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UNIT 4
ANNUAL REPORTS AND ANALYSIS OF PERFORMANCE
4.1 PRINCIPLES OF ACCOUNTING

Basic Accounting Principles

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1. Economic Entity Assumption

2. Monetary Unit Assumption
3. Time Period Assumption
4. Cost Principle
5. Full Disclosure Principle
6. Going Concern Principle
7. Matching Principle
8. Revenue Recognition Principle
9. Materiality
10.Conservatism

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole

proprietorship separate from the business owner's personal transactions.
For legal purposes, a sole proprietorship and its owner are considered to be
one entity, but for accounting purposes they are considered to be two
separate entities.

2. Monetary Unit Assumption

Economic activity is measured in Rupees, and only transactions that can be

expressed in Rupees are recorded. Because of this basic accounting
principle, it is assumed that the Rupees’ purchasing power has not changed
over time.

As a result accountants ignore the effect of inflation on recorded amounts.

For example, Rupees from a 1960 transaction are combined (or shown
with) Rupees from a 2007 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex

and ongoing activities of a business in relatively short, distinct time intervals
such as the five months ended May 31, 2007, or the 5 weeks ended May 1,
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2007.

It is imperative that the time interval (or period of time) be shown in the
heading of each income statement, statement of stockholders' equity, and
statement of cash flows.

Labeling one of these financial statements with "December 31" is not good
enough—the reader needs to know if the statement covers the one week
ending December 31, 2007 the month ending December 31, 2007 the three
months ending December 31, 2007 or the year ended December 31, 2007.

4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount
spent (cash or the cash equivalent) when an item was originally obtained,
whether that purchase happened last year or thirty years ago.

For this reason, the amounts shown on financial statements are referred to
as historical cost amounts.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the

financial statements, that information should be disclosed within the
statement or in the notes to the statement.

It is because of this basic accounting principle that numerous pages of

"footnotes" are often attached to financial statements.

As an example, let's say a company is named in a lawsuit that demands a

significant amount of money.

When the financial statements are prepared it is not clear whether the
company will be able to defend itself or whether it might lose the lawsuit.

As a result of these conditions and because of the full disclosure principle

the lawsuit will be described in the notes to the financial statements.
6. Going Concern Principle
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This accounting principle assumes that a company will continue to exist

long enough to carry out its objectives and commitments and will not
liquidate in the foreseeable future.

If the company's financial situation is such that the accountant believes the
company will not be able to continue on, the accountant is required to
disclose this assessment.

The going concern principle allows the company to defer some of its
prepaid expenses until future accounting periods.

7. Matching Principle

The matching principle requires that expenses be matched with revenues.

For example, sales commissions expense should be reported in the period

when the sales were made (and not reported in the period when the
commissions were paid).

Wages to employees are reported as an expense in the week when the

employees worked and not in the week when the employees are paid.

8. Revenue Recognition Principle

Revenues are recognized as soon as a product has been sold or a service

has been performed, regardless of when the money is actually received.

Under this basic accounting principle, a company could earn and report
Rs.20,000 of revenue in its first month of operation but receive Rs.0 in
actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of

Rs.1,000, ABC should recognize Rs.1,000 of revenue as soon as its work is
done—it does not matter whether the client pays the Rs.1,000 immediately
or in 30 days. Do not confuse revenue with a cash receipt
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9. Materiality
Because of this basic accounting principle or guideline, an accountant might
be allowed to violate another accounting principle if an amount is
insignificant.

Professional judgement is needed to decide whether an amount is

insignificant or immaterial. An example of an obviously immaterial item is
the purchase of a Rs.150 printer by a highly profitable multi-million Rupee
company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for

reporting an item, conservatism directs the accountant to choose the
alternative that will result in less net income and/or less asset amount.

Conservatism helps the accountant to "break a tie."

The basic accounting principle of conservatism leads accountants to

anticipate or disclose losses, but it does not allow a similar action for gains.

For example, potential losses from lawsuits will be reported on the financial
statements or in the notes, but potential gains will not be reported.

Also, an accountant may write inventory down to an amount that is lower

than the original cost, but will not write inventory up to an amount higher
than the original cost.

INTRODUCTION TO THE ACCOUNTING EQUATION

The financial position of a company is measured by the following items:

• Assets (what it owns)

• Liabilities (what it owes to others)

• Owner’s Equity (the difference between assets and liabilities)

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The accounting equation (or basic accounting equation) offers us a simple

way to understand how these three amounts relate to each other.

The accounting equation for a sole proprietorship is:

Assets = Liabilities + Owner’s Equity

The accounting equation for a corporation is:

Assets = Liabilities + Stockholders’ Equity

Assets are a company’s resources—things the company owns.

Examples of assets include cash, accounts receivable, inventory, prepaid

insurance, investments, land, buildings, equipment, and goodwill.

Liabilities are a company’s obligations—amounts the company owes.

Examples of liabilities include notes or loans payable, accounts payable,

salaries and wages payable, interest payable, and income taxes payable (if
the company is a regular corporation).

Owner’s equity or stockholders’ equity is the amount left over after

liabilities are deducted from assets:

Assets – Liabilities = Owner’s (or Stockholders’) Equity.

Owner’s or stockholders’ equity also reports the amounts invested into the
company by the owners plus the cumulative net income of the company that
has not been withdrawn or distributed to the owners.

If a company keeps accurate records, the accounting equation will always be

“in balance,” meaning the left side should always equal the right side.

Assets = Liabilities + Equity

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4.2 BALANCE SHEET

♦ The balance sheet is also known as the statement of financial position and
it reflects the accounting equation.
♦ The balance sheet reports a company’s assets, liabilities, and owner’s (or
stockholders’) equity at a specific point in time.
♦ Like the accounting equation, it shows that a company’s total amount of
assets equals the total amount of liabilities plus owner’s (or stockholders’)
equity.
♦ The balance sheet presents a company's financial position at the end of a
specified date.
♦ Some describe the balance sheet as a "snapshot" of the company's financial
position at a point (a moment or an instant) in time.
♦ For example, the amounts reported on a balance sheet dated December 31,
2006 reflect that instant when all the transactions through December 31
have been recorded.

Uses of a Balance Sheet

• Because the balance sheet informs the reader of a company's financial

position as of one moment in time, it allows someone—like a creditor—to
see what a company owns as well as what it owes to other parties as of the
date indicated in the heading.

• This is a valuable information to the banker who wants to determine

whether or not a company qualifies for additional credit or loans.

• Others who would be interested in the balance sheet include current

investors, potential investors, company management, suppliers, some
customers, competitors, government agencies, and labor unions.

Types of Balance Sheet

The balance sheet is called classified if assets and liabilities are grouped into
classifications, and consolidated if it contains all divisions and subsidiaries of
the firm.
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CLASSIFIED BALANCE SHEET

• Accountants usually prepare classified balance sheets.

• "Classified" means that the balance sheet accounts are presented in distinct
groupings, categories, or classifications.

Classifications Of Assets On The Balance Sheet

What are Assets?

• Assets are things that the company owns.

• They are the resources of the company that have been acquired through
transactions, and have future economic value that can be measured and
expressed in monetary units.

• Assets also include costs paid in advance that have not yet expired, such as
prepaid advertising, prepaid insurance, prepaid legal fees, and prepaid rent.

Examples of asset accounts that are reported on a company's balance sheet

include:

• Cash
• Petty Cash
• Temporary Investments
• Accounts Receivable
• Inventory
• Supplies
• Prepaid Insurance
• Land
• Land Improvements
• Buildings
• Equipment
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• Goodwill
• Bond Issue Costs etc.

Usually these asset accounts will have debit balances. (Assets are shown on
the left hand side of a Balance Sheet).

The “Asset Classifications” and their order of appearance on the balance sheet
are:

• Current Assets

• Investments

• Property, Plant, and Equipment

• Intangible Assets

• Other Assets

Classifications Of Liabilities On The Balance Sheet

What are liabilities?

• Liabilities are obligations of the company;

• they are amounts owed to creditors for a past transaction and they usually
have the word "payable" in their account title.

• Along with owner's equity, liabilities can be thought of as a source of the

company's assets.

• They can also be thought of as a claim against a company's assets.

• For example, a company's balance sheet reports assets of Rs.100,000 and
Accounts Payable of Rs.40,000 and owner's equity of Rs.60,000.
• The source of the company's assets are creditors/suppliers for Rs.40,000 and
the owners for Rs.60,000.
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• The creditors/suppliers have a claim against the company's assets and the
owner can claim what remains after the Accounts Payable have been paid.
• Liabilities also include amounts received in advance for future services. Since
the amount received (recorded as the asset Cash) has not yet been earned,
the company defers the reporting of revenues and instead reports a liability
such as Unearned Revenues or Customer Deposits.

Examples of liability accounts reported on a company's balance sheet include:

• Notes Payable
• Accounts Payable
• Salaries Payable
• Wages Payable
• Interest Payable
• Other Accrued Expenses Payable
• Income Taxes Payable
• Customer Deposits
• Warranty Liability
• Lawsuits Payable
• Unearned Revenues
• Bonds Payable etc.

These liability accounts will normally have credit balances. (Liabilities are
shown on the right hand side of a Balance Sheet).

The “liability classifications” and their order of appearance on the balance sheet
are:

• Current Liabilities
• Long Term Liabilities etc.

Current vs. Long-term Liabilities

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If a company has a loan payable that requires it to make monthly payments

for several years, only the principal due in the next twelve months should be
reported on the balance sheet as a current liability. The remaining principal
amount should be reported as a long-term liability.

Classifications of Owner's Equity On The Balance Sheet

What is Equity?

• There are actually 2 types of Equity, namely owner’s equity and stockholder’s
equity.

• Owner's Equity—along with liabilities—can be thought of as a source of the

company's assets. Owner's equity is sometimes referred to as the book value
of the company, because owner's equity is equal to the reported asset
amounts minus the reported liability amounts.

• Owner's equity may also be referred to as the residual of assets minus

liabilities. These references make sense if you think of the basic accounting
equation:

Assets = Liabilities + Owner's Equity

and just rearrange the terms:

Owner's Equity = Assets – Liabilities

• "Owner's Equity" are the words used on the balance sheet when the
company is a sole proprietorship.

• If the company is a corporation, the words Stockholders' Equity are used

instead of Owner's Equity.

• An example of an owner's equity account is Mary Smith, Capital (where Mary

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Smith is the owner of the sole proprietorship).

Examples of stockholders' equity accounts include:

Common Stock
Preferred Stock
Paid-in Capital in Excess of Par Value
Paid-in Capital from Treasury Stock
Retained Earnings etc.

Both owner's equity and stockholders' equity accounts will normally have
credit balances. (Equities are shown alongwith liabilities on the right hand
side of a Balance Sheet).

These classifications make the balance sheet more useful.

The following sample balance sheet is a classified balance sheet.

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Snowboarding Components
Balance Sheet (Partial)
January 31, 2008
ASSETS
Current assets
Cash $ 6,500
Short-term investments 2,100
Accounts receivable 4,400
Merchandise inventory 27,500
Prepaid expenses 2,400
Total current assets $ 42,900
Long-term investments
Notes receivable 1,500
Investments in stocks and bonds 18,000
Land held for future expansion 48,000
Total investments 67,500
Plant assets
Store equipment $ 33,200
Less accumulated depreciation 8,000 25,200
Buildings 1,70,000
Less accumulated depreciation 45,000 1,25,000
Land 73,200
Total plant assets 2,23,400
Intangible assets 10,000
Total assets $ 3,43,800
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Snowboarding Components
Balance Sheet (Partial)
January 31, 2008
LIABILITIES
Current liabilities
Accounts payable $ 15,300
Wages payable 3,200
Notes payable 3,000
Current portion of long-term liabilities 7,500
Total current liabilities $ 29,000
Long-term liabilities:
Notes payable (net of current portion) 1,50,000
Total liabilities $1,79,000
EQUITY
T. Hawk, Capital 1,64,800
Total liabilities and equity $3,43,800
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USEFULNESS OF A BALANCE SHEET

The balance sheet provides information for evaluating:

Capital structure
Rates of return
Analyzing an enterprise’s:
Liquidity
Solvency
Financial flexibility

LIMITATIONS OF A BALANCE SHEET

• Most assets and liabilities are stated at historical cost.
• Judgments and estimates are used in determining many of the items.
• The balance sheet does not report items that can not be objectively
determined.
• It does not report information regarding off-balance sheet financing.

4.3 INCOME STATEMENT

• The income statement is the financial statement that reports a company’s
revenues and expenses and the resulting net income.

• While the balance sheet is concerned with one point in time, the income
statement covers a time interval or period of time.

• The income statement will explain part of the change in the owner’s or
stockholders’ equity during the time interval between two balance sheets.

• The income statement is sometimes referred to as :

• Profit and loss statement (P&L),

• Statement of operations, or
• Statement of income.

An income statement reports on operating activities. It lists sales (revenues),

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costs, and expenses over a period of time. The relationship is expressed:

Net Income = Revenues – Expenses

NIKE
Income Statement (in millions)
For the Year Ended May 31, 2000

Revenues $ 8,995.1
Costs and Expenses 8,416.0
Net Income $ 579.1

S c ott Com pa ny
Inc om e S ta t e m e nt
F or M o nth En de d De ce m b e r 3 1, 20 0 7

R e v e nu e s:
C onsu ltin g re ve nue $ 3 ,0 00
E x p e nse s:
S a la rie s e x pe nse 8 00
N e t i nc om e $ 2 ,2 00

Net income is the difference between Revenues and Expenses.

Thus, The income statement describes a company’s revenues and expenses along
with the resulting net income or loss over a period of time due to earnings
activities.

Importance of Income Statement

• The income statement is important because it shows the profitability of a

company during the time interval specified in its heading.

• The period of time that the statement covers is chosen by the business and
will vary.

• For example, the heading may state:

"For the Three Months Ended December 31, 2006" (The period of October
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1 through December 31, 2006.)

The Four Weeks Ended December 27, 2006" (The period of November 29
through December 27, 2006.)

"The Fiscal Year Ended September 30, 2006." (The period of October 1,
2005 through September 30, 2006.)

It is to be noted that:

the income statement shows revenues, expenses, gains, and losses;

it does not show cash receipts (money you receive) nor cash disbursements
(money you pay out).

People pay attention to the profitability of a company for many reasons.

• For example, if a company was not able to operate profitably—the bottom

line of the income statement indicates a net loss—a banker/lender/creditor
may be hesitant to extend additional credit to the company.

• On the other hand, a company that has operated profitably—the bottom line
of the income statement indicates a net income—demonstrated its ability to
use borrowed and invested funds in a successful manner.

A company's ability to operate profitably is important to current lenders and

investors potential lenders and investors, company management, competitors,
government agencies, labor unions, and others.

Format of the Income Statement

A. Revenues and Gains
1. Revenues from primary activities
2. Revenues or income from secondary activities
3. Gains (e.g., gain on the sale of long-term assets, gain on lawsuits)

B. Expenses and Losses

1. Expenses involved in primary activities
2. Expenses from secondary activities
3. Losses (e.g., loss on the sale of long-term assets, loss on lawsuits)
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If the net amount of revenues and gains minus expenses and losses is positive, the
bottom line of the profit and loss statement is labeled as net income.

If the net amount (or bottom line) is negative, there is a net loss.

A1. Revenues from primary activities

Often referred to as operating revenues or sales revenues. The primary activities

of a retailer are purchasing merchandise and selling the merchandise.

The primary activities of a manufacturer are producing the products and

selling them.

A2. Revenues from secondary activities

Often referred to as nonoperating revenues.

These are the amounts a business earns outside of purchasing and selling
goods and services.

For example, when a retail business earns interest on some of its idle cash, or
earns rent from some vacant space, these revenues result from an activity
outside of buying and selling merchandise.

Both the revenues mentioned above are reported on the profit and loss
statement during the period when they are earned, not when the cash is
collected.

A3. Gains

Refers to the gain on the sale of long-term assets, or lawsuits result from a
transaction that is outside of the primary activities of most businesses.

A gain is reported on the income statement as the net of two amounts: the
proceeds received from the sale of a long-term asset minus the amount
listed for that item on the company's books (book value).

A gain occurs when the proceeds are more than the book value.

Consider this example:

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Assume that a clothing retailer decides to dispose of the company's car and
sells it for Rs.6,000.

The Rs.6,000 received for the car will not be included with sales revenues
since the account ‘Sales’ is used only for the sale of merchandise.

Since this retailer is not in the business of buying and selling cars, the sale of
the car is outside of the retailer's primary activities.

Over the years, the cost of the car was being depreciated on the company's
accounting records and as a result, the money received for the car (Rs.6,000)
was greater than the net amount shown for the car on the accounting
records (Rs.3,500).

This means that the company must report a gain equal to the amount of
the difference—in this case, the gain is reported as Rs.2,500.

This gain should not be reported as sales revenues, nor should it be shown as
part of the merchandiser's primary activities.

Instead, the gain will appear in a section on the income statement labeled as
"nonoperating gains" or "other income".

The gain is reported in the period when the disposal occurred.

B1. Expenses involved in primary activities

These are expenses that are incurred in order to earn normal operating
revenues.

e.g., wages earned by employees, employee bonuses and vacations, utilities,

and sales commissions.

B2. Expenses from secondary activities

These are referred to as non-operating expenses.

For example, interest expense is a nonoperating expense because it involves

the finance function of the business, rather than the primary activities of
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buying/producing and selling.

B3. Losses
Refers to the loss from the sale of long-term assets, or the loss on lawsuits
result from a transaction that is outside of a business's primary activities.

A loss is reported as the net of two amounts: the amount listed for the item
on the company's books (book value) minus the proceeds received from the
sale.

A loss occurs when the proceeds are less than the book value.

Let's assume that a clothing retailer decides to dispose of the company's car.

The proceeds from the disposal are Rs.2,800.

This is less than the Rs.3,500 amount shown in the company's accounting
records.

Since this retailer is not in the business of buying and selling cars (the sale of
the car is outside of the operating activities of buying and selling clothing),
the money received for the car will not be included in sales revenues, and the
loss experienced on the sale of the car (Rs.700) will not be included in
operating expenses.

Instead, the Rs.700 loss will appear in a section on the income statement
labeled "nonoperating gains or losses" or "other income or losses".

The loss is reported in the time period when the disposal occurs.

Thus, we can understand that the income statement or profit and loss statement
shows revenues, expenses, gains, and losses and

It does not show cash receipts and cash disbursements.

Types of Income Statement Formats

1. Single-Step
2. Multiple-Step
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An income statement can be prepared in either a multiple-step or single-step

format.
The single-step format is simpler. The multiple-step format provides more
detailed information.

The Single Step Income Statement

This statement presents information in broad categories.

Major sections are Revenues and Expenses.
The Earnings per Share amount is shown at the bottom of the statement.
There is no distinction between operating and non-operating activities.
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Format of a single step Income Statement

The Multiple Step Income Statement

The presentation divides information into major sections on the statement.

The statement distinguishes operating from non-operating activities.
Continuing operations are shown separately from irregular items.
The income tax effects are shown separately as well.
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Format of a Multi Step Statements

Multiple-Step Income Statement Sample:

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A detailed view of single-step and multiple-step income statements

A single-step income statement format uses only one subtraction to arrive at

net income.

Net Income = (Revenues + Gains) – (Expenses + Losses)

An extremely condensed income statement in the single-step format would

look like this:

Single-Step Income Statement Sample

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The heading of the income statement conveys critical information.

The name of the company appears first, followed by the title "Income Statement."
The third line tells the reader the time interval reported on the profit and loss
statement.
Since income statements can be prepared for any period of time, it must be made
to inform the reader of the precise period of time being covered.
For example, an income statement may cover any one of the following time
periods: "Year Ended May 31," "Five Months Ended May 31," "Quarter Ended May
31," "Month Ended May 31, or "Five Weeks Ended May 31".

A sample income statement in the single-step format would look like this:
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MULTIPLE STEP INCOME STATEMENT

• The multiple-step income statement uses multiple subtractions in computing

the net income shown on the bottom line.

• The multiple-step profit and loss statement segregates the operating

revenues and operating expenses from the nonoperating revenues,
nonoperating expenses, gains, and losses.

• The multiple-step income statement also shows the gross profit (net sales
minus the cost of goods sold).

Here is a sample income statement in the multiple-step format:

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Three benefits to using a multiple-step income statement instead of a single-step

income statement:

1. The multiple-step income statement clearly states the gross profit amount.

• Many readers of financial statements monitor a company's gross margin

(gross profit as a percentage of net sales).

• Readers may compare a company's gross margin to its past gross margins
and to the gross margins of the industry.
2.The multiple-step income statement presents the subtotal operating income,
which indicates the profit earned from the company's primary activities of buying
and selling merchandise.

3.The bottom line of a multiple-step income statement reports the net amount
for all the items on the income statement.

If the net amount is positive, it is labeled as net income.

If the net amount is negative, it is labeled as net loss.

Income statements (whether single-step or multiple-step) report nearly all

revenues, expenses, gains, and losses.

• Sometimes rare or extraordinary events will occur during the income

statement's time interval along with the normally recurring events.

• It is helpful to the reader of the statement if these unique items are

segregated into a special section near the bottom of either the single-step or
multiple-step income statement.

• These unique or rare items are:

1. Discontinued Operations
2. Extraordinary Items
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1. Discontinued operations

It pertains to the elimination of a significant part of a company's business,

such as the sale of entire division of the company.

2. Extraordinary items

It includes things that are unusual in nature and infrequent in occurrence.

A loss due to an earthquake would certainly be extraordinary.

Note that the two unique items are shown near the bottom of the income
statement.

• The notes (or footnotes) to the income statement and to the other financial
statements are considered to be part of the financial statements.

The notes inform the readers about such things as significant accounting
policies, commitments made by the company, and potential liabilities and
potential losses.

The notes contain information that is critical to properly understanding and

analyzing a company's financial statements.

It is common for the notes to the financial statements of large companies to

be 10-20 pages in length.

Usefulness of Income Statement

Evaluate the past performance of the enterprise.

Provide a basis for predicting future performance.
Help assess the risk or uncertainty of achieving future cash flows.

Limitations of the Income Statement

Items that cannot be measured reliably are not reported in the income
statement.
Income numbers are affected by the accounting methods employed.
Income measurement involves judgment.
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4.4 FINANCIAL RATIOS

Definition

Financial ratios are tools for interpreting financial statements to provide a

basis for valuing securities and appraising financial and management
performance.

Financial Ratios represent an attempt to standardize financial information in

order to facilitate meaningful comparisons over time (time series) and
between firms or firm to industry (cross section).

Uses of Financial Ratios

Financial Ratios are used as a relative measure that facilitates the

evaluation of efficiency or condition of a particular aspect of a firm's
operations and status

Ratio Analysis involves methods of calculating and interpreting financial

ratios in order to assess a firm's performance and status

Example

(1) (2) (1)/(2)

Year End Current Assets/Current Liab. Current Ratio
1994 Rs.550,000/Rs.500,000 1.10
1995 Rs.550,000/Rs.600,000 0.92

Groups of Financial Ratios

I. Liquidity
II. Activity
III. Debt
IV. Profitability
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I. Liquidity Ratios

Liquidity refers to the solvency of the firm's overall financial position, i.e. a
"liquid firm" is one that can easily meet its short-term obligations as they
come due.

A second meaning includes the concept of converting an asset into cash with
little or no loss in value.

Three Important Liquidity Measures

1. Net Working Capital (NWC)

NWC = Current Assets - Current Liabilities

2. Current Ratio (CR)

Current Assets
CR = Current Liabilities

3. Quick (Acid-Test) Ratio (QR)

Current Assets - Inventory

QR = Current Liabilities

II. Activity Ratios:

Activity is a more sophisticated analysis of a firm's liquidity, evaluating the

speed with which certain accounts are converted into sales or cash; also
measures a firm's efficiency

Five Important Activity Measures

1. Inventory Turnover (IT)

2. Average Collection Period (ACP)
3. Average Payment Period (APP)
4. Fixed Asset Turnover (FAT)
5. Total Asset Turnover (TAT)
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Cost of Goods Sold

IT = -----------------------------------
Inventory

Accounts Receivable
ACP =-----------------------------------
Annual Sales/365

Accounts Payable
APP= ---------------------------------------
Annual Purchases/365

Sales
FAT = ------------------------------------
Net Fixed Assets

Sales
TAT = ------------------------------------
Total Assets

III. Debt Ratios:

Debt is a true "double-edged" sword as it allows for the generation of profits

with the use of other people's (creditors) money, but creates claims on
earnings with a higher priority than those of the firm's owners.

Financial Leverage is a term used to describe the magnification of risk and

return resulting from the use of fixed-cost financing such as debt and
preferred stock.

Measures of Debt

There are Two General Types of Debt Measures

Degree of Indebtedness
Ability to Service Debts

Four Important Debt Measures

1. Debt Ratio (DR)

2. Debt-Equity Ratio (DER)
3. Times Interest Earned Ratio (TIE)
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4. Fixed Payment Coverage Ratio (FPC)

Total Liabilities
DR=-----------------------
Total Assets

Long-Term Debt
DER=-----------------------------
Stockholders’ Equity

Earnings Before Interest & Taxes (EBIT)

TIE=---------------------------------------------------------------
Interest

Earnings Before Interest & Taxes + Lease Payments

FPC= ---------------------------------------------------------------------------------
Interest + Lease Payments +{(Principal Payments + Preferred Stock Dividends)

IV. Profitability Ratios:

Profitability Measures assess the firm's ability to operate efficiently and

are of concern to owners, creditors, and management

A Common-Size Income Statement, which expresses each income

statement item as a percentage of sales, allows for easy evaluation of
the firm’s profitability relative to sales.

Seven Basic Profitability Measures

1. Gross Profit Margin (GPM)

2. Operating Profit Margin (OPM)
3. Net Profit Margin (NPM)
4. Return on Total Assets (ROA)
5. Return On Equity (ROE)
6. Earnings Per Share (EPS)
7. Price/Earnings (P/E) Ratio

Gross Profits
GPM=------------------------
Sales
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Operating Profits (EBIT)

OPM =------------------------------------------
Sales

Net Profit After Taxes

NPM=---------------------------------------
Sales

Net Profit After Taxes

ROA= ----------------------------------------
Total Assets

Net Profit After Taxes

ROE= -----------------------------------
Stockholders’ Equity

Earnings Available for Common Stockholders

EPS =--------------------------------------------------------------------------------------------
Number of Shares of Common Stock Outstanding

Market Price Per Share of Common Stock

P/E =-------------------------------------------------------------
Earnings Per Share

SUMMARY OF FINANCIAL RATIOS

• Ratio analysis is used as a major tool for financial analysis :

– For a meaningful study of information contained in the financial statements

– Ascertaining the overall financial position of a Business Organization
– Ratios are calculated from the past financial statements
– Ratios could also be worked out based on the projected financial statements of
the same firm

• Easiest way of evaluating the performance of a firm is by comparing past and

present ratios

• Used to judge operational efficiency, financial health, solvency or soundness

• To find out the liquidity position

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• Major categories of ratios

Liquidity ratios
Debt or Leverage or solvency ratios
Activity Ratios
Profitability Ratios

Thus, Ratios help to:

– Evaluate performance

– Structure analysis

– Show the connection between activities and performance

Benchmark with

– Past for the company

– Industry

Ratios adjust for size differences

Limitations of Ratio Analysis

● A firm’s industry category is often difficult to identify

● Published industry averages are only guidelines
● Accounting practices differ across firms
● Sometimes difficult to interpret deviations in ratios
● Industry ratios may not be desirable targets
● Seasonality affects ratios

Sample Calculations(refer note)

4.5 ANALYSIS OF PERFORMANCE & GROWTH

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An annual report is a comprehensive report on a company's activities

throughout the preceding year.

Annual reports are intended to give shareholders and other interested

people information about the company's activities and financial
performance.

Most jurisdictions require companies to prepare and disclose annual

reports, and many require the annual report to be filed at the company's
registry.

Companies listed on a stock exchange are also required to report at more

frequent intervals (depending upon the rules of the stock exchange
involved).

Typically annual reports will include:

Chairman's report
CEO's report
Auditor's report on corporate governance
Mission statement
Corporate governance statement of compliance
Statement of directors' responsibilities

as well as financial statements including:

Auditor's report on the financial statements

Balance sheet
Statement of retained earnings
Income statement
Cash flow statement
Notes to the financial statements
Accounting policies

Other information deemed relevant to stakeholders may be included, such

as a report on operations for manufacturing firms or corporate social
responsibility reports for companies with environmentally or socially
sensitive operations.
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The details provided in the report are of use to investors to understand the
company's financial position and future direction. The financial statements are
usually compiled in compliance with GAAP, as well as domestic legislation.

Financial Statement Analysis for Decision Making

Consider the following example to demonstrate the financial statement

analysis:

Consider Bristol-Myers Squibb, a leading company in the health-care and

consumer products industry

Sales revenues of Rs.14-billion

Assets of Rs.13-billion

How would you compare Bristol-Myers Squibb’s performance against other

industry competitors?

Companies differ in size, so you can’t compare absolute dollar amounts

Need to use ratios - tools to translate financial data into percentages - which
can be compared across companies.

Now consider another company PROCTER & GAMBLE:

PROCTER & GAMBLE

Sales revenues Rs.33.4
Net income 2.6
Assets 28.0

BRISTOL-MYERS SQUIBB
Sales revenues Rs.13.7
Net income 1.8
Assets 13.0
Which company was better in generating net income from sales revenues
earned?
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We can use the return on sales ratio to compare

PROCTER & GAMBLE

Sales revenues $33.4
Net income 2.6

ROI = $2.6/ $33.4

= 7.78%

BRISTOL-MYERS SQUIBB
Sales revenues $13.7
Net income 1.8

ROI = $1.8/$13.7
= 13.13%

Although P&G’s sales were higher, Bristol-Myers’ return on sales was nearly twice
that of P&G.

Financial Statement Analysis

External users rely on publicly-available information to perform financial
analysis.Such information is contained in corporate annual report

Annual Report Main Contents

Four basic financial statements

Footnotes to the financial statements
Summary of accounting methods
Management’s discussion and analysis of financial statements
Auditor’s report
Comparative financial data for a series of years

Tools to Evaluate Financial Information in Annual Reports:

I. Horizontal Analysis
II. Vertical Analysis
III. Ratio Analysis

I. Horizontal Analysis
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Examines percentage change in each item on the financial statements

Compares current year’s dollar amount with prior year’s dollar amount
Expresses the change in
∆ Money (Rs.)
∆ Percentage

Horizontal Analysis Example

1996 1995 Diff. %

Receivables (net) Rs.325,384 Rs.272,225 Rs.53,159 19.5%
Leasehold Improv. 314,933 273,015 41,918 15.3

Trend Percentages

• Specialized form of horizontal analysis

• Shows trend of financial statement items over longer time periods such as 5
or 10 years

• Base year (earliest year in the time series) set at 100%

• All other years expressed as percentage of base year
Trend Percentages Example
(AMOUNTS IN THOUSANDS )

1998 1997 1996 1995 1994 1993

Net Sales Rs.714 Rs.553 Rs.502 Rs.474 Rs.451 Rs.346

Divide 451 by base year value 346 x 100 gives 130% for 1994

Similarly we have,
Net Sales 206% 160% 145% 137% 130% 100%

Horizontal Analysis and Trend Percentages are thus tools used to compare
financial results of companies of different sizes and/or in different industries
II. Vertical Analysis
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Compares each item on the financial statement to a key, or base, item

Base-item dollar amount always set to 100%

The base item for Income statement is : Net sales = 100%

The base item for Balance sheet is : Total assets = 100%

Vertical Analysis Example:

1997 1996
AMOUNT % AMOUNT %

Net sales Rs.430,013 100% Rs.362,386 100%

Cost of Goods Sold 336,589 78 284,897 79
Gross Profit 93,424 22 77,489 21
Selling, General & Admin. 72,363 17 65,096 18
Income from Operations 21,061 5 12,393 3
Income Taxes 7,072 2 4,350 2
Net Income Rs.13,989 3% Rs.8,043 2%

Once financial statement items are converted into percentages of the base
item, users can compare one company’s financials against another. These are
called common-size statements

III. Ratio Analysis

Using Ratios to Make Business Decisions

Ratios - the relationship between two items on financial statements - permit

users to calculate a variety of financial comparisons

These ratios can be compared to:

× Prior years’ financial results
× Industry averages
× Benchmark entities’ ratios
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Ratios measure an entity’s ability to:

o Pay current liabilities
o Sell inventory and collect receivables
o Pay long-term debt
o Generate profits from operations
o Sustain shareholder wealth

(NOTE: POINTS FROM 4.4 FINANCIAL RATIOS CAN BE INCLUDED HERE)

Limitations of Financial Analysis

No one ratio or year’s worth of financial information should be relied upon

to provide a complete assessment of a corporation’s financial condition

Analysts should:

o Examine trends over time

o Benchmark to industry and key competitors
o Seek answers about why ratios are different

Business environment is complicated by numerous local, regional, national, and

global issues - all must be considered when evaluating current financial condition
or forecasting future potential for income