Financial Statements & Analysis: Types, Formats & Interpretation

1. The Three Financial Statements: Definitions & Purposes

Financial statements are structured reports that summarize a company’s financial health over a period. They follow GAAP (Generally Accepted Accounting Principles) in Nepal (adapted from IFRS). Each statement answers a critical question:

1.1 Income Statement (Profit & Loss Statement)

Definition: Shows revenues, expenses, and net profit/loss over a period. Key Line Items:

• Revenue (Sales): Income from core business (e.g., Daraz’s e-commerce sales).
• Cost of Goods Sold (COGS): Direct costs to produce goods (e.g., Kathmandu’s retail inventory).
• Gross Profit = Revenue – COGS.
• Operating Expenses: Rent, salaries, marketing (e.g., Pathao’s driver commissions).
• Net Profit = Revenue – All Expenses – Taxes.

Example (Nepali Retail Shop: Kathmandu Mart):

| **Particulars**               | **Amount (NPR)** |
|-------------------------------|------------------|
| **Sales Revenue**             | 5,000,000        |
| Less: COGS                    | (3,200,000)      |
| **Gross Profit**              | 1,800,000        |
| Less: Operating Expenses     | (1,200,000)      |
| **Operating Profit**          | 600,000          |
| Less: Interest Expense        | (50,000)         |
| **Profit Before Tax**         | 550,000          |
| Less: Tax (25%)               | (137,500)        |
| **Net Profit**                | **412,500**      |

Why It Matters:

• eSewa uses its income statement to show transaction fees vs. operational costs to justify its valuation.
• Ncell reports ARPU (Average Revenue Per User) here to attract investors.

2. Balance Sheet: The "Snapshot" of Assets, Liabilities & Equity

Definition: A snapshot of a company’s financial position at a specific date, showing:

• Assets = What the company owns (cash, inventory, property).
• Liabilities = What the company owes (loans, bills).
• Equity = Owner’s claim (share capital + retained earnings).

Fundamental Equation: Assets = Liabilities + Equity (This is the accounting identity—always true!)

2.1 Classifying Assets, Liabilities & Equity

Example Balance Sheet (Kathmandu Mart, 31 Dec 2023):

| **Assets**                     | **Amount (NPR)** | **Liabilities & Equity**          | **Amount (NPR)** |
|---------------------------------|------------------|-----------------------------------|------------------|
| **Current Assets**              |                  | **Current Liabilities**           |                  |
| Cash                            | 200,000          | Bank Loan (Short-term)            | 1,000,000        |
| Inventory                       | 1,500,000        | Trade Payables                    | 300,000          |
| Accounts Receivable             | 150,000          | **Total Current Liabilities**     | 1,300,000        |
| **Total Current Assets**        | 1,850,000        |                                   |                  |
| **Non-Current Assets**          |                  | **Non-Current Liabilities**       |                  |
| Furniture & Fixtures            | 800,000          | Long-term Loan                    | 2,000,000        |
| Land                            | 5,000,000        | **Total Liabilities**             | 3,300,000        |
| **Total Non-Current Assets**    | 5,800,000        |                                   |                  |
| **Total Assets**                | **7,650,000**    | **Equity**                        |                  |
|                                 |                  | Paid-up Capital                   | 2,000,000        |
|                                 |                  | Retained Earnings                 | 500,000          |
|                                 |                  | **Total Equity**                  | 2,500,000        |
|                                 |                  | **Total Liabilities + Equity**    | **7,650,000**    |

Key Ratios from Balance Sheet:

1. Current Ratio = Current Assets / Current Liabilities
   • Kathmandu Mart: 1,850,000 / 1,300,000 ≈ 1.42 (Liquid but not ideal; aim for 1.5–2.0).
2. Debt-to-Equity = Total Debt / Total Equity
   • Kathmandu Mart: 3,300,000 / 2,500,000 = 1.32 (Moderate risk).

3. Cash Flow Statement: The "Lifeblood" of Business

Definition: Tracks actual cash inflows and outflows (not profits), divided into three activities:

1. Operating Activities (Core business cash flows).
2. Investing Activities (Buying/selling assets like land or machinery).
3. Financing Activities (Loans, dividends, share issuance).

Why It’s Critical:

• Nepal Rastra Bank (NRB) checks banks’ cash flows to ensure liquidity.
• Daraz uses this to plan warehouse expansions (investing cash).

Example (Kathmandu Mart, FY 2023):

| **Category**               | **Cash Inflows (+)** | **Cash Outflows (-)** | **Net Cash Flow** |
|----------------------------|----------------------|------------------------|-------------------|
| **Operating Activities**   |                      |                        |                   |
| Cash from Sales            | 4,800,000            |                        |                   |
| Less: Payments to Suppliers|                      | (3,000,000)           |                   |
| Less: Salaries             |                      | (800,000)             |                   |
| **Net Operating Cash Flow**|                      |                        | **1,000,000**     |
| **Investing Activities**   |                      |                        |                   |
| Purchase of Furniture      |                      | (500,000)             |                   |
| **Net Investing Cash Flow**|                      |                        | **(500,000)**     |
| **Financing Activities**   |                      |                        |                   |
| Bank Loan Received         | 1,000,000            |                        |                   |
| Dividend Paid              |                      | (100,000)             |                   |
| **Net Financing Cash Flow**|                      |                        | **900,000**       |
| **Total Cash Flow**        |                      |                        | **1,400,000**     |
| **Opening Cash Balance**   |                      |                        | 200,000           |
| **Closing Cash Balance**   |                      |                        | **1,600,000**     |

Real-World Link:

• eSewa’s Cash Flow: Most cash comes from operating activities (transaction fees), while investing cash goes into server upgrades.
• NTC’s Cash Flow: Heavy investing cash outflow for fiber expansion, but operating cash covers it via telecom service fees.

4. Linkages Between Financial Statements

The three statements are interconnected. Here’s how they flow:

flowchart TD
    A["Income Statement"] -->|"Net Profit"| B["Cash Flow Statement<br/>(Operating Section)"]
    A -->|"Depreciation"| B
    B -->|"Net Cash Flow"| C["Balance Sheet<br/>(Cash Account)"]
    D["Balance Sheet<br/>(Assets/Liabilities)"] -->|"Ending Inventory"| E["Next Period's Income Statement<br/>(COGS)"]
    D -->|"Ending Retained Earnings"| A
    F["Cash Flow Statement<br/>(Investing/Financing)"] -->|"Asset Purchases/Loans"| D

Trace Example (Kathmandu Mart):

1. Income Statement shows Net Profit (₹412,500) → Adds to Retained Earnings in the Balance Sheet.
2. Balance Sheet shows Land (₹5M) → If sold, it appears in Cash Flow (Investing).
3. Cash Flow shows Net Cash (₹1.4M) → Updates Cash in the Balance Sheet.

5. Financial Statement Analysis Techniques

5.1 Horizontal Analysis (Trend Analysis)

Compares year-over-year changes to spot growth/decline. Example (Daraz’s Revenue Growth):

Insight: Daraz’s revenue doubled in 2 years—strong growth!

5.2 Vertical Analysis (Common-Size Statements)

Converts absolute numbers to percentages of a base (e.g., total assets or revenue). Example (Kathmandu Mart’s Balance Sheet, Vertical Analysis):

| **Item**               | **Amount (NPR)** | **% of Total Assets** |
|------------------------|------------------|-----------------------|
| Cash                   | 200,000          | 2.6%                  |
| Inventory              | 1,500,000        | 19.6%                 |
| Land                   | 5,000,000        | 65.4%                 |
| **Total Assets**       | 7,650,000        | **100%**              |

Why? Helps compare Kathmandu Mart to competitors like Gorkha Bazar.

5.3 Ratio Analysis

Key Ratios & Interpretation:

Real-World Application:

• Ncell’s Debt-to-Equity: ~0.4 (safe), while Nepal Electricity Authority (NEA) has a ratio of 2.1 (high risk).
• Pathao’s Inventory Turnover: Not applicable (service business), but driver payouts are a high operating expense.

6. Limitations of Financial Statements

While powerful, financial statements have blind spots:

1. No Qualitative Factors: Customer satisfaction, brand reputation (e.g., Khalti’s trust vs. competitors).
2. Window Dressing: Companies manipulate timing (e.g., delaying payments to boost cash).
3. Inflation Effects: Historical cost accounting understates asset values in high-inflation economies like Nepal.
4. Off-Balance-Sheet Items: Leases (e.g., Daraz’s warehouse leases) may not appear as liabilities.

In the Real World

1. eSewa’s Financial Statements

   • Cash Flow Statement: Shows 90% of revenue comes from operating cash (transaction fees), while investing cash goes into digital infrastructure.
   • Income Statement: Reports gross margins of ~60% (high due to low incremental costs per transaction).

2. Daraz’s Inventory Turnover

   • Ratio: ~8 (very high for e-commerce).
   • Why? Uses just-in-time inventory and third-party warehouses to minimize stock holding.

3. Nepal Rastra Bank (NRB) Supervision

   • Key Focus: Banks’ liquidity ratios (e.g., Cash Reserve Ratio) to prevent runs like in 2001 financial crisis.
   • Tool Used: Cash Flow Statements to ensure banks hold enough high-quality liquid assets (HQLA).

4. NEPSE-Listed Companies (e.g., NMB Bank)

   • Debt-to-Equity: ~0.6 (safe).
   • ROE (Return on Equity): ~12% (attractive for shareholders).

Exam Tip

What Examiners Look For

1. Precision in Definitions:

   • ❌ "Balance sheet shows profits." → Wrong (it shows assets/liabilities).
   • ✅ "Balance sheet provides a snapshot of assets, liabilities, and equity at a point in time."

2. Linkages Between Statements:

   • Always trace how Net Profit (Income Statement) → Retained Earnings (Balance Sheet) → Cash Flow (Financing).

3. Ratio Calculations:

   • Show workings! For example:
     • Current Ratio = Current Assets / Current Liabilities = 1.42 (not just the number).
   • Compare to benchmarks (e.g., "This is below the retail industry average of 1.8").

4. Real-World Applications:

   • Expect 3–4 marks for linking concepts to Nepali businesses (e.g., "Like Ncell, Kathmandu Mart should improve its inventory turnover to reduce holding costs").
   • Avoid vague answers: Instead of "Daraz is profitable", say: *"Daraz’s gross profit margin of 55% (2023) is higher than Kathmandu’s 36%, reflecting lower COGS due to economies of scale in e-commerce."*

5. Common Pitfalls:

   • Mixing up "Profit" and "Cash":
     • Example: A company can be profitable (net income) but cash-starved (e.g., NEA has high receivables).
   • Ignoring Non-Current Items:
     • Always check long-term debt (e.g., NEA’s power plant loans) in solvency analysis.

High-Scoring Answer Structure

Use the SOAR framework for ratio analysis:

• Situation: "Kathmandu Mart’s current ratio is 1.42."
• Observation: "This is below the ideal range of 1.5–2.0 for retail."
• Analysis: "The quick ratio of 0.27 indicates heavy reliance on inventory liquidation."
• Recommendation: "Reduce inventory levels or secure short-term loans to improve liquidity."

Practice Question (Worked Example)

Question: "Analyze the financial health of Kathmandu Mart using ratios. Suggest two improvements."

Answer:

1. Liquidity Issues:

   • Current Ratio (1.42) and Quick Ratio (0.27) are weak.
   • Problem: High inventory (₹1.5M) ties up cash.
   • Fix: Implement just-in-time inventory (like Daraz) or offer discounts to sell excess stock.

2. Profitability Concerns:

   • Net Profit Margin (8.25%) is low vs. industry average (10%).
   • Problem: High operating expenses (₹1.2M) or thin margins.
   • Fix: Negotiate bulk supplier discounts or reduce rent by relocating to a cheaper area.

3. Solvency Risk:

   • Debt-to-Equity (1.32) is high.
   • Problem: Too much long-term debt (₹2M loan).
   • Fix: Issue equity shares or refinance debt at lower interest rates.

Visual Summary (Mermaid):