Financial Statements

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1 Financial Statements The financial information forms the basis of financial planning, analysis & decision making for an organization or an individual. Financial information is needed to predict, compare & evaluate the firm s earning ability. All these financial information is contained in the financial statements. The three most important financial statements at our disposal are: Balance Sheet Profit & Loss Account Statement (Income statement) Cash flow statement 1. Balance Sheets: A balance sheet is the most significant financial statement & it indicates the financial condition or the state of affairs of a business at a particular point of time. It provides detailed information about a company s assets, liabilities and shareholders equity. (1) Assets are things that a company owns that have value. This typically means they can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property, such as plants, trucks, equipment and inventory. It also includes things that can t be touched (intangible) but nevertheless exist and have value, such as trademarks, goodwill and patents. The money claims i.e. the receivables & stock also is a part of company s asset. And cash itself is an asset. So are investments a company makes. Assets can further be classified as fixed and current assets. Current assets sometimes referred to as liquid assets are those resources which are held in the form of cash or can easily be converted into cash within an accounting period (one year).these include cash, tradable securities, account receivables, stock of raw material, work in progress & finished goods. Fixed assets these are long term in nature & held for more than an accounting period. The tangible fixed assets include land, building, machinery, equipment, furniture etc. The tangible assets depreciate over a period of their life time. The intangible fixed assets represent the firm s rights & include patents, franchises, goodwill, trademark, copyright etc. These are amortised over a period of time. (2) Liabilities are amounts of money that a company owes to others. This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup costs,

2 or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the future. Liabilities are further classified as current & long term liabilities. Current liabilities are the debts which are repayable within an accounting period. These include creditors, bills payable, banks overdraft, outstanding expenses & income received in advance. Current assets are converted into cash to pay the current liabilities. Long term liabilities are the obligations payable in a period more than an accounting year. These include bonds, debentures and secured loans from financial institutions (3) Shareholders equity is residual in nature. It is arrived at after deducting the liabilities from the assets. It is sometimes called capital or net worth. It s the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company. It comprises of two parts: Paid up Share capital Reserves & Surplus or Retained earnings Paid up capital is the amount of funds directly contributed by the shareholders through the purchase of shares. Reserves & Surplus is the undistributed profits. From this some amount can be distributed to the share holders as dividends when the company makes profit. Analyzing a balance sheet: A typical balance sheet has two main divisions viz: (1) Sources of funds: The liability part (2) Application of funds: The asset part The Source of funds part thus shows the share capital, the reserves & surplus & other debt components like loans taken. The Reserves & Surplus amount in the balance sheet is equal to the Profit after Tax (PAT) of the P&L account. Share capital plus Reserves & Surplus is equal to the Net worth of the company or the shareholders fund or the owners fund. Application of funds includes fixed assets, current assets & Investments.

3 Thus in the balance sheet the total value reflecting under the head sources of funds should be same as that under the head application of funds. Note: There can be a component called as contingent liability which is not actually included in the balance sheet because it may arise only when some event occurs. 2. Profit & Loss Account / Income Statement: Balance sheet is considered as a very significant statement by bankers & lenders as it gives the solvency & the liquidity position of an organization. However, the creditors, particularly the bankers & financial analysts in India have started paying more attention to firm s earning capacity as a measure of its financial strengths. Thus there arises a need of studying the P&L account or the income statement. In contrast to the balance sheet which gives information of the business as on a particular day, P&L gives the information of the business over a period of time. Profit & Loss account presents the summary of revenues, expenses & net income of a firm. Revenue is the amount earned by the company in exchange of the products/services provided to the customers. In order to earn these revenues, there are a lot of operational expenses involved. Thus there is a matching Revenues & expenses carried out over a period of time. This matching is done for an accounting period (normally a year). This matching is known as the matching concept. A firm is said to be profitable if its revenues exceed the expenses made in the process of providing the customer with the products/services. The revenues can of two types namely the operating revenue & the non operating revenue. The revenues arising from the main operation of the business are the operating revenues. For example: Total receipts from the sale of the manufactured goods by a firm. The revenues which are incidental or indirect to the main operations of the firm are non operating revenues. Eg: Receipts from the sale of equipments, Interest & dividend earned from temporary business is said to a non operating one. Expenses incurred in generating non operating revenues are called the non operating expenses Understanding the P&L: The P&L statement consists of all the revenues & expenses that the business incurs in an accounting period. Thus the topmost line of the P&L is the Sales; from the sales all the expenses the company comes across are subtracted. These expenses are operational in nature i.e the expenses incurred in the

4 course of manufacturing. These can be the raw material cost, rent of the workshop or manufacturing unit, wages rolled out to the employees, costs of researching new products and the electricity bill. After the mentioned deductions, depreciation is deducted to obtain Profit before interest & tax (PBIT). From PBIT, further there is a deduction of Interest & then the income tax. The residual value is called the Profit after tax (PAT). This quantity actually signifies whether the company actually earned or lost during the accounting period. The value obtained in the PAT field is what goes to the Reserves & Surplus of the balance sheet, 3. Cash flow Statement: A cash flow provides an investor insight into a company's credit worthiness and overall financial health. While for a company the cash flow is one of the major components for budgeting efforts and future planning. Cash flow statements report a company s inflows and outflows of cash. This is important because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash. The cash flow statement shows the changes over a period of time. The result obtained at the last line of the cash flow shows the net increase or decrease in the cash flow of the company. The cash flow statement is divided into 3 parts, namely: (1) Operating cash flow (2) Cash flow from Financing (3) Cash flow from Investment (1) Operating Cash flow: Operating activities represents the incoming and outgoing cash activities to run the day-to-day operation of a business. The net cash flow from operating activities represents the monies made from the sales of products and services. These include receipts from goods sold and tax payments. The operating activities is the most critical component of the cash flow statement, because it shows if a company is able to turn a profit based on its current business model at this exact moment in time. If a company is unable to turn a profit from their business activities, odds are the company will be experiencing finance issues and or making investments in hardware or software without any proof of success. In India, dividend is considered as an operating cash flow.

5 (2) Cash flow from Financing: Financing cash flow is related to money in and out to investors and shareholders. When a company raises funds from bonds or stock, this is considered cash in. The interest expense is considered as a financing cash flow. (3) Cash flow from Investment: Investment activities represent the cash flow from the purchase of long term assets required to make or sell goods and services. Investment activities also include purchases of stocks or other securities. A major issue that potential investors have with the investing activities section is that the money listed here represents activities paid for in cash. So, if a company were to purchase $5 million dollars worth of equipment with only $1 million cash and $4 million in financing, only the $1 million will show up under investing activities. Cash flow Statement preparation: - Increase in the account receivable is to be added. - Increase in inventory is to be subtracted. - Decrease in prepaid expenses is to be added since there is a saving by virtue of lesser prepaid expense - Increase in account payable is to be added since there is more of cash in hand. - Increase in salary payable is to be added - Increase in Income tax payable is to be added. After all the addition subtraction operations, the final result obtained would be either Cash flow from operations or cash flow from financing or cash flow from investment as may be the available inputs & situation.

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