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.