CAIIB ABM Module C Unit 2 : Analysis of Financial Statements

CAIIB Paper 1 (ABM) Module C Unit 2 : Analysis of Financial Statements (New Syllabus) 

IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 1 (Advanced Bank Management) includes an important topic called “Analysis of Financial Statements”. Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.

In this article, we are going to cover all the necessary details of CAIIB Paper 1 (ABM) Module C (CREDIT MANAGEMENT) Unit 2 : Analysis of Financial Statements, Aspirants must go through this article to better understand the topic, Analysis of Financial Statements and practice using our Online Mock Test Series to strengthen their knowledge of Analysis of Financial Statements. Unit 2 : Analysis of Financial Statements

Financial Statements

There are basically two financial statements which every business enterprise is required to prepare. These are:

• Balance sheet
• Profit & Loss account (Income & Expenditure statement in case of non-profit organizations)

Apart from these, the auditors’ report, explanatory schedules and notes on accounts, if applicable, provide useful information to the bankers.

A funds flow statement also provides useful information but, this is only a mathematical analysis of changes in the structure of two consecutive balance sheets and can be easily prepared by the banker/ analyst himself if the basic statements, i.e. the balance sheets, are available. Accounting Standard-3 makes it mandatory for some enterprises to prepare Cash Flow statement for the accounting period (these enterprises are those whose equity or debt is listed or is in the process of being listed on a recognized stock exchange and also all other commercial, industrial and business enterprises whose turnover for the accounting period exceeds Rs.50 crore. These enterprises are also required to do segment-wise reporting as per A S -1 7.

Users of Financial Statements

Apart from bankers, the other users of financial statements are:

• Other creditors and lenders
• Investors
• Government agencies
• Rating agencies
• Customers
• Employees
• General public
• Analysts

Basic Concepts Used in Preparation of Financial Statements

The important concepts are as under:

• Entity Concept
• Money Measurement Concept
• Stable Monetary Unit Concept
• Going Concern Concept
• Cost Concept
• Conservatism Concept
• Dual Aspect Concept
• Accounting Period Concept
• Accrual Concept
• Realization Concept
• Matching Concept

The format of balance sheet can be either Vertical or Horizontal  as  illustrated below (activities like banking, insurance, electricity generation etc, which are governed   by acts other than Companies Act, need not follow these formats)

Horizontal Form: Horizontal form is maintained in two columns. The first column shows the Liabilities and the second one shows the Assets.

The items shown in the first column against Liabilities are:

• Share Capital Reserves
• Surplus Secured loans
• Unsecured loans
• Current liabilities
• Provisions

The items shown in the second column against Assets are:

• Fixed assets
• Investments
• Current assets
• Loans and advances
• Miscellaneous expenditure

Vertical Form: In the Vertical Form, the different items are shown one below the other.

(A)Sources of funds

1. Shareholders’ funds

(a)Share capital

(b)Reserves and surplus

2. Loan funds

(a)Secured loans

(b)Unsecured loans

(B)Application of funds

1.Fixed assets

2.Investments

3.Current assets, loans and advances

Less: Current liabilities and provisions Net current assets

4.Miscellaneous expenditures

I. Equity and Liabilities

Shareholder’s funds

• Share capital
• Reserve and Surplus
• Money received against share warrants

Share application money pending allotment

Non-current liabilities

• Long-term borrowings
• Deferred tax liabilities (Net)
• Other long term liabilities
• Long term provisions

Current liabilities

• Short-term borrowings
• Trade payables
• Other current liabilities
• Short-term provisions

Total-

II. Assets

Non-current assets

• Fixed assets

(i)Tangible assets

(ii)Intangible assets

(iii)Capital work-in-progress

(iv)Intangible assets under development

• Non-current investments
• Deferred tax assets (net)
• Long-term loans and advances
• Other non-current assets

Current Assets

• Current investments
• Inventories
• Trade receivables
• Cash and cash equivalents
• Short-term loans and advances
• Other current assets

Total-

Accounting

As per Income Tax rules, April to March is considered as the financial year for tax purposes. However, as per Companies Act, this can be different. Only restriction, as per Companies Act, is that the maximum duration of the financial year can be 15 months, and can be extended up to 18 months with the permission of Registrar of Companies (ROC).

Profit And Loss Account

It is a statement of income and expenditure of an entity for the accounting period. Every P and L account must indicate the accounting period for which it is prepared The items of a P & L account are:

• Gross and Net sale
• Cost of goods sold
• Gross profit
• Operating expenses
• Operating profit
• Non-operating surplus/deficit
• Profit before interest and tax
• Interest
• Profit before tax
• Tax
• Profit after tax (Net Profit)

Cash Flow Statement

• It is critical to evaluate the ability of an enterprise to generate cash and cash equivalents along with the timing and certainty of their generation. It is in this context that a need has been felt to reiterate the insights which can be derived from proper analysis of Cash Flow Statement (CFS) in understanding the financial capability of an enterprise.
• It states the movement of cash and cash equivalents, into or out of, a business during a given period of time. It narrates the travelogue of opening cash balance at the beginning of the period in its journey to reach the closing cash balance at the end. Cash comprises cash on hand and demand deposits with the Banks, while cash equivalents are short-term and highly liquid instruments readily convertible into cash at any time, without any significant erosion in value.

The following are the components of cash flow:

• Operating Cash Flows: Cash received or expended for conducting business operations including expenses therefor. On netting the expenses from receipts, the resultant figure should be positive for the company to remain solvent.
• Investment Cash Flows: Cash receipts and expenses, other than for or from operations, in the nature of long term. But this does not include transactions relating to capital and debt.
• Financing Cash flows: Cash transactions relating to capital and debt. This is the story of financing the company.

Use of Cash Flow Statement (CFS)

• CFS speaks about the alignment between profitability and net cash flow.
• CFS speaks about the deepness of the pocket the business has.
• CFS speaks about the accuracy of past assessment of future cash flows in terms of the amount, timing and certainty of future cash flows and, thereby, provides insights into operational efficiency of the business during given period against the corresponding past period;
• CFS speaks about the acceptability of income accounted as per accrual concept.
• CFS speaks about the ability of the business to meet in time a specific and sure cash out flows like repayment of an ad-hoc loan or retirement of a usance LC, etc.

Funds Flow Statement

• Each item in the balance sheet represents either source of funds or use of funds. All items on the liabilities side represent the funds provided to the enterprise and all items on the assets side (except cash) represent use of these funds.
• Cash in the balance sheet represents the unutilised portion of funds, available to the enterprise. If cash is also perceived as a use of funds then all the uses of funds are equal to all the sources of funds.
• This perception of available cash, as a use of funds, is what causes the wide spread confusion about difference in a Funds flow statement and a Cash flow statement. When we compare two balance sheets of different dates, change in each item (or introduction of a new item) in the balance sheet of later date, as compared to that item in the balance sheet of earlier date, will represent either addition of funds or additional use of funds in the intervening period.
• Any increase in any item on the liabilities side means additional funds available.

Projected Financial Statements

• Actual financial statements are for the past period and analysis of these gives very useful financial information to the banker. But for assessing the need for bank credit and to examine the viability of the activity, it is necessary to anticipate the financial position of the enterprise in future.
• For example, for assessing the working capital needs, the statement of assets and liabilities of the last year will not be adequate. We will have to anticipate the level of operations during the current year and accordingly project the level of assets and liabilities to arrive at the need for bank’s loan.
• Of course, the financial statements for the past period serve as the most important guide for this estimate. Also, in case of a new enterprise, where no financial statements are available, it becomes necessary to decide on a level of activity and accordingly prepare the projected financial statements.
• Generally, in case of smaller enterprises, where adequate financial expertise may not be available, the projected financial statements for the next year are prepared by the bank by interviewing the concerned person.
• In case of term loans for new projects/ expansion, the projected financial statements are normally prepared for the entire duration of bank loan to establish the viability of operations as also to determine the disbursal and repayment schedule.
• Whenever the projected financial statements are submitted by the borrower, these are critically examined for their reasonability and if projections are considered to be unreasonable, the matter is discussed with the borrower and suitable consensus arrived at.

Purpose Of Analysis Of Financial Statements By Bankers

• Assessment of Performance and Financial Position
• Projection of Future Performance
• Detecting Danger Signals
• Assessment of Credit Requirements
• Cross Checking

Rearranging The Financial Statements For Analysis

In keeping with the above objectives, a banker rearranges the figures in the financial statements under distinct groups for a meaningful analysis.

Balance Sheet

The assets and liabilities are normally regrouped as follows:

P&L Account

The format prescribed under erstwhile Credit Monitoring Arrangement (CMA), under which banks used to report sanction of large credit proposals to RBI, still serves as a useful guide for rearranging the items in P&L account. The important groups of items are as follows:

Important Points for Rearranging Financial Statements 

While rearranging the financial statements, the following points should be examined by the banker and suitable changes made in different items:

• Instalment of term loans due within one year
• Advance tax/provision of tax
• Deferred tax assets and liabilities
• Non moving inventory
• Receivables more than 6 months old
• Revaluation of assets and Intangible assets
• Investments and that in and loans/advances to associates and subsidiaries
• Bills purchased/discounted
• Contingent liabilities
• Provisioning
• Depreciation method
• Inventory valuation
• Expenses relating to earlier years
• Important events after account period.

Techniques Used In Analysis Of Financial Statements

Bankers mostly use three methods for analysis of financial statements

• Funds Flow Analysis
• Trend Analysis
• Ratio Analysis

Funds Flow Analysis

• Funds Flow statement is not part of Financial Statements nor a return certified by auditor. It is a requirement of the lenders to trace diversions, if any. However, while submitting the estimates for current year and projections for next year, most companies use the model of CMA format, which contains Funds Flow statement also.
• If the borrower has not submitted the funds flow statement, bank prepares the same from the last two balance sheets. The total sources of funds are categorised as ‘Long term’ and ‘Short term’. Similarly, the total uses are also categorised as ‘Long term’ and ‘Short term’. If the short-term sources are more than the short-term uses, (correspondingly long-term uses are more than long-term sources), it indicates diversion of working capital funds and needs to be probed further.

Trend Analysis

Under trend analysis, bankers adopt the following methodology:

• The items, for which trend is required to be seen, are arranged in vertical form, with actual figures of past two years, ensuing year’s estimates and next year’s projections on the right side of it. The percentage increase (decrease) from the previous year’s figure is indicated below it. Generally, this is used to see the trends of sales, operating profit, PBT, PAT, etc. from P&L account. Similarly, the balance sheet items, arranged in vertical order give the trends of increase or decrease of various items.
• Common Size Statements are prepared to express the relationship of various items to one item in percentage terms. For example, consumption of raw materials is expressed as a percentage of sales for different years and comparison of these figures gives indication of trend of operating efficiency.

Ratio Analysis

• This is the most favourite method of bankers for analysis of financial statements. A ratio is comparison of two figures and can be expressed as a percentage (e.g., profitability is 23.7 per cent), as a number (e.g., current ratio is 1.33) or simply as a proportion (e.g., debt equity is 1:2).
• Both the figures, used in calculation of a ratio, can be from either P&L account, or balance sheet or one can be from P&L account and the other from balance sheet. Ratios help in comparison of the financial performance and financial position of an entity with other entities, as also for comparison with its own status over the years. While different users of financial statements are interested in different ratios, the ratios which interest a banker most, are the following:

Liquidity Ratios

• Current Ratio is the indicator of liquidity, that is the ability to meet commitments in time. It is expressed as simple ratio by dividing Total Current Assets by Total Current Liabilities and is benchmarked normally to 1.33: 1, where the 0.33 over 1 is the surplus of Long Term Sources over Long Term Uses, technically called the Net Working Capital [NWC]
• NWC Ratio gives the long term support available to build-up on current assets, indicating margin available over CL to finance current assets. Expressed in per cent, the formula is NWC/TCA × 100.

Profitability Ratios

Leverage Ratio or Solvency Ratio or Gearing Ratios

Coverage Ratios

Holding Ratios or Turnover Ratios:

These are basically used to assess the length of the operating cycle and amount of Working Capital Gap, that is TCA–OCL. These ratios are used to estimate the amount of TCA required and OCL available.

 

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CAIIB Paper 1 (ABM) Module C Unit 2-Analysis of Financial Statements (Ambitious_Baba)

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