CHAPTER - 3

CONCEPTUAL FRAME WORK

INTRODUCTION:
The word “Financial Statements” send cold shivers down many people’s
backs; this is the language of business, a language investors need to know before
buying stocks, the role of financial reporting for companies is to provide
information about their fiscal health and financial performance. As investor, we
use financial reports to evaluate the past current and prospective performance
and financial position of a company. These statements allow us to compare one
firm to another and form the bases of valuing the worth of a stock.

Several financial statements are reported by companies, the most important three
used most often by investors, are:
 The income statement
 The balance sheet and
 The cash flow statement

The word ‘Performance is derived from the word ‘performer’, which means
‘to do’, ‘to carry out’ or ‘to render’. It refresher act of performing; execution,
accomplishment, fulfillment, etc. In border sense, performance refers to the
accomplishment of a given task measured against preset standards of accuracy,
completeness, cost, and speed. In other words, it refers to the degree to which an
achievement is being or has been accomplished. In the words of Frich Kohlar “The
performance is a general term applied to a part or to all the conducts of activities of an
organization over a period of time often with reference to past or projected cost
efficiency, management responsibility or accountability or the like. Thus, not just the
presentation, but the quality of results achieved refers to the performance.
Performance is used to indicate firm’s success, conditions, and compliance.

Financial performance refers to the act of performing financial activity. In

broader sense, financial performance refers to the degree to which financial objectives
being or has been accomplished. It is the process of measuring the results of a firm's
policies and operations in monetary terms. It is used to measure firm's overall
financial health over a given period of time and can also be used to compare similar
firms across the same industry or to compare industries or sectors in aggregation.

TYPES OF FINANCIAL PERFORMANCE ANALYSIS:

Financial performance analysis can be classified into different categories on
the basis of material used and modes operandi as under:

Financial Analysis

Material Used Modus Operandi

External Internal Horizontal Vertical

Analysis Analysis Analysis Analysis

Income statement:
The income statement reports how much revenue the company generated
during a period of time, the expenses it incurred and the resulting profits or losses. All
companies use a reporting period of one year, which can start and end at the same
time as a calendar year, could start and end at the same time as a calendar year, or
could start and end at different point in the year.

Balance sheet:
Although the income statement may be the most popular financial statement,
the balance sheet provides vital information on a company’s financial position.
Features of Balance Sheet:
 It is the last stage of final accounts.
 It is prepared on the last day of an accounting year.
 It is not an account under the double entry system.
 It has two side-left hand side known as asset side and right hand side known as
liabilities side.

Objectives of Balance Sheet:

 Principal objective: The main purpose of preparing balance sheet is to know
the financial position of the business at a particular date.
 Subsidiary objective: Though the main aim is to know the exact financial
position of the firm at a particular date, yet it serves other purpose as well.

MEANING OF FINANCIAL STATEMENT:

Financial statements is a record of the financial activities and position of a
business, person or other entity ,A balance sheet or statement of financial position,
reports on a company’s assets, liabilities and owners equity at a given point in time.

Recent researchers have been show that one of the main causes of indigenous
business failure in this country is failure to maintain proper financial records ,
Many business have been operated with merely a single entry memorandum record of
transactions and others with no records whatever, except possible cheque stubs. As a
result, business decision are based on guesses and intuition, Ola (1985)
A financial statement is the combination of the three major reports on a business;
it will contain the cash flow statement. The income statement and the balance sheet of
the business. All three together produce an overall picture of the health of the
business.
A financial statement is a collection of data organized according to logical and
consistent

Accounting procedures. Its purposes are to convey an understanding of some

financial aspects of a business firm. It may show a position at a moment in time, as in
the case of a balance sheet, or may reveal a series of activities over a given period of
time, as in the case of an income statement.

The term ‘financial statements’ generally refer to the two statements:

(i) The position statement or the balance sheet; and
(ii) The income statement or the profit and loss account.

These statements are used to convey to management and other interested outsider
the profitability and financial position of a firm. Financial statements are the outcome
of summarizing process of accounting.

Nature of financial statements:

The financial statements are prepared on the basis of recorded facts. The
recorded facts are those which can be expressed in monetary terms. The statements
are prepared for a particular period, generally one year. The transactions are recorded
in a chronological order, as and when the events happen.

The accounting records and financial statements prepared from these records
are based on historical costs. The financial statements, by nature, are summaries of the
items recorded in the business and these statements are prepared periodically,
generally for the accounting period.

The following points explain the nature of financial statements:

1. Recorded facts:
The term ‘recorded facts’ refers to the data taken out from the accounting records.
The records are maintained on the basis of actual cost data. The original cost or
historical cost is the basis of recording various transactions. The figures of various
accounts such as cash in hand, cash in bank, bills receivables, sundry debtors, fixed
assets etc.

2. Accounting conventions:
Certain accounting conventions are followed while preparing financial statements.
The conventions of valuing inventory at cost or market price, whichever is lower, is
followed. The valuing of assets at cost less depreciation principle for balance sheet
purposes is followed

3. Postulates:
The accountant makes certain assumptions while making accounting records. One
of these assumptions is that the enterprise is treated as a going concern. The other
alternative to this postulate is that the concern is to be liquidated, this, is untenable if
management shows an intention to liquidate the concern.

4. Personal judgments:
Even though certain standard accounting conventions are followed in preparing
financial statements but still personal judgment of the accountant plays an important
part. For example, in applying the cost or market value whichever is less to inventory
valuation the accountant will have to use his judgment in computing the cost in a
particular case? There are a number of methods for valuing stock, last in first out, first
in first out, average cost method, standard cost, base stock method, etc.

Uses of Financial Statements:

The following major uses of financial statements:
1) As a report of stewardship;
2) As a basis for fiscal policy
3) To determine the legality of dividends
4) As guide to advise dividend action
5) As a basis for the granting of credit
6) As information for prospective investors in an enterprise
7) As a guide to the value of investment already made
8) As an aid to government supervision
9) As a basis for price or rate regulation
10) As a basis for taxation.
Measures of Dispersion
Average is the central value which represents the entire series but it fails to
give any idea about the scatter of the values of items of a series around the true value
of average. In order to measure this scatter, measures of dispersion are calculated.
Measures of dispersion, indicates the extent, to which the individual values fall away
from the average or the central value. Range, mean deviation and standard deviation
are the important measures of dispersion.

These measures can be stated in two ways. One method of statements shows
the absolute amount of deviation, while the other presents the relative amount of
deviation. For purpose of comparison, the absolute amount of a measurement is not
always as valuable as an expression of the relative amount. The measures of
dispersion, which are expressed in terms of the original units of a series, are termed as
‘absolute measure’. Relative measures of dispersion are obtained as ratios or
percentages known as ‘co-efficient’ which are pure numbers independent of
measurement. “Percentages of variation are known as co-efficient of dispersion or co-
efficient of variation. They state the degree of variation.” Therefore, for the purpose
of comparison of variability the relative measures of dispersion should be computed.

Correlation and Regression Analysis

Correlation is a statistical technique which measures degree and direction of
relationship between the variables. It always lies between ±1. It is a relative measure.
While regression measures the nature and extent of average relationship in terms of
the original units of the data. If one of the regression coefficients is greater than unit
the other must be less than unit. It is an absolute measure of relationship.

Correlation analysis is a method of determining whether two sets of data are

related in a manner such that they increase together, if one increases, the other
decreases. Regression analysis, on the other hand, hypothesizes a particular direction
of the relationship. With regression one variable is determined by the others.
Analysis of Time Series
The time series refers to the arrangement of statistical data in accordance with
the time of its occurrence. It is dynamic distribution which reveals a good deal of
variations over time. Various types of sources are at work to influence dynamic
changes in a time series. It aims to find the pattern of change in statistical data over
the regular interval of time and to arrive at an estimate with this pattern for business
decision making.

The four component elements which bring variations in time series can be
classified as secular variation (trend), cyclical variation (regular), seasonal variation
(regular) and erratic variation (irregular). The combined impact, either additive or
multiplicative, of these components brings changes in statistical data.

DEFINITION OF FINANCIAL STATEMENT:

Financial statements are reports prepared by a company’s management to present
the financial performance and position at a point in time. A general purpose set of
financial statements usually includes a balance sheet, income statements, statement of
owner’s equity, and statement of cash flows. These statements are prepared to give
users outside of the company, like investors and creditors more information about the
company’s financial positions. Publicly traded companies are also required to present
these statements along with others to regulatory agencies in a timely manner.

Financial statements refer to the balance sheet, income statement, and statement
of cash flows, statement of retained earnings, and statement of stockholders equity.

The balance sheet reports information as of a date. The income statement,

statement of cash flows, statement retained earnings, and the statement of
stockholders equity report information for a period of time such as a year, quarter, or
month.
SIGNIFICANCE OF FINANCIAL STATEMENTS:
A financial statement helps the finance manager in:
 Assessing the operational efficiency and managerial effectiveness of the company.
 Analyzing the financial strengths and weaknesses and creditworthiness of the
company.
 Analyzing the current position of financial analysis,
 Assessing the types of assets owned by a business enterprise and the liabilities
which are due to the enterprise.
 Providing information about the cash position company is holding and how much
debt the company has in relation to equity.
 Studying the reasonability of stock and debtors held by the company.

Top Management
Financial analysis helps the top management
 To assess whether the resources of the firm are used in the most efficient manner.
 Whether the financial condition of the firm is sound
 To determine the success of the company’s operations
 Appraising the individual’s performance
 Evaluating the system of internal control
 To investigate the future prospects of the enterprise.

Trade Payables
Trade payables analyze of financial statements for:
 Appraising the ability of the company to meet its short-term obligations
 Judging the probability of firm’s continued ability to meet all its financial
obligations in the future.
 Firm’s ability to meet claims of creditors over a very short period of time.
 Evaluating the financial position and ability to pay off the concerns.
Lenders
Suppliers of long-term debt are concerned with the firm’s long-term solvency and
survival. They analyze the firm’s financial statements
 To ascertain the profitability of the company over a period of time,
 For determining a company’s ability to generate cash, to pay interest and
repay the principal amount
 To assess the relationship between various sources of funds ( i.e. capital
structure relationships)
 To assess financial statements which contain information on past
performances and interpret it as a basis for forecasting future rates of return
and for assessing risk.
 For determining credit risk, deciding the terms and conditions of a loan if
sanctioned, interest rate, and maturity date etc.

The Purpose of Financial Statements

The general purpose of the financial statements is to provide information
about the results of operations, financial position, and cash flows of an organization.
This information is used by the readers of financial statements to make decisions
regarding the allocation of resources. At a more refined level, there is a different
purpose associated with each of the financial statements. The income statement
informs the reader about the ability of a business to generate a profit. In addition, it
reveals the volume of sales, and the nature of the various types of expenses,
depending upon how expense information is aggregated. When reviewed over
multiple time periods, the income statement can also be used to analyze trends in the
results of company operations.

The purpose of the balance sheet is to inform the reader about the current
status of the business as of the date listed on the balance sheet. This information is
used to estimate the liquidity, funding, and debt position of an entity, and is the basis
for a number of liquidity ratios.

Finally the purpose of the statement of cash flows is to show the nature of cash
receipts and disbursements, by a variety of categories. This information is of
considerable use, since cash flows do not always match the revenues and expenses
shown in the income statement.

As a group, the entire set of financial statements can also be assigned several
additional purposes, which are:
 Credit decisions. Lenders use the entire set of information in the financials to
determine whether they should extend credit to a business, or restrict the amount
of credit already extended.
 Investment decisions. Investors use the information to decide whether to invest,
and the price per share at which they want to invest. An acquirer uses the
information to develop a price at which to offer to buy a business.
 Taxation decisions. Government entities may tax a business based on its assets or
income, and can derive this information from the financials.
 Union bargaining decisions. A union can base its bargaining positions on the
perceived ability of a business to pay

 Aspects of financial statement analysis

 There are basically two aspects of financial statement analysis, namely,
quantitative and non-quantitative financial statement analysis.

 Quantitative financial statement analysis

 The quantitative aspect of financial statement analysis has to do with the use of
mathematical models and ratios to predict the pattern of future event. This is the
traditional imagery that one conjures any time financial analysis is mentioned.
There are software that can be used to run these iterative and simulations. The
focus has long moved from this aspect to the non quantitative area as that is where
most expert systems cannot perfectively fit in yet. Nonetheless, accountants and
financial analysis still need these financial models and tools so as to be better
placed to interpret them.
 Non- Quantitative financial statement analysis
My interaction with successful businessmen and businesswomen has revealed to
me that it takes more than figures and number crunching to understand the direction
that a business is heading. More of our sixth sense is needed when faced with the
challenge of tearing down the annual report of a business while searching for the grail
message that will aid our investment decision. Investment is an art and should be
treated as one else, good investment opportunities

 Three qualities of a good qualitative financial statement analyst

ability to understand the unwritten language of economic
indicators
Economic indicators carry both written and unwritten messages. Your ability
to hear the unwritten part of the communication between a company and the economy
both at the micro and macro level is what distinguishes success investors and those
that failed while trying to delve into the world of investment. Remove bias and
sentiment, then ask yourself questions that will reveal the true implication of
government policies or potential government policies on major information contained
in the financial statement you are analyzing.

Ability to see the intent of managers before they become obvious

There is a load of information in the accounts of corporate bodies that serves as
green light to better or worse tomorrow. Carefully read the different documents that
are contained in the financial statement and then establish a form of correlation to see
where the vehicle is going to. It is not enough to only read the chairman’s report and
take every single word you find there on their face meaning – probe a little. This is
easily done by pulling words from different documents to see if they added up.

IMPORTANCE OF STUDY:
Financial statements are importance sources of information to all the user of
sources of information like ; management, owners, debtors, creditors, employees,
government agencies, financial analysis , etc. The following are the points which
height the importance of financial statement;
  Financial statements are the summary of information relating to profitability and
resources owned by the firm.
 Financial statements provide the information which can be compared with those
of other firms.
 Employs can use them to demand for increment in salary and other benefits.
 Bankers and other financial institutions can use them to make the lending
decisions.
 Government bases financial statements of the companies for the calculation of
tax revenue from the firms.
 Financial statements can be used as the basis for management decision making
purpose like planning, promotion, research and development decision, etc...
The importance of financial statements lies in their utility to satisfy the varied interest
of different categories of parties such as management, creditors, public, etc.

Importance to Management:
 Increase in size and complexities of factors affecting the business operations
necessitate a scientific and analytical approach in the management of modern
business enterprises.
 The management team requires up to date, accurate and systematic financial
information for the purposes. Financial statements help the management to
understand the position, progress and prospects of business vis-à-vis the
industry.
 By providing the management with the causes of business results, they enable
them to formulate appropriate policies and courses of action for the future. The
management communicates only through these financial statements, their
performance to various parties and justify their activities and there by their
existence.
 A comparative analysis of financial statements reveals the trend in the progress
and position of enterprise and enables the management to make suitable
changes in the policies to avert unfavorable situations.
Importance to the Shareholders:
 Management is separated from ownership in the case of companies.
Shareholders cannot, directly, take part in the day-to-day activities of business.
However, the results of these activities should be reported to shareholders at the
annual general body meeting in the form of financial statements.
 These statements enable the shareholders to know about the efficiency and
effectiveness of the management and also the earning capacity and financial
strength of the company.
 By analyzing the financial statements, the prospective shareholders could
ascertain the profit earning capacity, present position and future prospects of
the company and decide about making their investments in this company.
 Published financial statements are the main source of information for the
prospective investors.
Importance to Lenders/Creditors:
 The financial statements serve as a useful guide for the present and future
suppliers and probable lenders of a company.
 It is through a critical examination of the financial statements that these groups
can come to know about the liquidity, profitability and long-term solvency
position of a company. This would help them to decide about their future
course of action.
Importance to Labour:
 Workers are entitled to bonus depending upon the size of profit as disclosed
by audited profit and loss account. Thus. P & L a/c becomes greatly important
to the workers. In wages negotiations also the size of profits and profitability
achieved are greatly relevant.
Importance to the Public:
 Business is a social entity. Various groups of society, through directly not
connected with business, are interested in knowing the position, progress and
prospects of a business enterprise.
 They are financial analysts, lawyers, trade associations, trade unions, financial
press, research scholars and teachers, etc. it is only through these published
 financial statements these people can analyze, judge and comment upon
business enterprise.
Importance to National Economy:
 The rise and growth of corporate sector, to a great extent, influence the
economic progress of a country. Unscrupulous and fraudulent corporate
managements shatter the confidence of the general public in joint stock
companies, which is essential for economic progress and retard the economic
growth of the country.
 Financial statements come to the rescue of general public by providing
information by which they can examine and assess the real worth of the
company and avoid being cheated by unscrupulous persons.