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FINANCIAL STATEMENTS
IBS Bangalore23 October 2010
Faculty : Aparna Hawaldar
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Forms of Business Organization
Sole Proprietorship
Partnership
Company
Private Limited Company
Joint Stock/Public Limited Company
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Users of Financial Statements
Accounting system is the information
system that identifies, records and
communicates the economic events of an organization to the interested users
Internal Users and External Users
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People who work
for the business
Resource providers
(investors &
creditors)
Recipients of goods
and services
(customers)
Parties performing a
review or a oversight
function (Regulatory
agencies)
Internal Users External Users
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Generally Accepted Accounting
Principles (GAAP)Assumptions:
Accounting Entity
Going Concern
Monetary
Period Principles:
Historical Cost
Full Disclosure
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Accounting Entity AssumptionAccounting Entity Assumption The business is separate and distinct
from its owners.
Entity·s assets and other financialelements are not commingled with
those of the owners.
The economic entity assumption is an
accounting concept, and not a legal
construct.
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The business is assumed to continue
indefinitely unless terminated by
owners.
The basis of recording financial
elements is historical accounting .
Going Concern AssumptionGoing Concern Assumption
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Money is the common unit of measure of economic transactions.
Use of a monetary unit is relevant, simpleto understand and universally available.
Price level changes are ignored inaccounting, leading to the assumption thatthe rupee remains relatively stable.
Monetary Unit AssumptionMonetary Unit Assumption
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Economic activity of an entity may be
artificially divided into time periodsfor reporting purposes.
Shorter time periods are subject torevisions but may be more timely.
Periodicity AssumptionPeriodicity Assumption
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Historical Cost Principle
Transaction is recorded at its acquisition pr ice .
It is not changed to reflect market price.
The principle applies to most assets and
liabilities.
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The Matching Principle
Expenses are matched to the revenuesthey help generate.
There should be a logical, rational association of revenues and expenses.
If a cost does not benefit future periods,it is recorded in the current period as anexpense.
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Full Disclosure Principle Financial statements must report what
a reasonable person would need to
know to make an informed decision. Disclosure may be made:
within the body of the financial
statements,
as notes to those statements, or
as supplementary information.
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Constraints: Cost Benefit Rule
Cost-Benefit Relationship :: The cost of
providing information should not
outweigh the benefit derived.
Costs and benefits are not always
obvious or measurable.
Sound judgment must be used in
providing information.
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Constraints: Materiality Materiality refers to an item·s importance
to a firm·s overall financial operations.
An item must make a difference to bematerial and be disclosed.
It is a matter of the relative significance
of the element.
Both quantitative and qualitative factors
are to be considered in determining
relative significance.
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Constraints: Industry PracticesConstraints: Industry Practices The nature of some industries sometimes
require departures from basic accounting
theory.
If application of accounting theory results
in statements that are not comparable or
consistent, then industry practices must
be examined for possible explanations.
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Constraints: ConservatismConstraints: Conservatism Conservatism suggests that the preparer,
when in doubt, choose a conservative solution .
This solution will be least likely to overstate
assets and income.
Conservatism does not suggest that net assetsor net income be deliberately understated.
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Qualitative Characteristics
R elevance - Information that is capable of nformation that is capable of
making a difference in a decision contextmaking a difference in a decision context
R eliability - Can be relied on to representthe true, underlying situation.
C omparability - measured & reported in a
similar manner for different businesses
U nderstandability
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Elements of Financial Statements
Assets
Revenues
Expense Losses
Gains
Equity
Liabilities
Financial
Statements
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Assets: Probable future
economic benefitsresulting from pasttransactions
Liabilities: Probablefuture sacrifices of
economic benefitsresulting from pasttransactions
Equity: Residual orownership interest
Investment by Owners: Distributions to
Owners:
Comprehensive Income:
All changes in equity from non-owner sources
Revenues: Inflows from
entity·s ongoing
operations Expenses: Outflows from
entity·s ongoing
operations
Gains:
Losses:
Balance SheetBalance Sheet IncomeIncome StatementStatement
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Elements of Financial Statements
Assets
Revenues
Expense Losses
Gains
Equity
Liabilities
Financial
Statements
Result fromResult from
delivering or delivering or producing goods,producing goods,
rendering services,rendering services,
or other activitiesor other activities
that constitute thethat constitute the
entity¶s major or entity¶s major or
central operationscentral operations
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Elements of Financial Statements
Assets
Revenues
Expense Losses
Gains
Equity
Liabilities
Financial
Statements
Result fromResult from
delivering or delivering or
producing goods,producing goods,
rendering services,rendering services,
or other activitiesor other activities
that constitute thethat constitute theentity¶s major or entity¶s major or
central operationscentral operations
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Elements of Financial Statements
Assets
Revenues
Expense Losses
Gains
Equity
Liabilities
Financial
Statements
Revenues
-
Expenses
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Principal Financial Statements
IncomeStatement
Balance
Sheet
Cash FlowStatement
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Balance Sheet
CapitalShare Capital
Retained Earnings
Reserves
Non current liabilities
Debentures
Long term Loans
Current LiabilitiesAccount payables
Outstanding
payments
Non Current/ FixedAssets
Land & Building
Plant & Machinery
Investments Intangible Assets
Current Assets
Inventories
Account Receivables
Prepaid Expenses
Cash
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FIN A NCI AL R AT IOS
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Objectives of Ratio Analysis Standardize financial information for
comparisons
Evaluate current operations Compare performance with past
performance
Compare performance against other firms or
industry standards
Study the efficiency of operations
Study the risk of operations
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Rationale Behind Ratio Analysis A firm has resources
It converts resources into profits through production of goods and services
sales of goods and services
Ratios Measure relationships between resources and
financial flows
Show ways in which firm·s situation deviates fromIts own past
Other firms
The industry
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Types of Ratios Financial Ratios:
Liquidity Ratios
Leverage Ratios : Structural & CoverageOperational Ratios:
Activity (Turnover) Ratios
Profitability Ratios
Valuation Ratios
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Liquidity RatiosAssess the firm· ability to cover current
obligations to maintain sound liquidity
Current Ratio: Current Assets
Current Liabilities
Quick (Acid Test) Ratio:
Current Assets ² Inventories
Current Liabilities
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Assess ability to cover long term debt obligations
Debt Equity Ratio: Debt
Shareholders funds Capital Gearing Ratio :
Fixed interest bearing securities
Equity Shareholders funds Fixed Asset Ratio : Fixed Assets
Capital Employed
Leverage Ratios ² Structural
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Ability of the firm to service the debt
Interest Coverage Ratio: EBIT
Interest Expense
Debt Service Coverage Ratio :
Leverage Ratios - Coverage
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Gross Profit Margin Ratio
Net Profit Margin Ratio
Return on Capital Employed (ROCE):
EBIT
(Average total Debt + shareholders equity)
Return on Equity (ROE): Net Income
Average Equity
Profitability Ratios
Assess profits relative to amount of resources used
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Total Asset Turnover Ratio:
Sales
Average total assets
Debtors Turnover Ratio
Net Credit Sales
Average Debtors
Inventory Turnover Ratio:Cost of goods sold
Average Inventory
Activity (Turnover) RatiosAssess amount of activity relative to amount of resources
used
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Valuation RatiosAssess market price relative to assets or earnings
Earnings Per Share (EPS)
Net Income (PAT)
Number of shares
Price-Earnings Ratio (PE Ratio)
Market price of the share
Earnings Per Share
Capitalization ratio : 1/PE Ratio
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The DuPont Analysis Method to breakdown ROE into:
ROA and Equity Multiplier
ROA is further broken down as:Profit Margin and Asset Turnover
Helps to identify sources of strength andweakness in current performance
Helps to focus attention on value drivers
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The DuPont Analysis
Profit Margin Total Asset Turnover
ROA Equity Multiplier
ROE
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The DuPont Analysis
EquityCommon
AssetsTotal
AssetsTotal
Income Net
Multiplier EquityROAROE
v!
v!
AssetsTotalSales
SalesIncome Net
Turnover AssetTotalMarginProfitROA
v!
v!
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Summary of Financial Ratios Ratios help to:
Evaluate performance
Structure analysisShow the connection between activities andperformance
Benchmark with
Past for the company Industry
Ratios adjust for size differences
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Limitations of Ratio Analysis A firm·s industry category is often difficult
to identify
Published industry averages are only guidelines
Accounting practices differ across firms Sometimes difficult to interpret deviations
in ratios Industry ratios may not be desirable
targets
Seasonality affects ratios