UNIT IV

Principles of accounting; balance sheet; income statement; financial ratios; analysis of

performance and growth.

Principles of accounting:

Accounting is the analysis & interpretation of book keeping records. It includes not only
the maintenance of accounting records but also the preparation of financial & economic
information which involves the measurement of transactions & other events relating to entry.

There are various terminology used in the Accounting which are being explained as under: -

1) Assets: An asset may be defined as anything of use in the future operations of the enterprise &
belonging to the enterprise. E.g., land, building, machinery, cash etc.

2) Equity: In broader sense, the term equity refers to total claims against the enterprise. It is
further divided into two categories.
i. Owner Claim - Capital
ii. Outsider’s Claim – Liability
Capital: The excess of assets over liabilities of the enterprise. It is the difference between the
total assets & the total liabilities of the enterprise. e.g.,: if on a particular date the assets of the
business amount to Rs. 1.00 lakhs & liabilities to Rs. 30,000 then the capital on that date would
be Rs.70,000/-.
Liability: Amount owed by the enterprise to the outsiders i.e. to all others except the owner.
e.g.,: trade creditor, bank overdraft, loan etc.

3) Revenue: It is a monetary value of the products or services sold to the customers during the
period. It results from sales, services & sources like interest, dividend & commission.

4) Expense/Cost: Expenditure incurred by the enterprise to earn revenue is termed as expense or

cost. The difference between expense & asset is that the benefit of the former is consumed by the
business in the present whereas in the latter case benefit will be available for
future activities of the business. e.g., Raw material, consumables & salaries etc.

5) Drawings: Money or value of goods belonging to business used by the proprietor for his
personal use.

6) Owner: The person who invests his money or money’s worth & bears the risk of the business.
7) Sundry Debtors: A person from whom amounts are due for goods sold or services rendered
or in respect of a contractual obligation. It is also known as debtor, trade debtor, accounts
receivable.

8) Sundry Creditors: It is an amount owed by the enterprise on account of goods purchased or

services rendered or in respect of contractual obligations. e.g., trade creditor,
accounts payable.

In the modern world no business can afford to remain secretive because various parties such as
creditors, employees, Government, investors & public are interested to know about the affairs of
the business.

Accountants to develop some principles, concepts and conventions which may be regarded as
fundamentals of accounting. The need for generally accepted accounting principles arises from
two reasons:
1) to be logical & consistent in recording the transaction
2) to conform to the established practices & procedures

1. Going Concern:
In the ordinary course accounting assumes that the business will continue to exist & carry on its
operations for an indefinite period in the future. The entity is assumed to remain in operation
sufficiently long to carry out its objects and plans. The values attached to the assets
will be on the basis of its current worth. The assumption is that the fixed
assets are not intended for re-sale.

2. Consistency:
There should be uniformity in accounting processes and policies from one period to another.
Material changes, if any, should be disclosed even though there is improvement in technique.
when the accounting procedures are adhered to consistently from year to year the results
disclosed in the financial statements will be uniform and comparable.

3. Accrual:
Accounting attempts to recognize non-cash events and circumstances as they occur. It is the
accounting process of recognizing assets, liabilities or income amounts expected to be received
or paid in future. Common examples of accruals include purchases and sales of goods or services
on credit, interest, rent (unpaid), wages and salaries, taxes. In order to keep a complete
record of the entire transactions of any business it is necessary to keep the
following accounts:

a) Assets Accounts: These accounts relate to tangible and intangible assets. e.g., Land a/c,
building a/c, cash a/c, goodwill, patents etc.
b) Liabilities Accounts: These accounts relate to the financial obligations of an enterprise
towards outsiders. e.g., trade creditors, outstanding expenses, bank overdraft, long-term loans.
c) Capital Accounts: These accounts relate to the owners of an enterprise. e.g., Capital a/c,
drawing a/c.

d) Revenue Accounts: These accounts relate to the amount charged for goods sold or services
rendered or permitting others to use enterprise’s resources yielding interest, royalty or dividend.
e.g., Sales a/c, discount received a/c, dividend received a/c, interest received a/c.

e) Expenses Account: These accounts relate to the amount spent or lost in the process of earning
revenue. e.g., Purchases a/c, discount allowed a/c, royalty paid a/c, interest payable a/c, loss by
fire a/c.

Balance sheet:

A balance sheet is a financial statement that reports a company's assets, liabilities, and
shareholder equity. The balance sheet is one of the three core financial statements that are used
to evaluate a business. It provides a snapshot of a company's finances (what it owns and owes) as
of the date of publication.
The balance sheet adheres to the following accounting equation, with assets on one side, and
liabilities plus shareholder equity on the other, balance out:

This formula is intuitive. That's because a company has to pay for all the things it owns (assets)
by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholder
equity).
 Components of a Balance Sheet

Assets
 Accounts within this segment are listed from top to bottom in order of their liquidity.
This is the ease with which they can be converted into cash.
 They are divided into current assets, which can be converted to cash in one year or less;
and non-current or long-term assets, which cannot.
Here is the general order of accounts within current assets:
 Cash and cash equivalents are the most liquid assets and can include Treasury bills and
short-term certificates of deposit, as well as hard currency.
 Marketable securities are equity and debt securities for which there is a liquid market.
 Accounts receivable (AR) refer to money that customers owe the company. This may
include an allowance for doubtful accounts as some customers may not pay what they
owe.
 Inventory refers to any goods available for sale, valued at the lower of the cost or market
price.
 Prepaid expenses represent the value that has already been paid for, such as insurance,
advertising contracts, or rent.
Long-term assets include the following:
 Long-term investments are securities that will not or cannot be liquidated in the next
year.
 Fixed assets include land, machinery, equipment, buildings, and other durable, generally
capital-intensive assets.
 Intangible assets include non-physical (but still valuable) assets such as intellectual
property and goodwill.
 These assets are generally only listed on the balance sheet if they are acquired, rather than
developed in-house.
 Their value may thus be wildly understated (by not including a globally recognized logo,
for example) or just as wildly overstated.

LIABILITIES
 A liability is any money that a company owes to outside parties, from bills it has
to pay to suppliers to interest on bonds issued to creditors to rent, utilities and
salaries.

 Current liabilities are due within one year and are listed in order of their due
date. Long-term liabilities, on the other hand, are due at any point after one year.
 CURRENT LIABILITIES ACCOUNTS MIGHT INCLUDE:

 Current portion of long-term debt is the portion of a long-term debt due within the next
12 months. For example, if a company has 10 years left on a loan to pay for its
warehouse, 1 year is a current liability and 9 years is a long-term liability.
 Interest payable is accumulated interest owed, often due as part of a past-due obligation
such as late remittance on property taxes.
 Wages payable is salaries, wages, and benefits to employees, often for the most recent
pay period.
 Customer prepayment is money received by a customer before the service has been
provided or product delivered. The company has an obligation to (a) provide that good
or service or (b) return the customer's money.
 Dividends payable is dividends that have been authorized for payment but have not yet
been issued.
 Earned and unearned premiums is similar to prepayments in that a company has received
money upfront, has not yet executed on their portion of an agreement, and must return
unearned cash if they fail to execute.
 Accounts payable is often the most common current liability. Accounts payable is debt
obligations on invoices processed as part of the operation of a business that are often due
within 30 days of receipt.

LONG-TERM LIABILITIES CAN INCLUDE:

 Long-term debt includes any interest and principal on bonds issued

 Pension fund liability refers to the money a company is required to pay into its
employees' retirement accounts
 Deferred tax liability is the amount of taxes that accrued but will not be paid for another
year. Besides timing, this figure reconciles differences between requirements
for financial reporting and the way tax is assessed, such as depreciation calculations.

Some liabilities are considered off the balance sheet, meaning they do not appear on the
balance sheet.

SHAREHOLDER EQUITY:

Shareholder equity is the money attributable to the owners of a business or its

shareholders. It is also known as net assets since it is equivalent to the total assets of a
company minus its liabilities or the debt it owes to non-shareholders.

Retained earnings are the net earnings a company either reinvests in the business or uses
to pay off debt. The remaining amount is distributed to shareholders in the form of
dividends.
Treasury stock is the stock a company has repurchased. It can be sold at a later date to
raise cash or reserved to repel a hostile takeover.

 Some companies issue preferred stock, which will be listed separately

from common stock under this section.

 Preferred stock is assigned an arbitrary par value (as is common stock, in some
cases) that has no bearing on the market value of the shares.

 The common stock and preferred stock accounts are calculated by multiplying
the par value by the number of shares issued.

 Additional paid-in capital or capital surplus represents the amount shareholders

have invested in excess of the common or preferred stock accounts, which are
based on par value rather than market price.
INCOME STATEMENT:
FINANCIAL RATIOS; ANALYSIS OF PERFORMANCE AND GROWTH
ANALYSIS OF PERFORMANCE AND GROWTH

Financial statement analysis is a process conducted on organizations by internal and external

parties to gain a better understanding of how a company is performing. The process consists of
analyzing four critical financial statements in a business.

The four statements that are extensively studied are a company’s balance sheet, income
statement, cash flow statement, and Rates of Return and Profitability Analysis

1. Balance Sheet

In financial statement analysis, an organization’s balance sheet is looked at to determine the

operational efficiency of a business.

Firstly, asset analysis is conducted and is primarily focused on more important assets such as
cash and cash equivalents, inventory, and PP&E, which help predict future growth.

Next, long-term and short-term liabilities are examined in order to determine if there are any
future liquidity problems or debt-repayment that the organization may not be able to cover.

Lastly, a company’s owner’s equity section is inspected, allowing the user to determine the share
capital distributed inside and outside of the organization.

financial statement analysis, we will evaluate the operational efficiency of the business. We will
take several items on the income statement and compare them to accounts on the balance sheet.

The balance sheet metrics can be divided into several categories, including liquidity, leverage,
and operational efficiency.

The main liquidity ratios for a business are:

 Quick ratio

 Current ratio

 Net working capital

The main leverage ratios are:

 Debt to equity

 Debt to capital

 Debt to EBITDA

 Interest coverage

 Fixed charge coverage ratio

The main operating efficiency ratios are:

 Inventory turnover

 Accounts receivable days

 Accounts payable days

 Total asset turnover

 Net asset turnover

Using the above financial ratios, we can determine how efficiently a company is generating
revenue and how quickly it’s selling inventory.

2. Income Statement

In financial statement analysis, a business’s income statement is investigated to determine

overall present and future profitability.

Examining a company’s previous and current fiscal years income statement enables the user to
determine if there is a trend in revenue and expenses, which in turn, shows the potential to
increase future profitability.

There are two main types of analysis we will perform: vertical analysis and horizontal analysis.

Vertical Analysis

With this method of analysis, we will look up and down the income statement (hence, “vertical”
analysis) to see how every line item compares to revenue, as a percentage.

For example, in the income statement shown below, we have the total dollar amounts and the
percentages, which make up the vertical analysis.
The key metrics we look at are:

 Cost of Goods Sold (COGS) as a percent of revenue

 Gross profit as a percent of revenue

 Depreciation as a percent of revenue

 Selling General & Administrative (SG&A) as a percent of revenue

 Interest as a percent of revenue

 Earnings Before Tax (EBT) as a percent of revenue

 Tax as a percent of revenue

 Net earnings as a percent of revenue

Horizontal Analysis

Now it’s time to look at a different way to evaluate the income statement. With horizontal
analysis, we look at the year-over-year (YoY) change in each line item.

In order to perform this exercise, you need to take the value in Period N and divide it by the
value in Period N-1 and then subtract 1 from that number to get the percent change.

For the below example, revenue in Year 3 was $55,749, and in Year 2, it was $53,494. The YoY
change in revenue is equal to $55,749 / $53,494 minus one, which equals 4.2%.
3. Cash Flow Statement

A cash flow statement is critical in a financial statement analysis in order to identify where the
money is generated and spent by the organization.

If one segment of the business is experiencing large outflows, in order to stay viable, the
company must be generating inflows through financing or sales of assets.

The cash flow statement, or statement of cash flow, consists of three components:

 Cash from operations

 Cash used in investing

 Cash from financing

Each of these three sections tells us a unique and important part of the company’s sources and
uses of cash over a specific time period.
4. Rates of Return and Profitability Analysis:

In this part of our analysis of financial statements, we unlock the drivers of financial
performance. By using a “pyramid” of ratios, we are able to demonstrate how you can determine
the profitability, efficiency, and leverage drivers for any business.

This is the most advanced section of our financial analysis course, and we recommend that you
watch a demonstration of how professionals perform this analysis.

The course includes a hands-on case study and Excel templates that can be used to calculate
individual ratios and a pyramid of ratios from any set of financial statements.
The key insights to be derived from the pyramid of ratios include:

 Return on equity ratio (ROE)

 Profitability, efficiency and leverage ratios

 Primary, secondary and tertiary ratios

 Dupont analysis

By constructing the pyramid of ratios, you will gain an extremely solid understanding of the
business and its financial statements.