Financial statement analysis

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Chapter 11

Financial Statement Analysis

Financial Statements:

.      The result from the process of accounting are:

–      Balance Sheet

–     Profit and Loss Account (also known as Income Statement)

–     Cash Flow Statement

.      A Profit and Loss Account is an Account, while Balance Sheet is a Statement.

.      Cash flow statement is a statement of the sources from which funds or cash were raised and the uses to which these funds or cash were put during a certain period.

Users of Financial Statements:

.      Management

.      Shareholders

.      Lenders

.      Suppliers

.      Customers

.      Employees

.      Government and Regulatory Agencies

.      Research

Contents of Balance Sheet:

.      Assets

            Assets represent resources which are of some value to the firm.

–     Fixed Assets

–     Investments

–     Current Assets, Loans and Advances

–     Miscellaneous Expenditure and Losses

.      Liabilities

            Liabilities (or equities), represent what the business entity owes others.

–     Share Capital

–     Reserves and Surplus

–     Secured Loans

–     Unsecured Loans

–     Current Liabilities and Provisions

Contents of Income Statement:

            This statement is on adjunct to Balance Sheet because it provides details relating to net profit/loss which represents the change in owner’s equity between two successive balance sheets.

.      Cost of Goods Sold

.      Gross Profit

.      Operating Expenses

.      Operating Profit

.      Non – Operating Surplus

.      Profit before Interest and Taxes

.      Interest

.      Profit before Taxes

.      Tax

.      Profit after Taxes

.      Dividends

.      Retained Earnings

Cash Flow Statement:

.      The main purpose of the statement of cash flows is to provide information to decision makers about a company’s cash inflows and outflows during the period.

.      The statement of cash flows should be viewed as an explanation of the changes to the cash balance reported on the balance sheet.


.      Operating Activities

            Operating activities include acquiring and selling products in the normal course of business.

.      Investing Activities

            Cash flows from investing activities include: cash inflows from the sale of property, plant, and equipment; the sale of securities (stock and bonds) of other companies; and receipt of loan payments.

.      Financing Activities

            Cash flow from financing activities includes cash flows from issuance of debentures, bonds, shares, etc

Cash Equivalents:

.      A cash equivalent is an item that can be readily converted to a known amount of cash and has a maturity of three months or less.

Non – Cash Transactions:

.      It is common for firms to have exchange transactions that do not directly involve cash inflows or outflows but still warrant disclosure on a statement of cash flows.

.      These transactions are primarily in the financing and investing areas.

Statement of Cash Flows And Accounting Equation:

  Assets = Liabilities + Owner’s Capital

  Cash + NCCA + LTA = CL + LTL + CS + RE

 Hence, Cash = CL + LTL + CS + RE – NCCA – LTA

Where, CL = Current Liabilities

   LTL = Long Term Liabilities

   CS = Capital Stock

   RE = Retained Earnings

  NCCA = Non Cash Current Assets

   LTA = Long term Assets

Preparing Cash Flows Statement:

  1. Compute Net Change in Cash
  2. Compute the Net Cash provided or used by Operating Activities
  3. Compute the Net Cash provided or used by Investing Activities
  4. Compute the Net Cash provided or used by Financing Activities
  5. Compute Net Cash Flow

Why Analyses Financial Statements?:

To analysis financial statements is that it provides useful information to supplement information directly provided in financial statements.

Horizontal Analysis:

.      Analyzing financial statements over a period of time is called horizontal analysis.

Trend Analysis:

.      Horizontal analysis of financial statements can and should include more than just two years of data.

.      Supports to build prediction model and forecasts financial statements

Vertical analysis:

.      Compares the financial statements of different companies as well as the financial statements of the same company across time after controlling for differences in size. When comparing the companies of different sizes, it is useful to standardize the statements.

Common-size financial statements:

.      Statements in which all items have been restated as a percentage of a selected item on the statements. Common-size financial statements remove size as a relevant variable in ratio analysis and can be used to compare companies that make similar products and that are different in size. They can also be used to compare the same company across years.

Ratio analysis:

.       Financial statement ratios simply refer to a relationship between two financial statement amounts stated as a percentage.

Ratio analysis:

.      Return on investment

.      Acid test ratio

.      Activity ratio

.      Solvency ratio

.      Profitability ratio





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