A. Financial Statements


1.0 Introduction


Accounting is defined as an information system receiving its input from various financial transactions, processing these transactions and giving as output the financial statements and other reports that will enable the users to make suitable decision dealing with business and economic entities. The records of the transactions are summarized into two major statements known as 'financial statements' or 'final accounts'. They comprise of:


a)     Balance sheet, which shows the financial position of the concern, by listing out all the assets and properties that the concern owns and the amount it owes to others and

b)     Profit and Loss Account (or Income Statement) which shows the various sources of income and the different heads of expenditure. The difference between the income and expenditure is the profit made by the concern.


2.0 Balance sheet


The final accounts, which are the ultimate output of accounting, are studied not only by the management, but also by outsiders who have something to do with the concern. Statutorily, companies are required to publish their final accounts. These statements are therefore available to anyone who wants to know about the financial position of the company. The form in which a company should prepare its balance sheet is given below.

Table 1: A Typical Balance Sheet

Liabilities

Assets

Share capital

Reserves and surplus

Secured loans

Unsecured loans

Current liabilities and provisions

Fixed assets

Investments

Current assets, loans and advances

Miscellaneous expenditure

Profit and loss account (loss)



2.1. Liabilities


2.1.1 Share Capital


A share is the unit into which the capital of the company is divided. The value for which each share is divided is known as the face value or nominal value of the share. At the time of incorporating company, the promoters take a futuristic look and decide on the maximum capital that the company may require during its life time. This amount will be included in the capital clause of the Memorandum of Association which they file with the Registrar of Companies.


The amount mentioned in the capital clause of the Memorandum of Association of the company is known as the authorized or nominal capital of the company. Authorized capital is the maximum that the company can raise as share capital during its life time.


As and when need arises, and to the extent required, the directors of the company may issue shares to the public. The face value of the shares offered to the public is known as the issued capital of the company. Of the issued capital that portion which has been actually taken up by the public is known as the subscribed capital of the company. Not the entire money on the shares issued may be required to be paid by the subscribers. The portion of the subscribed capital which the company has called upon the shareholders to pay is the called-up capital of the company.


 

There may be defaulters in paying the calls made by the company. Of the amount called up by the company the amount actually paid by the shareholders is the paid-up capital of the company.


Shares are of two types: (i) equity shares, and (ii) preference shares. The equity shareholders are the real owners of the company; they elect the board of directors to carry on the day-to-day management of the company. The dividend paid on equity shares is not fixed, but will depend upon the profits made by the company and the recommendations of the board of directors. Preference shares carry a specified rate of dividend. In the event of liquidation they will be repaid in priority to equity shareholders, but after all outside creditors are paid.


2.1.2. Reserves and Surplus


A portion of the profits is distributed as dividend to shareholders and the balance is retained in the business in the form of reserves. In ultimate analysis, reserves belong to shareholders. Therefore, the total amount due to the shareholders (or owner's funds) constitutes the capital and reserves. The presence of sizeable reserves in a balance sheet is a plus point as it adds to the financial strength of the company. Different reserves may be created by the company to meet specific purposes.


2.1.3. Secured Loan


These represent borrowings by the company against charging of its specific assets. Details regarding debentures, loans and advances from banks, loans and advances from subsidiaries and loans from directors are to be shown separately. The banker should carefully study the item and verify the extent to which the assets of the company are charged to creditors; this will help him to estimate the assets that are available to him as security.


2.1.4. Unsecured Loans


These include borrowings of the company without creation of any charge on its assets. The Companies Act requires that borrowings in the form of fixed deposits, loans and advances from subsidiaries and borrowings from banks should be shown separately. As regards bank borrowings details of short-term borrowings that are due for repayment not later than one year from the date of balance sheet are required to be shown separately.


2.1.5. Current Liabilities and Provisions


Current liabilities include short-term liabilities of the company, other than borrowings. Of the current liabilities, sundry creditors require closer study. The banker should see if they bear a reasonable proportion to the total purchases. Provisions such as provision for taxes should be scrutinized to verify if adequate provision has been made.


2.2. Assets


2.2.1. Fixed Assets


Fixed assets are of two types: (i) Tangible fixed assets and (ii) Intangible fixed assets. Tangible fixed assets include permanent assets like land, buildings, plant and machinery. Intangible fixed assets include items like goodwill, patents and trademarks.


2.2.2. Investment


Instead of keeping excess cash idle, it may be invested in good short-term investments and thus earn interest. The following definitions given in the Companies Act may be noted:


i)        Quoted investment: It means an investment as respects which there has been granted a quotation or permission to deal on a recognized stock exchange.

ii)      Trade investment: It means an investment by a company in the shares or debentures of another company, not being its subsidiary, for the purpose of promoting the trade or business of the first company.


 

2.2.3. Current Assets, Loans and Advances


Important among the items falling under this category is discussed below.


Stock in trade: This item includes (a) raw materials, (b) stock in process, (c) consumables stores and spares, and (d) finished goods. The stock in trade is valued at cost or market price, whichever is lower. This is also known as inventory.


Receivables: This item includes book debts and bills receivable. This represents the total amount due from the customers of the concern for credit sales made to them. The Companies Act requires the companies to show debts outstanding for more than six months separately from other debts.


Loans and advances: The company may advance to other companies with which it has business relations, its subsidiary or sister concerns and to its staff.


2.2.4. Miscellaneous Expenditure


This includes items of deferred revenue expenditure and other items of expenditure which are written off over a period of time. Deferred revenue expenditure is a revenue expenditure of huge amount (e.g., advertisement campaign on launching a new product) whose benefit is expected to be received over a period of time. Total expenditure incurred is initially treated as an asset and shown in the balance sheet. Every year a portion of the expenditure is written off against profits.


3.0. Profit and Loss Account (P&L Account Statement)


Profit or Loss incurred by a company during a year or accumulated over the past years is shown under this item. It can be followed in two ways. (1) T type account statement and another one is called as (2) Vertical type account statement. In the earlier type Income is plotted in right side and expenditure on the left side. In the latter type net sales have to be recorded first and cost of items next in vertical fashion. The difference gives gross profit. Profit leads to increase owners equity of the company. A typical P&L Account Statement shows flow of Statements or Financial performance of the company. Where as the Balance sheet is a static statement or shows cumulative financial performance (snapshot of actual financial position).P&L statement contains information pertain to reserve fund, dividend paid, corporate tax, operation expenses, and cost of sales based on total sales income. For business organizations this statement is called as Profit and Loss account. For the Non- profit organizations, it is called as income and expenditure statement.


B. Ratio Analysis


1.0 Introduction


The most prevalent method of analyzing a balance sheet is through ratio analysis. The ratio analysis can be for a single year or it may extend to more than one year. The ratios can also be compared with similar ratios of others concerns to make a comparative study.

  • First, all ratios will be worked out for each year and each set of comparable items.
  • The ratios worked out will be put in the context of a trend over several years.
  • They will be compared with similar companies/ standard ratios.

i)        for the year concerned, and

ii)      Over a period of time.


Any number of ratios can be prepared by comparing any two figures available in the balance sheet or profits and loss account or both. But to serve its purpose, the figures compared should be meaningful, having a link between them, and should satisfy the needs of the person who analysis the financial statements.


Ratios are also classified differently on different bases. The mostly used one is the financial classification under which the ratios are broadly divided into the following five classes:


 

  • Liquidity ratios concerned with the short term solvency of the concern or its ability to meet financial obligation on their due dates.
  • Activity ratios concerning efficiency of management of various assets by the concern.
  • Leverage ratios concerning stake of the owners in the business in relation to outside borrowings or long term solvency.
  • Coverage ratios concerned with the ability of the company to meet fixed commitments such as interest on term loans and dividend on preference shares and
  • Profitability ratios concerned with the profitability of the concern.


2.0 Liquidity Ratio


2.1. Current Ratio


The ratio is worked out by dividing the current assets of the concern by its current liabilities.


Current Ratio


Current ratios indicate the relation between current assets and current liabilities. Current liabilities represent the immediate financial obligations of the company. Current assets are the sources of repayment of current liabilities. Therefore, the ratio measures the capacity of the company to meet financial obligation as and when they arise. Textbooks claim a ratio of 1.5 to 2 is ideal; bit in practice this is rarely achieved. This ratio is also known as working capital ratio.


2.2. Acid Test Ratio

Acid Test Ratio =


Quick assets represent current assets excluding stock and prepaid expenses. Stock is excluded because it is not immediately realizable in cash. Prepaid expenses are excluded because they cannot be realized in cash.


One of the defects of current ratio is that it does not measure accurately to meet financial commitments as and when they arise. This is because the current assets include also items that are not easily realizable, such as stock. The acid test ratio is a refinement of current ratio and is calculated to measure the ability of the company to meet the liquidity requirements in the immediate future. A minimum of 1: 1 is expected which indicates that the concern can fully meet its financial obligations. This also called as Liquid ratio or Quick ratio.


3.0. Activity Ratios


3.1. Debtors Velocity

Debtors Velocity


It is expressed in number of days;

(Or)


(* 52 if result require in number of weeks)


The ratio obtained should be compared with that of other similar units. If the ratio of the company being studied is greater (say, 10 weeks as against 6 weeks for the industry), it indicates that the company is allowing longer than the usual credit periods. This may be justified in the case of new companies or existing companies entering into new ventures because initially they may have to extend longer credits to capture the market. In other cases, the position needs a deeper study; it is possible that many unrealizable and long pending items are included in debtors. The companys collection machinery may need gearing up. The chances of larger bad debts are imminent.

 

3.2. Creditors velocity


Creditors Velocity

When the opening balance of creditors and the figure of credit purchases are not available, the ratio can be computed as follows.


A high ratio as compared to that obtaining in the industry (e.g., 12 weeks as compared to 8 weeks for the industry) may mean that:


  • The company in unable to pay its debts and is therefore taking longer than usual time to pay its creditors ; or
  • The company is enjoying good reputation in the market and therefore the suppliers are extending more credit ; or
  • The company may be a near-monopoly consumer and the supplier is agreeable to the credit terms dictated by the company.

Reversely, a lower ratio would mean any of the following:

  • The company has a comfortable financial position and is paying off the creditors promptly ; or
  • The creditors may offer discount on early payments to avail of which the company is paying early. The company may do so provided the cost of borrowing is less than the discount offered ; or
  • The company does not enjoy good reputation in the market and its creditors have restricted credits ; or
  • The suppliers may be monopolists dictating terms to the company.


The real reason should be found by going into the facts of individual cases. This ratio should be studied along with the debtors velocity and current ratio to judge the real situation.


3.3. Inventory Velocity

Inventory Turnover


The ratio is usually expressed as number of times the stock has turned over. Inventory management forms the crucial part of working capital management. As a major portion of the bank advance is for the holding of inventory, a study of the adequacy of abundance of the stocks held by the company in relation to its production needs requires to be made carefully by the bank.


A higher ratio may mean (higher turnover or less holding periods):

  • The stocks are moving well and there is efficient inventory management ; or
  • The stocks are purchased in small quantities. This may be harmful if sufficient quantities are not available for production needs; secondly, buying in small quantities may increase the cost.


Contrarily, a lower ratio (i.e.., lower turnover of longer holding period may be an index of (1) Accumulation of large stocks not commensurate with production requirements, (2) A reflection of inefficient inventory management or over-valuation of stocks for balance sheet purposes ; or Stagnation in sales, if stocks comprise mostly finished goods.


3.4. Working Capital Turnover


Working Capital Turnover


The use of this ratio is two fold. First, it can be used to measure the efficiency of the use of working capital in the unit. Secondly, it can be used as a base for measuring the requirements of working capital for an expected increase in sales.


 

3.5. Current Assets Turnover Ratio



The ratio is calculated to ascertain the efficiency of use of current assets of the concerns. With an increase in sales, current assets are expected to increase. However, an increase in the ratio shows that current assets turned over faster resulting in higher sales for a given investment in current assets. Higher ratio is generally an index of better efficiency and profitability of the concern. This ratio gives a general impression about the adequacy of working capital in reaction to sales.


3.6. Fixed Assets Turnover Ratio



The ratio shows the efficiency of the concern in using its fixed assets. Higher ratios indicate higher efficiency because every rupee invested in fixed assets generates higher sales. A lower ratio may indicate inefficiency of assets. It may also be indicative of under utilizations or non-utilization of certain assets. Thus with the help of this ratio, it is possible to identify such underlined or unutilized assets and arrange for their disposal.


4.0 Leverage Ratio


4.1. Debt-Equity Ratio

Debt-Equity Ratio


This is a measure of owners stake in the business. The proprietors may desire more of funds to be from borrowings because it carries two main advantages. First, their stake in the venture is reduced and correspondingly their risk also. Secondly, interest on borrowings is allowed as expenditure in computing taxable profits but not dividend shares. The tax is computed on the profits before any dividend is declared. But a considerable contribution from the proprietors is necessary from the creditors point of view to sustain the interest of the proprietors in the venture and also as a margin of safety of the creditors. Besides, excessive liabilities tend to cause insolvency.


Generally a ratio of 2: 1 (i.e., 2 units of debt for 1 unit of equity) is considered normal, but in certain cases relaxations are allowed.


4.2. Total-Indebtedness Ratio


Total Indebted Ratio


This ratio should be watched for a period of 3 to 5 years to see its trend, if declining or decreasing. A declining trend in the ratio is a welcome sign as it shows that the company is augmenting its own sources of funds by ploughing back profits or by reducing its dependence on outside borrowing by repaying them. On the other hand, an increasing trend in the ratio should be carefully looked into by the banker. Similar to the debt-equity ratio, there is no standard single ratio of total indebtedness that can be applied to all industries. But a ratio of 4: 1 is considered normal. This ratio supplements the information supplied by the debt-equity ratio. A company may have declining debt-equity ratio but the total outside liabilities may not decrease because of increased borrowing on short term. This will be revealed by the present ratio.


 

4.3. Proprietary Ratio

Proprietary Ratio


This ratio indicates the general financial strength of the concern. It is a test of the soundness of the financial structure of the concern. The ratio is of great significance to creditors since it enables them to find out the proportion of shareholders funds in the total investment in the business. In case of companies which depend entirely on owned funds and have no outside liabilities, the ratio will be 100%. A high ratio is welcome to the creditors because it secures their position by providing a high margin of safety. A ratio above 50% is generally considered safe for creditors.


5.0. Coverage Ratios


5.1. Interest Coverage Ratio

Interest Coverage Ratio


Since, EBIT is calculated after depreciation, it can be added back to arrive at the total funds available for payment of interest. The formula can be modified as follows.


Interest Coverage Ratio


Higher the ratio, better is the coverage. The firm may not fail on its commitments to pay interest even if profits fall substantially.


5.2. Preference Dividend Coverage Ratio


Preference Dividend Coverage Ratio


Higher ratio indicates better coverage.


6.0. Profitability Ratios


6.1. Gross Profit Ratio

Gross Profit Ratio


A comparison with the standard ratio for the industry will reveal a picture of the profitability of the concern. Also the ratio may be worked out for a few years and compared to verify if a steady ratio is maintained.


6.2. Net Profit Ratio


Net Profit Ratio


This ratio serves a similar purpose as, and is used in conjunction with, the gross profit ratio.


6.3. Return on Investment


This ratio measures the profits of the concern as a percentage of the total investment made. However, both the important terms involved, viz., profit and investment, have been interpreted in various ways and hence the formula used for this ratio also varies widely. We shall adopt the formula


Return on Investments

 

For the purpose of this ratio, the operating profit is calculated by adding back to net profit: (1) Interest paid on the long term borrowings and debentures; (2) Abnormal and non-recurring losses; (3) Intangible assets written off. Similarly, from the net profit abnormal and non-recurring gains are deducted. The idea is to get profit generated out of total investments made.


The ratio of return on investment is an important ratio in computing the profitability of the concern. It computes the profitability as against profits. A company may maintain the profits at absolute value every y ear but its efficiency lies in maintaining the same percentage of profit as compared to the total investment made. When one wants to analyze an increase or decrease in the rate of return, it can be done by further analysis of the ratio. Profit is decided by the rapidity with which sales are made (turnover) and the margin of profit on sales. Therefore the ratio can be calculated also as:


Return on Investments

                                 (Margin)                   (Turnover)


Profit can be increased by increasing the margin or increasing the turnover. A further analysis of the different components that enter into the above will pinpoint the factors that contributed to the increase of decrease in profits.


Return on investment is also known as Return on Capital Employed. Capital employed is used to mean the total investment in the unit, i.e., total assets.


6.4. Return on Proprietors funds


Return on Proprietors Funds


This ratio serves the requirements of the shareholders specially to know the return on their investments in the business.


Return on net worth, Return on shareholders Funds.


6.5. Earnings/ Share


Earnings per share


The numerator indicates the funds available for distribution as dividend to equity share holders. As the name indicates the ratio indicates the earnings made by the company per equity share. A comparison with the ratio for similar companies will indicate whether the company is using its capital effectively or not.


6.5. Dividend / Share

Dividend per share


Not all the earnings available for distribution are declared as dividend of the company. This ratio indicates the actual amount declared as dividend by the company.


6.6. Dividend Payout Ratio

Dividend payout ratio


This ratio indicates the actual dividend paid to the shareholders. It throws light on the dividend policies of the company.


 

6.7. Price Earnings Ratio

Price Earnings Ratio

(Earnings per share


A higher price earnings ratio as compared to that of other companies shows higher confidence the company enjoys with the public. This ratio is also used by the investors to know whether the shares of the company are undervalued or overvalued. Based on this fact they would decide to purchase the shares at the particular price or not. For instance, suppose the market price of the shares of the Company A is Rs. 80 when it earnings per share is Rs. 10. (The price earnings ratio of the company is 8.) The price earnings ratio of other companies is 9. Based on the general price earnings ratio, the market price of the shares of Company A should be (Rs. 10) Rs. 90. The shares of Company A are undervalued since they are quoted at Rs. 80.


6.8. Dividend Yield Ratio

Dividend Yield Ratio


Yield is the actual return for the shareholders on the investment. The dividend is declared on the face value of shares. Thus 20% dividend declared on a share of the face value of Rs. 10 would fetch Rs. 2 as dividend. But, if the shareholder has acquired the share from the market for Rs. 40, the actual yield will be

Dividend Yield Ratio

6.9. Earnings Yield Ratio

Earnings Yield Ratio


This ratio measures the yield earned by the company per share.


7.0 Summary


The Financial statements and ratios furnished in this paper are normally used in the accounting section are for validation, verification and for improvement of the company. The real success of any management lies with proper vision, mission towards the up-gradation of our society.


Reference:


1)     Prof. C. Jeevanadam, Sardar Vallabhbhai Institute of Textile Management, Coimbatore, Notes on Financial Statements, Short Term Programme on Financial Management at Bannari Amman Institute of Technology, Sathyamangalam on 05.01.2005.

2)     Principles of Accounting, Dr. Vinayagam, P. C. Mani, K. L. Nagarajan, Kalyani Publications, New Delhi, 2002.

3)     Financial Management, Dr. R. S. Kulsherestha, Kalyani Publications, New Delhi,2002

4)     Dr. B. K. Behra, Class notes on Costing and Management,IIT-Delhi,2003


About the Authors:


The authors are associated with Department of Textile Technology, Bannari Amman Institute of Technology and Department of Textile Technology, PSG College of Technology, Tamilnadu, respectively.



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