Analysis of Financial Statements

pvajpayee@iiitd.ac.in

9810295313
 The three key financial statements

The financial statements are a record of the financial activities of a business.

1. Balance sheet 2. Income statement 3. Statement of cash flows

Operating
Liabilities
Expenses
Assets Revenues Investing

Equity
Profit or loss Financing
Session objectives

In this session we will:

01. Explain the format of

the balance sheet

02. Record transactions

03. Prepare a simple balance

sheet
The balance sheet

Total Assets Total liabilities & equity

Current liabilities
Current assets Due within one year
Used within one year
e.g. accounts payable
e.g. cash, inventory, accounts
receivable Non-current liabilities
Due in more than a year

e.g. long-term debt

Non-current assets
Last more than a year
Shareholders’ equity
e.g. property, plant and e.g. common shares and retained
equipment, earnings
technology, patents,
trademarks
 Balancing the balance sheet

A balance sheet must always balance

To ensure this is the case, all
transactions are recorded in the
balance sheet in two places.

Liabilities & Double Entry Accounting

Assets Equity

Debit Credit
 Balancing the balance sheet

A balance sheet must always balance To ensure this is the case, all
transactions are recorded in the
balance sheet in two places.

KEY TAKEAWAYS:
•The terms debit (DR) and credit (DR) have Latin roots: debit comes
from the word debitum, meaning "what is due," and credit comes
from creditum, meaning "something entrusted to another or a loan." Double Entry Accounting
•An increase in liabilities or shareholders' equity is a credit to the
account, notated as "CR."
•A decrease in liabilities is a debit, notated as "DR."
Debit Credit
•Using the double-entry method, bookkeepers enter each debit and
credit in two places on a company's balance sheet.
The first known recorded use of the terms is Venetian Luca Pacioli's 1494 work,
Summa de Arithmetica, Geometria, Proportioni et Proportionalita (All about
Arithmetic, Geometry, Proportions and Proportionality).

Pacioli devoted one section of his book to documenting and describing the
double-entry bookkeeping system in use during the Renaissance by Venetian
merchants, traders and bankers. This system is still the fundamental system in
use by modern bookkeepers.

Indian merchants had developed a double-entry bookkeeping system, called bahi-

khata, predating Pacioli's work by at least many centuries, and which was likely a
direct precursor of the European adaptation 1447 – 1517 AD
 Balancing the balance sheet

Two options:
Assets Liabilities & Shareholders’
01. Current assets Equity
Cash (100) Current liabilities
Record the transaction on both sides of Short-term debt (100)
the balance sheet Non current assets
Non current liabilities
Total Assets (100) Shareholders’ equity
Total Liabilities & SE (100)

02. Assets Liabilities & Shareholders’

Current assets Equity
Record the transaction twice on the same Cash (100) Current liabilities
side of the balance sheet as both positive and Non current assets
negative number 100 Non current liabilities
Equipment
Shareholders’ equity
Total Assets 0
Total Liabilities & SE 0
 Recording transactions

• A company engaged in the following

transactions: How would they be recorded in
the balance sheet?
• Issued shares for 100 in cash

• Took out a four year bank loan of 50

• Bought equipment and machinery for 80

• Bought inventory for 60

• Sold all the inventory for 90

• Paid salaries of 20

• Paid interest of 3
 Issuing shares for 100 in cash

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets
Cash 100 Non current liabilities

Shareholders’ equity
Non current assets Common stock 100

Total 100 Total 100

 Taking out a 4 year bank loan
of 50

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets from(100)
Cash [100 + 50] 150 Non current liabilities
50
Shareholders’ equity
Non current assets Common stock 100

from (100)
Total 150 Total (from 100) 150
 Buying a machinery for 80

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets Down from 150

Cash [100 + 50 ]– 80]

70
Non current liabilities 50

Shareholders’ equity
Non current assets
80 Common stock 100
Equipment up from zero

Total 150 Total 150

 Buying inventory for 60

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets
Cash [100 + 50 – 80 ]– 60] Down from 70 10
Inventory 60 Non current liabilities 50

Non current assets Shareholders’ equity

80 Common stock 100
Equipment

Total 150 Total 150

 Selling all inventory for 90

Assets Liabilities & Shareholders’ Equity

Current assets Current liabilities

up from 10 100
Cash [100 + 50 – 80 – 60 ]
+ 90] Non current liabilities 50
down from 60 0
Inventory [60 – 60] Bank loan

Shareholders’ equity
Non current assets 100
Common stock
Equipment 80 Retained earnings 30
Revenues 90
Cost of sales (60)

Total shareholders’ equity up from 100 130

Total up from 150 180 180
Total
 Paying salaries of 20

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets down from 100 80
Cash [100 + 50 – 80 – 60 Non current liabilities
+ 90]– 20] 50
0 Bank loan
Inventory [60 – 60]

Shareholders’ equity
Common stock 100
Non current assets 80 Down from 30 10
Equipment Retained earnings
Revenues 90
Cost of sales (60)
Salaries (20)
Total shareholders’ equity Down from 130 110
Total down from 180 160
Total down from 180 160
 Paying interest of 3

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets 77 Non current liabilities
Cash [100 + 50 – 80 – 60 + 90 – Down from 80 50
20 ]– 3]
Bank loan
Inventory [60 – 60] 0
Shareholders’ equity 100
Common stock
Non current assets Retained earnings down from 10 7
80 Revenues 90
Equipment
Cost of sales (60)
Salaries (20)
Interest (3)
down from 160 Total shareholders’ equity 107
Total 157
Total down from 160 157
 This is what it looks like

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets 77 Non current liabilities
Cash [100 + 50 – 80 – 60 + 90 – 50
20 ]– 3]
Bank loan
Inventory [60 – 60] 0 Shareholders’ equity 100
Common stock
Non current assets Retained earnings 7
80 Revenues 90
Equipment
Cost of sales (60)
Salaries (20)
Interest (3)
Total shareholders’ equity 107
Total 157
Total 157
 Buying and selling on credit
• Bought inventory for 60 on credit rather than using cash.
• Sold all the inventory for 90 on credit rather than for cash.

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets (-60+90) Accounts payable 60
Cash [100 + 50 – 80 – 20 – 3] Down from 77 47
Non current liabilities
Accounts receivable Up from zero 90 50
Inventory [60 – 60] 0
Bank loan
Shareholders’ equity
Common stock 100
Retained earnings 7
Non current assets 90
80 Revenues
Equipment (60)
Cost of
sales (20)
Salaries (3)
217 Interest
217
Aditi Industries engaged in the following transactions:

1. Issued common shares of 300.

2. Bought equipment for 200.
3. Bought inventory of 100. 80 of this was paid in cash. The remainder is outstanding at the balance sheet date.
4. Sold 75% of the inventory for 120. 100 of this had been received in cash at the balance sheet date.
5. Paid cash expense of 15.

Construct the balance sheet

Balance Sheet
Assets Liabilities
Current assets: Current liabilities:

Non-current liabilities:
Total current assets -
Shareholders' equity
Non-current assets:

Total non-current
assets -

-
Total liabilities and
Total assets - shareholders' equity -
Aditi Industries engaged in the following transactions:
1. Issued common shares of 300.
2. Bought equipment for 200.

3. Bought inventory of 100. 80 of this was paid in cash. Remainder is outstanding at the balance sheet date.
4. Sold 75% of the inventory for 120. 100 of this had been received in cash at the balance sheet date.
5. Paid cash expense of 15.

Balance Sheet
Assets Liabilities
Current assets: Current liabilities:
Cash 105 Accounts payable 20
Accounts receivable 20
Inventory 25 Non-current liabilities:
Total current assets 150
Shareholders' equity
Non-current assets: Common shares 300

Plant and equipment 200 Retained earnings

Total non-current assets 200 Revenues 120
Cost of sales (75)
Expenses (15)
30
Total liabilities and shareholders'
Total assets 350 equity 350
The role of the income statement

Income Statement of Statement of

Statement Operations Profit and Loss

In principle, it is only necessary for a

company to produce a balance sheet.

However in practice, the detailed items that

make up the retained earnings for the year
are shown in the income statement.
 The income statement

Revenues

Direct operating cost

(e.g. Cost of goods sold)
Gross profit
Indirect operating cost
(e.g. R&D, administration, selling,
distribution, depreciation &
amortization) Operating income
= Earnings Before Interest
Cost of debt financing and Taxes (EBIT)
(e.g. Interest, bank charges)

Tax
Net income
 Creating a full income statement

Assets Liabilities & Shareholders’

Income statement Equity
Balance sheet extract
Revenues
Current liabilities 90
Current assets CostAccounts
of payable (60)
60
Cash[100 +equity
Shareholder 50 – 80 – 20 – 3] 47 sales
Accounts stock
receivable 90 Non current
Gross profit liabilities 30
Common 100 SG&A expenses 50
(20)
Inventoryearnings
Retained [60 – 60] 0 Bank loan
7
Revenues 90
Cost of sales (60) Operating profit 10
Salariesassets
Non current (20) Interest expenses (3)
80
Equipment
Interest (3) Tax (0)

Net profit 7
217
Recording income and expenses

How much insurance would be

The income statement includes only the included in the income
revenues and expenses that relate to the statement?
accounting year.

Example
During the last month of the year the company
buys insurance for 12 months at a cost of
12,000.
 Prepayments

Month 1…. …Month 12

1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 |

One month of
What happens to the
insurance expense on
remaining 11,000?
the income statement
is 1,000

Balance sheet - current asset Prepayments result if payments

• Prepaid expense 11,000 are made in advance
 Recording income and expenses

How much of this expense should

Another example be included in the income
2,000 worth of office supplies were used in the statement for the current year?
current year but were not paid for until the
following year.
 Accrued expenses

The full expense of 2,000 as this is Since we haven’t paid for the office
the value of the office supplies supplies, how do we record the
used in the current year. second half of the transaction?

Balance sheet – current liabilities

• Accrued expense 2,000

Accrued expenses have been reflected on the income statement, but not yet paid for.
Depreciation

Assets Liabilities & Shareholders’ Equity

Current liabilities
Current assets Accounts payable 60
Cash [100 + 50 – 80 – 20 – 3] 47
Non-current liabilities
Accounts 50
receivable Bank loan
90
Inventory [60–60] Shareholders’ equity
0 Common stock 100
Retained earnings 7
Non current assets 80 Revenues 90
Equipment Cost of sales (60)
Salaries (20)
Interest (3)
217 217
 Depreciation

Let’s assume that the useful life of this equipment is 4 years, that
we can allocate that usefulness evenly over the years of use, and
that after 4 years the equipment has a salvage value of 30.

Year 1 | Year 2 | Year 3 | Year 4

How would we account for the We record an expense called

reduction in value of the equipment as “depreciation”.
we use it in our operations?
The impact of depreciation
Purchaseprice Salvagevalue

Depreciation = 80 – 30
= 12.5
4
# of useful life

Income statement – the depreciation expense is calculated by

taking the purchase price (80), deducting the salvage value (30)
and dividing the difference by 4 years. This gives us a
depreciation expense of 12.5 a year.
The impact of depreciation

Purchase price 80.0 67.5 55.0 42.5

(Depreciation expense)
(12.5) (12.5) (12.5) (12.5)
PP&E = Closing balance 67.5 55.0 42.5 30.0

Balance sheet – the balance sheet value of the equipment would start
at 80 but would reduce by 12.5 a year for the next 4 years. At the end
of 4 years, the equipment would be valued on the balance sheet at 30
(the expected salvage value).
QUESTIONS ?
pvajpayee@iiitd.ac.in

9810295313