Unit 7

Analysis of financial statements: Introduction,

income statements and balance sheet(simple
ratio’s).
“Accounting is the art of recording, classifying, and

summarising in a significant manner and in terms of money,

transactions and events which are, in part at least, of a

financial character, and interpreting the result thereof.”

[Link] Statements: These are the primary outputs of financial accounting and typically
include:
1. Income Statement (Profit and Loss Statement): Presents the revenues and expenses
of a business over a specific period, resulting in the net income or net loss.
2. Balance Sheet (Statement of Financial Position): Shows the assets, liabilities, and
equity of a business at a specific point in time, providing a snapshot of its financial
position.
3. Statement of Cash Flows: Details the cash inflows and outflows from operating,
investing, and financing activities, helping users understand the liquidity and cash flow
management of the business.
[Link] (Generally Accepted Accounting Principles): These are a set of standard accounting
principles, standards, and procedures that companies use to compile their financial
statements. GAAP ensures consistency, comparability, and transparency in financial
reporting.
[Link]-Entry Accounting: This is the fundamental accounting principle that every
transaction affects at least two accounts: a debit and a credit. Debits and credits must
balance, ensuring the equality of assets and liabilities.
3. Accounting Cycle: This refers to the process of recording, summarizing, and reporting
financial information. It typically includes steps like journalizing transactions, posting to
ledgers, preparing trial balances, making adjusting entries, and ultimately preparing
financial statements.
4. Assets, Liabilities, and Equity: These are the three main components of the balance
sheet.
1. Assets: Economic resources owned or controlled by the business, such as cash,
inventory, property, and equipment.
2. Liabilities: Debts or obligations owed by the business, such as loans, accounts
payable, and accrued expenses.
3. Equity: Represents the residual interest in the assets of the business after deducting
liabilities. It includes contributed capital (common stock) and retained earnings.
5. Revenue Recognition and Matching Principle: Revenue is recognized when it is earned,
regardless of when the cash is received, and expenses are recognized when they are
incurred, matching them with the related revenues.
6. Financial Ratios and Analysis: These are tools used to evaluate a company's
financial performance and position, such as profitability ratios, liquidity ratios, and
solvency ratios. They help investors and creditors assess the company's financial
health and make informed decisions.
Overall, financial accounting plays a crucial role in providing relevant and reliable
financial information to stakeholders, enabling them to make informed decisions
about investing, lending, or operating with the business.
Accounting Concepts
[Link] entity concept: A business and its owner should be treated
separately as far as their financial transactions are concerned.
[Link] measurement concept: Only business transactions that can be
expressed in terms of money are recorded in accounting, though records of
other types of transactions may be kept separately.
[Link] aspect concept: For every credit, a corresponding debit is made. The
recording of a transaction is complete only with this dual aspect.
[Link] concern concept: In accounting, a business is expected to continue
for a fairly long time and carry out its commitments and obligations. This
assumes that the business will not be forced to stop functioning and liquidate
its assets at “fire-sale” prices.
Accounting Concepts
5. Cost concept: The fixed assets of a business are recorded on the basis of
their original cost in the first year of accounting. Subsequently, these assets
are recorded minus depreciation. No rise or fall in market price is taken into
account. The concept applies only to fixed assets.
6. Accounting year concept: Each business chooses a specific time period to
complete a cycle of the accounting process—for example, monthly, quarterly,
or annually—as per a fiscal or a calendar year.
7. Matching concept: This principle dictates that for every entry of revenue
recorded in a given accounting period, an equal expense entry has to be
recorded for correctly calculating profit or loss in a given period.
8. Realisation concept: According to this concept, profit is recognised only
when it is earned. An advance or fee paid is not considered a profit until the
goods or services have been delivered to the buyer.
Accounting Conventions
There are four main conventions in practice in accounting: conservatism;
consistency; full disclosure; and materiality.
Conservatism is the convention by which, when two values of a transaction
are available, the lower-value transaction is recorded. By this convention,
profit should never be overestimated, and there should always be a provision
for losses.
Consistency prescribes the use of the same accounting principles from one
period of an accounting cycle to the next, so that the same standards are
applied to calculate profit and loss.
Materiality means that all material facts should be recorded in accounting.
Accountants should record important data and leave out insignificant
information.
Full disclosure entails the revelation of all information, both favourable and
detrimental to a business enterprise, and which are of material value to
creditors and debtors.
Trial balance format
Ratio analysis

A Ratio is a mathematical number calculated as a reference to relationship of two or

more numbers and can be expressed as a fraction, proportion, percentage and a

number of times. Ratio analysis is indispensable part of interpretation of results

revealed by the financial statements. It provides users with crucial financial

information and points out the areas which require investigation. Ratio analysis is a

technique which involves regrouping of data by application of arithmetical

relationships, though its interpretation is a complex matter.

1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business
to pay the amount due to stakeholders as and when it is due is known as liquidity, and the ratios
calculated to measure it are known as ‘Liquidity Ratios’. These are essentially short-term in nature.
2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations
towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure
solvency position are known as ‘Solvency Ratios’. These are essentially long-term in nature.
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the
efficiency of operations of business based on effective utilisation of resources. Hence, these are also
known as ‘Efficiency Ratios’.
4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from operations or funds
(or assets) employed in the business and the ratios calculated to meet this objective are known as
‘Profitability Ratios’.