Financial Statement Analysis

This assignment explores the concept of financial statement analysis across various business structures. It presents illustrative examples of income statements, balance sheets, and profit & loss appropriation accounts for sole traders, partnerships, and limited companies. The aim is to demonstrate how financial information can be analyzed to understand a business's performance and financial position.

FINANCIAL ACCOUNTING
AND REPORTING
1

TABLE OF CONTENTS
INTRODUCTION ...............................................................................................................................4
TASK 1.................................................................................................................................................4
AC 1.1 Different types of users and their need................................................................................4
AC 1.2 Influence of legal and regulatory framework of financial statement..................................5
AC 1.3 Implication of legal and regulatory framework for users....................................................6
AC 1.4 Different legal and regulation dealt with accounting and reporting standards....................7
AC 3.1 Explain how information needs of different user groups vary............................................8
AC 3.2 Fundamental principles towards preparing financial statements of different organizations
.........................................................................................................................................................8
TASK 2.................................................................................................................................................9
AC 2.1 Prepare financial statements for a variety of businesses from trial balance with
adjustments......................................................................................................................................9
AC 2.2 Prepare financial statements from incomplete records.....................................................12
AC 2.3 Prepare consolidated financial statements and profit and loss account for a simple group
of companies..................................................................................................................................14
TASK 3...............................................................................................................................................16
AC 4.1 Calculation of accounting ratios........................................................................................16
AC 4.2 Prepare a report incorporating and interpreting accounting ratios with suitable
comparison.....................................................................................................................................19
CONCLUSION..................................................................................................................................20
REFERENCES...................................................................................................................................21
2

INDEX OF TABLES
Table 1: Profitability statement of Mohan, a sole trader for the year ended 31st March, 2015.........10
Table 2: Balance sheet of Mohan as on 31st March, 2015.................................................................10
Table 3: Profit and loss account of ABC Ltd for the year ending 31st March, 2015.........................13
Table 4: Balance sheet of ABC Ltd, as on 31st March, 2014.............................................................14
ILLUSTRATION INDEX
Illustration 1: Income statement of sole trader ....................................................................................9
Illustration 2: Balance sheet of sole trader.........................................................................................10
Illustration 3: profit and loss appropriation account of partnership...................................................10
Illustration 4: Balance sheet of partnership........................................................................................11
Illustration 5: Consolidated statement of comprehensive income of limited company.....................12
Illustration 6: Consolidated statement of financial position of limited company...............................13
3

INTRODUCTION
Process of recording, classifying, summarizing and analysing the financial information
reported in company's accounts is known as financial accounting. In UK, there are some legislation
and accounting regulations which organizations need to comply while preparing their financial
statements. It includes UK Generally Accepted Accounting principles (GAAP), International
Financial Reporting Standards (IFRS), International Accounting Standards (IAS), Partnership Act,
Company Act, 2006, EU directives etc. Present assignment will address the importance of such
regulations to represent true and fair financial positions of firms. Moreover, report focuses on the
way in which legal and regulatory framework will help different internal and external users to
satisfy their distinct needs. In addition to this, financial statements for different types of
organizations such as sole trader, partnership and companies will be prepared. At the end, financial
performance of ABC Ltd will be evaluated on the basis of ratio analysis.
TASK 1
AC 1.1 Different types of users and their need
Scenario stated that EL Ltd is a London established company who is offering domestic and
electrical services. In order to provide excellent services, EL Ltd, hired an experienced and
electrician team, named NICEIC. It operates through two divisions that are EL-home who provide
services to the homes and EL-business who provide electrical services to businesses.
There are two types of users internal and external who are directly or indirectly affected by
EL's operations hence, having some kind of interest in company. Internal users are the part of
organizations itself, also called primary users (Asare and Wright, 2012). However, external users
are outsiders and they are also called as secondary users. With references to EL Ltd, employees,
managers and owners are the internal users whilst creditors, investors, customers, lenders and
taxation authorities are external users.
Internal users:
 Management intend to analyse operational excellence, performance and financial position.
Hence, they evaluate the success of the business by examining revenues, costs, profits and
financial strength. Thus, effective decisions can be carried out to meet the objectives and to
improve EL's financial position (Deegan, 2013).
 Employees assess EL's profitability performance and determine its consequences on their
potential remuneration and job security. They intend to know EL's stability so that they will
be highly confident about their job security, high remuneration and good employment
conditions.
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 Owners analyse viability and profitability of their investment and identify future course of
action.
External users:
 Creditors evaluate EL's credit worthiness to decide credit terms and amount of credit. They
provide high credit on favourable conditions if EL Ltd is able to pay off creditors timely.
 Investors provide funds and take risk by investing in the form of share capital. So they are
more concern about inherent risk and associated return on their investment (Ormiston and
Fraser, 2013). Hence, they analyse investment feasibility to assure reasonable return.
 Customers are interested in business sustainability so that EL Ltd. can maintain regular
product supply for longer duration.
 Lenders assess financial risk hence, they examine solvency, profitability and cash generating
ability. It enables lenders to identify that EL Ltd is able to discharge loan timely or not. So
that, they can take decisions that whether they should provide funds or not.
 Taxation authority determines credibility of filled tax returns by evaluating profitability
(Chen and Gavious, 2015).
AC 1.2 Influence of legal and regulatory framework of financial statement
Company Act, 2006
The act came into force on 8th November, 2006 and applied to all the UK companies who
need to comply with act provisions. In context to EL, CA, 2006 impose legal obligation to keep
detailed records of all the historical trading affairs such as revenues and expenses. It has to prepare
profitability statement, balance sheet, statement of changes in equity, cash flow statement with
required disclosure notes (Overview of Financial Reporting Framework, 2015). Moreover, auditing
is compulsory so as to publish fair and true position to the external users.
UK GAAP
It includes accounting policies, rules, conventions and necessary principles who works as
guidelines to record transactions in the financial statements (Collings, 2015). Thus, each transaction
will be fairly recorded by EL Ltd which represents true and fair business results.
IAS
IASB issued detailed set of IAS which entities need to follow while presenting accounting
information into the financial statements. These are the global accounting standards which is a
single accounting framework at international level.
IFRS
These are the global reporting standards which have been issued to bring comparability in
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the financial statements of organizations that are operating across international boundaries (Epstein
and Jermakowicz, 2010). In the world of globalisation, investors invest their money across lands
hence, IFRS provide great assistance to them to compare and evaluate business performance and
take qualitative decisions.
Partnership Act, 1890
This legislation is applied to all the UK partnership firms. The act comprises rules for
partnership deed, interest on capital, interest on loan, capital contribution, profit-loss sharing ratio,
remuneration, bonus, commission, provisions for retirement, death and admission etc (Donn,
Hillman and Weidner, 2014).
EU directives
EU directives are applied to all the European countries. As per these regulations, all
organizations are strictly abided to follow prescribed content and format of the financial statements.
The directives also made provisions for consolidated financial statements, auditor’s responsibilities,
their qualification and other regulations (Barry and Kanematsu, 2016).
AC 1.3 Implication of legal and regulatory framework for users
EL users communicated information by the published audited financial statements. Hence, it
is essential for the financial statements to cater diverse users need through providing reliable
information which helps to take sound decisions.
As per the framework, EL Ltd's managers are liable to follow prescribed provisions in the
CA, 2006, UK GAAP etc. Auditing helps to obtain qualitative and prominent information so that
they can effectively evaluate EL's operational performance and financial status to take better
decisions. They can examine EL's turnover, costs, profitability, liquidity status, capital structure,
assets using capability and cash availability. However, in the absence of following standards,
financial statement may provide misleading information which may lead to take harmful decisions
(Haller and Wehrfritz, 2013). Owners will be able to assess their investment viability and
profitability aspect through generating reliable information. Auditing also helps owner to identify
employees who are using business assets for personal use so that they can terminate such person
and recruit reliable personnel. Employees can assess profitability and evaluate the sustainability
position. Thus, they can take decisions whether they should continue to work in the organization or
not. High job security, better pay scale and other benefits helps to attract talented personnel and
retain it in the business.
CA, 2006 provide rights to the shareholders to obtain any information required by them.
Moreover, as per this law, EL Ltd has to conduct an annual general meeting in which all the
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investors will be communicated about company's financial position. Lenders will be able to obtain
authentic information about EL Ltd's status and can take good lending decisions. Moreover,
accounting regulations made provisions that how borrowing costs will be recorded in the financial
statements (Alfredson and et.al., 2012). Accounting regulations for reporting current assets, current
liabilities and stock helps suppliers to analyse short-term payment ability through acquiring
qualitative information. Further, taxation authorities will be able to determine EL's tax obligation by
obtained information about business profit. As per the regulations, EL Ltd has to disclose income
tax paid in their profitability statement.
AC 1.4 Different legal and regulation dealt with accounting and reporting standards
CA, 2006 dealt with accounting standards because as per this act, all the companies has to
prepare complete set of accounting standards by constructing following statements:
 Profitability statements
 Statement of financial position (SOFP)
 Statement of changes in equity
 Statement of cash flow (SOCF)
 Notes to disclosure
All this statements are audited by an independent certified accountant who judges the
correctness of financial statements. UK GAAP also deals with accounting standards because these
guidelines assist accountants to record each and every transaction on the basis of certain rules,
conventions and principles (Alali and Foote, 2012). Moreover, IAS is global accounting standards
which make it compulsory for all the organizations whether national or foreign to comply strictly
with the provisions. After issuance of IAS, all the business organizations follow same accounting
standards to draft their financial statements.
On the other hand, IFRS is reporting standards which all the companies have to implement
to report their financial performance in specified format. It greatly assists capitalist who invest their
own capital in foreign market. It improves comparability, reliability, verifiability, timeliness and
understanding of business performance that are operating at distinct lands. These global reporting
standards improve confidence in the investors and makes international transactions possible. EU
directives especially for format and content structure are a reporting standard which bring
homogeneity in the financial reporting frameworks (Barbehön, 2015).
AC 3.1 Explain how information needs of different user groups vary
It has been discussed earlier that different types of primary and secondary users need varied
information from company's financial statements. Primary (internal) users collect accounting
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information usually through management accountants, constructed budgets, forecasts and prepared
financial statements. However, secondary (external) users are communicated only through the use
of published sources such as financial statements.
Managers are responsible to administrate operations effectively so that they can make
business growth and sustainability as well (Eierle and Schultze, 2013). They manage core business
functioning and take decisions to improve it on a continuous basis. Hence, they evaluate operational
result and financial strength so as to take strategic decisions and enhance potential performance.
Similarly, owners are also interested to ensure sustainability and competitive strengths so that it can
run business successfully in present highly competitive business world (Kadous, Koonce and
Thayer, 2012). Further, employees make their efforts and skills in order to ensure high security and
better monetary reward. Otherwise, employees will search for other employment opportunities at
high salary and favourable employment terms.
Externally, investors evaluate dividend policy, shareholder's earnings and dividend as well as
capital appreciation. Hence, they examine firm’s operational results and financial position so that
they can earn maximum return for their risky investment. Lenders are more concern about funds
security hence, they funding organizations only that are capable to repay debt funds on maturity
(Crawford and Power, 2015). Creditors assess cash management strategy so that high working
capital in terms of liquidity will enable organization to pay them timely. Taxation authority only
requires timely and appropriate receipts of corporations’ tax obligations.
AC 3.2 Fundamental principles towards preparing financial statements of different organizations
Fundamental principles are the basic principles or guidelines which entities need to follow
when reporting financial data in their accounts.
Accrual principle
This principle states that entities should report financial data at the time of their occurrences
without recognising their cash impact (Reeve and et.al., 2012). Hence, revenues will be recorded
when they earned whereas expenditures will be recorded when they accrued for construction of
business accounts.
Consistency principle
This principle demonstrates that one accounting method that business adopted earlier will be
use consistently, until and unless the new better accounting standard comes. They can not jump to
the new accounting principles because it makes very difficult to understand long-term financial
results.
Full disclosure principle
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This principles states that enormous and wide range of informational disclosure should be
done for recording each and every business transactions in financial statements (Edwards and et.al.,
2013).
Going concern principle
According to this principle, business will run its operations for longer period hence, some of
the expenses will be defer for more than one year such as depreciation.
Monetary unit principle
As per this, all the organization records only those transactions which can be measured in
monetary units means in currency. For instance, effectiveness of quality control cannot be measured
in value hence; it will not be reported in financial statements.
Time period principle
In accordance with this, all the accountants will prepare financial statements for a standard
time period. It helps to make comparative analysis of the business performance over the period.
Preparing financial statements of sole trader, partnership and limited company
Illustration 1: Income statement of sole trader
9

Illustration 2: Balance sheet of sole trader
Illustration 3: Profit and loss appropriation account of partnership
\
10

Illustration 4: Balance sheet of partnership
11

12

Illustration 6: Consolidated statement of financial position of limited company
13

TASK 2
AC 2.1 Prepare financial statements for a variety of businesses from trial balance with adjustments
Sole trader
Question: Mohan's trial balance is given hereunder:
Other information:
 Closing inventory is £180000
 Depreciation rate on furniture is 10% p.a.
 Accrued salary is £20000
Solution:
Table 1: Profitability statement of Mohan, a sole trader for the year ended 31st March, 2015
Particulars Amount Particulars Amount
To opening stock 110000 By sales 970000
To purchase
430000 Less: Return 20000 950000
Less: purchase return 2000 418000 By closing stock 180000
To freight 40000
To Gross profit(b/f) 562000
1130000 1130000
By gross profit 562000
To salary 210000 By discount received 9000
Add: Outsranding 20000 230000
To depreciation on furniture 35000
To discount allowed 19000
To bad debts 5000
To office expense 150000
To net profit 132000
571000 571000
Table 2: Balance sheet of Mohan as on 31st March, 2015
Liabilities Amount Assets Amount
Capital 650000 Furnitures 350000
Add: Net profit 132000 782000 Less: depreciation 35000 315000
Accounts payables 190000 Current assets
Outstanding salary 20000 stock 180000
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Accounts receivables 210000
Investment in govt. Securities 100000
Cash at bank 187000
992000 992000
Partnership accounts:
Question: profit before making adjustments is £32000
A B
Capital contribution 50000 40000
Additional capital in the mid of
the year
10000
Drawing 4000 5000
Interest on capital 6.00% 6.00%
Interest on drawing Nil Nil
Salary Nil 500 per month
Solution
Profit and loss appropriation account, partner's capital account and partner's current account
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Company: Its profitability statement and balance sheet are prepare as per company act requirement
and other provisions as per accounting and reporting standards such as IAS and IFRS.
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AC 2.2 Prepare financial statements from incomplete records
From the following incomplete records of ABC Ltd, prepare profitability statement
and balance sheet (Accounts from incomplete records, n.d.).
Receipts Amount Payment Amount
Balance B/F (opening) 8000 Cash purchase 14000
Cash sales 40000 Paid to creditors 20000
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Received from accounts
receivables
30000 Sundry expenses 6000
Carriage inward 2000
Drawings 8000
Balance C/F (closing) 28000
78000 78000
Other information:
2014 2015
Debtors 9000 12000
Creditors 14400 6800
Stock 10000 16000
Washing equipments 40000 40000
Furniture 3000 3000
Discount allowed 1400
Discount received 1700
Depreciating washing equipment @ 10% per annum.
Solution:
Table 3: Profit and loss account of ABC Ltd for the year ending 31st March, 2015
To opening stock of
marterial
10000 By cash sales 40000
To cash purchase 14000 By credit sales 34400
To credit purchase 14100 By closing stock of
material
16000
To carriage inward 2000
To Gross profit(c/f) 50300
90400 90400
To sundry expenses 6000 By Gross profit b/f 50300
To discount allowed 1400 By discount received 1700
To depreciation on
washing equipment
@10%
4000
To net profit trasnferred
to capital a/c (b/f)
40600
52000 52000
Table 4: Balance sheet of ABC Ltd, as on 31st March, 2014
Liabilities Amount Assets Amount
Owner's capital 55600 Washing equipment 40000
Add: net profit 40600 Less: depreciation 4000 36000
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Less: drawing 8000 88200 Furniture 3000
Creditors 6800 Material 16000
Debtors 12000
Cash 28000
95000 95000
Working note:
Balance sheet of ABC Ltd, as on 31st March, 2014
Accounts receivable a/c
Accounts payable a/c
AC 2.3 Prepare consolidated financial statements and profit and loss account for a simple group of
companies
For instance, X parent co. purchased 600000 shares in Y Ltd at £1.60 per share. Fair value of
Y Ltd's tangible assets is £126000 and retained profit is £120000 on 1st April, 2006. The surplus of
fair value over book value is attributed to building held and its estimated life is 21 years.
Both companies’ separate financial statement as on 31st March, 2010 is given as under:
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Adjustments:
 Interim dividend at the end of 2009 is £50000.
 Y Ltd sent cheque worth £20000 to holding company at the end of 2010.
 In Nov., 2009, X Ltd, sold goods worth £90000 at mark-up costs of 50%. But still, Y Ltd
does not paid for this stock and it is involved in its inventory yet.
Solution:
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Consolidated profitability statements for the year ended on 31st March, 2010
Consolidated balance sheet as on 31st March, 2016
TASK 3
AC 4.1 Calculation of accounting ratios
Scenario presented that ABC Ltd is a private Ltd company who sell electronic products and
household appliances to their customers. Now, finance manager wishes to evaluate the performance
of ABC Ltd. Henceforth, ratio analysis is an effective method which helps to examine business
results on the basis of different kind of ratios.
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Profitability ratios: This ratio measures the effectiveness of ABC Ltd's operations to
generate high amount of profit in the business (Healy and Palepu, 2012).
Gross margin: This ratio has been chosen to determine the ability to generate profit on ABC Ltd’s
turnover.
Formula: Gross profit *100
Total revenue
2015 = £6000000 *100 = 21.43%
£28000000
2014 = £5200000 *100 = 20.63%
£25200000
Net margin: It helps to evaluate ABC Ltd's net earning ability after making payment of all the
business expenditures.
Formula: Net profit *100
Total revenue
2015 £1800000 *100 = 6.43%
£28000000
2014 £1392000 *100 = 5.52%
£25200000
Liquidity ratios: This ratio helps to examine ABC Ltd's ability to discharge their short-
period liabilities.
Current ratio: This ratio determines the relationship between ABC Ltd's current assets and current
liabilities. ABC Ltd has to maintain high CA so that it can pay creditors timely.
Formula: Current assets
Current liabilities
2015 £4800000
£3240000
= £1.48:£1
2014 £3840000
2800000
= £1.37:£1
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Acid test ratio: Inventory is the second liquid assets after cash. This ratio measure that if ABC Ltd
does not have any stock than in what extent it will be able to discharge their short-term obligations.
Formula: Current assets-Closing inventory *100
Current liabilities
2015 (£4800000-£3400000) *100
£3240000
2014 (£3840000-£2840000) *100
£2800000
Efficiency ratios: This ratio evaluates ABC Ltd manager's ability to utilize business assets
in an effective manner so as to generate more profit (Feng and Wang, 2000.).
Assets turnover ratio: It examines ABC Ltd's manager’s ability to use all the business assets.
Formula: Total turnover
Total assets
2015 £28000000
£8600000+ £4800000
2014 £25200000
£8080000+ £3840000
= 2.11 times
Stock turnover ratio: It evaluates stock using efficiency.
Formula: Cost of sales
Inventory
2015 £22000000
£3400000
= 6.47 times
2014 £20000000
£2840000
= 7.04 times
Inventory days: The time period in which inventory is being converted into sales is called inventory
days.
Formula: 365 days
Stock turnover ratio
2015 365
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6.47 times
= 56.41 days
2014 365
7.04 times
= 51.85 days
Solvency ratio: This ratio evaluates ABC Ltd's ability to pay long term obligations.
Debt/equity ratio: Debt
Equity
2015 £3200000
£6960000
= 0.46
2014 £2600000
£6520000
= 0.4
Investment ratio: This ratio assists shareholders to examine potential earnings on their
investment (Kumbirai and Webb, 2013).
Earnings per share: It helps to forecast dividend which shareholders can earn on their invested
money.
Formula: Total dividend distributed
Number of equity shares outstanding
2015 £360000
16000000
= 0.0225
2014 £280000
16000000
= 0.0175
AC 4.2 Prepare a report incorporating and interpreting accounting ratios with suitable comparison
To: ABC Ltd's Board of Directors
From: Financial analysts
Date: 27th April, 2016
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Analysis of profitability
ABC Ltd's GM and NM have been improved to 21.43% and 6.43% respectively. It is a sign
of improved operational performance of ABC Ltd. High increase in turnover by 11.11% and an
effective control on costs are the reasons behind high profit performance (Heikal, Khaddafi and
Ummah, 2014). As a result, ABC Ltd’s GP has been increased by 15.38% and NP has been
increased by 29.31%.
Analysis of liquidity
CR has been increased from 1.48 to 1.37 while QR has been increased from 0.43 to 0.36
respectively. It is because proportionate changes in ABC Ltd’s CA are 25% while CL has been
improved by 15.71%. Thus, high increase in CA due to higher stock, debtors and cash as compared
to creditors indicates that ABC Ltd's liquidity position has been improved. Thus, company has
enough resources to meet short-term liabilities effectively.
Analysis of efficiency
Assets turnover ratio shows a little bit decline by 0.02 while stock turnover decreased to
6.47. It indicates that ABC Ltd's managers are not utilizing assets optimum to get high earnings
(Marr, 2012). As a result, stock days enhanced to 56.41 days which indicates that ABC Ltd takes
more time to convert their stock into sales. It will create an adverse impact on ABC Ltd's cash flow
position and may generate operational difficulties in the future.
Analysis of solvency
Debt-equity ratio improved to 0.46 because of high debt increase as compare to equity.
Thus, it indicates high risk in investment. But still, standard debt/equity ratio is 0.5:1 which
indicates that debt funds should be half of equity funds (Chen, Lai and Lin, 2014). On the basis of
this, it can be said that debt/equity ratio moved in favourable direction and indicates that ABC Ltd
management tried to achieve idle ratio by managing their capital structure.
Analysis of investment ratios
EPS has been improved from 0.0175 to 0.0225. The reason is ABC Ltd paid higher dividend
in 2015 because of higher profitability return. In 2015, total dividend has been increased from
£280000 to £360000 by 28.57%. It indicates that ABC Ltd is providing good return to their
investors so that it more of the capitalist will be interested to invest funds so as to get high return.
CONCLUSION
In conclusion of the entire report, it can be said that accounting legislation and regulations
makes it essential for all the organizations to comply with the provisions when reporting financial
data into financial statements. So that, true and fair position can be presented to internal as well as
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external users for their decision-making purpose. The report concluded sole trader, partnership and
companies prepare their financial statements as per their organizations structure and legislation's
requirement. Financial performance analysis of ABC Ltd concluded that its financial performance
has been improved in the year 2015.
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