Financial Statements: Types, Analysis & Preparation

TAKEAWAYS:

• Financial statements are the language of business, translating transactions into meaningful reports for stakeholders (owners, investors, creditors, and regulators).
• The Income Statement shows profitability over a period, while the Balance Sheet captures a snapshot of assets, liabilities, and equity at a point in time.
• Cash Flow Statement reveals liquidity and operational efficiency—critical for survival, especially in volatile markets like Nepal’s.
• Horizontal and vertical analysis of statements helps compare performance over time or against industry benchmarks (e.g., NEPSE-listed companies).
• Limitations (e.g., historical data, subjective estimates) mean statements must be used alongside qualitative analysis (e.g., management interviews).
• Integrated preparation: Every transaction flows through the accounting cycle (journal → ledger → trial balance → financial statements), which we’ll visualize step-by-step.

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1. The Four Core Financial Statements

Financial statements are standardized reports that summarize a company’s financial health. They follow GAAP (Generally Accepted Accounting Principles) in Nepal (adapted from IFRS for consistency with global markets). Below are their structures, purposes, and how they connect.

1.1 Income Statement (Profit & Loss Statement)

Purpose: Measures profitability over a fiscal year (e.g., 2023/24 for Nepali businesses). Key Components:

| **Particulars**               | **Amount (NPR ’000)** |
|--------------------------------|-----------------------|
| **Revenue**                    |                       |
|   Sales                        | 50,000                |
|   Other Income (e.g., rent)   | 5,000                 |
| **Total Revenue**              | **55,000**            |
| **Expenses**                   |                       |
|   Cost of Goods Sold (COGS)    | 30,000                |
|   Operating Expenses           |                       |
|     Salaries                   | 10,000                |
|     Rent                       | 3,000                 |
|     Utilities                  | 2,000                 |
|     Depreciation               | 1,500                 |
| **Total Operating Expenses**   | **16,500**            |
| **Operating Income (EBIT)**    | **18,500**            |
| **Interest Expense**           | 2,000                 |
| **Tax Expense (27.5%)**        | 4,187.5               |
| **Net Profit**                 | **12,312.5**          |

Real-World Tie-In:

• Daraz Nepal’s Income Statement would show gross profit from sales (revenue minus COGS for inventory) and operating expenses (warehouse rent, logistics, salaries). Investors use this to judge if Daraz’s EBITDA margin (Earnings Before Interest, Taxes, Depreciation, Amortization) is sustainable compared to competitors like Symbiosis or Nepal Online.

Visual: Income Statement Flow

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1.2 Balance Sheet (Statement of Financial Position)

Purpose: Shows what a company owns (assets) and owes (liabilities) at a specific date (e.g., 31 Dec 2023). Structure:

| **Assets**                     | **Liabilities + Equity** |
|--------------------------------|--------------------------|
| **Current Assets**             | **Current Liabilities**  |
|   Cash & Bank                 | 15,000                  | Loans Payable          | 8,000               |
|   Accounts Receivable         | 7,000                   | Trade Payables         | 5,000               |
|   Inventory                   | 12,000                  | **Total Current Liab.**| **13,000**          |
| **Total Current Assets**       | **34,000**              | **Long-Term Liabilities**|
| **Non-Current Assets**         |                          | Long-Term Loans        | 20,000              |
|   Property, Plant & Equipment  | 50,000                  | **Total Liabilities**  | **33,000**          |
|   Less: Accumulated Depreciation| -10,000                 | **Equity**             |
|   Net PPE                      | 40,000                  | Paid-Up Capital        | 40,000              |
|   Goodwill                     | 5,000                   | Retained Earnings      | 12,000              |
| **Total Assets**               | **79,000**              | **Total Equity**       | **52,000**          |
|                                |                          | **Total L+E**          | **79,000**          |

Key Ratios Derived from Balance Sheet:

• Current Ratio = Current Assets / Current Liabilities = 34,000 / 13,000 ≈ 2.61 (Good for short-term solvency).
• Debt-to-Equity = Total Debt / Total Equity = 33,000 / 52,000 ≈ 0.63 (Lower is safer; banks like NMB target <0.7).

Real-World Tie-In:

• Ncell’s Balance Sheet would show:
  • Assets: Spectrum licenses (non-current), mobile towers (PPE), and cash from prepaid balances.
  • Liabilities: Subscriber deposits (current), long-term debt for network expansion.
  • Equity: Government ownership (via NTC) vs. private stakes.
  • Ratio Check: Ncell’s current ratio must stay above 1 to pay suppliers like Ericsson or Nokia on time.

Visual: Balance Sheet Equation

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1.3 Cash Flow Statement

Purpose: Tracks actual cash inflows/outflows (not just profits on paper). Divided into 3 activities:

1. Operating Activities: Cash from core business (e.g., retail sales).
2. Investing Activities: Cash spent on assets (e.g., Pathao buying new bikes).
3. Financing Activities: Cash from loans, dividends, or share issuance.

Example for a Kathmandu Retail Shop (e.g., FabFashion):

| **Activity**               | **Cash Inflow (+)** | **Cash Outflow (-)** |
|----------------------------|---------------------|----------------------|
| **Operating**              |                     |                      |
|   Sales                    | 60,000              |                      |
|   Inventory Purchases      |                     | 40,000               |
|   Salaries                 |                     | 10,000               |
| **Net Operating Cash Flow**| **10,000**          |                      |
| **Investing**              |                     |                      |
|   Bought New Shelves       |                     | 5,000                |
| **Net Investing Cash Flow**|                     | **-5,000**           |
| **Financing**              |                     |                      |
|   Bank Loan                | 15,000              |                      |
|   Loan Repayment           |                     | 2,000                |
| **Net Financing Cash Flow**| **13,000**          |                      |
| **Net Change in Cash**     | **18,000**          |                      |

Why It Matters:

• FabFashion’s positive operating cash flow (NPR 10,000) means it generates cash from sales, but the negative investing cash flow (NPR -5,000) shows it’s reinvesting in growth.
• NEPSE-listed companies like Cement India Nepal must disclose cash flows to prove they can pay dividends (e.g., NPR 5/share in 2023).

Visual: Cash Flow Statement Flow

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1.4 Statement of Changes in Equity

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

• Net profit/loss
• Dividends paid
• New share issuance
• Other comprehensive income (e.g., foreign exchange gains)

Example for a Nepali Startup (e.g., Khalti):

| **Particulars**             | **Paid-Up Capital** | **Retained Earnings** | **Total Equity** |
|-----------------------------|---------------------|-----------------------|------------------|
| **Opening Balance (2022)**  | 50,000              | 20,000                | 70,000           |
| **Add: Net Profit (2023)**   |                     | +15,000               | +15,000          |
| **Less: Dividends Paid**    |                     | -5,000                | -5,000           |
| **Add: New Investment**     | +20,000             |                       | +20,000          |
| **Closing Balance (2023)**  | 70,000              | 30,000                | **100,000**      |

Real-World Tie-In:

• Khalti’s equity growth reflects its funding rounds (e.g., NPR 20M from Ant Group in 2021) and retained earnings from transaction fees (NPR 100/cash-in).
• NMB Bank’s equity changes show how bonus shares (e.g., 1:5 in 2022) dilute ownership but increase capital.

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2. How Financial Statements Are Prepared: The Accounting Cycle

Every transaction follows this cycle, which we’ll trace for a Kathmandu grocery shop (e.g., Green Grocers).

Worked Example: Green Grocers’ Monthly Cycle Transaction: Bought NPR 50,000 worth of vegetables on credit from Kathmandu Fruit Mart.

1. Journal Entry:

   | **Date**       | **Particulars**               | **Dr (NPR)** | **Cr (NPR)** |
   |----------------|-------------------------------|--------------|--------------|
   | 2023-10-01     | Inventory                     | 50,000       |              |
   |                | To Accounts Payable           |              | 50,000       |
   

2. Ledger (T-Account) Posting:
3. Impact on Financial Statements:
   • Balance Sheet: Assets (Inventory ↑), Liabilities (Accounts Payable ↑).
   • Income Statement: No direct impact yet (COGS will reduce profit later when sold).

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3. Analyzing Financial Statements

3.1 Horizontal vs. Vertical Analysis

Real-World Use:

• NTC’s vertical analysis: If operating expenses are 80% of revenue, it signals inefficiency (vs. Ncell’s 60%).
• NEPSE companies: Investors compare P/E ratios (Price-to-Earnings) to decide if Cement India Nepal is overvalued.

3.2 Common Ratios

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4. Limitations of Financial Statements

While essential, statements have blind spots:

1. Historical Data: Show past performance, not future potential (e.g., Daraz’s 2023 profits don’t guarantee 2024 success).
2. Subjective Judgments:
   • Depreciation methods (e.g., straight-line vs. accelerating) affect net income.
   • Inventory valuation (FIFO vs. LIFO) distorts COGS in inflationary Nepal.
3. Off-Balance-Sheet Items: Leases (e.g., Pathao’s bike rentals) may not appear as liabilities.
4. Qualitative Factors Ignored: Brand reputation (e.g., Thamel’s cafes), management quality, or government policies (e.g., new VAT rules).

Real-World Example:

• Ncell’s Balance Sheet doesn’t show the risk of spectrum license expiry (a qualitative threat).

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5. Integrated Example: Full Set of Financial Statements for a Nepali Business

Let’s prepare statements for Mountain Bikes Nepal (MBN), a Kathmandu shop selling imported bikes.

Assumptions (for 2023):

• Sold 50 bikes at NPR 50,000 each.
• COGS: NPR 1,500,000 (import costs + customs).
• Operating expenses: NPR 800,000 (rent, salaries, marketing).
• Purchased equipment for NPR 2,000,000 (useful life: 5 years, straight-line depreciation).
• Took a NPR 1,000,000 loan from NMB Bank (5% interest).
• Paid NPR 200,000 as dividends.

1. Income Statement

| **Particulars**               | **Amount (NPR)** |
|--------------------------------|------------------|
| **Revenue**                    | 2,500,000        |
| **COGS**                       | 1,500,000        |
| **Gross Profit**               | 1,000,000        |
| **Operating Expenses**         | 800,000          |
| **Operating Income (EBIT)**    | 200,000          |
| **Interest Expense**           | 50,000           |
| **Taxable Income**             | 150,000          |
| **Tax (27.5%)**                | 41,250           |
| **Net Profit**                 | **108,750**      |

2. Balance Sheet (as of 31 Dec 2023)

| **Assets**                     | **Liabilities + Equity** |
|--------------------------------|--------------------------|
| **Current Assets**             | **Current Liabilities**  |
|   Cash                         | 300,000                 | Accounts Payable        | 500,000            |
|   Accounts Receivable          | 200,000                 | **Total Current Liab.** | **1,500,000**      |
| **Total Current Assets**       | **500,000**             | **Long-Term Liabilities**|
| **Non-Current Assets**         |                          | Bank Loan               | 1,000,000          |
|   Equipment (Cost)             | 2,000,000               | **Total Liabilities**   | **2,500,000**      |
|   Less: Accumulated Depreciation| -400,000                | **Equity**              |
|   Net Equipment                | 1,600,000               | Paid-Up Capital        | 1,000,000          |
| **Total Assets**               | **2,100,000**           | Retained Earnings      | 68,750             |
|                                |                          | **Total Equity**       | **1,068,750**      |
|                                |                          | **Total L+E**          | **2,100,000**      |

3. Cash Flow Statement

| **Activity**               | **Cash Flow (NPR)** |
|----------------------------|---------------------|
| **Operating**              |                     |
|   Net Profit               | 108,750             |
|   + Depreciation           | +400,000            |
|   - Increase in Receivables| -200,000            |
| **Net Operating Cash Flow**| **308,750**         |
| **Investing**              |                     |
|   Purchase of Equipment     | -2,000,000          |
| **Net Investing Cash Flow**| **-2,000,000**      |
| **Financing**              |                     |
|   Bank Loan                 | +1,000,000          |
|   Dividends Paid            | -200,000            |
| **Net Financing Cash Flow** | **800,000**         |
| **Net Change in Cash**      | **108,750**         |
| **Opening Cash Balance**    | 200,000             |
| **Closing Cash Balance**    | **308,750**         |

4. Statement of Changes in Equity

| **Particulars**             | **Paid-Up Capital** | **Retained Earnings** | **Total Equity** |
|-----------------------------|---------------------|-----------------------|------------------|
| **Opening Balance (2022)**  | 1,000,000           | 50,000                | 1,050,000        |
| **Add: Net Profit (2023)**  |                     | +108,750              | +108,750         |
| **Less: Dividends**         |                     | -200,000              | -200,000         |
| **Closing Balance (2023)**  | 1,000,000           | 58,750                | **1,058,750**    |

Key Insights for MBN:

• Liquidity: Current Ratio = 500,000 / 1,500,000 ≈ 0.33 (Critical! Needs to improve by reducing inventory or taking short-term loans).
• Profitability: Gross Margin = (2,500,000 - 1,500,000)/2,500,000 = 40% (Good, but operating expenses are high).
• Cash Flow: Negative investing cash flow shows growth investment, but operating cash flow is positive, which is healthy.

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## In the Real World

1. eSewa’s Financial Statements:

   • Cash Flow Statement: Shows how transaction fees (NPR 50/cash deposit) generate operating cash flow to pay Nepal Rastra Bank (NRB) for licenses.
   • Balance Sheet: High current assets (cash reserves) due to high liquidity needs (users demand instant payouts).

2. NMB Bank’s Ratios:

   • ROA (Return on Assets): NMB’s 1.2% (2023) vs. Global Standard Bank’s 1.5% shows room for efficiency gains.
   • NPL (Non-Performing Loans): If NMB’s NPL ratio rises above 3%, it signals credit risk (e.g., loans to failed microfinance institutions).

3. Daraz Nepal’s Vertical Analysis:

   • COGS as % of Revenue: ~70% (higher than Amazon’s 50%) due to import duties and logistics costs in Nepal.
   • Operating Expenses: Marketing (30% of revenue) reflects aggressive growth strategy to beat Symbiosis.

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## Exam Tip

1. Structure Answers in Order:

   • Always present statements in this sequence: Income Statement → Balance Sheet → Cash Flow → Equity Changes.
   • Use headings and clear labels (e.g., "As of 31 Dec 2023").

2. Show Workings for Ratios:

   • If asked to calculate current ratio, write:

     Current Ratio = Current Assets (NPR X) / Current Liabilities (NPR Y) = Z:1
     

   • Never leave it as "Z"—show the full calculation.

3. Common Exam Questions:

   • "Prepare the Income Statement for XYZ Ltd." → Use a table format with clear Dr/Cr columns.
   • "Analyze the liquidity position of ABC Company." → Calculate current ratio, quick ratio, and compare to industry benchmarks (e.g., retail: >1.5).
   • "What are the limitations of financial statements?" → List 3-4 points (e.g., historical data, subjective estimates).

4. Real-World Application Marks:

   • Examiners love Nepali examples. If asked about cash flow importance, relate it to:
     • Pathao’s need for positive operating cash flow to pay bike rentals.
     • NEPSE companies’ dividend payouts (e.g., Cement India Nepal’s NPR 5/share).

5. Avoid These Mistakes:

   • Ignoring adjusting entries (e.g., depreciation, accrued expenses).
   • Mismatched totals (e.g., Balance Sheet assets ≠ liabilities + equity).
   • Assuming all expenses are tax-deductible (e.g., capital expenditures are depreciated, not fully deducted).

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Final Visual Summary: