FINANCIAL STATEMENTS Every company or individual for that matter is involved in financial transactions in the course of his life. Financial statements provide an efficient manner of capturing and presenting this information. Analysis of financial information of any company gives an insight into the financial position of the company. Financial statements can be used by different stakeholders for different purposes – • Owners – To understand the financial health of their company and design strategies so as to improve and sustain the condition of the firm • Employees – To predict the short-term performance of the company which can be helpful in taking day to day decisions for running the company more efficiently and determining compensation, promotion etc. • Investors – To assess the viability of investing in a given company and take a call on the long-term goals of the company • Financial institutions – To decide whether to grant funds to a company or not on the basis of its performance in the previous years and its expected future performance As managers, you will not be expected to create the financial statements for the companies. However, you will be required to read and understand the financial statements and more importantly, draw useful conclusions from them. You are expected to keep this at the back of your mind while studying this topic. The financial statements at the broadest level can be categorized into three categories 1. Balance Sheet 2. Income Statement / Profit & Loss Statement 3. Cash Flow Statement In this primer, we have discussed briefly about the first two financial statements. Cash flow statements and in-depth study of all the financial statements will be covered subsequently, in future. Basic Accounting Principles Before we get on with the analysis of financial statements, it is key to understand certain accounting principles (or assumptions) that one needs to keep in mind while preparing or analysing financial statements of a company. It is advisable that you understand these concepts before going forward, in order to better appreciate the concepts explained in subsequent sections 1. Economic Entity Assumption - This assumption implies that the company is a separate entity and the accounts of the company are treated separately from those running it. 2. Going Concern Assumption - This assumption implies that the entity will be in existence for an indefinitely long period in the future. 3. Accounting Period - The time between two successive presentations of financial statements for which transactions are recorded. 4. Matching Principle - This principle means that the revenues and expenses for a given period must be matched. For e.g. sales commission must be recognized as an expense in the period where corresponding sale is made and not when payment for it is received. 5. Accrual Concept - According to this concept, income and expenses need to be recognized when the transaction occurs and not when actual cash is received/given out. (Refer this) 6. The Accounting Equation and the Dual Aspect Concept - The dual aspect concept states that every business transaction requires recordation in two different accounts. This concept is the basis of double entry accounting, which is required by all accounting frameworks in order to produce reliable financial statements. The concept is derived from the accounting equation, which states that: Assets = Liabilities + Equity This might sound a bit confusing right now, but hang in there! All this will make much more sense once we understand the financial statements in greater detail. 3.1 Balance Sheet The balance sheet gives the financial position of the firm at a specified moment in time. Listed companies require disclosing their financial position at the end of every quarter (3 months) or every year (12 months). Given below is a sample balance sheet as on 31st March 2019 and 2018 Balance Sheet March 31, 2019 Particulars Notes (₹ million) Equity and Liabilities Shareholders' Funds Share capital Reserves and surplus Non-Current Liabilities Long-term borrowings Deferred tax liabilities (Net) Other long term liabilities Long term provisions Current Liabilities Short-term borrowings Trade payables Other current liabilities Short term provisions Total Assets Non-current Assets Fixed Assets Tangible assets Intangible assets Capital work-in-progress Intangible assets under development Non current investments Long- term loans and advances Other non-current assets Current Assets Current investments Inventories Trade receivables Cash and bank balances Short-term loans and advances Other current assets Total March 31, 2018 (₹ million) 5 6 19,987 762,742 19,987 647,293 7 8 9 10 196,267 10,721 42,036 1,969 72,717 9,475 39,394 2,095 6,259 71,232 140,675 12,349 1,264,237 12,510 62,663 106,454 9,453 982,041 256,552 277,892 26,561 64,108 383,958 88,381 19,221 240,682 158,100 12,442 340,348 145,180 17,901 47,211 94 33,110 3,887 53,942 9,320 1,264,237 4,891 11 21,655 4,460 24,218 12,153 982,041 11 12 13 14 15 16 16 17 18 19 20 21 22 23 24 25 Any balance sheet will have below mentioned 3 things: 1. Shareholder’s Funds/Equity - This constitutes the owners share in the entity. The total shareholder’s funds in a company can be broken down into 2 parts – Share capital and reserves/surplus. a Share capital is the initial amount that shareholders have invested in the firm b Reserves and surplus is the profits that the company has generated over the years. 2. Liabilities - Liability is a financial obligation that company owes which arises due to business operations. Liabilities can be of two typesa. Non-Current (Long Term) Liabilities - Long term liabilities are those which have to be repaid more than one year into the future. These can be in the form ofi. Long term Borrowings - They are the principals associated with loans that the company has taken and whose repayment doesn’t need to be done in the next one year. This generally includes bonds issued by company or long-term loans taken from banks. ii. Deferred Tax Liabilities - Due to differences between taxation laws and the accounting standards adopted by the company, differences in the taxation amount can arise. This temporary difference between the same is mentioned as a liability that the firm may need to pay in the future. b. Current (Short Term) Liabilities - These are the items which need to be paid within the accounting period of one year. It includesi. Short-term Borrowings - Loans that the company may take for raising short term capital, and whose maturity is within the accounting period. ii. Account/trade payables – This accounts for any good or service that the company has used in the current accounting period but payment for the same has not been made in the same accounting period iii. Accrued Expenses – Expenses that have been incurred, but not yet paid for such as salaries, wages, and utility charges (water, electricity) iv. v. vi. Current portion of long-term debt - The principle portion of a long-term debt that the company needs to pay in the current accounting period. Interest – The interest that is charged by creditors on the long-term debt Other current liabilities 3. Assets - An asset is anything that the company owns and is likely to provide benefits to the company for a period beyond the time at which the balance sheet has been prepared. Assets can also be classified into two a. Non-Current (Long-Term) Assets - A long term asset is one that will not turn into cash or be consumed in the next one year. It can be in the form ofi. ii. Property Plant & Equipment (Tangible Assets) – PP&E is often the largest line item on a firm's balance sheet. That makes sense, considering that many companies make huge investments in things like factories, computer equipment and machinery. Intangible Assets – An intangible asset is something without a physical substance. Examples include trademarks, copyrights and patents. iii. Goodwill (Intangible Asset) – Goodwill is the excess amount (over fair value) a company pays when it acquires another company because of the brand value. It can't be bought or sold, and is gradually amortized to income over its useful life. (which cannot exceed 5 years in India – What does it mean?? Hold that thought for now) b. Current Assets - These are assets, which can be converted into cash within the accounting period. These includei. Trade (Accounts) Receivables – The amount to be received for the goods/ services that the company has rendered but hasn’t got paid yet (for e.g. - from customers who have taken products on credit) ii. Inventories - The raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a business's assets those are ready or will be ready for sale. iii. Prepaid Expenses – This is opposite to Accrued expenses. These include future expenses that have been paid in advance but have not yet been incurred. For e.g. – Insurance premium, advance rent etc. As and when the benefits are realized, these are reflected as expenses in income statement. iv. 3.2 Cash and cash equivalents - Cash equivalents are extremely safe assets, like government bonds, that can be easily transformed into cash. Income Statement The income statement summarizes a firm's financial transactions over a defined period of time (notice the difference between a balance sheet and an income statement here), whether it's a quarter or a whole year. The income statement shows how the money is coming in (revenues, also known as sales) and the expenses that are tied to generating those revenues. The difference between the expenses and revenues is the profit that the company earns. The basic equation underlying the income statement is: Revenue - Expense = Net Income The income statement is also known as a "profit & loss statement", or a "P&L". Revenue is also known as “top line”. Net income is also known as "earnings" and "profit," in addition to being called "the bottom line". Refer to the income statement given below to better understand the different data points captured in an income statement: March 31, 2019 Particulars Notes (₹ million) Income Revenue from operations Other income Total income Expenses Access charges License fee and spectrum charges (revenue share) Cost of goods sold Employee benefits expenses Power and fuel Rent Other expenses Charity and donation [includes March 31, 2018 29 30 31 32 33 33 33 Total expenses Profit before finance costs, depreciation, amortisation, exceptional items and tax Finance costs Depreciation and amortisation expense 34 35 Profit before exceptional items and tax Exceptional items 36 (₹ million) 554,964 51,930 606,894 499,185 8,534 507,719 79,601 67,062 76 16,915 41,151 59,790 95,766 292 73,015 54,682 22 16,481 41,697 56,904 92,711 685 360,653 246,241 336,197 171,522 14,091 13,364 75,597 156,553 72,313 85,845 156,553 2,071 83,774 31,092 19,980 (7,790) (180) 1,246 132,005 (2,028) 66,002 33.02 16.69 Profit before Tax Tax expense (including exceptional items) Current tax MAT credit Deferred tax Profit for the year Earnings per share (equity shares of par value ₹5 each) Basic and Dilute 39 Let us start by understanding some of the most important things to look for in an income statement Total Revenue: This is the total money that a company earns over a defined period of time. A company needs to sell its product in order to stay in business, and this is where you can see that process in action. If you compare total revenue from one year (or quarter) to the next, you should be able to see patterns. Are revenues growing? Are they shrinking? Gross profit: Gross profit is the difference between sales price and the cost of producing the products. Thus, it is the difference between total revenues and cost of goods sold. Cost of the goods sold is the cost of the raw materials and direct labour involved in making the finished items that the company sells to generate revenues. If this is negative, the company is in real trouble. Operating Expenses: Operating expenses are costs that a company must pay in the normal course of business. A company needs to pay employees that are not involved directly in manufacturing, research & develop new products, pay rent, and so on. Operating Profit: Operating Profit = Gross Profit – Operating Expenses. Operating profits are earned from a company's everyday core business operations. Operating profits also are called "Earnings Before Interest and Taxes (EBIT). Finance Cost: Well, if you take a debt to run your business, you need to pay interest. This interest payment is often referred to as Finance cost. Tax: The company pays money to government in form of tax. Note that interest to creditors is paid before tax. Net Income: Always found towards the bottom of the income statement (hence, also called the bottom line), it is the most-watched number in a P&L. Net income is, in theory, the amount of sales that are left over to be distributed to shareholders. Concept of Depreciation and Amortization: As per the ‘matching principle’, expenses must be matched to the revenues in a period. Hence for all large, onetime expenses such as building of a plant, purchase of machinery, furniture, computers, or promotion of a new product, the expense is spread over time. That is, a portion of the expense is recorded each year. This expense is called Depreciation or Amortization. The logic behind using such a technique is that although a machine is bought in a given year, its benefits are reaped over the next few years. So, it makes sense to distribute the expense incurred in purchasing the machinery over a span of the machine’s working life. The term ‘Depreciation’ is used when physical assets are purchased, whereas the term ‘amortization’ is used when intangible assets are purchased, or for reasons such as the one mentioned above – one time promotion/advertising expenses for the launch of a new product. Amortization is also used for land. Let’s look at an example to better understand the concept of depreciation and amortization. Assume you bought a machine for INR 5 Lacs and it was used to produce XYZ product for 4 years. According to the matching principle, a portion of this INR 5 Lacs expense has to be attributed to each of these 4 years annually. This needs to be captured under the Depreciation and Amortization head. One way of distributing the expense over 4 years is to evenly distribute the cost of the machine over 4 years. Another technique suggests that the benefits (and hence the costs) of a machine are more in its initial years, so an accelerated depreciation technique needs to be used. Details about the methods mentioned here will be covered at a later point of time. The layout of an income statement can be summarized as follows – Sales (Top Line) - Cost of Goods Sold = Gross Profit - Operating Expenses (includes SG&A, Depreciation & Amortization, etc.) = Operating Profit (also known as EBIT; if you add back Depreciation and Amortization from Operating Expenses, you’ll get EBITDA) - Interest = PBT (Profit before Taxes) - Taxes = Net Income (Bottom Line or PAT (Profit After Tax)) 3.3 Interlinkage between Balance Sheet and Income Statement The connection between the balance sheet and the income statement arises due to the use of double-entry accounting (mentioned in Section 3 – Basic Accounting Principles). Though the nature of linkages between balance sheet and income statements can be complex, for the sake of simplicity, we have mentioned the following major ones 1. The profit for the year from the income statement that is retained by the company is added back in the reserves and surplus at the end of the year. This amount belongs to the shareholders but is kept by the company for certain strategic requirements. 2. The depreciation and amortization that the assets of a company goes through during the course of operation in the period are recognised as an expense in the income statement. This amount is deducted from the total of tangible and intangible assets from the balance sheet, at the end of the period. 3. According to the accrual concept, even though revenues need to be recognised when a transaction occurs, the actual payment could be received later. Hence, the entire revenue from sales is recognised in the income statement once the sale occurs, but the part of the sale for which the customer is yet to pay for goes into the accounts (trade) receivable line item of the balance sheet. 4. Similar to point 3, in case of expenses, if the company uses a good or a service in the accounting period, the entire cost for it is mentioned in the income statement. The portion of this that the company is yet to pay its suppliers is mentioned in the Balance sheet under accounts (trade) payables 4 WHAT WE EXPECT FROM YOU Having gone through this document, you are advised to read up on the latest happenings in the world of Finance to understand the real-life applications of these concepts. Trust us, these will go a long way in helping you in the days to come. Staying up to date with recent news is of utmost importance for an MBA student. Install Mint & Economic Times apps & ensure that you are well updated with all major happenings in the financial world. TASKS 1. Watch this video. Prepare a summary explaining the cause and effects of 2008 financial crises in not more than 400-500 words. Also mention steps taken to avoid such crises in future (100 words). Please note that we won’t appreciate financial jargons and content copied from internet. However, you are free to refer any source for enhancing your understanding. 2. Further read on profitability, solvency, liquidity and activity ratios. Explain their significance in detail and their ideal values for companies.