Understanding Financial Statements: Dr. Charles Suresh David

Understanding financial Statements
Dr. Charles Suresh David 1

Financial (Accounting) Statements
• Financial or Accounting statements are

used for reporting corporate activity.
For Stakeholders
2
Financial Statements
• The Balance Sheet

• The Income Statement
• Statement of Cash Flows
3
The Balance Sheet
• The balance sheet is an accountant’s

snapshot of the firm’s accounting value
on a particular date.
• The balance sheet states what the firm

owns and how it is financed.
4
The Balance Sheet (Cont.)
Assets Liabilities + Stakeholders’ equity
5
LIABILITIES ASSETS
Equity Shares xxx Good will xxx
Preference Shares xxx Land & Buildings xxx
General Reserve xxx Plant & Machinery xxx
Profit& Loss Account xxx Furniture & Fittings xxx
Debentures xxx Stock xxx
Bank/Mortgage Loan xxx Sundry Debtors xxx
Sundry Creditors xxx Bills Payable xxx
Bills Payable xxx Bank xxx
Cash xxx
TOTAL LIABILITIES xxx TOTAL ASSETS xxx
6
The Income Statement
• The income statement measures
performance over a specific period of
time, say, a year.
• The accounting definition of income is:

Revenue – Expenses Income
7
TRADING ACCOUNT
To Opening Stock xxx By Sales
xxx
To Purchases xxx By Closing Stock xxx
To Expenses on Purchases xxx
To Gross profit
xxx
TOTAL TOTAL
xxx xxx
By Gross Profit
xxx
To Factory Expenses By Non –business Incomes
xxx xxx
To Office& Administrative Exp.
xxx
To Selling & Distribution Exp.
xxx 8
To Depreciation xxx
Analysis & interpretations of Financial
Statements
• Financial Statements are primarily prepared for
decision-making
• Information provided in the financial statements are
inadequate to draw any conclusion
• It is necessary to analyze the information provided in
these statements to arrive at any logical conclusion.
• According to Metcalf and Titard, analysis of financial statement is

“ a process of evaluating the relationship between components
parts of a financial statement to obtain a better understanding of a
firm’s position and performance”.
• So, the purpose of financial analysis is to diagnose

the information provided in financial statements and
to judge the profitability and financial soundness of
the firm.
9
TYPES OF FINANCIAL ANALYSIS
• On the basis of material used:-

(i) External analysis. The outsiders who use the
published data to analyze the financial position of the
company. The investors; creditors; banks; and the
government agencies are included in this list.
(ii)Internal analysis. Those who have access to
accounting and other information perform this function.
They are the executives and employees of the
organization.
• On the basis of modus operand.
(iii)Horizontal Analysis. Horizontal analysis refers to the
comparison of financial statements for several years.
Information is provided in number of columns for easy
comparison.
(iv)Vertical Analysis. This refers to the study of the
relationship of various items in the financial statements
of a particular year.
RATIO ANALYSIS
• Ratio-analysis is a concept or technique
which is as old as accounting concept.
• It has assumed important role as a tool

for appraising the real worth of an
enterprise, its performance during a
period of time and its pit falls.
• Ratio analysis is a vital apparatus for

the interpretation of financial
statements.
11
Ratio Analysis
• Unlike in the past when security was
considered to be sufficient consideration for
banks and financial institutions to grant loans
and advances, nowadays the entire lending is
need-based and the emphasis is on the
financial viability of a proposal and not only on
security alone.
• Further all business decision contains an
element of risk. The risk is more in the case of
decisions relating to credits. Ratio analysis and
other quantitative techniques facilitate
assessment of this risk.
12
Ratio Analysis
It’s a tool which enables the banker or lender
to arrive at the following factors :
 Liquidity position
 Profitability
 Solvency
 Financial Stability
 Quality of the Management
 Safety & Security of the loans & advances to
be or already been provided
13
How a Ratio is expressed?
As Percentage - such as 25% or 50% . For
example if net profit is Rs.25,000/- and the
sales is Rs.1,00,000/- then the net profit can
be said to be 25% of the sales.
As Proportion - The above figures may be

expressed in terms of the relationship
between net profit to sales as 1 : 4.
As Pure Number /Times - The same can

also be expressed in an alternatively way
such as the sale is 4 times of the net profit or
profit is 1/4th of the sales. 14
Some important notes
• Liabilities have Credit balance and Assets have Debit
balance
• Current Liabilities are those which have either become
due for payment or shall fall due for payment within 12
months from the date of Balance Sheet
• Current Assets are those which undergo change in their
shape/form within 12 months. These are also called
Working Capital or Gross Working Capital
• Net Worth & Long Term Liabilities are also called Long
Term Sources of Funds
• Current Liabilities are known as Short Term Sources of
Funds
• Long Term Liabilities & Short Term Liabilities are also
called Outside Liabilities 15
• Current Assets are Short Term Use of Funds
CURRENT ASSETS CURRENT LIABILITIES
Inventory/Stock Tax provisions
Sundry Debtors Sundry Creditors
Bills Receivable Bills Payable
Short-term Investments Short-term Loan
Prepaid Expenses Outstanding Expenses
Bank Bank Overdraft
cash Dividend payable
16
LIABILITIES ASSETS
Equity Shares xxx Good will xxx
Preference Shares xxx Land & Buildings xxx
General Reserve xxx Plant & Machinery xxx
Profit& Loss Account xxx Furniture & Fittings xxx
Debentures xxx Stock xxx
Bank/Mortgage Loan xxx Sundry Debtors xxx
Sundry Creditors xxx Bills Payable xxx
Bills Payable xxx Bank xxx
Provision for Tax xxx Cash xxx
TOTAL LIABILITIES xxx TOTAL ASSETS xxx
17
Ratio Calculation
Formula of Ratios Ideal ratio
1.Current Ratio Current Assets 2:1
Current Liabilities
2. Quick Ratio Quick Assets 1:1
Current Liabilities
3. Debt-Equity Ratio Outsider’s Funds 2:3
Shareholder’s Funds
Outsider’s Funds = Debentures+ Bank/ Mortgage
Loans+ Sundry Creditors+ Bills Payables.
Shareholder’s Funds = Equity Capital+ preference
capital+ General Reserves+ Profit& Loss A/c.
4. Capital Gearing Shareholder’s Fund

Ratio Preference Capital + Debenture+
Bank/Mortgage Loan
5. Gross Profit Ratio Gross Profit x 100
Sales
6. Net Profit Ratio Net Profit x 100
Sales 18
Ratio Calculation
Formula of Ratios Ideal ratio
7. Earnings Per Share Net Profit
No. of Equity Shares
8. Return of Equity Net Profit
Capital Equity Capital
9. Solvency Ratio Outsider’s Funds
Total Assets
Total Assets+ Fixed Assets+ Current Assets
19

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Understanding financial Statements

Dr. Charles Suresh David 1

• Financial or Accounting statements are

• The Balance Sheet

• The balance sheet is an accountant’s

• The balance sheet states what the firm

Assets Liabilities + Stakeholders’ equity

TOTAL LIABILITIES xxx TOTAL ASSETS xxx

• The accounting definition of income is:

• According to Metcalf and Titard, analysis of financial statement is

• So, the purpose of financial analysis is to diagnose

• On the basis of material used:-

• It has assumed important role as a tool

• Ratio analysis is a vital apparatus for

As Proportion - The above figures may be

As Pure Number /Times - The same can

TOTAL LIABILITIES xxx TOTAL ASSETS xxx

4. Capital Gearing Shareholder’s Fund

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