FINANCIAL ACCOUNTING AND ANALYSIS

SYLLABUS
UNIT-1
Introduction to Financial Accounting. Basic Concepts and Conventions: Business
Entity, Dual Aspect, Going Concern, Accounting Period, Money Measurement,
Accrual, Disclosure, Materiality, Consistency, and Conservatism. The Accounting
Equation. Understanding Assets, Liabilities, Revenues, and Expenses. Understanding
Capital Expenditure, Revenue Expenditure, Deferred Revenue Expenditure, Capital
Receipts, and Revenue Receipts. Nature of Accounts and Rules of Debit and Credit.
Recording transactions in General Journal. Preparation of Ledger Accounts. Opening
and Closing Entries. Preparation of Trial Balance.

Introduction to Financial Accounting

Financial Accounting is the process of recording, summarizing, and reporting the financial
transactions of a business.

The primary purpose of financial accounting is to provide accurate and useful financial
information to external users such as investors, creditors, and regulatory agencies.

The foundational concepts and conventions in financial accounting guide the process of
recording and reporting financial information.

Basic Concepts and Conventions in Financial

Accounting
1. Business Entity Concept
The business entity concept states that the business is considered separate from its owners
or other businesses. Financial transactions of the business should be recorded
independently of the personal transactions of the owners or shareholders. This means that
the business's financial statements reflect only the business's activities and not the personal
affairs of the owner.

Example: If an owner of a business withdraws money from the company for personal use, it
should be treated as a drawing and not as an expense of the business.

2. Dual Aspect Concept

This principle is also known as the Duality Principle. It states that every transaction has two
aspects: a debit and a credit. The accounting equation, Assets = Liabilities + Owner’s
Equity, reflects the dual nature of financial transactions.

Example: If a business purchases equipment worth $5,000 on credit:

 ● The assets (equipment) increase by $5,000.
● The liabilities (accounts payable) increase by $5,000.

3. Going Concern Concept

The going concern assumption assumes that a business will continue to operate for the
foreseeable future and will not be forced to close down or liquidate its assets in the near
term. This assumption allows businesses to defer the recognition of certain expenses to
future periods.

Example: When a business purchases long-term assets such as machinery, the cost is
spread over its useful life rather than expensing it all at once, as the business is expected to
continue operating and generating revenue.

4. Accounting Period Concept

The accounting period concept divides the life of a business into specific time periods (e.g.,
monthly, quarterly, or annually) for reporting financial information. This period allows for
consistent measurement of financial performance.

Example: A company may prepare its financial statements at the end of each fiscal year,
such as December 31st, to reflect its performance for that year.

5. Money Measurement Concept

This concept states that only transactions that can be measured in monetary terms should
be recorded in financial accounting. Non-monetary items, like employee skills or customer
loyalty, cannot be recorded.

Example: While the goodwill of a business may be valuable, it cannot be recorded in the
financial statements unless it is bought or sold.

6. Accrual Concept
The accrual concept requires that revenues and expenses be recognized when they occur,
regardless of when cash transactions take place. This concept leads to the use of accrual-
based accounting.

Example: If a company provides services in December but receives payment in January, the
revenue is recognized in December when the service was rendered, not in January when the
payment is received.

7. Disclosure Concept
The disclosure concept asserts that all material and relevant information that may affect the
understanding of the financial statements should be disclosed. This helps users of financial
statements make informed decisions.

Example: If a company has a significant lawsuit pending, the potential financial impact
should be disclosed in the notes to the financial statements.

8. Materiality Concept
According to the materiality concept, only significant financial information that could influence
the decisions of users should be recorded in financial statements. Insignificant information
may be disregarded for practical reasons.

Example: A small office supply purchase may not be recorded in detail in the financial
statements because it’s not significant enough to impact decision-making.

9. Consistency Concept
The consistency concept dictates that businesses should use the same accounting methods
and procedures from period to period unless there is a valid reason for changing them. This
ensures comparability of financial statements over time.

Example: If a company uses the straight-line method for depreciation in one year, it should
continue using the same method in the next years unless a change is required for specific
reasons.

10. Conservatism Concept

The conservatism concept advises that accountants should exercise caution when
recognizing revenue and expenses. It suggests that anticipated losses should be recognized
while anticipated gains should not be recognized until they are actually realized.

Example: If a business is unsure about the collectibility of an accounts receivable, it may

create a provision for doubtful debts as a precautionary measure.

The Accounting Equation

The accounting equation is the foundation of the double-entry bookkeeping system. It
represents the relationship between a company’s assets, liabilities, and owner’s equity.

Accounting Equation:

Asset = Capital + Liabilities

Example:
The accounting equation will be:

Q.1 What will be effect of the following on the Accounting Equation?

(i) Started business with cash ₹ 45,000
(ii) Opened a Bank Account with a deposit of ₹ 4,500
(iii) Bought goods from M\s. Sun & Co. for ₹ 11,200

The solution for this question is as follows:

For better understanding of practical knowledge :- :- Accounting Equation Class 11
Accounts ONE SHOT. Complete Concept & Questions Revision in Easiest way

This equation is always balanced, ensuring the integrity of the financial records.

Understanding Assets, Liabilities, Revenues, and

Expenses
1. Assets
Assets are resources owned by the business that are expected to bring future economic
benefits. They are classified as either current (short-term) or non-current (long-term).

Example:

● Current Asset: Cash, accounts receivable.

● Non-Current Asset: Property, plant, and equipment.

2. Liabilities
Liabilities are obligations that the business owes to others. They are classified as current
(due within one year) and non-current (due after one year).

Example:

● Current Liability: Accounts payable, short-term loans.

● Non-Current Liability: Long-term debt, mortgage loans.

3. Revenues
Revenue is the income earned by the business from its operations, such as sales of goods
or services.

Example: A company sells a product for $1,000. This $1,000 is recorded as revenue.

4. Expenses
Expenses are the costs incurred to generate revenue. They represent the outflow of
resources from the business.

Example: If the business pays $500 for raw materials to produce the product, this $500 is an
expense.

Understanding Capital Expenditure, Revenue

Expenditure, Deferred Revenue Expenditure, Capital
Receipts, and Revenue Receipts
1. Capital Expenditure (CapEx)
Capital expenditure refers to the purchase of long-term assets that will provide benefits for
more than one accounting period.

Example: Purchasing machinery for $10,000 is a capital expenditure.

2. Revenue Expenditure (RevEx)

Revenue expenditure refers to costs that are incurred for the day-to-day running of the
business, and they are expensed in the period in which they occur.

Example: Salaries paid to employees for their work in the current period are a revenue
expenditure.

3. Deferred Revenue Expenditure

Deferred revenue expenditure is a payment made by the business for benefits that will be
realized in future periods, often over several years.

Example: Advertising costs that benefit the business for several years are deferred revenue
expenditures.

4. Capital Receipts
Capital receipts are funds received by a business that do not form part of the regular
revenue cycle, typically relating to long-term financing.

Example: Loan received from a bank is a capital receipt.

5. Revenue Receipts
Revenue receipts are funds received as a result of the business's operations and regular
activities.
Example: Revenue from the sale of goods or services.

Nature of Accounts and Rules of Debit and Credit

There are three types of accounts in financial accounting:

1. Personal Accounts: Accounts that relate to individuals, companies, or other

organizations.
2. Real Accounts: Accounts related to assets (tangible or intangible).
3. Nominal Accounts: Accounts that relate to incomes, expenses, gains, and losses.

Rules of Debit and Credit

1. Personal Accounts: Debit the receiver, credit the giver.
2. Real Accounts: Debit what comes in, credit what goes out.
3. Nominal Accounts: Debit all expenses and losses, credit all incomes and gains.

Recording Transactions in the General Journal

The general journal is the initial point where all business transactions are recorded. Each
journal entry includes the date, account titles, debit and credit amounts, and a brief
description of the transaction.

Example:
A company purchases office supplies worth $500 on credit.

● Debit: Office Supplies $500 (Asset increase)

● Credit: Accounts Payable $500 (Liability increase)

For better understanding of practical knowledge :- :- Journal ONE SHOT | All Basic and
Most important Jouranl entries. Class 11 Accountancy | Don't Miss

Preparation of Ledger Accounts

After transactions are recorded in the journal, they are posted to the relevant accounts in the
ledger. Each account in the ledger represents a specific category (e.g., cash, accounts
payable, revenue, etc.).

Opening and Closing Entries

1. Opening Entries:
Opening entries are made at the start of an accounting period to transfer balances from the
previous period’s closing entries.

2. Closing Entries:
Closing entries are made at the end of an accounting period to transfer temporary account
balances (revenues and expenses) to permanent accounts (retained earnings or capital).
For better understanding of practical knowledge :- Ledger One shot | Class 11
Accountancy. Ledger Posting & Balancing. Practical Problems #cbseclass11

Preparation of Trial Balance

The trial balance is a summary of all ledger balances. It ensures that the total debits equal
the total credits. If they do not balance, it indicates that errors have been made in the journal
or ledger.

Example: A trial balance might show:

● Total Debits: $50,000

● Total Credits: $50,000

If the trial balance does not balance, adjustments must be made to correct the errors before
preparing the final financial statements.

For better understanding of practical knowledge :-Trial Balance One Shot. Class 11
Accountancy. Complete chapter in one go | Easiest Explanation.

SYLLABUS

Unit 2 (4 Weeks)
Preparation of Financial Statements: Preparing Trading Account, Profit & Loss
Account and Balance Sheet for a Sole Proprietor. Format for preparing financial
statements for IND-AS companies as per Division II, Schedule III, Companies Act,
2013. Understanding of Financial Statements of a Joint Stock Company as per new
accounting standards: IND-AS (Balance sheet, Profit & Loss, Statement of
Comprehensive Income, Cash Flow Statement); Understanding the contents of a
Corporate Annual Report (Actual latest annual reports to be used).
Unit 2: Preparation of Financial
Statements
The preparation of financial statements is a critical part of financial accounting. It involves
summarizing the financial transactions and presenting them in the form of a Trading
Account, Profit & Loss Account, and Balance Sheet. These statements provide insights
into the financial performance and position of a business.

1. Preparation of Financial Statements for a Sole

Proprietor
The financial statements for a sole proprietor include three key components:

● Trading Account (for calculating the Gross Profit or Loss)

● Profit & Loss Account (for calculating the Net Profit or Loss)
● Balance Sheet (to show the financial position at the end of the period)

A. Trading Account
The Trading Account is prepared to determine the Gross Profit or Gross Loss by
matching Sales and Cost of Goods Sold (COGS).

Format of Trading Account:

Key Components:

● Sales: Total revenue earned from selling goods or services.

● Opening Stock: Value of stock at the beginning of the period.
● Purchases: Cost of goods purchased during the period.
● Returns Outward: Value of goods returned by customers.
● Closing Stock: Value of stock remaining at the end of the period.
● Direct Expenses: Expenses directly related to the production or purchase of goods
(e.g., freight, wages for production).

Example:
● Opening Stock: ₹20,000
● Purchases: ₹50,000
● Sales: ₹100,000
● Returns Outward: ₹5,000
● Closing Stock: ₹25,000
● Direct Expenses: ₹10,000

Using the Trading Account formula:

COGS= Opening Stock+Purchases−Closing Stock+Direct Expenses

=20,000+50,000−25,000+10,000=₹55,000

The Gross Profit can now be calculated:

Gross Profit =Sales−COGS=100,000−55,000=₹45,000

For better understanding of practical knowledge :-Trading account | Profit and loss
account | Basics | Financial Statements | Class 11

B. Profit & Loss Account

The Profit and Loss Account is prepared to determine the Net Profit or Net Loss of the
business by considering both Operating Revenues and Operating Expenses.

Format of Profit & Loss Account:

Key Components:

● Indirect Income: Income not related to the main operations of the business (e.g.,
interest income).
● Indirect Expenses: Expenses that are not directly related to the production process
but are necessary for running the business (e.g., rent, salaries).
● Net Profit: The residual profit after all expenses (including both direct and indirect)
have been deducted from gross profit.

Example:
● Gross Profit: ₹45,000
● Indirect Income (Interest): ₹2,000
● Rent: ₹5,000
● Salaries: ₹10,000
● Office Supplies: ₹3,000

The Net Profit calculation:

Net Profit=Gross Profit + Indirect Income − Indirect Expenses

=45,000+2,000−(5,000+10,000+3,000)=₹29,000

For better understanding of practical knowledge :-

C. Balance Sheet

The Balance Sheet represents the financial position of the business at a specific point in
time. It provides a snapshot of the business’s assets, liabilities, and owner’s equity.

Format of Balance Sheet:

Key Components:

● Assets: Economic resources owned by the business.

○ Non-Current Assets: Long-term assets like property, plant, and equipment.
○ Current Assets: Short-term assets like cash, accounts receivable, inventory.
● Liabilities: Obligations owed by the business.
○ Long-term Liabilities: Obligations due after one year (e.g., loans).
 ○ Current Liabilities: Obligations due within one year (e.g., accounts payable).
● Owner’s Equity: The owner’s residual interest in the business after liabilities are
deducted from assets.

For better understanding of format and questions : Financial Statements | Trading

account | Class 11 | Accountancy | Part 1
Financial Statements | Trading account | Class 11 | Accountancy | Part 2
Financial Statements | P/L Account | Class 11 | Accountancy | Part 3
Financial Statements | P/L Account | Class 11 | Accountancy | Part 4
Financial Statements | P/L Account | Class 11 | Accountancy | Part 5

2. Financial Statements for IND-AS Companies as per

Division II, Schedule III of the Companies Act, 2013
The format for financial statements of companies adhering to IND-AS (Indian Accounting
Standards) is more complex than for sole proprietors, with specific guidelines provided in
Division II of Schedule III of the Companies Act, 2013.

The financial statements for such companies include:

● Balance Sheet
● Profit & Loss Account (referred to as the Statement of Profit and Loss)
● Statement of Comprehensive Income
● Cash Flow Statement
BALANCE SHEET AND PROFIT AND LOSS A/C FOR COMPANY : Financial
statements of a company | Heading & Sub heading. ONE SHOT Revision. 12
Accounts Board 2023or One Shot | Financial Statements of a company | Class
12
P&L a/c : Financial Statement Analysis | Statement of profit and loss | Class 12
| Basics

Format of Balance Sheet (IND-AS):

Profit & Loss Account Format:
3. Statement of Comprehensive Income (IND-AS)
This statement includes both the Profit & Loss and other comprehensive income items
that are not recognized in the Profit & Loss Account, such as gains or losses on
revaluation of assets or foreign currency translations.

Watch this : What is other comprehensive income in the financial results ?

Format of Statement of Comprehensive Income:

Particulars Amount (₹)

Net Profit XXXX

Other Comprehensive XXXX

Income

Total Comprehensive Income XXXX

4. Cash Flow Statement (IND-AS)

The Cash Flow Statement provides a summary of the cash inflows and outflows from
operating, investing, and financing activities over a period.

VIDEO OF CASHFLOW STATEMENT :Cash Flow Statement | ONE SHOT | Concept &
Questions. Class 12 Accounts for Board Exam 2024 #cbse

Format of Cash Flow Statement:

Cash Flow from Three Different Activities

1. Format of Cash Flow from Operating Activities

* Net profit before taxation and extraordinary items is calculated as:

2. Format of Cash Flow from Investing Activities
3. Format of Cash Flow from Financing Activities
5. Understanding Corporate Annual Reports
A Corporate Annual Report typically includes:

● Balance Sheet
● Profit & Loss Statement
● Cash Flow Statement
● Notes to Accounts (disclosures about accounting policies, related party
transactions, etc.)
● Management Discussion and Analysis (MDA)

Example: Using an actual annual report from a public company (e.g., Reliance Industries,
Tata Motors) will provide details on these financial statements, disclosures, and performance
over the year.

SYLLABUS

Unit 3 (3 Weeks)
Global Accounting Standards/IFRS: Meaning & need for globalisation of
accounting standards, Adoption versus Convergence, Needfor convergence of
Indian GAAP with IFRS; Benefits of achieving Convergence with IFRSs to
different stakeholders in India. Salient features of Ind-AS/IFRS (Fair Value
Accounting, Substance versus form, Time value of money). Introduction to
Indian Accounting Standards (Ind-AS); Understanding IND-AS 1: Presentation
of Financial Statements, IND-AS 7: Cash Flow Statement, IND-AS 109:
Financial Instruments.

Unit 3: Global Accounting

Standards/IFRS
In the contemporary business world, global financial integration has necessitated a
standardized approach to accounting practices, which led to the development of
International Financial Reporting Standards (IFRS). This unit focuses on
understanding the need for global accounting standards, the adoption versus
convergence debate, the benefits of convergence for India, and specific Indian
Accounting Standards (Ind-AS) that align with IFRS.

1. Global Accounting Standards/IFRS: Meaning & Need

for Globalisation of Accounting Standards
A. Meaning of Global Accounting Standards

Global Accounting Standards are standardized accounting principles that

companies worldwide must adhere to when preparing financial statements. The main
set of global accounting standards is the International Financial Reporting
Standards (IFRS), which are developed by the International Accounting
Standards Board (IASB).

B. Need for Globalisation of Accounting Standards

The globalization of businesses and the interconnectedness of financial markets

have created a strong need for uniform accounting standards. The reasons for
adopting global accounting standards include:

● Facilitation of Cross-border Investments: Investors find it easier to

compare financial statements from companies in different countries if the
same set of accounting standards is followed.
● Improved Transparency: Standardization promotes transparency in financial
reporting, which reduces the possibility of fraudulent financial practices.
● Enhanced Market Efficiency: With consistent accounting practices, markets
can function more effectively, as information asymmetry is reduced.
 ● Globalization of Trade: As businesses expand internationally, the adoption
of global standards helps streamline their financial reporting, making it easier
to assess financial health across borders.

2. Adoption versus Convergence

A. Adoption of IFRS

● Full Adoption refers to the implementation of IFRS standards in their entirety

as the official accounting standard in a country.
● Example: Countries like the European Union and Canada have adopted
IFRS, where companies are required to prepare their financial statements
based on IFRS without modifications.

B. Convergence of Indian GAAP with IFRS

● Convergence refers to aligning a country’s existing accounting standards

with IFRS while maintaining some of its local practices. This approach allows
countries to retain certain unique provisions while ensuring compatibility with
global standards.
● India chose the Convergence Approach by aligning its Indian GAAP
(Generally Accepted Accounting Principles) with IFRS, creating Ind-AS.

Adoption vs. Convergence:

● Adoption means full implementation of IFRS, while convergence is about

aligning national standards with IFRS over time.
● Convergence is seen as a more flexible approach, allowing countries to
retain certain elements of their local standards while benefiting from global
harmonization.

3. Need for Convergence of Indian GAAP with IFRS

A. Reasons for Convergence

1. Global Integration: India, being one of the world’s largest economies, needs
to ensure that its financial reporting is aligned with global standards to attract
foreign investments.
2. Improved Comparability: Convergence with IFRS allows investors to
compare the financial statements of Indian companies with those from other
countries.
3. Enhanced Credibility: Convergence helps improve the credibility of Indian
companies in the global marketplace, ensuring their financial statements are
accepted globally.
 4. International Reporting Requirement: Many international investors and
companies demand financial reports based on IFRS. Convergence allows
Indian companies to comply with these expectations.

B. Benefits of Achieving Convergence with IFRS to Different

Stakeholders in India

1. To Investors:
○ Easier comparison between Indian companies and global peers.
○ Improved transparency and reduced information asymmetry.
2. To Companies:
○ Access to global capital markets due to adoption of global reporting
standards.
○ Easier communication with foreign investors, leading to improved
investment inflows.
3. To Regulators:
○ Consistent monitoring of financial activities in the global context.
○ Facilitates better enforcement of financial regulations on global
standards.
4. To Auditors:
○ Standardized procedures for auditing financial statements.
○ Reduces the complexity of auditing companies with cross-border
operations.

4. Salient Features of Ind-AS/IFRS

A. Fair Value Accounting

● Fair Value refers to the price at which an asset could be bought or sold in an
orderly transaction between market participants at the measurement date.

● Under IFRS, certain assets and liabilities are measured using fair value,
which provides a more accurate reflection of the market value compared to
historical cost.

Example: For investment in marketable securities, IFRS requires that the

securities be measured at fair value, which fluctuates with market prices.

B. Substance Over Form

● This principle states that the economic substance of transactions should be

recognized rather than just their legal form. In other words, the financial
statements should reflect the real economic impact of transactions and
events, rather than merely the way they are structured legally.

Example: A lease agreement classified as an operating lease in legal terms

could still be treated as a finance lease in financial reporting if the substance
 of the lease is similar to a purchase.

C. Time Value of Money

● The time value of money concept recognizes that money received today is
worth more than the same amount received in the future due to its potential
earning ability. IFRS requires that the time value of money be considered
when calculating the value of long-term liabilities or assets.

Example: The discounting of future cash flows for determining the present
value of pension liabilities or long-term debt.

5. Introduction to Indian Accounting Standards (Ind-AS)

Ind-AS represents the Indian adaptation of IFRS, with certain modifications for the
Indian context. The Institute of Chartered Accountants of India (ICAI) issued
these standards, aligning India’s accounting practices with global norms.

A. Importance of Ind-AS:

1. Better Comparability: Indian companies can now have their financials

comparable with global counterparts.
2. Improved Transparency: Aligning with IFRS improves the clarity and
transparency of financial statements.
3. Global Investment Access: Ind-AS-compliant companies can attract foreign
investors, boosting capital flows into India.

6. Key Ind-AS Standards

A. IND-AS 1: Presentation of Financial Statements

This standard outlines the overall framework for the presentation of financial
statements, ensuring that the financial statements of companies provide a clear and
accurate picture of their financial position.

Key Features:

● General Requirements: Financial statements must provide a true and fair view
of the financial performance, position, and cash flows.
● Components of Financial Statements:
○ Balance Sheet: A statement of financial position at the end of the
reporting period.
○ Statement of Profit and Loss: Reflects the financial performance over
a specific period.
 ○ Cash Flow Statement: Summarizes the cash inflows and outflows.
○ Notes: Notes to the financial statements providing additional detail and
explanations.

Example:

Under Ind-AS 1, the statement of profit and loss should clearly separate operating
profit, financial expenses, and non-operating income.

B. IND-AS 7: Cash Flow Statement

IND-AS 7 governs the preparation of the Cash Flow Statement, which provides
information about the cash inflows and outflows of an entity, classified under three
categories:

● Operating Activities: Cash flows directly related to operations (e.g., receipts

from customers, payments to suppliers).
● Investing Activities: Cash flows related to the purchase and sale of long-
term assets (e.g., purchase of equipment).
● Financing Activities: Cash flows related to borrowing and repaying loans or
issuing shares (e.g., issuance of capital stock).

Example:

A company might show cash inflows from operations as ₹5,00,000, cash outflows for
investing activities (e.g., purchasing machinery) as ₹2,00,000, and financing
activities (e.g., repaying loans) as ₹1,50,000.

C. IND-AS 109: Financial Instruments

IND-AS 109 establishes principles for the recognition, measurement, and

derecognition of financial instruments. It also defines how to account for and report
financial instruments, including:

● Financial Assets: Investments, loans, and receivables.

● Financial Liabilities: Borrowings, trade payables, etc.
● Equity Instruments: Stocks and shares.

Key Features:

● Classification of Financial Instruments: Financial instruments are classified

into amortized cost, fair value through profit or loss (FVTPL), or fair value
through other comprehensive income (FVTOCI).
● Impairment of Financial Assets: Provision for expected credit losses for
financial assets carried at amortized cost.

Example:

A company holding debt instruments that meet the conditions for amortized cost
would measure and report these instruments using the amortized cost method,
considering interest income and impairment losses.
SYLLABUS

Unit 4
Analysing Financial Statements: Objectives of Financial Statement
Analysis; Sources of information; Standards of Comparison; Techniques
of Financial Statement Analysis (Through a case study of real company)
- Ratio analysis, Cash flow analysis, Net working capital analysis, Trend
analysis. Use of ratios to predict financial crisis of a company by using
Altman Z –score. Use of Beyond the Balance Sheet indicators of
analysing financial position of a company. Introduction to Earnings
Management.

Unit 4: Analyzing Financial Statements

.

1. Objectives of Financial Statement Analysis

The primary objectives of financial statement analysis are:
 1. Evaluating Financial Health: By analyzing financial statements,
stakeholders can determine whether the company is in a sound
financial position to meet its obligations, grow, and create value.
2. Profitability Assessment: This helps to measure the company's
ability to generate profit relative to its revenue, assets, or equity.
3. Liquidity Evaluation: It assesses a company’s ability to meet
short-term obligations with its current assets.
4. Operational Efficiency: Financial statement analysis can
determine how efficiently a company is utilizing its resources to
generate revenue.
5. Investment Decision: Investors use the analysis to evaluate
whether they should invest in or withdraw from a company’s stock.
6. Creditworthiness: Creditors use the analysis to decide whether to
lend money to a company and under what terms.
7. Trend Analysis: This involves comparing financial data over time
to identify patterns and potential issues.

2. Sources of Information
The main sources of information for financial statement analysis include:

1. Company's Financial Statements:

○ Balance Sheet (Statement of Financial Position)

○ Profit & Loss Account (Income Statement)
○ Cash Flow Statement
○ Statement of Changes in Equity
2. Notes to the Accounts: Provide detailed explanations of
accounting policies, contingent liabilities, and other financial
transactions not apparent in the main financial statements.

3. Annual Reports: Typically include audited financial statements,

management discussion, and analysis, which provide context to
the numbers.

4. Industry Reports: Provide comparative data from similar

companies in the same industry.

5. Stock Market Data: Publicly listed companies often provide

relevant information through quarterly earnings reports, stock
performance, and analyst opinions.
3. Standards of Comparison
When analyzing financial statements, it is essential to have some
standards of comparison to assess a company's performance
accurately. These include:

1. Historical Comparison: Comparing the company's current

performance with its past performance. This helps in
understanding trends in profitability, liquidity, and solvency over
time.

2. Industry Standards: Comparing the company’s financial ratios

and performance with industry averages. This provides context
about whether the company is outperforming or underperforming
its peers.

3. Benchmarking: This involves comparing a company with a set of

leading competitors or industry leaders in terms of key financial
metrics.

4. Budgetary Standards: Comparing actual performance with

budgeted or forecasted figures to assess variances.

4. Techniques of Financial Statement Analysis

A. Ratio Analysis

Ratio analysis is one of the most common techniques used to analyze

financial statements. Ratios provide a quick way to assess the
performance, financial health, and potential issues of a company.

Ratio Analysis video : One Shot | Accounting Ratios | Class 12 | All

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Term 1 Most Important | Must Revise Before Exam

B. Cash Flow Analysis

Cash flow analysis is important because a company may report profits,

but if it does not have sufficient cash flows, it may struggle to pay its bills
or invest in growth opportunities. Cash flow analysis helps identify the
source and use of cash and measures a company's liquidity.
Key Types of Cash Flows:

● Operating Cash Flow: Cash generated or used by core business

activities.
● Investing Cash Flow: Cash used or generated from buying or
selling investments or long-term assets.
● Financing Cash Flow: Cash received from or paid to
shareholders or creditors (e.g., issuing bonds or paying dividends).

C. Net Working Capital Analysis

Net Working Capital (NWC) measures a company's short-term financial

health and its efficiency in using its assets and liabilities. It is calculated
as:

Net Working Capital=Current Assets−Current Liabilities

A positive NWC indicates that the company can cover its short-term
obligations with its current assets. A negative NWC might indicate
liquidity problems.

D. Trend Analysis

Trend analysis involves analyzing financial data over several periods to

identify patterns and trends. This analysis is useful for forecasting future
performance and identifying areas of concern.
Example:

If a company has been increasing its debt levels over the past few years,
trend analysis might indicate a rising risk of solvency problems in the
future, prompting corrective actions.

5. Use of Ratios to Predict Financial Crisis (Altman Z-

Score)
The Altman Z-score is a tool used to predict the likelihood of a company
going bankrupt. It is calculated using several financial ratios and is
commonly used to assess the financial health of manufacturing
companies.

The Z-score formula is:

ζ = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

● Zeta (ζ) is the Altman’s Z-score

● A is the Working Capital/Total Assets ratio
● B is the Retained Earnings/Total Assets ratio
● C is the Earnings before Interest and Tax/Total Assets ratio
● D is the Market Value of Equity/Total Liabilities ratio
● E is the Total Sales/Total Assets ratio

What Z-Scores Mean?

The Z-Score can be interpreted in terms of its numeric value. Different

ranges of Z-Scores indicates different risk levels of bankruptcy which is
discussed as below:

a) Z-score < 1.8: If the Z-score is low, then it indicates higher chances
of a company going for bankruptcy. A Z-score lower than 1.8 implies that
the company is in deep financial distress and there exists higher
chances of company going bankrupt.

b) Z-score >1.8 and <3: A score of between 1.8 and 3 implies that the
company is in a grey area and face a moderate risk of filing for
bankruptcy. In other words, there is no immediate problem or danger to
face inability to meet long term debt obligations.
c) Z-score>3: A Z-score of 3 and above implies that the company is in a
safer zone and there are very less chances to file for bankruptcy.

Altman’s Z-score is used by investors to decide whether to buy or sell a

company’s stock, depending on the financial strength.

If there is a company with a Z-score near to 3, investors will be

purchasing the company’s stock because there is very less risk of the
company going bankrupt in the coming two years.

If a company shows a Z-score closer to 1.8, the investors will sell the
company’s stock to avoid losing their investments because such a lower
score implies a high probability of going bankrupt.

6. Beyond the Balance Sheet Indicators

While traditional financial statement analysis focuses on the balance
sheet, income statement, and cash flow statement, Beyond the
Balance Sheet indicators provide additional insights into a company’s
financial health. These include:

● Brand Value and Intangible Assets: Companies with strong

brands, patents, or intellectual property often have substantial
intangible assets that aren't reflected in traditional financial
statements.
● Customer Loyalty and Retention Rates: High customer loyalty
can indicate a strong future revenue stream, though it’s not directly
shown in financial statements.
● Employee Engagement: Companies with highly engaged
employees are often more productive and have lower turnover
rates, which indirectly boosts profitability.
● Market Share and Competitive Advantage: A company’s
position in its market and the strength of its competitive advantage
can affect its long-term financial stability.

7. Introduction to Earnings Management

Earnings management refers to the use of accounting techniques to
influence reported financial results. Companies may manage earnings to
meet analysts’ expectations, smooth out fluctuations, or achieve specific
financial targets.
Common Techniques:

● Revenue Recognition:
Accelerating or delaying revenue recognition to
meet financial targets.
● Expense Recognition: Capitalizing operating expenses or
deferring expenses to improve current-period profits.
● Off-Balance-Sheet Financing: Using special purpose entities
(SPEs) or other methods to keep liabilities off the balance sheet.
Example:

A company might delay recognizing a sale until the next period to

improve