Corporate Finance 9th Edition Chapter 6 Question 30
Financial statements and reports are prepared from the output of the accounting function produced by the accounting and then communicated to the financial analysts as the users of the financial statements. The function of the financial analyst begins in terms of the termination of the accountant's post to complete a substantial financial function of the entity's functions related to the accounting function and not separate from it. The function of the financial analyst is based on the analysis of the financial statements, which is one of the main tools used in the financial and economic decision-making by the various parties related to the entity such as management, employees, investors, shareholders, lenders, customers, the government and the public in general. The analysis of the financial statements includes a set of basic and useful topics that the student can understand. The most prominent of these topics are the theoretical framework of financial analysis, the study of financial statements, the statement of funds flows, the cash flow statement and financial analysis by using financial ratios and prediction financial failures of companies and banks. This book was prepared in a simplified methodology for the student and the reader to ensure the translation of terms and titles and some important texts into Arabic, as well as that the topics of the book were based on syllabus approved by the Sectoral Committee of the Faculty of Management and Economics in the Ministry of Higher Education and Scientific Research. We hope that the modest scientific effort in this book will ensure the acceptance and satisfaction of students and readers to take advantage of practical and professional life.
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1
ANALYSIS
OF
FINANCIAL STATEMENTS
Prof.Dr. Saoud Chayed Mashkour Alamry
Muthanna University
First Edition
2020
2
Copy right: All rights reserved International and local laws and regulations strictly prohibit the
printing of a limited number of pages or all pages of this book, using
any method of printing, photocopying, reproduction, display,
translation, audiovisual, computer and other technical means without
the written consent of the author.
Copy right ©
All rights reserved
Second Edition: 2020
Book : Analysis of Financial
Statements
Author: Dr. Saoud Ch. MASHKOOR
3
Introduction
Financial analysis has emerged since the beginning of the financial function
as an independent function and as other functions in the firm and has emerged
specifically in 1900 when field studies were conducted using the analysis in the study
of the financial position of the enterprises. This function of Financial analysis was in
the United States of America in 1900, when a study was conducted on 981
companies through the use of seven financial ratios to study the status of these
companies
Financial analysis generally functions as the basis for the development of this
function. It also follows the developments in both the financial and accounting
functions that, after the Second World War, became the basic rule from which the
function of financial management and accounting function was launched until it
became an integral part of the administration Financial and autonomous subject
taught in universities and schools specialized in the field of finance and business
The concept of financial analysis is based on two types of analysis: Ratio
Financial Analysis and Quantitative Analysis. Analysis generally means diagnosing a
situation and highlighting weaknesses or strengths
The concept of analysis using ratios is based on the definition of the ratio,
where (%) means "the relationship between two variables or two items that share
common characteristics or a similar situation". If the analysis is based on ratios, it is
intended to establish relationships between two accounting variables that have
common relationships or characteristics to study a particular case
The concept of analysis using quantitative methods can be said to have been
used in the second half of the twentieth century as a result of the evolution of
financial function in the field of business and financial decision-making. Then the
analysis using quantitative methods is the method that uses quantitative methods in
the analysis of phenomena or activities carried out by organizations and the creation
of relationships between the variables that control the direction of its activities and
decisions to organize events such as investments, loans and financial portfolios and
other programs
4
The syllabus of this book contains all the topics which are adopted by the
Accounting Sectorial Committee, in Iraq Ministry ofHigher Education and Scientific
Research, for the third class in Colleges of Administration & Economic, the chapters
of this book are the following:-
Chapter (1) : Overview of Financial Statements Analysis
Chapter (2): Financial Statements
Chapter (3): Financial Statements Analysis Preview
Chapter (4): Fund Flow Statement
Chapter (5): Cash Flow Analysis
Chapter (6 ): Analyzing the Activities of Cash Flows Statement
Chapter (7): Common Size Analysis
Chapter (8): Financial Ratios Analysis
Chapter (9): Financial Leverage
Chapter (10): Predict Financial Failure
We hope that all the students, professional, and users will easily be find out
their interests and benefits in this book, because it involve many subjects in financial
analysis supported by practical examples and exercises. In addition, this book
includes a translation of all the terms, titles and some important texts from English to
Arabic in order to simplify the process of understanding. We hope that we have
succeeded in accomplishing this modest scientific work.
The Author
2020
5
Table of Contents
Chapter (1) : Overview of Financial Statements Analysis
Introduction to Financial Analysis
Types of Financial Analysis
Components of Financial Analysis
♦ Questions
Chapter (2): Financial Statements
Basic of Analysis
Business Activities
Financial Statements Reflect Business Activities
Additional Information
♦ Questions and Exercises
Chapter (3): Financial Statements Analysis Preview
Analysis Tools
Valuation Models
Analysis in an Efficient Market
Financial Reporting and Analysis :
Reporting Environment
Statutory Financial Reports
Factors Affecting Statutory Financial Reports
♦ Questions and Exercises
Chapter (4): Fund Flow Statement
Concept of Fund
Fund Flow Statement (Meaning)
Important Definitions of Fund Flow Statements
Uses/Advantages of Fund Flow Statement (FFS):
Limitations / Disadvantages of Fund Flow Statement
(FFS):
6
Preparation of Fund Flow Statement
♦ Questions and Exercises
Chapter (5): Cash Flow Analysis
Statement of Cash Flows
Relevance of Cash
Reporting by Activities
Constructing the Cash Flow Statement
Special Topics
Direct Method
Analysis Implications of Cash Flows
♦ Questions
Chapter (6 ): Analyzing the Activities of Cash Flows Statement
Analyzing Operating Activities
Analyzing Investing Activities
Analyzing Financing Activities
♦ Questions
Chapter (7): Common Size Analysis
What is Common Size Analysis?
Types of Common Size Analysis
Importance of Common Size Analysis
Vertical Common Size Analysis
Horizontal Common Size Analysis
♦ Questions
Chapter (8): Financial Ratios Analysis
Liquidity Ratio
Activity Ratio
Profitability Ratio
Solvency Ratio
Project Evaluation
7
Investment Policies
♦ Questions and Exercises
Chapter (9): Financial Leverage
Concept of Leverage Ratios
Leverage Ratios
Degree of Financial Leverage
Leverage Degree Analysis
♦ Questions?
Chapter (10): Predict Financial Failure
Predict of Financial Failure
Predict Financial Failure Models
♦ Questions and Exercises
8
CHAPTER (1)
Overview
of
Financial Statements Analysis
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Introduction to Financial Analysis
Financial Statement Analysis (Meaning)
Definitions of Financial Statement Analysis
Users of Financial Statements Analysis
Types of Financial Analysis
Components of Financial Analysis
9
CHAPTER 1
Overview
of
Financial Statements Analysis
Introduction to Financial Analysis
Financial Statement Analysis is a method of reviewing and analyzing a
company's accounting reports (financial statements) in order to gauge its past,
present or projected future performance. This process of reviewing the financial
statements allows for better economic decision making.
Globally, publicly listed companies are required by law to file their financial
statements with the relevant authorities. For example, publicly listed firms in America
are required to submit their financial statements to the Securities and Exchange
Commission (SEC). Firms are also obligated to provide their financial statements in
the annual report that they share with their stakeholders. As financial statements are
prepared in order to meet requirements, the second step in the process is to analyze
them effectively so that future profitability and cash flows can be forecasted.
10
The main purpose of financial statement analysis is to utilize information
about the past performance of the company in order to predict how it will fare in the
future. Another important purpose of the analysis of financial statements is to identify
potential problem areas and troubleshoot those.
Financial Statement Analysis (Meaning)
1. Financial statement analysis is an analysis which highlights the important
relationships in the financial statements.
2. It focuses on evaluation of past operations as revealed by the analysis of basic
statements.
3. Financial statement analysis embraces the methods used in assessing and
interpreting the result of past performance and current financial position as they
relate to particular factors of interest in investment decisions.
4. Financial statement analysis is an important means of assessing past
performance and in forecasting and planning future performance.
5. Financial statement analysis is a systematic and specialized arrangement of
information for the purpose of its interpretation.
Definitions of Financial Statement Analysis
(a) "Financial statement analysis is an information processing system designed
to provide data for decision-making models, such as the portfolio selection
model, bank lending decision models and corporate financial management
models."
. "
(b) "Financial statements analysis is largely a study of relationship among the
various financial factors in a business as disclosed by a single set of
statements and a study of the trends of these factors as shown in series of
statements."
11
"
Users of Financial Statements Analysis
There are different users of financial statement analysis. These can be
classified into internal and external users. Internal users refer to the management of
the company who analyzes financial statements in order to make decisions related to
the operations of the company. External users do not necessarily belong to the
company but still hold some sort of financial interest. These include owners,
investors, creditors, government, employees, customers, and the general public.
These users are elaborated on below:
1. Management
The managers of the company use their financial statement analysis to make
intelligent decisions about their performance. For instance, they may gauge cost per
distribution channel, or how much cash they have left, from their accounting reports
and make decisions from these analysis results.
2. Owners
Small business owners need financial information from their operations to
determine whether the business is profitable. It helps in making decisions like
whether to continue operating the business, whether to improve business strategies
or whether to give up on the business altogether.
3.Investors
Investors who have purchased shares in a company need financial
information to known the method which used by the company in performance
evaluation process. The investors use financial statement analysis to determine what
to do by through their investments in the company, So depending on how the
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company is doing, the investors will either hold onto their shares, sell them or buy
more.
4. Creditors
Creditors are interested in knowing if a company will be able to pay its debts
or loans as they become due. The creditors use cash flow analysis of the company's
accounting records to measure the company's liquidity, or its ability to make short-
term payments.
5. Government
Governing and regulating bodies of the state look at financial statement
analysis to determine how the economy is performing in general so they can plan
their financial and industrial policies. Tax authorities also analyze a company's
statements to calculate the tax burden that the company has to pay.
6.Employees
Employees need to know if their employment is secure and if there is a
possibility to increase their salaries. The employees want to be abreast of their
company's profitability and stability. Employees may also be interested in knowing
the company's financial position to see whether there may be plans for expansion
and hence, career prospects for them.
7.Customers
Customers need to know about the ability of the company to service its clients
into the future. The need to know about the company's stability of operations is
heightened if the customer (i.e. a distributor of specialized products) is dependent
wholly on the company for its supplies.
8.General Public
Anyone in the general public, like students, analysts and researchers, may be
interested in using a company's financial statement analysis. They may wish to
evaluate the effects of the firm on the environment, or the economy or even the local
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community. For instance, if the company is running corporate social responsibility
programs for improving the community, the public may want to be aware of the future
operations of the company.
Types of Financial Analysis
The classification of financial analysis can be made either on the basis of
material used for the same or according to modus operandi of the analysis.
(A) According to Material Used
(a) External Analysis
1. This is effected by those who do not have access to the detailed accounting
records of the concern.
2. This group comprising investors, credit agencies, government and public
depends almost entirely on published financial statements.
3. With the recent development in the government regulations requiring business
concern to make available detailed information to the public through audited
accounts, the position of the external analysis has been considerably
improved.
(b)Internal Analysis
1. This is effected by those who have access to the books of accounts and other
information relating to the business concern.
2. Any financial analysis conducted with reference to a part or the whole unit.
3. This type of analysis is meant for managerial purpose and is conducted by
executives and employees of the business concerns as well as governmental
agencies which have statutory control and jurisdiction over such units.
(B) According to Modus Operandi of Analysis
(a) Horizontal Analysis
1. When financial statements for a certain number of years are examined and
analyzed, the analysis is called "Horizontal Analysis."
2. Horizontal analysis is also called "Dynamic Analysis ".
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3. This is based on the data or information spread over a period of years rather
than on one date or period of time as a whole.
(b) Vertical Analysis
1. This refers to analysis of ratios developed for one date and for one accounting
period.
2. Vertical analysis is also known "Static Analysis ".
3. Vertical analysis does not facilitate a proper analysis and interpretation of
figures in perspective and also comparisons over a period of years. As such
this type of analysis is not generally resorted to by the financial analysts.
Advantages and Disadvantages of Methods of Financial
Statements Analysis
There are two main methods of analyzing financial statements: horizontal or
trend analysis, and vertical analysis. These are explained below along with the
advantages and disadvantages of each method.
Horizontal Analysis
Horizontal analysis is the comparison of financial information of a company
with historical financial information of the same company over a number of reporting
periods. It could also be based on the ratios derived from the financial information
over the same time span. The main purpose is to see if the numbers are high or low
in comparison to past records, which may be used to investigate any causes for
concern.
This method of analysis is simply grouping together all information, sorting
them by time period: weeks, months or years. The numbers in each period can also
be shown as a percentage of the numbers expressed in the baseline
(earliest/starting) year. The amount given to the baseline year is usually 100%. This
analysis is also called dynamic analysis or trend analysis.
15
Advantages and Disadvantages of Horizontal Analysis
When the analysis is conducted for all financial statements at the same time,
the complete impact of operational activities can be seen on the company's financial
condition during the period under review. This is a clear advantage of using
horizontal analysis as the company can review its performance in comparison to the
previous periods and gauge how it's doing based on past results
A disadvantage of horizontal analysis is that the aggregated information
expressed in the financial statements may have changed over time and therefore will
cause variances to creep up when account balances are compared across periods
Horizontal analysis can also be used to misrepresent results. It can be
manipulated to show comparisons across periods which would make the results
appear stellar for the company.
Vertical Analysis
Vertical analysis is conducted on financial statements for a single time period
only. Each item in the statement is shown as a base figure of another item in the
statement, for a given time period, usually for year. Typically, this analysis means
that every item on an income and loss statement is expressed as a percentage of
gross sales, while every item on a balance sheet is expressed as a percentage of
total assets held by the firm Vertical analysis is also called static analysis because it
is carried out for a single time period.
Advantages and Disadvantages of Vertical Analysis
Vertical analysis only requires financial statements for a single reporting
period. It is useful for inter-firm or inter-departmental comparisons of performance as
16
one can see relative proportions of account balances, no matter the size of the
business or department.
Because basic vertical analysis is constricted by using a single time period, it
has the disadvantage of losing out on comparison across different time periods to
gauge performance. This can be addressed by using it in conjunction with timeline
analysis, which shows what changes have occurred in the financial accounts over
time, such as a comparative analysis over a three-year period. For instance, if the
cost of sales comes out to be only 30 percent of sales each year in the past, but this
year the percentage comes out to be 45 percent, it would be a cause for concern.
Components of Financial Analysis
The first step toward improving financial literacy is to conduct a financial
analysis of your business. A proper analysis consists of five key areas, each
containing its own set of data points and ratios.
1. Revenues
Revenues are probably your business's main source of cash. The quantity,
quality and timing of revenues can determine long-term success.
Revenue growth (revenue this period - revenue last period) ÷ revenue
last period. When calculating revenue growth, don't include one-time
revenues, which can distort the analysis.
Revenue concentration (revenue from client ÷ total revenue). If a single
customer generates a high percentage of your revenues, you could face
financial difficulty if that customer stops buying. No client should represent
more than 10 percent of your total revenues.
Revenue per employee (revenue ÷ average number of employees). This
ratio measures your business's productivity . The higher the ratio, the better.
17
Many highly successful companies achieve over one million Dinar in annual
revenue per employee.
2. Profits
If you can't produce quality profits consistently, your business may not survive
in the long run.
Gross profit margin (revenues – cost of goods sold) ÷ revenues. A
healthy gross profit margin allows you to absorb shocks to revenues or cost of
goods sold without losing the ability to pay for ongoing expenses.
Operating profit margin (revenues – cost of goods sold – operating
expenses) ÷ revenues. Operating expenses don't include interest or taxes.
This determines your company's ability to make a profit regardless of how you
finance operations (debt or equity). The higher, the better.
Net profit margin (revenues – cost of goods sold – operating expenses –
all other expenses) ÷ revenues. This is what remains for reinvestment into
your business and for distribution to owners in the form of dividends.
3. Operational Efficiency
Operational efficiency measures how well you're using the company's
resources. A lack of operational efficiency leads to smaller profits and weaker
growth.
Accounts receivables turnover (net credit sales ÷ average accounts
receivable). This measures how efficiently you manage the credit you extend
to customers. A higher number means your company is managing credit well;
a lower number is a warning sign you should improve how you collect from
customers.
18
Inventory turnover (cost of goods sold ÷ average inventory). This
measures how efficiently you manage inventory. A higher number is a good
sign; a lower number means you either aren't selling well or are producing too
much for your current level of sales.
4. Capital Efficiency and Solvency
Capital efficiency and solvency are of interest to lenders and investors.
Return on equity (net income ÷ shareholder's equity). This represents the
return investors are generating from your business.
Debt to equity (debt ÷ equity). The definitions of debt and equity can vary,
but generally this indicates how much leverage you're using to operate.
Leverage should not exceed what's reasonable for your business.
5. Liquidity
Liquidity analysis addresses your ability to generate sufficient cash to cover
cash expenses. No amount of revenue growth or profits can compensate for poor
liquidity.
Current ratio (current assets ÷ current liabilities). This measures
your ability to pay off short-term obligations from cash and other current
assets. A value less than 1 means your company doesn't have sufficient liquid
resources to do this. A ratio above 2 is best.
Interest coverage (earnings before interest and taxes ÷ interest
expense). This measures your ability to pay interest expense from the cash
you generate. A value less than 1.5 is cause for concern to lenders.
Exercise
The following information abstracted from a company books for the financial
year ended 31/12/2020. (Amounts in thousands)
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1 - The profit and loss account for the year ended 31/12/2020
Total revenues
(-) Cost of goods sold
= Profit before extraordinary items
+ Net capital gains and losses(100,000 – 130,000
capital gains capital losses)
= Profit before interest and taxes
(-) Interest
= Profit before tax
(-) Taxes
2 - The Balance sheet as it is in 31/12/2020
5,000,000
1,200,000
1,500,000
750,000
190,000
Equity
Reserves are not subject to tax
Long-term loans (8%)
Current liabilities
Revenue received in advance
3,000,000
(400,000)
2,600,000
640,000
3,300,000
1,200,000
900,000
Fixed Assets
(-) depreciation Accum.
Net fixed assets
Prepaid expenses
Stock
Accounts receivable
Cash
Additional information
Revenue last period 2,000,000
Revenue from client 1,500,000
Average number of employees 1,500
Required: - calculate the following:
1. Revenue growth
2. Revenue concentration
3. Revenue per employee
4. Gross profit margin
5. Operating profit margin
6. Net profit margin
20
7. Accounts receivable turnover
8. Inventory turnover
9. Rate of return on equity
10. Total Debt to equity Ratio
11. Current ratio
12. Interest coverage
Solution
1.
Revenue growth = (revenue this period - revenue last period) ÷ revenue last
period
2,500,000 – 2,000,000 2,000,000 = 0.25 = 25%
2. Revenue concentration = (revenue from client ÷ total revenue)
1,500,000 2,500,000 = 0.6 = 60%
3. Revenue per employee = (total revenue ÷ average number of employees)
2,500,000 =
4. Gross profit margin = (total revenues – cost of goods sold) ÷ revenues
2,500,000 – 1,500,000 , , = 0.40 = 40%
5. Operating profit margin (total revenues – cost of goods sold – operating
expenses) ÷ total revenues.
(2,500,000 – 1,500,000 – 450,000) ÷ 2,500,000 = 0.22 = 22%
6. Net profit margin (revenues – cost of goods sold – operating expenses – all
other expenses) ÷ revenues.
(2,500,000 – 1,500,000 – 450,000 – 252,000) ÷ 2,500,000 = 0.12 = 12%
7. Accounts receivables turnover= (net credit sales ÷ average accounts
receivable).
1,000,000 ÷ 1,200,000 = 0.83
8. Inventory turnover = (cost of goods sold ÷ average inventory)
1,500,000 ÷ 3,, = 0.45 = 45%
9. Return on equity = (net income ' shareholder's equity)
268,000 6,200,000 = 0.043 = 4,3%
10. Debt to equity (debt ÷ equity).
21
2,440,000 6,200,000 = 0.3935= 39.35%
11. Current ratio (current assets ÷ current liabilities).
6,040,000 940,000 = 6.425
12. Interest coverage (earnings before interest and taxes ÷ interest expense).
120,000 = 4.333 520,000
Questions
1. What do you mean by financial statements ?
2. Define of Financial Statement Analysis.
3. What are the Users of Financial Statements Analysis?
4. Explain the Types of Financial Analysis.
5. Classifies the methods of financial analysis.
6. Explain the External Analysis.
7. Explain the Internal Analysis.
8. Define Horizontal Analysis.
9. Define Vertical Analysis.
10. Explain Advantages and Disadvantages of Horizontal Analysis.
11. Explain Advantages and Disadvantages of Vertical Analysis.
12. What are the Components of financial analysis?
22
CHAPTER (2)
Financial Statements
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Basic of Analysis
Financial Statements (meaning)
Important Definitions of Financial Statements
Nature of Financial Statements
Objectives of Financial Statements
Importance of Financial Statements
Interpretation of Financial Statements
Business Activities
Financial Statements Reflect Business Activities
Additional Information
Elements of Financial Statements
Chart of Accounts
Basic Financial Statements
Preparation of Final Accounts of Sole Proprietary Firm
23
Making Financial Decisions on the Basis of Financial
Statements
CHAPTER (2)
Financial Statements
Introduction
Financial statements are the final outputs for applying the accounting cycle which
supply with creditable, relevant, and timely financial information to take rational
economic decision.
The object of a firm is to get profit. It is something of vital importance to all firms. The
profit made by a firm is the difference between the total revenues earned and the
total expenses incurred during a particular period of time. The owner is also
interested to know their financial position. The preparation of Trading and Profit and
Loss Account and Balance Sheet is known as the preparation of final accounts.
Basic of Analysis
Financial Statements (meaning)
1. Financial Statement is a statement prepared for evaluating past performance
and predicting future performance.
2. Financial Statements are regarded as indices of business enterprises
performance and position.
3. The term 'Financial statement' as used in modern accounting refers to two
statements, the position statement reflecting the assets, liabilities and capital
24
of a business entity on a particular date called the balance sheet, and the
other called the profit and loss account showing the results of the business
operations during a given period.
Important Definitions of Financial Statements
(a) ―The financial statements provide a summary of the accounts of a business
enterprise , the balance sheet reflecting the assets , liabilities and capital as
on a certain data and the income statements showing the results of
operations during a certain period ―. (John N. Meyer 2009).
(b) ―The end product of financial accounting is a set of financial statements
prepared by the accountant of a business enterprise that purport to reveal the
financial position of the enterprise the result of its recent activities, and an
analysis of what has been done with earnings''. (Smith and Ashburn 2017 ).
Nature of financial statements
6. The American institute of certified public accountants (AICPA) states the nature
of financial statements as , ―financial statements are prepared for the purpose
of presenting a periodical review or report on progress by the management and
deal with the status of investment in the business and the results achieved
during the period under review financial statements reflect a combination of
recorded facts, accounting principles and personal judgements ― .
7. Financial statements are plain statements based on historical recorded facts
and figures .
25
8. Financial statements reflect a judicious combination of recorded facts ,
accounting principles concepts and conventions, personal judgements and
estimates .
9. According to ( john N. Meyer 2009 ) , ―The financial statements are composed
of data which are the results of a combination of the following:
(1) Recorded facts concerning the business transactions .
(2) Conventions adopted to facilitate the accounting techniques .
(3) Postulates or assumptions made to , and
(4) Personal judgments used in the application of the conventions and
postulates .
Objectives of Financial Statements
1. To communicate to their interested users , quantitative and objective
information, this information is useful in making economic decisions.
2. To meet the specialized needs of conscious creditors and investors .
3. To provide reliable information about the earnings of business enterprise and
its ability to operate at a profit in future .
4. To provide financial base for tax assessments .
5. To provide valuable information for predicting the future earning power of the
enterprise .
6. To provide reliable information about the changes in economic resources .
7. To provide information about the changes in net resources of the organization
8. To provide reliable information about the changes in net economic resources.
9. To provide information about the changes in net resources of the organization
that result from profit directed activities.
10. To play a very important role in accounting and corporate reporting.
26
11. To regulate equity and debenture issues by companies.
Importance of Financial Statements
1. The financial statements are mirror which reflect the financial position of
operating strength or weakness of the business concern .
2. These statements are useful to management , investors , creditors, bankers ,
workers, government and public at large .
3. Financial statements are the indicators of two significant factors namely, the
profitability and financial soundness of a business enterprise.
4. The following major uses of financial statements which shows its importance .
(a) As a report of stewardship .
(b) As a basis of fiscal policy .
(c) To determine the legality of dividends.
(d) As a guide to dividend policy.
(e) As a basis for granting the credit.
(f) As informative for prospective investors in an enterprise.
(g) As guide to the value of investment already made.
(h) As an aid to government supervision.
(i) As a basis for price or rate regulation.
(j) As a basis for taxation.
Interpretation of Financial Statements
(1) Interpretation of financial statements is the mental process of understanding
the terms or the simple elements resulting from the analysis of the
compounded financial statements and forming opinions or inferences or
conclusions about the various aspect of a business enterprise , such as
solvency , profitability , efficiency etc .
(2) Interpretation Financial Statements which follows analysis of financial
statements, is an attempt to reach to logical conclusion regarding the position
and progress of the business on the basis of analysis .
(3) Interpretation Financial Statements aims to explain the meaning and
27
significance of the data simplified by analysis.
(4) Interpretation of financial statements is the process of drawing inferences or
conclusions about the various aspects of business .
(5) Integration Financial Statements aims to explain the meaning and significance
of the data simplified by analysis.
Business Activities
Business activity is the process of transforming inputs into outputs by addition value.
An accounting is a system that collects, records, stores, and processes data to
produce information for decision makers into several firms. The type of a business
depends on size of activity which is performed by the business .Thus the accounting
must be carefully addressed because of the tax, managerial, legal and liability
impacts that business formation has.
From Commercial and Legal angles, a business may be organized in many ways.
There are a number of different forms of Business firms. However, the common
forms of organizing are: Sole proprietorship, Partnership, Limited Company and
corporation.
1- Sole proprietorship
The Sole proprietorship is carried on by single individual. All the profits of the
business earn go to him. The sole proprietors' liability is unlimited, and he is
personally liable for paying of the debts.
2- A partnership
A partnership comprises a minimum of two and a maximum of (20) persons
trading together as one firm and sharing in the profits. In addition to sharing the
profits, each partner shares unlimited Liability for all the debts and obligations of the
firm and is responsible for the Liabilities in the firm of his fellow partners as well as
his own.
28
3- A Limited Company
A limited company is a Legal entity and is treated by the law like a natural person; it
must be run according to the rules set out by the company law. Among other
provisions, it is laid down that financial statement must be prepared and audited
every year and be made available for inspection on a public register.
4- Corporation
The Corporation structure consists of the shareholders and the board of directors.
The shareholders a point the board of directors to manage the company. The capital
of a company is divided into units of ownership called shares .The shares of a public
company are freely transferable from one individual to another.
Financial Statements Reflect Business Activities
Advantages of Analysis of Financial Statements
(a) Knowing the Exact Position
1. Everybody who is interested in knowing the exact financial position of the
concern is benefited by the 'analysis' of financial statement.
2. Interested party gets the valuable information about the exact facts and
figures of the concern by analyzing the financial statements by various
methods.
(b) Decision-making
1. Every interested party is in a position to assess the exact financial
position of the concern when it analyses financial statements of that
concern by reliable methods.
2. Thus, such an analysis ultimately helps that party in taking various types
of decisions such as investment, sale, purchase etc.
(c) Forecasting
After analyzing the financial statements, one is in a position to forecast
whether it would be profitable or not to invest in or to deal with the business concern.
29
Making Financial Decisions on the Basis of Financial Statements
1. The major advantage of financial statement analysis is to provide decision
makers information about our a business enterprise decision-making
2. Financial statements are used by financial institutions, loaning agencies,
banks and others to make sound loan or credit decisions.
3. Financial statements helps in predicting the earning prospects and growth
rate in earnings which are used by investors while comparing investment
alternatives and other users interested in judging the earning potential of
business enterprises.
4. Analysis of financial statements is a significant tool in predicting the
bankruptcy and failure probability of business enterprises.
5. Financial statement analysis is defined as the process of identifying financial
strengths and weaknesses of the firm - by properly establishing relationship
between the items of the balance sheet and the profit and loss account.
Disadvantages of Analysis of Financial Statements
(a) Completely Ignore Current Costs
Financial analysis is always based on financial statements which are
generally prepared on the basis of historical costs. Thus, it may reflect
distorted results.
The financial analysis based on such financial statements would not portray
the effects of price level changes over a period of time.
(b) Financial Statements are Essentially Interim Reports
The amount of profit or loss as shown by the Profit and Loss account or the
financial position as shown by the Balance Sheet of any unit is always based
on certain accounting concepts and conventions. Therefore, these figures
may not reflect the exact position.
Further, the existence of contingent liabilities, deferred revenue expenditure
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etc. may make them inaccurate.
(c) Financial Analysis is Only a Means Not an End
The financial analysis should not be considered as the ultimate objective test
but it may be carried further based on the outcome and revelations about the
causes of variations. It is the part of the larger information processing system.
In other words, it is a means to an end and not the end in itself and therefore,
it should be used only as a starting point and conclusion should be drawn
keeping in view the overall picture and the prevailing economic and political
situation.
(d) Completely Ignores Non-monetary Facts
Financial statements reveal only those facts which can be expressed in terms
of money.
For example, the financial statements will show only the amount paid to
workers and staff as wages, salaries and other perks.
But these will not reveal how loyal they are to their organization or how
trained and efficient are they in the work assigned to them.
These matters are also of considerable importance for the business and play
a crucial role in efficient working of an organization.
However, these are completely ignored in financial statement as these cannot
be measured in terms of money.
Additional Information
Elements of Financial Statements
The elements of financial statements are the general groupings of line items
contained within the statements. These elements are as follows:
Assets . These are items of economic benefit that are
expected to yield benefits in future periods. Examples are accounts
receivable, inventory, and fixed assets.
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Liabilities . These are legally binding obligations payable to
another entity or individual. Examples are accounts payable, taxes payable,
and wages payable.
Equity () . This is the amount invested in a business by its owners,
plus any remaining retained earnings.
Revenue . This is an increase in assets or decrease in liabilities caused
by the provision of services or products to customers. It is a quantification of
the gross activity generated by a business. Examples are product sales and
service sales.
Expense (). This is the reduction in value of an asset as it is used to
generate revenue. Examples are interest expense, compensation expense,
and utilities expense.
The elements of, assets, liabilities, and equity are included in the balance sheet.
Revenues and expenses are included in the income statement. Changes in these
elements are noted in the statement of cash flows.
♦Assets
Assets are items with money value that are owned by a business. Some examples
are: cash, accounts receivable (selling goods or services on credit), equipment
(office, store, delivery, etc.), and supplies (office, store, delivery, etc.).
♦ Fixed Assets
Fixed assets are acquired by the firm its productive operations and not for resale.
Fixed Assets include land, building, fixtures, and equipment. Sometimes called long-
term assets, long-lived assets, or plant and equipment.
♦ Current Assets
FASB was defined the current assets as follows: they are economic benefits owned
by a firm which are reasonably expected to be converted into cash or used up during
the entity's normal operating cycle or one year, whichever is longer.
Current assets constitute cash, items expected to be realized in cash, sold or
consumed during operating cycle of the business or one year, whichever is longer.
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Current assets are defined "Cash and other assets that are expected to be converted
into cash or consumed in the production of goods or rendering of services in the
normal course of business". Items are included under current assets on the basis of
whether they are expected to be realized within one year or within the normal
operating cycle of the enterprise, whichever is the longer.
The classification of current assets, one typically finds the following:
♦ Inventories
Inventories include those items of tangible property that are:
(1) Held for sale in the ordinary course of business,
(2) Used in process of production for such sale.
The cost of inventory includes all expenditures that were incurred directly or
indirectly to bring an item to its existing condition and location.
♦ Accounts Receivables
Accounts Receivables encompass () monetary claims against debtors of the firm.
The term of accounts receivable is commonly used to refer to () receivables from
trade customers that are not supported by written notes ( ).
♦ Marketable Securities
Marketable Securities represent temporary investments made to secure
( ) a return on funds. To be considered a temporary investment, a security must
not only be marketable, but management must plan to disposeit if the management
needs to obtain cash.
♦ Cash
Cash is the most liquid asset owned by a firm. Cash Includes coin and currency on
hand, bank deposits (if subject to immediate withdrawal, (e.g. checking accounts),
negotiable paper (i.e., transferable by endorsement(), in including bank checks,
money orders, bank drafts, etc.).
♦ Owner's Equity
Owner's Equity is sum of funds owned by the proprietors of firm for financing its
activities .The difference between total of Assets and Liabilities is Owner's Equity.
They can also be called capital, or net worth.
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Owner's Equity = Total of Assets - Liabilities
♦ Liabilities
Liabilities are debts owed by the business. Paying cash is often not possible or
convenient, because the firms purchase goods and services on credit. The name of
the account used is Accounts Payable. Another type of liability is Notes Payable.
This is a formal written promise () to pay a specific amount of money at a
definite future date.
Chart of Accounts
Accounts in the Ledger are normally arranged in the following order: Assets,
Liabilities, Owner's equity, revenues and expenses and for quick and easy reference,
each account is numberedaccording to the accounting system applied. A complete
listing of these numbers along with the respective account titles is known as a chart
of accounts. The chart of accounts is shown in the following chart.
Chart of Accounts
Cash
Accounts receivable
Inventory
Creditors
Accounts Payable
Loan Short-Term
Loan Long-Term
Land
Building
Office Equipment
Furniture
Capital
Retained Earnings
Reserves
Salaries
Electricity
Supplies
Sales
Fees Earned
Interest Received
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Telephone
Rent
Insurance
Depreciation
Discount Received
Commission Received
Basic Financial Statements
The accounting process (also called the accounting cycle) consists of the
following groups of functions:-
(1) Accounting observes many events and identify and measure in financial terms
those events considered evidence of economic activity.
(2) The evidence events are recorded, classified into meaningful groups and
summarized for conciseness.
(3) Accountants report a business activity by preparing financial statements and
special reports.
The purpose of financial accounting statements is mainly to show the financial
position of a business at a particular point in time and to show how that business has
performed over a specific period.
The three basic financial accounting statements that help achieve this function are:
(1) The trading account and the profit and loss account () for
the reporting period: an analysis of revenue and expenses of a business, exactly at
the end of the year.
(2) A balance sheet for the business at the end of the reporting period: a
statement showing the assets, liabilities and capital of a business.
(3) A cash flow statement for the reporting period: a statement
showing how cash is generated and how it has been spent by the business.
Final statements consist of trading account and profit & loss account and balance
sheet. All the amounts from trial balance are taken to prepare these statements.
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Preparation of Final Accounts of Sole Proprietary Firm
(a) Journal
1. 'Journal' is derived from the French Word "Jour" which means a day. Journal
therefore, means a daily record.
2. A Journal is a book of "Original Entry" or "Primary Entry".
3. First of all the business transactions are recorded in the 'Journal' and
subsequently they are posted in the ledger.
4. To study "Book-Keeping", one must learn first how to journalise the business
transactions.
5. To journalize the transaction means to record the two-fold effects of a
transaction in terms of debit and credit. This has to be done by observing the
rules of debit and credit.
Definition of Journal
"A Journal is a book of original entry in which the transactions are recorded in a
particular way by following the rules of debit and credit." (Dictionary for
Accountants written by E.L. Kohler 1983).
Specimen (Format) of Journal: Journal of………..
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(b) Ledger
1. A ledger is the principle book of accounts.
2. All the entries made in the journal must be posted into the ledger.
3. The ledger is a book containing many ledger accounts. It is a group or set of
accounts.
4. in other words, ledger is a book in which various accounts (personal, real and
nominal) are opened.
5. Its source of information are the books of original entry called journals.
6. Usually, only one account is placed on each page of the ledger.
7. A businessman cannot get the information about the transactions from the
Journal. For example, the amount receivable from the debtors, the amount
payable to creditors, total payments on any head of the expenditure etc. In
order to get this information, a ledger has to be maintained.
8. While transferring the transactions from the journal to the ledger, the
transactions are classified.
9. For each person, head of income, head of expenditure, asset, etc., separate
accounts are opened in the ledger book.
Specimen (Format) of a Ledger : Ledger
Dr. Name of the Account Cr.
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(c) Trial Balance
1. ―Trial Balance is a schedule or list of those debit and credit balances which
are expected from various accounts in the ledger and balances of cash in
hand and at bank as shown by the cash book are also included in it.
(R.N. Carter,www.slideshare.net- Published on Dec 9, 2014.)
2. "Trial Balance is a list or abstract of the balances or of total debits and total
credits of the accounts in a ledger, the purpose being to determine the
equality of the posted debits and credits and to establish a basic summary for
financial statements‖.( The Dictionary for Accounts by E. L. Kolher 1983).
3. "The final list of balances totaled and combined is called Trial Balance".
Specimen (Format) of Trial Balance :
Trial Balance (As on……. )
(d) Trading Account
1. After preparing a Trial Balance at the end of an accounting period, the next
step is to prepare the ‗Trading Account'.
2. Trading Account is one of the financial statement which shows the result of
buying and selling of goods and or services during an accounting period.
3. Trading Account is a flow statement and not a static statement. It is prepared
for a particular accounting period and not at a particular point of time.
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4. Trading Account is prepared to know the gross profit or gross loss during the
accounting period.
5. The basis for the preparation of Trading account is the matching of selling
prices of goods and services with the cost of the goods sold and services
rendered.
Cost of goods sold = Opening Stock + Purchases +
Direct Expenses on purchases - Closing Stock
Specimen of Trading Account:
Dr. Trading A/c Cr.
To Opening Stock
To Wages
To Purchases
Less : Return Outward
To Carriage Inward
To Motive Power
To Factory' Expenses ( )
To Freight
To Gross Profit c/d
By Sales
Less : Return Inward
By Closing Stock
By Gross Loss c/d
[() Factory Expenses : It includes factory lighting, factory rent, rates, factory repairs
etc.] .
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(e) Profit and Loss Account
1. Profit and Loss Account is an account in the books of an organization to which
incomes and gains are credited and expenses and losses are debited, so as
to show the net profit or loss over a given period.
2. The Profit and Loss Account has the unique characteristic feature of enabling
the organization to judge the performance of the factors of production as well
as enabling it to take note of the expenses for future of the organization.
3. The Profit and Loss Account enables the organization to make provision for
expenses such as bad debts etc.
Specimen of Profit and Loss Account:
By Transfer Fees (Received)
By Interest on Investment in
By Interest on Investment (Received)
To Provident Fund Contribution
To Provision for Taxation
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(f) Balance Sheet
1. A Balance Sheet is one important financial statement.
2. A Balance Sheet is a statement of assets and liabilities of an enterprise at a
given date.
3. It is called as Balance Sheet because it is a sheet of balances of those ledger
accounts which have not been closed till the preparation of the Trading and
Profit and Loss Account.
4. A Balance Sheet is a list of assets and claims of a business at some specific
point of time and is prepared from an adjusted Trial Balance.
5. A Balance Sheet shows the financial position of a business by detailing the
sources of funds and the utilization of these funds.
6. A Balance Sheet shows the assets and liabilities grouped, properly classified
and arranged in a specific manner.
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Specimen of Balance Sheet:
Balance Sheet (For the Year Ended ……… )
Capital
Add : Net Profit
Less : Net Loss
Less : Drawings
Sundry Creditors
Bills Payable
Loans
Bank Overdraft
Outstanding Expenses
Goodwill
Land and Building
Plant and Machinery
Furniture
Investments
Cash in Hand
Cash at Bank
Bills Receivables
Sundry Debtors
Prepaid Expenses
Stock in Trade
Exercises Solved
Exercise No.1
The Trial Balance of Gany Co. as on 31st March, 2020 was as follows :
Customs duties and clearing
charges
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Adjustments :
1. Closing Stock was valued at 8,000 IQD .
2. Depreciate Motor Vehicle and Office Furniture at 5 % and Office Equipment's
at 10%.
3. Create 5 % Reserve for Doubtful Debts and Debtors.
4. Goods costing 100 IQD was taken for personal use by Mr. Ganesh and it was
included in Debtors.
5. Goods worth 1,000/- IQD were destroyed by fire and the Insurance Company
admitted a claim for 800 IQD.
Solution :
In the Books of Gany Co.
Dr. Trading and Profit and Loss Account as on 31-3-2020 Cr.
(-) Returns 1,500
By Goods Destroyed by fire
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To Depreciation :
Motor Vehicle : 400
Office Furniture 100
Office Equipment 600
To Loss by Fire
To Net Profit c/d
Balance Sheet of Gany Co. for Year ended 31-3-2020
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Exercise No. 2
From the following information prepare Trading and Profit and Loss Account of
Passel Co. for the year ended 31st March 2020 and Balance Sheet as on that date.
Trial Balance as on 31-3-2020
Rent, Rates and Insurance
Adjustments :
1. Stock on 31st March 2020 IQD 45,000.
2. There were outstanding liabilities in respect of Rent of IQD 250, and Wages
IQD 200.
3. Insurance paid in advance amounted to IQD 150 and Salaries were unpaid to
the extent of IQD 350.
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4. Write-off IQD 400 as further bad debts and provide for doubtful debts at 5 %
on Sundry Debtors.
5. Depreciate Building by 2.5 %, Machinery by 7.5 % and Furniture by 10 %.
Solution : In the Books of Passel Co.
Dr. Trading and Profit and Loss Account as on 31-3-2020 Cr.
To Miscellaneous Expenses
To Rent, Rates & Insurance
To Interest and Commission
Balance Sheet of Passel Co. for Year ended 31-3-2020
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Outstanding Expenses :
Rent
Wages
Salaries
(-) Bad Debts
400
45.600
(-) 5% R.D.D. 2.280
Furniture 5,000
(-) 10% Depreciation 500
Closing Stock
Prepaid Insurance
Exercise No. 3
The following Trial Balance was taken out from the books of Baraq Co. as on 31 st
March 2020.
Trial Balance as on 31st March 2020
Provision for Doubtful Debts
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Adjustments :
1. Closing Stock was valued at IQD 14,000.
2. Depreciation on Furniture and Fixtures at 10% p.a.; Land and Buildings at
10%.
3. Office rent outstanding was IQD 2,500.
4. Prepaid insurance IQD 1,000.
5. Provision for Doubtful Debts to be maintained on debtors at 5%.
Required: prepare a Trading and Profit and Loss Account for the year ended 31st
March, 2020 and a Balance Sheet as on that date.
Solution : In the Books of Baraq Co.
Dr. Trading and Profit and Loss A/c for the year ending 31st March 2020 Cr.
To Depreciation
Land and Building
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To General Expenses To
R.D.D. (New)
Balance Sheet as on 31st March, 2020
Exercise No. 4
The following is the Trial Balance of Aram Co. on 31st March, 2020
Trial Balance
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Prepare the Trading and Profit and Loss Account for the year ended 31st March,
2020 and the Balance Sheet as on that date after considering the following
adjustments :
1. Closing Stock on 31st March, 2020 IQD 16,000, Market Price of which was
IQD 20,000.
2. Machinery and Plant to be depreciated at 10% p.a. and 20% p.a. respectively.
3. Goods of IQD 1,000 withdrawn by Aram Co. for personal use not recorded in
books.
4. Create 5% provision for bad and doubtful debts on debtors and 5% reserve
for discount on creditors.
5. Establishment Charges outstanding IQD 2,000 and Power and Fuel Prepaid
IQD 1,000.
Solution :
In the Books of Aram Co.
Dr. Trading and Profit and Loss Account for the year ended 31-3-2020 Cr.
To Opening Stock (1-4-2019)
50
By Reserve for Discount on
To Establishment Charges 14,000
Balance Sheet of Mr. Aram (for the year Ended 31-3-2020)
Outstanding Establishment
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Questions and Exercises
A- Questions
1. What do you mean by Financial Statements ? State its Nature.
2. Explain the Meaning and Nature of Financial Statements.
3. State the importance of Financial Statements.
4. State the Various Objectives of Financial Statements.
5. Explain Preparation of Final Accounts of Sole Proprietary Firm.
6. Explain Making Financial Decisions on the Basis of Financial Statements.
7. What is Trading Account? Give its specimen form.
8. What is gross profit?
9. What is profit and loss account? Give its specimen form.
10. What is a Balance Sheet? Give its specimen form.
11. Choose the correct answer from the following options:
(1) Preparation of financial statements consists of :-
(a) Revenue accounts alone (b) Balance Sheet only (c) Trial Balance
(2) Prepaid insurance appears in:-
(a) Trading account (b) Profit and Loss account (c) List of assets.
(3) Depreciation is a:-
(a) Gain (b) Loss (c) Appreciation
(4) Revenue earned but not received is:-
(a) A liability (b) An asset (c) Nominal account
(5) Interest on Drawings is deducted from:-
(a) Net profit (b) Drawings (c) Capital
(6) Closing Stock is valued at:-
(a)Cost price (b) Market price (c) Cost price or market price whichever is lower.
12.Choose the correct answer from the following:-
(1) Gross loss will result if:
a- Sales revenues are greater than cost of goods sold.
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b- Operating expenses are greater than net income.
c- Sales revenues are less than cost of goods sold.
d- Sales revenues are less than operating expenses.
13.State whether the statements given below are True or False.
(a) Capital is a liability account.
(b) Balance sheet consists of debit side and credit side.
(c) All Assets will show debit balances.
(d) All Liabilities will show credit balances.
(e) An account with debit balance will be either expense or asset.
(f) Adjustment entries are passed throughout out the year like other entries.
14.Choose the correct answer and write it against each of the following
statements
Deducted from asset concerned
Is a liability of the business.
Is an asset of the business.
Investment made into the business
by proprietor
Indicates net profit or loss.
Indicates gross profit or loss.
Not an account, but a statement.
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B- Exercises
1- Ascertain purchases from the following figures:
Cost of goods sold IQD 81000
Opening Stock IQD 6000
Closing Stock IQD 7000
2- Calculate Gross Profit from the following figures:
Cost of goods sold IQD 80000
Sales IQD 140000
3- Ascertain cost of goods sold from the following figures:
Opening Stock IQD 4000
Purchases IQD 21000
Closing stock IQD 3000
4- Ascertain cost of goods sold from the following figures :
5- Ascertain Gross Profit from the following figures:
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6- From the following ascertain Gross Profit and Net Profit:
Accrued Manufacturing Wages
7- The following information about the first half of 2019 for Quick meal
restaurant:
55
Required:
A: Determine the following:
1. The cost of goods purchased.
2. The cost of goods sold.
3. Gross profit.
4. Net income.
B: Prepare trading account for quick meal for the half ended June 30,2019.
8- The following balances are showed at Dec. 31, 2020 for Ali's company:
Merchandise inventory 1/1
Ending inventory at market
Required:
1. Prepare income statement for the year ended Dec, 31, 2020
2. Prepare trading A/c, profit and loss account.
3. Prepare the balance sheet as of Dec. 31, 2020.
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CHAPTER (3)
Financial Statements Analysis Preview
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Analysis Tools
Valuation Models
Analysis in an Efficient Market
Financial Reporting and Analysis :
Reporting Environment
Statutory Financial Reports
Factors Affecting Statutory Financial Reports
57
CHAPTER (3)
Financial Statements Analysis Preview
Financial Statement Analysis Tools
Financial statements are usually the final output of a company's accounting
operations. These statements contain information relating to the revenues,
expenses, assets, liabilities and retained earnings of the business.
Business owners often pay close attention to this information since the
statements can provide detailed information about the company's operational
performance. Many business owners and managers use specific analysis tools to
closely review their company's financial statements for decision-making purposes.
Financial Ratios
A traditional financial statement analysis tool is financial ratios. These ratios
take information from the company's financial statements and calculate economic
indicators for comparison to another company or the industry standard.
Financial ratios include liquidity, asset turnover, financial leverage and
profitability calculations. Liquidity ratios calculate the company's ability to meet short-
term financial obligations. Asset turnover ratios indicate how well the company uses
its assets to generate profits. Financial leverage ratios calculate the long-term
58
solvency of a company. Profitability ratios help companies determine how much
profit they are generating from the sale of various goods or services.
Valuation Models
Financial statements prepared in accordance with generally accepted
accounting principles(GAAP) show many assets based on their historic costs rather
than at their current market values. For instance, a firm's balance sheet will usually
show the value of land it owns at what the firm paid for it rather than at its current
market value. But under GAAP requirements, a firm must show the fair values (which
usually approximates market value) of some types of assets such as financial
instruments that are held for sale rather than at their original cost.
There are commonly three pillars to valuing business entities: comparable
company analyses, discounted cash flow analysis, and precedent transaction
analysis.
Discounted cash flow method
This method estimates the value of an asset based on its expected future
cash flows, which are discounted to the present (i.e., the present value). This
concept of discounting future money is commonly known as the time value of money.
For instance, an asset that matures and pays $1 in one year is worth less than $1
today. The size of the discount is based on an opportunity cost of capital and it is
expressed as a percentage or discount rate.
For a valuation using the discounted cash flow method, one first estimates the
future cash flows from the investment and then estimates a reasonable discount rate
after considering the riskiness of those cash flows and interest rates in the capital
markets. Next, one makes a calculation to compute the present value of the future
cash flows.
59
Guideline companies method
This method determines the value of a firm by observing the prices of similar
companies (called "guideline companies") that sold in the market. Those sales could
be shares of stock or sales of entire firms. The observed prices serve as valuation
benchmarks. From the prices, one calculates price multiples such as the price-to-
earnings ,one or more of which used to value the firm. For example, the average
price-to -earnings multiple of the guideline companies is applied to the subject firm's
earnings to estimate its value.
Many price multiples can be calculated. Most are based on a financial
statement element such as a firm's earnings (price-to-earnings) or book value (price-
to-book value) but multiples can be based on other factors such as price-per-
subscriber.
Net asset value method
The third-most common method of estimating the value of a company looks to
the assets and liabilities of the business. At a minimum, a solvent company could
shut down operations, sell off the assets, and pay the creditors. Any cash that would
remain establishes a floor value for the company. This method is known as the net
asset value or cost method.
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Analysis in an Efficient Market
Efficient Market Hypothesis
EMH Definition
The Efficient Market Hypothesis (EMH) essentially says that all known
information about investment securities, such as stocks, is already factored
into the prices of those securities. Therefore, assuming this is true, no amount
of analysis can give an investor an edge over other investors.
(EMH)
The EMH considers how much information about a company and its
stock price is readily available to investors. The less information there is, the
weaker EMH is, and the more information there is, the stronger EMH is."
EMH
EMH .
EMH does not require that investors be rational; it says that individual
investors will act randomly but, as a whole, the market is always "right." In
simple terms, "efficient" implies "normal." For example, an unusual reaction to
unusual information is normal.
Defining the Forms of EMH
There are three forms of EMH: Weak, Semi-strong and Strong. Here's
what each says about the market.
: EMH .
A. Weak Form EMH:
Suggests that all past information is priced into securities.
Fundamental analysis of securities can provide an investor with
information to produce returns above market averages in the short term
but there are no "patterns" that exist. Therefore fundamental analysis
does not provide long-term advantage and technical analysis will not
work.
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.
B. Semi-Strong Form EMH:
Implies that neither fundamental analysis nor technical analysis
can provide an advantage for an investor and that new information is
instantly priced in to securities.
C. Strong Form EMH:
Says that all information, both public and private, is priced into
stocks and that no investor can gain advantage over the market as a
whole. Strong Form EMH does not say some investors or money
managers are incapable of capturing abnormally high returns but that
there are always outliers included in the averages.
Efficient Market Hypothesis
1. The EMH argues that stock prices incorporate relevant market
information arriving at fair prices.
2. Weak form EMH argues that stock prices incorporate past public
information.
3. Semi-strong form argues that stock prices incorporate all current public
information.
4. Strong form argues that stock prices incorporate all information
including private insider knowledge.
.
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Financial Reporting and Analysis
The users of financial reporting information include investors, creditors,
analysts, and other interested parties. There are several sources of
information available to users. These include statutory financial reports and
alternative information sources such as economic information and industry
information.
.
Reporting Environment
Financial reporting is shaped by the interplay of the parties in society
that have an interest in this information, including the preparers (managers of
reporting companies) and users of the information, information intermediaries,
regulators and auditors. Together, these parties constitute the financial
reporting environment.
.
Financial reporting includes financial statements and other forms of
communication that provide financial information, such as earnings
announcements, analyst presentations, press releases and prospectuses. In
market-based economies, financial reporting information is used by external
parties for at least two reasons: to evaluate investment opportunities (ex-ante)
and to monitor management (ex-post).
(ex-ante
.( ex-post
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The ex-ante demand for this type of information arises from information
asymmetry between the outside investors (users of the information) and the
managers of the company (preparers of the information). Information
asymmetry exists because managers typically have more information about
the company's expected performance than outsiders. If outside capital
providers lack credible information to evaluate investment opportunities, an
efficient allocation of resources in a market economy is impeded. An important
role of financial reporting information is therefore to mitigate information
asymmetry and provide information that is useful to assess future cash flow
prospects and make investment decisions (valuation role).
The second, ex-post role of financial information emerges from agency
problems between managers and outside capital providers. Once the
investment is made, potential conflicts of interest between investor (owner)
and management arise. In an attempt to alleviate these problems, investors
use financial information to monitor management's behavior. According to this
stewardship role of information, the objective of financial reporting is to
facilitate contracting. Together the two distinct, but related, roles of financial
reporting provide an information based perspective on financial reporting,
where investors (users) have information demands and managers (preparers)
have incentives to supply financial information. From this point of view, the
financial reporting environment is shaped by the extent of information
asymmetry and agency problems (Beyer et al., 2010).
Although financial reports have been published for hundreds of years,
the regulation of these reports is a relatively recent phenomenon. In most
developed economies, the regulation of accounting commenced in the early
twentieth century, when the separation of ownership and management of
business entities was on the rise and the information asymmetry problem
emerged. Accounting systems evolved independently in most countries which
led to considerable variation among countries. Depending on specific
characteristics of the legal system, tax regulation and the financing system,
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countries developed different regulatory institutions and different accounting
rules.
By the end of the twentieth century, when capital markets became more
and more international, the regulatory diversity was considered to be a
problem. A demand arose for international accounting standards, which would
facilitate the international comparison of financial information. Currently, the
vast majority of countries use some form of international accounting
standards rather than domestically developed standards. The rise of
international accounting standards, especially during the past decade, has
shaped the assumptions on which financial reports are based as well as their
primary objective.
The most influential accounting standards in the world, IFRS and US
GAAP3 , state objectives in their underlying frameworks that emphasize the
central role of corporate reporting for the functioning of an efficient financial
market. The main concern is the usefulness of financial reporting information
for investment purposes. The international consensus with respect to this
decision usefulness approach is an illustration of the influence that regulators
have over the shape of financial reports. In order for the financial reports to be
useful they have to be credible. The regulation of financial reports and the use
of accounting standards are not sufficient to achieve that. Auditors play a key
role in this respect. External auditors can provide the outside users of
financial reports with independent assurance that the disclosed information is
credible. In many countries, public interest companies are required to have
their financial statements certified by an independent auditor. Assuming
higher quality audits are more costly, companies have an incentive to select
an audit firm that provides the optimal level of quality. Understanding this
selection process would enhance our understanding of the role that auditors
play in the financial information environment.
Finally, information intermediaries, such as financial analysts, rating
agencies and the financial press, generate new information about business
65
entities and increase their visibility. For example, sell side analysts
disseminate the information prepared by companies and provide additional
information by means of their reports and recommendations. The role of the
financial press as intermediary has not received much attention, although its
spreads news from financial reports to the broader public affecting the
companies' information environment. But in addition to the informational role,
the scrutiny of the press may also have a disciplining effect on company's
financial reporting strategy.
statutory reporting
Statutory reporting is the mandatory submission of financial and non-
financial information to a government agency. Each industry has its own set of laws
and regulations that mandate reports. In many countries, International Financial
Reporting Standards (IFRS) has replaced country-specific Generally Accepted
Accounting Principles for statutory reporting.
(IFRS) .
Definition of Statutory Financial Statements
Statutory Financial Statements means financial statements required to be filed
by the Operating Subsidiaries with insurance regulatory authorities under applicable
insurance regulatory laws, including the Annual Financial Statement and the
Quarterly Financial Statements for each such Operating Subsidiary.
.
Definition of Statutory Financial Statements in Loan and Security
Agreement
Statutory Financial Statements means, in relation to any member of the
Group, those financial statements required to be prepared in respect of that member
66
of the Group in its jurisdiction of incorporation and prepared in accordance with
generally accepted accounting principles.
Definition of Statutory Financial Statements in Credit Agreement
Statutory Financial Statements means all financial statements of the
Sponsor's subsidiary insurance companies for each relevant period, prepared in
accordance with Applicable Accounting Principles.
Factors Affecting Statutory Financial Reports
Statutory financial reports are prepared according to the set of generally
accepted accounting principles (GAAP). A regulatory hierarchy that includes the
Securities and Exchange Commission, the American Institute of Certified Public
Accountants, and the Financial Accounting Standards Board promulgates these
principles. GAAP is also influenced in some industries by specialized industry
practices. Managers prepare the statutory financial reports. Thus, the reports are
subject to manipulation based on incentives of managers to present the company in
its best light.
GAAP
SEC AICPA
FASB
GAAP
There are many of external and internal factors effected on financial analysis,
we can briefly mention some of them as follow:
i. Enterprise Ownership
1. Managers have the main responsibility for ensuring fair and accurate financial
reporting by a company.
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2. Managers have discretion in financial reporting in most cases. This discretion
may result from either of two sources. First, managers often have a choice
between alternative generally accepted rules in accounting for certain
transactions. Second, managers often have to make estimates of uncertain
future outcomes. Each of these managerial judgments creates managerial
discretion.
3. Monitoring and control mechanisms include SEC oversight, internal and
external auditor review, corporate governance such as Board of Director
subcommittees assembled to oversee the audit and financial reporting, and
the omnipresent threat of litigation.
4. Managers have several potential incentives to manage earnings.
a. First, managers that earn bonus payments as a function of reported
earnings may manage earnings to maximize their bonus.
b. Second, if the company is subject to debt contract constraints (debt
covenants) such as minimum net income, minimum working capital,
minimum net worth, or maximum debt levels then the manager might
have incentive to manage earnings to minimize the probability that the
company will violate any of the debt covenant constraints.
c. Third, the company might choose to manage earnings because of
potential stock price implications.
d. Forth, coming merger or security offering, or plans to sell stock or
exercise options. Managers also smooth income to lower market
perceptions of risk and to decrease the cost of capital
5. There are several popular earnings management strategies:
a. First, managers often adhere to a strategy of increasing income where
latitude exists. The motivation is to portray the success of the company
more favorably.
b. Second, managers might take a big bath. This strategy involves takin g
all discretionary losses in the current period.
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c. Third, managers might follow a strategy of income smoothing in which
slightly higher than usual earnings are reduced in line with the trend of
earnings and slightly lower than usual earnings are increased in line
with the trend of earnings.
6. Earnings management is the ―purposeful intervention by management in the
earnings determination process, usually to satisfy selfish objectives‖.
7. There are powerful incentives at work, which motivate companies and their
employees to engage in income smoothing.
ii. Finance and capital markets
1. The Securities and Exchange Commission SEC serves as an advocate for
investors. As such, the SEC requires registrant companies to file periodic
standard reports. These reports allow the SEC to oversee the financial
reporting activities of the company and allow the SEC to make key financial
information available to all investors.
SEC
SEC SEC
SEC
2. Financial intermediaries (analysts) play an important role in capital markets.
They are an active and sophisticated group of users that provide useful
information to market participants.
3. Market approach: As the name implies, this approach directly or indirectly
uses prices from actual market transactions. Sometimes, market prices may
need to be transformed in some manner in determining fair value.
iii. Accounting Profession
The accounting profession currently establishes accounting standards. The
Financial Accounting Standards Board is currently the primary rule making body. The
SEC and the AICPA oversee the activities of the FASB. The FASB proposes rules by
first issuing a discussion memorandum.
SEC AICPA
69
FASB
.
iv. Economic growth and development
1. The two basic income concepts are economic income and permanent income.
Economic income is typically determined as cash flow during the period plus
the change in the present value of expected future cash flows, typically
represented by the change in the fair value of the business's net assets.
Permanent income (also called sustainable income or recurring income) is the
stable average income that a business is expected to earn over its life, given
the current state of its business conditions. Economic income measures
change in shareholder value and is useful in evaluating the total shareholder.
2. Economic income measures the net change in shareholder value during a
period.
3. Accounting income is the excess of revenues and gains over expenses and
losses measured using accrual accounting.
4. Economic income is a measure of the change in shareholder value over a
period of time. Permanent income is the normal, recurring amount of income
that a company is able to earn each period. Accounting income has aspects
of both.
5. The permanent component of accounting income is the portion of total
earnings that is expected to persist indefinitely (recur). Revenues and cost of
goods sold components are largely permanent income components.
6. Value irrelevant income components have no economic content and, as the
name suggests, have no effect on the value of the company.
7. Core income refers to a current period's recognized income from which all
transitory components have been removed.
8. Some of the major adjustments to net income for determining economic
income are including various unrealized gains and losses that are included in
other comprehensive income, such as unrealized gains/losses on marketable
securities or net pension assets.
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9. Following are some of the circumstances that can point to areas of high audit
risk:
a. Growth industry or company with need for continuing earnings growth
to justify high market price or to facilitate acquisitions.
b. Company in difficult financial condition requiring financing urgently and
frequently.
c. Company with high market visibility issuing frequent progress reports
and earnings estimates.
d. Management dominated mostly by one or a few strong-willed
individuals.
e. Personal financial difficulties of members of management.
f. Deteriorating operating performance.
g. Excessively complex capital structure.
h. Management which has displayed a propensity for earnings
manipulation. Problem industry displaying weaknesses, in such areas
as receivable collection, inventories, contract cost overruns,
dependence on few products, etc.
i. Dealings with insiders on related parties or stockholder lawsuits.
j. Turnover of key officers, legal counsel or auditors.
v. Inflation
Historical cost model generates more reliable accounting information, since all
numbers are based on actual transaction, i.e. the exact price paid by the company at
acquisition; Fair value model is more relevant, as it reflects market participant (e.g.,
investor) assumptions about the present value of expected future cash inflows or
outflows arising from an asset or a liability.
vi. Legal system
1. To manipulate the financial reports is limited by several monitoring and
enforcement mechanisms including the SEC, internal and external auditors,
71
corporate governance, and the possibility of litigation against the company
and/or the managers.
2. Statutory financial reports are not the only source of information about a
company that is available to interested parties outside of the organization.
Other sources include forecasts and recommendations of information
intermediaries (analysts), general economic information, general information
about the company's industry, and news about the company. Also,
management will often provide voluntary disclosure of information that is not
required by GAAP or other regulatory mandate.
vii. Accounting regulation
1. Earnings announcements provide summary information about the company's
performance and financial position during the quarter and/or year just ended.
The earnings announcement contains much less detail than the financial
statements, which are only released after they are prepared and audited.
2. Under the historical cost model, asset and liability values are determined on
the basis of prices obtained from actual transactions that have occurred in the
past. Under the fair value accounting model, asset and liability values are
determined on the basis of their fair values (typically market prices) on the
measurement date (i.e., approximately the date of the financial statements).
72
3. In accounting, conservatism states that when choosing between two
solutions, the one that will be least likely to overstate assets and income
should be selected. The two main advantages of conservatism are that:
a. it naturally offsets the optimistic bias on the part of management to
report higher income or higher net assets; and
b. it is important for credit analysis and debt contracting because creditors
prefer financial statements that highlight downside risk.
4. The two types of conservatism are unconditional and conditional
conservatism. Unconditional conservatism understates assets (or income)
regardless of the economic situation.
5. Finance and accounting researchers have established that accounting
information is indeed relevant for decision making. For example, researchers
have shown that accounting earnings explain much (50% - 70%) of the
fluctuation in stock price changes.
6. Financial statement information has several limitations.
First, financial statements are released well after the end of the quarter
and/or fiscal year. Thus, they are not entirely timely.
Second, they are only released on a quarterly basis. Investors often
have a need for information more often than just on a quarterly basis.
Thus, financial statements are limited by the relative infrequency of
their release.
Third, financial statements have little forward-looking information.
Investors must use the largely backward looking financial statements to
generate their own beliefs about the future.
Fourth, financial statements are prepared using rules that are
promulgated with a relevance and reliability trade-off. The need for
reliability causes the relevance of the information to be, in certain
instances, compromised.
Fifth, the usefulness of financial statement information may also be
limited by the bias of the managers that prepare the statements. For
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example, managers in certain instances may have incentives to
overstate or understate earnings, assets, liabilities, and/or equity.
7. Short-term accruals arise because of the timing differences between income
and cash flows.
8. Cash flow measures of performance almost always suffer from the timing and
matching problems that accrual accounting was developed to mitigate.
9. Cash flows are highly reliable because the receipt or payment of cash
measures the cash flows. Accounting net income is less reliable than cash
flows because calculating net income often requires estimations of future
outcomes.
10. Income (also referred to as earnings or profit) summarizes, in financial terms,
the net effects of a business's operations during a given time period.
Economic income differs from cash flow because it includes not only current
cash flows but also changes in the present value of future cash flows.
Similarly, accounting income considers not only current cash flow but also
future cash flow implications of current transactions.
11. Preparers of financial statements must make certain estimates of uncertain
outcomes and make judgments about other uncertainties.
12. Accounting analysis is the process of evaluating the extent to which a
company's accounting numbers reflect economic reality.
13. Accounting analysis involves several interrelated processes and tasks. First,
the analyst must evaluate the quality of the financial information. Second, the
analyst must adjust the financial information based on the findings in the
evaluation of the quality of the financial information.
14. Accounting distortions are deviations of reported information in financial
statements from the underlying business reality. These distortions arise from
accounting policy choices, errors in estimation, the trade-off between
relevance and reliability, and the latitude in application.
15. Earnings management may take many forms. Listed here are some forms to
which the analyst should be particularly alert:
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a. Changing accounting methods or assumptions with the objective of
improving or modifying reported results.
b. Misstatements, by various methods, of inventories as a means of
redistributing income among the years.
c. The offsetting of extraordinary credits by identical or nearly identical
extraordinary charges as a means of removing an unusual or sudden
injection of income that may interfere with the display of a growing
earnings trend.
16. The "quality" of earnings of an enterprise is a measure of the degree of care
and unbiased judgment with which they are determined, the extent to which
all important and necessary costs have been provided for and the variability
which industry conditions subject these earnings to. Analysts must assess the
quality of earnings in order to render them comparable to those of other
enterprises. The quality of earnings depends, among other factors, on:
17. The degree of conservatism with which the estimates of present and future
conditions are arrived at. That is, the degree of risk that real estimates or
assumptions may prove over-optimistic or downright unwarranted and
misleading.
18. Management's discretion in applying GAAP. This requires the analysis of
discretionary and future directed costs.
19. The relation between earnings and business risk. The stability and the growth
trend of earnings as well as the predictability of factors that may influence
their future levels.
viii. Accounting and Standards Principles
1. Contemporary generally accepted accounting principles (GAAP) is the set of
rules and guidelines of financial accounting that are currently mandated as the
acceptable rules and guidelines for preparing financial reports for the external
users of financial information.
2. Timing and matching problems make short-term performance measurement
difficult and often less meaningful.
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3. Accrual accounting calls for recognizing revenue when the revenue is both
earned and realizable. Revenues are earned when the company delivers the
products or services. Revenues are realized when cash is received.
4. Accrual accounting requires that the economic efforts required to generate
revenues be matched against the related revenues.
5. Accrual accounting is a superior measure of performance and financial
position relative to cash flows. The factors that give rise to this superiority are
the more appropriate timing of revenue recognition and the more precise
matching of costs against these revenues.
6. Accrual-accounting based income measures repeatedly out-perform cash
flow-based measures such as operating cash flow or free cash flow at
explaining changes in stock price.
7. Accounting principles can, in certain cases, create differences between
financial statement information and economic reality.
8. Under the historical cost model, asset and liability values are determined on
the basis of prices obtained from actual transactions that have occurred in the
past. Under the fair value accounting model, asset and liability values are
determined on the basis of their fair values (typically market prices) on the
measurement date (i.e., approximately the date of the financial statements).
9. The fair value accounting periodically updates asset/liability values even in the
absence of explicit transactions.
10. Under historical cost accounting, income is the accountants estimate of what
an enterprise has ―earned‖ during a period. Under fair value accounting,
income is merely the residual amount that measures the net change in the fair
values of assets and liabilities.
11. Formally, SFAS 157 defines fair value as exchange price, that is, the price
that would be received from selling an asset (or paid to transfer a liability) in
an orderly transaction between market participants on the measurement date.
12. Financial assets/liabilities are easier to fair value. This is because they are
more homogenous and usually have liquid markets with traded quotes.
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13. Some of the issues that the analyst needs to consider when evaluating fair
value accounting are:
a. balance sheet and not income statement is the most important
statement under fair value accounting;
b. income under fair value accounting measures change in net assets, it
is not a measure of profitability and cannot be used for directly valuing
an enterprise;
c. use of fair value assumptions.
14. Different persons use accrual accounting information and cash flow
information to varying degrees in their valuation models. Accrual accounting
information is often used in valuation models based on price to earnings
multiples, market to book multiples, and abnormal accounting earnings-based
valuation models. Cash flow information is used in such models as discounted
dividend and discounted cash flow models.
15. Accounting concepts and standards are subject to individual judgments and
incentives in the promulgation process. Accounting regulation is proposed by
accounting regulators and then commented upon by the financial reporting
community.
16. Auditing standards are broad generalizations that come in three sets:
a. General standards define the personal qualities required of the
independent CPA.
b. Standards of fieldwork cover the actual execution of the audit and
cover the planning of the work, evaluation of the client's system of
internal control, and the quality and sufficiency of the evidence
obtained.
c. Reporting standards govern the preparation and presentation of the
auditor's report.
17. Auditing procedures are tests applied to a company's accounts to develop
evidence to support or refute the hypothesis that the reported numbers are
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prepared according to generally accepted accounting principles and are fairly
presented.
18. The auditor's opinion deals with:
a. The fairness of presentation of the financial statements,
b. Their conformity with generally accepted accounting principles, and
c. Disclosure when a material change in accounting principles has
occurred.
19. Auditing is based on a sampling approach to the data under audit. Statistical
sampling, while lending itself to many applications in theory, is more limited in
actual practice.
20. The auditor maintains that s/he expresses an opinion on management's
statements. Auditors are very insistent on this point and attach considerable
importance to it. It means that, normally, the auditor did not prepare the
financial statements nor did the auditor choose the accounting principles
embodied in them.
ix. Other Factors
There are many factors that affect regular financial reporting: legal
requirements, specialized accounting standards, tax laws and the financial structure
of companies. Some of these variables can be controlled, while others cannot be
controlled, resulting in a difference in the calculation of profits. For example, DAFSA,
a financial analysis firm, uses the following method to calculate profits:
s.m = 1- (d.m- d.r) ÷ [d.m]
This means that:
sm = indicator of measurement behavior
dm = Adjusted earnings
dr = disclosed earnings
Measurement behavior= (Adjusted earnings - disclosed
earnings) Adjusted earnings
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The measure of profit pessimistic when the indicator (s.m> 0.95), and can be
a measure neutral when the indictor (1 ≤ s.m ≤ 0.95) and be optimistic when the
indictor (s.m> 1.05).
DAFSA
indicator of measurement behavior
adjusted earnings
disclosed earnings
pessimistic > ,
neutral ≤ ≤ optimistic
Example
An Egyptian company operating in Iraq announced that annual profits, which
amounted to (5,000,000) Egyptian pounds during 2020, has provided financial
statements to the tax authorities by the Egyptian re-preparation of financial
statements and adjusted in accordance with the laws in in Egypt.
Required: calculate the behavior of the scale, assuming the following: -
(1) adjusted earnings (6,000,000) pounds.
(2) adjusted earnings (4,000,000) pounds.
1 - The first assumption
S m = 1- (6,000,000 – 5,000,000) ÷ 6,000,000 = 1 - 0.16 = 0,84
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S m = 0.84 which is less than (0.95) any (pessimistic).
2 - The second assumption
S M = 1 - (4,000,000 – 5,000,000) ÷ 4,000,000 = 1 - (1,000) / 4,000
S m = 1 - (- 0.25) = 1 + 0.25 = 1.25
S M = 1.25, that is more than of 1,05 (optimistic)
Questions
1. Describe the Analysis Tools.
2. What are the Valuation Models?
3. Analysis in an Efficient Market
4. What are the outsides related with the Financial Reporting and Analysis?
5. Explain the Reporting Environment .
6. Want is the meaning of Statutory Financial Reports ?
7. Explain the Factors Affecting Statutory Financial Reports.
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CHAPTER (4)
Fund Flow Statement
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Concept of Fund
Fund Flow Statement (Meaning)
Important Definitions of Fund Flow Statements
Uses/Advantages of Fund Flow Statement (FFS):
Limitations / Disadvantages of Fund Flow Statement
(FFS):
Preparation of Fund Flow Statement
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CHAPTER (4)
Fund Flow Statement
Concept of Fund :
Fund refers to economic value of assets expressed in terms of money.
In a broader sense, fund includes all resources i.e. total resources used in the
business whether in the form of men, materials, money, machinery, methods
etc.
However, in the narrow sense, funds means only cash resources of the
business.
Funds is also taken as synonymous to working capital which is the excess of
current assets over current liabilities.
Fund Flow Statement (Meaning)
Fund flow statement is a statement showing sources and application of funds
for a period of time.
Fund flow statement is one of the valuable tool in the hand of management to
evaluate the uses of funds by the organization and in determining as to how
these uses are financed.
Fund flow statement is statement which discloses the analytical information
about the different sources of fund and the application of the same in the
specific accounting cycle.
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In other words, it incorporates those transactions which change either the
amount of current assets or current liabilities (in the form of increased or
decreased working capital) or fixed assets, long-term loans and equity capital.
Fund flow statement is also called the 'Statement of Sources and Application
of Fund 'Movement Funds Statement'.
Fund flow statement attempts at providing a link in the completion of final
statements .
Fund flow statement is a statement in summary form that indicates the
changes occurring in items of financial condition between two different
balance sheet dates .
Important Definitions of Fund Flow Statements :
(a) "The Fund Flow Statement describes the sources from which additional funds
were derived and the uses to which these funds were put".
".
(b) "The Fund Flow Statement is a statement of sources and application of funds
is a technical device designed to analyze the changes in the financial
condition of a business enterprise between two dates.
Uses/Advantages of Fund Flow Statement (FFS)
1. Fund flow statement is helpful in estimating the budgets or the amount of
funds required in future for modernization and expansion programs.
2. Fund flow statement provides the information how the funds have been
obtained from different sources, i.e. External, Internal etc. and how they have
been spent.
3. Fund flow statement helps to know where did the profits go.
4. Fund flow statement leads to improvement in the rate of profit on assets by
directing the flow of funds to those activities with higher margins.
5. Fund flow statement helps the management for declaration of dividends,
planning of a dividend policy, or issue of bonus shares.
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6. Fund flow statement helps in avoiding the situation of running out of funds by
obtaining additional working capital, when required.
7. Fund flow statement helps in planning the temporary investment of idle funds
and planning the repayment schedules of long-term debt.
8. Fund flow statement helps in planning for retirement of long-term debts.
9. Fund flow statement helps in assessing the relative points of strength and
weakness of the organization.
10. Fund flow statement helps in financial planning, decision-making and
allocating the resources for productive investments.
Limitations / Disadvantages of Fund Flow Statement (FFS)
1. Non-fund transactions are ignored and hence it cannot provide full financial
analysis unless supported by ratio analysis etc.
2. It is criticized for just re-arranging the financial information obtained from the
financial statements.
3. It is historic statement and it does not indicate any price level changes.
4. It does not show any changes in working capital for which a separate
statement has to be prepared.
Preparation of Fund Flow Statement
(a) Funds from Operations
The concept of funds from operations is extremely important.
Fund from operations is the working capital flow arising out of operating
activities.
In calculating funds from operations, non-business expenses like dividend
paid as well as non-cash expenses like depreciation etc. are added to the net
profits shown by the Profit and Loss A/c.
Similarly , non – cash as well as non - business income is deducted from net
profits.
The method of finding out funds from operations is as follows :
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Adjusted Profit and Loss A/c
To Non-cash Items :
Depreciation on fixed assets
Preliminary expenses written-
off
Goodwill written-off
Discount on issue of shares
and debentures written-off
Transfer to reserve
Proposed dividend
Loss on sale of assets
Provision for taxation
To Dividend Paid
To Income Tax Paid
To Balance c/d (Closing Balance)
By Balance b/d (Opening Balance)
By Non-operating Income :
Interest received
Profit on sale of fixed assets
Dividend received
Refund of taxation
Other items
By Funds from Operations
(Balancing Figure)
The funds from operations can also be calculated by preparing a statement.
The items shown on the debit side of the adjusted Profit and Loss A/c. are
added in the net profits while the items on the credit side are deducted from
net profits.
(b) Statement of Changes in Working Capital
It shows net increase or decrease in working capital.
In the funds flow statement, net increase in working capital is shown on the
application side, while net decrease in working capital is shown on the
sources side.
In order to find out this figure, the following statement is prepared.
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statement showing Changes in Working Capital
Increase/ Decrease
in Working Capital
1.Current Assets
Cash
Debtors
Bills Receivable
Stock
Prepaid expenses
Income outstanding
Short-term investments
II. Current Liabilities:
Creditors
Bills payable
Bank overdraft
Expenses outstanding
Short-term loans
Net Increase / Decrease In Working Capital (1) - (II):
Notes:
Working Capital = Current Assets - Current Liabilities.
Increase in Current Assets means Increase in Working Capital.
Decrease in Current Assets means Decrease in Working Capital.
Increase in Current Liabilities means Decrease in Working Capital.
Decrease in Current Liabilities means Increase in Working Capital.
(c) Funds Flow Statement
1. Funds flow statement is a financial statement drawn to know the changes in
financial position over the year.
Preformat of Fund Flow Statement:
Funds Flow Statement for the year ended on 31st March, 20XX
Funds from business
operations
Loss of funds due to
operations
Issue of additional capital
Redemption of preference
shares
Redemption of debentures
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Purchase of investments
Decrease in working capital
Increase in working capital
Exercise No. 1
The financial position of ABC Ltd. on 1st Jan., 2020 and 31th December, 2020 was as
follows :
During the year IQD 52,000/- were paid as Dividends. The provision for depreciation
against machinery as on 1st Jan. 2020 was IQD 54,000/- and as on 31st Dec. 2020
IQD 72,000/-.
Required :prepare the Fund Flow Statement.
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Solution :
Working Notes :
Statement Showing Changes in Working Capital:
Increase in
Working
Capital IQD
Decreased in
Working
Capital IQD
(B) Current Liabilities (CL):
Net Decrease in Working Capital: IQD 10,000 (16,800 - 6,800)
To Bank A/c (Balancing Figure)
(Opening Bal (+) Provision)
To Bank A/c (Additions) (Bal. Fig.)
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Dr. Provision for Depreciation A/c Cr.
By P & L A/c (Balancing Figure)
Dr. Funds from Operations Cr.
To Depreciation Provision
Funds Flow Statement of ABC Ltd.
(As on 31-12-2020)
Loan from Associate Company
Net Decreases in Working
Capital
Exercise No. 2
Following are the summarized Balance Sheet of NDA Ltd. As on 31st March, 2019
and 2020. You are required to prepare a Funds Flow statement for the year ended
31st March, 2020.
89
Balance Sheet
Additional information :
1. Depreciation written-off on Plant and Machinery IQD 14,000 and on Land and
Building IQD 10 ,000.
2. Provision for tax was made during the year IQD 33,000.
3. Dividend of IQD 23,000 was paid.
Solution :
(1) Working Notes :
Statement Showing changes in Working Capital
increase in
Working
Capital IQD
Decrease in
Working
Capita!
IQD
(B) Current Liabilities :
Net Increase in Working Capital
= IQD 158,100 (-) IQD 41,800 = IQD 116,300
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(2) Dr. Plant and Machinery A/c Cr.
To Bal. b/d
To Bank A/c (Machinery
Purchased)
By Adj. P & L A/c. (Dep.n )
By Bal. c/d
(3) Dr. Land and Building A/c Cr.
By Adj. P&L A/c (Dep.n )
By Bal. c/d
4) Dr. Provision for Taxation A/c Cr.
(5) Dr. Funds From Operations / Adjusted P & L A/c Cr.
Funds Flow Statement
91
Increase in Working Capital
Exercise No. 3
Prepare a Fund Flow Statement from the following balance sheets of AL-ARABIA
Company:
Additional Information
1. Income for the period was IQD 10,000.
2. A building that cost IQD 4,000 and which had a book value of IQD 1,000 was
sold for IQD 1,400.
3. The depreciation charge for the period was IQD 800.
4. There was an issue of IQD 5,000 of common stock.
5. Cash dividends of IQD 2,000 and stock dividends of IQD 3,500 were
declared.
92
Solution :
Working Notes :
1) Computation of Profit on Sale of Building
Less : Depreciation to the date of sale (4,000 - 1,000) (Acquisition Cost -
Undepreciated Book Value)
Undepreciated Book Value of Building Sold
Profit on Sale of Building
This IQD 400 has been credited to P & L A/c and IQD 10,000 profit for the year has
been arrived at after credited profit of IQD 400. Since this profit is not an item of
trading profit, it should be deducted from the profit figure to arrive at funds from
operations. IQD 1,400 sales price of the building should be considered at an item of
source of funds in the funds flow statement.
(2) Calculation of Funds from Operations :
Income for the Period (Given)
Add : Amortization of Patents
Add : Amortization of Discount Bonds
Less : Profit on Sale of Building (W. N. -1)
(3) Schedule of Changes in Working Capital:
Changes in Working Capital
Less : (B) Current Liabilities
(CL)
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Net Increase in Working
Capital
To Bank (Purchase)
(Balancing Fig.)
AL-ARABIA Company
Funds Flow Statement (As on 31-12 -2020)
Increase in Working Capital
Exercise No. 4
From the following Balance Sheets of 'Sammal Ltd.' Prepare :
(a) Statement showing changes in Working Capital,
(b) Funds Flow Statement.
Discount on Issue
of Debentures
94
Other Information :
1. Depreciation on Machinery and Building for 2020 amounted to IQD 2,500 and
IQD 1,500 respectively.
2. The above company acquired the assets of Small Co. for IQD 10,000 and
paid the purchase consideration by issuing fully paid shares amounting to IQD
7,500 and by paying the balance in cash. The assets consists of Plant and
Machinery IQD 5,500, Stock IQD 2,500, and Goodwill IQD 2, 000.
3. Income tax paid during 2020 amounted to IQD 3,500.
4. Interim dividend paid during 2020 was IQD 5,000.
5. Debentures were issued at a discount of IQD 1,000.
6. Decided to value stock at cost, whereas previously the practice was to value
stock at cost, less 20%. The stock according to the books was IQD 10,000 on
2019.
7. The stock on 2020 was IQD 11,500 and it was correctly valued at cost.
Solution :
(a) Statement showing Changes in Working Capital of 'Sammal Ltd.':
Current Assets (CA): (Stock + Debtors + B/R + Bank)
Less ; Current Liabilities (Creditors + B/P + Unclaimed
Dividend)
Decrease in Working Capital = 15,500 - 12,000 = 3,500 (Source)
Now, Revalued Opening Stock (2019) = 10,000 x
= 12,500
This is clarified below : Let the Cost Price be IQD 100
Reduced Price = 100 - 20 = 80
95
(b) Funds Flow Statement of Sammal Ltd. for the year 2020 :
Purchase of Land and Building
Decrease in Working Capital
Payment of Tax
Interim Dividend
Working Notes :
(1) Dr. Land and Building A/c
To Bank - (Purchase) (Bal. Figure)
(2) Dr. Plant and Machinery A/c
To Bank - (Purchase) (Bal.
Figure)
96
(4) Dr. Goodwill A/c Cr.
Dr. Adjusted Profit and Loss A/c
By Stock (Increase in Value)
97
Questions
1. Explain the concept of Fund.
2. What is Fund Flow Statement ?
3. State the various Uses of Fund Flow Statement.
4. State the Advantages of Fund Flow Statement.
5. Write Short Notes about of the Utility of Funds Flow Statement.
6. State the Limitations of Fund Flow Statement.
7. Explain : Preparation of Fund Flow Statement.
98
CHAPTER (5)
Cash Flow Analysis
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Statement of Cash Flows
Relevance of Cash
Reporting by Activities
Constructing the Cash Flow Statement
Special Topics
Direct Method
Analysis Implications of Cash Flows
99
CHAPTER (5)
Cash Flow Analysis
Statement of Cash Flows (Meaning)
Relevance of Cash
1. A Cash flow statement deals with the inflow and outflow of cash between two
balance sheet dates.
2. Cash flow statement aims at listing the various items which brings about
changes between two balance sheet dates and therefore any items which
affects the business cash either by increasing or decreasing it is included in
this statement.
3. Cash flow statement is more useful in short-term planning.
4. Cash flow statement indicates simply cash receipts and cash payments and
does not take into consideration other current assets.
5. Cash flow statement highlights the changes in cash and cash equivalents
during the course of the year due to various cash flows.
100
Objectives of Cash Flow Statement
1. Efficient Cash Management
i. To manage the cash resources in such a way that adequate cash is
available for meeting the expenses.
ii. To plan and co-ordinate the financial operations of the business.
2. Internal Financial Management
To provide a clear picture of cash flows from operations.
3. Projected Cash Flow
To help management to know the projected cash inflows and cash outflows.
4. Tool of Analysis
To act as an effective analysis tool for short-term decisions.
5. Success or Failure of Cash Planning
To help management to know the success or failure in cash management by
comparison of actual and budgeted cash flow statements.
Constructing the Cash Flow Statement
1. The Cash Flow Statement can be prepared on the same pattern on which a
Funds Flow Statement is prepared.
2. Sources, which generate cash are termed as "Inflows of cash" while the
applications of the same are termed as "Outflows of cash".
3. The sources of cash inflows and cash outflows are described as follows :
(A) Sources of Cash
The following are the sources of cash :
a) internal Sources
Cash generated from operations is the internal source of generating cash
inflows.
The net profit as shown by the Profit and Loss Account is the starting point for
the computation of the cash from operations.
101
The net profit shown by the Profit and Loss Account is not equal to the cash
from operations as several non- cash items are taken into consideration while
computing the same. Therefore, the net profit will have to be adjusted for non-
cash items to find out the cash from operations.
Some of these items are as follows :
Special Topics
1. Depreciation
Depreciation is a non- cash item, which reduces the net profit but does not result in
any cash outflows. Hence, the amount of depreciation will have to be added back in
the amount of profit.
2. Loss on Sale of Fixed Assets
a) Sometimes, fixed assets like land and building, plant and machinery, furniture
etc. are sold out and the loss on their sale is debited to the Profit and Loss
Account.
b) The amount of loss does not result into cash outflows and therefore is added
back in the amount of net profit.
3. Creation of Reserves
If profits for the year have been arrived at after charging transfers to reserves, such
transfers should be added back to the profits.
4. Writing off the Intangible Assets
a) Intangible assets like goodwill, preliminary expenses etc. are normally written-
off against profits.
b) Such writing off the assets reduces the net profits but do not result in cash
outflows. Therefore, this item should be added back in the amount of net
profits.
5. Gains on Sale of Fixed Assets
Fixed assets may have been sold at a gain. Such item should be deducted from the
net profit, as it is a non- cash item.
(b)External Sources
1. issue of New Shares
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If new shares are issued for cash, the net proceeds i.e. after deducting the issue
expenses will be treated as cash inflows.
2. Raising of Term Loans
If new term loans are raised through debentures or otherwise, such term loans are
the sources of cash inflows.
3. Purchase of Fixed Assets
a) If fixed assets are purchased, it will be an outflow of cash.
b) However, if they are purchased on deferred payment System, it should be
shown as a separate source of cash to the extent of deferred credit.
c) However, the cost of machinery purchased will be shown as an application of
cash.
4. Short-term Borrowings
Short-term borrowings etc. from banks increase cash available and they have to be
shown separately under this head.
5. Sale of Fixed Assets, Investments etc.:
Such sale results in generation of cash and therefore is a source of cash generation.
(B) Application of Cash
The following items result in applications of cash or cash outflows :
a) Purchase of Fixed Assets
The purchases of fixed assets will result in application of cash and will be shown as
cash outflows.
b) Payment of Long-term Loans
The payments of term loans, debentures etc. will be treated as cash outflows as the
available cash is reduced.
c) Redemption of Preference Shares and Buy Back of Equity Shares
Redemption of Preference Shares and Buy Back of Equity Shares result in reduction
in availability of cash and hence it is an outflow.
d) Payment of Income Tax
This is also an application of cash.
103
e) Payment of Dividend
This will also reduce the availability of cash and hence it is an outflow.
f) Decrease in Unsecured Loans, Deposits etc.
The decrease in these liabilities indicates the repayment of these liabilities and
hence it is an outflow of cash.
g) Loss from Operations
Cash generated from operations is a source of cash while, any loss from operations
is an outflow of cash as the available cash is reduced.
Format of Cash Flow Statement:
Cash Flow Statement For The Year Ended on
Opening Balance : Cash Bank
Add : Sources of Cash :
Issue of Shares
Raising of Long-term Loans
Sale of Fixed Assets
Short-term Borrowings
Cash from Operations
Less : Applications of Cash :
Redemption of Preference Shares
Buy Back of Equity Shares
Redemption of Long-term Loans
Purchase of Fixed Assets
Decrease in Deferred Payment Liabilities
Loss from Operations
Income Tax Paid
Dividends Paid
Decrease in Unsecured Loans, Deposits etc.
104
Closing Balance : Cash Bank
Methods of Cash Flow Statement
(a) Direct Method
1) Under this method, major classes of gross cash receipts and gross cash
payments are obtained from the records for determination of cash flow from
operating activities.
2) Various items in the P & L Account are adjusted for changes in related items
in current assets and current liabilities in order to decide P & L Account on
cash basis.
3) The balancing figure in P & L Account reveals cash from operating activities.
Format of Direct Method
Cash Sales
Add : Cash collection from Debtors
Gross Cash Receipts from Operations
Less : Cash Operating Expenses
Net Cash Generated by Operations
(b) Indirect Method
1) Under this method, cash from operating activities is calculated by adjusting
net profit and loss instead of individual items, disclosed in the P & L Account.
2) Net Profit and Loss is adjusted in the light of changes during the period.
105
3) After ascertaining Net Operating Profit, adjustments regarding changes in
current assets and current liabilities are made as per the following table :
Adjustment of Changes in Current Assets and Liabilities :
Current Assets and Current Liabilities
Adjustments to be made to Net Profit
Analysis Implications of Cash Flows
Uses of Cash Flow Statement/importance of Cash Flow Statement
a) Short-term Planning of Business
It is helpful in the short-term planning of the business unit by indicating in advance as
to how much funds are needed in future, how much of these funds can be raised
internally and how much should be arranged from outside etc.
b) Useful in Internal Financial Management
Since Cash-flow statement reveals the amount of cash inflow from operations (and
not income from operations), it will be helpful in internal financial management either
in liquidity of a plant or any other fixed asset or in devising the dividend policy of the
business unit.
c) Useful in Capita! Budgeting Decisions
It is helpful in taking capital budgeting decisions by indicating the availability of funds
or otherwise during the period under consideration.
d) Focusing on Trend of Movement
1) The cash flow statement prepared for a particular accounting year
when compared with the budget already prepared for that year would
106
indicate to what extent the sources of business unit were raised and
applied in consonance with the budget.
2) In short, this comparison would facilitate focusing on trend of
movement that would have gone undetected otherwise.
e) Planning in Replacement of Outdated Assets
It is helpful to management in planning replacement of outdated assets and in
formulating dividend policies.
f) Useful to Financial Analyst
It explains to the financial analyst, the reason why the business unit has run out of
money, despite the fact that the unit has made a profit, or it has surplus of cash
despite the fact that the business has incurred a loss.
g) Movement of Cash
It discloses the movement of cash.
Limitations of Cash Flow Statement
1) When the business unit extends sales on credit basis and takes into
consideration all prepaid and accrued items, there would be an increase in the
working capital. But all the same, equating the net income of the business unit
to mere cash flow would not proper and accurate, since a large number of
"non cash" items would affect the net income of the unit ultimately.
2) In all business concerns, fixed assets involve cash payments in the year of
installation and depreciation thereon are charged against operating income
every year. By this the net income moves away from net cash flow. Thus, to
equate the net operating income with the net cash flow into the business is
highly improper technique.
3) It can be very easily manipulated by the management by postponing
purchases and other payment.
107
Exercise No. 1
Following are the summarized Balance Sheets of XYZ Co. Ltd. as on 31-3-2019 and
31-3-2020.
Addition information :
During the year ended 31 -3-2020.
1. Dividend of IQD 23,000 was paid
2. Assets of another company were purchased for a consideration of IQD 50,000
payable in shares. The following assets were purchased : Stock IQD 20,000;
Machinery IQD 25,000; Goodwill IQD 5,000.
3. Machinery was further purchased for IQD 8,000
4. Depreciation written-off on machinery IQD 12,000 income-tax provided during
the year IQD 33,000 loss on sale of machinery IQD 200 was written off to
general reserve.
Requirement: Prepare a Cash Flow Statement.
Solution :
Cash Flow Statement
Opening Cash and Bank Balance (1-4-2019)
• Realization From Debtors (IQD 80,000 - IQD 64,200)
108
Payment of Bank Loan
Payment of Dividend
Reduction in Sundry Creditor
Purchase of Machine For Cash
70.000
23,000
14,800
8,000
Closing Cash and Bank Balance (31-3-2020)
Working Notes :
(1) Dr. Machinery A/c Cr.
By General Reserve(Loss on Sale)
To Share Capital (Purchase by Issue
By Cash (Sale) - (Balancing Figure)
(2) Dr. General Reserve A/c
By P & L A/c - (Balancing Figure)
To Transfer to General Reserve
To Depreciation on Machinery
To Depreciation on Land and Building
109
Exercise No. 2
The following are the Summarized Balance Sheet of M/S Ltd. as on 31-12-2019 and
31- 12 -2020.
Additional Information :
During the year ended 31-12-2020.
1. Dividend of IQD 30,000 was paid.
2. Assets of another company were purchased for a consideration of IQD 50,000
payable in shares. The following Assets were purchased Stock IQD 20,000;
Goodwill IQD 15,000. Machinery 15,000.
3. Machinery was further purchased for IQD 10,000.
4. Depreciation written off of machinery IQD 2,000.
5. Income Tax provided during the year was IQD 33,000.
6. Loss on sale of Machinery IQD 1,000 was written-off to General Reserve.
Required :prepare the Cash Flow Statement.
110
Solution :
Books of M/S Ltd.
Cash Flow Statement for Year Ending 31-12 -2019
Opening Cash Balance as on 2019
Closing Cash and Bank Balances
As on 31 -12-2020 (IQD 2,000 + IQD 8,000)
Working Notes:
(1) Dr. Machinery A/c Cr.
To Depreciation on Building
To Transfer to General Reserve
To Depreciation on Machinery
111
(3) Dr. General Reserve A/c Cr.
By P & L A/c (Balancing Figure)
(4) Dr. Provision for Taxation A/c
To Bank A/c (Balancing Figure)
(5) Dr. Land and Building A/c
By Depreciation on Building
112
Questions
1. State the meaning of Cash Flow Statement.
2. State the various Objectives of Cash Flow Statement.
3. State the various Uses of Cash Flow Statement.
4. Explain the importance of Cash Flow Statement.
5. State the various Limitations of Cash Flow Statement.
6. Explain : Preparation of Cash Flow Statement.
7. Explain : Preparation of Cash Flow Statement.
113
CHAPTER (6)
Analyzing the Activities
of
Cash Flows Statement
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Analyzing Operating Activities
Analyzing Investing Activities
Analyzing Financing Activities
114
CHAPTER (6)
Analyzing the Activities of
Cash Flows Statement
A cash flow statement is a financial statement that provides aggregate data
regarding all cash inflows a company receives from its ongoing operations and
external investment sources, as well as all cash outflows that pay for business
activities and investments during a given period.
The various Cash Flow Activities
a) Cash Flow from Operating Activities
1. The cash flows generated from major revenue producing activities of the
entities are covered under this head.
2. Cash Flow from operating activities shows the extent to which the operations
of the enterprise have generated sufficient cash to maintain the Operating
Capability to pay dividend, repay loans and make new investments.
3. Examples of Cash Flow from Operating Activities
(1) Cash receipts from sale of goods and services.
(2) Cash receipts from royalties, fees, commission etc.
(3) Cash payments to employees.
(4) Cash payments or refunds of income tax.
(5) Cash receipts and payments relating to future contracts, forward contract etc.
b) Cash Flow from Investing Activities
115
1. These are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
2. This represents the extent to which the expenditures have been made for
resources intended to generate future incomes and cash flows.
3. Examples of Cash Flow from Investing Activities
(1) Cash payments for purchase of fixed assets.
(2) Cash receipts from sale of fixed assets.
(3) Cash payments for purchase of shares/debentures in other entities.
(4) Loans and advances given to third parties.
(5) Repayment of loans given.
c) Cash Flow from Financing Activities
1. Financing activities are the activities that result in changes in the size and
composition of the owner's capital and borrowings of the enterprise.
2. Separate disclosure is important because it is useful in predicting claims in
future cash flows by providers of funds.
3. Examples of Cash Flow from Financing Activities :
(1) Cash receipts from issue of share capital.
(2) Cash receipts from issue of debentures, loans (short or long term).
(3) Cash repayments of amounts borrowed.
(4) Cash payment to redeem preference shares.
116
Distinguish between : Funds Flow Statement and Cash Flow
Statement
Funds Flow Statement and Cash Flow Statement;
Funds flow statement shows
the changes in the working
capital.
Cash flow statement shows
changes in the cash position
between the two periods.
(b) Consideration of
Assets and Liabilities:
Funds flow statement
considers changes in all
current assets and current
liabilities.
Cash flow statement indicates
simply cash receipts and cash
payments and does not consider
other current assets which can be
easily converted into cash and
used to meet the current or short-
term liabilities.
(c) improvement of
Working Capital and
Cash Position :
Improvement in working
capital does not mean
improvement in cash
position.
Cash is only one of the
constituent of working capital.
An improvement in cash position
results in the improvement of
working capital.
Funds flow statement is one
of the tools of managing
working capital. It acts as an
instrument for the allocation
of resources.
Cash flow statement is more
useful to the management as a
tool of financial analysis in short
period.
Analyse of Cash Flow Statement
Cash flow is the movement of cash into or out of a business, project, or financial
institution. It is usually measured during a specified, finite period of time.
Measurement of cash flow can be used:
117
(1) To determine a project's rate of return or value.
(2) To determine problems with a business's liquidity
(3) As an alternate measure of a business's profits when it is believed that
accrual accounting concepts do not represent economic realities.
(4) Cash flow can be used to evaluate the "quality" of Income generated by
accrual accounting.
(5) To evaluate the risks within a financial institution.
The total net cash flow is the sum of cash flows that are classified in three areas:
1. Operational cash flows () : Cash received or expended as a
result of the company's internal business activities. It includes cash earnings
plus changes to working capital.
2. Financing cash flows ) : Cash received from the from the
loans received and issuance of shares, or paid out as dividends, shares
repurchases or debt repayments.
3. Investment cash flows ): Cash received from the sale of
long-life assets, or spent on capital expenditures (investments, acquisitions
and long-life assets).
♦ preparing the statement of cash flows
Unlike the major financial statements, cash flow statement is not prepared from the
adjusted trial balance. The information to prepare this statement usually comes from
three sources:
1) Current income statement data help the reader determine the amount of cash
provided or used by operations during the period.
2) Selected transactions data from the general ledger provide additional detailed
information needed to determine how cash was provided or used during the
period.
3) Comparative balance sheets provide the amount of the changes in assets,
liabilities, and equities from the beginning to the end of the period.
(1) Direct Method
The direct method reports cash receipts and cash disbursements from operating
activities. The difference between these two amounts in the net cash flow from
operating activates. In other words, the direct method deducts from operating cash
receipts the operating cash disbursements. The direct method results in the
presentation of a condensed cash receipts and cash disbursements statement.
The statement of cash flow using direct method by adjusting each item in the income
statement from the accrual basis to cash basis.
118
Exercise No. 1
The following are the income statement and Comparative Balance sheet for
Tiger Company:
Income statement for the year ended December, 31, 2019
Cost of goods sold
Operating expenses
Income before income tax
Income tax
Tiger Company Comparative Balance sheet (Thousands IQD)
Dec., 31/12/2019
Liabilities and stockholders'
equity
Additional information:
1) The company was declared and paid IQD 30000 as dividend in 2019.
2) Common stock of IQD 10000 was issued.
Required: Prepare the statement of cash flow by using Direct Method.
119
Solution:
Working Notes :
▪ Accounts receivable = 50000 – 90000 = - 40000 Decrease
▪ Cash receipts from costumers = Revenues - Accounts receivable
= 200000 – 40000 = 160000
▪ Accounts payable = 40000 – 25000 = 15000 Decrease
▪ Cash payments to suppliers = 80000 + 15000 = 95000
▪ Income taxes = 15000 – 10000 = 5000
Tiger Company
Statement of cash flows (Direct method) for the year ended Dec., 31, 2019
1- Cash flows from operating activities:
(1) Cash receipts from customers
(2) Cash payments:
To suppliers
For operating expenses
For income taxes
Net cash provided by operating activities
2-Cash flows from investing activities:
Purchase of furniture
Net cash used by investing activities
3-Cash flows from financing activities:
Issuance of common stock
Payment of cash dividends
Net cash used by financing activities
Net increase in cash
Cash at the beginning of the period
Cash at the end of the period
(2) Indirect Method
This method starts with net income and converts it to net cash flow from operating
activities. In other words, the indirect method adjusts net income by the items that
are affected on the net income but not affected on cash.
120
Rule:
Increase in current assets and decrease in current liabilities is deducted from net
income, Decrease in current assets and increase in current liabilities is added to net
income for the purpose of conversion net income to net cash from operating
activities.
Exercise No.2
The following information's are abstracted from books Bassam Co. (Amounts in IQD
thousands) :
1) Net Income was IQD 120000
2) Bonds payable increased IQD 50000
3) There was a gain on sale of equipment of IQD 20000 (the equipment had a
book value of IQD 30000).
4) Accounts Receivable decreased IQD 50000
5) Accounts Payable decreased IQD 20000
6) Prepaid Rent increased IQD 10000
7) Dividends totaling IQD 20000 were paid.
8) Depreciation was IQD 20000
9) Common Stock increased IQD 50000
10) Land increased IQD 100000 (purchased land for IQD 100000)
11) Beginning cash IQD 10000
12) Ending Cash IQD 180000
Required: Prepare the statement of cash flows by using the indirect method.
Solution: Cash Flow Statement of Bassam Corporation
For Year Ending 31/12/2019
121
Total Cash from Operations
Total Cash from Financing
Total cash from Investing
Net Increase in Cash Flow
Exercise No.3
The following are the income statement and the comparative balance sheets at the
beginning and the end of 2019 for Anssam's Co.(Amount in IQD thousands):
Income statement for the year ended December, 31, 2019
Revenues 100000
Less/ operating expenses (70000)
Income before income taxes 30000
Income tax expense (10000)
Net income 20000
change
Increase
/decrease
122
Additional information:
1) New computer equipment was purchased at the end of 2019, no depreciation.
2) The owner drew IQD 4000 during the year.
3) No additional investments by the owner.
4) The increase in long term debt is the issuance of bonds.
Required: Prepare the statement of cash flows for the year ended December, 31,
2019 by using Indirect Method.
Solution: Anssam's Co.
Statement of cash flows (Indirect Method)
Cash flows from operating activities:
Net income
Adjustment to reconcile net income to net
cash provided by operating activities:
Increase in accounts receivable
Decrease in notes receivable
Increase in accounts payable
Decrease in notes payable
Net cash provided by operating activities
Cash flows from investing activities:
Purchase of computer equipment
Net cash used by investing activities
Cash flows from financing activities:
Payments to the owner (Drawings)
Issuance of bonds
Net cash provided by financing activities
Net increase in cash
Cash at the beginning of the period
Cash at the end of the period
123
Questions and exercises
1. Describe the various Cash Flow Activities.
2. Give the Examples of Cash Flow from Operating Activities
3. Give the Examples of Cash Flow from Investing Activities
4. Give the Examples of Cash Flow from Financing Activities :
5. The total net cash flow is classified in three areas
6. what are the sources for preparing the cash flow statement?
7. How the measurement of cash flow can be used?
8. Describe the various Cash Flow Activities.
9. Distinguish between : Funds Flow Statement and Cash Flow Statement.
Exercise No.1
The following is the income statement and financial position of a corporation for the
year ended 31/12/2020
Income statement (amounts in thousands IQD)
Less: The cost of the goods sold
Administrative and general expenses
Depreciation of fixed assets
124
Balance Sheet (amounts in thousands IQD)
less: provision of Depreciation
less: Current liabilities
Administrative expenses due
Total current liabilities
Additional information's
1. Purchases of fixed assets during the year amounted to IQD (11,480,000).
2. The nominal value of the issuance of the new shares has been collected to
increase the capital.
Required :Prepare the cash flow statement in any method accepted
125
Exercise No.2
A comparative balance sheet for AL-Fourkan Company is presented below
Liabilities and Stockholders'
equity
Additional information:
1) Net income for 2020 was IQD 105000.
2) Cash dividends of IQD 40000 were declared and paid.
3) Bonds payable amounting to IQD 50000 were redeemed for IQD50000.
4) Common stocks were issued for IQD 50000 cash.
Required: Prepare a statement of cash flows for 2020 by using the indirect
method?
126
CHAPTER (7)
Common Size Analysis
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able
to understand the following subjects :
What is Common Size Analysis?
Types of Common Size Analysis
Importance of Common Size Analysis
Vertical Common Size Analysis
Horizontal Common Size Analysis
127
CHAPTER (7)
Common Size Analysis
What is Common Size Analysis?
Common size analysis, also referred as vertical analysis, is a tool that
financial managers use to analyze financial statements. It evaluates financial
statements by expressing each line item as a percentage of the base amount for that
period. The analysis helps to understand the impact of each item in the financial
statement and its contribution to the resulting figure.
The technique can be used to analyze the three primary financial statements,
i.e., balance sheet, income statement and cash flow statement. In the balance sheet,
the common base item to which other line items are expressed is total assets, while
in the income statement, it is total revenues.
There are many methods that a business can use to compare its financial
results to that of its competitors to see how successful that business is. In this
subject, we will explain the common size analysis.
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Types of Common Size Analysis
Common size analysis can be conducted in two ways, i.e., vertical analysis
and horizontal analysis.
Vertical analysis refers to the analysis of specific line items in relation to a
base item within the same financial period. For example, in the balance sheet, we
can assess the proportion of inventory by dividing inventory line using total assets as
the base item.
Horizontal analysis refers to the analysis of specific line items and
comparing it to a similar line item in the previous or subsequent financial period.
Although common size analysis is not as detailed as trend analysis using ratios, it
does provide a simple way for financial managers to analyze financial statements.
Importance of Common Size Analysis
One of the benefits of using common size analysis is that it allows investors to
identify drastic changes in a company's financial statement. It mainly applies when
the financials are compared over a period of two or three years. Any significant
movements in the financials across several years can help investors decide whether
to invest in the company. For example, large drops in the company's profits in two or
more consecutive years may indicate that the company is going through financial
distress. Similarly, considerable increases in the value of assets may mean that the
company is implementing an expansion or acquisition strategy, making the company
attractive to investors.
Common size analysis is also an excellent tool to compare companies of
different sizes but in the same industry. Looking at their financial data can reveal
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their strategy and their largest expenses that give them a competitive edge over
other comparable companies. For example, some companies may sacrifice margins
to gain a large market share, which increases revenues at the expense of profit
margins. Such a strategy allows the company to grow faster than comparable
companies because they are more preferred by investors.
.
Vertical Common Size Analysis
Common size or, vertical analysis, is a method of evaluating financial information by
expressing each item in a financial statement as a percentage of a base amount for
the same time period. A company can use this analysis on its balance sheet or its
income statement.
A balance sheet summarizes the company's assets (things that it owns that
have value), its liabilities (the amounts it owes to others), and its equity (an owner's
investment in the business).
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An income statement shows the company's revenues (amount of money it
made by selling its goods and services) and its expenses (the amount of money it
spent to earn its revenues).
The formula used in common size analysis is:
Common Size Amount = (Analysis Amount / Base Amount) x 100%
The base amount will change depending on whether the company is
completing its analysis on the balance sheet or the income statement. If the
company completes its analysis on the balance sheet, then the base amount will be
total assets or total liabilities and owner's (or shareholders') equity. If the income
statement is used, the base amount will be net sales.
Balance Sheet Common Size Analysis
The balance sheet common size analysis mostly uses the total assets value
as the base value. On the balance sheet, the total assets value equals the value of
total liabilities and shareholders' equity. A financial manager or investor uses the
common size analysis to see how a firm's capital structure compares to rivals. They
can make important observations by analyzing specific line items in relation to the
total assets.
For example, if the value of long-term debts in relation to the total assets
value is too high, it shows that the company's debt levels are too high. Similarly,
looking at the retained earnings in relation to the total assets as the base value can
reveal how much of the annual profits are retained on the balance sheet.
Let's take the example of SALAM Company whose balance sheet for 2020.
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SALAM Co.
Applying Common Size Analysis to the Balance Sheet
Let's assume that Salam's cash balance is IQD75,000 and his total assets are
IQD1,835,000. If we apply common size analysis, the common size amount would
be:
= (analysis amount / base amount of total assets) x 100%
= (IQD75,000 / IQD1,835,000) x 100%
= 4.1%
Therefore, 4.1% of Salam's total assets are made up of cash.
Salam could also compare this common size amount to last year to determine
changes that occurred. Let's assume that last year's cash balance was IQD85,000
and total assets were IQD1,595,000. At first glance, it appears that the cash balance
has only decreased by IQD10,000 (IQD85,000 - IQD75,000). If we apply common
size analysis to last year's cash balance, we can see that cash comprises 5.3% of
Salam's total assets calculated as follows:
= (analysis amount / base amount of total assets) x 100%
= (IQD85,000 / IQD1,595,000) x 100%
= 5.3%
Common size analysis reveals that Salam's cash balance decreased by 1.2%
(5.3% - 4.1%) of his total assets.
Here is Salam's common size analysis for his balance sheet:
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Salam's Co.
Balance sheet
December 31, 2020
Total Shareholders' equity
Total liabilities & Shareholders' equity
Common Size Balance sheet
Income Statement Common Size Analysis
The base item in the income statement is usually the total sales or total
revenues. Common size analysis is used to calculate net profit margin, as well as
gross and operating margins. The ratios tell investors and finance managers how the
company is doing in terms of revenues, and they can make predictions of the future
revenues. Companies can also use this tool to analyze competitors to know the
proportion of revenues that goes to advertising, research and development and other
essential expenses.
We can compute common size income statement analysis for SALAM
Company for 2020.
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SALAM Co.
Applying Common Size Analysis to the Income Statement
Let's assume that Salam's operating income is IQD52,000 and his net sales
for the year are IQD760,000. If we apply common size analysis, we calculate that
operating income represents 6.8% of Salam's net sales calculated as follows:
= (analysis amount / base amount of net sales) x 100%
= (IQD52,000 / IQD760,000) x 100%
Here is a figure of Salam's common size analysis for his income statement for
the year:
Salam's Co.
Income Statement
For the year ended Dec. 31 , 2020
Sales returns and allowances
Common Size Income Statement.
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Horizontal Common Size Analysis
(a) Comparative Financial Statements
Comparative (financial) statements are statements of the financial
position of a business so designed to facilitate comparison of different
accounting variables for drawing useful inferences (conclusions).
Importance of Comparative Financial Statement
1. Financial statements indicate the direction of the movement of the financial
position and performance over the years.
2. Financial statements present a review of the past activities and their
cumulative effect on the financial position of the concern.
3. Comparative Financial statements enhance the usefulness of reports and
bring out more precisely the nature and trends of current changes affecting
the business enterprise.
(b) Trend Analysis
1. Trend Percentages as a tool of analysis, are employed when it is required to
analyze the trend of data shown in a series of financial statements of several
successive years. The trend obtained by such an analysis is expressed as
percentages.
2. Trend percentage analysis moves in one direction, either upward or
downward - progression or regression. This method involves the calculation of
percentage relationship that each statement bears to the same item in the
base year.
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3. Trend percentage analysis facilitates an efficient comparative study of the
financial performance of a business enterprise over a period of time.
(c) Horizontal Analysis
1. Horizontal analysis requires financial statements of two or more years for
comparative analysis.
2. Horizontal analysis gives information in absolute as well as in percentage
form.
3. Horizontal deals with same item of different years.
4. Horizontal analysis is used for time series analysis.
(d) Common Size Financial Statements
1. Common size statement analysis refers to the statement prepared to bring out
the ratio of each asset or liability to the total balance sheet and the ratio of
each item of expense or revenue to net sales.
2. These common size statements are often called " Common measurement" or
"Component percentage" or "100 percent statements ".
3. Since each statement is reduced to the total of 100 and each individual
component of the statement is represented as a percentage of the total of
100, which invariably serves as the base.
Example : If the total assets of the firm amounts to 300,000 and plant and
machinery amounts to 30,000, the common size representation would be as follows :
Common Size=
=
011× = 10%
A horizontal financial statement analysis compares current financial
statements to a previous year's financial information. Companies often conduct this
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analysis by putting several years of financial statements in a side-by-side
comparison format. This enables business owners and managers to review the same
month over several years to determinate if revenues, expenses, assets or liabilities
have increased, decreased or stayed the same. Companies can also use a
horizontal analysis to compare changes in Dinar amounts or a percentage change
when comparing financial statements.
Vertical Analysis
A vertical financial statement analysis is conducted using common size
financial statements. A common size financial statement shows each item on a
financial statement in a percentage figure for each statement line item.
A vertical analysis gives managers a different option for reviewing financial
information; managers may be more comfortable looking at percentages rather than
Dinar amounts. The percentage figure represents how individual line-item amounts
compare to the aggregate total of the financial statements.
For example: business owners or managers may wish to know what
percentage office supplies were out of the total expenses reported on Mayson's
income statement. A common size statement would divide Mayson's total office
supplies expense by the total expenses listed on Mayson's income statement. This
percentage is then listed where the office supplies expense amount would be on the
financial statement.
Trend Percentage Analysis
A trend percentage analysis is an enhanced horizontal analysis technique.
Trend percentage analyses help companies identify consistent revenues or
expenses from past accounting periods. These trends can help managers make
business decisions regarding future operations.
Companies will use a specific financial statement as a base year for
comparing all future financial statements. Changes for each future time period are
expressed as a percentage when compared to the base financial statement.
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Companies can conduct a trend percentage analysis at various times of the year or
use different financial statements as the base during this comparison process.
The concept of Ratio (Meaning)
1. Ratio can be defined as numerical or an arithmetical relationship between two
figures.
2. Ratio is expressed when one figure is divided by the other..
3. A ratio is one figure expressed in terms of another figure.
4. For example, if 4,000 is divided by 10,000, the ratio can be expressed as 0.4
or 2:5 or 40%.
5. Absolute figures alone not convey any meaning unless they are compared
with each other.
6. Accounting ratios show an inter-relationship which exists among various
figures shown in the financial statements.
Ratio Analysis (Meaning)
1. The financial analysts always need certain yardsticks to evaluate the
efficiency and performance of any business unit. The one of the most
frequently used yardstick is "Ratio Analysis".
2. Ratio analysis is an attempt to derive quantitative measures or guides
concerning the financial health and profitability of a business enterprise.
3. Ratio analysis involves the use of various methods for calculating and
interpreting financial ratios to assess the performance and status of the
business unit.
4. Ratio analysis is a tool of financial analysis which studies the numerical or
quantitative relationship between two variables or items.
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5. Ratio analysis is the method or process by which the relationship of items or
groups of items in the financial statements are computed, determined and
presented.
Role of Ratio
(a) The Ratio is Showing the Financial Position of a Business
1. Accounting ratios reveal the financial position of a business firm.
2. Accounting ratios helps banks, insurance companies as well as other financial
institutions in assessing a firm before sanctioning any loan to them.
3. Similarly, the ratios are also helpful to investors for finding the profitability of a
firm.
(b) The Ratio is Useful In Inter-firm and Intra-firm Comparison
1. The ratios are very useful in inter-firm and intra-firm comparisons.
2. Inter-firm comparison is necessary to find out the exact position of a firm as
compared to other firms in the same industry.
3. Intra-firm comparison is also necessary to compare the performance of a firm
of current year with that of previous years.
(c) The Ratio is Calculated for a Number of Years
1. If accounting ratios are calculated for a number of years, a.trend can be
established.
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2. This trend helps in setting future plans and forecasting. For example, Net
Profit as expressed as a percentage of sales can be forecasted on the basis
of the past percentage of the same.
(d) The Ratio is Locating the Weak Spots Points in the Business
1. Accounting ratios are of great assistance in locating the weak spots in the
business.
2. This weakness may exist in a business in spite of a satisfactory performance
otherwise.
3. For example, if a firm finds that increase in selling and distribution expenses is
more than proportionate to the results expected or achieved, remedial steps
can be taken to overcome this situation.
Advantages of Ratio Analysis
1. Ratio analysis reflects the working efficiency of a business concern.
2. Ratio analysis facilitates comparison between one firm and another firm in the
same industry over a number of years to ascertain profitability.
3. Since ratio analysis reflect the financial health of a business concern, bank,
insurance and other financial institutions rely on them while judging loan
applications and in taking vital investment decisions.
4. Ratio analysis helps in establishing trend since the results are analyzed over
a number of years.
5. Ratio analysis is helpful in forecasting likely events in future.
Limitations of Ratio Analysis
(a) Absence of an Explicit Theoretical Structure
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1. The striking aspect of ratio analysis is the absence of an explicit theoretical
structure.
2. Different methods of calculations are adopted by different concerns.
(b) Full Adjustments
1. For correct analysis, inside information must be known by the analyst since
most concerns resort to portray a rosy picture of the financial attainments.
2. For example, a concern may draft its balance sheet when its inventory level is
low to reflect better liquidity position etc.
3. Thus, to come to correct conclusions, ratios must be calculated after full
adjustments are made.
(c) Changes in the Basis of Accounting
Change in the basis of accounting may pose difficulty in analyzing ratios
between one period and another period.
(d) Unable to Provide Complete Information
1. There may be some peculiar circumstances which may not be reflected in
ratio analysis. For example, a concern's debentures may be due for
redemption.
2. In such a situation, although Current Ratio =
may appear to be
favorable, there may be shortage of funds due to payment requirements.
Interpretation of Ratios
Ratios may be interpreted in different ways. They are as follows :
(a) Simple / Pure Ratios
It is merely a quotient arrived by simple division of one number by another.
Example
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When the current assets of a business organization are 40,000 and current
liabilities are 10,000, then the ratio is derived as follows :
i.e.
= 4 or as 4 :1
(b) Percentages
Ratios are expressed as percentage relations when the simple or pure ratios
are multiplied by 100.
Example
The current ratio in the (a) above can be expressed in percentage by multiplying 4 by
100. The ratio will be expressed as 400%.
i.e.
= 400%
(c) Rate
Sometimes, ratios are expressed as rates which refer to ratios over a period
of time.
Example : Stock has turned over ‗6 times a year'.
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Questions
1. What is Common Size Analysis?
2. Describe the formula used in common size analysis.
3. What are the Types of Common Size Analysis?
4. Explain Importance of Common Size Analysis.
5. Describe the various Tools of financial analysis.
6. Explain the Importance of Comparative Financial Statement.
7. What is the meaning of Trend Analysis?
8. Comment the Horizontal Analysis.
9. Explain Common Size Financial Statements.
10. Comment the Trend Percentage Analysis.
11. Explain the concept of Ratio.
12. What is Ratio Analysis ?
13. Write a Note about Interpretation of Ratios.
14. Describe the Classification of Ratios.
15. State the Role of Ratio.
16. State the Advantages of Ratio Analysis.
17. State the Limitations of Ratio Analysis.
18. Discuss in detail the Merits and Limitations of Ratio Analysis
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CHAPTER (8)
FINANCIAL RATIOS ANALYSIS
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Liquidity Ratio
Activity Ratio
Profitability Ratio
Solvency Ratio
Project Evaluation
Investment Policies
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CHAPTER (8)
FINANCIAL RATIOS ANALYSIS
(Classification and Interpretation of Ratios )
A ratio analysis is a quantitative analysis of information contained in a company's
financial statements. Ratio analysis is used to evaluate various aspects of a
company's operating and financial performance such as its efficiency, liquidity,
profitability and solvency.
Classification/Types of Ratios
Liquidity Ratios/Solvency Ratios
Liquidity ratios refers to the ability of a firm to meet its obligations in short-run,
usually, one year.
Liquidity ratios are generally based on relationship between current assets
and current liabilities.
The important liquidity ratios are :
(i) Current ratio,
(ii) Acid Test Ratio, and
(iii) Fund Flow Ratio.
Activity Ratios (Turnover Ratios)
Turnover ratios measure how effectively the assets are employed by the firm.
These ratios are based on the relationship between level of activity
represented by sales or cost of goods sold and levels of various assets.
The important turnover ratios are :
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1. Inventory Turnover Ratio,
2. Receivables Turnover Ratio,
3. Fixed Assets Turnover Ratio,
4. Average Collection Period Ratio, and
5. Total Assets Turnover Ratio.
Profitability Ratios
Profitability ratios reflects the final result of business operations.
There are two types of profitability ratios, i.e.
(i) Profit Margin Ratios, and
(ii) Rate of Return Ratios.
Profit margin ratios show the relationship between profit and sales.
The two popular profit margin ratios are gross profit margin ratio, and net
profit margin ratio.
Solvency Ratios
Solvency ratios are also known as "Liquidity Ratios ".
Miscellaneous Group Ratios
(1) Balance Sheet Ratios
These ratios are classified into the following categories, viz. :
i. Current Ratio
Current ratio indicates the solvency of the business, i.e. abilities to meet the liabilities
of the business as and when they fall due.
Formula : current ratio =
ii. Proprietary Ratio :
It is primarily the ratio between proprietor's funds and total assets. It indicates the
strength of the funding of the company.
Formula: Proprietary Ratio =
iii. Debt Equity Ratio
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This ratio is calculated to measure the comparative proportions of outsiders
funds and shareholders' funds invested in the company.
The Debt-Equity Ratio indicates how many Dinars have come from
borrowings for every Dinar of shareholders' funds.
Formula: Debt Equity Ratio =
A low debt equity ratio indicates that the management of the firm is following a
very conservative policy which is quite satisfactory from creditors angle.
A very high debt equity ratio indicates a risky situation as proportion of
borrowed funds is quite high.
(2) Profit and Loss Account Ratios
These ratios are classified into the following categories, viz.:
i. Net Profit Ratio
This ratio shows the earnings left for shareholders (equity and preference) as
a percentage of net sales.
This ratio measures overall efficiency of all the functions of a business firm
like production, administration, selling, financing, pricing, tax management etc.
This ratio is very useful for prospective investors as it reveals the overall
profitability of the firm.
Higher the ratio, the better it is because it gives an idea of overall efficiency of
the firm.
This ratio is calculated as follows :
Formula :
Net Profit Ratio =
Example :
Net Profit : 600,000
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Net Sales: 6,000,000
Net Profit Ratio=
=10%
ii. Operating Ratio
Operating Ratio is the relationship between cost of activities and net sales.
Operating Ratio show at what percentage the operating expenses are
comprised in net sales.
This Ratio is expressed as a percentage.
Formula :
Operating Ratio =
100
(3) Composite Ratios
These ratios are classified into the following categories, viz. :
i. Return on Capital Employed Ratio :
This ratio indicates the percentage of net profits before interest and tax to total
capital employed.
The capital employed is calculated as follows :
Formula : Capital Employed = Equity Capital (+) Preference Capita! (+) Reserves
and Surplus (+) Long-term Borrowings (-) Fictitious Assets.
This ratio is calculated as follows :
Formula :
Return on Capital Employed Ratio =
100
This ratio is considered to be a very important because it reflects the overall
efficiency with which capital is used.
This ratio of a particular business should be compared with other business
firms in the same industry to find out the exact position of the business.
ii. Return on Equity Ratio
This ratio is also known as Return on shareholders' funds or Return on
proprietor's funds or Return on net worth.
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This ratio indicates the percentage of net profit available for equity
shareholders. In other words, this ratio measures the return only on equity
shareholders' funds and not on total capital employed.
Formula :
Return of Equity =
100
[Note : Equity Shareholders' Funds = Equity Capital (+) Reserves, retained earnings
and Surplus].
This ratio indicates the productivity of the owned funds employed in the firm.
However, in judging the profitability of a firm, it should not be overlooked that during
inflationary periods, the ratio may show an upward trend because the numerator of
the ratio represents current values whereas, the denominator represents historical
values.
iii. Price Earnings Ratio
This ratio is calculated with the help of the following formula :
Formula : Price Earnings Ratio =
Example :
If the share price of a company is 240 and EPS is 40, the P/E ratio will be
= 6 times. It indicates that the market value of every Dinar of earnings is six times,
iv. Dividend Payout Ratio :
Dividend payout ratio indicates the percentage of profit distributed as dividends to
the shareholders.
A higher ratio indicates that the organization is following a liberal policy
regarding the dividend, while a lower ratio indicates a conservative approach
of the management towards the dividend.
The ratio is calculated as shown below :
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Formula :
Dividend Payout Ratio =
x 100
Project Evaluation
The following points highlight the top four methods of project evaluation in a firm.
The methods are:
1. Return of Investment (ROI)
2. Payback Period Method
3. Net Present Value (NPV)
4. The Internal Rate of Return (IRR).
We will address the method of return on investment as one of the methods
of financial analysis. Other methods are the study of financial management.
1. Return of Investment (ROI)
The ratio of profit expected from an investment project and the proposed investment
for the project is called Return on Investment (ROI).
This ROI ratio is used as a criterion for the evaluation of an investment project. The
greater the ROI of a project, the greater is its acceptability. There are three concepts
about the amount of investment on a project. The amount of investment may mean
the amount of assets, amount of capital invested, or the amount of equity capital. We
may obtain three types of ROI on the basis of these three concepts.
These are:
(i) Return on Assets (ROA)
By definition, ROA is the ratio between net profit and the assets. We may write,
therefore,
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ROA = net profit excluding taxes total assets
Here net profit does not include the interest to be paid to the lenders. But, since
interest is included in the real return on total assets, an improved form of ROA is:
(ii) Return on Capital Employed (ROCE)
ROA = ( net profit excluding taxes+ interest paid) total assets
ROCE is the second type of ROI. Here net profit, excluding tax, is expressed as a
ratio of the total amount of invested capital. The total amount of capital provided by
the owner of the firm and the lenders is the total invested capital in this case.
We may have this estimate of capital in two ways
First, the total amount of invested capital is the sum total of long-term
liabilities and equity of the shareholders.
Second, invested capital is the summation of the net circulating capital and
fixed assets. Therefore, we may write here:-
ROCE=
Add the interest paid in net profit and write:
ROCE =
(iii) Return on Shareholders' Equity (ROSE)
By definition, a general estimate of ROSE is:
ROSE =
Now the shares of a company may be of two types: preference shares and ordinary
shares. Here, if the shares are ordinary shares, then we may write:
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ROSE =
We may mention here two more measures of the rate at which the owners of
ordinary shares may obtain return from their company. These two rates of return
are ― earning per share‖ (EPS) and ― dividend per share‖ (DPS).
By definition, we have:-
EPS =
DPS =
It may be noted here that the share owners may earn at the rate of EPS only when
the company actually distributes all the money equal to the numerator of the formula
for EPS among the shareholders.
Investment Policy
The investment decisions are to choose the assets on which the money is being
spent. The assets are divided into two parts
1. Long-term assets: which have an impact over many years
2. Short-term assets: All assets that can be converted into cash or cash
equivalents during the period and are highly liquid
Accordingly, asset selection has two aspects
The first aspect relates to capital investments
The second aspect relates to the management of working capital
For the capital investments, there are key elements that are involved in making
capital decisions, including the group of assets in the entity and its composition, the
risks related to the entity's business in general, as well as the theory of measuring
the cost of capital
Working capital management is one of the main tasks of financial
management. It must create a an equilibrium between profitability and liquidity
because of a conflict between the two
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Working capital means the difference between current assets and current liabilities
as in the following equation
Working capital = Current assets - Current liabilities
If this difference is significant, there is a large amount of money frozen in current
assets that could have been invested in other areas effectively. If the difference is
small or negative, it means that the company is suffering from financial difficulties,
poor financial situation or financial failure. In this case, the entity must increase its
working capital so that it can meet its outstanding obligations during the financial
period. The company will resort to this in a number of ways, including the
introduction of new shares in the market, the increase in current assets or the sale of
part of the fixed assets
Procedures of Investment Policy
You can increase the value of your business and increase your income by investing
the profits from your company. This policy will help you control how profits are
invested.
Establishing an Investment Clearing Process
You can set up a procedure for reviewing and approving investments. This
procedure should designate who can present investment ideas, who will approve
them and who will monitor the profits and losses from investments.
Listing Prudent Investments
You can avoid making emotional investments by creating a list of the types of
investments you will consider. The "prudent man rule,"( )which comes
from common law but is endorsed by the Federal Deposit Insurance Corporation,
dictates that each investment must be considered on its own merits.
Setting Objectives
Your investment policy should include investment objectives. For example, you may
seek to create income by investing in dividend-paying stocks or interest-paying
bonds.
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Choosing a Strategy
Your investment policy should lay out a strategy for investing. That means explaining
exactly how and when you will invest.
Exercises Solved
Exercise No. 1
The following are the summarized Profit and Loss A/c and Balance Sheet of Zane
Ltd. for
Dr. Profit and Loss Account Cr.
Balance Sheet
Other Current Liabilities
Requirement: Calculate the following:
1. Gross Profit Ratio.
2. Operating Profit Ratio.
3. Return on Capital Employed.
4. Stock Turnover Ratio.
5. Debtors Turnover Ratio.
6. Current Ratio.
7. Sales to Fixed Assets Ratio.
8. Net Profit to Fixed Assets Ratio.
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9. Sales to Capital Employed Ratio.
10. Turnover to Total Assets Ratio.
Solution :
(1) Gross Profit Ratio =
=
= 46.32 %
(2) Operating Profit Ratio =
=
= 24.24%
(3) Return on Capital Employed =
=
= 56.52%
(4) Stock Turnover Ratio =
=
= 4.088
(5) Debtors Turnover Ratio =
=
=
= 19
(6) Current Ratio =
=
= 2:1
(7) Sale to Fixed Assets Ratio =
=
= 2.88 Times
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(8) Net Profit to Fixed Assets Ratio =
=
= 78.79%
(9) Sales to Capital Employed Ratio =
=
= 2.06
(10) Turnover to Total Assets Ratio =
=
= 1.61 Times
Exercise No.2
Betal Manufacturing company submits the following Profit and Loss Account for the
year ended 31st March, 2020.
Dr. Profit and Loss A/c Cr.
To Opening Stock
To Purchase
To Wages
By Sales
By Closing Stock
To Manufacturing Expenses
To Selling & Distribute
Expenses
To Administrative Expenses
By Profit on Sale of
Shares
To Loss on Sale of Furniture
Calculate :
1. Gross profit ratio,
2. Net profit ratio,
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3. Operating profit ratio,
4. Operating net profit ratio.
Solution :
(i) Gross Profit Ratio =
=
= 32.5%
(ii) Net Profit Ratio =
=
= 17.5%
(iii) Operating Ratio =
=
= 84.25%
(iv) Operating Profit Ratio =
=
=
= 15%
Exercise No.3
From the following Balance-sheet of XYZ Ltd., calculate the following ratios:
1. Current ratio,
2. Liquid ratio,
3. Absolute liquidity ratio,
4. Current assets to Fixed assets ratio,
5. Debt to equity ratio,
6. Proprietary ratio,
7. Capital gearing ratio,
8. Fixed assets ratio.
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Balance Sheet as on 31st March, 2020
Solution :
I. Current Ratio =
=
= 2.5:1
Note : Current assets include inventories, debtors, bills receivable, bank balance and
short-term investments.
Current liabilities include creditors, bills payable, bank overdraft, taxation provision.
II. Liquid Ratio =
=
Liquid Assets= Current Assets (-) Stock
Liquid Liabilities = Current Liabilities (-) Bank Overdraft
Overheads =
= 1.05:1
III. Absolute Liquidity Ratio =
=
= 0.55:1
IV. Current assets to fixed assets =
=
= 0.526:1
Note : Fixed assets include Goodwill, Plant and Machinery, Furniture and Land and
Building.
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V. Debt to Equity Ratio
a.
=
Equity Capital (+) Preference Capital (+) General Reserve (+) Profit and Loss A/c
=
=0.25:1 b.
=
a. =
b. = 0.20:1
VI. Proprietary Ratio =
=
= 0.69 : 1
VII. Capital Gearing Ratio =
=
=
= 0.66:1
VIII. (viii) Fixed Assets Ratio =
=
(Shareholders' Funds + Long-term debt)
= 0.76:1
159
Exercise No. 4
From the following details prepare the balance sheet of ABC Ltd.
Fixed Assets Turnover Ratio
The Gross Profit IQD 6,00,000. Closing Stock IQD 5,000 in excess of Opening
Stock.
Solution :
Balance Sheet of ABC Ltd,
Working Notes:
1. Gross Profit Ratio
2%=
2=
Sales = 300,000 IQD
Cost of Goods Sold = Sales - Gross Profit
= 300,000 - 60,000
= 240,000 IQD
160
2. Stock Turnover =
6 =
= 40,000 IQD
But. =
40,000 IQD =
…….(1)
5,000 IQD = …….(2)
Solving the above two equations.
- Closing Stock + Opening Stock = 80,000 IQD
- Closing Stock - Opening Stock = 5,000 IQD …..(3)
Subtracting equation (2) from equation(3) , we get
2 (Opening Stock) = 75,000 IQD
Opening Stock =37,000 IQD
But, Closing Stock + Opening Stock = 80,000 IQD
Closing Stock + IQD 37,500 = 80,000 IQD
Closing Stock =42,500(80,000- 37,500)
3. Capital Turnover Ratio =
2 =
Capital = 120,000 IQD
4. Fixed Assets Turnover Ratio =
4=
= 60,000 IQD
5. Debt Collection Period = 2 Months
Debtor Turnover Ratio =
=
= 6
OR Debtors Turnover Ratio =
Assuming Sales as Credit Sales and Debtors Turnover Ratio is based on year-end
figures, we have,
161
Debtors =
= 50,000 IQD
6. Creditors Payment Period = 73 Days
Creditors Turnover Ratio =
=
= 5 days
Assuming all purchases to be credit purchases, the amount of purchase is
determined as follows :
Cost of Goods Sold= Opening Stock (+) Purchases (-) Closing Stock
240,000 = 37,500 (+) Purchases (-) 42,500
240,000 (+) 42,500 (-) 37,500= Purchases
Purchases = 245,000 IQD
Now. Creditors Turnover Ratio =
5=
= 49,000 IQD
Exercise No. 5
Following are the ratios relating to the trading activities of an organization.
- Debtors Velocity = 3 months
- Stock Velocity = 4 months
- Creditors Velocity = 2month
- G. P. Ratio = 25%
- Capital Turnover Ratio =3
- Fixed Assets Turnover Ratio =4
Gross Profit for 2019-19 IQD 750,000. Stock as on 31-3-2020 was 30,000 IQD more
than it was on 1-4-2019. At the end of the year Bills Payable and Bills Receivable
were 45,000 IQD and 50,000 IQD and Bank Overdraft was 110,000 IQD.
Requirement: Prepare a statement of Proprietary Fund for the year ended 31 -3-
2020.
162
Solution :
Statement Showing Proprietary Fund as on 31-3-2020
Add : Current Assets (CA):
Less : Current Liabilities (CL):
Working Notes :
1- Debtors Velocity =
OR 3 =
=
= 750,000 IQD
2- G.P. Ratio =
25
=
Sales = 4
= 3,000,000 IQD
3- Stock Velocity=
Here, Stock Velocity = 4 months
=
months
= 3 times
Now, Cost of Goods Sold = Sales – G.P.
Cost of Goods Sold = 3,000,000 – 750,000
163
= 2,250,000 IQD
Let the Opening Stock be y.
Closing Stock = y + 30,000
=
=
= y + 15,000
Now. Stock Velocity =
i.e., 3=
3y+45,000 = 2,250,000
3y = 2,205,000
y =
= 735,000 IQD
Opening Stock = 735,000 (y)
Now. Closing Stock = y+ 30,000
Closing Stock = 735,000 + 30,000
= 765,000 IQD
4- Capital Turnover Ratio =
3 =
IQD
5- Fixed Asset Turnover Ratio =
4=
Fixed Assets = 750,000 IQD
6- Creditors Velocity =
12
164
2=
12
= 380,000 IQD
( )The Purchase figure of 2,280,000 IQD can be found by Opening Trading A/c.
Trading A/c (31-3-2020)
To Opening Stock
To Purchase (Balancing Figure)
To Gross Profit
735,000
2,280,000
750,000
By Sales
By Closing Stock
Exercise No. 6
With the help of the following ratios regarding Kachin Ltd. draw the balance sheet for
the year ended 31 March, 2020.
Current ratio 2.5 Liquid ratio 1.5
Net working capital 300,000 IQD.
Stock turnover ratio (cost of sales/closing stock) 6 times Gross profit ratio
20%
Fixed assets turnover ratio (on cost of sales) 2 times Debt collection period 2
months Fixed assets to shareholders net worth 0.80
Reserve and surplus to capital 0.50.
Solution :
Working Notes:
(1) Working Capital = CA -CL
=
2.5 =
CA= 2.5 CL
Working Capital = 2.5 CL – CL
300,000 = 1.5 CL
165
CL = 200,000
CA = 2.5 200,000
CA= 500,000 IQD
(2) Liquid Ratio =
1.5=
= 300,000
500,000 – 300,000
200,000 IQD
(3) Stock Turnover Ratio =
6 =
Cost of Sales = 1,200,000 IQD
(4) Sales = Cost of Sales (+) Gross Profit
= 1,200,000 (+)300,000
= 1,500,000 IQD
Sales Cost of Sales G.P.
100 80 20
1,200,000 ?
1,200,000 x
= 300,000 - (Gross Profit)
(5) Debtors =
= 250,000
(6) Fixed Assets = 2 x 12,00,000
= 2,400,000 IQD
(7) Fixed Assets to Net worth =
0.80 =
Net Worth = 3,000,000 IQD
(8) Reserves and Surplus to Share Capital
=
= 0.50
Reserves and Surplus =
of Equity Share Capital
But, Net Worth = Capital (+) Reserve
166
= 3,000,000 IQD
3,000,000 = [Equity Share Capital (+)
Equity Share Capital]
Share Capital = 3,000,000x
= 2,000,000
Reserves and Surplus = 0.50 of 2,000,000
= 1,000,000 IQD
Balance Sheet of Kachin Ltd. for the year ended 31-3-2020
Exercise No. 7
Following information is given for two companies A Ltd. and B Ltd.
Requirement: Analyze the financial position of the two companies.
Solution :
(a) Current Ratio of A. Ltd is 1.25 which is not favorable. Hence, the short-term
financial position of the company is not strong.
Current Ratio of B. Ltd. is 1.01 which is not favorable. Hence, the short-term
financial position of the company is not strong.
(b) Liquid Ratio of A. Ltd. is 0.96, which shows that the solvency position of A.
Ltd. is not strong.
satisfactory. (0.96 < 1)
Liquid Ratio of B. Ltd. is 0.69, which shows that the solvency position of B. Ltd. is
not satisfactory.(0.69 < 1)
Share Capital
Reserves and Surplus
Current Liabilities
2,000,000
1,000,000
200,000
Fixed Assets
Current Assets:
Stock 200,000
Debtors 250,000
Cash 50,000
Investment (Balancing
Figure)
2,400,000
00,000
300,000
167
(c) Gross Profit Ratio of A. Ltd. is 26.7% and B. Ltd is 33.3% which shows
that the profitability of both the companies seems to be satisfactory. However,
whether there is an improvement in the profitability or not depends on the
comparative study of figures of the previous accounting periods.
(d) Debt Equity Ratio of A. Ltd is 0 and B. Ltd is 0.33. Banking Companies
consider debt equity ratio up to 2 : 1 as normal. Debt equity ratio in both our
cases was lower than the normal debt equity ratio. This shows that there was
a greater margin of safety available to loan creditors. Both the companies was
eligible for long-term financial assistance.
(e) The Net Profit Ratio of A. Ltd is 15%, which shows that the profitability of
the company seems to be quite satisfactory.
The Net Profit Ratio of B. Ltd. is 10% which is quite low. This shows that the
profitability position of the company is quite unsatisfactory. The management is not
efficient in controlling cost.
Exercise No. 8
The Current Ratio is twice than Quick Ratio. Calculate value of stock, if working
capital is 40,000/- IQD , & bank overdraft is 10,000/- IQD .
Solution :
Here, Current Ratio = 2
Now, Current Ratio =
2 =
2CL = 40,000 + CL
CL = 40,000 IQD
and CA= 80,000 IQD
now Quick Ratio = 1
Quick Ratio =
1 =
1=
30,000=
50,000 IQD
Ca cl = 40.000 IQD
CA =40.000 + CL
168
Questions and Exercises
Questions
1. Describe the Classification and Types of Ratios.
2. What is the Liquidity Ratios and Solvency Ratios?
3. What are The important liquidity ratios?
4. What are The important turnover ratios ?
5. What are types of profitability ratios?
6. Indicate the Balance Sheet Ratios.
7. Indicate the Profit and Loss Account Ratios.
8. Explain the Composite Ratios.
9. Indicate the methods of project evaluation in a firm.
10. Explain the Investment Policy.
11. What is the meaning of Working capital?
12. Explain the Procedures of Investment Policies.
Exercises
Exercise No.1:
The following is the balance sheet of Iraqi Rubber Industries Company for the
financial year ended 31/12/2020:
inventory 31/12 at a sales
price
Provision for depreciation
169
Provision for doubtful
debts
Additional Information:
1. The value of the beginning inventory at 1/1/2020 was 320,000 dinars at
cost.
2. The selling price is determined in accordance with the company's policy
plus 20% as the profit margin for the cost.
3. Total profit for the year amounted to 360,000 dinars.
4. Credit purchases represent two-thirds (2/3) of the cost of net sales.
5. The discount rate charged by the bank is 5%. The average maturity of
the notes receivable is 4 months.
6. Payment period average planned by the company is 3 months.
7. Storage period average planned by the company is 80 days.
8. Cash ratio (monetary standard) accepted by the company is 50%.
Required:
1. Rebalancing the balance sheet in accordance with accounting standards
and applying financial analysis.
2. Use the revised balance sheet data to extract the following ratios:
Cash ratio (cash standard).
Creditors Turnover.
Payment period average
Inventory turnover.
Storage period average .
Fixed asset turnover
170
Exercise No.2
The net profit before interest and tax for an industrial company for the year 2020 is
520,000 dinars and the debit annual interest is 80,000 and the annual installments
due for the same year are 120,000.
Required : Determine the company's ability to service its debt for the year 2020 and
compare it with the year 2019 by 1.5 times
Exercise No.3
The following is the financial data extracted from the records of a company for the
years 2019 and 2020.
Net profit before interest and taxes
Required:
A. Determine the profit margin, and turnover of operating assets.
B. Determine The company's earning power during the two years and comment
on it
Exercise No.4
the following data abstracted from records of an industrial company for the years
2019 and 2020
Total assets (fixed and current)
Total long and short term debt
Require : find the ratio of debt (financial leverage) of the company for 2019 and
2020.
171
Exercise No.5
The following is the data of a company for the period ended 31/12/2020:
Total current liabilities
Expenses paid in advance
Total Liabilities and Equity
Additional Information:
1. Inventory turnover = 10 times
2. Quick Liquidity ratio = 2:1
3. Gross profit = 7,800,000
4. Net profit = 2,080,000
5. Total debt to the equity ratio = 1:4
6. Asset turnover rate = 2
7. Profit margin ratio = 8%
8. Debtors Turnover rate = 8 times
9. Balances of accounts receivable, inventory, equity and total assets as of
31/12/2020 are identical to their balances as at 31/12/2019.
10. Convertible quick assets to cash consist of the following:
cash 27%
notes receivable 8%
debtors 65%
11. All sales and procurement results.
Required:
a. Find the values of the balances indicated by a question mark (?).
b. Find a rate of return on assets.
c. Find a rate of return on equity
172
Exercise No.6
The balance sheet of an industrial corporation for the year ended 31 December 2020
is as follows:
(-)
Depreciation of
Fixed assets
net profit for
the year
Short - term
liabilities
provision of
doubtful debts
Total Current
Liabilities
additional information
• Annual net sales of 1,260,000 dinars
• Annual net purchases of 600,000 dinars
• Cost of sales is 1,181,600 dinars
Required: Calculate the following financial ratios:
1. Current ratio
173
2. Quick liquidity ratio
3. Creditors turnover and notes payable
4. Creditors payment period average and notes payable
5. Inventory turnover
6. Storage period average
7. Fixed asset turnover
8. Debtors collection period average and notes receivable and their comparison
with creditors payment period average and notes payable
Exercise No. 7
The following elements of a balance sheet as on 31/12/2020:
Assets: Cash Inventory Total current assets fixed assets ?
Liabilities : Loans Current liabilities Total liabilities equity
Information's additional:
1. Equity of stockholders = 500,000 IQD
2. Ratio of Current Liabilities to Total Debt = 40%
3. Total debt to equity = 60%
4. Ratio of fixed assets to equity = 60%
5. Asset turnover = 2 times
6. Inventory turnover = 8 times
Required: Complete the balance sheet using the information available above
174
Chapter (9)
Financial Leverage
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Concept of Leverage Ratios
Leverage Ratios
Degree of Financial Leverage
Leverage Degree Analysis
175
Chapter (9)
Financial Leverage
Financial leverage refers to the use of debt to acquire additional assets.
Financial leverage is also known as trading on equity. Financial leverage is the
amount of debt that an entity uses to buy more assets. Leverage is employed to
avoid using too much equity to fund operations. An excessive amount of financial
leverage increases the risk of failure, since it becomes more difficult to repay debt.
Concept of Leverage Ratios
Leverage ratios are used to determine the relative level of debt load that a
business has incurred. These ratios compare the total debt obligation to either the
assets or equity of a business. A high ratio indicates that a business may have
incurred a higher level of debt than it can be reasonably expected to service with
ongoing cash flows.
The two main leverage ratios are:
Debt ratio . Compares assets to debt, and is calculated as total
debt divided by total assets. A high ratio indicates that the bulk of asset
purchases are being funded with debt.
Debt to equity ratio . Compares equity to debt, and is
calculated as total debt divided by total equity. A high ratio indicates that the
business owners may not be providing sufficient equity to fund a business.
Leverage ratios are essentially measures of risk, since a borrower that cannot
pay back its debt obligations is at considerable risk of entering bankruptcy protection.
176
However, a modest amount of leverage can be beneficial to shareholders, since it
means that a business is minimizing its use of equity to fund operations, which
increases the return on equity for existing shareholders.
A prospective lender may use leverage ratios as part of its analysis of whether
to lend funds to a business. However, these ratios do not provide sufficient
information for a lending decision. A lender also needs to know if a business is
generating sufficient cash flows to pay back debt, which involves a review of both
the income statement and statement of cash flows. A lender will also review a
company's budget, to see if projected cash flows can continue to support ongoing
debt payments.
In addition, the nature of the industry in which a business is located plays a
significant role in the lending decision. For example, if an industry has few
competitors, there are high barriers to entry, and there is a long history of above-
average profits, then an organization could probably maintain a high debt load over a
long period of time. Conversely, in an industry where market share changes
continually, product cycles are short, and capital investment requirements are high, it
is quite difficult to have stable cash flows - and lenders will be less inclined to lend
money.
In short, leverage ratios are used for a portion of the analysis when
determining whether to lend money, but a great deal of additional information is
needed before a lending decision can be made.
Leverage Ratios
A leverage ratio is any one of several financial measurements that look at how
much capital comes in the form of debt (loans), or assesses the ability of a company
to meet its financial obligations.
The leverage ratio is important given that companies rely on a mixture of
equity and debt to finance their operations, and knowing the amount of debt held by
a company is useful in evaluating whether it can pay its debts off as they come due.
Leverage Ratios for Evaluating Solvency and Capital Structure. The most
well-known financial leverage ratio is the debt-to-equity ratio. It is expressed as:
177
D/E Ratio = Total Debt Total Equity
The equity multiplier is similar, but replaces debt with assets in the
numerator:
Equity Multiplier = Total Assets Total Equity
The equity multiplier is a component of the DuPont analysis for
calculating return on equity (ROE):
ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
An indicator that measures the amount of debt in a company's capital
structure is the debt-to-capitalization ratio, which measures a company's financial
leverage. It is calculated as:
Long-term Debt to Capitalization Ratio = Long-term Debt (Long-Term Debt +
minority interest + equity)
In this ratio, operating leases are capitalized and equity includes both
common and preferred shares. Instead of using long-term debt, an analyst may
decide to use total debt to measure the debt used in a firm's capital structure. The
formula, in this case, is:
Total Debt to Capitalization Ratio = (current liabilities + Long-Term Debt)
(current liabilities + Long-Term Debt + minority interest + equity)
Degree of Financial Leverage
Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a
company's earnings per share (EPS) to fluctuations in its operating income, as a
result of changes in its capital structure. It measures the percentage change in EPS
for a unit change in earnings before interest and taxes (EBIT), and is represented as:
DFL =
178
DFL can also be represented by the equation below:
DFL =
This ratio indicates that the higher the degree of financial leverage, the more
volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies
returns and EPS. This is good when operating income is rising, but it can be a
problem when operating income is under pressure.
Leverage Degree Analysis
A lever is defined as the extent to which profits can be increased in an
enterprise as a result of increased reliance on fixed costs or borrowed funds or
together.
Thus, the concept of crane covers three main areas:
1. Operational leverage: It is linked to the cost structure.
2. Financial leverage: It is linked to the financing structure.
3. Common leverage: A combined result of the operational and financial
leverage
Operating Leverage
The operating leverage is concerned mainly with fixed costs as the cost
incurred by the firm in a continuous manner regardless of the volume of production
and sales. Thus, the share of fixed unit costs will decrease when the production
increases. This will result in additional net profits. The variable costs are directly
179
related to the production. The share of an unit of variable costs remains constant as
production levels change and the price is associated with the policy of the firm and
often by factors beyond control
operating leverage
Therefore, the efficiency of the operational leverage is related to the maximum
utilization of available operational capacity to increase production and thus increase
sales. Therefore, the operational leverage measures the degree to which the change
in operating profit responds to the change in sales and accordingly: Operational
leverage is defined as the extent or percentage of increase in profits use fixed costs
..
Determine the operating leverage by the following equation:
Operational leverage =
This means that any change in the number of units sold will result in a positive
(or negative) change in the net profit, so that the operational leverage is a key
indicator of what is known as business risk or operational risks.
180
Another method to calculate the operating leverage by using profit as a
percentage of sales is to what extent the change in the operating profit of the change
in sales is accounted for by the following equation:
If we assume that the change in sales is 10%, any that year's sales are more
than 10% sales last year, leading to a 20% change in profits before interest and
taxes, the operational leverage level is 2.
Financial leverage
A financial leverage is defined as the extent or proportion of the increase in
profits as a result of the use of the money of others in the business of the firm. The
effect of the financial leverage is positive on the return if the management of the
entity succeeds in investing the borrowed funds at a rate of return that exceeds the
interest paid on them. In other words, a financial leverage is in favor of the company
if the rate of return on investment is greater than the interest rate and vice versa, and
thus the financial leverage is related to the financial risks.
181
Financial leverage =
Common leverage (Total)
A common leverage is defined as the extent or proportion of the increase in
profits due to the optimal use of fixed costs and the use of borrowed funds in
operations. Therefore, the common leverage arises from the combined effect of both
the operational leverage and the leverage so that it reflects the combined effect of
the business risk and the risk of borrowing. Accordingly, the common leverage is a
measure of the overall risk of management and shareholders.
The common leverage is measured by the following equation:
common leverage = Operational Leverage Degree× Financial Leverage Degree
.
=
combined leverage
182
Example :
The sales of the Company (x) were (400,000) IQD. The variable costs of
these sales amounted to (150,000) IQD. The fixed costs were (50,000) IQD and the
interest was 10,000 IQD.
Required : Prepare an Interpretation and analysis of:
1. Operational Leverage Degree.
2. Financial leverage Degree.
3. Common leverage Degree .
solution :
1. Operational Leverage Degree
DOL= (400,000 – 150,000 ) 400,000 – (50,000 + 150,000)
DOL = (250,000) (200,000) = 1.25 times
DOL
This means that each change in the number of units sold by one unit will
result in a positive net change in net profits of 1.25 times.
2. Financial leverage (DFL)=
DFL
Since the degree of leverage is positive and greater than the right one, it
means that the decision of the firm to invest in borrowed money was a sound and
feasible decision, it was able to achieve a profit that covers the interests of debts and
achieve a net profit.
183
3. common leverage = Operational Leverage Degree× Financial Leverage
Degree .
DCL = 1.25 × 1,05 = 1.31 times
In this case the company has achieved a degree of operational leverage
positive as well as the degree of financial leverage positive, the degree of common
leverage will be affected by both grades, which led to a positive degree of common
leverage also
184
Questions and Exercises
Questions
1. What is the Concept of Leverage Ratios?
2. What are The main leverage ratios?
3. Define the leverage ratio.
4. Explain the Degree of financial leverage (DFL).
5. Define A lever?
6. Explain the concept of crane covers .
Exercises
Exercise No.1:
The sales of a company amounted to 1,200,000 dinars, the variable costs
400,000 dinars, the fixed costs 400,000 dinars, and the interest of 40,000 dinars.
Required: Compute and interpret the following:
1. operational leverage degree
2. financial leverage degree
3. common leverage degree
Exercise No.2:
The sales of a company amounted to 1,00,000 dinars, the costs of sales
600,000 dinars, the fixed costs 140,000 dinars, and the interest of 16,000 dinars.
Required: Calculate and interpret the following:
1. Operational leverage degree
2. Financial leverage degree
3. Common leverage degree
185
Exercise No. 3:
The following data has been extracted from the books of a company:
Depreciation of fixed assets
other revenues and
miscellaneous
purchases transport expenses
Selling and distribution
expenses
publicity and Advertising
expenses
bank commissions
payable
Capital (20% of capital is preferred
shares)
Required :
Calculate and analyze the following:
1. Operational leverage degree.
2. Financial leverage Degree.
3. Common leverage degree
186
Chapter (10)
Predict Financial Failure
LEARNING OBJECTIVES …..
After reading this chapter, you can certainly be able to
understand the following subjects :
Predict of Financial Failure
Predict Financial Failure Models
Altman and Mccovgh Model Z-Score (1974)
Kida Model Z-Score (1984)
Sherrod Model Z-Score (1987)
187
Chapter (10)
Predict Financial Failure
Predict of Financial Failure
Predicting the strength or weakness of an enterprise, and predicting its potential
failure may require the use of certain financial ratios, these are representative of
performance factors. The results of these ratios are then measured in the knowledge
of the performance of the entity. The scientific literature presents the existence of
many predictive models of the financial failure of the enterprises
The American Institute of Certified Public Accountants (AICPA) and the Securities
and Exchange Commission (SEC) have been credited with finding and developing
these models in the wake of major corporate and banking crises that swept through
the United States after the Second World War and the accountability of accountants ,
the legal accountants were charged with taking responsibility for misinformation in
the financial statements. Hence, the role of the legal accountant in conducting tests
on the ability of the audited entity to audit the continuity of activity or giving early
warning about its failure and bankruptcy.
188
AICPA SEC )
Predict Financial Failure Models
There are many analytical models to predict the financial failure put forward by many
researchers for the purpose of application in industrial and banking companies. Most
of these analytical models are based on the compound financial ratios. They are
based on quantitative indicators derived from published and sometimes unpublished
financial statements, which are aggregated from different sources. The main
difference between these models is the difference in the relative weight given to
each financial ratio used, and in the number of ratios used as independent variables.
The most common analytical models used to support the financial failure of a
business is:
1. ( Altman and Mccovgh ) Model Z-Score (1974)
2. (Kida) Z-Score Model 1984
3. (Sherrod) Z-Score Model 1987
Altman And Mccovgh)
Kida
Sherrod
189
Altman and Mccovgh Model (1974)
Altman is the first to use multivariate analysis to predict business failure problems.
He has collected more than one variable to achieve this goal. In a comparison of 33
failed companies and 33 successful companies in the same activity, an equation
known as z- score.
The Altman and Mccovgh model is one of the most common models of business
failure forecasting. This model was developed in 1974 to complement a previous
model by Altman in 1968
Altman And Mccovgh)
Altman
z-score
Altman And Mccovgh)
Altman
Ratio of net working capital to
total assets
Ratio of reserves and retained
earnings to total assets.
Ratio of net profit before interest
and tax to total assets
Ratio of market value of capital
to book value of debt (liabilities)
ratio of net sales to total assets
190
Altman and Mccovgh, using statistical analysis, have developed a quantitative model
that gives the possibility of predicting failure in case of application according to the
following equation:
Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.0999X5
X1 to X5 = The variables, i.e. the financial ratios above, used in the model are any
ratios that vary from a firm to another depending on their performance. In other
words, this model is based on five financial ratios that study five independent
variables and a dependent variable denoted by the z symbol. This model is
expressed mathematically by the following formula:
Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.010X5
The ratios used in the model are:
X1 = Net working capital / total assets.
X2 = Retained Earnings / Total Assets
X3 = EBITDA / total assets
X4 = Market value of equity / total liabilities
X5 = Sales / Total Assets
Z = Continuity Guide
191
Z=0.012X1+0.014X2+0.033X3+0.006X4+0.0999X5
X1 X5
z
Z=0.012X1+0.014X2 +0.033X3+0.006X4+0.010X5
X1
X2
X3
X4
X5
Z
According to this model, companies are classified into three categories in terms of
failure or success in continuity of work and these categories are:
1. Successful companies should have a value of (Z) in them (2,99) and more.
2. Companies whose existence and probability of bankruptcy are doubtful are
limited to (Z) between (1,81) and (2,99).
3. Failed Companies The value of (Z) is less than (1,81).
This model is a good example of a financial failure study, which proved its ability to
predict the detection of financial failure two years earlier
192
Z ,99
Z
,81 ,99
Z ,81
Example :
The following is the financial data extracted from the books of a business entity:
Total assets 1,600
Total Liabilities 600
Retained earnings 300
Net operating profit 350
Stock Market Value 700
Current assets 800
Current Liabilities 500
Sales 1,200
Z = 0.012 (300/1600) + 0.014 (300/1600) +0.033 (350/1600) +0.006 (700/600)
+0.010 (1200/1600)
0.027 = 0.002 + 0.003 + 0.007 + 0.007 + 0.008
Comparing the results of the example with the indicators of the three categories
mentioned above, we find that the probability of failure of this company is certain
since the value of Z is (0.027) much lower than (1.81)
193
Kida Model (198 ):
This model is also based on five main financial ratios:
Net Profit after Tax / Total
Assets
Current Assets / Current
Liabilities
Assets Cash / Total Assets
Kida
The equation of this mathematical model is as follows:
Z = 1.042X1 + 0.42X2 - 0.461X3 - 0.463X4 + 0.271X5
The probability of failure is high according to this model when the value of (Z) is
negative, but if the value of Z is positive, the firm is safe. That is, according to this
model, the probability of failure of the companies increases as the value of (Z)
negative, but if the result is positive, the company's potential to continue to work
without financial failure
194
Z = 1.042X1+0.42X2-0.461X3-0.463X4+0.271X5
Z Z
Z
Example :
The following balances appeared in the records of an industrial company:
Total Assets 3000
Total liabilities 1800
Sales 4000
Cash Assets 800
Current Liabilities 1200
Shareholders' Equity 2000
Net profit after tax 150
Required: prepare an analytical study of these data by using the KIDA model to
determine the extent of the entity's ability to continue.
Solution:
Z = 1.042 (150/3000) +0.42 (2000/1800) -0.461 (800/1200) -0.463 (4000/3000)
+0.271 (800/3000)
Z = 0.052 + 0.466-0.307-0.617 + 0.072
Z = (0.334)
According to this model, we find that the firm of subject of the study is under the
probability of a high failure, this is because the value of (Z) was negative (0.334).
Sherrod Model (1987)
This model aims to achieve two main objectives:
1. Credit risk assessment: - The model is used by banks to assess the credit
risk when granting loans to economic projects, as the loans are divided into
five categories according to the degree of risk as in the following table:
195
Sherrord
2. Financial failure: It is used to ascertain the principle of continuity of the
project in economic life to identify the extent of the project's ability to carry out
its activity in the future.
This model is prepared on the following regression equation:
Z = 17X1 + 9X2 + 3.5X3 + 20X4 + 1.2X5 + 0.1X6
whereas :
Z = Bankruptcy Index
X1 = Net Working Capital / Total Assets
X2 = Liquid Assets / Total Assets
X3 = Total Equity / Total Assets
X4 = Net profit before taxes / Total Assets
196
X5 = Total Assets / Total Liabilities
X6 = Total Equity / Fixed Assets
Weighing weights according to the importance of each
The relative weight of the variable in points
Z=17X1+9X2+3.5X3+20X4+1.2X5+0.1X6
Z
X1
X2
X3
X4
X5
X6
197
This model serves the purposes of credit analysis in commercial banks from two angles.
First, it can be used to assess the creditworthiness of companies applying for bank loans, as
a tool to guide the credit manager and the loan committee in granting facilities or loans.
Second, the model can also be used by the bank's audit department or by the external
auditor as a tool to assess the risk surrounding the loan portfolio and then to estimate the
provision for non-performing loans to be made in respect of this portfolio. It also helps in
determining the interest rate for loans as well as in the design of follow-up or review of loans,
and notes from this above model the following:
1. The biggest weight of the financial ratios of its constituent is the share of those that
test the customer's ability to repay a liquidity ratios, due largely to the use of the
model to two key goals to determine the organization's ability to continue its
economic effectiveness and then to meet its obligations on time.
2. The quality or quality index used in the classification established student loan or in
the classification of portfolio loans is moving in the reverse direction to the direction
of risk, in other word that the high value of this indicator shows the loan quality or the
strength of the financial position of the current company student loan and then lower
the degree of risk, and vice versa
198
Example
The following balances appeared in the records of an industrial company:
Total assets 8000
Current assets 3500
Fixed assets 4500
Total liabilities (liabilities) 6000
Cash assets 1000
Current liabilities 1500
Total shareholders' equity 2000
Net profit after tax 500
Required: Prepare an analytical study of these data using the Sherrod model to
determine the sustainability of the business
Solution:
Working Capital Net = Current Assets - Current Liabilities
3500 - 1500 = 2000
Z = 17 (2000/8000) +9 (1000/8000) +3.5 (2000/8000) +20 (500/8000) +1.2
(8000/6000) +0.1 (2000/4500)
Z = 4.25 + 1.125 + 0.875 + 1.25 + 1.600 + 0.044
Z = 9.144
From the application of the Sherrod model above, the value of (Z) is equal to
(9.144).This value according to the degree of risk in granting loans to economic units
is in third category, In other words the loans granted by the company to the
economic units are medium risk loans
At the end, it should be noted that the benefit of these models and others like them
remain the focus of interest of researchers and related parties after they have proved
useful, but the application of any of them as in its original form to study the
possibilities of financial failure in all circumstances is subject to some difficulties, The
study is different in the nature of its activity or in the environmental conditions
199
surrounding it. This is normal, because the economic, political and social conditions
surrounding the business companies varyfrom a country to another.
The published financial literature on bankruptcy has identified many proportions that
were important in predicting bankruptcy. There are no specific ratios used to predict
the company's failure (Barnes, 1987; Altman, 1993; Mohamed, Li and Sanda, 2001).
Most researchers chose financial ratios based on their popularity and
predictive ability in pre-bankruptcy studies (Beaver, 1966; Altman, 1968; Olson,
1980; Altman and Cau, 1985; Casey and Parshak, 1985; Nur Adiana et.al; 2008,
Lifschuts and Jacobi, 2010; Y. Wu et.al 2010).
The most common financial ratios used by researchers were net income to total
assets (Beaver, 1966; Deakin, 1972; Libby, 1975; Ohlen, 1980; Lennox, 1999), total
liabilities to total assets (Beaver, 1966; Deakin, 1972; Ohlson, 1980; Zmijewski,
1984) and size (Ohlson, 1980; Lennox, 1999; Shumway, 2001; Halim et al., 2008).
The net income rate was used by Ohlson (1980) to represent growth. To explain the
bankruptcy in the UK, Lenox (1999) used cash to carry liabilities, turnover of debtors
and total cash flow to cash flow.
To explain bankruptcy in Korea, the result of Nam and Jinn (2000) was that
the financial expenses of sales, debt coverage and turnover were important. The
Nam and Jane study (2001) was consistent with Lenox (1999). Zulkarnain et al.
(2001) used the MDA model, which showed that total liabilities to total assets, sales
to current assets, cash to current liabilities, and market value of debt were significant
in explaining the financial failure of Malaysian companies between 1980 and 1996.
Altman (1968) created a model (Altman Z Score) consisting of a set of financial
ratios analyzed using multiple discrimination analysis (MDA), based on the
200
assumption of a relationship between financial ratios in previous years and the time
of bankruptcy for subsequent years
Barnes 1987 Altman 1993 Mohamed Li and Sanda
2001
al. 2005 Adiana et.al Lifschuts Jacobi 2010 Y. Wu
et.al 2010
Beaver 1966
Deakin 1972 Libby 1975 Ohlson 1980 Lennox 1999
Beaver 1966 Deakin 1972 Ohlson 1980 Zmijewski 1984 Ohlson
1980 Lennox 1999 Shumway 2001 Halim et al 2008
Ohlson 1980
Nam and Jinn (2000)
).
Zulkarnain MDA
.
Altman (1968) (Altman Z Score)
(MDA)
.
201
Questions and Exercises
Questions
1. Define the Predict of Financial Failure.
2. Explain the most common analytical models used to support the financial
failure of a business.
3. Write the Altman and Mccovgh Model.
4. Write the (Kida) Model .
5. Write the Sherrod Model.
Exercises
Exercise No.1
The following are the data extracted from the records of the Iraqi National Metallurgical
Industries Company:
Total Current Assets
Total Current Liabilities
Total Assets
Total Liabilities
Retained earnings
Net operating profit
Sales
Market value of shares
Required: Prepare an analytical study of these data by using the Altman and Mccovgh
model to determine the sustainability of the business.
202
Exercise No. 2
The following balances appeared in the records of an industrial company:
Total Assets 6,000
Total liabilities 3,600
Sales 10,000
Cash Assets 1,600
Current Liabilities 2,400
Shareholders' Equity 4,000
Net profit after tax 500
Required: prepare an analytical study of these data by using the KIDA model to
determine the extent of the entity's ability to continue.
Exercise No.3
The following balances were extracted from the statements of a company (in
thousand dinars)
Current assets 52,410
Fixed assets 29,840
Current liabilities 25,431
Long term loans 2,315
Cash 6,240
Shareholders' equity 33,719
Net profit before taxes 7,570
Required: Use the (Sherrod model) to classify the degree of risk surrounding the
loan if the company makes a loan from a bank
203
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207
Book in brief
Financial statements and reports are prepared from the output of the
accounting function produced by the accounting and then communicated to
the financial analysts as the users of the financial statements. The function of
the financial analyst begins in terms of the termination of the accountant's
post to complete a substantial financial function of the entity's functions
related to the accounting function and not separate from it
The function of the financial analyst is based on the analysis of the
financial statements, which is one of the main tools used in the financial and
economic decision-making by the various parties related to the entity such as
management, employees, investors, shareholders, lenders, customers, the
government and the public in general
The analysis of the financial statements includes a set of basic and
useful topics that the student can understand. The most prominent of these
topics are the theoretical framework of financial analysis, the study of financial
statements, the statement of funds flows, the cash flow statement and
financial analysis by using financial ratios and prediction financial failures of
companies and banks
This book was prepared in a simplified methodology for the student and
the reader to ensure the translation of terms and titles and some important
texts into Arabic, as well as that the topics of the book were based on syllabus
approved by the Sectorial Committee of the Faculty of Management and
Economics in the Ministry of Higher Education and Scientific Research.
We hope that the modest scientific effort in this book will ensure the
acceptance and satisfaction of students and readers to take advantage of
practical and professional life.
-The Book Finished-
ResearchGate has not been able to resolve any citations for this publication.
- Augustas Degutis
-
![Lina Novickytė]()
The development of the capital markets is changing the relevance and empirical validity of the efficient market hypothesis. The dynamism of capital markets determines the need for efficiency research. The authors analyse the development and the current status of the efficient market hypothesis with an emphasis on the Baltic stock market. Investors often fail to earn an excess profit, but yet stock market anomalies are observed and market prices often deviate from their intrinsic value. The article presents an analysis of the concept of efficient market. Also, the market efficiency evolution is reviewed and its current status is analysed. This paper presents also an examination of stock market efficiency in the Baltic countries. Finally, the research methods are reviewed and the methodology of testing the weak-form efficiency in a developing market is suggested.
-
![Sanobar Anjum Siddiqui]()
Businesses are enterprises which produce goods or render services for profit motive. To be able to predict the financial soundness of a business has led to many research works. Financial ratios are a key indicator of financial soundness of a business. Financial ratios are a tool to determine the operational & financial efficiency of business undertakings. There exist a large number of ratios propounded by various authors. Altman developed a z-score model using ratios as its foundation. With the help of the Z- Score model, Altman could predict financial efficiency/bankruptcy up to 2-3 years in advance. The following research paper describes in detail the studies carried out by Altman to predict business bankruptcy. Altman made regular changes to achieve the perfect equation which could predict bankruptcy. The following research paper summarizes the research of Altman that have being made to develop the Altman Z score model. It can be safely said that Altman's Z score Model can be applied to modern economy to predict distress and bankruptcy one, two & three years in advance.
- Burton G. Malkiel
Revolutions often spawn counterrevolutions and the efficient market hypothesis in finance is no exception. The intellectual dominance of the efficient-market revolution has more been challenged by economists who stress psychological and behaviorial elements of stock-price determination and by econometricians who argue that stock returns are, to a considerable extent, predictable. This survey examines the attacks on the efficient market hypothesis and the relationship between predictability and efficiency. I conclude that our stock markets are more efficient and less predictable than many recent academic papers would have us believe.
Dar Wael for printing and distribution
- Alamry Abd Alsattar Alsayah
- Mashhour
Abd Alsattar Alsayah, Alamry Mashhour (2007): "Financial Management" , Dar Wael for printing and distribution, Amman 2007.
Prediction of failure for companies using financial analysis in Iraq
- M Ali
- Buthaeena Rashed
Ali ghalf al_Rakabi M.D Buthaeena Rashed (2013 ): "Prediction of failure for companies using financial analysis in Iraq ", Journal of Administration and Economics, Issue 94, Al-Mustansyriah UniversityIraq.
The financial reporting environment
Walther (2010) : "The financial reporting environment", Review of the recent literature, Journal of Accounting and Economics 50 (2010) 296-343, United States.
A Manual of Advanced Book-Keeping and Accountancy for Accountants, Book-Keepers and Business Men
- R N Carter
- Ltd Sons
- London
Carter, R. N. (1939):"Advanced Accounts, A Manual Advanced Accounts",A Manual of Advanced Book-Keeping and Accountancy for Accountants, Book-Keepers and Business Men, SIR ISAAC PITMAN & SONS, LTD. LONDON 1939.
Financial Reporting &Analysis
- Charles H Gibson
Charles H. Gibson (2009): "Financial Reporting &Analysis", 11th Edition, South Western Cengage Learning, 2009, 2007 South-Western, a part of Cengage Learning USA.
- Gary A Porter
- Curtis L Norton
Gary A. Porter, Curtis L. Norton (2014 ) :"Financial Accounting", the impact on decisions makers, 9 Edition, Cengage Learning, Jan 1, 2014 -Business & Economics.
Corporate Finance 9th Edition Chapter 6 Question 30
Source: https://www.researchgate.net/publication/338385318_ANALYSIS_OF_FINANCIAL_STATEMENTS
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