1Financial Statements and Financial Statement Analysis

The purpose of financial statements and reports is to communicate to users

of accounting information the effect of activities on an accounting entity
during a specified period of time and the financial position of the entity at
the end of a given period of time. Financial statements provide information
about the performance, financial position and financial adaptability of an
enterprise.
A complete set of financial statements comprises:
(i)

a statement of financial position (balance sheet)

(ii) a statement of comprehensive income (profit and loss account)

(iii) a statement of changes in equity
(iv) a statement of cash flows
(v) notes to the financial statements; comprising

a summary of

significant accounting policies and other explanatory notes.

(vi) a statement of financial position as at the beginning of the
earliest comparative period when an entity applies an accounting
policy retrospectively or makes a retrospective restatement of
items in its financial statements, or when it reclassifies items in
its financial statements.
The Statement of Comprehensive Income
The statement of comprehensive income should provide information about the
performance of the entity. The statement of comprehensive income should
include all items of income and expenses recognized in a period.
An income statement is a statement that shows the results of operations of
a business entity during an accounting period. This is reflected by the
revenues
revenue.

earned

matched

with

the

expenses

incurred

to

generate

the

Revenue refers to increases in owners equity resulting from sale of goods or

performance of services in the ordinary course of business. It consists of
cash, claims to cash or a promise to receive cash in the future (accounts
receivable).
Revenue represents compensation for the sale of goods or performance of
services. Other types of revenue may include:
i)

Interest earned

ii)

Dividend earned

iii)

Rent earned

iv)

Royalty earned

Expenses refer to decreases in owners equity resulting from the costs

incurred in order to earn revenue. They are measured by the amount of
asset consumed or the amount of liability incurred. They may involve
immediate cash payment or promises to pay in the future.
Other

comprehensive

incomes

are

items

of

income

and

expenses

not

recognised in profit or loss items that ordinarily would not be included in the
profit or loss for the period.
Examples include:
(a) changes in revaluation surplus
(b) actuarial gains and loses on defined benefit plans
(c) exchange gains arising from translating financial
statements of foreign operations
(d) gains and losses on re-measuring available for sale financial
assets
An entity has the alternative of presenting an analysis of expenses in the
profit or loss using a classification based on either the nature or their

function within the entity. The guiding criteria in selecting the basis of the
classification should be relevancy and reliability.
The following is an illustrative example of a statement of comprehensive
income, where expenses are classified by their function.
XYZ Limited
Statement of Comprehensive Income
For the year ended 31st December

2010

2009

Sh.million

Sh.million

Turnover

1660

1400

Cost of sales

(840)

(720)

820

680

Gross profit
Other operating income

60
880

680

Administration expenses

(240)

(200)

Selling and distribution costs

(220)

(180)

Finance costs

(40)

(40)

20

15

Profit before taxation

400

275

Income tax expense

(180)

(105)

Profit for the period

220

170

Investment income

Other comprehensive income

Exchange differences on translating
foreign operations

Gains on property revaluation

of associates

Income tax relating to components of

Share of other comprehensive income

other comprehensive income

Other comprehensive income for the
year, net of tax

TOTAL COMPREHENSIVE INCOME

FOR THE YEAR

The following is an illustrative example of a statement of comprehensive

income, where expenses are classified by their nature.

XYZ Limited
Statement of Comprehensive Income
For the year ended 31st December

Turnover
Other operating income
Changes in inventories
Purchases
Staff costs
Rent and rates
Depreciation and amortization
Directors emoluments
Advertisement and promotion
Audit fees
Light and power
Uncollectible debts
Insurance expense
Telephone and postage
Printing and stationery
Vehicle running expenses
Finance costs
Investment income
Profit before taxation
Income tax expense

2010
Sh.million
1660
60
20
(860)
(220)
(50)
(70)
(10)
(35)
(5)
(30)
(7)
(5)
(3)
(5)
(20)
(40)
20
400
(180)

2009
Sh.million
1400
(20)
(700)
(181)
(45)
(55)
(8)
(30)
(5)
(24)
(5)
(5)
(4)
(3)
(15)
(40)
15
275
(105)

Profit for the period

Other comprehensive income
Exchange differences on translating
foreign operations
Gains on property revaluation
Share of other comprehensive income
of associates
Income tax relating to components of
other comprehensive income
Other comprehensive income for the
year, net of tax
TOTAL COMPREHENSIVE INCOME
FOR THE YEAR

220

170

X
X

X
X

The Statement of Financial Position

It is a statement that reports (reflects) the financial position of an entity at
a given point in time. The financial position of an entity is reflected by the
amounts of:
i)

assets,

ii)

liabilities, and

iii)

owners equity of the entity.

The statement of financial position is a detailed expression of the accounting

equation.
The basic accounting model is illustrated as follows:
Assets = Liabilities + Equity
The model shows that the total assets of an accounting entity must be
equal to the total claims against those assets by the creditors and the
owners. The creditors claims take legal precedence over the claims of the

owners.

Any donation given to an accounting entity should be part of the

owner's equity. When an entity is liquidated and the assets are sold, the
creditors must be paid before the claims of the owners are recognized. The
owner's equity must be the residue that is, Equity = Assets - Liabilities.
Assets refer to cash and non-cash resources owned or controlled by a
business entity. They may be tangible or intangible. Tangible assets include;
property, plant and equipment, inventories and cash. Intangible assets on the
other hand include patents, accounts receivable, trademarks, franchises, and
copyrights.
Assets have economic values since they contain service benefits that can be
used in future or can be sold to other entities.

Liabilities are debts owed by an entity to outside parties. These outside

parties are also known as creditors. Examples of liabilities include amounts
owed to suppliers, amounts from suppliers, amount borrowed from banks,
amount owed to employees for wages and salaries or wages payable or
amount owed to tax agencies or taxes payable and National Social Security
Fund payable. Cancellation of a liability may require an outlay of assets or
giving up of assets or performance of services. Creditors have a first claim
against the assets of an entity.
Owner's equity in an entity is the owner's claim against the assets of the
entity.
In the accounting model owners equity is the residual.
Equity = Assets Liabilities
The following is an illustrative example of a statement of financial position

XYZ Limited
Statement of financial position
As at 31st December
2010

2009
Sh.million

Sh.million
Assets
Non current assets
Freehold property

164

60

Plant and machinery

450

360

Furniture and fittings

32

40

Motor vehicles

20

23

Goodwill

10

10

Investments

351

334

46

34

1027

827

Current assets
Inventories
Accounts receivable
Prepayments

164
10

203
15

Cash and cash equivalents

76

33

296
285
Total assets

1323

1112

Equity and Liabilities

Capital and reserves:
Share capital

350

Share Premium

30

Revaluation reserve
Accumulated Profit

273

66
590

27
66

480

Shareholders funds

1036

846
Non-current liabilities
16% loan stock

164

132

Accounts Payable

98

112

Taxation Payable

25

Current liabilities

123
Total equity and liabilities

1323

22
134
1112

Statement of cash flows

The basic purpose of a statement of cash flows is to provide information
about the sources and application of cash and cash equivalents of an entity.
It communicates information about the financial adaptability of an enterprise
for a given period of time.

Financial Statement Analysis

Introduction:
Financial statements are essentially historical and static documents. They tell
us what has happened during a particular period or series of periods of
time. The most valuable information to most users of financial statements or
reports, however, concerns what probably will happen in the future. The
purpose of financial statement analysis is to assist statement users in
predicting the future by means of comparison, evaluation and trend analysis.
The

first

procedure

in

financial

statement

analysis

is

to

obtain

useful

information. The main sources of financial information include, but are not
limited to, the following: published reports, registrar of companies, credit and
investment advisory agencies, audit reports, government statistics and market
research organizations.
Objectives of financial statement analysis
Financial analysis is the process of critically examining in detail, accounting
information given in financial statements and reports. It is a process of
evaluating relationships between component parts of financial statements to
obtain a better understanding of a firm's performance and financial position.
Financial statement analysis involves three basic procedures:
1. Selection
This involves the selection from the total information available about an
enterprise, the information that is relevant to the decision under consideration.

2. Relation
This involves arranging the information in a manner that will bring out a
significant relationship(s).
3. Evaluation
This involves the study of the relationship and interpretation of the result
thereof.
The specific objectives of financial statement analysis
Financial statements are essentially a record of the past. Business decisions
naturally affect the future. Analysts therefore study financial statements as
evidence of past performance that may be used in the prediction of future
performance.
The specific objectives of financial statement analysis are to:
(a) assess the past, present and future earnings of an enterprise,
(b) assess the operational efficiency of the firm as a whole and its
various divisions or departments,
(c) assess the short term and long term solvency of the firm,
(d) assess the performance of one firm against another or the industry
as a whole and the performance of one division against another,
(e) assist in the developing of forecasts and preparation of budgets,
(f) assess the financial stability of the business under review, and
(g) assist in the understanding of the real meaning and significance of
financial information.
Usefulness of Analysis
The figures in the financial statements are rarely significant or important in
themselves. It is their relationships to other quantities, amounts and direction
of change from one point in time to another point in time that is of
importance. It is only through comparison that one can gain insight into

trends and make intelligent judgments as to their significance. Analysis thus

involves establishing significant relationships that point to change as well as
trends.
Techniques of analysis
The techniques widely used for analytical purpose are:
1. Trend analysis,
2. Cross sectional analysis, and
3. Ratio analysis
Trend analysis
This is also known as time series analysis, horizontal analysis or temporal
analysis. It involves the comparison of the present performance with the
result of previous periods for the same enterprise. Trend analysis is therefore
usually employed when financial data is available for three or more periods.
It can be carried out by computing percentages for the element of the
financial statement that is under observation. Trend percentage analysis states
several years' financial data in terms of a base year, which is set to be
equal to 100%.
Problems of Trend analysis
i.

To ensure comparability of figures, the results of each year will

have to be adjusted using consistent accounting policies when the
same has not been applied.

ii.

Comparison

overtime

becomes

difficult

when

the

unit

of

measurement changes in value due to general inflation.

iii.

If the enterprises environment changes over time with the result

that performance that was considered satisfactory in the past may
no longer be considered so, more specific measures rather than
general trends may be preferred in such instances.

Cross sectional analysis

This involves the comparison of the financial performance of a company
against other companies within the same industry. It may simply involve
comparison of the present performance or a trend of the past performance.
The idea under this approach is to use a comparable company as a yardstick to gauge the performance of a company. Cross sectional analysis may
involve the use of ratios for a particular company or the entire industry.
Problems of Cross sectional analysis
i.

It is difficult to find a comparable firm within the same industry.

This is because firms may have businesses which are diversified to
a greater or lesser extent.

ii.

Businesses operating in the same industry may be substantially

different in that, they may manufacture the same product but one
may

be

using

rented

equipment

while

the

other

uses owned

equipment making comparison difficult.

iii.

Two firms may use accounting policies which are quite different
resulting in differences in financial statements. It is usually very
difficult for an external user to identify differences in accounting
policies yet one must bear them in mind when interpreting two sets
of accounts.

Ratio analysis
A ratio is simply a mathematical expression of an amount or amounts in
terms of another or others. A ratio may be expressed as a percentage, a
fraction, or a stated comparison between two amounts. The computation of a
ratio does not add any information not already existing in the amount or
amounts under study. A useful ratio may be computed only when a
significant relationship exists between two amounts. A ratio of two unrelated
amounts is meaningless.

A ratio by itself is useless, unless compared with the same ratio over a
period of time and or similar ratio for a different company and the industry.
It is important to note that ratios focus attention on relationships which are
significant but the full interpretation of a ratio usually

requires, further

investigation of the underlying data. Thus ratios are an aid to analysis and
interpretation and not a substitute for sound thinking.
Classification of Ratios
Ratios may be classified into the following broad categories.
1. Short-term liquidity ratios also known as working capital management
ratios,
2. Long-term risks and capital structure ratios also known as leverage or
debt management ratios, and
3. Operating efficiency ratios and Profitability ratios
4. Investment ratios
Short-term liquidity ratios
Liquidity refers to an enterprises ability to meet its short-term debts as and
when they fall due. A firm which cannot meet its short- term obligations
may be forced into bankruptcy and therefore fail to be provided with the
opportunity to operate in the long-run. Liquidity ratios are used to assess a
firms ability in meeting its short-term obligations as and when they fall due.
They include:
i) Working capital ratio
This ratio represents current assets that are financed from long term capital
resources that do not require repayment in the short-run, implying that the
portion that is financed from long term capital resources is still available for
repayment of short term debts.

It is computed as follows:

Example:
Balance sheet extract
As at December 31

2005
Sh.000

Current assets
Current liabilities

2004
Sh.000

26,400

15,600

(13,160)
13,240

(6,400)
9,200

In the year 2004 Sh.9.2 million of working capital, representing current

assets financed by long term capital resources is available to pay short term
debts and in 2005 Sh.13.24 million is available of working capital to pay
short term obligations.
ii) Current ratio
A current ratio similarly tests short-term debt-paying ability of an enterprise.
It measures the amount of liquid and near liquid resources available to meet
short-term debts. A high current ratio is assumed to indicate a strong
liquidity position while a low current ratio is assumed to indicate a relatively
weak liquidity position. The rule of the thumb is that current assets should
be twice current liabilities. The ratio is computed as follows:

Illustration:
Balance sheet extract
As at December 31
2005

2004

Sh.000

Sh.000

Current assets

26,400

15,600

Current liabilities

(13,160)

(6,400)

The current ratio;

2005

2004

Sh.000

Sh.000

26400/13160

15600/6400

2: 1

2.4: 1

Observation
The enterprise appears to have a strong liquidity position. There has been,
however, a slight drop from year 2004 to year 2005.
For every shilling that is owed of current liabilities in 2005, the firm has
Sh.2 of current assets to pay the debt and for every shilling owed of
current liabilities in 2004, the firm had Sh.2.4 of current assets available to
meet the liability.
iii) Quick ratio or Acid test ratio
The current ratio has further been refined to Quick Ratio or Acid Test
Ratio. This ratio tests the short-term debt paying ability of an enterprise
without having to rely on inventory and prepayments. The ratio concentrates
on more readily realizable or liquid assets available to meet short-term

debts. The rule of the thumb is that for every shilling of current liability
owed, the enterprise should have a shilling of current quick assets available
to meet it. It is given by

iv) Average collection period (Age of accounts receivable) ratio

The ratio measures the average number of days taken by an enterprise to
collect its trade receivables. The ratio is computed as follows:

365

OR
365

Where,
Average trade receivables = Beginning trade receivables + Ending trade receivables

v) Accounts receivable turnover ratio

The accounts receivable turnover ratio measures the number of times an
enterprise

has

turned

accounts

receivable

into

cash

during

the

year,

measuring efficiency of collection. The higher the times the more efficient a
company will be assumed to be in collecting its debts.
Where,

vi) Average payment period (Age of trade payables) ratio

This ratio measures the average number of days taken to pay an accounts
payable. It is computed as follows:

365

OR

365

Where,
Average accounts payable= Beginning accounts payable + Ending accounts payable
2

vii)

Accounts payable turnover ratio

The accounts payable turnover ratio measures the efficiency with which firms
pay their trade creditors. The higher the number of times, the more efficient
the enterprise is assumed to be in paying its creditors
Where

viii)

Average sales period ( Age of inventory) ratio

This ratio measures the average number of days taken to sell inventory one
time.
It is given by;

365
"

Where,
Average inventory = Beginning inventory + Ending inventory
2

ix) Inventory turnover ratio

Inventory turnover ratio measures the frequency with which inventory is turned
over during the period.
Where,
#

" $
#

Long-term solvency ratios

A firm is said to be leveraged whenever it finances a portion of its assets
by debt. Debts commit a firm to payment of interest and repayment of
capital. Borrowing increases the risk of default and it is only advantageous
to shareholders if the return earned on the funds borrowed is greater than
the cost of the funds. Long-term solvency ratios include;

i) Debt to equity ratio

This ratio measures the amounts of assets provided by creditors for each
shilling of assets provided by the shareholders. It is computed as follows:

&

'

'

&

ii) Proprietory ratio

This ratio measures the proportion of assets financed by the owners. It is
calculated as follows:
)

'
'

&

100

iii) Debt to total assets ratio

This ratio measures the proportion of assets financed by outsiders. It is
calculated as follows:

%

'

'

100

iv) The times interest earned ratio

This is also known as the interest cover ratio. This ratio measures the
ability of a firm to meet its interest payment out of the current earnings. It
reflects the likelihood that creditors will continue to receive their interest
payments by calculating the number of times the interest payable is covered
by profits available for such payments.
It is computed as follows:
=

"

"

,
,

Profitability ratios and Operating efficiency ratios

Profitability analysis consists of tests used to evaluate a firm's earnings
performance during the year. These ratios combined with other data can be
used to forecast the earning potential of a firm since in the long run, the
firm has to operate profitably in order to survive. The ratios are of
importance to long term creditors, shareholders, suppliers, employees and
their representative groups. All these parties are interested in the financial
soundness

of

an

enterprise.

The

ratios

commonly

used

to

measure

profitability include:i) Profit margin (Return on sales ratio)

This ratio describes the company's ability to earn income. It is a measure of
the proportion of sales that contribute to profit. It is computed as follows:
)

"

-
-

100

ii) Total assets turnover

This ratio describes the ability of a company to use its assets to generate
sales. It is computed as follows:
'

- $

iii) Return on total assets

This ratio measures how well management has employed assets. It is given
by

100

iv) Return on common stock holders equity

This ratio measures the ability of an enterprise to generate income for its
owners. It is computed as follows:
=

"

&

100

Where, Common stockholders equity = Total equity preference share capital

Investment ratios
These ratios help equity shareholders and other investors to assess the value
and quality of an investment in the ordinary shares of a company. The
value of an investment in ordinary shares in a listed company is its market
value, and so investment ratios must have regard not only to information in
the companys published accounts, but also to the current price.
These include:

i) Earnings per share (EPS)

This ratio represents or reflects the amount of shillings or cents earned per
ordinary share. It is a requirement of IAS 33 that it be disclosed on the
face of the income statement for quoted companies. It is given by
.)$ =

-
'

ii) Dividend pay-out ratio

) "
"

This ratio reflects a companys dividend policy. It is computed as follows:

=

%
.

100

Where,
Dividends per share =

Ordinary dividends
Number of ordinary shares

iii) Dividend yield ratio

This shows the dividend return being provided by the share. It is given by
%

%
/

100

iv) Price earnings ratio (The PE ratio)

This ratio is used in comparing stock investment opportunity. It is an index
of determining whether shares are relatively cheap or relatively expensive. It
is given by
).

/
.

The price earnings ratio reflects the consideration that investors are willing to
pay for a stream of a shillings of earnings in the future. The price-earnings
ratio is widely used by investors as a general guideline in gauging stock
values. The ratio reflects the stock market expectations of the future earnings
of the company. Investors increase or decrease the price-earnings ratio that
they are willing to accept for a share of stock according to how they view
its future prospects. Companies with ample opportunity for growth generally

have high price-earnings ratios, with the opposite being true for companies
with limited growth.
Limitations:
1. Ratios are insufficient in themselves as a basis of judgment about the
future. They are simply indicators of what to investigate. Therefore,
they should not be viewed as an end, but as a starting point from
which to identify further questions.
2. They are useless when used in isolation. They have to be compared
over time for the same firm or across firms or with the industry's
average.
3. Ratios

are

based

on

financial

statements.

Any

weakness

of

the

financial statements is also captured within the ratios.

Comparing ratios across firms may be difficult because the firms may not be
comparable. Data among companies may not provide meaningful comparisons
because of factors such as use of different accounting policies and the size
of the company.