Financial statements of Business 2013

Learning Objectives

Now that business and business resources are understood, the next step would be to examine
and understand the financial statements of business. Here, the funds flow statement that is
exclusive finance in nature is excluded and the other statements are detailed & discussed. The
statements are:
1. Profit and Loss statement
2. Balance sheet &
3. Cash flow statement

The students should understand how to draw simple financial statements as above, besides
understanding the fundamental differences between finance and accounts functions. They
should also appreciate that in the ultimate analysis the functions of finance and accounts
integrate to achieve the objective of wealth maximization.

The role of statutes or laws should be understood by the learner in respect of accounts and
finance functions. While accounting function is statute-oriented, the finance functions are more
market oriented and less statute-oriented.

Contents Index
2.1 Finance & Accounts functions – differences & integration
2.2 Financial performance & financial statements
2.3 Third financial statement – Cash flow statement
2.4 Solved Questions
2.5 Unsolved Questions
2.6 Summary
2.7 Handout

2.1 Finance & Accounts functions – differences & integration

2.1.1 Accounts functions & objectives
Introduction
Financial Accounting is done on the basis of certain Accounting Principles that are universal in
nature

It is based on a specific accounting system and has to follow certain basic rules that are again
universal in nature

It also involves specific standards called Accounting standards and practices called Generally
Accepted Accounting Practices (GAAP), which are different from country to country. Indian

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Accounting standards are known as “AS” and Generally Accepted Accounting Practices are
known as GAAP, India

At present, readily available application software has simplified maintenance of financial

accounts and generation of required financial statements

Why Financial Accounting

Running a business, as we may recall, involves financially, certain amount of money coming in
and certain amount of money going out. The money coming in could be from the owners of the
business enterprise, loans from banks and others or due to the operations of the business
enterprise. Similarly, the money going out could be for purchasing of assets required by the
business or for meeting expenses of the business enterprise or for paying off loans earlier
taken.
Whatever be the purpose of money coming in and money going out, these financial
transactions are required to be recorded on a day-to-day basis so that at any given time, the
owners will be in a position to know:
How much money has come into the business and what the source of this money is
How much money has gone out of business and the purposes for which the money has
been spent
This is called “Financial Accounting”. In short, Financial Accounting faithfully records all the
transactions in a business enterprise that involve money and these transactions are referred to
as “Financial” or “Accounting” transactions. Let us examine the following examples to
understand the purpose of Financial Accounting.
Example no. 1
I have purchased goods for sale worth Rs.20,000/- against cash – I need to record the details to
know the value of goods purchased by me and against what – like cash or credit and in case it is
a credit transaction, from whom as I will be required to pay the supplier later, what is the
quantum of goods purchased so that I can know any given time how much unsold items I have
on hand (called “stocks”)
Similarly I have taken a loan of Rs. 1,00,000/- from a bank to run my business. I need to record
the details to know who has given me money so that I can return the same to the lender as and
when required and as and when agreed at the time of taking the loan.
Another example – I am selling goods worth Rs.50,000/- on credit. The buyer is going to pay me
after some time. I need to record the details to know who my customer to whom I have sold
goods on credit is, so that I can follow-up for getting the payment.
If we carefully go through the above examples, we will notice that Financial Accounting
transactions could involve:
Cash or credit (the manner of payment, now or later respectively)

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Income or Expense (revenue coming in due to sale of goods or services and revenue going out
due to purchase of goods or services respectively)
Asset (what the business enterprise owns, purchased out of capital, owners’ contribution
and/or loans from others) and Liability (what the business enterprise owes to an outsider who
has given it financial resources for purchase of assets)
Thus the objective of Financial Accounting is:
To know the financial position of the business enterprise in terms of:
How much revenue has come in (Income) and how much revenue has gone out (Expense)
At the end of a given period, say one year, whether the business is in profit (Income > Expenses
and difference between Income & Expenses) or Loss (Expense > Income and difference
between Expense & Income)
What the sources of money coming into the business enterprise (Liabilities) are and where they
have been used (Assets)
How much money did the owners bring into the business enterprise at the beginning and what
its current value is (owners’ funds – original investment as enhanced by profits retained in the
business)
Related terms in connection with the above objective are:
Accounting principles – these are common for the entire globe. For example, the owner of the
business enterprise and the business enterprise are different from each other from Accounting
angle. Proof of this principle – the owner’s contribution called capital to the business enterprise
is reflected as “Liability” in the Accounts of the enterprise, while the owner accounts for it as an
“Asset” as it is an investment.
Accounting Rules & Regulations – these are again common for the entire globe. These rules and
regulations essentially tell us which account is to be credited or which account is to be debited.
For example – I sell goods against cash – Goods account is credited and cash account is debited.
Accounting system – Cash system that can be followed by a proprietorship firm or partnership
firm – this follows cash coming in or going out for accounting for an item of income (that could
result cash coming in) or expense (that could result cash going out). This system does not
consider “credit” transactions. Hence accounting is not done of outstanding transactions. There
is no “receivable” or “payable” in this case
Accounting standards (AS) – given by the Institute of Chartered Accountants of India (ICAI)
along with Generally Accepted Accounting Practices (GAAP), India.
Operating income (coming from the main operations of the enterprise like trading,
manufacturing or services) and non-operating income (coming from investments made outside
the business in some other business – could be share capital or debt instruments like
debenture, bond etc.)

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Accounting period – this would depend upon the country in which the business enterprise
operates. For instance in India, the accounting period is from 1st April to 31st March – this is also
called Uniform Accounting Period (as all kinds of business organizations like Proprietorship firm
or Partnership firm or Limited company have to follow this uniformly in India) or Financial Year
Profit and Loss statement – statement prepared at the end of the Accounting period as above
showing the summary of all income items and expense items besides the result of performance,
namely Profit or Loss for the period.
Balance Sheet – statement of Assets and Liabilities as at the end of the Accounting period as
above, i.e., the sources of funds (term indicating money) – Liabilities and uses of funds – Assets
Other Accounting Terms have been explained in the Chapter “Glossary of Terms”
“Fund”– this represents financial resource taken or given by the business enterprise depending
upon whether money comes in or goes out. This is a “macro” term and includes both cash and
credit. For example, a supplier giving goods on credit does not give cash but gives goods that
are worth certain specified value.
The above information will be useful to the following users of financial statements:
Owners of the Business Enterprise
Lenders who have given money to the Business Enterprise
Other stakeholders of the Business Enterprise like employees, suppliers etc.
Government agencies like Income Tax authorities and others who are interested in investing in
the business enterprise in Share capital or loan, like debenture or bond
Functions of Accounts Department that does Financial Accounting
1. Maintenance of Accounts strictly in accordance with the Accounting Principles, following
Accounting Rules as per prescribed Accounting system and observing Accounting
standards as well GAAP depending upon the country of operations.
2. Control over amounts receivable, amounts payable, bank accounts, cash on hand etc.
3. Preparation of budgets, both revenue and capital, with the objectives of allocation of
resources, control and monitoring of expenses
4. Compliance with payment of Advance Tax as per the Rules and Regulations in this behalf
5. Thorough understanding of Income Tax Rules and Regulations with a view to minimize
tax payable by the enterprise
6. Maintenance of Financial Management Information System (popularly known as MIS)
that is a review of performance of key financial parameters vis-à-vis the estimates – this
is an important tool in taking corrective action in time and hence forms an integral part
of decision-making process

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7. Being responsible for the process of “Audits” of various kinds – Internal Audit, Statutory
Audit, Tax Audit etc.
Accounting Process
Decide on which Account Transactions are maintained in
Financial transaction takes
ledgers – Creditors’, debtors’
place in the Enterprise – it To be debited or credited etc. and Registers – Sales,
could be cash or on credit – Purchases etc. on individual
if it is Cash, it could result In accordance with transaction basis
in cash inflow or outflow
Accounting principles, the

Relevant Rules &

Regulations & prescribed
Verification step – whether the sum of all credits is equal Transactions are consolidated in a
to sum of all debits as it should be in case Accounting
the businesssystem control book of accounts named
enterprise is following double-entry book-keeping “General Ledger” – this contains a
system also known as Accrual Accounting System single consolidated account for each
This is done by extracting all the balances of General item of income, expense, asset and
Ledger in a statement known as “Trial Balances”. In this
liability – example, one account for
statement, the income and liabilities will appear under
“Credit” side while assets and expenses will appear operating income, one debtors
under “Debit” side. This statement will however disclose account, one creditors account etc.
errors of some types like wrong head of accounting,
error of omission or commission on both the sides to the
same extent. Example customer debited for credit sale
by Rs.10,000/- more and sales also credited by
Rs.10,000/- more.

Process of rectification of errors pointed out by the Trial Closing entries are then made –
Balance statement. Further where the errors are not shown depreciation on fixed assets, provision
by the Trial Balance, the process of reconciliation is for bad and doubtful debts, provision
for outstanding expenses, outstanding
initiated especially in the case of creditors, debtors and
income, adjustment for pre-paid
bank accounts. This is done by asking for statements of our expenses and income received in
accounts with them so that we can go through entry by advance etc. are made before
entry and verify whether the entries are correct or not. If preparation of final financial
there is a mistake correction is carried out statements for the accounting year,
namely Profit & Loss statement &
Step no. 1 – Accounting transaction analysis and deciding which Balance Sheet
Account to be debited and which account to be credited
Profit & Loss statement and Balance
Step no. 2 – Entering the various transactions in the basic books of
sheet are prepared – in the case of
Accounts – Registers and ledgers excluding General Ledger
proprietorship firms and partnership
Step no. 3 – Posting the consolidated figures each account-wise in the
firms, the two statements can be
Control book called General Ledger
prepared in any format whereas in the
Step no. 4 – Verification of the double-entry bookkeeping process
case of limited companies, the business
Through Trial Balance
enterprise has to prepare in accordance
Step no. 5 – Rectification of errors pointed out by Trial Balance
with the formats provided for in
Step no. 6 – Closing and adjustment entries at the end of the Accounting period
Schedule VI of The Companies’ Act
Step no. 7 – Preparation of Profit & Loss Statement and Balance Sheet as per
prescribed formats in the case of limited companies as per Schedule VI of
the Companies’ Act

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2.1.2 Finance functions & objectives

 Financial planning and estimation of finance required for the organisation
 Mobilization of financial resources required as above
 Ensuring that the funds are available in adequate quantity at appropriate time and at an
affordable cost
 Management of cash in the organisation through cash flow statement
 Management of investment outside the business enterprise in other organizations
 Management of risk in dealing with foreign exchange for imports and exports
Let us examine briefly the above functions with some examples.
Financial planning and estimation of finance required for the organisation

Any activity in a business enterprise requires planning for proper execution in time. Finance
is required for any activity at least in the beginning and hence financial planning is the
prime function of “Finance”. This involves detailed study of any activity from understanding
the total funds requirement for that activity, when the funds will be required and how
much funds will be required at different stages. For a new enterprise the entire resources
have to come from outside (externally); for an existing enterprise, a part of the resources at
least will be available from the profits made in the past and retained in business after
declaring dividend.

Example No.2:
We require Rs.10 Lacs for an activity. Let us see how it affects an existing enterprise. Let us
assume the profits available to be Rs.5 Lacs. Then we require further resources of Rs.5lacs
only. This is the difference between an existing enterprise and a new one. Financial
planning will take this into account.

Mobilization of financial resources

Having ascertained in the above example that we require Rs.10lacs for a set activity, for a
new enterprise we require the entire amount to be mobilized. For an existing enterprise
with available profits of Rs.5lacs, we require only Rs.5lacs. The Financial manager will then
assess all the alternative resources available to him (for details please refer to Chapter 7 –
Financial Planning and Analysis) keeping in mind the following requisites:
Adequacy (availability in adequate quantity)
Timeliness (availability in time) and
Cost (at an affordable cost)

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Adequate supply in time etc.

This has been explained this in the above point. For reinforcement the student’s attention is
drawn to one of the objectives of financial management at least in the short run, the
objective of maximizing profits of the organisation. The profits so maximized in turn
enhance the Earning Per Share (Please refer to Chapter 7 – Financial Planning and Analysis)
Management of cash in the organisation
This involves the following steps:
Ascertaining the average cash requirement by looking at the past figures and for a new
enterprise, estimating this figure.
Preparing the cash flow statement for a given period, taking all the cash inflows and cash
outflows during the period to determine whether there is a surplus or deficit at the end of
the period (For format of cash flow statement – please refer to Chapter 1 – Sensitizing to
Financial Accounting)
Arranging for funds from outside especially through a bank with whom the enterprise has
loan facilities in case of deficit in the cash flow statement; if on the contrary, the cash flow
statement reveals a surplus, dealing with this surplus in a suitable manner (For further
details, please refer to chapter 8 - Working Capital Management)
Management of investment outside the organisation
Over a period of time the enterprise reinvests a part of the profits for future growth of the
organisation in business. The Finance manager can invest such funds outside the business in
other enterprises also provided the parent enterprise does not require them immediately.
Short-term surplus as revealed by the Cash flow statement is also invested for short
duration. Thus investment outside one’s own business becomes the responsibility of the
Finance Manager
Management of risk in foreign exchange etc.
A business enterprise may require imports and do exports also. Whenever this is done the
invoice is in foreign currency. In imports the business enterprise requires foreign exchange
while in exports it gets foreign exchange. There is a risk involved while doing imports or
exports. The risk is that the exchange rate of the foreign currency in terms of Indian Rupees
can keep changing. We will explain this through an example.

Example no.3
We have exported goods worth US Dollars 1000. The money is to be received in a month’s
time. Presently the exchange rate is 1 US Dollar = Rs.44/-. By the time the money is received

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after a month, in case the rate is less than Rs. 44/-, we will lose money. On the contrary if
the exchange rate is more than Rs. 44/-, we will gain. Exactly opposite will be the effect in
the case of imports. The importer will pay less if the exchange rate decreases and more if
the exchange rate increases. There are ways and means of minimizing the risk of foreign
exchange. Finance manager is expected to take care of such risks.

2.1.3 Characteristics of these functions and how they integrate

1. Accounting functions start only when finance is brought into the enterprise; hence
finance as a function is earlier than accounting function
2. As we have seen under ‘Accounting functions and objectives’ above, there are strict
rules and regulations to be complied with in the case of accounting function. The rules
could be universal or be specific to a country or system. It does not make any difference
3. Financial accounting relates to accounting of financial transactions while financial
reporting refers to the ultimate step in financial accounting of preparation of financial
statements of the enterprise.
4. Thus the accounting function can be said to be statute oriented. At present there could
be differences in the formats and contents of financial statements of P & L and Balance
sheet from country to country. Slowly the nations all over the world are moving towards
what is known as ‘International financial reporting standards’ (IFRS), that will render the
financial statements of P & L, Balance sheet and Cash flow uniform in their content and
presentation. India as a signatory nation will also be affected.
5. Finance functions are more dictated by market developments in terms of new financial
instruments, demand and supply for investment in different countries, rates of interest
that keep fluctuating etc.
6. Hence it can be said safely that finance functions are less statute oriented and more
market oriented.
7. Finance as a function primarily aims at increasing wealth of the owners or shareholders
by adding to the wealth of the enterprise. This can well be achieved only if finance
function is supported by accounting function in terms of indicators of financial
performance of the enterprise through relevant financial statements.
8. Thus although functionally these two could be different, they integrate in achieving the
corporate objective.
We give below a matrix depicting the differences between accounts and finance functions
and a note on how they integrate:

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Difference between finance function and accounts function

Financial Accounting Functions Corresponding Finance Functions

Maintenance of Accounts – strict compliance
with statutory provisions as per ICAI
guidelines, Accounting Standards, GAAP
(India) provisions, Income Tax Act provisions
etc.
Responsible for budgets – both revenue and
capital
Tax compliance and tax planning besides audit
Management Information System & Reports
for Finance
Financial planning and Resources mobilization.
Adequate resources in time and in a cost-
effective way. More of market orientation
than statute-orientation
Cash management – stand-by arrangements,
both in case of excess and deficit
Responsible for treasury management –
largely, liquidity management, risk
management and investment management
Strategic Financial Management initiatives like
expansion, diversification etc.

Finance and accounts functions may be integrated in an organisation. This means that one
department handles both. In most of the small and medium size units in India, the functions will
be integrated. A business enterprise will require a full-fledged finance department only when
the functions listed above are predominant functions impacting business in a big way. If the
finance functions are not predominant functions, Accounts department looks after Finance
also. Constant requirement of funds, surplus for investment etc, could be some of the factors
influencing the need for a full-fledged Finance department.

Case let:
BSL steering Limited has both accounts and finance departments separate. A new CFO has
taken over both the functions. The company is having a very near tight position of liquidity. The
creditors overdue are by 13 days as against 45 days usual credit. The debtors are delaying their
payments by more than 30 days as against usual credit of 60 days.

Accounts officer is at logger heads with finance officer openly stating that the finance is
inadequate and holds the finance officer responsible for the same. He goes to the extent of
saying that he is prepared to go the bank himself and ask for extension of the overdraft.
The CFO asks the accounts officer to keep restraint in the matter.

Evaluate the stand taken by the accounts officer and explain the constraints before the finance
officer in asking for further finance from the bank at this juncture.

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Class activity:
You have learnt the financial stages in business in Chapter 1. Now you have learnt finance
functions. You should try and link the financial stages with the finance functions in a suitable
manner and try and cover all the finance functions as discussed here.

2.2 Financial performance & financial statements

2.2.1 Role of financial accounting in business – a quick recap

Indicating financial performance through financial statements of Profit & Loss, Balance sheet &
cash flow statements is the ultimate objective of ‘Financial accounting’. That is why this last
step is called ‘Financial reporting’, as through these financial statements, reports on financial
performance are being made to the stakeholders of business – owners, employees, creditors,
lenders, debtors etc.

This is an attempt to know the characteristics of these fundamental financial statements and
not look at them only through an accountant’s eyes. Cash flow statement is separately
discussed and the funds angle of cash flow statement is kept out of discussion in the chapter,
keeping in mind that the students undergoing TechnoManagement program will never be
employed in the accounts department or finance department. This course is more aimed at
sensitizing the students to the accounts and finance functions in the business and the impact of
diverse decisions on the bottom line of the business, (bottom line = profits or loss of the
enterprise).
Let us see some examples of P & L statement and Balance sheet before we start
understanding the import of the numbers given in these statements.

Statement no. 1 – Profit & Loss statement - Denotes profit or loss for the enterprise for the
year. Usually prepared for a year that is referred to as “Financial year”. This is also called
“Uniform Accounting Period”. Can be prepared on a monthly basis too. The result will not be
accurate as some of the figures like depreciation will be more accurate only on an annual basis.
The same thing goes for provision for outstanding income or expenses too. Profit and Loss
statement indicates the financial performance of the year just gone by.

Profit & Loss

Example no. 4 - A sample of “Profit and Loss” Account (Figures are in Indian Rupees in Millions)

Income from operations 100

Operating expenses:

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Salaries 30
Repairs and maintenance 3
Depreciation 10
Office and general expenses 10
Marketing expenses including
Commission, if any 7
Interest and other
Charges 10
Total expenses 70
Profit before tax 30
Tax at 30% 9
Profit after tax 21
Dividend 10
Profit retained in
Business [Retained Earnings] 11

Learning points:

 Interest is charged to income before determining the profit of the organisation. Once the
profit of the organisation is determined, tax is paid at the stipulated rate and the dividend is
paid only after this. Thus, dividend is profit allocation.
 This difference between “interest” and “dividend” gives opportunity to business
enterprises, to have a mix of capital of the owners and loans taken from outside, so that
they can save on tax, through the interest charged as expense on the income. The amount
of tax so saved is called “tax shield” on the interest.
 In the case of profit distributed among the partners as well in the case of dividend
distributed among the shareholders, these are not taxed again in the hands of the owners.

Statement no. 2 – Balance Sheet – Denotes position of Assets and Liabilities as on a particular
date. It is useful for a business enterprise for knowing the sources of funds for the business
enterprise and their uses. Further, any user of this statement will come to know how the
original investment in share capital by the owners has grown due to profits retained in
business, also known as “Reserves & Surplus”.
In short, capital shareholders’ funds = Total assets (-) External funds invested in business, both
short-term (not exceeding 12 months duration) and term liabilities (exceeding 12 months
duration). This usually indicates the financial performance of the past including the year just
gone by.

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Example no. 5:
Suppose the sum total of all assets = Rs. 120 million and the external funds invested in business
= Rs. 80 million. The shareholders’ funds are = Rs. 120 million (-) Rs. 80 million = Rs. 40 million.
Suppose the starting point for this business enterprise is Rs. 20 million from the owners
towards capital, this means that at present the original investment of Rs. 20 million has grown
to Rs. 40 million over a period of time.

Linkage between balance sheet and profit and loss accounts

The above statement is known as the “Profit and Loss Account”. This records the income and
expenditure for a given period and is closed as soon as the period is over. The residual profit,
as it belongs to the owners, gets transferred to the capital account in another statement, called
“Balance Sheet”.

The balance sheet tells us about the following:

 How much money has the business enterprise raised?

 Which are the sources for the money?
 What is the use for this money?

Example no. 6
The balance sheet is also known as “Assets and Liability” statement. A sample balance sheet is
shown below: (Rupees in millions)

Liabilities Assets

Share capital: 100 Fixed Assets 60

Reserves: 150 Less: Depreciation 30
(Retained profits Net Fixed Assets: 30
over a period of Investments: 80
time) Current Assets:
Net worth 250 Bills Receivable 100
Current liabilities
Bank overdraft 30 Cash and Bank 35
Creditors for expenses 10 Other current assets 60
Other current liabilities 15 Total current assets 195
Total current liabilities 55
Total Liabilities 305 Total Assets 305

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Suppose profit for the year is Rs.30 million after paying tax and dividend. This would be
transferred to the balance sheet and the reserves at the end of the current year would be
Rs.150 million + Rs.30 million = Rs.180 million. Similarly the depreciation claimed on the fixed
assets and shown as an operating expense would also get transferred to the balance sheet to
reduce the value of the fixed assets.

Let us assume that there is no increase in the fixed assets during the year that there are no
other changes and the depreciation for the year is Rs.10 million. We can construct the balance
sheet for the next year without much change, excepting to accommodate these figures of
depreciation and increase in reserves.

The balance sheet as at the end of the next year would look as under:

(Rupees in millions)

Liabilities Assets
Share capital 100 Fixed assets 60
Reserves and surplus 180 Less: depreciation 40
Net worth 280 Net fixed assets 20

Current liabilities:
Bank overdraft 30 Investments 100
Current assets
Creditors for expenses 10 Bill Receivable 120
Other current liabilities 15 Cash and Bank 35
Total current Other current assets 60
liabilities 55 Total current assets 215
Total liabilities 335 Total Assets 335

We see that between the two balance sheets, there are two changes –
Investment has gone up by Rs.20 million and

Bill receivable has gone up by Rs.20 million

The total is Rs.40 million. Where have these funds come from? This amount is the total of
profit transferred to balance sheet from the profit and loss account and depreciation added
back, as it does not involve any cash outlay. The figure is Rs.30 million + Rs.10 million = Rs.40
million. This figure is referred to as “internal accruals”.

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This need not be the case all the times. Where we use these funds entirely depends upon the
business priority and what we have shown is only a sample.

Learning points:
 The business enterprise generates funds from operations, known as “internal accruals”
comprising depreciation (which is added back, being only a book-entry) and profit after tax
and dividend;
 Where these funds are used is entirely dependent upon business exigencies;
 Depreciation claimed in the books as an expense goes to reduce the value of the fixed
assets in the books, while profit after tax and dividend is shown as “Reserves” and increases
the net worth of the company.

2.2.2 Financial statements as a measure of financial performance

Profit and Loss statement:
This gives annual performance year after year. This is more like ‘here and now’ of financial
performance. When we have P & L statements say for 5 years, we can analyze the year-on-year
basis the growth in revenues as well as growth in costs and profits.
As we have already seen, the assets and income belong to the enterprise, while share capital
and reserves and surplus belong to the shareholders of the enterprise.

If required, further analysis can be done on the P & L statement to probe which particular
expense is going up disproportionately. Further the budgeting exercise annually done in all the
enterprises is based on the figures from Profit and Loss statement.

For example, during the current year, the sales have gone up by 15% while expenses have gone
up by 18%. Will it affect the profits of the enterprise? Answer is yes. Then we go into further
analysis as to which of the expenses have shot up disproportionately to sales revenues. This will
give us the areas that require control for better performance in future.

Pointers in Profit & Loss statement:

1. Whether the business earns operating profit? That is = operating income (-)
operating expenses (operations being trading, manufacturing or services) and this
excludes income from investment made in some other enterprise or other activity
not connected with the main operations of the enterprise – example sale of fixed
asset, rent income, sale of scrap generated during the process of manufacturing.

2. Is it that the business is in profit only due to “non-operating income” as described

above? If it is so, it means that the main operations of the enterprise are in loss and

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the firm is able to keep its head above waters only due to profit coming from other
than main operations.

3. How do operating expenses behave? Are they increasing in proportion to the

increase in revenue or disproportionately to the increase in revenue? If they
increase disproportionately, it means that stricter control over expenses is indicated.

4. In case operating expenses have gone up, which group/s of operating expenses have
gone up? – Is it manufacturing/operations or administrative or selling/marketing or
finance expense that is going up disproportionately?

5. What is the level of closing stock in the Profit and Loss statement? Has the level
gone up disproportionately to the increase in revenue? This is important, as increase
in levels of inventory is going to involve carrying cost like “return on investment”
made in it and this will surely reduce the profits of the enterprise.

The above is only suggestive and not meant to be exhaustive

Balance sheet:
Balance sheet on the other hand gives the position of net worth (shareholders’ funds) in
comparison with loan funds so that a reader can estimate whether there is excess risk of
borrowing by the enterprise.

Suppose to begin with an enterprise had Rs.10 million as net worth. Over a period of say 5
years, the net worth has increased to Rs.20 million. What does it mean? This means over a
period of 5 years the cumulative figure of profit retained in business is Rs. 10 million. What
does it indicate to an analyst? This indicates that after paying dividend year after year, the
enterprise has been able to retain Rs.10 million in business. This indicates reasonably good
financial policy of dividend and profit retention.

Thus studying balance sheet over a period of time, say a minimum of 5 years will tell us how the
enterprise has progressed in terms of net worth and loans taken from banks etc. Further
balance sheet also would tell us the investment that the management has made within
(business assets) and without (investment in other companies including their subsidiaries).

Pointers in the balance sheet:

1. What is the level of funds employed in business? Is it increasing disproportionately
to the level of revenue?

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2. What is the relationship between owners’ contribution and borrowed funds? Is it in

line with what the lenders usually accept – 1.5:1 to 2:1 (excluding short-term
liabilities)
3. Will the enterprise be able to meet the short-term liabilities from its short-term
assets? Current assets should be higher in value than current liabilities
4. Whether the capacity of the business enterprise to pay interest and repay loan
installments is satisfactory? – This is again a combination of Profit & Loss statement
for earnings and Balance sheet for the repayment liability

2.2.3 Differences between ‘Profit & loss’ & ‘Balance sheet’ as financial
statements
As we have seen the differences in format and contents of P & L statement and Balance sheet,
let us now study the objectives of these financial statements as under:

While the contents may be more or less clear to a practitioner, the objectives may not be. Let
us briefly see the different objectives of these three primary financial statements of business.
Profit and Loss – financial performance for a year, profit or loss
Balance sheet – financial position of the enterprise in terms of owners’ funds, loan funds and
how these funds have been used in business
Profit and loss indicates figures of revenue, both income and expenses.
Balance sheet indicates the cumulative position right from the first day of the business

2.2.4 Preparation of simple ‘P&L’ statements & ‘Balance sheet’ from the given
figures
To begin with we are looking at preparation of simple P & L statement and ‘T’ form balance
sheet. In the second phase, we can familiarize with the limited companies’ formats as per
Schedule VI of The Companies Act.

A simple form of Profit & loss statement (for a manufacturing enterprise):

Income:
Operating income
Non-operating income
= Total income

Expenses:
Manufacturing expenses (other than labour wages):
Materials consumed

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Other manufacturing expenses

Employee cost (all including bonuses)
Depreciation on fixed assets
Marketing expenses (excl. employee cost)
Administrative expenses (excl. employee cost)
Finance expenses (incl. bank charges)
(+) opening stock of semi-finished and finished goods
(-) closing stock of semi-finished and finished goods
= Total expenses

Profit before tax = Total income (-) Total expenses

(-) Tax on profits
= Profit after Tax
(-) Dividend (incl. dividend distribution tax)
= Amount transferred to Reserves & surplus

A note on terms:
1. Operating income = coming from main operations like trading, manufacturing or
services
2. Other income = coming from investments & other than operations like rent, sale of
scrap, capital gains on sale of investment or fixed assets etc.
3. Dividend distribution tax = to be paid by all limited companies who declare dividend
bother on equity share and preference share; it is currently around 16% of the dividend
amount. This was introduced in 1997 when dividend income in the hands of
shareholders was exempted from tax.
4. Opening stock of semi-finished goods and finished goods were deducted last year as
closing stocks and hence added here to the costs, while the current year’s opening and
closing stocks are deducted. The underlying principle is ‘income recognition’ and
‘matching principle’. When you do not realize income on stocks that are unsold, the
underlying costs are not allowed as expenses.

A simple form of ‘T’ balance sheet:

Liabilities Assets
Current liabilities: Current assets:
Creditors Cash and bank balances
Bills payable Inventory

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 Financial statements of Business 2013

Provisions Bills receivable

Bank borrowing (short-term) Sundry debtors
Other current liabilities Investments tradable (short-term)
Total current liabilities Other current assets
Total current assets
Non-current liabilities: Non-current assets:
Term loans Tangible fixed assets (net of depreciation)
Bonds Intangible fixed assets
Debentures Capital work-in-progress
Fixed deposits from public (above 12 months) Intangible assets in progress
Other non-current liabilities Other non-current assets
(Including deferred tax liabilities)
Preference share capital (redeemable variety)
Total non-current liabilities Total non-current assets

Shareholders’ funds (Net worth):

Paid-up capital
Reserves & surplus
Net worth

Total liabilities Total assets

A note on balance sheet:
1. The above format is derived from Schedule VI form of balance sheet, although it is not in
the vertical form. In Schedule VI, it is in the vertical form
2. As per the current format (introduced w.e.f. 01.04.2011), the liabilities and assets are
bifurcated into – current and non-current
3. Deferred tax liabilities form a part of non-current liabilities
4. Similarly deferred tax assets form a part of non-current assets
5. Short-term investments that are not strategic in nature and are tradable are given in the
current assets
6. Intangible assets like technology transfer fees etc. are depreciable w.e.f. 01.04.1999
7. Capital work-in-progress means:
a. Advances given to suppliers of equipments, technology etc.
b. Incomplete fixed assets that are not yet operative for claiming depreciation
c. Building material etc. at site
8. Intangible assets in progress:
a. Captive technology in progress

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 Financial statements of Business 2013

b. Product development in progress

9. Other non-current assets:
a. Deferred revenue expenditure
b. Investments in subsidiary companies
c. Loans that are not recoverable within 12 months
d. Other strategic investments with long-term interests
e. Long-term advances like deposit with electricity board etc.
10. Bill receivable and bill payable mean that a bill of exchange is involved in the
outstanding amounts, accepted by the buyer and the company respectively
11. Sundry debtors and creditors mean other debtors and creditors not covered by bill of
exchange
12. Inventory components:
a. Raw materials
b. Packing materials
c. Consumables that get used in the process of manufacture but do not form a part
of finished goods

Case let:
The profit after tax for ABC Private Limited for the financial year 2012-13 was Rs.17 million. The
depreciation for the period was Rs.3 million & amount amortized was Rs.0.5 million. The
company had to repay loan installment of Rs. 6 million. Further the company is required to
invest in routine fixed assets to the extent of Rs. 8 million and increase its investment in current
assets due to increase in size of business to the extent of Rs. 3 million.

It is under pressure to give dividend of Rs.7 million to its equity share holders due to the
investors’ expectations and the competitors’ expected dividend distribution. The management
wants to oblige the market expectations. Examine the figures and comment whether this idea
of management is feasible in view of the financial commitments required to be met by the
management.

Class activity:
Attempt the following numerical exercise
1. Simple P & L and balance sheet
a. Arrange the following items of liabilities and assets in the form of a balance sheet:
(All figures are in thousands) Figures as at 31.03.2011
Capital 20
Provisions 10

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Creditors 15
Inventory 25
Debtors 18
Bank overdraft 20
Loans for fixed assets 25
Fixed assets 35
Investments 8
Cash and bank the balance

b. The key figures for the year 2011-12 are as under:

Increase in investment 15
Increase in creditors 5
Increase in debtors 8
Depreciation for the period 10
New fixed assets 20
Profit after tax and dividend 18
Increase in provisions 4
Increase in inventory 10
Repayment of term loans 10
New term loan 12
Cash and bank nil
Balance increase in bank overdraft
With the help of the above figures prepare balance sheet as at 31.03.2012

2.3 Third financial statement

2.3.1 Cash flow statement
Cash flow statement:
It should be noted that the cash flow statement referred to here is not the cash flow statement
as per Schedule VI. This is the usual cash flow statement meant for controlling liquidity in the
enterprise.

Even before learning the format and how to prepare the statement, let us know the ‘why’ of
this statement. There are two finance principles that are being discussed in detail in the next
chapter. Here we will only briefly mention that the relationship between liquidity and
profitability is inverse. This means that if an enterprise enjoys very good liquidity the chances of
it recording good profits are less. Hence through cash flow statement, it is ensured that the
system does not have excess liquidity or suffer from ‘lack of liquidity’.

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 Financial statements of Business 2013

Denotes the position of cash inflow and cash outflow for a particular period. The period is
usually one month, but can be more frequently done. This is useful to a business enterprise
from the point of view of control and monitoring the amount of cash available in business, also
known as “liquidity”. This information is required both for planning, i.e., arranging for backup in
case the available cash is less than required and control, in case the available cash is more than
required. The business enterprise cannot afford to keep more cash than required, as idle cash
does not earn any return and it is better to save tax by putting the excess cash back into
overdraft etc. The loss incurred by keeping more cash than required is often referred to as
“opportunity cost”. (Please refer to the term ‘opportunity cost’ in glossary of terms).

Example no. 7:

My enterprise requires Rs.1 million on an average by way of cash. Suppose my projected

receipts for May 2013 are Rs.25 million and projected outflows are Rs.26 million with opening
balance of Rs.1 million. This will result in my closing balance of cash of Rs.2 million.

This is far in excess of my requirement of Rs. 1 million. What do I do with this excess cash? I put
it back into my bank account so that I can earn some interest especially if my bank account is
overdraft like account in which case, I pay interest on the amount used by me. Once I prepare
the cash flow statement, I compare it with the actual position at the end of the month so that I
can verify as to how far I have been good in projecting my cash position for the month under
review.

Pointers in the Cash flow statement

1. Has the month just gone by generated any surplus of cash or has it resulted in
deficit?
2. If there is a surplus, how to utilize the same and if there is a deficit, what is the
alternative source that can give cash to fill the gap?
3. Whether the cash flow statement is useful to the business enterprise as a tool in
financial planning? – This can happen only if the estimate is realistic and the actual
at the end of the month does not differ from the estimate by a wide margin

So the cash flow statement = cash inflow and cash outflow and the frequency of preparing is
monthly. A sample format of cash flow statement is given below:

Opening Balance for Period

+ (Plus) Receipts during the period
- (Minus) Expenses during the period
= Closing Balance for the period (is the same as Opening Balance for the “next period”)

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 Financial statements of Business 2013

(Rupees in millions)

Cash Receipts
Revenue Receipts
Sales Receipts 100
Dividend income on shares 5
Rent income 10
Total 115

Capital Receipts
Fresh debenture 50
Fresh term loan 100
Sale of fixed asset 10
Sale of shares 20
Total 180
Total Receipts 295

Cash Payments

Revenue expenditure
Payment to creditors 75
Payment of interest 15
Payment of expenses 25
Total 115

Capital expenditure
Purchase of fixed assets 150
Repayment of term loan 25
Purchase of UTI Units 2
Total 177
Total Payments 292

Opening balance of cash 3

Add: Total Receipts 295
Less: Total Payments 292
Closing balance of cash 6
(Opening balance for the next period)
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 Financial statements of Business 2013

Case let:
You have learnt in chapter 1 under ‘functions of finance’, investment outside the business as
one of the functions. Shippers’ Union Private Limited had a cash surplus for the month of April
2013 a cash surplus of Rs. 3 million (Cash flow for the month revealed a closing balance of Rs.13
million as against Rs. 10 million which is the usual level of cash carried by the company).
The management is fully aware of this. They want to invest this surplus in their subsidiary
company at least to the extent of Rs. 2 million.

Examine the proposal and advise the prudence of the decision or otherwise.

Class activity
Prepare a cash flow statement for the month of April 2013 with the following figures and
analyse whether the cash flow statement is healthy or not? Where is cash maintained, in the
physical form?
What does the firm do to manage its required cash? (All figures are in Indian Rupees in millions)
Debtors realized 18
Payment to creditors 10
Operating expenses 15
New loans 15
New fixed assets 20
Dividend received 3
Dividend paid 7
Opening balance of cash 12

2.4 Solved questions

Question no. 1:
Explain how finance and accounts function integrate.

Answer:
Finance is the beginning of the enterprise. Accounting is recording of finance and financial
transactions before operations and during operations of the enterprise. Both are inter-
dependent and supporting functions. Let us say one or two examples as under:
Finance brings in resources while through budgets, accounts department allocates the
resources.
Both of them integrate to fulfill the finance objective of wealth maximization. For wealth
maximization, continuous growth is required and this is possible with financial controls.
Financial controls are more a function of accounts rather than finance.
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 Financial statements of Business 2013

Question no. 2
Classify the following items as revenue and capital for preparing cash flow statement. Also state
receipt or outflow against the respective items.
1. Payment to creditors
2. Dividend received
3. Income tax paid
4. Credit purchases
5. Equity share capital coming into the enterprise
6. Repayment of loans
7. Cash purchase of consumables

Answer:
Item nos. 1, 3 & 7 – cash outflow – revenue
Item no. 2 – cash receipt – revenue
Item no. 4 – will not appear in cash flow statement as it is on credit
Items no. 5 – capital receipt
Item no. 6 – capital outflow

Question no. 3
Explain the significance of bifurcating income in the P & L statement into operating and non-
operating.

Answer:
Operating income is from main operations of the enterprise. Why this bifurcation? It is for the
purpose of transparency and analysis to users of financial statements. Suppose the operating
income of an enterprise is coming down while its overall profits including other income are
maintained, is it ok?

Obviously the answer is ‘no’. Since the main operations are less and less profitable, this is
danger signal. If ignored by not controlling operating costs, sooner or later it will see the day
when its operating profit is nil or negative and it will be forced to close down its operations.

Question no. 4:
In the profit and loss statement, why do we add opening stock of semi-finished and finished
goods and deduct closing stock of semi-finished goods and finished goods?

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 Financial statements of Business 2013

Answer:
This year’s opening stock of semi-finished goods and finished goods are last year’s closing
stocks. As they were held in stocks form, they were not sold. Hence income is not recorded. As
per matching principle and income recognition, when income is not recorded by sale, the costs
involved in producing unsold stocks cannot also be recorded as expenses in that year.

However in the subsequent year, the same are recorded as expenses while the current year’s
closing stocks of semi-finished goods and finished goods are carried over to the next year. This
practice happens on a continuous basis.

2.5 Unsolved questions (with suggested answers in the teacher’s handbook)

1. Explain how accounts function is more statute oriented while finance function is more
market oriented
2. Explain the significance of the following terms in Schedule VI statements:
a. Capital work-in-progress
b. Short-term investments in current assets
c. Dividend tax
d. Investment in a subsidiary company
3. Some intangible assets are depreciable while some others are amortized. Explain
suitably.
4. What are the two different cash flow statements that you know of? Explain the
differences between them.

2.6 Summary:
The distinction between accounts and finance functions seems to be blurred. They are quite
distinct although could be handled by the same chief at the highest level. The statutory
bodies for these functions at the national level are quite different. In spite of the
differences between them, they integrate very well to meet the corporate objective of
wealth maximization.

The students, who are getting initiated into basics of finance, should understand financial
performance of an enterprise as measured on a yearly basis and on a cumulative basis. The
difference between financial performance and financial position should be clear to them.

They also should know the existence of other financial statements like cash flow and its use
to business. They should be able to prepare simple financial statements.

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2.7 Handouts:

Key pointers in a limited company’s financial statements:

1. What is the increase in operating income in % terms?

2. What is the increase in non-operating income in % terms?
3. What is the increase in PBT in % terms?
4. Is there any discrepancy in % terms? That is, is the % increase in PBT less than
proportionate to % increase in operating income?
5. If so, what does it indicate?
6. What is important is to determine ‘operating profit’. Formula for operating profit = PBT
(-) non-operating income
7. Can we compare the % increase in PBT with % increase in PAT?
8. What is the relationship in % terms between provision for tax and PBT?
9. Does it indicate any tax savings?
10. How does an enterprise save income tax?
11. Do they compare well? If not, what does it indicate?
12. What is the analysis of increase in employee costs as these constitute the major cost in
an IT enterprise? Is there any discrepancy between increase in revenues and increase in
employee costs?
13. What is the increase in EPS? Is it keeping up with % increase in PBT?
14. What is the % increase in investments overall? Is it different from % increase in PAT?
15. What is the % increase in investment in subsidiary companies?
16. What is the % increase in provision for bad and doubtful debts? What does it indicate?

Comprehensive case covering all the objectives: - Finance function and financial performance if
not statements

Mr. Ram Singh has been progressing reasonably well. His bank is however not very happy with
his conduct of business. They do not suspect his integrity or intentions. They say that he does
not have financial control or discipline. He at the end of three years has reached a sales figure
of Rs. 80 lacs as against estimated sales of Rs.90 lacs. The bank authorities further feel that
there is no one responsible at the factory to reply to them, in the absence of the owner. What
could be the reasons for the bank’s disappointment?

At this time, he gets an opportunity to be a sub-contractor with a reputed all-India

manufacturer of office furniture. The revenue inflow will be upwards of Rs.150 lacs in the very
first year with minimum additional investment in infrastructure. The payment terms are – 45

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 Financial statements of Business 2013

days after raising the invoice. Mr. Ram Singh agrees for 5% reduction over his established prices
in Dharwad looking at the large contract. He signs the contract and then informs the bank. He
also approaches the bank for further finance, after signing the contract. The bank is very
reluctant to agree to the proposal. After the intervention of the principal, the all-India
manufacturer and their guarantee, the bank agrees to give further finance. However this comes
with a number of conditions to which he readily agrees. He also arranges for putting in further
capital of Rs. 3 lacs for this business. Why should the banks be unhappy with the
“Entrepreneur”? Why should they put in additional conditions for the loan this time?

Two more years pass by. The sales are quite okay. However Mr. Ram Singh has liquidity
problem, a shortage of cash. He is finding it extremely difficult to manage things and over a
period of time, the all-India manufacturer shows his true colours by being stiff in payment
terms; of late payment is released only after 75 days.

As a result of all these developments, he has been late in paying up installments both to KSIDC
& Corporation Bank. The bank is extremely uncooperative now.

Examine reasons for the situation & how it could have been avoided.

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