FINANCIAL STATEMENT ANALYSIS
Financial statements are the statements that convey
information about the firm in financial terms. All the activities
of the firm (including HR, production, marketing etc) have
financial implications which are captured and presented
through financial statements.
IMPORTANT FINANCIAL STATEMENTS
Two commonly used financial statements are Profit and
Loss Account and Balance Sheet. Other financial statements,
which have specific uses, are the Funds Flow Statement and
Cash Flow Statement. In case of the companies, the audited
financial statements are supported by Schedules, Notes to
Accounts, Director’s Report, Auditor’s Report etc. Various
aspects of the financial statements are presented below mainly
from banker’s point of view.
1. PROFIT & LOSS ACCOUNT
Profit & Loss Account (P&L Account) presents the net
result of operations of the firm over a period of time. It is,
therefore, called the Operating Statement or Income
Statement.
A. Features of P&L Account:
(i) It is prepared for an accounting period, which is
normally one year. (i.e. accounting period concept).
However, the companies may prepare their financial
statements for an accounting period of maximum
15 months (or 18 months with approval of Registrar
of Companies).
(ii) Income is captured in P&L Account on accrual basis
(i.e. accrual concept) - hence, income is different
from cash.
(iii) For any income, the matching expense needs to be
accounted for (i.e matching concept)
(iv) Income is to be reckoned only if it is reasonably
certain whereas expense is to be provided if it is
reasonably possible (i.e. prudence concept)
(v) It records only revenue receipts and revenue
expenditure (and not capital receipts/expenses)
pertaining to the period.
B. Components of P&L Account
P&L Account can be studied broadly at 4 stages:
(i) Net Sales (i.e. revenue generated)
(ii) Cost of Sales (i.e. manufacturing cost of goods sold)
(iii) Operating Profit (i.e. income from main operations)
and
(iv) Net Profit (i.e. net result available for shareholders).
i. Net Sales:
It is computed as Gross Sales less Excide Duty and
adjusted for Sales Returns, Discounts etc.
Gross Sales: It is the number of units sold multiplied
by the average unit price. ‘Gross Sales’ is also adjusted for
Sales Returns and Discounts. Sales Returns represent goods
sold but subsequently returned. Thus, ‘Sales Returns’ reduce
the ‘quantity sold’. Discounts (which are given for bulk
purchase, timely payment, cash purchase etc) represent the
reduction in ‘unit price’. Thus, both Sales Returns and
Discounts effectively lower the sales figure during the period
and, hence, should be reduced from Gross Sales.
Excise Duty: It is deducted from Gross Sales because
excise duty is applicable as soon as the manufacturing process
is completed to make the product saleable (in other words,
excise duty is linked to production and precedes sale). Excise
duty is also collected for the government and, hence, does
not constitute a part of revenue of the firm. Moreover the
rate of excise duty may differ from year to year, which may
mislead while comparing sales over consecutive years.
For above reasons, ‘net sales’ is a more meaningful
parameter for analysis than ‘Gross Sales’.
ii. Cost of Sales
It is also called the Cost of Goods Sold. It is computed in
two stages, namely (a) Cost of Production and (b) Cost of
Sales.
(a) Cost of Production: It includes only those expenses
which directly go into producing the goods during the
period (regardless of whether the goods are sold or not).
These expenses, called direct expenses, include:
(a) raw materials and stores & spares consumed
(b) direct labour (i.e wages of manpower engaged in
production)
(c) power & fuel (on factory side)
(d) other manufacturing expenses (e.g. repairs &
maintenance)
(e) depreciation of fixed assets and
(f) adjustments for semi-finished goods or Stocks-In-
Process (i.e. add opening SIP and subtract closing
SIP)
‘Raw materials consumed’ is the value of raw materials
which go into production. It is different from raw materials
purchased as under
Raw materials consumed =
Raw materials purchased + Opening Stock - Closing Stock
of raw materials
Similar method is used for calculation of stores and spares
consumed during the accounting period.
Direct Labour and Power & Fuel: Only those expenses
which pertain to the manufacturing side are taken here. For
example, the direct wages and the salaries of the production
staff form a part of direct labour whereas the salary of
administrative staff is excluded.
Depreciation: It is a notional charge towards wear and
tear of the fixed assets through use or efflux of time or
obsolescence. It needs to be fully provided for replacement
of fixed assets in future. (In fact, companies are not
permitted to pay dividends or managerial remuneration before
providing for dividend in full). Being notional, it is a non-cash
expense.
Calculation of depreciation is based on three factors: (a)
the original cost of fixed asset (b) its estimated scrap value
and (c) its useful life. The original cost less scrap value is
depreciated over the useful life of the asset.
Two commonly used methods of depreciation (which are
also recognized by the Companies Act 1956) are the Straight
Line Method and Written Down Value Method.
In Straight Line Method(SLM), the depreciable value of
the fixed asset is divided equally over the number of years of
its useful life:
Annual Depreciation = (Original Cost - Scrap Value)/
Useful Life
Thus, in SLM, the depreciation is a constant amount every
year.
In Written Down Value (WDV) Method, the depreciation
is calculated with reference to the book value of the asset
(and not the original cost). Here, the applicable rate of
depreciation is first determined (based either on useful life
or as given in statutes) and then the book value is multiplied
by the rate of depreciation. Since the book value is more in
initial years, the amount of depreciation is more in initial
years than in later years.
A comparison of SLM and WDV methods of depreciation
would show the following:
• The amount of depreciation is constant in SLM whereas
it is progressively reducing in WDV method. It is less in
SLM than in WDV method in initial years and more in
later years
• The resultant net profit of the firm with SLM will be more
in initial years (as depreciation expense is less under
SLM) than with WDV method.
Accounting Standard (AS-6) permits change in method
of depreciation in case of (a) change in statute (b) change in
accounting standard or (c) to present information in a more
appropriate manner. Many companies change the method of
depreciation to suit their needs and the financial analyst needs
to probe into the same.
Stock-In- Process (SIP): The manufacturing expenses
are adjusted for the SIP consumed in production. For the
purpose, the opening SIP is added (as it is used in production
in current period) and the closing SIP is subtracted (as it is
not used in current period).
Above expenses added together give the Cost of
Production (COP) of goods.
(b) Cost of Sales: It is the Cost of Production adjusted for
the stock of finished goods. The opening stock of finished
goods is added to COP and the closing stock of finished
goods is subtracted to ascertain the Cost of Sales
(because the opening stock of finished goods has gone
into sales whereas the closing stock is still left out).
iii. Operating Profit
Operating Profit is profit generated from operations. It is
ascertained at three stages (a) Gross Profit (b) Operating
Profit before Interest and (c) Operating Profit after Interest.
(a) Gross Profit: It is computed as Net Sales – Cost of
Sales. It is the net amount that the production process
has given to the firm to sell the goods and make profits.
It is a measure of business risk (i.e. more gross profit
means lower risk in business).
(b) Operating Profit Before Interest: It is calculated as
the amount of Gross Profit less Selling, General and
Administrative (SGA) expenses. SGA expenses include
the staff salaries, bonus, marketing expenses,
administrative expenses and all non-manufacturing
expenses (except interest cost).
Operating Profit Before Interest is also called the Earnings
Before Interest & Tax (EBIT). It measures the operating
efficiency of the firm (prior to financing charges/interest)
(c) Operating Profit After Interest: It is calculated as
the amount of Operating Profit before Interest less
Interest expenses.
Interest expense: It is the amount of financing cost of
the firm, i.e. its expense towards borrowed funds. The
borrowings can be by way of loan from banks, public deposits,
debentures etc. Interest cost should bear a relationship to
the outstanding borrowing amount and the applicable rate of
interest. Other expenses like discounts, ancillary costs,
financial charges, exchange differences etc should be
segregated.
Operating Profit After Interest shows the overall operating
efficiency of the firm.
iv. Net Profit
This is the amount of profit available to the shareholders.
It is calculated in 2 stages: (a) Profit Before Tax (PBT) and
(b) Profit After Tax (PAT).
(a) Profit Before Tax: It is the profit earned by the
firm after all operating, financing and non-operating
expenses are accounted for. PBT is, therefore,
calculated as Operating Profit (after Interest) plus
net non-operating income. The non-operating
income (Other Income) and non-operating expenses
(Other Expenses) are kept ‘below the line’ of
operating profit for financial statement analysis as
they do not accrue from core operations.
(b) Profit After Tax: It is calculated as the PBT less
Provision for Tax. Net Profit is the net amount
available to the firm (and its shareholders) after all
expenses are paid for.
In case of companies, dividend, if declared, is paid out
of the net profit. In such a case, the balance amount is called
the Retained Profit, which is transferred to Reserves & Surplus
Account of Balance Sheet.
Banker’s Approach to Analysis of P&L Account
The approach of bankers to analysis of P&L account
differs from that of the shareholders mainly in following
respects:
(i) Bankers break down the income and expenses into
operating and non-operating items in their CMA format
as they are interested in operating efficiency of the firm.
(In contrast, companies present the P&L Account as
Income & Expenditure Statement, where the Total
Income and Total Expenditure are given over major
heads). Bankers also segregate the revenue of core
operations from non-core operations (e.g. trading profit)
(ii) Secondly, bankers look for full provision of various
expenses in the P&L account (e.g. depreciation, prior
period expenses, events after balance sheet date etc).
(iii) Thirdly, they ignore pure accounting transactions like
revaluation of fixed assets, deferred tax accounting etc.
(iv) Fourthly, they look for consistency in presentation of
various components of P&L account for inter-year
comparison of efficiency of operation.
The resultant profitability will show a reasonably correct
picture of viability of operations.
Financial statements are the statements that convey
information about the firm in financial terms. All the activities
of the firm (including HR, production, marketing etc) have
financial implications which are captured and presented
through financial statements.
IMPORTANT FINANCIAL STATEMENTS
Two commonly used financial statements are Profit and
Loss Account and Balance Sheet. Other financial statements,
which have specific uses, are the Funds Flow Statement and
Cash Flow Statement. In case of the companies, the audited
financial statements are supported by Schedules, Notes to
Accounts, Director’s Report, Auditor’s Report etc. Various
aspects of the financial statements are presented below mainly
from banker’s point of view.
1. PROFIT & LOSS ACCOUNT
Profit & Loss Account (P&L Account) presents the net
result of operations of the firm over a period of time. It is,
therefore, called the Operating Statement or Income
Statement.
A. Features of P&L Account:
(i) It is prepared for an accounting period, which is
normally one year. (i.e. accounting period concept).
However, the companies may prepare their financial
statements for an accounting period of maximum
15 months (or 18 months with approval of Registrar
of Companies).
(ii) Income is captured in P&L Account on accrual basis
(i.e. accrual concept) - hence, income is different
from cash.
(iii) For any income, the matching expense needs to be
accounted for (i.e matching concept)
(iv) Income is to be reckoned only if it is reasonably
certain whereas expense is to be provided if it is
reasonably possible (i.e. prudence concept)
(v) It records only revenue receipts and revenue
expenditure (and not capital receipts/expenses)
pertaining to the period.
B. Components of P&L Account
P&L Account can be studied broadly at 4 stages:
(i) Net Sales (i.e. revenue generated)
(ii) Cost of Sales (i.e. manufacturing cost of goods sold)
(iii) Operating Profit (i.e. income from main operations)
and
(iv) Net Profit (i.e. net result available for shareholders).
i. Net Sales:
It is computed as Gross Sales less Excide Duty and
adjusted for Sales Returns, Discounts etc.
Gross Sales: It is the number of units sold multiplied
by the average unit price. ‘Gross Sales’ is also adjusted for
Sales Returns and Discounts. Sales Returns represent goods
sold but subsequently returned. Thus, ‘Sales Returns’ reduce
the ‘quantity sold’. Discounts (which are given for bulk
purchase, timely payment, cash purchase etc) represent the
reduction in ‘unit price’. Thus, both Sales Returns and
Discounts effectively lower the sales figure during the period
and, hence, should be reduced from Gross Sales.
Excise Duty: It is deducted from Gross Sales because
excise duty is applicable as soon as the manufacturing process
is completed to make the product saleable (in other words,
excise duty is linked to production and precedes sale). Excise
duty is also collected for the government and, hence, does
not constitute a part of revenue of the firm. Moreover the
rate of excise duty may differ from year to year, which may
mislead while comparing sales over consecutive years.
For above reasons, ‘net sales’ is a more meaningful
parameter for analysis than ‘Gross Sales’.
ii. Cost of Sales
It is also called the Cost of Goods Sold. It is computed in
two stages, namely (a) Cost of Production and (b) Cost of
Sales.
(a) Cost of Production: It includes only those expenses
which directly go into producing the goods during the
period (regardless of whether the goods are sold or not).
These expenses, called direct expenses, include:
(a) raw materials and stores & spares consumed
(b) direct labour (i.e wages of manpower engaged in
production)
(c) power & fuel (on factory side)
(d) other manufacturing expenses (e.g. repairs &
maintenance)
(e) depreciation of fixed assets and
(f) adjustments for semi-finished goods or Stocks-In-
Process (i.e. add opening SIP and subtract closing
SIP)
‘Raw materials consumed’ is the value of raw materials
which go into production. It is different from raw materials
purchased as under
Raw materials consumed =
Raw materials purchased + Opening Stock - Closing Stock
of raw materials
Similar method is used for calculation of stores and spares
consumed during the accounting period.
Direct Labour and Power & Fuel: Only those expenses
which pertain to the manufacturing side are taken here. For
example, the direct wages and the salaries of the production
staff form a part of direct labour whereas the salary of
administrative staff is excluded.
Depreciation: It is a notional charge towards wear and
tear of the fixed assets through use or efflux of time or
obsolescence. It needs to be fully provided for replacement
of fixed assets in future. (In fact, companies are not
permitted to pay dividends or managerial remuneration before
providing for dividend in full). Being notional, it is a non-cash
expense.
Calculation of depreciation is based on three factors: (a)
the original cost of fixed asset (b) its estimated scrap value
and (c) its useful life. The original cost less scrap value is
depreciated over the useful life of the asset.
Two commonly used methods of depreciation (which are
also recognized by the Companies Act 1956) are the Straight
Line Method and Written Down Value Method.
In Straight Line Method(SLM), the depreciable value of
the fixed asset is divided equally over the number of years of
its useful life:
Annual Depreciation = (Original Cost - Scrap Value)/
Useful Life
Thus, in SLM, the depreciation is a constant amount every
year.
In Written Down Value (WDV) Method, the depreciation
is calculated with reference to the book value of the asset
(and not the original cost). Here, the applicable rate of
depreciation is first determined (based either on useful life
or as given in statutes) and then the book value is multiplied
by the rate of depreciation. Since the book value is more in
initial years, the amount of depreciation is more in initial
years than in later years.
A comparison of SLM and WDV methods of depreciation
would show the following:
• The amount of depreciation is constant in SLM whereas
it is progressively reducing in WDV method. It is less in
SLM than in WDV method in initial years and more in
later years
• The resultant net profit of the firm with SLM will be more
in initial years (as depreciation expense is less under
SLM) than with WDV method.
Accounting Standard (AS-6) permits change in method
of depreciation in case of (a) change in statute (b) change in
accounting standard or (c) to present information in a more
appropriate manner. Many companies change the method of
depreciation to suit their needs and the financial analyst needs
to probe into the same.
Stock-In- Process (SIP): The manufacturing expenses
are adjusted for the SIP consumed in production. For the
purpose, the opening SIP is added (as it is used in production
in current period) and the closing SIP is subtracted (as it is
not used in current period).
Above expenses added together give the Cost of
Production (COP) of goods.
(b) Cost of Sales: It is the Cost of Production adjusted for
the stock of finished goods. The opening stock of finished
goods is added to COP and the closing stock of finished
goods is subtracted to ascertain the Cost of Sales
(because the opening stock of finished goods has gone
into sales whereas the closing stock is still left out).
iii. Operating Profit
Operating Profit is profit generated from operations. It is
ascertained at three stages (a) Gross Profit (b) Operating
Profit before Interest and (c) Operating Profit after Interest.
(a) Gross Profit: It is computed as Net Sales – Cost of
Sales. It is the net amount that the production process
has given to the firm to sell the goods and make profits.
It is a measure of business risk (i.e. more gross profit
means lower risk in business).
(b) Operating Profit Before Interest: It is calculated as
the amount of Gross Profit less Selling, General and
Administrative (SGA) expenses. SGA expenses include
the staff salaries, bonus, marketing expenses,
administrative expenses and all non-manufacturing
expenses (except interest cost).
Operating Profit Before Interest is also called the Earnings
Before Interest & Tax (EBIT). It measures the operating
efficiency of the firm (prior to financing charges/interest)
(c) Operating Profit After Interest: It is calculated as
the amount of Operating Profit before Interest less
Interest expenses.
Interest expense: It is the amount of financing cost of
the firm, i.e. its expense towards borrowed funds. The
borrowings can be by way of loan from banks, public deposits,
debentures etc. Interest cost should bear a relationship to
the outstanding borrowing amount and the applicable rate of
interest. Other expenses like discounts, ancillary costs,
financial charges, exchange differences etc should be
segregated.
Operating Profit After Interest shows the overall operating
efficiency of the firm.
iv. Net Profit
This is the amount of profit available to the shareholders.
It is calculated in 2 stages: (a) Profit Before Tax (PBT) and
(b) Profit After Tax (PAT).
(a) Profit Before Tax: It is the profit earned by the
firm after all operating, financing and non-operating
expenses are accounted for. PBT is, therefore,
calculated as Operating Profit (after Interest) plus
net non-operating income. The non-operating
income (Other Income) and non-operating expenses
(Other Expenses) are kept ‘below the line’ of
operating profit for financial statement analysis as
they do not accrue from core operations.
(b) Profit After Tax: It is calculated as the PBT less
Provision for Tax. Net Profit is the net amount
available to the firm (and its shareholders) after all
expenses are paid for.
In case of companies, dividend, if declared, is paid out
of the net profit. In such a case, the balance amount is called
the Retained Profit, which is transferred to Reserves & Surplus
Account of Balance Sheet.
Banker’s Approach to Analysis of P&L Account
The approach of bankers to analysis of P&L account
differs from that of the shareholders mainly in following
respects:
(i) Bankers break down the income and expenses into
operating and non-operating items in their CMA format
as they are interested in operating efficiency of the firm.
(In contrast, companies present the P&L Account as
Income & Expenditure Statement, where the Total
Income and Total Expenditure are given over major
heads). Bankers also segregate the revenue of core
operations from non-core operations (e.g. trading profit)
(ii) Secondly, bankers look for full provision of various
expenses in the P&L account (e.g. depreciation, prior
period expenses, events after balance sheet date etc).
(iii) Thirdly, they ignore pure accounting transactions like
revaluation of fixed assets, deferred tax accounting etc.
(iv) Fourthly, they look for consistency in presentation of
various components of P&L account for inter-year
comparison of efficiency of operation.
The resultant profitability will show a reasonably correct
picture of viability of operations.
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