Chapter Three

ANALYZING FINANCIAL STATEMNETS

Course: FINANCIAL MANAGEMENT 1

Course Code: (BAFI2109
Specialization: Accounting and Finance
Department of Business Studies

Image Source: https://www.google.com/url?sa=i&source=images&cd=&ved=2ahUKEwiR8fndvbfnAhUhx4UKHc3zAckQjRx6BAgBEAQ&url=https%3A%2F%2Fyourfinancebook.com%2Ffinancial-statements

%2F&psig=AOvVaw3l-bJFadmPz-wWoWfhbzqy&ust=1580891226555736
Outcome Understand the basic financial statements, calculate financial ratios,
and analyze and interpret those ratios;

Contents

o Balance sheet
o Income statement
o Statement of cash flows
o Statement of changes in equity
 Comparative financial statements
 Financial ratio analysis
 Profitability ratios
 Activity ratio
 Liquidity ratios
 Leverage ratios

2
Essential Reading
Paramasivan, C.. Financial Management, New Age International Ltd, 2009. ProQuest Ebook
Central

URL: https://ebookcentral.proquest.com/lib/momp/detail.action?docID=437705
Recommended Reading

Weetman, P. 2011, Financial and Management Accounting An Introduction, 5th Edition,

Prentice Hall

Open Educational Resource

Provider: Financial Management Training Center 
Author: Matt H Evans
URL : http://www.oercommons.org/courses/evaluating-financial-performance/view

3
 Introduction to financial statements
A financial statement is an official document of the firm, which explores the
entire financial information of the firm.
The main aim of the financial statement is to provide information and
understand the financial aspects of the firm.

John N. Nyer also defines it

“Financial statements provide a summary of the

accounting of a business enterprise, the balance-sheet
reflecting the assets, liabilities and capital as on a
certain data and the income statement showing the
results of operations during a certain period”.
Image source: https://www.google.com/url?
sa=i&source=images&cd=&cad=rja&uact=8&ved=2ahUKEwiBudatwLfnAhUINRoKHYNhBtkQjRx6BA
gBEAQ&url=https%3A%2F%2Faccountingplay.com%2Fglossary%2Ffinancial-statement-
relationships%2F&psig=AOvVaw2wCYSPUKAwCl0HGuyiTKxw&ust=1580892087238324
4
Introduction to financial statements

1. The income statement or profit and loss account.

2. Balance sheet or the position statement.
3. Statement of changes in owner’s equity.
4. Statement of changes in financial position.

5
Income statement

 Income statement is also called as profit and loss account,

which reflects the operational position of the firm during a
particular period.
 Normally it consists of one accounting year.
 Income statement helps to ascertain the gross profit and net
profit of the concern.
 Gross profit is determined by preparation of trading or
manufacturing a/c and net profit is determined by preparation
of profit and loss account.

6
Balance sheet / Position Statement

 Which reflects the financial position of the firm at the

end of the financial year.
 Position statement helps to ascertain and understand the
total assets, liabilities and capital of the firm.
 One can understand the strength and weakness of the
concern with the help of the position statement.

7
 FORMAT OF INCOME STATEMENT BALANCE SHEET FORMAT
Particulars Amount Amount
Sales   0.0000
Less sales return and sales discount 0.0000 0.0000   Balance Sheet Format for ( Business Name)    
Net sales   0.0000 (I) Assets    
Less cost of goods sold     a) Current Assets Amount (OMR) Amount (OMR)
Opening stock 0.0000     Accounts Receivable xxxx  
Add Purchase ( less return and discounts) 0.0000     Prepaid Expenses xxxx  
Add direct wages 0.0000     Closing Inventory (Stock) xxxx  
Add direct expenses 0.0000     Supplies on Hand xxxx  
  Bills receivable xxxx  
Add Carriage inwards ( Transportation in) 0.0000  
  Debtors xxxx XXXXX
Less Closing Stock 0.0000  
b) Fixed Assests    
Cost of goods sold   0.0000
  Equipment's and Tools xxxx  
Gross Profit/ Loss   0.0000
  Less: Depreciation (xx)  
Add Other Incomes :-    
  Machines xxxx  
Interest received 0.0000  
  Vehicles xxxx  
Dividend revenue 0.0000  
  Property and Land xxxx  
Commission received 0.0000  
  Furniture xxxx XXXXX
Rent received 0.0000 0.0000
  Total Assets   XXXXXXXX
Total income   0.0000
       
Less Expenses:-     Liabilities    
(II)
Selling and distribution expenses 0.0000   Current /Short Term Liabilities    
c)
Sales man salaries, commission 0.0000   Accounts Payable xxxx  
 
Advertisement 0.0000   Wages payable xxxx  
 
Rent sales office 0.0000     Tax Payable xxxx  
Depreciation on vehicles used for sales 0.0000     Bank Overdraft xxxx  
Carriage outwards 0.0000 0.0000   Outstanding Expenses xxxx  
        Creditors xxxx XXXXX
Administrative Expenses     d) Long-Term Liabilities    
Salaries and wages 0.0000     Long term Loan    
Electricity 0.0000     Debentures    
Insurance 0.0000     Mortgage Payable   XXXX
Rent 0.0000     Total Liabilities   XXXXXXXXX
Utilities 0.0000   (III) Owner's Equity    
Depreciation expenses 0.0000     Capital xxxx  
Office supplies 0.0000     Retained Earnings xxxx  
Travel expenses 0.0000     Add: Net Profit /Less: Net Loss xxxx  
Maintenance 0.0000 0.0000   Dividend xxxx  
Net Income before interest and tax   0.0000   Less: Drawings (xxx) XXXXX
Interest expenses   0.0000   Total Liabilities + Owner's Equity   XXXXXXXXX
Net Income before taxes   0.0000 Note: It is based on following equation
8
 

Less Tax   0.0000   Assets = Liability + Owner's Equity

Income after Interest and tax   0.0000   (I = II + III)
Practice 1: From the following information calculate
Cost of goods sold and Gross profit
Particulars Amount (OMR)
Stock (01-01-2019) 3,000
Purchases 40,000
Purchases Returns 2,000
Direct Wages 4,000
Office Salaries 2,800
Carriage Outwards 2,400
Depreciation on assets 600

Office rent 1,600

Stock (31-12-2019) 4,000
Sales 78,000
9
Practice 2: From the following balances
calculate Net profit
Balances Amount (OMR)
Sales 47,500
Carriage inwards 1,100
Purchase discount 900
Interest received 2,500
Selling and distribution 2,000
expenses
Administrative expenses 2,000
Sales return/ return inwards 7,500
Opening stock 2,000
Closing stock 1,000
Purchase 18,000
Other direct expenses 500
Commission received 800
Purchase return/return 300 10
Practice 3: From the following, prepare income statement and
Balance sheet
  Dr Cr
     
Sales   28,000
Purchases 20,000  
Carriage inwards 800  
Electricity 400  
Salaries and wages 3,100  
Insurance 150  
Building 50,000  
Fixtures 2,000  
Debtors 3,500  
Return inwards 450  
Creditors   2,050
Bank Balance 3,250  
Opening stock 2,400  
Carriage Outwards 650  
Motor vehicles 8,000  
Capital   64,405
Return Outwards   745
Office Rent 500  
Total 95,200 95,200

Closing stock 2,500

11
 Statement of changes in equity

https://www.google.com/url?sa=i&url=http%3A%2F%2Fwww.accounting-basics-for-students.com%2Fstatement-of-owners-
equity.html&psig=AOvVaw0dCVQMfi_CYH5vE4tK697k&ust=1581412354524000&source=images&cd=vfe&ved=0CAIQjRxqFwoTCKDQ1bXRxucCFQAAAAAdAAAAABBw

12
Statement of changes in equity
 It is also called as statement of retained earnings.
 This statement provides information about the
changes or position of owner’s equity in the
company.
 Nowadays, preparation of this statement is not
popular and nobody is going to prepare the
separate statement of changes in owner’s equity.

13
 Statement of cash flows
It is a statement that shows flow (Inflow or outflow) of cash and cash equivalents during a given period
of time.

As per Accounting Standard-3 (Revised) the changes resulting in the flow of cash & cash equivalent
arises on account of three types of activities i.e.,

(1) Cash flow from Operating Activities.

(2) Cash flow from Investing Activities.
(3) Cash flow from Financing Activities.

Cash: Cash comprises cash in hand and demand deposits with bank.

Cash equivalents: Cash equivalents are short-term, highly liquid investment that are readily convertible
into known amount of cash and which are subject to an insignificant risk of change in the value e.g.
short-term investment. Generally, these investments have a maturity period of less than three months.

Some examples of cash equivalent: Short-term deposits, marketable securities. Treasury bills,
commercial papers, money market funds, money market funds, investment in preference shares if
redeemable within three months provided that there is no risk of the failure of the company.

Cash flow exclude movements between items that constitute cash or cash equivalents because these
components are part of the cash management of an enterprise rather than part of its operating,
investing and financing activities.
https://mycbseguide.com/blog/cash-flow-statement-class-12-notes-accountancy/

14
 Statement of cash flows

https://marketplace.corporatefinanceinstitute.com/wp-content/uploads/2019/04/cash-flow-statement-template-excel-image.png
15
Comparative financial statements
 Comparative financial statements present the same company’s financial
statements for one or two successive periods in side-by-side columns.

 The calculation of amounts changes or percentage changes in the statement

items or totals is horizontal analysis.

 This analysis detects changes in a company’s performance and highlights

trends.

 Comparative statement analysis is an analysis of financial statement at

different period of time.

 This statement helps to understand the comparative position of financial

and operational performance at different period of time.

 Comparative financial statements again classified into two major parts such
as comparative balance sheet analysis and comparative profit and loss
16
account analysis.
Comparative financial statements
Balance Sheet Analysis
 Comparative balance sheet analysis concentrates only the
balance sheet of the concern at different period of time.
 Under this analysis the balance sheets are compared with
previous year’s figures or one-year balance sheet figures are
compared with other years.
 Comparative balance sheet analysis may be horizontal or
vertical basis.
 This type of analysis helps to understand the real financial
position of the concern as well as how the assets, liabilities
and capitals are placed during a particular period. 17
The earliest period is usually used as
the base period and the items on the
statements for all later periods are
compared with items on the statements
of the base period.
The changes are generally shown both
in dollars and percentage.

Dollar and percentage changes are

computed by using the
following formulas:

https://www.accountingformanagement.org/horizontal-analysis-of-financial-statements/ 18
Comparative financial statement
Income statement Analysis
Another comparative financial statement analysis is
comparative profit and loss account analysis.

Under this analysis, only profit and loss account is taken to

compare with previous year’s figure or compare within the
statement.

This analysis helps to understand the operational

performance of the business concern in a given period.

It may be analyzed on horizontal basis or vertical basis.

19
In the analysis, 2007 is the base year and
2008 is the comparison year. All items
income statement for the year 2008 have
been compared with the items of balance
sheet and income statement for the year
2007.

The actual changes in items are

compared with the expected changes.
For example, if management expects a
30% increase in sales revenue but
actual increase is only 10%, it needs to
be investigated.

https://www.accountingformanagement.org/horizontal-analysis-of-financial-statements/ 20
 Ratio Analysis

●
● Debt to equity Ratio
●
● Current Ratio ●
● Debt to total funds
●
● Quick Ratio ratio

Liquidity Leverage
Ratio Ratio

Activity Profitability
Ratio Ratio
●
● Gross Profit
●
● Inventory Turnover ●
● Operating Profit
Net profit
Receivables turnover
●
●
●
●
●
● Return
Return on
on capital
capital employed
employed
●
● Payable turnover ●
● Return on equity
●
● Fixed Asset turnover ●
● EPS
●
● Price earning ratio
21
Liquidity ratios

  Liquidity is the basis of survival of any business



 Measures short term solvency of an enterprise

 Ability of a firm to meet its short term obligations as and when they become due

Current Ratio: The ratio is mainly used to give an idea of the company's ability to pay back its
short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).

22
Examples of Current Assets : Cash, Accounts receivable, inventory marketable securities and prepaid
expenses

Example of Current liabilities : Accounts payable, bank overdraft , short term loans (repayable within a
year) accrued expenses

A current ratio of 2:1 is considered as standard

Interpretation: Higher the ratio, greater margin of safety for short term creditors.

But too high ratio may indicate presence of idle funds

23
Liquidity ratios
 
Quick ratio is a measure of a company's ability to meet its short-term obligations using its most
liquid assets (near cash or quick assets).

Quick assets include those current assets that presumably can be quickly converted to cash at
close to their book values.

The ratio tells creditors how much of the company's short term debt can be met by selling all
the company's liquid assets at very short notice.

= (current assets – inventory)/ Current liabilities

Interpretation: Ideal ratio is 1:1 but may vary from business to business

24
Practice 4: Calculate Current Ratio and Quick Ratio from the
given Balance Sheet of Al-Madina LLC – for the year ending
December 31, 2012
Assets Amount Liabilities Amount
Current Assets     Current Liabilities    
Cash in hand 1,500   Creditors 500  
Debtors 800   Bank Overdraft 1,500 2,000
Stock in Hand 50 2,350 Net worth/ Capital    
Fixed Assets     Common Stock 5,500  
Plant & Machinery 14,000   Reserves & Surpluses 6,850 12,350
(-) Accumulated 4,500 9,500
Depreciation   2,500
Furniture

Total Assets 14,350 Total Liabilities & Capital 14,350

25
Profitability ratios

Profitability ratio helps to measure the profitability position

of the business concern.

OR
Profitability ratio is used to evaluate the company’s ability to
generate income as compared to its expenses and other cost
associated with the generation of income during a particular period.

General rule is higher the ratio it is considered as better

26
 Profitability Ratio

Based on Based on Market

Sales Investment ratios

27
Profitability ratios

28
Profitability ratios - Gross Profit margin

The gross profit margin ratio, also known as gross margin, is the ratio of gross margin
expressed as a percentage of sales.

Gross margin, alone, indicates how much profit a company makes after paying off its Cost
of goods sold.

Gross Profit Margin Ratio Formula

  Gross Profit Margin = (Gross profit ÷ Total revenue ) x 100

Or

= (Revenue  –  Cost of goods sold) ÷ Total revenue

Gross Profit Margin  = (Gross profit ÷ Total revenue ) x 100

29
Profitability ratios- Net Profit margin

The net profit margin, also known as net  margin, indicates how much net income  a company
makes with total sales achieved.

A higher net  profit  margin means that a company is more efficient at converting sale into
actual  profit.

Net Profit Margin Formula

Net Profit Margin = (Net profit ÷ Total revenue ) x 100

30
Profitability ratios- Return of Capital Employed(ROEC)

 Return on capital employed (ROCE) is a measure of the returns that a business is achieving
from the capital employed, usually expressed in percentage terms.

Capital employed equals a company's Equity plus Non-current liabilities (or Total Assets −
Current Liabilities), in other words all the long-term funds used by the company.

ROCE indicates the efficiency and profitability of a company's capital investments.

Calculation (formula):

Interpretation: Higher the ratio, more efficient the management and utilization of capital
employed

31
Return on Equity:

This ratio measures relationship between net profit after interest ,tax and
preference dividend with the equity shareholders' funds.

Interpretation: Higher ratio is better

32
Market ratios

Gives management indication of what investors think of co.’s past performance &
future prospects

Earnings
  Per Share (EPS)

Earnings per Share (EPS) is the portion of a company's profit allocated to each
outstanding share of common stock. EPS serves as an indicator of a company's
profitability.

Calculation (formula):

Interpretation: Higher EPS is better; EPS helps in determining the market price of the
equity share.

33
Market ratios

The price
  to earnings ratio (P/E ratio) is the ratio of market price per share to earnings per share.
It is calculated by dividing “Market Value per Share (Price)” to “Earnings per Share (EPS)”.
Market value of share can be taken from stock market or online and earning per share figure can
be calculated by dividing net annual earnings to total number of shares (Net Annual Earnings/Total
number of shares).
P/E ratio is a widely used ratio which helps the investors to decide whether to buy shares of a
particular company.
It is calculated to estimate the appreciation in the market value of equity shares.
Calculation (formula)
The formula used to calculate the price to earnings ratio is:

Interpretation: Higher ratio suggest the investors are expecting higher earnings
growth in future

34
Dividend Yield ratio:
The dividend yield is the amount of money a company pays shareholders (over the
course of a year) for owning a share of its stock divided by its current stock price—
displayed as a percentage.  

Interpretation : higher ratio is better

35
Debt to Total funds ratio
This ratio establishes relationship between a company’s long term debt and total assets:

Interpretation: High ratio indicates firm is heavily dependent on debt. It shows high level of
financial risk. Low ratio indicates lesser financial risk and stronger equity position.

Image source :https://www.google.com/url?sa=i&url=https%3A%2F%2Fwww.wallstreetmojo.com%2Fdebt-to-asset-ratio-formula

%2F&psig=AOvVaw2fqJLyr5jF0k0zq9Jb5hIh&ust=1581857110394000&source=images&cd=vfe&ved=0CAIQjRxqFwoTCPicuJ_L0-cCFQAAAAAdAAAAABAL 36
Leverage ratios/Gearing ratio/solvency ratio

This ratio shows long term financial solvency of the enterprise

Measures a firm’s ability to pay interest regularly and to repay principal on maturity or in pre-
determined installments at due dates

Debt Equity ratio:

Interpretation: High ratio indicates more debt than owners fund. Low ratio indicates company
owns more money from the owners than debt.

Image source: https://www.google.com/url?sa=i&url=https%3A%2F%2Fwealthyeducation.com%2Flong-term-debt-to-equity-

ratio&psig=AOvVaw21wIiNuPD6t5HpG4fcm1_F&ust=1581856649731000&source=images&cd=vfe&ved=0CAIQjRxqFwoTCJjElt7M0-cCFQAAAAAdAAAAABAD
37
Activity Ratios

1. Inventory turnover ratio : Cost of goods sold/Average inventory

2. Receivable turnover ratio : Net credit sales/ Average receivables

3. Payable turnover ratio: Net credit Purchases/Average payables

4. Fixed Assets turnover: Net sales/Net fixed assets

In detail will be covered in Chapter 4- Working Capital Management

38
 Essential Reading
Paramasivan, C.. Financial Management, New Age International Ltd, 2009. ProQuest Ebook Central,
https://ebookcentral.proquest.com/lib/momp/detail.action?docID=437705.URL:

Recommended Reading
Weetman, P. 2011, Financial and Management Accounting An Introduction, 5th Edition, Prentice
Hall
Open Educational Resource
Provider: Financial Management Training Center 
Author: Matt H Evans
URL : http://www.oercommons.org/courses/evaluating-financial-performance/view

www.accaglobal.com/middle-east/en/student/exam-support-resources/professional-exams-study-resources/strategic-business-leader/techn
ical-articles/performance-appraisal.html#Introduction

https://ebookcentral.proquest.com/lib/momp/reader.action?docID=437705&ppg=30

39
CONTACT INFORMATION:

Name of the Staff : Mr.Faheem Khan

Office: BS 046
Email:

Revised by: Ms. Sameena Begum

Room No : BS050
Email : sameena.begum@hct.edu.om

VERSION HISTORY

Version No. Date Approved Changes incorporated

1
2 16th February 2020
Revised by Ms.
Sameena

40