, .

• I ,

UNIT .I.I -

Evaluating Operating and

Perfor,-.ance
· · · Financial _
\

\ I

Chapter

5 -Understanding Financial Statement s

Assessment of the Firm's .Operating - .

Efficiency and Firuu1cial Position Through ~· ·
E'inancm,tstatemertts Analysis
I
I ,

7 ·c ash ~PW An~lysis . . '

8 Operating and F~nancial Leverage

 CHAPTER
.
UNDERSTANDING
_FINANCIAL STATEMENTS
I I

,·
~pectdl.earnin_J Oufcome1
Aft~r studying Chapter 5, you should be able to:

1. Understand how business activfties are reported

through the financial statements. · \ .

2. Apprecfate the·general _objectives of financial

· · statements.
3. Enumerate and identify the needs of various users •
that demand financial accouriting·in.formation.
-
4·. Enumerate -the sources of information about a
business enterpris:e.
5. Unde,:stand the benefits.and costs of supplying
accounting information.
6. . Identify the required financial statemen,ts and know
· . how they are interconneotetj. - .
7. Know the nature and significance of the ·
a. Statement of Financiai Position or
Balance Sl:)eet Statement
.' b. Statement of Comprehensive income

·I
,_ ·c. Statement of Sto~kholders' Equity, and
. d .i Statement of Cash Flows

♦ ♦ • ·• ·
 CHAPTER 5

UNl>ERSTANDING FINANCIAL .... ·

. . . STATE MENT $ . · · .. ~..
I r

INmOou tnON ' I /

.
Th·is·chaptety,rovides a framewor~ and_ sev~~I t~ls to help. us a~alyze companies
-and valne.'t°heir se.curities. At this pomt, 1t 1s helpful to imagine yourself as a .
sr,e¢ificuser<iffinancial statements. For example, assume that you are a manager
deciding whether to acquire another company or dfvest ~fa current division? Or
imagine you,rself as an equity or credit analyst - 'how do you ,assess and
communicate an investment appraisal or credit risk report? This focused
rperspectivewm enhance one's learning process and ma~es it relevant.

HOW BUSINESS AC11VIT IES ARE REPORTED

Yo be abJe to analyze a company effectively or infer its value, it is importa~t that

one must understand the company's business activities. This can be accomplish ed
through the financial statements . Financial statements report on a company's
perfonnance and financial condition and reveal executive manageme nt's
privileged information and_insights.

Financial statements serve the rieeds of different · users. The operation of the
accounting informatio n system involves application of accounting standards to ..' '
produce .financial statements t~~ provide .the insight oil .t he business activities of . . · t
the company under analysis. · ' . '
1

Accountin g informatio n should be used in the business context in which the

informatio n is created. All companies without exception, plan business activities,
finance those activities," invest in those activities and then, engage in operating
activities. Business firms conduct all these activities whi,e confronti.n g business
forccc~ including market constraint s and competitiv e pressures.

Financial statements also provide crucial input for strategic planning, as well as,
informatio n about the relative ~uccess of tho~ plans which can be used to
corrective action and make new operating, in~esting and financing decisions.
 "' . Under~tanding Financial Statements

GENE~ L OBJE ~ES OF FINANCIAL STATEMENTS

The important objectiv.es of financial statements are:

1• Providing 'Information for Economic Decisions

The ~conomic decisions that are taken by the users of financial statements ,
require an evaluation of the ability of an enterprise to generate cash and
c~~ •equi~alents, an<i the timing and certainty of their.generation. This
ab1hty ultimately determines the capacity of an enterprise to pay its
employees and suppliers, meet interest payments, repay loans and make -
distributions to its owners.-

2. Providing Informal/on About Financial Position

The financial position of an enterprise is affected by the economic

.;resources such as:

a. Infon,nation about the economic resources controlled by the. enterprise

and its capacity ih the past to modicy these resources is useful in
predictin·g the ability of the enterprise to generate cash anci cash
• I

equivalents in ~e future.
I •

b. . Information about financial structure is useful in predicting future

borrowing needs and how future profits and cash flows will be
distributed among those with an intere'st in the enterprise .

-c. lnfor~ation is ·usefu( in predicting how successful the enterprise is

likely to be in raising further finance. ·

d. Information about liquidity and solvency is useful in predicting the

ability of the enterprise to meet the financial commitments as fall due.
Liquidity refers to the availability of cash in the near future after taking
account of financial commitments _and solvency _refers to the
· · availabtlicy- of cash over th_e longer term to meet financial
.commitments as they fall due.

I •
 ~ Chapler5 . ' .
3. Providing Information Abou t Performance ofan Enterprise

Another importa,nt objective of the financi~I statem·~nts is that, it_provides

information about the performance and in particular its profitability, which
rces
· is required in order to assess potential. change~ in the econolJlic resou
of
t~at are -likely to contro! the future. Information a!>out variab'ility
the
performanc~ is important and useful in predic~ing the capacity of ,.
in
enterprise to generate cash flows from. its ~xist~ng resource base, and
t'
forming judgm ent about the effectiveness with whi~h ·the enterprise 'migh
employ additional resources. .- . ,.

4. Provit!ing Information about.Changes in Fina ncial Position

I
I
the
The financial statements provide information. concerning changes in
s its . ..
financial position of an enterprise, which is useful in -orde r to asses
I

d.
investing, financing and operating activities during the reporting perio
the
T~as· information is useful in providing the user with a basis to ass·ess
the
ability of the enterprise to generate cash and cash equivalents, and
needs of the enterprise to utilize those cash flows .

·INFO RMATION.
DEMAND FOR FINANCIA
' . TING
L ACCOUN -

comp any's
. Decision 'm&kers and other stakeholders demand information on the
g-and risk-
past,and. prospectiv~ ·returns and r.isks· to· facilitate· efficient contractin
sharing.
n in.elude
The broad classes of users that demand financial accounting ·informatio
the following: - · '
.· .

I. Manage~s and Employees _

and· · ,, -
For their own w~ll-being .and prospective earnings, potential mana gers
ition,
employe~s need accounting information on the financial cond
e , <·
profitabiHty and prospects of their companies· as well ~s comparativ
es. ·
financial information on competing companies and business opportunit~
any,
Mana geme nt uses ~nancial statements to raise fin~ncing for the comp
tive
to meet disclosure requirement and to serve as a basis for execu
osure·
remuneration 'and bonuses, for wage · negotiations .and to meet· di~cl
requirements.

I '
 ------ Understanding Financial Statements SS --
2. inve~ on and Analysts ·
I
' )
Financial statements are used by th . ·
sell equity share E . ese parties to decide whetber to buy or
• te h . sfl. X~JO about future profitability and theability to
genera cas m uencethe ns pn·ce f .. . _
borrow money at favorable term o0th secuntr es and a company's ability
. fi . .• . .
to
fl · . • • s. er m ormat10 n mtermedranes such
as, . n~nc19:1 press wnters and investment analysts are interested in
pred1ctmg_companies'.future performance.
I •

3. Creditors and Suppliers

I

Banks ~n~ other lenders need financial accounting information to help

detennme loan t~rms, loan amounts, interest rates and required collateral.
Suppliers demand fiQancial data to establish credit terms and to detennipe
their long-te~m commitment to supply~hain relations. Both creditors and •
suppliers use information to monitor and adjust their' contractual
requirements·and environment with a busi'ness finn.
I

4"1 Shareholders and Directors

Financial ~ccounting. information are needed by owners and directors ~f

the company to assess its profitability and risks, to evaluate managerial
perfor~an<;e an~ to help make leadership-decisions.

5. Regulatory and Tax Agencfes

Th~ , SEC, BIR, BSP an<i other legal in~titutions demand financial
accounting information to monitor the business-firm_s' complianc.e with
, laws, for public protection, price .setting and for setting tax and other
regulatory policies. . . ,

6. Custo,ners and Potential Strategic Partners

Customers both current and pote-ntial, need acco~nting infonnation to

evaluate a company's ability to provide products and services as agre~d
and · to assess the company's reli~b~lify and s~y_ing po~e_r.· Poten~1a\ _
str:ategic partners would wish to estimate_ the firm_s pro~tab1l~ty to as~ess
the fairness of returns <?" mutual tran~ct1ons and strateg1c ~lhances.
 56 Chapter 5

.. s
7. Other decision maker ,
Financial accounting infonnation ~e required for vari~d purpose_s by other .
parties from assessing damages for_e·nviron~ental abus~s ~o.n:ia~1~g_policy I ,
.
decisions involving economic, social, taxation and other IJ)ttlat1v~.
('

SOURCES OF INF~RMATION ABOUT BUSINESS_. ENTE~PRISE

ln general, the quantity and quality of accounting in!ormation that ·companies .,

supply are detennined by manager's asse~sment of th~ benefits and co~ts of
disclosure. In the Philippines, publicly -listed compame~ must file financial
acc.ountfog infonnat,ion ~ith the Securities and ~xch~nge Com~ission (SEC).
These are; ·

I. The audited annu~I report that includes ~he four financial statements
(Statement of Financial Position .[traditionally known as the Balan ce Sheet
Statement], Statement of Comprehensive Income, Statement of
Stockholders ' Equity, and Statement of Cash Flow) with explanatory notes
and the management' s discussion and analysis of financial results.
'
2. The unaudited quarterly or interim reports.that include summary v.ersion
of the four fin~ncial stat~ments and limited addition~! disclosure.

All other registered ·corporations and partnerships are likewise required to file -
annually audited financial statements with accompa~1ying explanatory notes ·with ·_
the SEC. .

BENE ms OF DISCLOSURE
'
'

The advantages of supplying accounting· information extend to a company's

· ~ital , labor, input and output markets: Companies compete in these markets. For
mstance, debt and equity financing are sourced fr.om capital markets and the better
a comp~ y's prospec~, the lowe'r will be its cost of capital as reflected in higher
stock P~~s or lower rnterest rate. The same is true for a compa ny's recruitment.
efforts m labor markets and its ability to establish and maintain superior supplier-
customer relations in the input and outp~t markets. '
. .
The company' s abi~ity to disclose reliable (~uditeiesd)°enable
ac·co.unting information about
them to·better compete
~ts pr~uc ts, processes and other business activit
m capital, labor, inp~t and output markets. I .· · · ·
~
I
 ',

Understanding Financial Statements 57

COSTS OF DISCLOSURE
• • I
. . . \
The preparation and dissemination . . ·
be substantial . and. the •b·i·costs of_supplym_g accounting informati~n can
disadvantages high.is 1
poss, •~ for mformatmn to produ~ competitive

Companies are apprehensive. that disclosures ofth e1r .-.t1vrt1es sueh as~prod uct or·.
· ...1.. • • •
segmen t successes or . failures .
strate · · · · · ·
.. . . ., g1c m1t1at1ves, technological or systems
mnovat1ons could _
harm their comnPtitive advantages c · 1 &.
· "bl 1 • • · r·.... . ompames a so ,ace
p~ss1 e awsmts ~hen ~•sclos~r~s create expectations that eventually are not met.
D1~closure costs mcludmg polrtacal costs are high for highly visible companies
such as_ large tel~mmunication conglomerates (e:g. PLOT and Digitel1 oil
com~~mes and softw~e companie~ because they are favorite targets of p'ublic
scrutmy. . ·
• I•
..
CONSTRAINTS ON REL-EVANT-AND RELIABLE INFORMATION

I • Timeliness
. '
If there is _undue delay in the reporting of information, it may lose its
relevance. Management may need to balance the relative merits of timely
reporting and th~ provision of reliable, information. To provide
information on a timely basis, it may often be necessary to report before
al I aspects of a transaction or other event are· known, thus impairing
reliability. Conve~ly; if reporting is delayed until alLaspects are-krio~ri,
the information may be highly reliable but of little use to users who hav·e
. had to make decisions in-the interim.n-n achieving. a balance between /

.. relevance and reliability, the overriding consid~ration is how best.to satisfy

the economic d~ision making needs of users.
. . . ""
2. Balance Between Benefit and Cost

The balance betw~en benefit.and cost is a pervasive constraint rather than

a qualitative characteristic. The benefits deri~e~ from info~mation shou~d ~
exceed the cost of providing it. The evaluatwn of benefits and costs 1s,
however, substant~ally ajudgmental·process.

I \
I
,s Chapter 5
.,
s
3. •Balance Between Qualitative Characteristic
I I
,

Htative characteristics is
In practice, a balancing or trade-off between quJ
an appropriate balance
often necessary. Generally, the aim is to. achieve
objective of financiai
among the characteristics in -order to meet the
eristics in different cases
statements. The relative importance oft~ e charact · .
·
. l judgment. ·
is a matter of professiona ~

) .

4. True Fair View or Fair Presentation

showin·g a true ·and fair .,
Fina~cial statements are· frequently described ·~
chan·ges in financial ·
view of the financial position, perforniance and
rk does not d~al directly _, -::
position of an enterprise. Although, _this framewo
principal qual~tative · ·
with · such concepts, the applications .o f the
dards, normally results . . ,.
characteristics and of appropriate acco1:1nting stan
ly unders(ooo·as a true ·
in finahcial statements that convey what·is general ·
and fair view of such information . - I. • \

FINANCIAL STATEMENTS ·.
companies using four financial
Business activities are periodically reported by
n, Statemen~ of Comprehensive
statements: the Statement of Financial Positio
the Statement,of Cash Flows .
Incon:ie, Statement of Stockholders' Equity and
..
rconnected across time. A
Figure 5-1 shows how these statements are int~ ncial -p,osition <;it .a
pan y's: fina
Statement of Fina~cial Pos~tion rew rts on ·a com
sive Income, Statement_ of
point in time. Tjle .Statement . of Comprehen
Flo ws _report on performance over ' ,
Stockholders' Equity and the Statement of Cash
a per iod of·time.
J link the statement of financial
The thre~ statements in the middle of Figure 57"
position from ~e beginning to the end ~fa period.
• 1

, I

,.
·, '

• •1
 Vnder,tanding Financial Stat eme nu 59

. ,
. ,

,.
Statement of
•
I Cash Flows ~-
.
Stat eme nt of Statement of
Financial
. Financial .
Statement of
' Position Stockholders' Position
~

, F.quity
' .
,

(beg inni ng-o f. (end-of•

•period) period)
.
Statement of .
I
Comprehensive ''
. . Income
. ~

,
I

' : •

e
~igure S.l. Financial Statement Links across Tim
'
UNKAGE OF FINANCIAL STATEMENTS
other and linked across time.
The fou r financial statements are linked with each
succeeding section •demonstrates
Thi s linkage is also kriown as articulation. The
nge Inc.
the articulation of financial statements using Ora
t of comprehensive income are
The statement of finaneial position and statemen
u~ ed each period and reflect
linked via retained earnings. Retained earnings are
ted to shareholders. Figure 5-2
cum ulat ive income that has not yet been distribu
n for 20X4.
sho ws Ora nge Inc. retained earnings reconciliatio

ORANGE INC . ·
Retained Earnings Reconciliation
For the Year Ended September 30, 20X4
(pesos in millions)

P5.607
Retained earnings, September 30, 2013
3.496
Add:· Net income . (0)
Less~ Divi9ends , (.002)
· Oth er adjustme~ts
, P9,IQI
Retained earnings, September' 30, 2014

Figure' S.2. Retained Earnings Reconciliation

. .
 60 Chapter 5
-
In the absence of1ransactions w.ith stockholders (e.g., st~k issuances, repurchases
and dividend payments), the change· in stockholders' equity equ~s income or ioss
for the period. The income statement, thus, measures the change 10 company value
as measw-ed in accordance with financial reporting standards.. This is not
oecessariJy company value as measured by the market. Of course, alJ value-
relevant items eventually find their way into the income stateme~t. So, from a long-
tenn perspective, the income statement does measure change m company vaJue.
This is why stock prices react to reported income and to analysts' expectatio!lS
about future income. -

Orange Jnc. begins the fiscal year 20X3-20X4 with assets of Pl}.205 million,
consisting of cash for P6.392 million ancl noncash assets for PI0.813 miJJion. ·;...
These investments are financed with P7.221 million from nonowners and P9.984.
million from shareholders. The owner financing consists of contributed capital of
P4.355 million, retained earnings of PS.607 million and othe~ stockholders' equity ·
of P22 million. .

Figure 5-3 shows statement of financial position at the beginning and end of
Orange Inc. The statement of cash flows explains how operating, investing and
. ,,,
financing activities increase the cash balanee by P2.960 million from P6.392
mi11ion at d1e beginning of the year to Jt9)52 million at year-end. ·

Orange Inc. 's PJ.496 million net income reported on the i~come statement is also
carried over to the statement of shareholders' equity. The net income explains
nearly all of the change in retai~ed earnings reported in t~e st~temen{ of
1

shareholders' equity because Orange Inc. paid no dividends in that year (other ,
adjustments reduced retained earnings by P.002 million).

There is an order to financial statement preparation. First,' a company prepares its

income statement using the statement of comprehensive income accounts. It then
uses_the net income num~er and dividend information to updat~ the retained_
earnmgs a~unt. S~nd, ,t prepares the statement of financial position using the
u~~ed reJamed earnmgs acco~nt along with the remaining statement of financial
posit,on acc?unts . from the tnal balance. Third, it prepares the statement .o f
~tockh~l~ers t:_<JUlty. Fourth, it prepares the statement" of cash flows using
mformat1on frorn the cash accounts and other sources.

I ' ..
 Understanding Financial Statements 61

SfJltement or Fiaandal Position

September 30, 20X4 & lOXJ
(pesos in million,)

20X4 lOXJ
Assets
. Cash·
P 9.352 P 6.392
Noncash assets ,s.m 10.813
Total 1mets '25.347 Pl 7.205

Liabilities and Owners' equity

Total liabilities
Owners· equity
PI0.815 . P 7.221

Contributed capital 5.368 4.355

Retained earnings 9.101 S.607
Other stockholders' equity .063 .022
Liabilities and Owners· equity P25.347 Pl7.205

Statement of Cash Flows Statement of Comprehensive Income

For the Vear Ended September 30, 2.0X4 For the Year [nded September JO, 20X4
(pesos in millions) (pesos in millions)

Operating cash flows P 5.470 Revenues P24.006

Investing cash flows (3.249) Expenses 20.SI0
Financing cash flows .739 Net earnings P 3.496
Net change in cash P2.960

Cash balance, Sep. 30, 20X3 6.392

Cash balance, Sep. 30, 20X4 P9.352

Statement of Stockholders' Equity

For the Vear Ended September 30, 20X4
(pesos in millions)

Contributed capital. Sep. 30. 20X3 P4.355

Stock issuance 1.013
Contributed capital, Sep. 30, 20X4 P5.368

Retained earnings, Sep. 30. 20X3. P5.607

Net income 3.496
0
Less: Dividends
Less: Other adjustments (.002)
Retained earnings. Sep. 30, 20X 4 P9.i01 '

Othe.r 'stockhold~rs• equity. Sep. 30, 20X3 P .022

Other changes in equity _ .041
. Other stOQCholders' equity, Sep. 38. 20X4 P .063

Figure 5-J. Articulation of Orange Inc. Financial St~tements

 l

62 Chapler5
STATEM,:NT OF FINANCIAL POSITION . '
. . .
A SJalement ofFinancial Position reports a compan y's financial position at a point
in time the comp.my's resources (assets) namely, what the compan y owns and also
the. so~rces of asset financing. There are two ways a compan y can finance -its
assets:
1 r Ownerfinancing. It c~ nuse money from shareho lders.
2. Nonowner financing. It can also raise money from banks or other
· creditors arid suppliers..
This , means that, both owners and nonown ers hold' claims on compan y assets.
• I
Owner claims on assets are referred to as Equity, and nonown er claims are referred
to as Liabilitie~ {or debt). Since all financing must be invested in somethi ng, we .
obtain the follo~ing basic relation : (investi ng= financin g). This equali~ is cal.led
the accounting equaiion which follows: (assets::::; liabiliti es+ own~rs ' equity).

Blue Compan y
r Stateme nt of Financial Position
,- December 31, 20X4
Report amounts
at a point
in time
, (pesos in millions)

( lnvestin2
~ Assets

Cash , 88.658
Total Noncash assets / 457.662
r1"~11rr.-c
Total assets P 546.320

( Financin2
~ Liabilities and Owners ' equity

I ,,.- Tota1 liabilities P 299.518 I

/
" Owners' Equity '
Nonowner
claim on Contributed capital 53.920
resources Retained earnings 144.306
\. ~ Other equity• 48.576 I

' '
Owner Total Owners' equity 246.802
claim on
resources
Total li~bilities and owners' equity r 546.320
Figure S-4. Statement of Financi al Position ·

• Financial statement titles sometimes begin with word consolidated. This means that the
financial statement includes a parent company and one or more subsidiaries, companies that
the parent company owns. For Blue Company, other equity includes accumulated other
comprehensive income and minority interests. ' ' ·
 Understanding Financial Statements 63
Investing Activltlu
St.atemenf
. . . of financial
· position ,·s. orgamLNU
·---' 1I·1ce
· •
the accountmg •
equation. •
Investing
activb•!•es _are _refpresented by the company's assets. These assets are financed by 8
~m matton o nonowner finan.cing (liabilities) and owner financing (equity).
Financing Activities
Assets must be p~id for, and funding is provided by a combination of owner and
nonowner financmg. Owner (or equity) financing includes resources- contributed
to th~ company by its owners along with·any profit retained by the company.
Nonowner (creditor or debt) financir,g is borrowed money. We distinguish
between these two financing sources for a reason: borrowed money entai Is a legal
obligation to repay amounts ow~ and failure to do so •can result in severe
consequences for th~ borrowel Equity financing entails no su~h obligation for
repayment.

· Some questions. that a reader of the Statement of Financial Position of Blue

Company might have at this early stage are:
,, .
• Blue Company reports P88.658 million of cash on· its 20X4 statement of
financial position, which is 16% of total assets. Many investment-type
companies s·uch as Blue Company and high-tech companies such as Cisco
,Systems carry high levels of cash. Why is'that? ls there a cost to holding
too much cash? Is it co_stly to'carry too little cash? ·1
• The relative proportion of short-term and long-term assets is largely
dictated by companies'·business models. Why is this the case? Why is the
composition of assets on statement of financial position for companies in
the same industiy similar? · By what. degree can a company's asset
composition safely deviate from indus1!)' norms?
• What are the 'trade-offs in financing a c9mpany by owner versus nonowner
financing? If nonowner financing is less costly, why• don't we see
companies financed entirely w·ith borrowed money?- .
• How do shareholders influence the strategic direction of a company? How
can' long-term.creditors influence strategic direction?
·• . Most assets and liabilities are ·reported on t~e .statement of financial
pQsitior:i at their acquisition l?rice, called hi~~ori~al c~st. Would reporting
assets and liabilities at fair values be more u1fonnat1ve? What problems
might fair-value reporting c~use? . . .. ,
Review -'~e Blu~ C6~pany Statement of Financial Position s~mmar~zed in Figure
5~4 and think about these questions. ·
 •
64 "'Chapter 5 ·

Working Capital
Cu~nt ~sets are
often called working capital .because these assets ''tum over", -
that is, they are used ~d then replaced throughout the year. . . _. ,

t
11.1 Icing carpital is the difference between current assets min~s current
He wo~ · I · h d·ffi ··b
liabilities while net operating working _cal!'!'! ts t e I erenc~ etween c~rrent
assets and non:interest bearing current habtltties.

STATEMENT OF COMPREHENSIVE INCO~E

The statement ofcomprehensive,income reports on a company's performance over

a period of time and 1ists amounts for revenues (also called sales), expenses and
other comprehensive income. Re~enues less expenses yield the bottom-line net
income amount. Figure 5-S shows ·· the Blue Company Statement of
Comprehensive fncome. Refer to .its income statement to verify the following:
revenu~s = P236.490 million; expenses = '210.064 million; and net- income
P26.426 million. Net income reflects the profit (also called earnings) to owners for ·
that specific period.
Report amounts over
a p·e nod of time
Blue Company
Statement of Comprehensive Income
For Year Ended December 31, 20X4
(pesos in_millions)
--
~
~

Goods Or services
· provided to customers
Reyenues P236.490 -~-
Expenses 210.064
Net Income (loss) 26.426 Costs incurred to
Other comprehensive income 0 generate revenues
Total P26.426

Figure 5-S. Statement of Comprehensive l~come

Manufacturing and merchandising companies typically 'include an additional

e'xpense account, called cost of goods ~old (or cost of sales), in the statement of
comprehensive income following revenues. It is also commoh to report a subtotal ·.
called gross pro.fit (or gross margin), which is revenues less cost of goods sold.
The company's remaining expenses are then reported below gross profit. This
income statement layout follows: ·
'
 Understanding Finan,cial Stat~ents 65
R,evenues
t
CoS of goods sold ~ Cost of materials, labor and overhead
= Gross profit ••---Revenues less cost of goods sold ·
Expenses ~ Expenses other than product cost of sales
= Net income (loss)

OperaJing A;ctiv/tia

Operating activiti~ use company "resources to produce, promote and sell its
produ_cts and serv1~. ~ese activities extend from input markets •involNing
supphers of matenals and labor to a company"s output markets involving
customers of products and services. Input markets generate most expenses (or
costs) such·as inven,tory, salaries, materials and logistics~Output markets generate
revenues (or sales) to cust(?mers. Output markets also generate some expenses
such as marketing and distributing products and services to customers. Net income
arises when ·revenues exceed expenses. A loss occurs when expenses exceed
revenues.

Differences exist in the relative profitability of companies across industries.

Although ·effective management can increase the profitability of a company,
business models play a large part in determining company profitability.

The followia:ig questions might be considered regarding the Statement of

Comprehensive Income.

Assume that a company sells a product to11 customer ~ho promises to pay
in 30 days.. Sltould the ~Iler recognize the sale when it is made or .~hen
·cash is c;ol1ected?

•
I
When 1 company purchases a long-term asset such as a building, its cost
is reported on the sta~ement of financial position as an asset. Should a
company, instead record the cost of that building as an expense when it is
acquired? If not, how should a company·report the cost of that asset'over
the course of its useful life?
• Manufacturers and merchandisers report the co~t of a product .as an
expense when the product sale is' recorded: How might we measure· the
costs of~ product that is old by a.merchandiser? By a manufacturer?
• If an asset, such as building, increases i_n value that increase is not_~p~rted
as income until 'the building is sold,_1f ever. What concerns anse ·1f we
record increases in asset values as part of income, when measurement of
that increase is based on appraised values?
 ..U Chapter J = , - := _

• Employees commonly eam wages that are ~et t~ be paid at the en_d of a
particular period. Should their wages ~e recognized as an ~pense in the
period that t_he work is performed, or when the wages are patd?
• Companies are n~t allowed to, report p~ofit on transacti_o ns ~elating to their
own stock. That 1s, they don t report mcome when stock 1s sold, nor do
they report an expense when divi~ends are paid to sharehol ders. Why is
this the case?
I
Review the Blue Company Statement of Compreh ensive Income summari zed in
Figure 5-5 and think about these questions. ·

STATEMENT OF STOCKH OLDERS ' EQUITY

The statement of stockholde_rs' equity reports on changes_in key types of equity

over a period of time. For each type of_equity, the statemen t reports the beginning
balance, a summary of the activity in the account during the year and the ending ,.
balance.
/

Blue Company
Statemen t or Stockho lden' Equity
For Year Ended Decembe r 31, 20X4
(pesos in ·millions)

Contributed Retained · Other

Capital Earnings Total
Equity

December 31, 20X3 P53,060 Pl 17,824 PS0,478 P221,362

Stock issuance
(repurchase) 860 860
Net income (loss) 26,426 26,426
D~vidends (0) (O)"
Other 56 (19Q2) (1'.846)
December 3 1, 20X4 P53.920 Pl~,3Q6 ~§.516 . t24~,§02
Figure 5-6. Statemen t or Stockhol den' Equity

I -

.·.. f

• I

•I
 Undentanding Financial Statements 61

Contributed capital represents the cash that the company received from the sale of
stock to stockholders (also called shareholders), less any f~ds expended for the
repurchase of stock. Retained earnings (also called earned capital or reinvested
capital) represent the cumulative total amount of income that the company has
earned and that has been retained in the business and not distributed to shareholders
in the f~nn of dividends. The change in retained eamirrgs links consecutive
statement of financial position via the income statement: Ending retained earnings
, .
= Beginning.retained earnings+ Net income - Dividends. For Blue Company, its
recent year's retained earnings increases from Pl 1.7.824 million to P144.306
million. This increase of ~6.482 million is explained by net income of P26.426
miJlion, no payment' of dividends and P0.056 million related to a mandated
accounting.change. ·

STATEMENT OF CASH FLOWS I

The statement of cash flows reports the change (either an increase or decrease) in
a company's cash balance over a period of time. The stat~ent ~ on cash
inflows and outflows from operating, investing and financmg activrt1es over a
period of time.

·e1ue Company
Statement of Cash Flows.
· For Year Ended December 31, 20X4
. · (pesos in millions)

Operating cash flows P12,550

Investing cash flows (13,428)
Financing cash flows . 1,464
Net increase.in casti 586
Cash, December 31, 20X3 43,743
. Cash, December 31 , 20X4 P44,329

Figure S-7. S~tement of Cash ~lows

·
Consider .
the following questions regard"mg th~ Statement of. Cash flows:
· · · ent of c-ash flows? Do the statement pf
• What is the use!ulness o!the state:temen~ provide sufficient cash flow
. financial . position and mcome s .
information? •
,· . . disclosed in the statement of cash flows and
• What types of mformat19n are , .
"?
why are they important·
68 Chapter 5

• Wh at kinds of activities are reported an eac

h of the-op era ting , inv esti ng
and financing sections of the statement of
cas h flow s? Ho w is this
infonnation useful? '
• Is it important for a company to report net cas
h infl ows (pos~tive am oun ts)
relating •to operating activities ove r , the
lon ger •term ~ Wh at are the
implications if operating ~h flows are neg ativ
e for an ext end ed per iod of
time?
• Why is it important'to know the compositio
n of a com pan y' s inv estm ent
activities? What kind of information mig ht
we loo k for? Are pos itiv e
i!'vesting cash flows favorable?
• Is it important-to know the sou rce of a com
pan y's fina nci ng acti viti es?
Wh at questions might that information help
us 'a nsw er? ' . · ·
• How might the composition of operating,
inv esti ng and fina nci ng cas h ·
flows cha nge ove r a com pan y's life cyc le?
• Is the bottom line increase in cas h flow the key
num ber ? Wh y or wh y n_o t?

,.