FINANCIAL MANAGEMENT

UNIT
FINANCIAL STATEMENTS
5

PRE-TEST
Identify.
1. What does IFRS stands for?
2. It provides information about the financial position, financial performance and cash
flows of an entity that is useful to a wide range of users in making economic decisions.

LET’S STARTED

After studying this Unit, you will be able to:

 Describe the component elements found in the statement’s comprehensive income,

financial position and cash flows
 Tell the difference between the various financial statements

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FINANCIAL STATEMENTS
Business transactions are recorded, summarized and reported by the use of different kinds of
financial statements, each serving a different purpose. Financial statements provides
information about the financial position, financial performance and cash flows of an entity that
is useful to a wide range of users in making economic decisions. They are essentially the report
cards for businesses. They tell the story, in numbers, about the financial health of the business.
They are prepared in order to reflect on the activities of an organization, to measure
performance, to benchmark and compare against other organizations. Financial statements are
the primary communication tool to stakeholders of an organization. It is through these reports
that the progress of an organization can be measured and corrective action be taken, if there
are deviations from the goals of the business.
The complete set of financial statements compliant with IFRS comprises 5 elements:

 a statement of financial position as at the end of the period

 a statement of comprehensive income for the period
 a statement of changes in equity for the period
 a statement of cash flows for the period
 notes containing a summary of significant accounting policies and other explanatory
information.
This course primarily focus on three financial statements, namely; the statement of
comprehensive income, the statement of financial position and statement of cash flows. It is
through these reports that the progress of an organization can be measured and corrective
action be taken, if there are deviations from the goals of the business.
STATEMENT OF COMPREHENSIVE INCOME
The statement of comprehensive income is one of the five financial statements required in a
complete set of financial statements for distribution outside of a corporation. It provides an
overview of revenues and expenses, including taxes and interest. It is the change in equity (net
assets) of a business enterprise during a period from transactions and other events and
circumstances from non-owner sources. The statement of comprehensive income illustrates
the financial performance and results of operations of a particular company or entity for a
period of time.
According to International Financial Reporting Standards since 1 January 2009 an entities make:

 a Statement of comprehensive income or

Two separate statements comprising:

 an Income statement displaying components of profit or loss where all items of income
and expenses must be recognized; and

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 a Statement of comprehensive income that begins with profit or loss (bottom line of the
income statement) and displays the items of other comprehensive income for the
reporting period (IAS 1 p.81) where items recognized directly to equity or reserves, such
as changes in revaluation surplus, gains or losses from subsequent measurement of
available-for-sale financial assets, etc.
At the end of the statement is the comprehensive income total, which is the sum of net income
and other comprehensive income. In some circumstances, companies combine the income
statement and statement of comprehensive income into one comprehensive statement.
However, a company with other comprehensive income will typically file this form separately.
This statement is not required if a company does not meet the criteria to classify income as
comprehensive income.

TWO STATEMENTS OF COMPREHENSIVE INCOME

 COMPONENTS OF THE PROFIT AND LOSS

The income statement (profit or loss) is based on the business transactions that have been
recorded for a specific period, usually 12 months. The International Accounting Standards (IAS)
number 1.88 stipulates that all items of income and expense recognized in a period must be
included in profit or loss unless a standard or an interpretation requires otherwise. As a result
of the 2003 revision to IAS 1, the Standard is now using 'profit or loss' rather than 'net
profit or loss' as the descriptive term for the bottom line of the income statement.
The profit and loss statement allows for the business to analyze how the income (profit
or loss) for the period was created. It provides a summary of a company’s revenues,
expenses, and profits/losses over a given period of time. The profit and loss statement does
not reflect the financial position of the firm, but tells us how profitable the transactions for
serving the customers were. The P&L statement shows a company’s ability to generate sales,
manage expenses, and create profits. It is prepared based on accounting principles that include
revenue recognition, matching, and accruals, which makes it different from the cash flow
statement.

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EXAMPLE OF THE COMPONENTS OF PROFIT AND LOSS STATEMENT

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 COMPONENTS OF THE STATEMENT OF COMPREHENSIVE INCOME IN A TWO STEP

APPROACH
Where the company presents two statements, the first statement is the income
statement (profit and loss), the bottom line of which is profit or loss. This approach is
consistent with some International Financial Reporting Standards (IFRSs) (see IAS 1.89) that
permit for some components to be excluded from profit or loss and instead to be
included in other comprehensive income. The second is the statement of comprehensive
income, which begins with the profit or loss from the income statement bottom line.
In a two statement approach, the comprehensive statement starts with the bottom line of the
profit and loss statement. The components of the comprehensive income should include:

 changes in revaluation surplus

 actuarial gains and losses on defined benefit plans recognized in accordance with
 gains and losses arising from translating the financial statements of a foreign operation
 gains and losses on re‐measuring available‐for‐sale financial assets
 The effective portion of gains and losses on hedging instruments in a cash flow hedge.
(IFRSs, 2013)
EXAMPLE OF STATEMENT OF COMPREHENSIVE INCOME

SINGLE STATEMENT OF COMPREHENSIVE INCOME

The single statement of comprehensive income combines the components of the income
statement and the statement of other comprehensive income.

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The International Accounting Standards (See IAS 1) stipulate for the minimum items in the
statement of comprehensive income to include the following:
a) revenue
b) finance costs
c) share of the profit or loss of associates and joint ventures accounted for using the equity
method
d) tax expense
e) a single amount comprising the total of (i)the post‐tax profit or loss of discontinued
operations and (ii) the post‐tax gain or loss recognized on the disposal of the assets or
disposal group(s) constituting the discontinued operation
f) profit or loss
g) each component of other comprehensive income classified by nature
h) share of the other comprehensive income of associates and joint ventures accounted
for using the equity method
i) total comprehensive income
j) The following items must also be disclosed in the statement of comprehensive
income as allocations for the period
k) profit or loss for the period attributable to non‐controlling interests and owners of the
parent
l) total comprehensive income attributable to non‐controlling interests and owners of the
parent
m) Additional line items may be needed to fairly present the entity's results of
operations.
n) No items may be presented in the statement of comprehensive income (or in the income
statement, if separately presented) or in the notes as 'extraordinary items'.
o) The AIS also requires for disclosure of the following, if material, either in the
statement of comprehensive income or in the notes.
p) write‐downs of inventories to net realizable value or of property, plant and
equipment to recoverable amount, as well as reversals of such write‐downs
q) restructurings of the activities of an entity and reversals of any provisions for the costs of
restructuring
r) disposals of items of property, plant and equipment
s) disposals of investments
t) discontinuing operations
u) litigation settlements
v) other reversals of provisions
The IAS further stipulates that the expenses in the profit or loss statement be categorized for
analysis either by nature (raw materials, staffing costs, depreciation, etc.) or by function (cost of
sales, selling, administrative, etc). Where the expenses are categorized by function, the IAS,

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additional information on the nature of expenses must be disclosed, for example at a minimum
depreciation, amortization and employee benefits expense.
EXAMPLE OF A SINGLE STATEMENT OF COMPREHENSIVE INCOME

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UNIT
STATEMENT OF FINANCIAL POSITION
6

LET’S STARTED
After studying this Unit, you will be able to:

 Describe the component elements found in the statement financial position

 Analyze and interpret the statement of financial position

STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)

The balance sheet statement provides an up to date statement of the financial position
or net worth of the company for a given period. It reports a company's assets, liabilities
and shareholders' equity at a specific point in time, and provides a basis for computing rates of

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return and evaluating its capital structure. It is a financial statement that provides a snapshot of
what a company owns and owes, as well as the amount invested by shareholders.

As stipulated by the International Financial Reporting Board, the statement of financial

position (balance sheet) presents and classifies the resources (assets), the obligations to
external parties (liabilities to creditors) and equity to shareholders for a certain period.
These comprise the accounting equation also known as the balance sheet equation, which
is expressed as:

The balance sheet is a snapshot representing the state of a company's finances at a moment in
time. By itself, it cannot give a sense of the trends that are playing out over a longer period. For
this reason, the balance sheet should be compared with those of previous periods. It should
also be compared with those of other businesses in the same industry since different industries
have unique approaches to financing.
A number of ratios can be derived from the balance sheet, helping investors get a sense of how
healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with
many others. The income statement and statement of cash flows also provide valuable context
for assessing a company's finances, as do any notes or addenda in an earnings report that might
refer back to the balance sheet.
The balance sheet can either be presented using a vertical format or a horizontal format.
The vertical format is mostly used for published accounts. According to the International
Accounting Standard 1,

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ASSETS
Within the assets segment, accounts are listed from top to bottom in order of their
liquidity – that is, the ease with which they can be converted into cash. They are divided
into current assets, which can be converted to cash in one year or less; and non-current
or long-term assets, which cannot.
Here is the general order of accounts within Current Assets:

 Cash and cash equivalents are the most liquid assets and can include Treasury bills
and short-term certificates of deposit, as well as hard currency.
 Marketable securities are equity and debt securities for which there is a liquid
market.
 Accounts receivable refers to money that customers owe the company, perhaps
including an allowance for doubtful accounts since a certain proportion of customers
can be expected not to pay.
 Inventory is goods available for sale, valued at the lower of the cost or market price.
 Prepaid expenses represent the value that has already been paid for, such as
insurance, advertising contracts or rent.
Long-term Assets include the following:

 Long-term investments are securities that will not or cannot be liquidated in the
next year.
 Fixed assets include land, machinery, equipment, buildings and other durable,
generally capital-intensive assets.
 Intangible assets include non-physical (but still valuable) assets such as intellectual
property and goodwill.
LIABILITIES
Liabilities are the money that a company owes to outside parties, from bills it has to pay
to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries.
Current liabilities are those that are due within one year and are listed in order of their
due date. Long-term liabilities are due at any point after one year.
Current Liabilities accounts might include:

 current portion of long-term debt

 bank indebtedness
 interest payable
 wages payable
 customer prepayments
 dividends payable and others
 earned and unearned premiums

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 accounts payable
Long-term Liabilities can include:

 Long-term debt: interest and principal on bonds issued

 Pension fund liability: the money a company is required to pay into its employees'
retirement accounts
 Deferred tax liability: taxes that have been accrued but will not be paid for another
year
SHAREHOLDER’S EQUITY
Shareholders' equity is the money attributable to a business' owners, meaning its
shareholders. It is also known as "net assets," since it is equivalent to the total assets of
a company minus its liabilities, that is, the debt it owes to non-shareholders.
Retained earnings are the net earnings a company either reinvests in the business or use
to pay off debt; the rest is distributed to shareholders in the form of dividends.
Treasury stock is the stock a company has repurchased. It can be sold at a later date to
raise cash or reserved to repel a hostile takeover.
Some companies issue preferred stock, which will be listed separately from common
stock under shareholders' equity. Preferred stock is assigned an arbitrary par value – as
is common stock, in some cases – that has no bearing on the market value of the shares
(often, par value is just $0.01). The "common stock" and "preferred stock" accounts are
calculated by multiplying the par value by the number of shares issued.
Additional paid-in capital or capital surplus represents the amount shareholders have
invested in excess of the "common stock" or "preferred stock" accounts, which are
based on par value rather than market price. Shareholders' equity is not directly related
to a company's market capitalization: the latter is based on the current price of a stock,
while paid-in capital is the sum of the equity that has been purchased at any price.
The International Accounting Standard 1 also requires that the minimum balance sheet items
should include:
a) Property, plant and equipment
b) Investment property
c) Intangible assets
d) Financial assets (excluding amounts shown under (e), (h), and (i)
e) Investments accounted for using the equity method
f) Biological assets
g) Inventories
h) Trade and other receivables

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i) Cash and cash equivalents

j) Assets held for sale
k) Trade and other payables
l) Provisions
m) Financial liabilities (excluding amounts shown under (k) and (l)
n) Liabilities and assets for current tax, as defined in IAS 12
o) Deferred tax liabilities and deferred tax assets, as defined in IAS 12
p) Liabilities included in disposal groups
q) Non‐controlling interests, presented within equity and
r) Issued capital and reserves attributable to owners of the parent
However, additional line items may be needed to fairly present the entity's financial position.
The International Accounting Standards further requires the following disclosures in relation to
issued share capital and reserves:
a) numbers of shares authorized, issued and fully paid, and issued but not fully paid
b) par value
c) reconciliation of shares outstanding at the beginning and the end of the period
d) description of rights, preferences, and restrictions
e) treasury shares, including shares held by subsidiaries and associates
f) shares reserved for issuance under options and contracts
g) a description of the nature and purpose of each reserve within equity
EXAMPLE OF STATEMENT OF FINANCIAL POSITION

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UNIT
STATEMENTS OF CASH FLOW
7

LET’S STARTED
After studying this Unit, you will be able to:

 Describe the component elements found in the statement cash flows

 Analyze and interpret statement of cash flow

STATEMENT OF CASH FLOWS

A cash flow statement is a financial statement that provides aggregate data regarding all cash
inflows a company receives from its ongoing operations and external investment sources. It
also includes all cash outflows that pay for business activities and investments during a given
period.

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The requirements for the presentation of the cash flow statement is stipulated in the
international accounting standard (IAS) 7. Generally the information for the preparation of the
cash flow statement is drawn from other accounting and financial statements, such as the
manufacturing account, the trading account, the profit and loss account, the profit and loss
appropriation account and the balance sheet.
A company's financial statements offer investors and analysts a portrait of all the transactions
that go through the business, where every transaction contributes to its success. The cash flow
statement is believed to be the most intuitive of all the financial statements because it follows
the cash made by the business in three main ways—through:

 Operating Activities- cash effects of transactions that create revenues and expenses
Operating Activities generally related to changes in current assets and currents
liabilities
Examples:
 CASH INFLOWS- Sale of goods/ services, interest income received on
loans, dividend income received on equity securities
 CASH OUTFLOWS- payment to suppliers, salaries and wages paid to
employees, taxed paid to the government, interest expense paid to
creditors and payments of other expenses

 Investing Activities- generally related to changes in non-current assets

Examples:
 CASH INFLOWS- sale of property, plant and equipment, sale of debt or
equity securities of other firm, collection of principal on loans
 CASH OUTFLOWS- purchase of property, plant and equipment, purchase
of debt or equity securities of other firm, lending of money to other firms

 Financing Activities. The sum of these three segments is called net cash flow.
Examples:
 CASH INFLOWS- sale of company’s own stocks, issuance of bond or notes
 CASH OUTFLOWS- payment of dividends to stockholders, redemption of
long-term debt, reacquisition of capital stock

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UNIT
ANALYSIS OF THE FINANCIAL STATEMENTS
8

LET’S STARTED

After studying this Unit, you will be able to:

 Describe the component elements found in the statements comprehensive income,

financial position and cash flows
 Tell the difference between the various financial statements
 Analyze and interpret the different financial statements

ANALYSIS OF THE FINANCIAL STATEMENTS

Businesses constantly gauge the performance of the business in terms of its management,
plans, financial situation and strategies to inform decision making. Business analysis is
therefore deemed an important exercise of the firm as it informs stakeholders about the state
of the firm.

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Financial Statement Analysis is based on the financial statements, which have been introduced.
It involves careful selection of data from financial statements in order to assess and evaluate
the firm’s past performance, its present condition and future business potentials. It is normally
performed by organizations and business analyst to highlight the company’s financial position.
The information derived from the analysis could help the business managers and investors to
gauge the financial position of the company by addressing questions pertaining to
availability of resources for growth and for investment. Other questions that could be
addressed by financial analysis to the managers and investors pertain to the level of
profitability of the firm and generally as to whether the company performs as was
expected.

Objectives
The primary objective of FS Analysis is to evaluate and forecast the company’s financial health.
Interested parties, such as the managers, investors and creditors, can identify the company’s
financial strengths and weaknesses and know about the:
1. Profitability of the business firm
2. Firm’s ability to meet its obligations
3. Safety of the investment in the business; and
4. Effectiveness of management in running the firm
Problems and Limitations
1. Comparison of Financial Data
a. Differences between companies- a ratio that is acceptable to one company may
not be acceptable to another when other factors are considered.

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b. Differences in accounting methods and estimates.

c. Valuation problem- financial statements are based on historical costs and
therefore, do not reflect the current market value of the firm’s assets. More so,
the effects of price level changes must be considered.
d. The timing of transactions and use of averages in applying the various techniques
in FS Analysis effect the results obtained.
2. The need to look beyond ratios

Ratios are not sufficient in themselves as basis for judgments about the future. Other
factors must be considered, such as:
a. Industry trends
b. Changes in technology
c. Change in consumer tastes
d. Changes in the economy as a whole
e. Changes that are taking place within the company itself

Techniques Used in FS Analysis

1. Horizontal Analysis (trend ratios and percentages)
2. Vertical Analysis (common-size statements)
3. Ratio Analysis
4. Cash Flow Analysis

HORIZONTAL ANALYSIS
Also known as trend analysis is a FS analysis technique that shows changes in the amounts of
corresponding financial statement items over a period of time. It is a useful tool to evaluate the
trend situations. It involves comparison of figures shown in the financial statements of two or
more consecutive periods. The difference between the figures of the two periods is calculated,
and the percentage change from one period to the next is computed using the earlier period as
the base.

Example:
Increase (Decrease)
  2018 2017 Pesos %
Sales 3,280.00 2,950.00 330.00 11.19%

3,280-2,950 =11.19
*Percentage change
2950 %

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VERTICAL ANALYSIS
is a popular method of financial statement analysis that shows each item on a statement as a
percentage of a base figure within the statement. The process of comparing figures in the
financial statements of a single period. It involves converting of figures in the statements to a
common base. These converted statements are called common size statements or percentage
composition statements.

To conduct a vertical analysis of balance sheet, the total of assets and the total of liabilities and
stockholders’ equity are generally used as base figures. All individual assets (or groups of assets
if condensed form balance sheet is used) are shown as a percentage of total assets. The current
liabilities, long term debts and equities are shown as a percentage of the total liabilities and
stockholders’ equity.

To conduct a vertical analysis of income statement, sales figure is generally used as the base
and all other components of income statement like cost of sales, gross profit, operating
expenses, income tax, and net income etc. are shown as a percentage of sales.

 Balance Sheet:

*Current assets:
2018: (550,000 / 1,139,500) × 100 = 48.3%
2017: (530,000 / 1,230,500) × 100 = 43.3%

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 Income Statement:

*Cost of goods sold:

2018: (1,043,000/1,498,000) × 100 = 69.6%
2017: (820,000/1,200,000) × 100 = 68.3%

RATIO ANALYSIS
Ratio analysis provides ways of comparing and investigating the relationships between
different pieces of financial information. There is a wide range of financial ratios ranging
from simple to complicated computations. Ratios are calculated from financial statements to
provide users of such statements with relevant information about the firm’s liquidity, use of
leverage, asset management, cost control, profitability, growth and valuation.

The following questions need to be taken into consideration when analyzing statements
using ratios:
1. How is the ratio computed?
2. What is the ratio intended to measure, and why might we be interested?

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3. What is the unit of measurement?

4. What might a high or low value be telling us? How might such values be misleading?
5. How could this measure be improved?

a. LIQUIDITY RATIOS- provide information about the firm’s ability to pay its current
obligations and continue operations.
RATIO FORMULA SIGNIFICANCE
__Current Assets__ Test of short-term debt paying
Current Ratio
Current Liabilities ability

___Quick Assets*__ Measures the firm's ability to

Acid Test Ratio or Quick Current Liabilities pay its short-term debts from its
Ratio most liquid assets without
*Quick Assets= Cash + Cash equivalents + having to rely on inventory
Net Receivables + Marketable Securities

b. PROFITABILITY RATIOS- measure earnings in relation to some base, such as assets, sales
or capital.

c. ASSET MANAGEMENT RATIOS- measure how the firm uses its assets to generate
revenue and income

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d. LEVERAGE RATIOS- measure the company’s use of debt to finance assets and
operations

e. COST MANAGEMENT RATIOS- measure how well a firm controls its costs

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f. GROWTH RATIOS- measure the changes in the economic status of a firm over a period
of time

g. VALUATION RATIOS- measure of shareholder value as reflected in the price of the firm’s
stock

CASH FLOW ANALYSIS

Cash flow is the primary focus of the financial manager both in managing finances and in
planning and decision making aimed at value creation of business. Important factors
affecting cash flow are any non‐cash charges e.g. Depreciation. From an accounting
perspective, cash flows of a business can be summarized in the statement of cash flows.
Whereas, from a financial perspective, business often focus on both operating cash flow,
and free cash flow. Operating cash flow is used in managerial decision making and free cash
flow is closely watched by investors and other parties.
 OPERATING CASH FLOW
Operating cash flow (OCF) of a business is generated by its normal operations of
producing and selling its output of goods or services. A variety of definitions of OCF can be
found in the financial literature. Equation introduced the simple accounting definition of
cash flow from operations. Here we refine this definition to estimate cash flows more
accurately. Unlike the earlier definition, this one excludes interest and taxes in order to
focus on the true cash flow resulting from operations without regard to financing costs and
taxes. Operating cash flow (OCF) in financial management terms it is defined in following
equation:
Operating Cash flow = Earning before interests and taxes ‐ Taxes+ Depreciation

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or
OCF = EBIT –Taxes + Depreciation

 FREE CASH FLOW

The free cash flow (FCF) of a business is the amount of cash flow available to
investors—the providers of debt (creditors) and equity (owners)—after the firm has met all
operating needs and paid for investments in net fixed assets and net current assets. Free
cash flow can be defined in equation form as:
Free cash flow = Operating Cash Flow ‐Net fixed asset investment ‐ Net current
asset investment
or
FCF = OCF – NFAI ‐ NCAI

The net fixed asset investment can be calculated as follows:

net fixed asset investment (NFAI) = Change in net fixed assets +Depreciation

LET’S SUM UP!

This unit described how capital is allocated and how the financial institutions, markets and
instruments used in the capital allocation process.
Financial institutions serve managers of firms as intermediaries and channel the savings of
individuals, businesses and governments into loans or investments. It has various categories
and diversified services being offered to their major customers. Financial institutions also
expanded internationally.
Financial Markets facilitate an efficient transfer of resources from individuals or business firms,
government who have idle resources to others, individual or business firms, government, who
have a pressing need for them is achieved through. It offers various types of market
securities and accommodates the needs of business firms who wish to invest their temporarily
excess funds/savings and of the investors who wish to liquidate their investments with the
intention of spending the proceeds or investing them in alternative investments.
Businesses, individuals, and governments often need to raise capital and if financial managers
are to make good financial decisions, they must understand how financial institutions and
markets operate.

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