Analysis of Financial Statements Part 1

As a banker first of all we should understand -

1)Various components of balance sheet

2) Classification of Current Asset and Current Liabilities

After having understood the above we should develop the skill to analyze the Balance sheet and the Ratios. When we are having ratios in hand, then we are able to interpret the ratios properly.

Having said that above things, we are able to read balance sheet, Profit & Loss statement and Fund Flow statement.

Now come to the most important part of our topic- 

BALANCESHEET

Definition:-It is nothing but a statement of financial position which reveals the money value of company's assets, liabilities and owner's equity (net worth) on a particular day is known as Balance sheet.

Horizontal Format B/S

Schedule III, of Companies Act 2013 prescribes modified formats for Balance sheet and statement of Profit & Loss as under:-

Balance sheet and Banker-

A bank calls for the B/S of a company/ firm when it is considering an application for a credit facility from the firm.

Analysis of financial statement is an important tool for taking a credit decision. It is collected to assess Net Worth of the applicant, Repayment capacity, Viability, Availability of unencumbered securities etc. A bank will not approve credit unless the B/S and P/L statement reveal that the company has:-

(i) a sound financial position (solvency test)

(ii) good liquidity (cash flows)

(iii) a good earning capacity (profitability)

Analysis by a banker to be done taking into considerations of below things-

It is a normal expectation that year after year the size of a going concern's B/S will grow in size. This is because the profits made in the business will be added to the capital funds of the business. There could be some profit from the investment function also. There will be additions to the machinery which will help the company to produce more and increase sales. Also obsolete machinery has to be replaced. 

Similarly, if a company losses, it will erode the capital funds. This could be due to lower realization on sales, losses due to bad debts, poor collection, or lower stock as liquidity was not sufficient to buy and store the material.

All these items will impact the B/S. Understanding these changes and analyzing the changes and how it could impact the loan account is important for the banker.

Classification of Assets and Liabilities for Analysis-

The assets and liabilities in a B/S are classified in a convenient form for the purpose of analysis into-

(A) Assets:-

(i) Current assets

(ii) Fixed Assets

(iii) Non-Current Assets

(iv) Intangible Assets

(B) Liabilities:-

(i) Current Liabilities

(ii) Medium & Long term Liabilities

(iii) Capital & Reserve

(A) ASSETS

(i) Current assets (CA)-

CA are those which can be converted to cash within an operating cycle or normally a period of 12 months. These are liquid assets.

CA are used in production and generate income from the sale of finished products. It includes raw materials, work in progress and finished goods. The quality of current assets and the speed with which it can be converted into cash determines the solvency of a company.

Example:- A motor car owned by a business for the CEO is its fixed asset where as the cars in the assembly line will be current assets for a car manufacturing company.

(ii) Fixed Assets-

These assets are long-term assets like land and building, plant and machinery, tools and dies, fittings and fixtures, motor vehicles etc.

(iii) Other (Non- Current Assets)-

Those assets are not expected to be converted into cash, consumed or sold within 12 months of the B/S date. Book debts outstanding (O/S) for more than 180 days are also included in other assets.

(iv) Intangible Assets/ Fictitious Assets-

Intangible assets are those assets which are not realizable and have no tangible value ,e.g., goodwill, patents, trade marks, preliminary expenses, directors' borrowings (which may represent money permanently withdrawn from business), commissions on underwriting of shares, bad and doubtful debts not provided for, adverse balance of Profit and Loss Account etc. 

Fictitious assets are like intangible assets which do not exist in physical form. they are deferred revenue expenditure whose benefits is derived over long period of time. Even accumulated losses are fictitious assets as they are written off over a period of time. These items which can't transfer to P/L account of a particular period that is why these are shown on assets side of the B/S to be written off to P/L account in reasonable years.

From a bank's point of view, for arriving at the net worth of a concern, value of intangible assets is deducted from the owner's funds.

(B)LIABILITIES

Liabilities are claims on the business and against all the assets by the owners and external creditors. These are the sources of funds for the firm's acquisition of assets and for it's activity. A business is carried on with owned funds supplemented by borrowed funds. Borrowed funds may be short-term for working capital or long term debt for acquisition of fixed assets.

(i) Current Liabilities-

It represents all short term obligations generally due and payable within a period of one year from the date of B/S. 

Current liabilities bear a relationship to Current Assets, why? As Current Liabilities raise to acquire Current assets.

Example:- Sundry Creditors, Bills Payable, Tax Liability, Bank Limits (Working Capital and Short-Term Finance). Instalment of term loan, becoming due in next 12 months should be classified under the head Current Liability.

(ii)Medium and Long Term Liabilities

These liabilities comprise mortgages, bonds, debentures, and other obligations payable after a period of one year from the dare of Balance Sheet.

(iii) Capital & Reserves-

Capital is funds invested by the owners in the business. Retained profits are added to this. Reserves are specified allocations of funds.

There are  two classes of reserves--

1. Capital Reserves
2. Revenue Reserves

Capital Reserves are the reserves whose use is restricted, hence are treated to be of more permanent nature. The promoters can't take away these amounts from the business.

Revenue Reserves are the reserves which are created out of profits.

Revenue reserves are classified into two categories--

1. Specific
2. Free

So it is essentials to obtain breakup of reserves, which is normally not made available in the financial statements submitted by the companies.

Next time we will go through more of analysis of financial statement....