted figures and to compare with the previous quarters, years, etc. figures and to compare with
other competitive business houses / companies

2. Share Holders : Share Holders have a statutory right to know the present and future earning of the
company and its comparison with previous years earning and with budgeted earning estimates.

3. Investors : General public who may be interested in investing in the companies equity or lending the
money (both secured and un-secured) are interested in knowing the present, future earning of the

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 company and future business proposals.

4. Debenture Holders : Before buying debentures of a company from open market or to buy from the
company during public offer, the investors would like to know the financial status of the company. The
Debenture Holders would also like to know whether the company will be able to pay them the
promised interest on Debenture and if their principle is safe in the hands of the company or not.

5. Financial Institution .: Banks and Non Banking Financial Institutions / Corporations invests money after
knowing the present and future financial status of the company. The large business houses need billions of
Rupees to implement large businesses. It is not practically possible to raise 100% funds through equity or
internal resources and they look upon financial institutions for debt participation. The financial institutions
help them after knowing the company's track record, present and future financial status and the purpose for
which the debt is solicited by the company.

6. Inter Firm Comparison : Inter firm comparison is only possible if comparative study of financial statements
is undertaken for comparing various firms or various points of views. This helps in deciding in which
company to invest or to which company to lend money or for which company one should work .

7. Creditors : Apart from financial institution, the general public, employees, etc.also extend credit to the
companies and .would like to know the financial status of the company and hence would like to have their
financial statements.

8. Employees and Trade .Unions : Employees are entitled for bonus and the quantum of bonus will depend
upon the profits earned. Financial Statements assist both trade unions and employees in negotiating the
wages and bonus.

9. Government : On knowing the particular type of industries growth and on comparing with other countries
similar type of industries, the Government makes the policies. In case of variation in prices the
Government changes the taxation, custom, excise policie'.J.

10. Taxation Authorities : Various tqxation authorities like Income Tax , yalue Added Tax , Excise, Customs,
etc.would like to have the financial statement of a company in order to ensure that the right tax is being paid
by individuals and companies.

11. Researchers : The financial statements are of great value to scholars undertaking research in business
affairs and practices.

Limitations of Financial Statements :

Financial statement helps us in knowing the financial position as on a particular date and for the period
covered by the accounts. Though the finaneial health of a company can be known but this is based on the
financial statements on certain accounting concepts and conventions. which can not be said to be fool
proof.
 The following are some of the limitations of financial statements :

1. Historical in Nature : The information given by the financial statement is about the past and hence
more of historical in nature. Where as, the investor would like to know the companies future
prospects.

2. Bias : Financial statements are the outcome of accounting concepts and conventions and are based on
the personal judgment which can be biased. The valuation of stock and treaijng a particular revenue
expense as deferred revenue expense can affect on th future earning and hence the prospective
investor may be duped.

3. Different Accounting Practices : Different companies may charge depreciation on Straight line method,
written down method or fixed method and this may affect on the profit of a company and hence the actual
financial position of the company 1s neither known nor two companies financial position can be
compared.

4. Non monetary status : The financial statements show the monetary figures but ignores completely the
man power, competition (present and future), Research and 'Development, etc status. The information
technology is drastically affected with the man power wealfh"Of a company. If a company has better
man power as compare to other information technology company then it will do better in future.

5. Different Interests : Different people may have different interests like a person interested in taking an
employment would like to see different points as compare to equity investor or debt investor and it is
not possible to satisfy the interests of different persons through financial statements prepared by the
companies.

6. Other Factors : The financial statements alone can not help in estimating the future position of the
company. There are other factors as well which should be considered: like the quality and caliber of
the management, labour management relations, estimation of future demands of the products,
estimation of the future competition of the products, estimation of the future cost of production and
selling price of the products, etc.

FINANCIAL PLANNING AND CAPITAL STRUCTURE

A company must be managed effectively and efficiently so that it can achieve its goals by using the
minimum resources. Financial Planning means a company's growth, performance, investments and
requirements of funds during a particular period which may be from two to five years.
There are various ways for raising funds for the company ; the financial manager must find out that funds
required are for what purpose and for how long and when they are required. The following are the most
commonly used ways for raising funds,
equity shares, preference shares, debentures, long term borrowings, short term borrowings both secured
and unsecured, etc. He should also keep in mind the interest burden before raising the funds from debt
market.

Objectives of Raising the Funds :

1. Expand Business : The most important objective is to expand the business so that goods can be
produced at large scale.

2. Pay Back Loans, Debentures, and Preference Shares : At times the funds are to be raised so that
money borrowed earlier can be'paid back on due dates.

3. Working Capital : Usually fund is raised to have sufficient working capital.

4. Modernised Plant : With the competition, the company needs to replace its plant to produce better
quality goods.

5. Liquid Cash : At times the company is short of liquid cash to pay back their current liabilities so
the funds are raised.

6. Debt Equity Ratio : Sometimes the debt equity ratio of the company is not very attractive and the
future borrowing is also not possible due to higher debt ratio. In this case the company comes out with
equity or preference share either on right basis or a public issue.

7. Long Term Planning : In case the company foresees the requirements of funds after a year or two or
may be more, they start planning and decide how to raise funds for their future needs.

A Financial Manager must make sure that the burden on the company should be the
least, while planning the financial plans.

The reputed company's with large scale cash earning usually do not distribute all their profits as
dividend to share holders but a major portion is retained as a 'Reserve' and this reserve is used for the
financial needs of the company. In fact most of the multi National Companies (MNC'S) and Indian
reputed companies maintain a large amount of reserve and this helps in the growth of the
company and company need not pay any interest on this fund and on the contrary earns of this
reserve.
The cost on the borrowings / raising of funds should be the least and if borrowed it must attract the
lower interest burden. If possible than a clause must be inserted that if company can pay back before
the maturity of the period. This clause must be put as the interest rates are falling and if company
feels that the interest paid by the company is very high than they can make arrangement for early
repayment of the debt. The finance is basically required either for long term or for short term.

The Financial Manager faces the following difficulties while planning the financial plans
1. It is very difficult to forecast the financial needs very accurately for future as it is always
uncertain.

2. The world is developing very fast due to innovations and the competition is also increasing very
fast so at times the modernization is required almost instantly to survive in the market.

3. To have a perfect financial plan, a perfect co-ordination among all the departments of the company
are required, which at times fail due to one reason or the other and this affects adversely on the
financial plans.

Capital Structure :
Capital Structure means the ratio between the different sources of finance. In other words, it
means the qualitative structure of financial resources. Most commonly used reference to Capital
Structure is the 'Debt Equity Ratio'. Here Debt means money borrowed from the market on interest
and Equity means the total share

CAPITAL STRUCTURE
Reasons to Raise Funds I
Replacement of Assets
Modernisation Expansion Diversion
Repayment of Loans / Preference Shares

Sources of Funds
Reserve & Surplus (Internal Sources) External Sources
Debt Equity or Preference Shares
 FINANCIAL MANAGEMENT
Financial management action means planning and controlling of the firm's resources. Financial
management is one of the youngest concepts as till 1890, it was a branch of economics. Financial
management is always eager to improve performance and to eliminate weaknesses and increase strengths.
Most important decision of the management is related to the finance. Though production and marketing are
the different activities of a business but they can not be discussed in isolation without talking about finance.
The financial management plans the financial activities for future q1.nd for the better financial
management.
Business Finance :
As it is discussed above, the business means, broadly, production and marketing for the motive of
profits. To produce and market the products finance is required at all stages. Business finance deals with
financial planning, acquisitions of funds, utilisation of funds and their control.
The business finance is required for all the three types of business :
1. Sole Proprietorship Business
2. Partnership Firms
3. Company
In case of Sole Proprietary, a single person, who is the owner of business, has to arrange for finance
for his business. He is solely responsible for his business promotions. finances, controls and also for all the
liabilities. In case of Partnership two or more than two persons join hands, get their partnership firm
registered and are jointly responsible for business arrd finance control. They have the unlimited liabilities
for their firm. They also share the profits and losses in the ratio it is mutually decided. On the contrary the
Joint Stock Company may be registered as a Private Limited Company or as a Public Limited Company.
Definition :
Wheeler defines Business Finance as, "That business activity which is concerned with the
acquisition and conversation of capital funds in meeting the financial needs and overall objectives of
business enterprise" .
Encyclopedia of Social Sciences defines, "Corporation finance deals with the financial problems of
corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and
their administrator during early development, the accounting problems connected with the distinction
between capital and income, the administrative questions created by growth and expansion, and finally, the
financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into
financial difficulties" .
Thus, the corporation finance or business finance means the process of raising funds, providing and
administering of all financial resources to be used in an enterprise. The scope of the financial activities of a
business starts with the idea or planning of business, the actual business, its growth and expansion and if
the need requires than for its winding up also.

The main function of business finance is to plan the financial resources at the minimum possible of
interest, cost and both short term and long term basis as and when required. This helps in successful
promotion of a. business, its growth and profitability.
 Financial Manager's Role :
The role of Financial Manager is to carry out the finance functions . The role of financial manager
is in all kinds of business activities it may be like production, purchasing, storing, staffing and of course
finance mobilisation. All these activities require finance, and it is he who will see to availability of funds
and its allocation to various activities so that reasonable returns can be made. Until recently the finance
manager's role was limited to the raising of the funds and he was not actively involved in the decision
making and in other management activities. But these days a business may be failure due to extra capital
mobilized on interest or higher interest paid on the funds mobilized or due to insufficient capital available
for business. In fact, insufficient capital is a biggest cause for the business failure and that is why as per the
SEBI guidelines, if a company is not able to subscribe minimum of 90% of the equity issued then the
company is required to refund all the money collected because the government is of the view that with less
than 90% of the available resources, the probability of the business failure are

FINANCIAL MANAGEMENT
The finance manager in consultation with other manager decide whether short term funds are
required or long term and also what should be the size of equity and at what price it should be subscribed to
the public, promoters, employees or financial institutions.
It is the duty of financial manager to decide that to which department. section or activity what
quantity of funds will be allocated so that utmost utilization of funds can take place and the management
can have the maximum return on investments and equity. He also plays a vital role in deciding the dividend
policy of the company. Financial Manager decides whether, dividend is to be declared or not. if yes than
how much dividend is to be declared. These days a part of the dividend is always kept in the form of
reserve and this reserve is used for the growth of the business.
He is expected to decide on the pricing, costing. volume of output. marketing, discounting.
distribution, etc. because these have a significant influence on business profitability.
He should know the debt-equity ratio and equity asset rat(o so that interest burden is kept within
control. An interest can be a major factor for a company to become sick in due course. The profit earned
should be partly reinvested in the business and or in the market and these enhance the prospects for making
high capital gains in the future.
Profit Maximisation :
A company which makes maximum profit is analysed as economically better than others. Mostly
the objective of companies is to maximize the profit and can be justified on following counts.
1. Utility Maximisation : A business man performing business activity aims at utility maximization and it
can be measured in terms of profits.
2. Economic Natural Selection : Those who make maximum profit survive in the long term business and
thus profit maximization ensures economic natural selection .
3. Social Economic Welfare : In majority of case the company which pursues its objective of profit
maximization, also maximizes social economic welfare.
4. Monopoly powers : Even if there is no competition in product markets, a free competitive capital market
will allocate monopoly rights over capital to those who can use it most profitably. Profit maximization is a
motive force to acquire the monopoly powers in the imperfect product markets.
The motive of every business is to have maximum profits.
 COST ALLOCATION
Basis of Cost Allocation :

Sr.No. Costs Basis for Allocation

1. Total Capital employed in the department

1 Interest 2. Square feet of area occupied
3. Ratio to Sales

1. Square feet of area occupied.

2 Insurance 2. Amount of each department insured
3. The total value of each asset

1. Ratio to Sales
3 Taxes
2. Basis of Tax

1. Ratio to Sale
4 Rent
2. Square feet of area occupied.

1. Square feet of area occupied (Building)

5 Depreciation 2. Value of the assets
3. Number of hours machines are used.

1. Each department can be metered

6 Telephone 2. Number of extensions sanctioned
3. Ratio to sales.

1. Number of employees.
7 Employee's Benefits
2. Refer to payroll records

8 Advertisement 1. 1.Ratio to sale

1 .Number of light / power points.

2 .Cubic feet of area occupied.
9 Light & Power
3. Number of hours the department operates .
4. Ratio to sales.