Introduction to Financial StatementsFinancial Statements Analysis NotesB.Com Notes 6th Sem CBCS Pattern
Unit 1: Financial Statements Analysis
Q. What
are financial statements? What are its various types? Explain them briefly. 2015, 2018
Q. What is
Financial Statements? What are their natures and objectives? What are various
limitations of Financial Statements? 2014,
2015, 2017
Q. What is
Financial Statement Analysis? What is its Significance? What are various
limitations of Analysis of Financial Statements? 2016, 2019
Q. What
are various tools and techniques used for Financial Analysis? Explain them
briefly with their respective merits and demerits. 2014, 2016, 2017, 2018, 2019SN
Q.
“Financial Reporting should be a part of Annual Report of the Companies and it
is the best way to provide information to its shareholders”. Considering this
statements write a brief note on financial statements and its types.
Q. Write
short notes on:
Ø Value added
Statements
Ø Economic
value added Statements
Ø Window
Dressing
Q. Practical Problems: Preparation of Comparative Financial Statements and Common size Statements 2019
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Meaning of Financial Statements
Financial statements are the summarized statements of accounting
data produced at the end of accounting process by an enterprise through which
accounting information are communicated to the internal and external users.
The American Institute of Certified Public Accountants states the
nature of financial statements as “Financial Statements are prepared for the
purpose of presenting a periodical review of report on progress by the
management and deal with the status of investment in the business and the results
achieved during the period under review. They reflect a combination of recorded
facts, accounting principles and personal judgments.”
In the
words of Myer,” The financial statements provide a summary
of accounts of a business enterprise, the balance sheet reflecting the assets,
liabilities and capital as on a certain date and income statement showing the
result of operations during a certain period”.
Nature of Financial Statements:
The nature of financial statements is the combination of the
following forms:
a) Recording
facts of a business transactions;
b) Accounting
Conventions;
c) Accounting
Concepts;
d) Legal
implications
e) Personal
judgments used in the application of conventions and postulates.
a) Recorded
Facts: The Financial statements are statements prepared on the basis of
recorded facts; they do not depict the unrecorded facts. Recorded facts means
recording of transactions based on evidence in the accounting books.
b) Accounting
Conventions: Certain accounting conventions are followed while preparing
financial statements such as convention of ‘Conservatism’, convention of
‘Materiality’, convention of ‘Full disclosure’, convention of ‘Consistency’.
According to convention of ‘Conservatism’, provisions are made of expected
losses but expected profits are ignored. This means that the real financial
position of the business may be better than what has been shown by the
financial statements. The use of accounting conventions makes financial
statements simple, comparable, and realistic.
c) Accounting
Concepts: While preparing financial statements the accountants make a number of
assumptions known as accounting concepts such as going concern concept, money
measurement concept, realisation concept, etc. According to the going concern
concept, it is assumed that the business of the concern shall be continued
indefinitely. The assets are shown in the balance sheet at their book value
rather than their market value.
d) Legal
implications: Financial statements are prepared following the legal obligations
of the country. For example, while preparing the financial statement of an
Indian company, the requirements as per the companies Act, 2013 and its
amendments from time to time must be followed.
e) Personal
Judgement: Personal judgement also has an important bearing on financial statements.
For example, selection of one method out of various methods of charging
depreciation, inventory valuation etc., depends on the personal judgement of
the accountant.
Characteristics/Essentials of Financial Statements
Financial statements are regarded as indices of an enterprise‘s
performance and position. As such, extreme care and caution should be exercised
while preparing these statements. Financial statements generally reflect the
following observable characteristics:
a) Internal Audience: financial
statements are intended for those who have an interest in a given business
enterprise. They have to be prepared on the assumption that the user is
generally familiar with business practices as well as the meaning and
implication of the terms used in that business.
b) Articulation: The
basic financial statements are interrelated and therefore are said to be
articulated‘. Example: Profit
and Loss account shows the financial results of operations and represents an
increase or decrease in resources that is reflected in the various balances in
the balance sheet.
c) Historical Nature: Financial
statements generally report what has happened in the past. Though they are used
increasingly as the basis for the future by prospective investors and
creditors, they are not intended to provide estimates of future economic
activities and their effect on income and equity.
d) Legal and economic consequences: Financial
statements reflect elements of both economics and law. They are conceptually
oriented towards economics, but many of the concepts and conventions have their
origin in law. Example: Conventions
of disclosure and materiality
e) Technical Terminology: Since
financial statements are products of a technical process called accounting‖,
they involve the use of technical terms. It is, therefore, important that the
users of these statements should be familiar with the different terms used
therein and conversant with their interpretations and meanings.
f)
Summarization
and Classification: The volume of business transaction
affecting the business operations are so vast that summarization and
classification of business events and items alone will enable the reader to
draw out useful conclusions.
g) Money Terms: All
business transactions are quantified, measured and related in monetary terms.
In the absence of this monetary unit of measurement, financial statements will
be meaningless.
h) Various Valuation Methods: The
valuation methods are not uniform for all items found in a Balance Sheet. Example: Cash is stated at current
exchange value; Accounts receivable at net realizable value; inventories at
cost or market price whichever is lower; fixed assets at cost less
depreciation.
i)
Accrual
Basis: Most financial statements are prepared on accrual basis rather
than on cash basis i.e., taking into account all incomes due but not received
and all expenses due but not paid.
j)
Need for
Estimates and judgement: Under more than one circumstance,
the facts and figures to be presented through financial statements are to be
based on estimates, personal opinions and judgements. Example: Rate of depreciation, the useful economic life of a fixed
asset, provision for doubtful debts are all instances where estimates and
personal judgements are involved.
k) Verifiability: it
is essential that the facts presented through financial statements are
susceptible to objective verification, so that the reliability of these
statements can be improved.
l)
Conservatism:
Wherever and whenever estimates and personal judgements become
essential during the course of preparation of financial statements, such
estimates, should be based moderately on a conservative basis to avoid any
possibility of overstating the assets and incomes.
m) Understandability:
Financial statements should be prepared following the accepted accounting principles
for better understanding of the users.
n) Comparable:
Financial statements should disclose the information in such a manner that they
are conformable for inter-firm and intra-firm comparison.
Types of Financial statements
A set of financial statements includes (Types):
a) Profit
and loss account or Income statements
b) Balance
sheet or Position statements
c) Cash
flow statements
d) Funds
flow statements or
e) Schedules
and notes to accounts.
a)
Profit and loss account or income statement: Income statement is one of the
financial statements of business enterprises which shows the revenues,
expenses, and profits or losses of business enterprises for a particular period
of time. Its main aim to show the operating efficiency of the enterprises.
Income Statement is sometime called the statement of financial performance
because this statement let the users to assess and measure the financial
performance of entity from period to period of the same entity or with
competitors.
b)
Balance sheet or Position statement: Balance Sheet is sometime called
statement of financial position. It shows the balance of assets, liabilities
and equity at the end of the period of time. Balance sheet is sometime called
statement of financial position since it shows the values of net worth of
entity. The net worth of the entity can be obtained by deducting liabilities
from total assets. It is different from income statement since balance sheet
report account’s balance as on a particular date while income statement report
that the account’s transactions during a particular period of time.
c)
Cash flow statement: A Cash Flow Statement is similar to
the Funds Flow Statement, but while preparing funds flow statement all the
current assets and current liabilities are taken into consideration. But in a
cash flow statement only sources and applications of cash are taken into
consideration, even liquid asset like Debtors and Bills Receivables are
ignored. A Cash Flow Statement is a statement, which summarises the resources
of cash available to finance the activities of a business enterprise and the
uses for which such resources have been used during a particular period of
time. Any transaction, which increases the amount of cash, is a source of cash
and any transaction, which decreases the amount of cash, is an application of
cash. Simply, Cash Flow is a
statement which analyses the reasons for changes in balance of cash in hand and
at bank between two accounting period. It shows the inflows and outflows of
cash.
d) Funds flow statement: The financial statement of the business indicates assets, liabilities
and capital on a particular date and also the profit or loss during a
period. But it is possible that there is enough profit in the business and the
financial position is also good and still there may be deficiency of cash or of
working capital in business. Financial statements are not helpful in analysing
such situation. Therefore, a statement of the sources and applications of funds
is prepared which indicates the utilisation of working capital during an
accounting period. This statement is called Funds Flow statement.
According to R.N. Anthony, “Fund Flow
is a statement prepared to indicate the increase in cash resources and the
utilization of such resources of a business during the accounting period.”
According to Smith Brown, “Fund Flow
is prepared in summary form to indicate changes occurring in items of financial
condition between two different balance sheet dates.”
From the above
discussion, it is clear that the fund flow statement is statement summarising
the significant financial change which have occurred between the beginning and
the end of a company’s accounting period.
e) Schedule and
notes to account: The notes to the
financial statements are integral part of a company's external financial
statements. They are necessary because not all relevant financial information
can be communicated through the amounts shown (or not shown) on the face of the
financial statements. Generally, the notes are the main method for complying with
the full disclosure principle and are also referred to footnote
disclosures. The first note to the financial statements is usually a summary of
the company's significant accounting policies for the use of estimates, revenue
recognition, inventories, property and equipment, goodwill and other intangible
assets, fair value measurement, discontinued operations, foreign currency
translation, recently issued accounting pronouncements, and others.
The first note is followed by many additional notes that contain the details (including schedules of amounts) for items such as inventories, accrued liabilities, income taxes, employee benefit plans, leases, business segment information, fair value measurements, derivative instruments and hedging, stock options, commitments and contingencies, and more. Each external financial statement should also include a reference (usually as footer) which states that the accompanying notes are an integral part of the financial statements.
👉👉Financial Statements Analysis
Users of Financial Statements
Users of
accounting information may be categorised into (1) Internal Users; and (2)
External Users.
(1)
Internal Users:
(i) Owners: Owners contribute capital in the business and they are
always exposed to risk. In view of risk involved, the owners are always
interested in knowing the profitability and financial strength of the company.
(ii) Management: Managers has the responsibility to not only
safeguard the owner’s investment but also to increase the value of business.
Financial statements help the management to find out the overall as well as
segment-wise efficiency of the business. It helps them in decision making as
well as in controlling and self evaluation.
(iii) Employees and Workers: Employees and workers are entitled to
bonus at the year end besides the salary and wages which is directly linked
with the profits of the enterprise. Therefore, the employees and workers are
interested in financial statements.
(2)
External Users:
(i) Banks and Financial Institutions: Banks and Financial
Institutions provide loans to the businesses. They watch the performance of the
business to ensure the safety and recovery of the loan advanced.
(ii) Investors and Potential Investors: Investors uses financial
statements to assess the earning capacity of the enterprise and ensure the
safety of their investment.
(iii) Creditors: Creditors supply goods and services on credit.
Before granting credit, Creditors satisfy themselves about the creditworthiness
of the business. The financial statement helps them in making such assessment.
(iv) Government authorities: The government makes use of financial
statements to compile national income accounts and other information. The
information so available to it enables them to take policy decisions.
(v) Consumers: Customers have an interest in information about the
continuance of an enterprise, especially when they have a long-term with the
enterprise. Sometime, prices of some products are fixed by the government, so
it needs accounting information to fix fair prices so that consumers and producers
are not exploited.
PURPOSES AND OBJECTIVES OF FINANCIAL STATEMENTS
Financial statements are very useful as they serve varied affected
group having an economic interest in the activities in the business entity. Let
us analyse the purpose served by financial statement:
a) The
basic purpose of financial statement is communicated to their interested users,
quantitative and objective information are useful in making economic decisions.
b) Secondly,
financial statements are intended to meet the specialized needs of conscious
creditors and investors.
c) Thirdly,
financial statements are prepared to provide reliable information about the
earning of a business enterprise and it ability to operate of profit in future.
The users who are interested in this information are generally the investors,
creditors, suppliers and employees.
d) Fourthly,
financial statements are intended to provide the base for tax assessments.
e) Fifthly,
financial statement are prepare in a way a provide information that is useful
in predicting the future earning power of the enterprise.
f)
Sixthly, financial statements are
prepares to provide reliable information about the changes in economic
resources.
g) Seventhly,
financial statements are prepares to provide information about the changes in
net resources of the organization that result from profit directed activities.
h) Thus,
financial statement satisfy the information requirements of a wide cross-section
of the society representing corporate managers, executives, bankers, creditors,
shareholders investors, labourers, consumers, and government institution.
Limitations of financial statements
Financial Statements suffers from
various limitations which are given below:
(i) Historical Records: Persons like
shareholders, investors etc., are mainly interested in knowing the likely
position in future. The financial statements are not of much help as the
information given in these statements is historic in nature and does not
reflect the future.
(ii) Ignores Price Level Changes: Price
level change and purchasing power of money are inversely related. Different
assets are shown at the historical cost in financial statements. It, therefore,
ignore the price level change or present value of the assets.
(iii) Qualitative aspect Ignored:
Financial statements considered only those items which can be expressed in
terms of money. Financial Statements ignores the qualitative aspect such as
quality of management, quality of labour force, Public relations.
(iv) Suffers from the Limitations of
financial statements: Since analysis of financial statements is based on the
information given in the financial statements, it suffers from all such
limitations from which the financial statements suffer.
(v) Not free from Bias: Financial
statements are largely affected by the personal judgement of the accountant in
selecting accounting policies. Therefore, financial are not free from bias.
(vi) Variation is accounting practices:
Different firms follow different accounting practices. For example,
depreciation can be provided either on SLM basis or WDV basis. Profits earned
or loss suffered will be different when different practices are followed.
Therefore, a meaningful comparison of their financial statements is not
possible.
Financial Statement Analysis Meaning
We know business is mainly concerned with the financial
activities. In order to ascertain the financial status of the business every
enterprise prepares certain statements, known as financial statements.
Financial statements are mainly prepared for decision making purposes. But the
information as is provided in the financial statements is not adequately
helpful in drawing a meaningful conclusion. Thus, an effective analysis and
interpretation of financial statements is required.
Financial Statement Analysis is the process of identifying the
financial strength and weakness of a firm from the available accounting and
financial statements. The analysis is done by properly establishing the
relationship between the items of balance sheet and profit and loss account.
In the words of Myer “Financial Statement analysis is largely a
study of relationship among the various financial factors in a business, as
disclosed by a single set of statements, and a study of trends of these
factors, as shown in a series of statements.”
In simple words, analysis of financial statement is a process of
division, establishing relationship between various items of financial
statements and interpreting the result thereof to understand the working and
financial position of a business.
Objectives (Purposes) and significance of Financial Statement analysis:
Financial analysis serves the following purposes and that brings
out the significance of such analysis:
a) To
judge the financial health of the company: The main objective of the financial
analysis is to determine the financial health of the company. It is done by
properly establishing the relationship between the items of balance sheet and
profit and loss account.
b) To
judge the earnings performance of the company: Potential investors are
primarily interested in earning efficiency of the company and its dividend
paying capacity. The analysis and interpretation is done with a view to
ascertain the company’s position in this regard.
c) To
judge the Managerial efficiency: The financial analysis helps to pinpoint the
areas wherein the managers have shown better efficiency and the areas of
inefficiency. Any favourable and unfavourable variations can be identified and
reasons thereof can be ascertained to pinpoint weak areas.
d) To
judge the Short-term and Long-term solvency of the undertaking: On the basis of financial analysis, Long-term
as well as short-term solvency of the concern can be judged. Trade creditors or
suppliers are mainly interested in assessing the liquidity position for which
they look into the following:
Ø
Whether the current assets are
sufficient to pay off the current liabilities.
Ø
The proportion of liquid assets to
current assets.
e) Indicating the trend of Achievements: Financial
statements of the previous years can be compared and the trend regarding
various expenses, purchases, sales, gross profits and net profit etc. can be
ascertained. Value of assets and liabilities can be compared and the future
prospects of the business can be envisaged.
f)
Inter-firm Comparison: Inter-firm
comparison becomes easy with the help of financial analysis. It helps in
assessing own performance as well as that of others.
g) Understandable: Financial analysis helps the users of the
financial statement to understand the complicated matter in simplified manner.
h) Assessing the growth potential of the business: The
trend and other analysis of the business provide sufficient information
indicating the growth potential of the business.
Types of financial Statement analysis:
The main objective of financial analysis to determine the
financial health of a business enterprise. The analysis may be of the following
types:
a) External
analysis: This analysis is performed by outside parties such as trade creditors,
investors, suppliers of long term debt etc.
b) Internal
analysis: This analysis is performed by the corporate finance and accounting
department and is more detailed than external analysis.
c) Horizontal
analysis: This analysis compares the financial statements viz., profit and loss
accounts and balance sheet of previous year along with the current year.
d) Vertical
analysis: This analysis converts each element of the information into a
percentage of the total amount of statement so as to establish relationship with
other components of the same statement.
e) Trend
analysis: This analysis compares ratios of different components of the
financial statements related to different period to those of a base year.
f)
Ratio analysis: This analysis
establishes the numerical relationship between two items of financial statement
so that the strength and weakness of a firm can be determined.
g) Funds
flow statement: This statement provides a comprehensive idea about the movement
of finance in a business unit during a particular period of time.
h) Break-even
analysis: This type of analysis refers to the interpretation of financial data
that represent operating activities.
Tools of Analysis of Financial Statements
The most commonly used techniques of financial analysis are as
follows:
1. Comparative Statements: These are the statements showing the
profitability and financial position of a firm for different periods of time in
a comparative form to give an idea about the position of two or more periods.
It usually applies to the two important financial statements, namely, balance
sheet and statement of profit and loss prepared in a comparative form. The
financial data will be comparative only when same accounting principles are
used in preparing these statements. If this is not the case, the deviation in
the use of accounting principles should be mentioned as a footnote. Comparative
figures indicate the trend and direction of financial position and operating
results. This analysis is also known as ‘horizontal analysis’.
Merits of Comparative Financial Statements:
a) Comparison
of financial statements helps to identify the size and direction of changes in
financial position of an enterprise.
b) These
statements help to ascertain the weakness and soundness about liquidity,
profitability and solvency of an enterprise.
c) These
statements help the management in making forecasts for the future.
Demerits of Comparative Financial Statements:
a) Inter-firm
comparison may be misleading if the firms are not of the same age and size,
follow different accounting policies.
b) Inter-period
comparison will also be misleading if there is frequent changes in accounting
policies.
2. Common Size Statements: These are the statements which
indicate the relationship of different items of a financial statement with a
common item by expressing each item as a percentage of that common item. The
percentage thus calculated can be easily compared with the results of
corresponding percentages of the previous year or of some other firms, as the
numbers are brought to common base. Such statements also allow an analyst to
compare the operating and financing characteristics of two companies of
different sizes in the same industry. Thus, common size statements are useful,
both, in intra-firm comparisons over different years and also in making inter-firm
comparisons for the same year or for several years. This analysis is also known
as ‘Vertical analysis’.
Merits of Common Size Statements:
a) A
common size statement facilitates both types of analysis, horizontal as well as
vertical. It allows both comparisons across the years and also each individual
item as shown in financial statements.
b) Comparison
of the performance and financial condition in respect of different units of the
same industry can also be done.
c) These
statements help the management in making forecasts for the future.
Demerits of Common Size Statements:
a) If
there is no identical head of accounts, then inter-firm comparison will be
difficult.
b) Inter-firm
comparison may be misleading if the firms are not of the same age and size,
follow different accounting policies.
c) Inter-period
comparison will also be misleading if there is frequent changes in accounting
policies.
3. Trend Analysis: It is a technique of studying the
operational results and financial position over a series of years. Using the previous
years’ data of a business enterprise, trend analysis can be done to observe the
percentage changes over time in the selected data. The trend percentage is the
percentage relationship, in which each item of different years bear to the same
item in the base year. Trend analysis is important because, with its long run
view, it may point to basic changes in the nature of the business. By looking
at a trend in a particular ratio, one may find whether the ratio is falling,
rising or remaining relatively constant. From this observation, a problem is
detected or the sign of good or poor management is detected.
Merits of Trend analysis:
a) Trend
percentages can be presented in the form of Index Numbers showing relative
change in the financial statements during a certain period.
b) Trend
analysis will exhibit the direction to which the concern is proceeding.
c) The
trend ratio may be compared with the industry, in order to know the strong or
weak points of a concern.
Demerits of Common Size Statements:
a)
These are calculated only for
major items instead of calculating for all items in the financial statements.
b) Trend
values will also be misleading if there is frequent changes in accounting
policies.
4. Ratio Analysis: It describes the significant
relationship which exists between various items of a balance sheet and a
statement of profit and loss of a firm. As a technique of financial analysis,
accounting ratios measure the comparative significance of the individual items
of the income and position statements. It is possible to assess the
profitability, solvency and efficiency of an enterprise through the technique
of ratio analysis.
5.
Funds flow statement: The financial statement of the business indicates assets, liabilities
and capital on a particular date and also the profit or loss during a
period. But it is possible that there is enough profit in the business and the
financial position is also good and still there may be deficiency of cash or of
working capital in business. Financial statements are not helpful in analysing
such situation. Therefore, a statement of the sources and applications of funds
is prepared which indicates the utilisation of working capital during an
accounting period. This statement is called Funds Flow statement.
6.
Cash Flow Analysis: A Cash Flow Statement is similar to
the Funds Flow Statement, but while preparing funds flow statement all the
current assets and current liabilities are taken into consideration. But in a
cash flow statement only sources and applications of cash are taken into
consideration, even liquid asset like Debtors and Bills Receivables are
ignored. A Cash Flow Statement is a statement, which summarises the resources
of cash available to finance the activities of a business enterprise and the
uses for which such resources have been used during a particular period of
time. Any transaction, which increases the amount of cash, is a source of cash
and any transaction, which decreases the amount of cash, is an application of
cash. Simply, Cash Flow is a
statement which analyses the reasons for changes in balance of cash in hand and
at bank between two accounting period. It shows the inflows and outflows of
cash.
Parties interested in Financial Analysis
Analysis of financial statements has become very significant due
to widespread interest of various parties in the financial results of a
business unit. The various parties interested in the analysis of financial
statements are:
(i) Investors: Shareholders
or proprietors of the business are interested in the well being of the business.
They like to know the earning capacity of the business and its prospects of
future growth.
(ii) Management: The
management is interested in the financial position and performance of the
enterprise as a whole and of its various divisions. It helps them in preparing
budgets and assessing the performance of various departmental heads.
(iii) Trade unions: They
are interested in financial statements for negotiating the wages or salaries or
bonus agreement with the management.
(iv) Lenders: Lenders
to the business like debenture holders, suppliers of loans and lease are
interested to know short term as well as long term solvency position of the
entity.
(v) Suppliers and trade creditors:
The suppliers and other creditors are interested to know about the solvency
of the business i.e. the ability of the company to meet the debts as and when
they fall due.
(vi) Tax authorities: Tax authorities are
interested in financial statements for determining the tax liability.
(vii) Researchers: They
are interested in financial statements in undertaking research work in business
affairs and practices.
(viii) Employees: They
are interested to know the growth of profit. As a result of which they can
demand better remuneration and congenial working environment.
(ix) Government and their agencies:
Government and their agencies need financial information to regulate the
activities of the enterprises/ industries and determine taxation policy. They
suggest measures to formulate policies and regulations.
(x) Stock exchange: The
stock exchange members take interest in financial statements for the purpose of
analysis because they provide useful financial information about companies.
Thus, we find that different parties have interest in financial
statements for different reasons.
Limitations of financial analysis
Financial analysis suffers from various limitations which are
given below:
a) Historical
Analysis: Financial analysis analysed what has happened till date but it does
not reflect the future. Persons like shareholders, investors etc., are mainly
interested in knowing the likely position in future.
b) Ignores
Price Level Changes: Price level change and purchasing power of money are
inversely related. A change in the price level makes the financial analysis of
different accounting years invalid because accounting records ignores change in
value of money.
c) Qualitative
aspect Ignored: Since the financial statements are based on quantitative
aspects only, the quality aspect such as quality of management, quality of
labour force etc., are ignored while carrying out the analysis of financial
statements.
d) Suffers
from the Limitations of financial statements: Since analysis of financial
statements is based on the information given in the financial statements, it
suffers from all such limitations from which the financial statements suffer.
e) Not
free from Bias: Financial statements are largely affected by the personal
judgment of the accountant in selecting accounting policies. Therefore,
financial are not free from bias.
f)
Variation is accounting practices:
Different firms follow different accounting practices. Therefore, a meaningful
comparison of their financial statements is not possible.
Economic Value-Added is the surplus generated by an entity after
meeting an equitable charge towards providers of capital. It is the post-tax
return on capital employed (adjusted for the tax shield on debt) less the cost
of capital employed. Companies which earn higher returns than cost of capital
create value, and companies which earn lower returns than cost of capital are
deemed harmful for shareholder value.
EVA Calculation:
EVA = (r-c) x
Capital
where: r = rate
of return, and
c = cost of
capital, or the weighted average cost of capital.
Value Added Statement
is a financial statement that depicts wealth created by an organization and how
is that wealth distributed among various stakeholders. The various stakeholders
comprise of the employees, shareholders, government, creditors and the wealth
that is retained in the business. As
per the concept of Enterprise Theory, profit is calculated for various
stakeholders by an organization. Value Added is this profit generated by the
collective efforts of management, employees, capital and the utilization of its
capacity that is distributed amongst its various stakeholders. Consider a manufacturing firm. A
typical firm would buy raw materials from the market. Process the raw materials
and assemble them to produce the finished goods. The finished goods are then sold
in the market. The additional work that the firm does to the raw materials in
order for it to be sold in the market is the value added by that firm. Value
added can also be defined as the difference between the value that the
customers are willing to pay for the finished goods and the cost of materials.
Advantages of a Value Added Statement
a) It
is easy to calculate.
b) Helps
a company to apportion the value to various stakeholders. The company can use
this to analyze what proportion of value added is allocated to which
stakeholder.
c) Useful
for doing a direct comparison with your competitors.
d) Useful for internal comparison purposes and to devise
employee incentive schemes.