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ANALYSIS OF
FINANCIAL STATEMENTS

Vibrant Banker
In this video You will learn-
• What are the Financial Statements?
• Types of Financial Statements.
• Formats and Contents of Financial Statements.
• Why We need to do analysis of Financial Statements?
• What are the Techniques of Analysis of Financial
Statement?
 WHAT ARE THE FINANCIAL STATEMENTS?
The statements Statements of a company are
• (i) Trading or Manufacturing account
• (ii) Statement of Profit & Loss account.
• (iii) Balance sheet
• (iv) Cash Flow Statements
• (v) Fund Flow Statement
• (vi) Statement of changes in Equity, wherever applicable
• (vii) Statement of disclosure on Associates, Subsidiaries and Joint Ventures
• (viii) Auditors' Report
• (ix) Board of Directors Report (in case of corporate bodies)
• (x) Income tax/sales Tax/service Tax assessment orders/Returns.
 Balance Sheet
• A Balance sheet is a financial statement that reports a company's
assets (What is owned), liabilities (What is Owed to others), and
shareholder equity.
• The "statement of financial position" which reveals the money
value of company's assets, liabilities and owners' equity (net worth)
on a particular day is known as the Balance Sheet. Generally this is
prepared at the end of the financial year of the company.
• The balance sheet is based on the fundamental equation:
Assets = Liabilities + Equity.
• Assets- Application of Funds
• Liabilities and Equity/Net worth- Sources of Fund
• The assets and liabilities in a balance sheet are classified in a
convenient form for the purpose of analysis into:
• (A) Assets: These are broadly classified into
• Current Assets
• Fixed Assets
• Non-Current Assets
• Intangible Assets
• (B) Liabilities:
• Current Liabilities
• Medium & Long-term liabilities
• Capital & Reserve
• Current Assets
• Current Assets are those which are held for sale or conversion into cash
with in an operating cycle or normally a period of 12 months.
• Current assets are used in production and generate income from the sale
of finished products.
• Normally a current asset is one which is used in production or held for
sales or will be converted into cash during the current period. It includes
raw material, work in progress and finished goods.
• The quality of current assets and the speed with which it can be converted
into cash determines the solvency of a company.
• Fixed Assets
These are capital assets in a business, otherwise known as block assets.
Fixed assets are long-term assets like land and building, plant and machinery,
tools and dies, fittings and fixtures, motor vehicles etc.
• Other (Non-Current) Assets
Other assets are assets that are not expected to be converted into cash,
consumed or sold within 12 months of the balance sheet date (or the normal
operating cycle of the firm or business) at the same time not fixed assets.
They are formally defined as anything not classified as a current asset.
Other (Non-Current) Assets include:-
Investments in and advances to subsidiary companies or sister concerns or to
companies in the same group,
trade investments,
unquoted investments,
book debts outstanding for more than 180 days,
non consumable stores and spares,
advances to suppliers of capital goods, etc.
• Intangible Assets/Fictitious assets-
• Intangible assets are the long-term resources of an entity, but have no physical
existence. They derive their value from intellectual or legal rights, and from the value
they add to the other assets.
• EX-patents, copyrights, and goodwill, trademarks etc.

• Fictitious assets are like intangible assets which do not exist in physical form. They are
deferred revenue expenditure whose benefit is derived over long period of time.
• Even accumulated losses are also fictitious assets as they are written off over a period of
time.
• All fictitious assets are intangibles, but, all intangible assets are not fictitious.
• For example, goodwill, patent, trademarks, copy rights are intangibles but not fictitious.
• Examples of fictitious assets are preliminary expenses, discount on issue of
debentures/shares, underwriting commission, miscellaneous expenditure, Profit & Loss
(Dr.), etc.
• From a bank's point of view, for arriving at net worth of a concern, value of intangible
assets/fictitious assets is deducted from the owners' funds.
• Current Liabilities
• These are short-term liabilities. All liabilities which are repayable within a period of 12 months are
grouped under this category. Current liabilities bear a relationship to current assets, as they normally
arise to acquire current assets.
• Examples of current liabilities are creditors, Bills payable, Tax liability, Bank limits (working capital and
short-term finance), derivatives held for trade, etc. Installment of term loan, becoming due in next 12
months.

• Medium & Long-term liabilities:

• Any loan (facility) payable back in installments -it is long-term in nature and it is not payable in the next
one year.
• These include
• Debentures (not maturing within one year),
• Term loans (exclusive of installment payable within one year),
• Redeemable Preference Shares (not maturing within one year but of maturity not exceeding 12 years),
• Deferred payment credits (exclusive of installments payable within one year),
• Deposits/borrowings from affiliates/subsidiaries due after one year and
• Deposits from public with residual maturity of more than one year.
• Capital & Reserves
• Capital is funds invested by the owners in the business. Retained profits are added to this.
• Reserves are specified allocations of funds.
• There are two classes of Reserves- Capital reserves and Revenue Reserves.
• Capital Reserves are the items of reserves, whose use is restricted, hence are treated or
considered to be of a more permanent nature. The promoters cannot take away these
amounts from the business.+
• Revenue Reserves are the ones, which are created out of profits.
• Revenue Reserves are further classified into two categories- Specific and free.
• Specific Reserves: These are those which created for some specific purpose and can be used
only for those specific purposes. Examples include investment fluctuation reserves,
debenture redemption reserves, Workmen Compensation Fund, Dividend Equalization Fund,
Sinking Fund, etc.
• hence use of these reserves is also restricted to the extent of the company's obligation
pertaining to the event.
• Free Reserves are the ones, which are available for the use of the company as per the
decision of the management.
 TRADING AND PROFIT & LOSS ACCOUNT
Trading account is prepared to ascertain gross results i.e. gross profit or
gross loss out of business activity. This is concerned with sales, cost of
goods sold, stock of material, sales return, wages, power etc.
Profit & Loss account gives the net profit numbers. All expenses except
those already shown in trading account are debited to this account to
arrive at net result. Miscellaneous income is reckoned here.
For the purpose of analysis, various business expenses are grouped into:
(a) Administration and establishment Expenses
(b) Selling & distribution expenses
(c) Management expenses
(d) Financial expenses
(e) Maintenance & Depreciation.
 Fund Flow Statement
• For the purpose of fund flow the information in the balance sheet is organized into two principal
groups;
• (i) Source of funds and
• (ii) Applications of the funds.
• Sources of funds are indicated by the decreases in assets and increases in liabilities or in the
shareholder's equity over the previous year while applications of funds are associated with the
increases in assets and decreases in liabilities or in the shareholder's equity over the previous year.
• Each item in the balance sheet represents either source of funds or use of funds. All items on the
liabilities side represent the funds provided to the enterprise and all items on the assets side (except
cash) represent use of these funds.
• When we compare two balance sheets of different dates, change in each item (or introduction of a
new item) in the balance sheet of later date, as compared to that item in the balance sheet of earlier
date, will represent either addition of funds or additional use of funds in the intervening period.
• Any increase in any item on the liabilities side means additional funds available. Please note that
additional funds are also available if there is decrease in any item on the assets side. Similarly, any
increase in any item on the assets side or decrease in any on the liabilities side means additional use of
funds. A statement of these additional sources of funds and additional uses of funds, is called Funds
flow statement for the intervening period.
 Sources of funds Uses of funds
Decrease in assets by sale and increase in assets, addition to fixed
depreciation, better control of assets, building up of inventory, piling
inventory and sundry debtors, up of sundry debtors, addition to
reduction in cash balance; investments;
Increases in liabilities, addition to decrease in liabilities by pay-off of a
current liabilities and provisions, long or short term loan, reduction of
increases in long term debt and issue creditors and
of debentures; Decrease in net worth, incurring of
Increases in net worth, addition to losses and withdrawal of funds from a
reserves and surplus, sale of business, dividend payments in periods
additional shares, retention of of no or low profits.
earnings.
 Cash Flow Statements
• A statement of changes in the financial position on cash basis is commonly
known as cash flow statement. This summarises the causes of changes in
cash position between two balance sheets.
• Thus this statement analyses the changes in non-current accounts as well
as current account - other than cash - to determine the flow of cash.
• For planning cash requirement a firm can make projections of cash inflows
and outflows to determine the availability of cash to meet the needs for
cash. If this is done it is possible to meet the deficit or invest surplus cash
temporarily.
• A historical analysis of cash flow provides insight on how to prepare
reliable cash flow projections for the immediate future.
 Sources of cash Uses of cash
◆ decrease in assets except cash ◆ the loss from operations.
◆ increase in liabilities including ◆ increase in assets except cash
debentures or bonds ◆ decrease in liabilities including
◆sale proceeds from an ordinary or redemption of debentures or bonds
preference shares ◆ redemption of redeemable
preference shares and cash dividends
 Auditors Note
• The Auditors Note forming part of a Balance Sheer is one of the important documents to be
studied/scrutinized thoroughly by the bankers while analyzing the financial statements.
• Every company is subject to audit. An auditor makes a Note/Report to the members of the company on
its state of affairs. It gives comments on the accounts and on balance sheet, profit and loss account and
other documents attached to the financial statements, which are laid in the AGM.
• Auditors Note/Report contains an opinion whether the financial statements present a true and fair
view of the state of affairs of the company in case of a balance sheet and of profit or loss in case of
profit and loss account.
• The Auditors also report whether the books of account are in agreement with and whether there is
any deviation from generally accepted accounting principles.
• The Auditors Note depicts in detail the disputed statutory liabilities such as Income Tax, Sales Tax,
Custom Duty, etc. not provided for and estimate their impact on the profitability in the event of any of
those crystallize/payable.
• The Note will also provide whether the company has defaulted in servicing its debt obligations and the
reasons thereof besides the stage at which each liability stands. They also comment on whether any
short term loans raised by the company has been used to finance long term investment and analyze its
impact on liquidity.
Why We need to do analysis of Financial Statements?
• A bank calls for the balance sheet and financial statements of a company/firm when it is
considering an application for a credit facility from the firm.
• Analysis of financial statements is an important tool in the hands of a bank for taking a credit
decision. This is possibly the most important tool.
• Financial statements are being invariably collected with a view to assessing
• the Net Worth of the applicant,
• Repayment capacity,
• Viability,
• Availability of unencumbered securities, etc.
A bank will not approve credit unless the balance sheet and financial statement reveal that the
company has:
◆ a sound financial position (solvency test)
◆ good liquidity (cash flows), and
◆ a good earning capacity (profitability).
• Analysis is the process of breaking down a complex set of
facts and figures into simple and comparable items.
• Interpretation is the critical examination of the classified
facts and figures and drawing conclusions.
• The prima facie classification of items and the numbers in a
financial statement do give a sense of the financial health
and performance of the business. But a bank has to make a
thorough analysis of the statements ratios and fund flows to
gain a real appreciation of the financial health.
 TECHNIQUES USED IN ANALYSIS OF FINANCIAL
STATEMENTS
Bankers mostly use three methods for analysis of financial
statements
(a) Funds Flow Analysis
(b) Trend Analysis
(c) Ratio Analysis
(a) Funds Flow Analysis:
If the borrower has not submitted the funds flow statement, bank
prepares the same from the last two balance sheets. The total
sources of funds are categorized as 'Long term and 'Short term'.
Similarly, the total uses are also categorized as "Long term' and 'Short
term.
If the short term sources are more than the short term uses it indicates
diversion of working capital funds and needs to be probed further.
Sometimes, it may be a desirable thing e.g., in case of companies
with very high current ratio, it may be desirable to use the idle
funds for creating additional capacity. The guiding principle is that
this diversion should not affect the liquidity position of the
company to unacceptable level.
(b) Trend Analysis:
Under trend analysis, bankers adopt the following methodology:
(i) The items, for which trend is required to be seen, are arranged in horizontal form and
percentage increase (decrease) from the previous year's fig is indicated below it.
Generally, this is used to see the trends of sales, operating profit, PBT, PAT etc., from P&L
account. Similarly, the balance sheets, arranged in horizontal order give the trends of
increase or decrease of various items.
(ii) Common size statements are prepared to express the relationship of various items to one
item in percentage terms. For example, consumption of raw materials is expressed as a
percentage of sales for different years and comparison of these figures gives indication of
trend of operating efficiency.
Common size financial statements contain the percentages of a key figure alone, without the
corresponding amount figures. The use of percentages is usually preferable to the use of
absolute figures. The use of common size statements can make comparisons of business
enterprises of different sizes much more meaningful since the numbers are brought to
common base, i.e., percent. Such statement allows an analyst to compare the operating
and financing characteristics of two companies of different sizes in the same industry.
(c) Ratio Analysis:
• A ratio is comparison of two figures and can be expressed as
a percentage (e.g., profitability is 23.7 per cent), as a number
(e.g., current ratio is 1.33) or simply as a proportion (e.g.,
debt equity is 1:2).
• Both the figures, used in calculation of a ratio, can be from
either P&L account, or balance sheet or one can be from P&L
account and the other from balance sheet.
• Ratios help in comparison of the financial performance and
financial position of an entity with other entities, as also for
comparison with its own status over the years.
 Thanks for Watching

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Vibrant Banker