Chapter Two: Financial Statements, Taxes and

Cash Flows
Definition: Statements prepared at the end of a certain accounting
period for representing operating performance and financial position of
an institution based on incurred transactions are called financial
statement. Generally financial statements may be the following types:
Income statement: Statement reports the results of operations of an
institution for a particular time period at the end of the period is called
income statement or profit and loss account.
Balance sheet: Statement reports the financial position i. e. amount of
equity, liability and assets of an institution at a particular time point at the
end of the certain time period is called balance sheet.
Cash flow statement: Statement shows the amount of cash receipts
and amount of cash payments from different sources and activities and
for different purposes and areas is known as cash flow statement.
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Statement of changes in owners equity: This statement reports the net

change in owners equity amount between beginning and ending of a
certain accounting period.
Liquidity: The easiness and quickness of converting an asset in cash and
cash equivalent is called liquidity.
Debt vs equity: The document or capital represents creditor position in
the issuing business of the holder is called debt and the document or
capital represents ownership position in the issuing business of the holder
is called equity.
Market value vs book value: The available value at which an asset is
tradable in the market at present is called market value and the value
obtained by dividing the difference between total assets and total liability
by the total number of shares outstanding in the market is called book
value. The value at which an asset is recorded in the book of account is
also called book value.
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Tax: The compulsory payment made by earning capable individuals and

institutions to the govt. at the end of a certain time period generally one
year without expecting any direct benefit is called tax. Tax may be:
Income tax: Tax paid by individuals on their earnings at the end of the one
year period.
Corporate tax: Tax paid by company form business on its earnings at the
end of the one year period.
Other classification of tax:
Average vs marginal tax rates
Direct and indirect tax
Proportional, progressive and regressive tax

Financial statement analysis:

It is defined as the process of identifying financial strengths and
weaknesses of the firm by properly establishing relationship between the
items of the balance sheet and the profit and loss account. The process of
reviewing and evaluating a companys financial statements (such as the
balance sheet or profit and loss statement), thereby gaining an
understanding of the financial health of the company and enabling more
effective decision making.
Standards of comparison:
1. Historical
2. Current/Budgeted
3. Selected firms
4. Industry average
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Objectives of financial statement analysis:

1. To provide analytical information to all interested parties.
2. To justify and analyse the earning capacity of the firm
3. To justify and analyse the financial position of the firm
4. To evaluate operations of the firm.
5. To evaluate progress of the business of the firm
6. To utilize resources properly and effectively
7. To analyze and evaluate management efficiency.

Techniques of financial statement analysis:

1. Common-size or vertical analysis
2. Horizontal analysis
3. Trend percentage analysis 4. Ratio analysis
5. Statement in changes in financial position (Cash flow
statement and funds flow statement)

Types of ratios:
A: Liquidity ratio - ratios that show the relationship of a firms
cash and other current assets to its current liabilities. This
includes (i) Current ratio (ii) Quick ratio
B: Asset management ratio - A set of ratios that measures
how effectively a firm is managing its assets. This includes (i)
Inventory turnover ratio (ii) Days sales outstanding or average
collection period (iii) Fixed asset turnover (iv) Total asset
turnover
C: Debt management ratio - ratios that show the relationship
of a firms total debt, equity and total assets. This includes (i)
Debt ratio (ii) Debt-equity ratio (iii) Times interest earned ratio
(iv) Fixed charge coverage ratio

Types of ratios:
D: Profitability ratio - a group of ratios showing the effect of
liquidity, asset management and debt management on
operating results. This includes (i) Gross profit margin (ii)
Operating profit margin (iii) Net profit margin (iv) Return on
total asset (v) Return on common equity (vi) Operating
expense ratio
E: Market value ratio a set of ratios that relate the firms
stock price to its earnings and book value per share. Ratios
under this are (i) Price/earnings ratio (ii) Market value/book
value ratio