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ToTCOOP+i O3 o4 unit-4_final_version_en

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Training for Board of directors in the agri-food cooperatives: Unit 1 - Financial Reporting

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ToTCOOP+i O3 o4 unit-4_final_version_en

  1. 1. STRATEGIC PARTNERSHIP FOR INNOVATING THE TRAINING OF TRAINERS OF THE EUROPEAN AGRI-FOOD COOPERATIVES ToTCOOP+i PROJECT Competence Unit 4 / Training Unit 4 : Financial reporting
  2. 2. Index - Activity 1: balance sheet - Activity 2: income statement - Activity 3: equity statement - Activity 4: cash flow statement - Activity 5: management discussion and analysis - MD&A - Activity 6: the case of the application to the cooperatives of the IAS 32 - Activity 7: the IAS 41 Agriculture - Activity 8: financial statement analysis
  3. 3. Activity 1 - Balance Sheet A financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. The accounting balance sheet is one of the major financial statements used by accountants and business owners. It is also referred to as the statement of financial position.
  4. 4. Assets – Its anything tangible or intangible which is owned or leased by a business. Liability – Its any obligation which a company owes to another business entity Owner’s equity - all claims of the proprietor, partners, or stockholders against the assets of a firm, equal to the excess of assets over liabilities. Basic accounting equation - relationship that states that assets equal liabilities plus owners’ equity. Components of Balance sheet
  5. 5. Assets Current Assets Cash Accounts receivable Inventories Prepaid Expenses Fixed Assets Land & Building Equipments Investments Goodwill Liabilities Current Liabilities Accounts payable Accrued Expenses IT Payable Short Term debt Non Current Liabilities Bonds Payable Long Term Borrowings Owner's Equity Common Stock Retained earnings Reading a Balance sheet
  6. 6. • A balance sheet offers a way to look inside your business and outline what it is really worth. A balance sheet is different from a measure of profit and loss. • It’s a list of assets and liabilities. Any good balance sheet includes some basics: • 1) What the business owns (real estate, vehicles, office equipment, etc.) • 2) Revenue you expect to take in (accounts receivable) • 3) Expenses you expect to pay out (accounts payable) Why Balance sheet
  7. 7. • The balance sheet is used to assess the value of your business at any given point • It helps to keep track of finances • It helps for showing it to investors & Bank Managers • It is also useful for annual accounts too.
  8. 8. Formulas
  9. 9. Continue...
  10. 10. 1. What Is Financial Statement ? 2. Overview Financial Statement 3. What Is Income Statement? 4. Why Income Statement ? 5. Usefulness 6. Limitation 7. Proforma of income statement 8. Contents of income statement 9. Sum solving Activity 2 - Income statement
  11. 11.  Income Statement - It presents financial record of a company’s revenues and expenses, and profits over a period of time.  It also gives firm’s financial performance in terms of revenues, expenses, and profits over a given time period.  It focus on revenues and costs associated with revenues.  Financial Statement is a group of reports that tell a company’s financial status  From company owners to potential investors everyone in between are interested  People are interested because they want to know how much money they made or how much money they spent  Some want to know how much money was reinvested in the company  There are three financial reports that are created during the accounting cycle 1. What Is Financial Statement ?
  12. 12. Reading an Income Statement Sales (-) Cost of goods sold Gross Profit Operating Expenses Operating Income Interest Expenses Income Before Tax (-) Taxes Net Income Available to Shareholders + General & Administrative Expenses + Selling & Marketing Expenses + Research & Development Expenses XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX
  13. 13.  Income Statement is the member of Financial Statement that tell us whether or not a company made a profit or incurred a loss.  It is something refers to Profit & Loss statement, Statement of Income  Important because it shows the profitability of a company during the time interval  It varies from company to company: Three months Four weeks Fiscal years (1st April – 31st March) 3. What Is Income Statement?
  14. 14.  In income statement all you have to know are two simple things:  1. Revenue (Money that company takes in)  2. Expenses (Money that company pays out)  Use this simple formula: Revenue – Expenses = Net Income (Amount of money that is left)
  15. 15.  The Income Statement is one of the major financial statement used by accountants and business owners  It shows the Profitability of a company during the time interval specified in its heading  It helps in Identifying Risk And Opportunities and forecast future performance for: ◦ Owners ◦ Creditors ◦ Competitors ◦ Investors 4. Why Income Statement ?
  16. 16.  Income statement should help investors and creditors of financial statement predict future cash flow in numbers of ways  Evaluate the past performance of the enterprise  Provide a basis for predicting future performance  Help assess the risk of uncertainty of achieving future cash flows 5. Usefulness
  17. 17.  Its is based on various assumptions & estimates. Therefore the net income measured by preparing an income statement is not absolutely accurate  Items that might be relevant but cannot be easily measure  Income numbers are affected by accounting methods  Income measurement involves judgments  While preparing income statement we take into account only those activities whose value can be objectively measured  A manipulation in net income is possible by using a particular inventory valuation method 6. Limitations
  18. 18. Activity 3 – Equity Statement Purpose: To reconcile the owner equity amount stated at the beginning of the time period, with the owner equity amount determined at the end of the time period. OWNER Equity  Term used to describe value of the business after the total claims of creditors are subtracted from the value of the assets.  The term “owner equity” refers only to a business and this statement includes no information for an individual person.
  19. 19. Net Worth  The term “net worth” is used to describe value of business plus personal valuation after the total claims of creditors are subtracted from the value of assets.  The term “net worth” refers to a statement for an individual person or a statement for a business which also contains data for an individual person.
  20. 20. Statement of Owner Equity  Components should include: 1. Beginning owner equity 2. Plus net income amount 3. Minus owner withdrawals 4. Plus contributions received by business 5. Minus contributions distributed to others 6. Equals Change in Retained Earnings/Contributed Capital 7. Ending Owner Equity (Cost Value Basis)
  21. 21.  Components should include: 7. Ending Owner Equity (Cost Value Basis) 8. Adjustment for change in Asset Values (Ending market value - cost value) - (Beginning market value - cost value) from beginning to end of time period and adjustment for change in Deferred Debt (+Beginning - Ending Deferred Liabilities) 9. Equals change in market valuation equity 10. Ending Owner Equity (Market Value Basis)
  22. 22. CONTENTS OF PROFIT AND LOSS / INCOME STATEMENT 1) Revenue From Operation : Note : In respect of company other than a financial finance company revenue from operation shall disclose separately in the notes revenue from  Sale of products  Sale of services  Other operating revenues Less: Excise duty PARTICULARS AMT AMT Gross Sale (If Sale Not Given Then Gross Profit) Less : Returns
  23. 23. while, in respect of a finance company revenue from operation shall include from  Interest and  Other financial services Revenue under each of above heads shall be disclosed separately by way of notes to accounts to extent applicable 2) Other Income PARTICULARS AMT AMT Rest Income Dividend Received Rent Received Transfer fees Profit on sale of fixed assets
  24. 24. 3) Cost Of Material Consumed , Purchase Of Stock In Trade : 4) Changes In The Inventories of Finished Goods , Stock In Trade, Work-in-progress : 5) Employee Benefits Expenses: PARTICULARS AMT AMT Opening Stock Add: Purchase Less: Closing Stock PARTICULARS AMT AMT Opening Stock Less: Closing Stock PARTICULARS AMT AMT Salaries And Wages Staff Welfare Expenses Contribution To Provident Fund Managing Directors Remuneration
  25. 25. 6) Finance Cost: 7) Depreciation And Amortization Expense: Amortization and depreciation are non-cash expenses on a company's income statement. Depreciation represents the cost of capital assets on the balance sheet being used over time, and amortization is the similar cost of using intangible assets like goodwill over time. PARTICULARS AMT AMT Interest On Debentures Interest From Borrowings From Banks/Financial Institution Interest By Tax Department Discount on issue of debentures w/off PARTICULARS AMT AMT Depreciation Of Plant And Machinery Depreciation On Furniture, Building
  26. 26. Other Expenses: PARTICULARS AMT AMT Rates Payment To Auditor Consumables Bad Debts Discount Commission Advertisement Trade Expenses Transit Expenses Transit Insurance Directors Sitting Fees Printing And Stationery Provision For Bad Debts Maintenance Of Motor Car General Expenses Loss No Sale Of Asset Establishment Expenses Selling Expenses
  27. 27. Power and fuel Rent Repairs to building Repairs to machinery Insurance Travelling expenses Freight and carriage outward Delivery expenses Preliminary expenses w/off
  28. 28. Exceptional items: When items of income and expenses from ordinary activities are of such size , nature or incidence that their disclosure are relevant to explain the performance of the enterprise for the period ,the nature and amount of such items should be disclosed separately . Eg , the disposal of items of fixed asset, provision for the costs of reconstruction. Extra ordinary items: These are those incomes or expenses that arises from event or transaction that are clearly distinct from ordinary activities of the enterprise and therefore are not expected to recur frequently or regularly E.g. loss from earthquake.
  29. 29.  A cash flow presents information about the cash flow with the oganisation’s main activity and those associated with its investing and financing activities of the period.It shows both inflow and out flow of the cash during the period  IAS 7 Cash Flow Statements Activity 4 - Cash flow statement
  30. 30.  This statement shows the dynamics of short-term liquidity and long- term solvency  Cash flow information is an essential input for economic decision models  It shows how much cash onlow or outflow is made during the period by operating,investing or financing activity Usage
  31. 31. Cash conversion cycles  Cash flows through the company continuously in a series of short- term and long-term conversion cycles  The ST - cash conversion cycle (operating cycle) relates to the main business operations = OPERATING ACTIVITIES
  32. 32. Format and structure of the cash flow statement  Cash flows from operating activities  + Cash flows from investing activities  + Cash flows from financing activities  Net change in cash during period  + Beginning cash balance  Ending cash balance
  33. 33. Cash flows from operating activities  Operating activities are primarily the revenue-generating activities of a organisation  “Operating cash flow” is conceptually most near to “net profit” Following iteams are added or deducted: 1. Non-cash expenses and non-cash revenues (f.i. depreciation expense) 2. Non-operating items (f.i. gain on disposal of tangible fixed assets) 3. Timing differences between net profit and underlying cash flow (f.i. changes in the level of inventories, receivables, creditors, etc.)`
  34. 34. Operating cash flows: Examples  Receipts from sale of goods and rendering of services (cashing in of receivables included)  Receipts from taxes on sales and VAT  Receipts from royalties, fees, commissions,…  Payments to suppliers (payment of creditors included)  Payments to employees  Payments of taxes, VAT, fines
  35. 35. Operating cash flows – Direct versus indirect method 2 methods for identifying and presenting the operating cash flow:  Direct method: engenders the presentation of the most important categories of gross operating cash inflows and cash outflows  Indirect method: net operating cash flow is determined by adjusting the (net) profit figure for the 3 types of differences
  36. 36. Direct method - Example  Cash receipts from customers 20250  Cash paid to suppliers and employees -17300  Cash generated from main operations 2950  Income taxes paid -1050  Net cash flow from operating activities 1900
  37. 37. Indirect method - Example
  38. 38. Cash flow
  39. 39. Cash flow
  40. 40. Cash flows from investing activities  This shows item on the cash flow statement that reports the aggregate change in a company's cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries and changes resulting from amounts spent on investments in capital assets  Examples: ◦ Payments for newly acquired equipment ◦ Receipts from the disposal of a building
  41. 41. Cash flows from financing activities  This catagory shows accounts for external activities that allow a firm to raise capital and repay investors, such as issuing stok, devidend etc. Examples: ◦ Inflow from issuing stock ◦ Inflow from new bank loan ◦ Outflow from buy-back of shares ◦ Outflow of loans
  42. 42. Constructing a cash flow statement 1. First determine under which method cash flow is made 2. Now begin with cash flow from operating activies then Investing and financing activities 3. Identify all transactions of the period leading operating,Investing and Financing activities 4. Construct a cash flow statement according to the formal rules
  43. 43. Classifying balance sheet movements as inflows or outflows of cash
  44. 44.  What do internal users use it for? Planning, evaluating and controlling company operations  What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management Activity 5 – Management discussion and analysis
  45. 45. Information is available from ◦ Published annual reports  (1) Financial statements  (2) Notes to financial statements  (3) Letters to stockholders  (4) Auditor’s report (Independent accountants)  (5) Management’s discussion and analysis 627 628
  46. 46. Information is available from ◦ Other sources  (1) Newspapers (e.g., Wall Street Journal )  (2) Periodicals (e.g. Forbes, Fortune)  (3) Financial information organizations such as: Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc., and Robert Morris Associates  (4) Other business publications 627 628
  47. 47.  Horizontal Analysis  Vertical Analysis  Common-Size Statements  Trend Percentages  Ratio Analysis Methods of Financial Statement Analysis
  48. 48. Horizontal Analysis Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next
  49. 49. Vertical Analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales
  50. 50. Common-Size Statements Financial statements that show only percentages and no absolute dollar amounts
  51. 51. Trend Percentages Show changes over time in given financial statement items (can help evaluate financial information of several years)
  52. 52. Ratio Analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)
  53. 53. Activity 6 - IAS 32 What is a financial instrument-1?  It can be a financial liability or an equity instrument  If it is an equity instrument then :  A) it does not any contractual obligations (deliver cash or exchange asset / liability)  B) it is either a non derivative (with no contractual obligations) alternatively  C) if it is a derivative then it is to be settled in either cash or by an asset for a fixed number of the entity’s own equity instruments
  54. 54.  When an entity is obligated to buy back its own shares (treasury shares) a liability exists  In a situation where an entity can exchange its own equity instruments to receive or deliver shares ( with a fixed amount) then this arrangement / contract is not an equity instrument but a financial asset or a financial liability What is a financial instrument-2?
  55. 55.  An instrument that gives right to the holder to sell it to the issuer for either cash or another financial asset is a liability to the issuer  An instrument is a liability when settlement depends on some uncertain events  A derivative financial instrument is either an asset or a liability when there is a choice for settlement. What is a financial instrument-3?
  56. 56.  While measuring a financial instrument, the asset and liability components are first separated & then the residual is considered as equity component.  Treasury shares- when an entity acquires or resells its own shares, this transaction represents a change of ownership and consequently no gain or loss arises.  The treasury share transaction costs are equity related and are deducted from equity. What is a financial instrument-4?
  57. 57. Scope within IAS 32- 1  This standard is applicable to all financial instruments except:  Subsidiaries, joint ventures, associates etc.  Employees’ benefits  Insurance contracts. However, where such contracts are embedded derivatives (IAS 39) then apply IFRS 4 (recognition and measurement of financial instruments)  Instruments where share based payments are involved, apply IFRS 2
  58. 58. Scope within IAS 32- 2  The standard applies to contracts to buy or sell non financial instruments which can be settled in cash by some other financial instruments  When settlement can be in cash / other financial instruments then watch for these: a) the contracts demand this type of settlements, b) when contract is not explicit then the traditional settlements like cash or other instruments will be in order, c) when it is the usual practice of the entity to quickly buy/sell to make short term gains or losses  When a contract is readily convertible in cash  A written option that can be settled in cash, cannot be settled in any other way.
  59. 59. Definitions- 1  A financial instrument is a contract that gives rise to a financial asset and a liability in two different entities  A financial asset is cash, equities in another entity, a contractual right to receive cash or exchange with another asset or liability that is potentially favorable to the entity.  A financial asset is also a contract that may be settled by the entity’s own equity if it is a non derivative. If it is a derivative, then it may be settled for either cash or another asset. An entity’s own equity instruments will not be included in these transactions.
  60. 60. Definitions- 2  A financial liability can be a contractual obligation to deliver cash or another asset or exchange financial assets / liabilities under unfavorable conditions to the entity.  A liability can also be a contract which can be settled with the entity’s own equity instrument which is when a non derivative can be settled by a certain number of the entity’s own equity instrument and if a derivative then settlement can be by means other than cash
  61. 61. Definitions- 3  An equity instrument is a contract that has a residual interest after deducting all liabilities  Fair value could be defined as a value that could be exchanged or liabilities settled between settled between willing and knowledgeable parties in an arm’s length transaction.  A puttable instrument is sellable for cash or any other financial asset or it is automatically transferred to the issuers on the occurrence of an uncertain event.  Contracts usually have clear economic consequences and the related parties have little discretionary power to avoid.  Entities include individuals, partnerships, incorporated bodies etc.
  62. 62. Presentation  The issuer of a financial instrument will classify the instrument either as an asset or an equity instrument,  Under certain conditions, an issuer will define an equity instrument if it has no contractual obligations to deliver cash or financial asset of another entity or to exchange any assets / liabilities under unfavorable conditions. If the instrument is to be settled with the issuer’s own equity instrument then if it is a non-derivative that includes no contractual obligations to deliver the entity’s own equity or if it is a derivative that would require settlement with a fixed amount of cash or a fixed number of shares of the entity.
  63. 63. Puttable instruments  These include contractual obligations for the issuer to repurchase or redeem instruments for cash or another financial asset when sold.  What is an equity instrument?- if an instrument entitles the holder to a pro-rata share after payment of all liabilities on liquidation. A pro-rata share is determined on dividing an entity’s assets into equal units of amounts and multiply the units held by the holder with the unit amount. The instrument is subordinate to all other instruments. A subordinate instrument has no priority over other claims to the assets. All subordinate instruments are puttable and the formula to calculate the redemption price is the same in that class.  Puttable instruments do not have any obligations apart from the contractual obligations by the issuer.
  64. 64. Obligations on liquidation  Some financial instruments hold conditions to transfer pro rata share of net assets to the holder on liquidation. Obligation arises when it is beyond control of the entity or it is uncertain to occur.  An equity instrument has features such as the holder is entitled to pro rata share on liquidation. The share is determined by unit rates multiplied by the number of units held. These are subordinate instruments. All subordinate instruments have identical obligations.
  65. 65. Reclassification of puttable instruments  An entity will reclassify a financial instrument as an equity instrument when it has all the necessary features. Reclassification will be done when an equity instrument ceases to have the specific features. The difference between the carrying amount of an equity instrument and the fair value of a financial instrument will be recognized in equity at the date of reclassification. To reclassify a financial liability as equity when it has all the requisite features. It is to be re-measured at carrying value at reclassification.
  66. 66. Absence of contractual obligations  With some exceptions, a financial liability differs from equity as it has contractual liabilities to deliver either cash or another financial asset. Substance rather the legal form governs the financial liability’s classification. Such as a preference share has a mandatory financial liability for redemption. When a holder of a financial instrument has the right to sell it back to the issuer for cash or another financial asset then it is a financial liability. If an entity does not have the right to avoid a liability by payment of cash or another asset then the obligation is a financial liability.
  67. 67. Settlement with the entity’s own shares  Even if it is contractual to settle an instrument with an entity’s own shares, this situation does not necessarily make it an equity instrument.  In a settlement, if an entity receives its own shares, then it is financial asset or a financial liability contract.  It is a financial liability when the entity has to buy back its own shares for cash.  A contract that requires delivery of an entity’s own shares in exchange for cash or another asset is a financial asset or a financial liability.
  68. 68. Contingent settlement provisions  A contingent settlement requires a financial instrument to deliver cash or another financial asset on the happening of a certain event in future which will render the instrument as a financial liability. Such events are beyond control of an entity.
  69. 69. Settlement options  When an instrument holder has a choice of settlement such as by net cash or by exchanging shares then the instrument is either a financial asset or a financial liability unless all the settlement alternatives point to the instrument being an equity instrument.  Financial instruments are either settled in cash or by exchanging shares. These are not equity instruments.
  70. 70. Compound financial instruments  The issuer of a non derivative financial instrument will examine the terms to determine whether the instrument contains both liability and equity elements in which case such different components will be separately displayed.  The instrument holders may have the option to convert financial instruments into equity ones at a later date. Example: convertible bonds converted into a fixed number of ordinary shares.
  71. 71. Treasury shares  If an entity acquires its own shares or equity instruments then these are termed as treasury shares and these are then deducted from entity’s shareholders equity.  No gain or loss arise on an entity’s own equity transactions.  All the treasury share related payments and receipts are accounted for under equity.  The details of all the treasury shares held are to be disclosed in the financial statements.
  72. 72. Interest, dividends, gains and losses  Interests, dividends, gains and losses relating to a financial instrument or a component that is a financial liability, shall be recognized in the profit and loss accounts.  Any dividend distributions to holders of financial instruments along with any transaction costs shall be directly debited to equity net of any income tax benefits.  The classification of any instrument such as whether it is a financial liability or an equity instrument will determine whether the related costs such as interests etc. will be recognized in the profit and loss.  The issue costs of equities should be deducted from equity. These costs are typically legal, accounting etc.  If dividends are classified as an expense then they should be presented in the statement of comprehensive income.  The requirements of IAS 1 and IFRS 7 are to be complied with.
  73. 73. Offsetting a financial asset and a financial liability  a financial asset and a financial liability shall be offset and the net amount shall be presented in the financial statements under the following circumstances:  A) there is a legal enforceable right of setoff  B) the entity wants to settle on a net basis or wants to realize asset and settle liability simultaneously  When transfer of an asset does not qualify for de-recognition, asset and liability set offs do not take place.  This standard requires a set off when doing so presents the future cash flows after settling two or three instruments. Net presentation has to reflect more meaningful expected cash flows.
  74. 74. Offsetting a financial asset and a financial liability (continued)  Offsetting assets with liabilities is generally inappropriate when:  A) several instruments are used to emulate one instrument  B) financial assets and liabilities have the same primary risk exposure (example: assets and liabilities of a portfolio involve different counterparties)  C) financial assets are pledged  D) assets are set aside in trust  E) obligations arising under an insurance contract  An entity may enter into a multiple instrumental transaction with a single counterparty with a master netting arrangement.
  75. 75. … the management by an entity of the biological transformation of living animals or plants (biological assets) for sale, into agricultural produce, or into additional biological assets. Activity 7 - The IAS 41 Agriculture Agricultural activity is… living animals plants TRANSFORMING INTO PRODUCE ASSETS
  76. 76. Harvesting from unmanaged sources (such as ocean fishing and deforestation) is not agricultural activity. 81 Agricultural activity? Biological transformation … … comprises the processes of growth, degeneration, production, and procreation that cause qualitative or quantitative changes in a biological asset.
  77. 77. … the incremental costs directly attributable to the disposal of an asset, excluding finance costs and income taxes. 82 Costs to sell are … Measure the biological assets at… … fair value less costs to sell from initial recognition of biological assets up to the point of harvest, other than when fair value cannot be measured reliably on initial recognition.
  78. 78. However, IAS 41 does not deal with processing of agricultural produce after harvest; for example, processing grapes into wine and wool into yarn. 83 IAS 41 for processing?
  79. 79. There is a presumption that fair value can be measured reliably for a biological asset. However, that presumption can be rebutted only on initial recognition for a biological asset for which quoted market prices are not available and for which alternative fair value measurements are determined to be clearly unreliable. In such a case, IAS 41 requires an entity to measure that biological asset at its cost less any accumulated depreciation and any accumulated impairment losses. 84 Always fair value?
  80. 80. In all cases, an entity should measure agricultural produce at the point of harvest at its fair value less costs to sell. 85 But, always!
  81. 81. IAS 41 requires that a change in fair value less costs to sell of a biological asset be included in profit or loss for the period in which it arises. 86 Where include? No income? Under a transaction-based, historical cost accounting model, a plantation forestry entity might report no income until first harvest and sale, perhaps 30 years after planting. On the other hand, an accounting model that recognises and measures biological growth using current fair values reports changes in fair value throughout the period between planting and harvest.
  82. 82. Biological assets that are physically attached to land (for example, trees in a plantation forest) are measured at their fair value less costs to sell separately from the land. 87 Separately or jointly?
  83. 83. IAS 41 requires an unconditional government grant related to a biological asset measured at its fair value less costs to sell to be recognised in profit or loss when, and only when, the government grant becomes receivable. 88 Unconditional government grant.
  84. 84. If a government grant is conditional, including when a government grant requires an entity not to engage in specified agricultural activity, an entity should recognise the government grant in profit or loss when, and only when, the conditions attaching to the government grant are met. 89 Unconditional government grant.
  85. 85. Activity 8 - Financial statement analysis
  86. 86. Business Survival: There are two key factors for business survival:  Profitability  Solvency  Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business.  The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.
  87. 87. Financial Statement Analysis  Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.
  88. 88.  Financial Statement Analysis is the collective name for the tools and techniques that are intended to provide relevant information to the decision makers. The purpose of the FSA is to assess the financial health and performance of the company.  FSA consist of the comparisons for the same company over the period of time and comparisons of different companies either in the same industry or in different industries.
  89. 89. Financial Statement Analysis Purpose:  To use financial statements to evaluate an organisation’s ◦ Financial performance ◦ Financial position ◦ Prediction of future performance  To have a means of comparative analysis across time in terms of: ◦ Intracompany basis (within the company itself) ◦ Intercompany basis (between companies) ◦ Industry Averages (against that particular industry’s averages)  To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.
  90. 90. Financial statement analysis involves analysing the information provided in the financial statements to: ◦ Provide information about the organisation’s:  Past performance  Present condition  Future performance ◦ Assess the organisation’s:  Earnings in terms of power, persistence, quality and growth  Solvency
  91. 91. Financial Statements…  1. The Income Statement  2. The Balance Sheet  3. The Statement of Retained Earnings  4. The Statement of Changes in Financial Position  Changes in Working Capital Position  Changes in Cash Position  Changes in Overall Financial Position
  92. 92. Effective Financial Statement Analysis  To perform an effective financial statement analysis, you need to be aware of the organisation’s: ◦ business strategy ◦ objectives ◦ annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors.
  93. 93. Requires that you:  Understand the nature of the industry in which the organisation works. This is an industry factor.  Understand that the overall state of the economy may also have an impact on the performance of the organisation. → Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing
  94. 94. Standards of Comparision…  1. Rule-of-thumb Indicators Financial analyst and Bankers use rule-of thumb or benchmark financial ratios.  2. Past performance of the Company  3.Industry Standards…
  95. 95. Tools of Financial Statement Analysis: The commonly used tools for financial statement analysis are:  Financial Ratio Analysis  Comparative financial statements analysis: ◦ Horizontal analysis/Trend analysis ◦ Vertical analysis/Common size analysis/ Component Percentages
  96. 96. Financial Ratio Analysis  Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements.  Ratio analysis also expresses relationships between different financial statements.  Financial Ratios can be classified into 5 main categories: ◦ Profitability Ratios ◦ Liquidity or Short-Term Solvency ratios ◦ Asset Management or Activity Ratios ◦ Financial Structure or Capitalisation Ratios ◦ Market Test Ratios
  97. 97. Profitability Ratios 3 elements of the profitability analysis:  Analysing on sales and trading margin ◦ focus on gross profit  Analysing on the control of expenses ◦ focus on net profit  Assessing the return on assets and return on equity
  98. 98.  Gross Profit % = Gross Profit * 100 Net Sales  Net Profit % = Net Profit after tax * 100 Net Sales Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would have over other expenses. Net Profit % = Net Profit before tax *100 Net Sales  Return on Assets = Net Profit * 100 Average Total Assets  Return on Equity = Net Profit *100 Average Total Equity
  99. 99. Liquidity or Short-Term Solvency ratios Short-term funds management  Working capital management is important as it signals the firm’s ability to meet short term debt obligations. For example: Current ratio  The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.
  100. 100.  Working Capital = Current assets – Current Liabilities  Current Ratio = Current Assets Current Liabilities  Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft
  101. 101. Asset Management or Activity Ratios  Efficiency of asset usage ◦ How well assets are used to generate revenues (income) will impact on the overall profitability of the business. For example: Asset Turnover  This ratio represents the efficiency of asset usage to generate sales revenue
  102. 102. Asset Management or Activity Ratios  Asset Turnover = Net Sales Average Total Assets  Inventory Turnover = Cost of Goods Sold Average Ending Inventory  Average Collection Period = Average accounts Receivable Average daily net credit sales* * Average daily net credit sales = net credit sales / 365
  103. 103. Financial Structure or Capitalisation Ratios Long term funds management  Measures the riskiness of business in terms of debt gearing. For example: Debt/Equity  This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.
  104. 104.  Debt/Equity ratio = Debt / Equity  Debt/Total Assets ratio = Debt *100 Total Assets  Equity ratio = Equity *100 Total Assets  Times Interest Earned = Earnings before Interest and Tax Interest
  105. 105. Market Test Ratios  Based on the share market's perception of the company. For example: Price/Earnings ratio  The higher the ratio, the higher the perceived quality of the earnings by the share market.
  106. 106.  Earnings per share = Net Profit after tax Number of issued ordinary shares  Dividends per share = Dividends Number of issued ordinary shares  Dividend payout ratio = Dividends per share *100 Earnings per share  Price Earnings ratio = Market price per share Earnings per share
  107. 107. Horizontal analysis/Trend analysis  Trend percentage  Line-by-line item analysis  Items are expressed as a percentage of a base year  This is a time series analysis  For example, a line item could look at increase in sales turnover over a period of 5 years to identify what the growth in sales is over this period.
  108. 108. Vertical analysis/Common size analysis/ Component Percentages  All items are expressed as a percentage of a common base item within a financial statement  e.g. Financial Performance – sales is the base  e.g. Financial Position – total assets is the base  Important analysis for comparative purposes ◦ Over time and ◦ For different sized enterprises
  109. 109. Limitations of Financial Statement Analysis  We must be careful with financial statement analysis. ◦ Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future. ◦ Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse.
  110. 110. Limitations of FSA….. 1. Financial Analysis is only a Means 2. Ignores the Price Level Changes 3. Financial Statements are essentially Interim Reports 4. Accounting Concepts and Conventions 5. Influence of Personal Judgments 6. Disclose only Monetary Facts

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