Accounting for Management (Mod III)

TKM Institute of Management, Kollam

Study Notes, Semester I
Accounting for Managers
Module III
Syllabus
Interpretation of final accounts of companies; Tools for analyzing financial
statements; Ratio analysis, Funds Flow and Cash Flow statements
Financial Statement: Analysis and Interpretation
A financial statement is an organized collection of data according to logical and
consistent accounting procedure. Tus te term !financial statements" generally refers to t#o basic
statements: $i% te income statement and $ii% te &alance Seet. 'f course, a business may also
prepare $iii% a statement of (etained )arnings, and $i*% a Statement of +anges in Financial
,osition in addition to te abo*e t#o statements.
Te meaning and significance of eac of tese statements is e-plained belo#:


,rofit . /oss A0c Financial condition ,rofit . /oss 1 Fund Flo# Statement
$(esults of operation of a business on a Appropriation A0c $+anges in 2or3ing
of a business o*er a particular date $Accumulated e-cess +apital position%
period of time.% of earnings o*er losses
. di*idends% 1 +as Flo# Statement
$+ange in cas ,osition%
1 S+F,
Prepared by Asst. Prof. Rajesh Janardhanan
Financial Statements
Income
Statement
&alance
Seet
Statement of
+anges in
Financial ,osition
Statement of
(etained
)arnings
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Accounting for Management (Mod III)
$Statement of canges in
o*erall financial
position%

Financial statements are indicators of te t#o significant factors:
4. ,rofitability, and
5. Financial Soundness
&asic ob6ecti*es of Financial Statement Analysis
4. To 6udge te financial ealt of te firm
5. To e*aluate profitability of te enterprise
7. To gauge te debt ser*icing capacity of te firm
8. To understand long term . sort term sol*ency of te firm
9. To 3no# te return on capital employed.
/imitations of Financial Analysis
1. Financial Analysis is only a Means
Financial analysis is a means to an end and not te end itself. Te analysis sould be
used as a starting point and te conclusion sould be dra#n not in isolation, but 3eeping in
*ie# te o*erall picture and te pre*ailing economic and political situation.
2. Ignores Price Level Changes
Financial statements are normally prepared on te concept of istorical costs. Tey
#ould not portray te effects of price le*el canges o*er te period.
3. Financial Statements are Essentially Interim Reports
Te e-act position of te business can be 3no#n only #en te business is closed
do#n.
. Acco!nting Concepts an" Conventions
As te financial statements are prepared on te basis of certain accounting concepts
and con*entions, te financial position as disclosed by tese statements may not be realistic.
For e-ample, fi-ed asset in te balance seet are so#n on te basis of going concern concept.
Tis means tat *alue placed on fi-ed assets may not be te same #ic may be realized on
teir sale.
#. In$l!ence o$ Personal %!"gment
Many items are left to te personal 6udgment of te accountant. For e-ample, te
metod of depreciation, mode of amortization of fi-ed assets, treatment of deferred re*enue
e-penditure : all depends on te personal 6udgment of te accountant.
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Accounting for Management (Mod III)
&. 'isclose only monetary Facts
Financial statements do not depict tose facts #ic cannot be e-pressed in terms of
money.
Types of Financial Statement Analysis
4. )-ternal Analysis
5. Internal Analysis
7. ;orizontal Analysis
8. <ertical Analysis
9. /ong Term Analysis
=. Sort Term Analysis
1. E(ternal Analysis
Tis analysis is done by tose #o are outsiders of te business suc as in*estors,
credit agencies, go*ernment agencies, and oter creditors #o a*e no access to te internal
records of te company. Tese persons mainly depends upon, te publised financial statements.
2. Internal Analysis
Tis analysis is done by persons #o a*e access to te boo3s of account and oter
information related to te business. >enerally, management is interested in te analysis of financial
statements for measuring te effecti*eness of its o#n policies and decisions. Sometimes, officers
appointed by court or go*ernment under statute #ill conduct internal analysis.
3. )ori*ontal Analysis
2en e*aluation is done for se*eral years simultaneously at a time for ma3ing
conclusions, it is called !horizontal analysis. Tis based on data from year to year, rater tan one
time a*ailable information. ;orizontal analysis is done for finding te trend ratios and in
comparati*e financial statements.
. +ertical Analysis
It is te study of ?uantitati*e relationsip of one financial item to anoter based on
financial statement on a particular date. +ommon size statement and ratio analysis are te
e-amples of *ertical analysis.
#. Long ,erm Analysis
It is done #it a *ie# to e*aluate te long : term sol*ency, profitability, li?uidity,
financial ealt, earning capacity of te firm, debt ser*icing capacity etc. of a business enterprise.
Te ob6ecti*e of long : term analysis is to determine #eter te earning capacity of te firm is
sufficient to meet te targeted rate of return on in*estment, and is ade?uate for future gro#t and
e-pansion of te business.
&. Short ,erm Analysis
It is underta3en mainly to determine te li?uidity position of te firm and sort :
term sol*ency of te firm. Te analysis is oriented on efficiency of #or3ing capital management
and profitability of current operations.
Metods0Tecni?ues of Financial Analysis
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+omparati*e Financial Statements: Figures of t#o or more period #ill be
pro*ided.
$+omparati*e Income Statement, +omparati*e &alance Seet%
+ommon@size Financial Statements: ;ere, figures reported are con*erted into
percentage to some common base.
$+ommon@size income Statement, +ommon@size &alance Seet%
Trend ,ercentages: Tis in*ol*es calculation
of percentage relationsip tat eac item bears
to te same item in te base year.
Fund Flo# Analysis: (e*eals te canges in
#or3ing capital position
+as Flo# Analysis: (e*eals te canges in cas position.
+ost <olume ,rofit Analysis: Studies te relationsip bet#een cost, *olume of
production, sales and profit. It specifies te *olume of sales at #ic te firm #ill
brea3@e*en te effect on profit on account of *ariation in output, selling price and
cost and te ?uantity to be produced and sold to reac te target profit le*el.
(atio Analysis: It so#s te matematical relationsip bet#een t#o interrelated
accounting figures.
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+omparati*e Financial Statements
+omparati*e financial statements are statements of financial position of a business
designed to pro*ide time perspecti*e to te consideration of *arious elements of financial position
embodied in suc statements. Financial statements of t#o or more firms can also be compared for
dra#ing inferences. Tis is called inter firm comparison.
Comparative Income Statement
A comparati*e income statement so#s te absolute figures for t#o or more periods and
te absolute cange from one period to anoter. Since te figures are so#n side by side, te user
can ?uic3ly understand te operational performance of te firm in different periods and dra#
conclusions.
C omparative .alance Sheet
&alance seets as on t#o or more different dates are used for comparing te assets,
liabilities and te net #ort of te company. +omparati*e balance seet is useful for studying te
trends of an underta3ing.
A"vantages o$ Comparative Financial Statements
4. +omparati*e statements indicate trends in sales, cost of production, profits etc., and elp
te analyst to e*aluate te performance of te company.
5. Tese statements can be used to compare te performance of te firm #it te a*erage
performance of te industry or inter : firm comparison. Tis elps in identification of te
#ea3nesses of te firm and remedial measures can be ta3en accordingly.
'isa"vantages o$ Comparative Financial Statements
4. Inter : firm comparison can be misleading if te firms are not identical in size . age and
#en tey follo# different accounting procedures #it regard to depreciation, in*entory
*aluation etc.
5. Inter : period comparison may also be misleading, if te period as #itnessed canges in
accounting policies, inflation, recession etc.
+ommon Size Statements
Te figures so#n in financial statements viz. profit and loss account and balance seet are
con*erted to percentages so as to establis eac element to te total figure of te statement and
tese statements are called !common size statements. Tese statements are useful in analysis of
te performance of te company by analyzing eac indi*idual element to te total figure of te
statement. Tese statements #ill also assist in analysing te performance o*er years and also #it
te figures of te competiti*e firm in te industry for ma3ing analysis of relati*e efficiency.
Common Si*e Income Statement
In common size income statement, te sales figure is ta3en as 4AA and all oter figure of
costs and e-penses are e-pressed as percentage to sales. 2en oter costs and e-penses are
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reduced from sales figure of !4AA", te balance figure is ta3en as net profit. Tis re*eals te
efficiency of te firm in generating re*enue #ic leads to profitability and #e can ma3e analysis
of different components of cost as proportion to sales. Inter : firm comparison of common size
income statements re*eal te relati*e efficiency of costs incurred.
C ommon Si*e .alance Sheet
In common size balance seet, te total of assets side or liabilities side is ta3en as !4AA" and
all figures of assets and liabilities, capital and reser*e are e-pressed as proportion to te total i.e.,
4AA. Te common size balance seet re*eals te proportion of fi-ed assets to current assets,
proportion of long term funds to current liabilities and pro*isions, composition of current liabilities
etc. it also elps in ma3ing inter : firm comparison and igligts te financial ealt and long :
term sol*ency, ability to meet sort : term obligations and li?uidity position of te enterprise.
(atio Analysis
According to B.&atty, Cthe term accounting ratio is used to describe significant
relationship which exist between figures shown in the balance sheet, in a profit and loss
account, in a budgetary control system or in any other part of the accounting
organization.
Te accounting ratios indicate a ?uantitati*e relationsip #ic is used for analysis .
decision ma3ing. It pro*ides basis for inter@firm as #ell as intra firm comparison. (atio analysis
allo# interested parties li3e sareolders, in*estors, creditors, >o*ernment and analysts to ma3e an
e*aluation of certain aspects of a firm"s performance. (atio analysis is a process of comparison of
one figure against anoter #ic ma3es a ratio. Te appraisal of te ratios #ill ma3e proper
analysis about te strengt and #ea3nesses of te firm"s operations.
(atio analysis is e-tremely elpful in pro*iding *aluable insigt into a company"s financial
picture. (atios normally pinpoint a business" strengt and #ea3ness in t#o #ays:
(atios pro*ide an easy #ay to compare present performance #it past
(atios depict te areas in #ic a particular business is competiti*ely ad*antaged or
disad*antaged troug comparing ratios to tose of oter businesses of te same size #itin
te same industry
Te ratio analysis is made under si- broad categories as follo#s:
/i?uidity (atios
/e*erage (atios
Asset Management (atios
,rofitability (atios
'perating (atios
Mar3et based (atios
Te ratio analysis is made under si- broad categories as follo#s:
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Accounting for Management (Mod III)
Li/!i"ity Ratios
Te li?uidity ratios measure te li?uidity of te firm and its ability to meet its
maturing sort : term obligations. /i?uidity is defined as te ability to realize *alue in money, te
most li?uid of assets. It refers to te ability to pay in cas, te obligations tat are due. Te
important ratios in measuring sort:term sol*ency are:
+urrent (atio
Duic3 0 Acid Test (atio
Absolute /i?uid 0 Super Duic3 (atio
Eefensi*e : Inter*al (atio
Leverage Ratios
Te long term financial stability of te firm may be considered as dependent upon
its ability to meet all its liabilities, including tose not currently payable. Te ratios #ic are
important in measuring te financial le*erage of te company is as follo#s:
Eebt : )?uity (atio
Sareolders )?uity (atio
/ong : term Eebt to Sareolders Net 2ort (atio
+apital >earing (atio
Fi-ed Assets to /ong : term Funds (atio
,roprietary (atio
Interest +o*er
Eebt Ser*ice +o*erage (atio$ES+(%
Ei*idend +o*er

Asset Management Ratios
Asset management ratios measure o# effecti*ely te firm employs its resources.
Tese ratios are also called !activity or turn over ratios #ic in*ol*e comparison bet#een
te le*el of sales and in*estment in *arious accounts. Asset management ratios are used to
measure te speed #it #ic *arious accounts are con*erted into sales or cas. Follo#ing are
te important asset management ratios:
In*entory Turno*er (atio
In*entory (atio
Eebtors Turno*er (atio
Eebtors +ollection ,eriod
&ad Eebts to Sales (atio
+reditors Turno*er (atio
+redit ,ayment ,eriod
Fi-ed Asset Turno*er (atio
Total Assets Turno*er (atio
2or3ing +apital (atio
Sales to +apital )mployed (atio
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Accounting for Management (Mod III)
Pro$ita0ility Ratios
Te purpose of study and analysis of profitability ratios are to elp assessing te
ade?uacy of profits earned by te company and also to disco*er #eter profitability is
increasing or declining. Te profitability ratios so# te combined effects of li?uidity, asset
management and debt management on operating results. Te ma6or profitability ratios are as
follo#s:
>ross ,rofit Margin
Net ,rofit Margin
+as ,rofit (atio
(eturn on Total Assets
(eturn on Sareolders Funds or (eturn on Net 2ort
(eturn on +apital )mployed $('+)%
-perating Ratios
Te ratio of all operating e-penses $i.e., materials used, labour, factory o*ereads,
administration and selling e-penses% to sales is te operating ratio. A comparison of te
operating ratio #ould indicate #eter te cost content is ig or lo# in te figure of sales.
Te different ratios in tis category are:
Materials +ost (atio
/abour +ost (atio
Factory '*eread (atio
Administrati*e )-pense (atio
Selling . Eistribution )-penses (atio
'perating (atio
Mar1et 0ase" Ratios
Te mar3et based ratios relates te firm"s stoc3 price to its earnings and boo3 *alue
per sare. Tese ratios gi*e management an indication of #at in*estors tin3 of te company"s
past performance and future prospects. If firm"s profitability, sol*ency, and turno*er ratios are
good, ten mar3et based ratios #ill be ig and its sare price is also e-pected to be ig. Te
mar3et based ratios are as follo#s:
)arnings ,er Sare $),S%
+as )arnings ,er Sare
Ei*idend ,ayout (atio
Ei*idend Gield
&oo3 <alue
,rice )arnings (atio $, 0 ) (atio%
Mar3et ,rice to &oo3 <alue (atio $, 0 &< (atio%
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Accounting for Management (Mod III)
Ad*antages of (atio Analysis
4. Simplifies Financial Statements: by e-plaining te canges in financial conditions of
te business.
5. Ma3es Intra@firm comparison: by e*aluating te performance of different di*isions of
te firm.
7. Facilitates Inter@firm comparison: by igligting te factors associated #it successful
. unsuccessful firms.
8. ;elps in planning . forecasting : future success or failure of te business by measuring
te profitability, li?uidity . sol*ency position.
/imitations of (atio Analysis
4. Te comparati*e study of ratios only pro*ides a glimpse of past performance and forecast
for future #ic may not be correct al#ays since se*eral oter factors li3e mar3et
conditions, management policies, uman resources efforts etc. may affect te future
operations.
5. A ratio doesn"t consider canges in *alue of money and oter non financial canges
#ic may ultimately affect te future profitability of te business.
7. Te comparison of one firm #it anoter on te basis of ratio analysis #itout ta3ing into
consideration te fact tat companies a*e different accounting policies #ill be
misleading . meaningless.
8. (atio analysis sometimes leads to 2indo# Eressing.
9. (atios are composite of different figures #ic are done mecanically #itout any basis.
=. No fi-ed standards can be laid do#n for ideal ratios because financial institutions may
differ from non@financial institutions
F. (atios are al#ays affected by price le*el canges and te tecni?ues of current
purcasing po#er are totally ignored #ic gi*es meaningless interpretation.
Trend Analysis
Te trend ratios of different items are calculated for *arious periods for comparison
purpose. Te trend ratios are te inde- numbers of te mo*ements of reported financial items in
te financial statements #ic are calculated for more tan on financial year. Te calculation of
trend ratios are based on statistical tecni?ue called Index umbers. Te trend ratios elp in
ma3ing orizontal analysis of comparati*e statements. It reflects te bea*ior of items o*er a
period of time. Te metodology used in computation of trend ratios is as follo#s:
4. Te accounting principles and policies sould be consistently follo#ed trougout
te period for #ic te trend ratios are calculated.
5. Te trend ratios sould be calculated only for te items #ic a*e logical
relationsip #it one anoter.
7. Te trend analysis sould be made at least for four consecuti*e years.
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8. Te financial statements of one financial year sould be selected as a base statement
and financial items of it sould be assigned #it *alue as 4AA.
9. Ten trend ratios of subse?uent years" financial statements sould be calculated by
applying te follo#ing formula:
Absolute figure of financial statement under study
J K 4AA
Absolute figure of same item in base financial statement
=. Tabulate te trend ratios for analysis of trend o*er a period.
Funds Flo# Analysis
Tis statement so#s te canges tat a*e ta3en place in actual cas and te #or3ing
capital of te firm as #ell as te sources and use of te #or3ing capital during te accounting
period.
It is a summary of a firm"s canges in financial position from one period to anoterL it is
also called te sources and uses of funds statement or a statement of canges in financial position.
Te flo# of cas0funds in a firm may be *isualized as a continuous process. For e*ery use of
cas0funds, tere must be an offsetting source. In a broad sense, te assets of a firm represent te
net uses of cas0fundsL its liabilities and net #ort represent net sources.
Te fund flo# statement is useful to 3no# #eter te uses of te funds can be met by te
a*ailable sources funds or tere is a need for e-ternal financing sources suc as ban3 o*erdrafts.
2ses o$ F!n"s Flo3 Analysis
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Accounting for Management (Mod III)
4. To determine financial conse?uences of business operations i.e., to identify and find out te
profit position, li?uidity position, di*idend position, sol*ency position etc. and effecti*ely
manage #or3ing capital.
5. To fill financial blind spots of te operating statement
7. To ascertain te #or3ing capital utilisation and allocate additional fund in case of scarcity
8. To aid in securing ne# finances or loans
9. To elp in allocating financial resources for different pro6ects on priority basis
=. To elp in e*aluation of operational issues i.e., study te trends of success or failures of
operations and a*ailable resources
F. To elp in identifying critical points #ere strategic decisions are to be ta3en regarding te
flo# of funds
H. To test te effecti*eness of use of #or3ing capital
Limitations o$ F!n"s Flo3 Analysis
4. Funds flo# analysis is istorical in nature #ic are based on only recorded data and
figures #ic does not estimate te true sources and application of funds.
5. Tey include only monitory aspects #ere non monitory aspects sometimes a*e ig
impact on flo# of funds.
7. Sometimes funds flo# statement may pro*e to be misleading. It is not necessary tat te
business is a*ing ea*y loss because of te only reason #or3ing capital is lo#.
8. Eefects in te financial statements #ill be carried for#ard to funds flo# statement also as it
is merely te rearrangement of data pro*ided in te balance seet and profit . loss account.
9. Structural canges in financial relationsip are not disclosed. For e.g., ma6or policy
canges.
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Accounting for Management (Mod III)
+as Flo# Analysis
In financial accounting, a cas flo# statement or statement of cas flo#s is a financial
statement tat so#s a companyMs incoming and outgoing money $sources and uses of cas% during
a time period $often montly or ?uarterly%. Te statement so#s o# canges in balance seet and
income accounts affected cas and cas e?ui*alents, and brea3s te analysis do#n according to
operating, in*esting, and financing acti*ities. As an analytical tool te statement of cas flo#s is
useful in determining te sort@term *iability of a company, particularly its ability to pay bills.
International Accounting Standard F $IAS F% is te International Accounting Standard tat deals
#it cas flo# statements.
Te cas flo# statement #as pre*iously 3no#n as te statement of canges in financial
position or flo# of funds statement. Te cas flo# statement reflects a firm"s li?uidity or sol*ency.
Te balance seet is a snapsot of a firmMs financial resources and obligations at a single point in
time, and te income statement summarizes a firmMs financial transactions o*er an inter*al of time.
Tese t#o financial statements reflect te accrual basis accounting used by firms to matc
re*enues #it te e-penses associated #it generating tose re*enues. Te cas flo# statement
includes only inflo#s and outflo#s of cas and cas e?ui*alentsL it e-cludes transactions tat do
not directly affect cas receipts and payments. Tese noncas transactions include depreciation and
#rite@offs on bad debts. Te cas flo# statement is a cas basis report on tree types of financial
acti*ities: operating acti*ities, in*esting acti*ities, and financing acti*ities. Noncas acti*ities are
usually reported in footnotes.
Te cas flo# statement as been adopted as a standard financial statement because it
eliminates allocations #ic migt be deri*ed from different accounting metods, suc as *arious
timeframes for depreciating fi-ed assets.
,eople and groups interested in cas flo# statements include
Accounting personnel, #o need to 3no# #eter te organization #ill be able to co*er
payroll and oter immediate e-penses
,otential lenders or creditors, #o #ant a clear picture of a companyMs ability to repay
,otential in*estors, #o need to 6udge #eter te company is financially sound
,otential employees or contractors, #o need to 3no# #eter te company #ill be able to
afford compensation
2ses o$ Cash Flo3 Analysis
4. ;elps in efficient cas management
5. ;elps in internal financial management by e-ploring te possibility of repayment of long
term debt #ic depends on te a*ailability of cas
7. Supplemental to funds flo# management as cas is a part of #or3ing capital
8. ;elps te finance manager to ascertain te sortage of cas despite iger profits . *ice
*ersa troug te disclosure of mo*ement of cas
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9. ;elps in comparison of actual . budgeted cas flo#s #ic discloses te success and
failure of business and ta3e de*iations in te strategy based on remedial measures.
=. For sort term analysis cas flo# statement is a better tool tan fund flo# statement.
F. ,ro*ide information on a firmMs li?uidity and sol*ency and its ability to cange cas flo#s
in future circumstances
H. ,ro*ide additional information for e*aluating canges in assets, liabilities and e?uity
I. Impro*e te comparability of different firmsM operating performance by eliminating te
effects of different accounting metods
4A. Indicate te amount, timing and probability of future cas flo#s.
Limitations o$ Cash Flo3 Statement
4. Misleading inter@industry comparison as ea*y capital in*estment company a*e more cas
flo#s tan small sector industries.
5. Misleading inter@firm comparison as purcases and sales figure differ from firm to firm.
7. +omparison of cas flo# o*er a period of time #ill be misleading . Bust because of te fact
tat te company"s cas flo# as increased in current year, #ill not mean tat it is in better
position tan te pre*ious year.
8. Influenced by canges in management policies, especially by canges in purcases and
sales policies, by delaying in postponing certain payments, ma3ing certain payments etc.
9. +annot be e?uated #it income statement #ic is more useful ence, it includes bot cas
and noncas items.
'i$$erences 0et3een F!n"s Flo3 Statement an" Cash Flo3 Statement
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F!n"s Flo3 Statement Cash Flo3 Statement
4. It is based on accrual accounting system.
5. It analyses te sources and application of
funds of long@term nature and net
increase or decrease in long@term funds
#ill be reflected on te #or3ing capital
of te firm.
7. It is more useful in long range planning.
8. It is a broader concept, it ta3es into account
bot long@term funds and sort term
funds into account in analysis.
9. It tallies te funds generated from *arious
sources #it *arious uses to #ic tey
are put.
=. Te canges in current items are ad6usted
in te statement of canges in #or3ing
capital.
F. It so#s te funds generated and applied as
regards long@term assets, long@term
liabilities and capital.
H. Sound fund position does not necessary
mean sound cas position.
4. 2ile preparation of tis
statement, all transactions effecting te
cas and cas e?ui*alents are ta3en to
consideration.
5. It considers only te increase or
decrease in current assets and current
liabilities in calculating te cas flo# from
operation.
7. It is more useful for identifying
and correcting te current li?uidity
problems of te firm.
8. It only deals #it one of te
current assets on assets side of te balance
seet.
9. It starts #it te opening
balance of cas and reac to te closing
balance of cas by proceeding troug
sources and uses.
=. In tis statement cas from
operations are calculated after ad6usting
te increase or decrease in current assets
and current liabilities to operating profit
before #or3ing capital canges.
F. It so#s te cas flo# from
operating, financing and in*estment
acti*ities.
H. Sound cas position is al#ays
follo#ed by sound fund position.
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