Assignment no: 1

Course Name: Financial Statement Analysis

Course Code: COMM-304

Section: BS 5th Accounting & Finance

Submitted By: MUHAMMAD UMAR

Roll No: 18221554-023

Submitted to: Ma’am Asma Usman

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CHAPTER NO: 1
INTRODUCTION TO FINANCIAL REPORTING

What is Financial Statement Analysis?

 An analysis of the financial reports of a company in a certain period of time by evaluating the
company’s economic prospects and risks.

 Relies on the past accounting data in order to predict about the future of the firm. and identify
problem areas.

 Includes analysis of company’s business environment, strategies and its financial position
and performance.

 Fundamentals of financial planning and analysis applicable to both for profit-seeking and for
non-profit-seeking organizations.

 Financial statement structure and analysis is discussed, with the objective of arriving at a
financial model for an organization such as:
 Operating activities

 Investing activities

 Financing activities
 Financial statement analysis is also employed as a tool to predict the financial results based
on a firm's strategic plans and objectives.
What are financial statements?
The medium by which a company discloses information concerning its financial performance.

Financial statements consist of:

 Income statement,
 Balance sheet,
 and Statement of Cash flow

How to analyze financial statements?

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The most commonly-used approaches across the industries are:
 Ratio analysis
 Cash flow analysis
 Common size analysis
 Index trend analysis
 Equity analysis and Valuation
Why do we analyze the financial statements?
To identify the state of the company in terms of their risk and return. Therefore, the results from
the analysis will shed light as to the performance of the company.
Who analyze the financial statements?
 Investors
 Creditors
 Government
BUSINESS ANALYSIS
 Business analysis is process of evaluating company’s prospects and risks for the purpose
of making business decisions. These business decisions extend to equity and debt
valuation, credit risk assessment, earning predictions, audit testing, etc.

 It’s an aids in making informed decision by helping structure the decision task through an
evaluation of a company’s business environment, its strategies, and its financial position
and performance.
FINANCIAL STATEMENT
 A financial statement is a transaction that flow through business activities.

 Each transaction or exchange, for example, the sale of a product or the use of a rented
building, contributes to the whole picture.

ACCRUAL ACCOUNTING
 Accrual basis accounting -record both revenues and expenses when they occur. Accrual
basis accounting is the method of accounting most businesses and professionals are
required to use by law.

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 In cash basis accounting, revenues are recorded when cash is actually received and
expenses are
CHAPTER # 2:
INTRODUCTION TO FINANCIAL STATEMENTS AND
OTHER FINANCIAL REPORTING TOPICS.

Business:
Any legal activity to earn profit.
 Sole Proprietorship:
A business owned and controlled by one person, is not a legal entity separate from its owner.
 Partnership:
A business owned by two or more individuals. Each owner, called a partner, is personally
responsible for debts of the partnership; Partners and business are separate entities.
 Joint Stock Company/Business Corporation:
Business which is formed under company’s ordinance 1984 and has legal right to act as a person.
A legal entity incorporated in a particular state. Ownership is evidenced by shares of stock.
The Financial Statements
1. Balance Sheet (Statement of Financial position)
Measures the financial position at any point in time.
Three major sections:
I. Assets: Resources of the firm
II. Liabilities: The debts of the firm.
III. Owners’ Equity: Owners’ claims against the assets of the business.
2. Income Statement (Statement of Earnings):
Summarizes revenues and expenses and gains and losses (operating costs), ending with net
income (at the end of an accounting period)
3. Statement of Owners’ Equity (Reconciliation of owners’ equity account):
Reconciliation of beginning and ending balances of their owners’ equity account. R/E links the
balance sheet to income statement.
4. Statement of Cash Flows:
Details the inflows and outflows of cash during a specified period of time.

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Three main Sections:
I. Cash flows from operation activities
II. Cash flows from investing activities
III. Cash flows from financing activities
5. Footnotes:
Footnotes to financial statements are used to present additional information about items included
in financial statements and to present additional financial information.
Accounting Period: it is a time period in which the business measures its operating results.
Accounting Cycle:
 The sequence of accounting procedures completed during each accounting period is the
accounting cycle.
Transaction:
An event that causes a change in a company’s assets, liabilities, or owners; equity, thus changing
the company’s financial position.
A transaction recorded in a journal is referred to as journal entry.
Working of steps:
 Recording to trial balances ( T-Account)
 Adjusting to ledgers
 Presenting to statements

Human Resources And Social Accounting

Human Resource Accounting:
Attempts to account for the services of employees.
Social Accounting:
Attempts to account for benefits to social environments within which the firm operates.
 Reporting in development phase.
 Disclosure is being started by many firms.

Auditor’s Report
An auditor’s report is the formal statement of the auditor’s opinion of the financial statement
after conducting an audit.
Audit:

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An auditor(Certified public accountant) conducts an independent examination of the accounting
information presented by the business and issues a report thereon.
 He/she inspect the conformity of GAAP.

Classification of auditor’s opinion:

Unqualified opinion (Clean):
Financial statements presents fairly, in all material respects, the financial position, results of
operations, and cash flows of the entity, in conformity with GAAP.
Qualified Opinion:
 States that, except for the effects of the matter(s) to which the qualification relates, the
financial statements present fairly, in all material respects the financial positions, results
of operations, and cash flows of the entity , in conformity with GAAP.
 A Qualified Opinion report is issued when the auditor encountered one of two types of
situations which do not comply with generally accepted accounting principles, however
the rest of the financial statements are fairly presented.
Adverse Opinion:
 It states that the financial statements do not present fairly the financial position, results of
the operations, and cash flows of the entity, in confirmatory with GAAP.
Disclaimer of Opinion:
 It states that auditor does not express an opinion on the financial statements. A disclaimer
of opinion is rendered when the auditor has not performed an audit sufficient in scope to
form an opinion.
Auditing Standards
1. General Standards
2. Fieldwork Standards
3. Reporting Standards
Review Report:
Outside accountant associated with financial statements to indicate that accountants are not
aware of any material modifications that should be made to FS in order for them to be in
confirmatory with GAAP or the report will indicate departures from GAAP.

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Accountant’s report indicates the deficiencies as:
 Omission of substantially all disclosures
 Omission of statement of cash flows
 Accounting principles not generally accepted.

CHAPTER NO: 3
THE BALANCE SHEET

The Basic Elements of the Balance Sheet

The Statement of Financial Position
 The balance sheet, also called the statement of financial position, is the expanded
expression of the accounting equation.
 Remember that the basic accounting equation states that assets equal the sum of liabilities
and owners' equity.
Assets = Liabilities + Owners’ Equity
 Another way to state the equation:
Uses of resources = Sources of resources

 Liabilities and owners' equity are the sources from which the firm has obtained its funds.
 The listing of assets shows the way that the firm's managers have put those funds to
work.
 The balance sheet is the cumulative result of the firm's past activities.
Assets
Assets are probable future economic benefits obtained or controlled by a particular entity as a
result of past transactions or events.
Liabilities
Liabilities are probable future sacrifices of economic benefits arising from present obligations of
a particular entity to transfer assets or provide services to other entities in the future as a result of
past transactions or events.
Owners' Equity
Owners' equity is the residual interest in the assets of an entity after deducting liabilities.

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Assets Are Either Current or Noncurrent
Current assets are those assets which will typically become cash or be consumed in one year or
one operating cycle, whichever is greater.
Noncurrent assets are assets used in the conduct of the business and for which the replacement
cycle is longer than one year.
Current Assets
Current assets are listed in order of their maturity or collectability.
Liquidity reflects the ability of the firm to generate sufficient cash to meet its operating cash
needs and to pay its obligations as they become due.
 Because of the liquidity focus, current assets are generally valued at the lower of their
acquisition costs or present resale values.
 Current assets include cash and cash equivalents, accounts receivable, inventories, and
prepaid expenses.
Cash and Cash Equivalents
 Cash and cash equivalents include currency, bank deposits, and various marketable
securities that can be turned into cash on short notice merely by contacting a bank or
broker.
 Cash is often considered to be any item which a bank will accept at face value for
deposit.
 Cash equivalents are only securities purchased within ninety days of their maturity dates.
Accounts Receivable
 Accounts receivable represent credit sales that have not yet been collected.
 A fast turnover period for accounts receivable is desirable.
 The longer a debt remains unpaid, the higher the chance that it will not ever be paid.
 Accounts receivable are listed on the balance sheet at their net realizable value, which is
the amount management thinks it will actually be able to collect.
Inventory
 Inventory represents items that have been purchased or manufactured for resale to
customers.

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 At times it is necessary for reporting purposes to reduce the historical cost of the
inventory to a lower value.
The Operating Cycle and Liquidity
 The operating cycle of a business is the time which elapses from the purchase of
inventory, to the exchange of inventory for accounts receivable, to the collection of
that receivable.
 It is sometimes called the cash-to-cash cycle because it is the time which elapses from
the time a company spends money to purchase inventory to the time it receives cash
for that inventory.
 Some businesses have a very short operating cycle, a week or two.
 Others have operating cycles which take years.
 Examples include companies in the forest products industry or the distilled spirits
industry.
Noncurrent Assets
 Noncurrent assets are assets used in the conduct of the business and for which the
replacement cycle is longer than one year.
 While the focus for current assets is their liquidity, the focus for noncurrent assets is
on the operating capacity of the firm.
 Property, plant, and equipment comprises the most common type of noncurrent assets.

Property, Plant, and Equipment

 Property usually represents the land upon which the firm's offices, factories, and other
facilities are located.

 Property is valued on the balance sheet at its historical acquisition cost.

 Buildings or plant may include buildings, warehouses, hospitals, and myriad other
assets.

 Equipment includes office furniture, tools, computers, and the like.

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Depreciation
 Because property, plant, and equipment assets wear out over time, they must be
reported on the balance sheet at their net book value.
 This reduction in the reported value during a period is called depreciation expense.
 Depreciation is a rational and systematic allocation of an asset's cost to expense over
the asset's life.
 It has nothing to do with writing assets up or down to market value or attempting to
accumulate cash for the purpose of replacing the asset.
Accumulated Depreciation
Accumulated depreciation is the total amount of depreciation expense that has been recognized
to date.
 If an asset's cost is $10,000 and the Accumulated Depreciation account shows a balance
of $2,000, then the net book value is $8,000.
Intangible Assets
 Intangible assets lack physical substance and yet are important resources in the regular
operations of a business.
Patents
 Patents, which protect invention, copyrights, which protect artistic works, and goodwill
are examples of intangible assets.
Goodwill
 Goodwill denotes the economic value of an acquired firm in excess of the value of its
identifiable net assets.
 Admire industry has assets of $500,000 and liabilities of $300,000. Therefore, its net
assets are $200,000. If Camel Company pays $250,000 to buy Admire Company, then
there is goodwill of $50,000 ($250,000 -$200,000).

Liabilities
 Liabilities include any probable obligation that the firm has incurred as a consequence of
its past activities.
Liabilities are either current or noncurrent.

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Current liabilities are short-term obligations that are expected to utilize cash or other current
assets within a year or an operating cycle, whichever is longer.

Noncurrent liabilities represent obligations that generally require payment over periods longer
than a year.
 Current liabilities include accounts payable, notes payable, warranty obligations and
accrued expenses.
Accounts Payable
 Accounts payable represent debts that the firm incurs in purchasing inventories and
supplies for manufacturing or resale purposes. Accounts payable also include anything
that a firm purchases on credit.

Notes Payable
 Notes payable are more formal current liabilities than the accounts payable. Notes are
usually written documents which involve payment of interest.
Warranty Obligations
 Warranty obligations represent the firm's estimated future costs to fulfill its obligations
for repair or refund guarantees. Warranties are reported on estimates because a company
cannot know for sure how many items will be returned for warranty work.
Accrued Expenses
 Accrued expenses represent liabilities for services already consumed but not yet paid for
or included elsewhere in liabilities.
Taxes Payable
 Taxes payable represent unpaid taxes owed to a governmental unit and will be paid
within one year.
Noncurrent Liabilities
Noncurrent liabilities represent obligations that generally require payment over periods longer
than a year. They are contracts to repay debt at specified future dates and often place some
restrictions on the activities of the firm until the debt is fully repaid.
Bonds Payable

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 Bonds payable are a major source of funds for larger companies. When it issues bonds, a
company obligates itself to make periodic interest payments and to pay back the entire
principal at the maturity date.
 A company usually issues bonds when the amount it is borrowing is too large to borrow
from one source.
Mortgage Payable
 A mortgage payable also involves payment of principal and interest, but it also
represents a pledge of certain assets that will revert to the lender if the debt is not paid.
Unreported Liabilities
 A company sometimes has liabilities which do not appear on the face of the balance
sheet.
 They may only be disclosed in the notes to the financial statements.
An example is a lawsuit.
Owners’ Equity
 Owners’ equity represents the owners’ claims on the assets of the business.
 Arithmetically, it is the difference between assets and liabilities.

Owner’s Equity = Assets –Liabilities

Owners’ Equity
A corporation’s shareholders’ equity consists of two items:
 Paid-in capital represents the direct investments by the owners of the firm.

 Retained earnings represent the earnings of the firm that have been reinvested in the
business.
 An important point to remember is that retained earnings do not represent cash available for
the payment of dividends.
 The retained earnings accountis the cumulative story of all the income the firm has earned,
all the losses it has incurred, and all the dividends it has paid out to shareholders.
Balance Sheet Analysis
 Using ratios, numbers on the balance sheet can be compared in order to gauge the
financial strength or weakness of a company. Ratios are useful only when they are

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compared with something else, such as that company's ratio in former years or industry
average ratios.
 Ratios are based on past data, which may be problematic, and they are also only as good
as the data that comprise them.
Vertical Analysis
 Vertical analysis, or vertical percentage analysis, is based on the percentage
relationship of each line in the balance sheet to the total.
Liquidity Ratios
 Liquidity ratios represent the ability of a company to convert its assets to cash.
The current ratio is computed by dividing total current assets by total current liabilities.
Current ratio = Current assets
Current liabilities
 The quick ratio, or acid-test ratio, is computed by dividing “quick” assets by current
liabilities. “Quick” assets are cash, cash equivalents, and net receivables.
Quick ratio= Cash and cash equivalents + Receivables
Current liabilities
Asset Management Ratios
Asset management ratios focus on the composition of the firm's assets as well as changes in the
composition of assets over time.
Debt Management Ratios
 Debt management ratios are the composition ratios drawn from a vertical analysis of
the right side of the balance sheet.
 Debt management ratios include the debt-to-assets ratio, which is computed by
dividing total debt by total assets.
 This ratio indicates the firm's changing reliance on borrowed resources.

 The lower the ratio, the lower the firm's risk.

Limitations of Balance Sheet Analysis
 Ratio calculations are only the first step in analyzing a firm's condition.
 Individual financial statements, such as the balance sheet, are seldom analyzed separately
from other statements.

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 Information useful for analyzing and clarifying financial statements is contained in other
parts of a company's financial reports, such as the notes to the financial statements.
 Different accounting methods used by businesses will have different effects on the
balance sheet numbers and therefore, on the ratios derived by using balance sheet
accounts.
CHAPTER # 4
INCOME STATEMENT

Usefulness of the Income Statement

 Evaluate past performance.
 Predicting future performance.
 Help assess the risk or uncertainty of achieving future cash flows
Limitations of income statements
 Companies omit items that cannot be measured reliably.
 Income is affected by the accounting methods employed.
 Income measurement involves judgment.
BASIC ELEMENTS OF THE INCOME STATEMENT
Net Sales (Revenues)
Sales (revenues) represent revenue from goods or services sold to customers. The firm earns
revenue from the sale of its principal products. Sales are usually shown net of any discounts,
returns, and allowances.
Cost of Goods Sold (Cost of Sales)
This category shows the cost of goods sold to produce revenue. For a retailing firm, the cost of
goods sold equals beginning inventory plus purchases minus ending inventory. In a
manufacturing firm, the cost of goods manufactured replaces purchases since the goods are
produced rather than purchased. A service firm will not have cost of goods sold or cost of sales,
but it will often have cost of services.
Other Operating Revenue
Depending on the operations of the business, there may be other operating revenue, such as lease
revenue and royalties.
Operating Expenses

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Operating expenses consist of two types: selling and administrative.
 Selling expenses, resulting from the company’s effort to create sales, include
advertising, sales commissions, sales supplies used, and so on.
 Administrative expenses relate to the general administration of the company’s
operation. They include office salaries, insurance, telephone, bad debt expense, and
other costs difficult to allocate.
Other Income or Expense
In this category are secondary activities of the firm, not directly related to the operations. For
example, if a manufacturing firm has a warehouse rented, this lease income would be other
income. Dividend and interest income and gains and losses from the sale of assets are also
included here. Interest expense is categorized as other expense.
Gains Increases in equity (net assets) from peripheral or incidental transactions.
Losses Decreases in equity (net assets) from peripheral or incidental transactions.
Gains and losses can result from
 sale of investments or plant assets,
 settlement of liabilities,
 Write-offs the debts
Single-Step Income Statement
 The single-step statement consists of just two groupings:
Revenues
-Expenses
Net Income
 No distinction between Operating and Non-operating categories.
Income Statement (in thousands)
Revenues:
Sales $ 285,000
Interest revenue 17,000
Total revenue 302,000
Expenses:
Cost of goods sold 149,000

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Advertising expense 10,000
Depreciation expense 43,000
Interest expense 21,000
Income tax expense 24,000
Total expenses 247,000
Net income $ 55,000
Earnings per share $ 0.75

Multiple-Step Income Statement

The presentation divides information into major sections.

 Operating Section
 Non-operating Section

3. Income tax

Income Statement (in thousands)

Sales $ 285,000
Cost of goods sold 149,000
Gross profit 136,000
Operating expenses:
Advertising expense 10,000
Depreciation expense 43,000
Total operating expense 53,000
Income from operations 83,000
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000

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Net income $ 55,000
Earnings per share $ 0.75
Multi-Step Income Statement

Sales
-Cost of goods sold
= Gross profit
Operating expenses:
-Selling expenses
-General and
Administrative expenses
= Income from operations
+ Other revenues and expenses
= Income before taxes
–Income tax expense

= income after taxes

Reporting Irregular Items

Discontinued Operations occurs when,

(a) Company eliminates the
 results of operations and
 Cash flows of a component.
(b) There is no significant continuing involvement in that component.
 Amount reported “net of tax.”

Discontinued Operations

 Discontinued Operations are reported after “Income from continuing operations.” Net of Tax
Gross Profit (Margin) % = Gross Profit
Sales
 Profit Margin % = Net Income
Sales

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Earnings Per Share
Calculation

= Net income - Preferred dividends

Weighted average number of shares outstanding
 An important business indicator.
 Measures the dollars earned by each share of common stock.
 Must be disclosed on the income statement.

CHAPTER #5
BASICS OF ANALYSIS

Ratio Analysis
 Liquidity
Measures a firm’s ability to meet its current obligations
 Leverage (borrowing capacity)
Measures the degree of protector for long-term creditors
 Profitability
Measures the earning ability of a firm
 Investor-focused

 Cash flow

Indicate liquidity, borrowing capacity, and profitability

Ratio Analysis
Interpreted in comparison with
 Prior ratios

 Competitor ratios

 Industry ratios

 Predetermined standards

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Complexities and Context
 Use of average data from balance sheet accounts
 Necessary when comparing against income statement data

 Does not
 Eliminate cyclical or seasonal variations

 Capture changes that occur unevenly throughout the year

 Analysis must be performed and understood within the context of
 Native accounting principles

 Native business practices and culture

The use of percentages is usually preferable to the use of absolute amounts

Vertical analysis
 All amounts of a year expressed as a percentage of a base amount (e.g., net sales revenue,
total assets)
Horizontal analysis
 Amounts for comparative years are expressed as a percentage of the base year amount
Industry variation

 Financial components vary by type of industry

 Merchandising
 Inventory is a principal asset

 Sales may be primarily for cash or on credit

 Service
 Inventory is low or nonexistent
 Manufacturing
 Large inventory holdings

 Substantial investment in plant assets

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