Executive Program in Healthcare Management

(EPHM)

Understanding and Analysis of Financial Statements

Session Topic
Day 1 Understanding Corporate Financial Reporting Framework
1&2 • Introduction to Accounting
- Basic Accounting Equation, Elements of Financial Statements
• HBS Case : Maria Hernandez & Associates

Day 2 Understanding Financial Statements- I

3 Understanding Income Statement

4 Understanding Balance Sheet

Day 3 Understanding Financial Statements- II

5&6 • Understanding Cash Flow Statement

• Analysis Cash Flow Statement

Day 4 Financial Statement Analysis

7 Financial Statement Analysis -
 Trend analysis, Horizontal Analysis
 Ratio Analysis- I
8 Financial Statement Analysis - II
 Ratio Analysis- II
 DuPont analysis

2
 Session- 1 & 2

Faculty : Prof. Arpita Ghosh, IIM Calcutta

 Learning Goals

• What is Accounting ?
– Business Activities, Users and uses of accounting information
• Basic Accounting Equation, Event Vs Transaction
– Effect of transactions on accounting equation (Dual Aspect)
• Elements of Financial Statements :
– Assets, Liabilities, Owners Equity, Dividends, Retained Earnings
– Revenues, Expenses
• Financial Statements and Interrelationships
 What is Accounting
An information system that identifies, measures, processes, and communicates
financial information about an economic entity to help users make decisions

Financial
Statements
• Balance
Users/
Business Sheet For
Data
Accounting Decision Makers
Activities: • Income
Statement Internal Users
(Transactions) Identify, Measure,
& communicate • Cash Flow
Operating External Users
Statement
Investing
• Retained
Financing Earnings
Statement

Decisions/Actions
Accounting is a link between Business activities & Decision makers
 Business Activities
Financing Activities – Includes obtaining funds to begin operations and continue
operating
• Borrowings : Party to whom amounts are owed are Creditors /Lenders -
Amounts owed/ obligations of business are called Liabilities
• Issuing shares: Amounts paid by stockholders to buy shares gives rise to
Common Stock - Payments to stockholders are called Dividends
Investing Activities – Spending funds in productive ways : Purchase of resources a
company needs to operate
• Buying Land,Buildings, Equipment, Furniture etc. – Resources owned by a
business are called Assets

Operating Activities - Once a business has the assets it needs, it can begin its
operations. Includes
• Selling goods and services to customers - Amounts earned from sale of
products are called Revenues
• Employing & paying managers and workers, buying & producing goods and
services, paying taxes - These are Expenses
 Users: Who uses accounting information ?
Accounting is a link between Business activities & Decision makers

Decision Makers/ Users

OUTSIDERS
INSIDERS
Those with Direct Financial Interest
Management • Investors
• Human Resources • Creditors
• Marketing
• Operations Those with Indirect Financial Interest
• Finance • Tax Authorities
• Regulatory Agencies
• Labour Unions
• Customers
• Economic Planners
 Accounting is complex
An information system that measures, processes, and communicates financial
information about an economic entity to help users make decisions
Management
GAAP: Choice
Concepts, Financial
Standards Statements
• Balance Users/
Business Sheet For
Data
Accounting Decision Makers
Activities: • Income
(Transactions) Measure, Process, Statement Internal Users
Operating & communicate • Cash Flow External Users
Investing Statement
Financing •Statement of
Auditors, Board, Retained
Companies Law, Earnings
Market Regulator Analysts, CRA , Media

Decisions/Actions
Accounting is a link between Business activities & Decision makers
 Event Vs Transaction
What does accounting measure ? Business transactions

A Business Transaction: An economic event that affects the financial position

of a business
– It can be an exchange of value (like Purchase, Sale, Payment,
Collection, Loan)
– It can be an event that have the same effect as an exchange of value
(like Loss from fire, flood, theft ; Accumulation of interest)

Every transaction affects the BASIC ACCOUNTING EQUATION

 Financial Position: Basic Accounting Equation
Economic Resources (OWNED) = Equities (OWED)

Economic Resources = Creditors’ Equities + Stockholders’ (or Owners’) Equity

Assets = Liabilities + Owners’ Equity

Assets = Liabilities + Contributed Capital + Retained Earnings

 Whether Transaction ?
Are the following events recorded in the accounting records as transactions?

Event Criterion Record/

don’t Record
1 GM purchases an office building Is the Record
financial
2 GAP announces a new marketing strategy Don’t Record
position
3 Wipro receives a new contract (assets, Don’t Record
4 Customer buys a product liabilities, or Record
stockholders’
5 Infosys pays wages to its workers Record
equity) of the
6 Kundu travels discusses a guided trip with a company Don’t Record
potential customer changed?
7 Cost of Supplies used by ABC Ltd Record

All transactions are events.

But all economic events are not transactions.
Only Transactions are recorded.
 Whether Transaction ?
Are the following events recorded in the accounting records as transactions?

Event Criterion Record/

don’t Record
1 GM purchases an office building Is the Record
financial
2 GAP announces a new marketing strategy Don’t Record
position
3 Wipro receives a new contract (assets, Don’t Record
4 Customer buys a product liabilities, or Record
stockholders’
5 Infosys pays wages to its workers Record
equity) of the
6 Kundu travels discusses a guided trip with a company Don’t Record
potential customer changed?
7 Cost of Supplies used by ABC Ltd Record

All transactions are events.

But all economic events are not transactions.
Only Transactions are recorded.
 Financial Position: Basic Accounting Equation
Economic Resources (OWNED) = Equities (OWED)

Economic Resources = Creditors’ Equities + Stockholders’ (or Owners’) Equity

Assets = Liabilities + Owners’ Equity

If an asset increases, there must be a corresponding 

• decrease in other asset, increase in a liability, or increase in Owners’ Equity
• Every transaction has dual-effect (double-sided) on Basic Accounting Equation
i.e. it affects at least two items in the accounting equation
• The accounting equation must always balance : the two sides of the equation
must always be equal

• It is important to identify the specific effects of every transaction on the

accounting equation. The process is called Transaction Analysis.
 Exercise on THE ACCOUNTING EQUATION
A = L + SE
$125,000 = $75,000 + SE
SE = $50,000
The liabilities of AC Ltd equal one third of total assets, and stock holders’
equity is $90,000. What is the amount of liabilities ?
Assets = 1/3 Assets + $90,000
2/3 Assets = $90,000
Assets = $135,000
Liabilities = 1/3 × $135,000 = $45,000
At the beginning of the year, LC’s assets were $6,20,000, and its stock
holders’ equity was $300,000. During the year, assets increased $90,000 and
liabilities decreased $45,000. What is stockholders’ equity at the end of the
year ?
Beginning: $620,000 = Liabilities + $300,000
Liabilities = $320,000
$620,000 = $320,000 + $300,000
Change: + 90,000 – 45,000
End: $710,000 = $275,000 + Stockholders' Equity
End: Stockholders' Equity = $435,000 14
 Basic Accounting Equation - Extension

Assets = Liabilities + Common Stock + Retained Earnings (RE)

• Change in Retained earnings during the year (∆ RE )

= (Revenues t – Expenses t – Dividends t )
• Retained Earnings at the end of the year (REt)
= Prior Retained Earnings (RE t-1) + ∆ RE
= Prior Retained Earnings (RE t-1) + (Revenues t – Expenses t – Dividends t )
= (Revenues – Expenses – Dividends) accumulated over the life of the entity
Thus,
Assets = Liabilities + Common stock + (Revenues - Expenses – Dividends)

Net Income

15
Basic Accounting Equation
 Exercise: THE ACCOUNTING EQUATION

• BC starts the year with $100,000 in assets and $80,000 in

liabilities. Net income for the year is $25,000 and dividends
paid is $5000. How much is owners’ equity at the end of the
year ?

A = L + SE
Beginning of year$100,000 = $80,000 +$20,000
+ Net income +$25,000
– Dividends –5,000
Stockholders’ equity at end of year $40,000
 EXERCISE CASE 1 CASE 2 CASE 3 CASE 4
Total assets, end of period $ 40,000 ? $ 75,000 $ 50,000
Total liabilities, end of period ? 15,000 25,000 10,000
Capital stock, end of period 10,000 5,000 20,000 15,000
Retained earnings, beginning of period 15,000 8,000 10,000 20,000
Net income for the period 8,000 7,000 ? 9,000
Dividends for the period 2,000 1,000 3,000 ?
 EXERCISE CASE 1 CASE 2 CASE 3 CASE 4
Total assets, end of period $ 40,000 34,000 ? $ 75,000 $ 50,000
Total liabilities, end of period 9,000 ? 15,000 25,000 10,000
Capital stock, end of period 10,000 5,000 20,000 15,000
Retained earnings, beginning of period 15,000 8,000 10,000 20,000
Net income for the period 8,000 7,000 23,000 ? 9,000
Dividends for the period 2,000 1,000 3,000 4,000 ?

A = L + CS + (Beg. RE + Net Income – Div.)

Case 1: 40 = L + 10 + (15 + 8 – 2)
Liabilities = 9

Case 2: A = 15 + 5 + (8 + 7 – 1)
Assets = 34
Case 3: 75 = 25 + 20 + (10 + N. Income – 3)
Income = 23
Case 4: 50 = 10 + 15 + (20 + 9 – Div.)
Dividends = 4
 Income Statement

Weiss Consultancy, Inc. • Summarizes revenues

Income Statement earned & expenses
For the Month Ended December 31, 2012 incurred over an
accounting period
Revenues Date reflects revenues
Commissions and expenses incurred $14,000 • Shows if the entity has
earned over a period of time earned profits
Expenses
• Net income if Revenues >
Equipment rental $2,800
Expenses, o.w. Net Loss
expense
Wages expense 1,600 • Flow Report
Utilities expense 1,200
Total expenses 5,600 • Use : Past net income
Income before income $8,400 provides information for
taxes predicting future net
Income taxes expense 1,200 income – investors,
Net income $7,200 lenders
Net income figure used to prepare
statement of retained earnings
 Statement of Retained Earnings

Weiss Consultancy, Inc.

Shows
Statement of Retained Earnings changes in
For the Month Ended December 31, 2012 retained
earnings over
Retained earnings, December 1, 2012 $0 an accounting
Net income for the month 7,200 period
Subtotal $7,200
Less dividends 2,400
Retained earnings, December 31, 2012 $4,800

Net income figure comes

Ending balance of retained
from income statement
earnings used to prepare the
balance sheet
 Balance Sheet Date reflects
account balances as
 Reports assets and Weiss Consultancy, Inc. of a certain date
claims to assets at a Balance Sheet
specific point in time. 31-Dec-2012

 Assets
= Liabilities + Assets Liabilities
Stockholders’ Equity. Cash $61,200 Accounts payable $2,400
Accounts receivable 4,000
 Status or stock
Supplies 2,000 Stockholders’ Equity
report
Land 40,000
 Use: Evaluate Building 100,000 Common stock $200,000
reliance on debt vs. Retained earnings 4,800
equity in funding its Total stockholders’ equity 204,800
assets, Cash
Total assets $207,200 Total liabilities and $207,200
stockholders’ equity

Ending balance of Retained Earnings comes

from statement of retained earnings
 Statement of Cash Flows
Weiss Consultancy, Inc. Begins with a net
Statement of Cash Flows income figure
For the Month Ended December 31, 2012
 Where did cash from income
come from during statement
Cash flows from operating activities
the period? Net income $ 7,200
Adjustments to reconcile net income to net
 How was cash cash flows from operating activities
Increase in accounts receivable ($4,000)
used during the
Increase in supplies (2.000)
period? Increase in accounts payable 2,400 (3,600)
Net cash flows from operating activities $ 3,600
 What was the Cash flows from investing activities
change in the Purchase of land ($40,000)
Purchase of building (100,000)
cash balance
Net cash flows from investing activities (140,000)
during the period? Cash Flows from financing activities
Investments by stockholders $200,000
 Cash effect of Dividends (2,400)
Operating, Net cash flows from financing activities 197,600
Net increase (decrease) in cash $61,200
Financing and
Cash at beginning of month 0
Investing Cash at end of month Cash at end of period should be $61,200
the same as Cash account
balance on balance sheet
24
 Impact of transactions on Accounting Equation
Transactions Assets = Liabilities + Shareholder’s Equity

Common stock issued for Cash +500,000 Common Stock

cash +500,000
Loan obtained from bank Cash + 100,000 Loan + 100,000

Bought Building on cash Cash -200,000

Building +200,000

Bought Equipment on Equipment +300,000 Lender +300,000

credit
Purchased inventory partly Inventory +120,000 Accounts Payable
in cash and partly on credit + 100,000
Cash -20,000

Made payment for prior Cash - 80,000 Accounts Payable

purchase on credit - 80,000
Sold goods on credit Accounts Receivable Sales +50,000
+50,000
Received Cash from Cash + 40,000
customers for prior Sales
Accounts Receivable
-40,000
Cost of goods sold Inventory -40,000 COGS -40,000
Paid Office Rent Cash - 1,000 Rent Expense -1,000
Paid Dividend Cash -2,000 Dividend -2,000
 Impact of transactions on Accounting Equation
Transactions Assets = Liabilities + Shareholder’s Equity

Common stock issued for Cash +500,000 Common Stock

cash +500,000
Loan obtained from bank Cash + 100,000 Loan + 100,000

Bought Building on cash Cash -200,000

Building +200,000

Bought Equipment on Equipment +300,000 Lender +300,000

credit
Purchased inventory partly Inventory +120,000 Accounts Payable
in cash and partly on credit + 100,000
Cash -20,000

Made payment for prior Cash - 80,000 Accounts Payable

purchase on credit - 80,000
Sold goods on credit Accounts Receivable Sales +50,000
+50,000
Received Cash from Cash + 40,000
customers for prior Sales
Accounts Receivable
-40,000
Cost of goods sold Inventory -40,000 COGS -40,000
Paid Office Rent Cash - 1,000 Rent Expense -1,000
Paid Dividend Cash -2,000 Dividend -2,000
 Summarize
Assets Liabilities Owner’s Equity
Changes during Accounts Building Equipment Inventory Accounts Loan Lender Common Retained
the period ? Cash Receivable Payable Stock Earnings

Changes 500,000 +50,000 - 200,000 300,000 120,000 - 1,00,000 100,000 300,000 500,000 50,000 -
+100,000 40,000 = 40,000 = -80,000= 40,000 -
-200,000 10,000 80,000 20,000 2,000 –
-20,000-80,000 1,000 =
+ 40,000 7,000
-1,000-2,000 =
337,000

Increase/ 337,000 10,000 200,000 300,000 80,000 20,000 100,000 300,000 500,000 7,000
Decrease

Equality Change in Assets = 927,000 = Change in Liabilities = 420,000 Change in Owner’s

maintained ? Equity = 507,000

Assets Liabilities Owner’s Equity

Cash Accounts Building Equipment Inventory Accounts Loan Lender Common Retained
Receivable Payable Stock Earnings
Let us say,
Opening Balances 10,000 20,000 0 0 90,000 = 10,000 0 0 100,000 10,000
Increase/ 337,000 10,000 200,000 300,000 80,000 20,000 100,000 300,000 500,000 7,000
Decrease
Closing Balances 347,000 30,000 200,000 300,000 170,000 30,000 100,000 300,000 600,000 17,000

Equality ASSETS =1047,000 LIABILITIES =430,000 OWNERS’ EQUITY =

maintained ? 6,17,000
 Summarize
Assets Liabilities Owner’s Equity
Changes during Accounts Building Equipment Inventory Accounts Loan Lender Common Retained
the period ? Cash Receivable Payable Stock Earnings

Changes 500,000 +50,000 - 200,000 300,000 120,000 - 1,00,000 100,000 300,000 500,000 50,000 -
+100,000 40,000 = 40,000 = -80,000= 40,000 -
-200,000 10,000 80,000 20,000 2,000 –
-20,000-80,000 1,000 =
+ 40,000 7,000
-1,000-2,000 =
337,000

Increase/ 337,000 10,000 200,000 300,000 80,000 20,000 100,000 300,000 500,000 7,000
Decrease

Equality Change in Assets = 927,000 = Change in Liabilities = 420,000 Change in Owner’s

maintained ? Equity = 507,000

Assets Liabilities Owner’s Equity

Cash Accounts Building Equipment Inventory Accounts Loan Lender Common Retained
Receivable Payable Stock Earnings
Let us say,
Opening Balances 10,000 20,000 0 0 90,000 = 10,000 0 0 100,000 10,000
Increase/ 337,000 10,000 200,000 300,000 80,000 20,000 100,000 300,000 500,000 7,000
Decrease
Closing Balances 347,000 30,000 200,000 300,000 170,000 30,000 100,000 300,000 600,000 17,000

Equality ASSETS =1047,000 LIABILITIES =430,000 OWNERS’ EQUITY =

maintained ? 6,17,000
 EXERCISE : CLASSIFICATION OF FINANCIAL STATEMENT ITEMS

Classify the items :

1. Whether it belongs on the Income statement (IS), Balance Sheet (BS)
2. Whether it is a revenue (R ), expense (E ), asset(A), liability(L) or
stockholders’ equity (SE)
Item Appears on the Classified as
Cash BS A
1 Salaries Expense IS E
2 Equipment BS A
3 Accounts Payable BS L
4 Membership fees earned IS R
5 Capital Stock BS SE
6 Accounts Receivable BS A
7 Buildings BS A
8 Advertising expense IS E
9 Retained Earnings BS SE
 EXERCISE : CLASSIFICATION OF FINANCIAL STATEMENT ITEMS

Classify the items :

1. Whether it belongs on the Income statement (IS), Balance Sheet (BS)
2. Whether it is a revenue (R ), expense (E ), asset(A), liability(L) or
stockholders’ equity (SE)
Item Appears on the Classified as
Cash BS A
1 Salaries Expense IS E
2 Equipment BS A
3 Accounts Payable BS L
4 Membership fees earned IS R
5 Capital Stock BS SE
6 Accounts Receivable BS A
7 Buildings BS A
8 Advertising expense IS E
9 Retained Earnings BS SE
Recollection : Basic Accounting Equation
CASE: Maria Hernandez
 Case Questions: Maria Hernandez
• State the transactions which took place during the two months of operations of
Maria’s Business
• For each transaction, analyze in the following lines:
– Name the accounts which might be involved and classify them as A, L or SE
– Show how each of the transactions affect the accounting equation
• Check if the accounting equation still holds after it is affected by all the transactions.
• Compare the accounting equation at the beginning and at the end of the two months
period.

• Segregate the transactions involving Cash

– Classify them into Operating, Financing and Investing Activities
• Segregate the transactions involving Revenues and Expenses.
– Calculate: total revenues – total expenses.
Thank You