Financial Statements: Types, Preparation & Analysis

TAKEAWAYS:

• Financial statements are the final output of the accounting cycle, summarizing a business’s performance, position, and cash flows in standardized formats.
• The Income Statement (Profit & Loss Account) shows revenue, expenses, and net profit over a period, while the Balance Sheet captures assets, liabilities, and equity at a point in time.
• The Cash Flow Statement explains how cash moves between operating, investing, and financing activities, bridging the gap between accrual-based and cash-based performance.
• The Value Added Statement breaks down how value is created and distributed among stakeholders (employees, government, owners), offering insights beyond traditional financial statements.
• Horizontal and vertical analysis (trend and common-size statements) help compare financial performance over time or against industry benchmarks.
• Ratio analysis (liquidity, profitability, solvency, efficiency) transforms raw financial data into actionable insights for decision-making.

1. Introduction to Financial Statements

Financial statements are formal records that communicate a company’s financial performance and position to stakeholders (investors, creditors, regulators, and management). They are prepared using data from the ledger accounts (after adjusting entries) and follow GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards).

Key Types of Financial Statements

2. The Accounting Cycle and Financial Statements

The accounting cycle culminates in the preparation of financial statements. Here’s how the process flows:

flowchart TD
    A["Journal Entries"] --> B["Post to Ledger"]
    B --> C["Prepare Trial Balance"]
    C --> D["Adjusting Entries"]
    D --> E["Adjusted Trial Balance"]
    E --> F["Prepare Financial Statements"]
    F --> G["Closing Entries"]
    G --> H["Post-Closing Trial Balance"]
    H -->|"Repeat"| A

Key Step: Adjusting Entries Before finalizing financial statements, adjusting entries are made to ensure:

• Accrual accounting is followed (revenue/expenses recognized when earned/incurred, not when cash changes hands).
• Matching principle is applied (expenses matched with revenues they help generate).
• Realization principle is honored (revenue recognized when earned).

Example: Adjusting Entry for Accrued Salaries If a company owes Rs. 50,000 in salaries for December but hasn’t paid it yet:

Dr. Salaries Expense (Expense)     50,000
    Cr. Salaries Payable (Liability) 50,000

3. Income Statement (Profit & Loss Statement)

The Income Statement answers: "How profitable was the business over a period?" It follows this structure:

Worked Example: Income Statement for "Kathmandu Retail Shop" (FY 2080)

Assume the following for a small retail shop in Kathmandu:

• Sales Revenue: Rs. 8,50,000
• Purchases: Rs. 5,00,000
• Opening Inventory: Rs. 1,00,000
• Closing Inventory: Rs. 1,50,000
• Salaries: Rs. 1,20,000
• Rent: Rs. 60,000
• Utilities: Rs. 40,000
• Depreciation (Equipment): Rs. 20,000
• Interest Expense: Rs. 10,000
• Tax Rate: 30%

Step 1: Calculate COGS

COGS = Opening Inventory + Purchases – Closing Inventory
     = 1,00,000 + 5,00,000 – 1,50,000
     = Rs. 4,50,000

Step 2: Prepare Income Statement

4. Balance Sheet

The Balance Sheet answers: "What does the business own and owe at a specific date?" It follows the accounting equation: Assets = Liabilities + Equity

Structure of a Balance Sheet

Key Notes:

• Current Assets: Converted to cash within 1 year (e.g., cash, inventory, receivables).
• Non-Current Assets: Long-term assets (e.g., equipment, land).
• Current Liabilities: Due within 1 year (e.g., payables, short-term loans).
• Non-Current Liabilities: Long-term debts (e.g., bank loans).

5. Cash Flow Statement

The Cash Flow Statement categorizes cash flows into three activities:

1. Operating Activities: Cash from core business (e.g., sales, salaries).
2. Investing Activities: Cash from buying/selling assets (e.g., equipment, investments).
3. Financing Activities: Cash from loans, dividends, or equity.

Indirect Method (Common in Nepal)

Starts with net profit and adjusts for non-cash items (e.g., depreciation, changes in working capital).

Example for Kathmandu Retail Shop:

6. Value Added Statement

The Value Added Statement shows how value is created and distributed among stakeholders. It answers: "Who benefits from the company’s profits?"

Structure

Advantages:

• Highlights employee compensation as a cost of production.
• Shows tax burden explicitly.
• Useful for labor negotiations and tax planning.

In the Real World

1. eSewa (Nepal)

   • Cash Flow Statement: eSewa’s operating cash flows include revenue from transaction fees (e.g., Rs. 5 per payment) and expenses like server costs and salaries. Their investing activities involve upgrading payment infrastructure (e.g., POS machines for merchants).
   • Income Statement: Gross profit is calculated as Total Transaction Volume × Fee Rate – Processing Costs. For example, if eSewa processes Rs. 10 billion in transactions at a 2% fee, gross revenue is Rs. 200 million, minus Rs. 50 million in costs = Rs. 150 million gross profit.

2. Nepal Rastra Bank (NRB) and Bank Reconciliation

   • Balance Sheet: NRB’s balance sheet includes non-performing loans (NPLs) as liabilities (assets impaired) and foreign exchange reserves as assets. Banks like NMB or Global IME reconcile their cash books with bank statements daily to detect fraud or errors (e.g., unrecorded deposits or outstanding cheques).

3. Daraz (Nepal)

   • Income Statement: Daraz’s COGS includes warehouse costs, shipping fees, and returns processing. Their operating expenses are high due to marketing (e.g., discounts during Dashain/Tihar). For example, if Daraz sells Rs. 500 million worth of goods with Rs. 300 million in COGS and Rs. 150 million in marketing, their gross profit is Rs. 200 million, but net profit may be lower after salaries and logistics.

4. NTC (Nepal Telecom)

   • Cash Flow Statement: NTC’s operating cash flows come from telecom subscriptions and data sales. Their investing cash flows include spending on 5G infrastructure (e.g., Rs. 20 billion in 2023). The financing section shows debt repayments or dividends to the government (as a majority shareholder).

5. Khalti (Digital Payments)

   • Value Added Statement: Khalti’s value added is the difference between transaction fees and its costs (e.g., Rs. 3 per transaction × 10 million transactions = Rs. 30 million revenue; minus Rs. 10 million in fraud losses and salaries = Rs. 20 million value added). This is distributed to:
     • Employees (salaries),
     • Government (taxes),
     • Investors (profits),
     • Partners (merchant discounts).

7. Financial Statement Analysis Techniques

A. Horizontal Analysis (Trend Analysis)

Compares financial data over multiple periods (e.g., 2079 vs. 2080) to identify growth/declines.

Example: Sales Growth

Formula:

Growth (%) = [(Current Year – Previous Year) / Previous Year] × 100

B. Vertical Analysis (Common-Size Statements)

Expresses each line item as a percentage of a base (e.g., sales for Income Statement, total assets for Balance Sheet).

Example: Common-Size Income Statement

C. Ratio Analysis

Ratios convert financial data into actionable metrics. Key categories:

Example: Ratio Analysis for Kathmandu Retail Shop

• Current Ratio = 3,20,000 / 2,10,000 = 1.52 (Healthy)
• Gross Profit Margin = 4,00,000 / 8,50,000 × 100 = 47.06%
• Inventory Turnover = 4,50,000 / [(1,00,000 + 1,50,000)/2] = 4.5 times/year

8. Limitations of Financial Statements

While powerful, financial statements have limitations:

1. Historical Data: Reflect past performance, not future potential.
2. Subjectivity: Estimates (e.g., depreciation, bad debts) involve judgment.
3. Window Dressing: Companies may manipulate timing (e.g., delaying expenses to boost reported profits).
4. Lack of Qualitative Data: Ignores brand reputation, employee morale, or customer satisfaction.
5. Inflation Impact: Not adjusted for price changes (e.g., Rs. 1,00,000 in 2079 ≠ Rs. 1,00,000 in 2080).

Exam Tip

1. Memorize the Format:

   • Always start the Income Statement with Sales Revenue and end with Net Profit.
   • Balance Sheet must balance (Assets = Liabilities + Equity).
   • Cash Flow Statement must reconcile to the change in cash balance.

2. Adjusting Entries Are Critical:

   • Exams often ask for adjusted trial balances before financial statements. Never skip adjustments (e.g., depreciation, accruals).

3. Link Statements Together:

   • Net Profit from the Income Statement flows to Retained Earnings in the Balance Sheet.
   • Depreciation appears in the Income Statement (expense) and Balance Sheet (asset reduction).

4. Ratio Analysis Questions:

   • Always calculate at least 3 ratios (e.g., one liquidity, one profitability, one solvency).
   • Compare with industry benchmarks (e.g., retail gross margin ~40-50%).

5. Real-World Application:

   • If asked about a bank (e.g., NMB), focus on liquidity ratios (current ratio, quick ratio).
   • For a retailer (e.g., Big Mart), emphasize inventory turnover and gross profit margin.
   • For a manufacturing firm, highlight COGS and depreciation of plant assets.

6. Common Pitfalls:

   • Ignoring Non-Cash Items: Depreciation is an expense but doesn’t affect cash flow.
   • Miscounting Working Capital: Changes in receivables/inventory impact cash flow.
   • Forgetting Taxes: Always deduct income tax from net profit before retained earnings.

Practice Question (Worked Solution)

Question: From the following trial balance of Everest Tours (P) Ltd. for the year ended 2080, prepare the Income Statement and Balance Sheet.

Solution:

Step 1: Prepare Income Statement

Step 2: Prepare Balance Sheet

Final Checklist for Exams

1. Label Clearly: Write "Income Statement" or "Balance Sheet" at the top.
2. Use Rupees (Rs.): Always specify currency.
3. Double-Check Totals: Ensure debits = credits in trial balances.
4. Show Workings: For ratios, write the formula and plug in numbers.
5. Assume Missing Data: If inventory is missing, state: "Assuming no change in inventory."

Visual Summary of the Accounting Cycle: