Financial Statements & Analysis: Types, Preparation & Interpretation

TAKEAWAYS:

• Financial statements are the language of business, summarizing transactions, performance, and financial position in standardized formats.
• The Income Statement shows profitability over a period, the Balance Sheet captures assets/liabilities at a point in time, and the Cash Flow Statement tracks liquidity.
• Horizontal and vertical analysis reveal trends and relative performance, while ratios (liquidity, profitability, leverage) quantify financial health.
• GAAP and IFRS ensure consistency, but companies may use creative accounting (e.g., revenue recognition timing) to manipulate results.
• Real-world applications include loan approvals (banks), investment decisions (NEPSE), and operational efficiency (Daraz/Khalti).

1. The Four Core Financial Statements

Financial statements are interconnected and follow a logical sequence. Below is the accounting cycle as a process:

A. Income Statement (Profit & Loss Statement)

Definition: Shows revenue, expenses, and net income over a period (month/year). Key Components:

Worked Example: Kathmandu Retail Shop (FY 2023)

| **Income Statement for Kathmandu Retail (NPR '000)** |       |
|------------------------------------------------------|-------|
| **Revenue**                                          |       |
| Sales Revenue                                        | 50,000|
| Less: Sales Returns                                  | (2,000)|
| **Net Revenue**                                      | 48,000|
| **Cost of Goods Sold (COGS)**                       |       |
| Opening Inventory                                    | 10,000|
| Purchases                                             | 30,000|
| Less: Closing Inventory                              | (12,000)|
| **Total COGS**                                       | 28,000|
| **Gross Profit**                                     | 20,000|
| **Operating Expenses**                               |       |
| Salaries                                             | 8,000 |
| Rent                                                  | 2,000 |
| Utilities                                            | 1,000 |
| Depreciation (Equipment)                             | 500   |
| **Total Operating Expenses**                         | 11,500|
| **Operating Income (EBIT)**                          | 8,500 |
| **Interest Expense**                                 | 500   |
| **Income Before Tax (EBT)**                          | 8,000 |
| **Income Tax (25%)**                                 | 2,000 |
| **Net Income**                                       | **6,000**|

Real-World Link:

• Daraz Nepal uses its Income Statement to report gross merchandise volume (GMV) and operating margins to investors. A declining GMV (revenue) would signal trouble, while high COGS (e.g., due to import costs) could hurt profitability.

B. Balance Sheet (Statement of Financial Position)

Definition: Shows assets, liabilities, and equity at a specific date (e.g., 31 Dec 2023). Key Equation: $$\text{Assets}=\text{Liabilities}+\text{Shareholders’ Equity}$$

Classification of Assets/Liabilities:

| **Assets**               | **Liabilities**               | **Equity**               |
|---------------------------|--------------------------------|--------------------------|
| **Current Assets**        | **Current Liabilities**        | **Paid-up Capital**      |
| - Cash & Bank             | - Accounts Payable             | - Share Capital          |
| - Inventory               | - Short-term Loans             | - Retained Earnings      |
| - Accounts Receivable     |                                |                          |
| **Non-Current Assets**    | **Non-Current Liabilities**    |                          |
| - Property, Plant, Eqpt.  | - Long-term Loans              |                          |
| - Intangible Assets       | - Deferred Taxes               |                          |

Worked Example: Kathmandu Retail Shop (31 Dec 2023)

| **Balance Sheet for Kathmandu Retail (NPR '000)** |       |
|----------------------------------------------------|-------|
| **Assets**                                          |       |
| **Current Assets**                                  |       |
| Cash & Bank                                         | 15,000|
| Accounts Receivable                                 | 5,000 |
| Inventory                                           | 12,000|
| **Total Current Assets**                            | 32,000|
| **Non-Current Assets**                              |       |
| Equipment (Cost: 20,000; Accum. Depn: 2,000)        | 18,000|
| **Total Assets**                                    | **50,000**|
| **Liabilities & Equity**                            |       |
| **Current Liabilities**                             |       |
| Accounts Payable                                     | 8,000 |
| Short-term Loan                                      | 5,000 |
| **Total Current Liabilities**                       | 13,000|
| **Non-Current Liabilities**                          |       |
| Long-term Loan                                       | 10,000|
| **Total Liabilities**                               | 23,000|
| **Shareholders' Equity**                            |       |
| Paid-up Capital                                      | 15,000|
| Retained Earnings (from Income Stmt)                 | 12,000|
| **Total Equity**                                    | 27,000|
| **Total Liabilities + Equity**                       | **50,000**|

Real-World Link:

• Nepal Rastra Bank (NRB) reviews banks’ Balance Sheets to check liquidity ratios (e.g., Current Ratio = Current Assets / Current Liabilities). If a bank’s ratio is <1, it may face liquidity crises (like Global IME Bank in 2020).

C. Cash Flow Statement

Definition: Tracks cash inflows and outflows from operating, investing, and financing activities. Why It Matters: Profitable companies can still run out of cash (e.g., Ncell’s past struggles despite high revenue).

Format:

| **Cash Flow Statement for Kathmandu Retail (NPR '000)** |       |
|--------------------------------------------------------|-------|
| **1. Operating Activities**                            |       |
| Net Income                                            | 6,000 |
| + Depreciation (non-cash)                             | 500   |
| - Increase in Accounts Receivable                     | (2,000)|
| + Increase in Accounts Payable                        | 1,000 |
| **Net Cash from Operations**                          | 5,500 |
| **2. Investing Activities**                           |       |
| Purchase of Equipment                                 | (5,000)|
| **Net Cash from Investing**                           | (5,000)|
| **3. Financing Activities**                           |       |
| Long-term Loan Proceeds                               | 10,000|
| Dividend Paid                                         | (2,000)|
| **Net Cash from Financing**                           | 8,000 |
| **Net Increase in Cash**                              | **8,500**|
| **Opening Cash Balance**                              | 6,500 |
| **Closing Cash Balance**                              | **15,000**|

Real-World Link:

• Pathao uses its Cash Flow Statement to justify driver incentives (operating cash) and expansion costs (investing cash). If operating cash is negative, it may struggle to pay drivers on time.

D. Statement of Changes in Equity

Definition: Shows how shareholders’ equity changes over time due to:

• Issuing new shares
• Retained earnings (net income – dividends)
• Other comprehensive income (e.g., foreign exchange gains)

Worked Example: Kathmandu Retail (FY 2023)

| **Statement of Changes in Equity (NPR '000)** |       |
|-----------------------------------------------|-------|
| **Beginning Balance (1 Jan 2023)**            |       |
| Paid-up Capital                                | 15,000|
| Retained Earnings                              | 6,000 |
| **Total Equity (1 Jan 2023)**                 | 21,000|
| **Additions**                                   |       |
| Net Income (from Income Stmt)                  | 6,000 |
| **Deductions**                                  |       |
| Dividends Paid                                 | (2,000)|
| **Ending Balance (31 Dec 2023)**               |       |
| Paid-up Capital                                | 15,000|
| Retained Earnings                              | 12,000|
| **Total Equity (31 Dec 2023)**                 | **27,000**|

Real-World Link:

• NEPSE-listed companies (e.g., Nabil Bank, Himalayan Bank) disclose changes in equity to show dividend policies. If retained earnings grow, it signals re-investment (good for long-term growth).

2. How Financial Statements Are Linked

The three main statements are interdependent:

flowchart TD
    A["Income Statement\n(Net Income)"]
    B["Balance Sheet\n(Retained Earnings)"]
    C["Cash Flow Statement\n(Operating Cash)"]
    D["Statement of Equity\n(Changes in Retained Earnings)"]
    A -->|"Net Income flows to"| D
    D -->|"Retained Earnings updates"| B
    B -->|"Cash & Non-Cash Items"| C
    C -->|"Cash Balance"| B

Key Connections:

1. Net Income from the Income Statement affects Retained Earnings in the Balance Sheet and Statement of Equity.
2. Depreciation (non-cash expense) is added back in the Cash Flow Statement (operating activities).
3. Cash in the Balance Sheet must match the ending cash balance in the Cash Flow Statement.

3. Financial Statement Analysis Techniques

A. Horizontal (Trend) Analysis

Compares financial data across multiple periods (e.g., 2021 vs. 2023). Example: Kathmandu Retail Sales Growth

| **Year** | **Sales (NPR '000)** | **Growth (%)** |
|----------|----------------------|----------------|
| 2021     | 40,000               | -              |
| 2022     | 45,000               | +12.5%         |
| 2023     | 50,000               | +11.1%         |

Interpretation:

• Sales grew 11.1% in 2023, but slower than 2022 → Possible market saturation or competition from Daraz.

B. Vertical (Common-Size) Analysis

Expresses each line item as a % of a base (e.g., total assets, sales). Example: Kathmandu Retail Balance Sheet (Vertical Analysis)

| **Item**               | **Amount (NPR '000)** | **% of Total Assets** |
|------------------------|----------------------|-----------------------|
| Cash & Bank            | 15,000               | 30%                   |
| Inventory              | 12,000               | 24%                   |
| Equipment              | 18,000               | 36%                   |
| **Total Assets**       | 50,000               | 100%                  |

Interpretation:

• High inventory (24%) → Risk of obsolescence or storage costs.
• Low cash (30%) → May need short-term financing.

C. Ratio Analysis

Key ratios categorized by purpose:

Worked Example: Kathmandu Retail Ratios (2023)

| **Ratio**               | **Calculation**                          | **Result** | **Industry Benchmark** | **Analysis**                                                                 |
|-------------------------|------------------------------------------|------------|------------------------|------------------------------------------------------------------------------|
| Current Ratio           | 32,000 / 13,000                         | 2.46       | 1.5-2.0                | **Strong liquidity** (can cover short-term debts easily)                     |
| Gross Profit Margin     | 20,000 / 50,000                         | 40%        | 30-45%                 | **Healthy margin** (but watch COGS rises)                                     |
| Debt-to-Equity          | 23,000 / 27,000                         | 0.85       | <1.0                   | **Moderate leverage** (not over-reliant on debt)                             |
| Inventory Turnover      | 28,000 / 11,000                         | 2.54       | 3-5                    | **Slow turnover** → May have **excess stock** or **poor sales strategy**      |

Real-World Link:

• NTC (Nepal Telecom) uses liquidity ratios to ensure it can pay salaries and supplier bills on time. A declining current ratio would trigger cost-cutting measures.

4. Limitations of Financial Statements

While essential, financial statements have flaws:

1. Historical Data: Reflects past performance, not future potential.
2. Subjectivity:
   • Revenue Recognition: Companies may recognize revenue early (e.g., Khalti’s subscription models).
   • Depreciation Methods: Straight-line vs. accelerated affects net income.
3. Off-Balance-Sheet Items: Leases, contingencies (e.g., lawsuits) are often omitted.
4. Inflation Impact: Nominal vs. real values (e.g., a 10% profit may be 5% in real terms due to inflation).

Example of Creative Accounting:

• Revenue Smoothing: Nepal’s microfinance banks sometimes delay loan loss provisions to show higher profits.
• Capitalizing Expenses: Treating R&D costs as assets (instead of expenses) to boost short-term earnings.

5. Real-World Applications in Nepal

A. Banking Sector (Nabil, Global IME, NMB)

• Loan Approval: Banks use debt-to-equity and cash flow ratios to assess borrower risk.
  • Example: A Kathmandu restaurant applying for a NPR 5M loan must show:
    • Current Ratio > 1.5 (can repay short-term debts).
    • Net Profit Margin > 10% (sustainable cash flows).

B. Stock Market (NEPSE)

• Investors rely on P/E ratios to compare stocks:
  • Nabil Bank (P/E ~12) vs. Cement India (P/E ~20) → Bank is cheaper but may have lower growth.
• Dividend Yield = (Dividend per Share / Market Price) × 100
  • Example: If Nepal Bank pays NPR 10/share and trades at NPR 500, yield = 2% (low compared to Global IME’s 5%).

C. E-Commerce (Daraz, Hamrobazaar)

• Inventory Turnover is critical:
  • Daraz’s turnover = COGS / Avg. Inventory
  • If turnover drops, it may mean overstocking or slow sales (e.g., fashion items in monsoon).

D. Government & NTC

• Budget Analysis: The Government of Nepal uses vertical analysis to compare revenue vs. expenditure across fiscal years.
• NTC’s Cash Flow: Must ensure operating cash > capital expenditures to avoid short-term defaults.

6. Common Mistakes to Avoid

1. Ignoring Footnotes: Critical for understanding accounting policies (e.g., depreciation methods).
2. Overlooking Cash Flow: A company can be profitable but cash-poor (e.g., Ncell’s past issues).
3. Benchmarking Poorly: Comparing Khalti (tech startup) to Nabil Bank (traditional bank) is unfair.
4. Assuming Liquidity = Profitability: A high current ratio doesn’t mean high profits (e.g., retailers with high inventory).

In the Real World

1. Khalti’s Financial Statements

   • Uses Income Statement to show transaction fees growth (e.g., NPR 5B in 2023).
   • Cash Flow Statement tracks digital wallet liquidity (must ensure enough cash for payouts).
   • Investors check revenue recognition policies (e.g., when fees are recorded).

2. Daraz Nepal’s Inventory Management

   • High inventory turnover = efficient supply chain (e.g., fast-moving electronics).
   • Low turnover in fashion → discounts or clearance sales needed.
   • Balance Sheet shows warehouse costs (asset side) vs. storage liabilities.

3. Nepal Rastra Bank’s (NRB) Supervision

   • Reviews banks’ liquidity ratios (e.g., Global IME’s collapse in 2020 was due to poor asset-liability management).
   • Checks capital adequacy ratio (CAR) to ensure banks can absorb losses.

Exam Tip

What Examiners Look For

1. Precision in Definitions:

   • Don’t confuse Income Statement (periodic) with Balance Sheet (snapshot).
   • Cash Flow Statement is not the same as profit.

2. Linking Statements:

   • Always show how Net Income → Retained Earnings → Balance Sheet.
   • Example: "If Net Income increases by NPR 1M, Retained Earnings rise by NPR 1M, increasing Shareholders’ Equity in the Balance Sheet."

3. Ratio Calculations:

   • Memorize formulas but explain what they mean.
   • Example:
     • Current Ratio = 2.5 → "For every NPR 1 of debt, the company has NPR 2.5 in liquid assets."
     • Gross Profit Margin = 40% → "60% of sales goes to COGS; pricing or cost control is key."

4. Real-World Applications:

   • Always relate to Nepali companies (e.g., "Like Ncell, Kathmandu Retail must maintain a current ratio >1.5 to avoid liquidity crises.").
   • Use hypotheticals:
     • "If Daraz’s inventory turnover drops from 5 to 3, what does it imply?" → Slower sales, possible overstocking.

5. Common Pitfalls in Exams:

   • Forgetting to reconcile (e.g., "Why does the Cash Flow Statement’s ending cash match the Balance Sheet?").
   • Ignoring non-cash items (e.g., depreciation is added back in operating cash flow).
   • Misinterpreting ratios:
     • High debt-to-equity = risky (but may be okay for growth firms like Nepal Investment Bank).
     • Low inventory turnover = bad (unless it’s a luxury brand like Kathmandu’s premium stores).

How to Score Full Marks

✅ Structure:

• Start with definitions, then worked examples, followed by analysis.
• Use tables for ratios, flowcharts for processes, and real examples.

✅ Visuals:

• Always draw T-accounts for journal entries.
• Show the accounting cycle flowchart.
• Highlight key ratios in bold.

✅ Critical Thinking:

• Don’t just compute ratios—interpret them.
  • Bad: "Current Ratio = 2.0"
  • Good: "A current ratio of 2.0 means Kathmandu Retail can cover its short-term debts twice over, indicating strong liquidity, but if inventory is high, working capital efficiency may still be a concern."

✅ Exam Strategy:

• First 10 mins: Skim the question → Identify which statements/ratios are needed.
• Last 5 mins: Cross-check calculations and ensure logical flow.

Final Reminder:

"Financial statements are like a car’s dashboard—cash flow is the speedometer (real-time health), the income statement is the fuel gauge (profitability), and the balance sheet is the odometer (what you own vs. owe). Master all three to drive any business successfully."