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Financial Statement

Financial Statements: Income Statement and Balance Sheet
Financial Statements (F/S)
From the viewpoint of the reporting entity, financial statements are the means of re economic activities of an enterprise to the stakeholders. On the other hand, from the stockholder’s point of view, it is a source of reliable financial information needed for taking economic decisions. Since financial statements are the means of reporting economic activities, the reporter must understand the economic activities of the enterprise.
But only understanding of the economic activities is not sufficient for preparing financial statements. The reporter must also comply with the local regulatory requirements, accounting standards and international accounting standards in the process of preparing the financial statements in so far it is concerned with reporting the external users. These regulations and standards decide the formats of the financial statements. This sort of standardization of the formats of financial statements is required to facilitate comparison of financial statements of different entities. Comparability is a great quality of accounting information as economic decisions are taken based on comparison.
Financial Statements as per International Accounting Standards (IAS)
As per International Accounting Standard-1 (revised 1997), a complete set of financial statements includes the following five components:

  • Balance Sheet: B/S is a statement of assets, liabilities, and owners’ equity. This is prepared to know the financial position (financial health) of a business entity at a particular point of time.
  • Income Statements: I/S is a statement of revenues and expenses in which periodic expenses are deducted from the periodic revenues. This statement is prepared to know the operating results (income or loss) of a business entity during a period of time.
  • Statement of Changes in Equity: This statement is prepared for a period of time to determine the owner’s claim on the resources of a business entity. It also reports how owner’s claim changes over a period of time.
  • Cash Flow Statement: It shows the inflows and outflows of cash of a business entity during a particular period of time and finally the balance of cash at the end of a period. This is a vital statement to a banker.
  • Accounting Policies and Explanatory Notes: This part includes supporting calculations, schedules, and disclosures regarding the accounting principles, policies, post balance sheet events etc.

Elements of Financial Statements
Elements of financial statements are the items that are included in the financial statements.
Basically there are five core elements of financial statements that are discussed below with example:

Assets:

Assets are the resources owned and controlled by a business entity. Assets are also defined as future economic benefits. It means that an organization receives benefits from the assets at present and will receive in future. Assests may be grouped into different categories based on their features.
Example: Cash, Account Receivable, Inventory, Land, Building, Machinery, Equipment, Goodwill etc.

(a) Current Assets: Current assets are cash and other resources that are reasonably expected to be realized in cash within one year of the balance sheet date or within an operating cycle whichever is longer. Example: Cash, Account Receivable, Short-term Investment (T-bill), Prepaid Expenses, Supplies, Inventory etc.

(b) Long-term Investments: Long-term Investments are the resources that are not expected to be converted into cash within one year. Rather these investments are made for a longer period of time. Example: Investment in Five Years Savings Certificates, Debentures, Shares etc.

(c) Property, Plant and Equipment: Property, Plant and Equipment are tangible resources of permanent nature and these assets are purchased for using in the business operations and not for resale. These assets are subject to depreciation and in B/S they are reported net of Accumulated depreciation. Example: Land, Building, Plant & Machinery, Equipment, etc.

(d)  Intangible Assets: Intangible Assets are non-current resources that do not have physical substance but have economic value. Example: Goodwill, Patent, Trade Mark, Copy Rights etc

  • Liabilities
    Liabilities are the obligations of an organization. In other words, it is the outsider’s claim on the resources of the business. Liabilities may be grouped into different categories based on their features. Example: Accounts Payable, Notes Payable, Salary Payable, Interest Payable, Short-term Loan, Long-term Loan, Debenture, Bond etc.
    (a) Current Liabilities: Current Liabilities are the obligations that are reasonably expected to be paid within one year of the balance sheet date. These are paid from the current assets. Example: Accounts Payable, Notes Payable (Short-term), Salary Payable, Interest Payable, Short-term Loan,
    (b) Long-term Liabilities: Long-term Liabilities are the obligations that are not expected to be paid within one year of the balance sheet date. These obligations are incurred for longer period of time. Example: Term Loan, Debenture, Bond etc.
  • Owner’s Equity
    It is the owner’s claim on the resources of the business. It can be found by deducting total liabilities from total assets. Components of owner’s equity in case of a company may include: Example: Common Stock (Paid up Capital), Paid up capital in excess of par value (Share Premium), Retained Earnings, General Reserve, other reserves, etc.
  • Revenues
    Revenues are inflows or other enhancement of assets of an organization from delivering goods or services or from the major business operation to the organization. Example: Service Revenue, Consulting Fee, Audit Fee, Sales, Interest, etc.
    (a) Operating Revenne: These reventes are earned form the operation of the business Service, Consulting Fee, Audit Fee, Sales Revetiue, ete.
    (b) Non-operating Revenue and Gains: These revenues are earned from non operating sources. For earning these revenue, concerned organization do not require any extra effort. Examples: Interest revenue, Gain from sale of assets, etc.
  • Expenses: Expenses are outflows or using up of assets or incurrence of liabilities from purchasing of goods or receiving services. Major types of expenses of merchandising and manufacturing organization may as below:
    (a) Cost of goods sold (COGS): COGS refer to the cost of the goods that are sold. It may include the production cost, purchasing cost of (raw) material and cost incurred to make the goods ready for sale
    (b) Operating Expense: These expenses are incurred to run the organization and to generate revenue for the Examples Salary, Rent, Audit Fee, Repairs, Stationary, Advertising, Depreciation etc. Operating expenses are reported under two categories which are as follows:
    General and Administrative Expense
    These expenses are incurred to run the organization. Example: Salary, Rent, Audit Fee, Repairs, Stationary, Depreciation etc
    Selling and Distribution Expenses
    These expenses are incurred to generate sales and distribute goods as sold.
    Example: Salesmen salary/commission, Advertising, Depreciation of delivery car, etc.
    Non-operating Expense
    These expenses are incurred for reasons other than business operations. Example: Interest
    Expense, Loss on sale of assets, etc.
  • Analysis of Income Statement and Balance Sheet
    Analyzing financial statements involves evaluation of different dimensions of financial health of an organization. These dimensions may include liquidity, profitability, coverage, operating efficiency, solvency etc. For example, a short-term creditor, such as a bank, is primarily interested in the ability of the borrower to pay obligations when they come due.
    The liquidity of the borrower in such a case is extremely important in evaluation of the safety of a loan. A long-term creditor, such as a bondholder, however, looks to indicators such as profitability and solvency that indicate the firm’s ability to survive over a long period of time. Similarly, stockholders are interested in the profitability and solvency of the enterprise when they assess the likelihood of dividends and the growth potential of the stock.
    Financial Statements Analysis
    Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company’s past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users
    Tools of Financial Statement Analysis
    Various tools are used to analyze income statement and balance sheet. Three commonly used tools are these:
    (a) Horizontal Analysis: Horizontal analysis is called trend analysis. It is a technique for evaluating a series of financial statement data over a period of time. It is used primarily in intra-company comparisons. Its purpose is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.
    Formula:  HA=Current Year Amount – Base Year Amount/Base year Amount

    Two features in published financial statements facilitate this type of comparison: First, each of the basic financial statements is presented on a comparative basis for a of two years. Second, a summary of selected financial data is presented for a series of 5 to 10 years or more.

    (b) Vertical Analysis: Vertical analysis is a technique for evaluating financial statement data that expresses each item in a financial statement in terms of a percent of a base amount. Sometimes it is referred to as common size analysis. The value of for balance sheet items and the value of sales for income statement items. Vertical analysis is used in both intra-company and inter-company comparison.

    (c) Ratio Analysis: Ratio Analysis is the most widely used tool of financial analysis. Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between two figures. Ratios are used to evaluate operating and financial performance of a firm. Financial ratios are designed to help one to evaluate financial performance of a firm i.e. through ratio analysis we can identify financial strength and weakness of a firm. By observing financials at a glance one cannot immediately understand the actual financial condition of a firm i.e. whether the financial condition of the firm is improving or not. Through ratio analysis we can easily understand the actual financial condition of the firm, comparing various ratios.
    For example: Is earnings of Tk.5,00,000 actually good? If we earn Tk.5,00,000 on Tk-50,00,000 of sales (10 % profit margin ratio) that might be quite satisfactory, whereas earnings Tk.5 ,00,000 on Tk.5 ,00,00,000 could be disappointing (ie. I % return)
    Mode of Expression
    1.Times: which is the ratio between the two numerical facts over a period of time, for example, stock turnover is three times a year
    2. Proportion: which is arrived at by the simple division of one number by another, for example, Current ratio is 2:1
    3. Percentage: which is a special type of rate expressing the relationship in hundred, for example, gross profit ratio 30%.

    Ratio Analysis Importance:

    1. To measure general efficiency
      2. To measure financial solvency
      3. Forecasting and planning
      4. To facilitate decision making
      5. Aid in corrective action
      6. Aid in intra-firm comparison

    Standard Of Comparison:
    1. Intra-company comparison: Compare the calculated ratios of the company over the period of time.
    2. Inter-company comparison: Another way of comparison is to compare the ratios of one firm with some selected firms in the same industry at the same point of time.
    3. Industry average: Calculated ratios may be compared with average ratios of the industry of which the firm is a member
    4. Ideal Ratio: Experts have laid down some standard after making numerous experiments in various companies and at various places. The calculated ratios are compared with those ideal ratios.
    According to Financial Spread Sheet (FSS) there are six types of ratios, which are as follows:
    (a) Growth Ratio: Growth ratios measure the company’s potentiality, performance. It also measures whether the company will survive. Example of growth ratios are sales growth, net sales growth, net income growth, total assets growth, total liabilities growth, net worth growth etc.

    (b) Profitability Ratio: Profitability indicates the efficiency of the unit in generating surplus.
    In order to have a ratio, we can compare profit to the factors, which regulate the quantum of profit directly, like sales and the total assets or equity. Profitability ratios measure the income or operating success of an enterprise for a given period of time e.g., gross profit margin, operating profit margin, net margin, Interest expense, Cushion, Depreciation , Amortization percemntage etc.

    (c) Coverage Ratio: These ratios measure the ability of a company to generate cash to pay interest and principal repayments e.g., interest coverage ratio, debt service coverage.

    (d) Activity Ratio: It has been widely accepted that the profitability of an enterprise to a large extent depends on its efficient asset utilization or activity performed. Activity ratios measure how efficiently the firm employs the assets. These ratios are also called efficiency ratios or asset management ratios. e.g. Receivables in days, Payable in days, Inventory in days, sales to total Assets.

    (e) Liquidity Ratio: The liquidity or short-term solvency of an organization can be measured with the help of current ratio and quick ratio. Liquidity implies to the ability of an organization to pay off its short-term obligations with the current assets.e.g. Working capital, Quick Ratio, Current Ratio, Sales to net working capital.

    (f) Leverage Ratio: Ratios, which measures the extent to which a firm has been financed by debt. It is also known as debt management ratios. Examples of leverage ratios are debt ratio, etc.

    Cash Flow Statement Analysis
    Cash Flow statement is a summary of a firm’s cash receipts and cash payments during a resulting from the operating, investing, and financing activities of an enterprise during a period of time In fact, it reports the cash receipts, cash payments, and net change in cash particular period.
    When used with the information contained in the other two basic financial statements and their related disclosures, it should help the financial manager/bankers to assess and identify.

    • A company’s ability to generate future net cash inflows from operations to pay debts, interest, and dividends.
    • A company’s need for external financing
    • The reasons for difference between net income and net cash flow from operating activities.
    • The effects of cash and non-cash investing and financing transactions

    C/F Statement Importance

    • To assess an entity’s ability to generate cash and cash equivalents in future.
    • To assess an entity’s ability to repay bank loan, dividend and to meet obligations.
    • To know the reasons for difference between the net income and cash provided by
      the operating activities
    • To know the cash investment and financing activities.
    • To assess an entity’s ability to meet unforeseen situation and to take advantage of new business opportunities
    • To identify and assess the sources and uses of cash during a period of time.
    • To help detection of frauds in the accounts.
    • To facilitate the effective comparison.

    Content of the statement
    The statement of cash flows explains changes in cash (and cash equivalents) by listing the activities that increased cash and those that decreased cash. Each activity’s cash inflow or outflow is segregated according to one of the three broad categories:

    (a) Operating activity: operating activities include the transactions that create revenues
    and expenses and thus enter into the determination of net income, It is the principal
    revenue producing activities.
    Cash Received from Sale of Goods and Services –  Cash Paid for Operations and Goods& Services
    =Cash Flow from Operations
    Cash Inflows (Cash Received): From sale of goods and services and From return on loans (interest income) and equity securities (dividend income)
    Cash Outflows (Cash Payment):

    • To pay suppliers for inventory
    • To pay employees for services
    • To pay lenders (interest)
    • To pay government for taxes

    (b) Investing activity: investing activity means the acquiring and disposing activities of long term assets and investments .

    Cash Inflows (Cash Received):

    • From sale of fixed assets (Property, Plant& Equipment)
    • From sale of debt or equity securities of other entities
    • From collection of principal on loans

    Cash Outflows (Cash Payment):

    • To purchase fixed asset
    • To purchase debt or equity securities of other entities

    (c) Financing activity: Financing activities include cash from issuing debt and borrowing, repaying the amounts borrowed, obtaining cash from stockholders and providing them with a return on their investment.
    Cash Inflows /Cash Received

    • From Borrowing (debt)
    • From the sale of company’s own equity
      Cash Outflows /Cash Payment:
    • To repay amounts borrowed (principal)
    • To pay dividends
      Methods of Preparing Cash Flow Statement
      The cash flow statement may be presented in two ways:
    • Direct Method: Under this method, Cash inflows and outflows from each item of
      operating activities are determined and then added together to get the net cash flow
      from operating activities.
    • Indirect Method: Under this method, Net Cash Flows from operating activities are
      determined by adjusting the net income. So it is started from the net income.

    The only difference between the direct and indirect methods of presentation concerns the
    reporting of operating activities; the investing and financing activity sections would be identical under either method. Under the direct method, operating cash flows are reported (directly) by major classes of operating cash receipt (from customers) and payments (to suppliers and employees). A separate (indirect) reconciliation of net income to net cash flow from operating activities must be provided. This reconciliation starts with reported net income and adjusts this figure for noncash income statement items and related changes in balance sheet items to determine cash provided by operating activities.

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