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    Unit 5-Financial Statement Analysis

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    Boris

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    Unit 5-Financial Statement Analysis

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    Boris
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    5 views15 pages

    Unit 5-Financial Statement Analysis

    Uploaded by

    Boris

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    © All Rights Reserved
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    Download as pdf or txt
    of 15

    Unit –V

    5 Financial statement analysis- 8


    Balance sheet and related concepts, profit and loss statement and related concepts, financial ratio
    analysis, cash-flow analysis, fundsflow analysis, comparative financial statement, analysis and
    interpretation of financial statements, capital budgeting techniques

    WHAT ARE THE COMPONENTS OF A BUSINESS BALANCE SHEET?

    The Balance Sheet represents one day in the life of a business. It shows how much of a
    business is owned (assets) and how much it owes (liabilities) on that one day it time. In other
    words it is a snap shot of a specific day in the life of a business. The difference between what is
    owned and what is owed on that day is the business’s net worth or equity.

    A business Balance Sheet has 3 components: assets, liabilities, and net worth or equity. The
    Balance Sheet is like a scale. Assets and liabilities (business debts) are by themselves normally
    out of balance until you add the business’s net worth.

    Assets minus Liabilities always = Net Worth or Equity

    What are Assets?


    An asset is a resource with economic value that a business owns with the expectation that it will
    provide future benefit to the business. As an example, a business owns a forklift with the
    expectation that it will assist in moving product that will be sold and upon the sale of the product
    income or value will be added to the business. Therefore, the forklift has brought economic
    value to the business.

    Business assets are broken into 2 categories: current assets and non-current assets. The
    liquidity of the asset determines into which category it falls. Liquidity is the ease in which an
    asset can be converted to cash. Assets that will be or should be converted to cash within 12
    months are considered current assets. The most common current assets of course include cash
    on hand, but also inventory and accounts receivable. An Account Receivable is short term
    financing a business offers to its customers. Normally a business will offer its customers 30 to
    60 days from the day of delivery of a product or the performance of service to pay for the
    product or service. They show this in dollar form on the Balance Sheet as Accounts Receivable
    until the customer pays and it is converted to cash. Inventory that a business holds is
    considered a current asset because the likelihood that the inventory will be sold within the next
    12 months, which will then convert it to cash. Non-current assets are assets that will not be
    converted to cash within 12 months and are normally used on-going to run the business, such
    as, the forklift in our prior example. Most non-current assets are considered fixed assets, and
    include equipment used in the running of the business, furniture and fixtures and also any real
    estate the business owns.
    What are Liabilities?

    A business’s liabilities are obligations the business owes. As with assets the liabilities are
    broken into current liabilities and non-current liabilities, most often called Long Term Debt.
    Current liabilities are obligations that are scheduled to be paid over the next 12 months. Most
    common current liabilities include accounts payable, business line of credit and the current
    portion of long term debt. Accounts payable are short term obligations owed to suppliers or
    other creditors and are normally paid within 30 to 60 days from the day of a delivery of a product
    or the performance of a service. Business Lines of Credit are used by businesses to service
    some short term needs and are paid generally from the collection of the businesses accounts
    receivable. The current portion of long term debt is the amount scheduled to be paid on long
    term obligations over the next 12 months. Long term debt are loans incurred by the business to
    finance long term or fixed assets for the business.

    What is Net Worth?

    Start up- Hotel/Restaurant (100 cr)

    Assets= Equity + Liability

    100 cr= 20 cr + 80 cr(Loan)

    20 (Equity)= 100(Asset)- 80(Liability), after completing your loan part—100=100-0

    0 yr ---20 cr
    1 yr--- 30 cr(Profit)
    100-50=
    2yr-30cr

    100=100
    7 yr—50 cr

    Sometimes referred to as the businesses equity, it refers to value of ownership. The ownership
    is limited by the businesses assets and debts.

    What can be analysed from a Balance


    Sheet?
    • The general financial state of the business at a specific point
    in time
    • The amount of capital retained in the business
    • The productivity, growth and solvency of the business
    • The pace at which the assets can be converted to capital

    Advantages of reporting the balance sheet


    • Business snapshot:

    Balance Sheet provides an accurate picture of the business status.


    While the profit and loss statement provides the profit made in a
    transaction, balance sheet gives the details of the bills the business
    owes to the vendors. Every balance sheet is unique; while a
    business may experience a high profit account, it can
    simultaneously have a poor balance sheet if the total net asset
    value is low and vice versa. Balance sheet determines the financial
    strength of a business and helps in future financial planning.

    • Provides information for apt decision making:

    Balance-Sheet provides the investors and potential lenders with the


    information needed to take decisions while lending money or
    resources. It reflects the company’s ability to collect and pay debts
    on time. On the basis of this, one can form an opinion of the
    company’s risk and return prospects.

    • Provides helpful financial ratios:

    Balance Sheet helps to calculate the ratios to determine a


    company’s long-term profitability and short-term financial outlook.
    Ratios like the current ratio and the acid test or liquidity ratio are
    calculated using information from the balance sheet. These ratios
    help obtain a very thorough summary of the company’s financial
    health by analyzing its cash position, working capital, liquidity and
    leverage. It also provides insight into the company’s likelihood of
    defaulting on its credit obligations or even its bankruptcy risk.

    Disadvantages of the balance sheet


    • Numbers could be misleading:

    As the balance-sheet gives the financial snapshot at a given point


    of time, it could be misleading sometimes. For e.g. the analysis
    could get distorted if the company’s cash position at year end is
    high, indicating high reserves, but the company may intend to
    distribute it in the form of dividends.

    • Doesn’t give true value of assets:

    The balance sheet does not provide the true value of the assets as
    they are reported at the historical costs. It does not reflect the
    current market valuation.

    • Other limitations:

    The balance sheet has some of the current assets valued on


    estimated basis, so it does not reflect the true financial position of
    the business. Also there is complete omission of the valuable non
    monetary assets from the balance-sheet.
    Conclusion
    Balance-sheet is one of the essential financial statements needed
    to take appropriate and sound financial decisions. Blended with the
    other components (Profit and Loss Statement, Cash Flow
    Statement and Statement of Owner’s Equity) of financial reporting,
    one can decide whether the business under focus is right as an
    investment option.
    Profit and Loss (P&L)
    Definition - What does Profit and Loss (P&L) mean?
    A profit and loss (P&L) statement is an accounting statement prepared at the end of a
    financial quarter or year which comprises revenue and expense items to indicate an
    accounting net profit or loss.
    A profit and loss statement needs to be studied, along with the balance sheet and
    statement of cash flows, to get a comprehensive idea of the firm's financial position.
    Because P&L statements are based on accounting rules which can vary or be subject
    to estimates, investors need to fully understand how different estimates would affect
    the company's performance particularly if aggressive estimates have been used to
    show better profit.

    A profit and loss statement is an indicator of the overall financial health of a firm. It
    summarizes the revenue costs and expenses incurred over a specific, fixed period of
    time. It discloses gains and losses that arise from commercial transactions. The cost
    of running the business — that is, the cost of goods sold, operating expenses, interest,
    tax, etc. — is subtracted from the revenue generated to arrive at profit and loss.
    In order to assess the cash flow available, to repay existing debt, to finance additional
    debt for business expansion, or to reinvest in the company, a careful analysis of the
    components of a profit and loss statement is necessary. In many merger and
    acquisition transactions, these statements may be prepared to comply with buyers'
    requirements. In some cases, firms looking to dispose of only a portion of their
    operations prepare separate financial statements, called carve-out financial
    statements, of the section being sold.
    In practice when assessing a business for sale, three to five year historical P&L
    statements are a minimum requirement. Buyers often attempt to estimate recurring
    EBITDA or EBIT from these statements. However, more important is estimated cash
    flows from these statements (which necessitates the balance sheets as well) and also
    figuring out what future performance would look like. In stable industries, the historical
    P&L may be a good proxy for future performance, but in growing businesses,
    projected P&L statements are often required.

    Features of Profit and Loss Account:


    1. This account is prepared on the last day of an account year in order to determine the
    net result of the business.
    2. It is second stage of the final accounts.
    3. Only indirect expenses and indirect revenues are shown in this account.
    4. It starts with the closing balance of the trading account i.e. gross profit or gross loss.
    5. All items of revenue concerning current year - whether received in cash or not - and all
    items of expenses - whether paid in cash or not - are considered in this account. But
    no item relating to past or next year is included in it.
    the assets less any debts with a pledge against those assets. This meaning is encapsulated in
    the fundamental accounting equation, which defines the owner’s equity in the business as equal
    to Assets minus Liabilities.

    How does a business grow its Net Worth or Equity?


    Businesses grow through building their Net Worth or Equity. A main goal of every business is to
    see this growth. There are various ways a business can grow their Net Worth, most evident is to
    decrease debt. This means a business will have more ownership in the businesses assets,
    since less of the assets will be pledged to debt. The greatest contributor to the growth in a
    business’s equity or net worth is retained earnings. The earnings of the business become equity
    in the business in the form of retained earnings, which is listed as such under the equity section
    of the Balance Sheet. Another way to grow a business’s net worth is through an outside capital
    injection. This is most often money put into the business by ownership or by outside investors.
    This normally shows as Capital under the equity section of the businesses Balance Sheet.

    This represents a general overview and is not considered accounting advice. Please seek direction from
    an accounting professional for detailed information regarding your business financials.

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