UNIT – 2 : FINANCIAL STATEMENTS & ANALYSIS

⭐ PART – 1 : FINANCIAL STATEMENTS

📌 Meaning

Financial Statements are the final reports prepared at the end of accounting period to show profit/loss and financial position of the business.

Simple words:
Financial Statements tell how much business earned, spent, owns & owes.


📌 Objectives

ObjectiveExplanation
Know Profit or LossFrom Trading A/c & P&L A/c
Know Financial PositionFrom Balance Sheet
Help in Decision MakingExpand, close, borrow etc.
Show Business HealthTo owners, investors, banks
Legal RequirementMust prepare annually

📌 Uses

  • Helps owners understand performance
  • Investors check before investing
  • Bank sees before giving loans
  • Government checks taxation
  • Managers use it for planning

📌 Limitations

  • Based on historical data, not future
  • Does not show non-financial factors (employee morale)
  • Asset values sometimes not realistic due to depreciation
  • Window dressing possible if management manipulates

📌 Types of Financial Statements

PartWhat it Shows
Trading AccountGross Profit or Loss
Profit & Loss AccountNet Profit or Loss
Balance SheetAssets & Liabilities
Cash Flow StatementInflow/Outflow of cash
Fund Flow StatementMovement of working capital

🔶 Trading Account

Shows Gross Profit = Sales – Cost of Goods Sold

Format (Easy)

Dr. | Trading Account | Cr.

ParticularsAmtParticularsAmt
Opening StockxxSalesxx
PurchasesxxClosing Stockxx
Direct Expensesxx
To Gross Profit c/dxx

Example

Sales = 2,00,000
Opening Stock = 20,000
Purchases = 1,00,000
Closing Stock = 30,000
Direct Wages = 10,000

Gross Profit = Sales + Closing Stock − (Opening Stock + Purchases + Wages)
= 2,00,000 + 30,000 − (20,000+1,00,000+10,000)
= 2,30,000 − 1,30,000 = 1,00,000 GP


🔶 Profit & Loss Account

Shows Net Profit = Gross Profit – Indirect Expenses + Other Incomes

ParticularsAmtParticularsAmt
SalariesxxGross Profit b/dxx
RentxxInterest Receivedxx
ElectricityxxCommission Receivedxx
To Net Profitxx

Example (continuation)

Gross Profit = 1,00,000
Rent 10,000; Salary 15,000; Electricity 5,000; Interest Received 2,000

Net Profit = Gross Profit – Indirect Exp + Incomes
= 1,00,000 – (10,000+15,000+5,000) + 2,000
= 1,00,000 – 30,000 + 2,000
= ₹72,000


🔶 Balance Sheet

Shows financial position:

Assets = Liabilities + Capital

LiabilitiesAmtAssetsAmt
CapitalxxCashxx
CreditorsxxDebtorsxx
LoanxxFixed Assetsxx
Closing Stockxx

Capital is adjusted:

Closing Capital = Opening Capital + Net Profit – Drawings


Example (final)

Capital (opening) = 5,00,000
Net Profit = 72,000
Drawings = 20,000

Closing Capital = 5,00,000 + 72,000 − 20,000 = 5,52,000

Balance Sheet

LiabilitiesAmtAssetsAmt
Capital 5,52,0005,52,000Cash 1,00,0001,00,000
Creditors 1,00,000Debtors 1,50,0001,50,000
Loan 50,000Fixed Assets 3,52,0003,52,000

Total = 7,02,000 both sides ✔


What you MUST prepare for exam from Part 1

TopicExpected questions
Financial Statement meaning/objectives5M theory
Trading/P&L/Balance sheet8-10M problem
Adjustments (Salary outstanding etc.)practical

Adjustment Examples (very important)

AdjustmentEffect in Accounts
Closing stockCredit Trading + shown in Assets
Outstanding ExpensesAdd in P&L + shown as liability
Prepaid ExpenseDeduct in P&L + shown in assets
DepreciationDr P&L + reduce asset value
Bad DebtsDr P&L + reduce debtors

PART – 2 : RATIO ANALYSIS

📌 Meaning

Ratio Analysis is a technique of analyzing financial statements using mathematical ratios to understand profitability, liquidity, solvency, efficiency and performance of the business.

Simple Words:
Ratios = Indicators which tell how strong or weak the business is financially.


📌 Objectives of Ratio Analysis

ObjectiveMeaning
Measure profitabilityHow much profit firm earns from sales
Test liquidityAbility to pay short-term obligations
Test solvencyAbility to pay long-term loans
Judge operational efficiencyAsset utilization, stock movement
Compare performanceTrend analysis over years
Assist in decision makingCredit, investment, management

📌 Advantages

  • Easy to understand business condition
  • Helps compare current vs past performance
  • Helps banks/investors judge creditworthiness
  • Quick decision support tool
  • Helps detect financial weakness early

📌 Limitations

  • Based on historical data
  • Window dressing may hide reality
  • Different firms use different accounting methods
  • Ratios alone cannot judge business health — need trends

🔥 Classification of Ratios (as per Syllabus)

CategoryRatios Included
Liquidity RatiosCurrent Ratio, Quick Ratio
Solvency RatiosDebt-Equity Ratio, Proprietary Ratio
Activity RatiosInventory Turnover, Debtor Turnover, Creditor Turnover, Working Capital Turnover
Profitability RatiosGross Profit, Net Profit, Operating Ratio, ROCE, ROI, EPS

Now each in detail with example.


🟦 1. LIQUIDITY RATIOS

Shows ability of business to pay short-term liabilities.


🔹 Current Ratio

Current Ratio = Current Assets / Current Liabilities

Ideal Ratio = 2 : 1

Example:
CA = 2,00,000
CL = 1,00,000
CR = 2,00,000 / 1,00,000 = 2 : 1 (Good position)


🔹 Quick Ratio (Acid Test Ratio)

Quick Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets − Stock − Prepaid Expenses

Ideal = 1 : 1

Example:
CA = 2,00,000
Stock = 50,000
Prepaid = 10,000
CL = 1,00,000

Quick Assets = 2,00,000−50,000−10,000 = 1,40,000
Quick Ratio = 1,40,000 / 1,00,000 = 1.4 : 1 (Good)


🟥 2. SOLVENCY RATIOS

Ability of business to pay long-term debt.


🔹 Debt-Equity Ratio

Debt-Equity = Long term Debt / Shareholders’ Funds

Ideal = 1:1

Example:
Long term loan = 5,00,000
Equity = 10,00,000
Ratio = 5,00,000 / 10,00,000 = 0.5 : 1 (Safe)


🔹 Proprietary Ratio

Proprietary Ratio = Shareholders’ Funds / Total Assets

Shows ownership portion in assets.

Higher ratio = strong financially.

Example:
Shareholder fund = 10,00,000
Total assets = 15,00,000
Ratio = 10,00,000/15,00,000 = 0.67 or 67%


🟩 3. ACTIVITY RATIOS / TURNOVER RATIOS

Measure efficiency in using assets.


🔹 Inventory (Stock) Turnover Ratio

ITR = Cost of Goods Sold / Average Stock
Average Stock = (Opening + Closing Stock)/2

Example:
COGS = 3,00,000
Opening = 40,000
Closing = 60,000
Avg = 50,000
ITR = 3,00,000/50,000 = 6 times

Higher turnover = goods selling fast.


🔹 Debtors Turnover Ratio

Debtors Turnover = Credit Sales / Average Debtors

Example:
Credit sales = 2,40,000
Debtors = 30,000
Ratio = 2,40,000/30,000 = 8 times

Collection efficiency good.


🔹 Creditors Turnover Ratio

Credit Purchases / Average Creditors

Shows payment speed.


🔹 Working Capital Turnover Ratio

WCTR = Sales / Working Capital
Working Capital = Current Assets − Current Liabilities

Higher better.


🟨 4. PROFITABILITY RATIOS


🔹 Gross Profit Ratio

GP Ratio = (Gross Profit / Sales) × 100

Example: GP = 80,000, Sales = 2,00,000
= 80,000/2,00,000×100 = 40%


🔹 Net Profit Ratio

NP Ratio = (Net Profit / Sales) × 100

Shows actual earning capacity.


🔹 Operating Ratio

Operating Ratio = (COGS + Operating Expense) / Sales ×100
Lower better.


🔹 Return on Capital Employed (ROCE)

ROCE = (Net Profit / Capital Employed) ×100

Shows return business earns on investment.


🔹 Earnings Per Share (EPS)

EPS = Net Profit after tax / No. of Shares

Investors’ favorite.


Short Summary Sheet

RatioFormulaIdeal
CurrentCA/CL2:1
Quick(CA−Stock−Prepaid)/CL1:1
Debt-EquityDebt/Equity1:1
ProprietaryEquity/Total AssetsHigher=better
Inventory TurnoverCOGS/Avg StockHigher
Debtor TurnoverCredit Sales/Avg DebtorHigher
GP RatioGP/Sales×100Higher
NP RatioNP/Sales×100Higher
ROCENP/Capital×100Higher
EPSNP/No. of SharesHigher

What will be asked in Exam?

✔ Meaning/objectives of ratio analysis (5M theory)
✔ Liquidity ratio calculations (CR, QR)
✔ Profitability ratios numericals
✔ Turnover ratios numericals

Mostly paper gives Balance Sheet + P&L → Find Ratios.

PART – 3 FUND FLOW STATEMENT


📌 Meaning

Fund Flow Statement is a statement that shows changes in financial position between two balance sheet dates in terms of sources of funds and applications (uses) of funds.

Fund = Working Capital
Fund Flow = Movement of working capital


📌 Objectives

ObjectiveExplanation
Know how funds were generatedIssue of shares, loan, profit
Know where funds were usedAsset purchase, loan repayment
Analyse financial positionIncrease or decrease in working capital
Helps for planning & controlLong-term investment decisions

📌 Sources of Funds (Inflow)

  • Issue of shares or debentures
  • Long-term loan raised
  • Sale of fixed assets
  • Operating profit
  • Decrease in working capital

📌 Application of Funds (Outflow)

  • Purchase of fixed assets
  • Repayment of loan/debentures
  • Payment of dividend/tax
  • Loss from operations
  • Increase in working capital

📌 Steps to Prepare Fund Flow Statement

  1. Prepare Schedule of Changes in Working Capital

Working Capital = Current Assets − Current Liabilities

  1. Find funds from operations (profit adjusted)
    Add non-cash items (Depreciation, Loss on sale)
    Less non-operating income (Profit on sale, interest received)
  2. Prepare Fund Flow Statement
    List sources → List applications → Balance = increase/decrease WC

📌 Format – Schedule of Changes in Working Capital

ParticularsYr-1 CAYr-2 CAIncreaseDecrease
Current Assetsxxxx
Current Liabilitiesxxxx

Increase in Working Capital = CA↑ or CL↓
Decrease in Working Capital = CA↓ or CL↑


📌 Example

Balance Sheets (Extract)

Particulars20232024
Debtors50,00060,000
Stock40,00030,000
Cash20,00025,000
Creditors30,00020,000

Schedule of WC

Particular20232024IncreaseDecrease
Debtors50,00060,00010,000
Stock40,00030,00010,000
Cash20,00025,0005,000
Creditors30,00020,00010,000↓ because CL decreased

Working Capital Change:
Increase = 10,000 + 5,000 + 10,000 = 25,000
Decrease = 10,000
Net Increase = 15,000


📌 Fund Flow Statement Format

Sources of FundsAmtApplication of FundsAmt
Issue of sharesxxPurchase of machineryxx
Fund from operationsxxRepayment of loanxx
Sale of assetxxIncrease in WCxx


📘 CASH FLOW STATEMENT


📌 Meaning

Cash Flow Statement shows movement of cash & cash equivalents during a period under operating, investing & financing activities.

Cash Flow = Cash Inflows − Cash Outflows

It tells how cash came & where it went.


📌 Objectives

  • Evaluate cash position & liquidity
  • Helps in short-term planning & budgeting
  • Useful for bankers, investors
  • Shows capability to pay dividends/loans
  • Measures real-time money movement

📌 Types of Activities

ActivityMeaningExamples
OperatingCash from main business activityCash from sales, payment to supplier, wages
InvestingCash spent/received on assetsPurchase/sale of machinery, land
FinancingCash related to capital & loansIssue of shares, repayment of loan

📌 Cash Flow Statement Format

A. Cash Flow from Operating Activities
   Net Profit
   + Non cash expenses (Depreciation)
   - Non-operating incomes 
   +/- Changes in working capital

B. Cash Flow from Investing Activities
   + Sale of assets
   - Purchase of assets

C. Cash Flow from Financing Activities
   + Issue of shares
   - Loan repayment

Net Cash Flow = A + B + C

📌 Example

Additional information:

  • Net Profit = ₹1,00,000
  • Depreciation = ₹20,000
  • Increase in Debtors = ₹10,000
  • Decrease in Creditors = ₹5,000
  • Machinery purchased = ₹50,000
  • Loan raised = ₹30,000

Stepwise Solution

A. Operating Activities

Net Profit                                   1,00,000
Add: Depreciation                              20,000
Less: Increase in Debtors                     (10,000)
Less: Decrease in Creditors                    (5,000)
---------------------------------------------
Cash from Operating Activities =             1,05,000

B. Investing Activities

Purchase of machinery                        (50,000)

C. Financing Activities

Loan taken                                    30,000

Net Cash Flow

= 1,05,000 - 50,000 + 30,000
= ₹85,000

Summary of Unit 2 – Final Revision Sheet

TopicMust Learn
Final AccountsTrading + P&L + Balance Sheet format
AdjustmentsOutstanding, prepaid, depreciation
Ratio AnalysisAll formulas + examples
Fund FlowWorking capital schedule + FFS
Cash FlowOperating/Investing/Financing method

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