UNDERSTANDING FINANCIAL STATEMENTS

Financial statements provide the basic source of information by managers and other
interested parties outside the organization regarding its financial conditions and results of
operations. Financial statements communicate the firm’s financial strengths and
weaknesses as well as its performance for the current period. Though financial
statements are primarily prepared for external users (stockholders, investors, government
agencies, etc.) managers find it equally useful for their making decisions such as
performance evaluation, developing operating plans and any other matters related to their
operating activities.
To be able to analyze a company effectively or infer its value, it is important that one must
understand the company’s business activities. This can be accomplished through the
financial statements.
Accounting information should be used in the business context in which the information
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 while confronting business forces, including market
constraints and competitive pressures.

General Objectives of Financial Statements

The important objectives of financial statements are:
 Providing information for economic decisions
 Providing information about financial position
 Providing information about performance of an enterprise
 Providing information about changes in financial position

STATEMENT OF FINANCIAL POSITION

The balance sheet is a statement that shows the financial position or condition of an entity
by listing the assets, liabilities and owner’s equity as at a specific date. The information
needed for the balance sheet items are the net balances at the end of the period, rather
than the total for the period.
Users of financial statements analyze the balance sheet to evaluate an entity’s liquidity,
its financial flexibility, and its ability to generate profits, and its solvency.
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Liquidity refers to the availability of cash in the near future after taking account of the
financial commitments over this period. Financial flexibility is the ability to take effective
actions to alter the amounts and timings of cash flows so that it can respond to
unexpected needs and opportunities.
Solvency refers to the availability of cash over the longer term to meet financial
commitments as they fall due.

ABC Corporation
Statement of Financial Position
November 30, 2016

Assets
Current Assets
Cash P 182,250
Accounts Receivable 10,000
Supplies 500
Prepaid Rent 14,000
Prepaid Insurance 22,000
Total Current Assets P 228,750
Property and Equipment
Vehicles P 300,000
Less: Accumulated Depreciation 4,500 P 295,500
Equipment P 54,000
Less: Accumulated Depreciation 1,000 53,000 348,500
Total Assets P 577,250
Liabilities
Current Liabilities
Notes Payable P 100,000
Accounts Payable 1,000
Salaries Payable 1,600
Interest Payable 1,400
Unearned Revenues 11,250
Total Current Liabilities P 115,250
Owner’s Equity
Retained Earnings, 11/30/2016 462,000
Total Liabilities and Owner’s Equity P 577,250

INCOME STATEMENT

The income statement is a formal statement showing the performance of the enterprise
for a given period of time. It summarizes the revenues earned and expenses incurred for
that period of time.
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 ABC Corporation
Income Statement
For the Month Ended November 30, 2016

Revenues
Lawn Cutting Revenues P42,250.00
Expenses
Salaries Expense 5,600.00
Supplies Expense 500.00
Rent Expense 7,000.00
Insurance Expense 2,000.00
Gas Expense 1,500.00
Advertising Expense 1,750.00
Depreciation Expense - Vehicles 4,500.00
Depreciation Expense – Equipment 1,000.00
Interest Expense 1,400.00
Total 25,250.00
Profit P17,000.00

STATEMENT OF CASH
FLOWS
The statement of cash flows provides information about the cash receipts and cash
payments of an entity during a period. It is a formal statement that classifies cash receipts
(inflows) and cash payments (outflows) into operating, investing and financing activities.
This statement shows the net increase or decrease in cash during the period and the
cash balance at the end of the period; it helps project the future net cash flows of the
entity.
Cash Flows from Operating Activities
Operating activities generally involve providing services, and producing and delivering
goods. Cash flows from operating activities are generally the cash effects of transactions
and other events that enter into the determination of profit or loss.
• Direct Method – the entity’s cash provided by (used in) operating activities is
obtained by adding the individual operating cash inflows and then subtracting
the individual operating cash outflows.
• Indirect Method – derives the net cash provided by (used in) operating activities
by adjusting profit for income and expenses items not resulting from cash
transactions.

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The following are the major classes of operating cash flows using the direct method:
Cash Inflows
 Receipts from sale of goods and performance of services
 Receipts from royalties, fees, commissions and other revenue
Cash Outflows
 Payments to suppliers of goods and services
 Payments to employees
 Payments for taxes
 Payments for interest expense
 Payments for other operating expenses

Cash Flows from Investing Activities

Investing activities include making and collecting loans; acquiring and disposing of
investments in debt or equity securities; and obtaining and selling of property and
equipment and other productive assets.
Cash Inflows
 Receipts from sale of property and equipment
 Receipts from sale of investments in debt or equity securities
 Receipts from collections on notes receivable
Cash Outflows
 Payments to acquire property and equipment
 Payments to acquire debt or equity securities
 Payments to make loans to others generally in the form of notes receivable

Cash Flows from Financing Activities

Financing activities include obtaining resources from owners and creditors.
Cash Inflows
 Receipts from investments by owners
 Receipts from issuance of notes payable
Cash Outflows
 Payments to owners in the form of withdrawals
 Payments to settle notes payables

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 ABC Corporation
Statement of Cash Flows
For the Month Ended November 30, 2016

Cash Flows from Operating Activities

Cash received from clients P 43,500
Payments to employees (4,000)
Payments for office rent (21,000)
Payments for insurance (24,000)
Payments for advertising (1,750)
Payments for other operating expenses (1,500)
Net cash provided by (used in) operating P (8,750)
activities
Cash Flows from Investing Activities
Payments to acquire vehicle (200,000)
Payments to acquire equipment (54,000)
Net cash provided by (used in) investing activities (254,000)
Cash Flows from Financing Activities
Cash received as investments by owner 450,000
Payments for withdrawals by owner (5,000)
Net cash provided by (used in) financing activities 445,000
Net Increase (Decrease) in Cash P 182,250
Cash balance at the beginning of the period 0
Cash balance at the end of the period P 182,250

The financial statements are linked with each other and linked across time. This linkage
is also known as articulation. The statement of financial position and statement of
comprehensive income are linked via retained earnings. Retained earnings are updated
each period and reflect cumulative income that has not yet been distributed to
shareholders.

FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is the process of extracting information from financial

statements to better understand a company’s current and future performance and
financial condition.
The most widely used techniques in financial statement analysis are:
1. Comparative analysis
a. Horizontal analysis
b. Trend analysis
c. Vertical analysis
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 2. Ratio or Component analysis including turnovers
Financial analysis involves comparing the firm’s performance to that of other firms in the
same industry and evaluating trends in the firm’s financial position over time.
Managers should look beyond the ratios. They should consider the technological
changes, industry trends, consumer tastes and various economic factors.
Here are some cautions about using financial ratio:
1. Ratios that reveal large deviations from the norm merely indicate the possibility of
a problem.
2. A single ratio does not generally provide enough information from which to judge
the overall performance of the firm.
3. The ratios being compared should be calculated using financial statements dated
at the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in the same way.
6. Results can be distorted by inflation.

Comparative Analysis
An item on a financial statement has little meaning by itself. The meaning of the numbers
can be enhanced by drawing comparisons. Percentage changes and relative ratios are
widely used in comparative and trend analyses.
Horizontal analysis is comparing two periods and becomes trend analysis if extended to
three or more periods having the earliest year as the base period. Vertical analysis, also
known as common-size statement is analysis of the component parts of a single
statement in a given period.

Horizontal Analysis
Horizontal analysis is a technique for evaluating a series of data over a period time to
determine the increase or decrease that has taken place, expressed as either an amount
or a percentage. The peso changes (increase or decrease) are normally presented in
each item as well as their percentage changes.
Quantifying peso changes over time serves to highlight the changes that are the most
important economically. Quantifying percentage changes over time serves to highlight the
changes that are the most unusual.
The following simple rules should be observed:
1. To compute for the peso changes, current year less prior year.

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 2. To compute for the percentage changes, peso change divided by the prior year
(serve as the base figure). If there is no amount in prior year, no percentage
change will be shown, as a matter of rule in mathematics.
3. To compute for the ratio presentation, current year divided by the prior year. Again,
if the base year is zero or no amount in prior year, no ratio will be shown in the
analysis, thus, peso amount presentation is important.

Illustration:

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Trend Analysis
An extended horizontal analysis could be developed as the so-called “Trend Analysis”.
Trend percentages state several years’ financial data in terms of a base year, which
equals 100%.
Illustration:

The trend could be developed as follows:

This trend would serve as what we call “attention-directing” where the analyst would focus
his attention on such trends in comparison with the industry standards. For instance, the
analyst knows that the industry grew tremendously and yet the company was unable to
have a significant sales growth.

Vertical Analysis
Vertical analysis is a technique that expresses each item within a financial statement as
a percentage of a relevant total or a base amount. It focuses on the relationship between
various financial items in a given financial statements in a single period. The financial
statements then will be presented in percentages commonly called “common-size
statements”.

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Certain rules are observed:
 For the balance sheet, Total Assets and Total Liabilities and Equity are both
considered 100% and each item in the particular section are presented as a certain
percent of the total.
 For the income statement, Net Sales is considered as the 100%. Each item in the
income statement represents a certain percent of sales.

Ratio Analysis
Many related items in the balance sheet help the analyst develop his interpretation as to
the company’s financial strengths and operation’s performance. Financial statements
report both the firm’s position as of a certain period and on its operations for a certain
period.
The real value of financial statements is in the fact that they can be used to help predict
the firm’s future earnings and dividends, thus, an analysis of the firm’s ratios is generally
the first step in a financial analysis.
The three major areas that concern the users of financial statements are:
1. Stability
2. Solvency or liquidity, and
3. Profitability
Analyzing ratios as a whole could be more meaningful, even though they are computed
individually; the totality of it could give the final interpretation about the company’s

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financial and operating conditions. The following are the most common ratios used by
financial analysts:
Analyzing the Balance Sheet
 Liquidity Ratios – ratios that show the relationship of the company’s cash and
other current assets to its current liabilities. Liquidity is the number one concern of
most financial analysts.

This will indicate whether the firm can meet its maturing obligations. The most
common liquidity ratios and their procedural computations are:

1. Working Capital = Current assets minus current liabilities

To some, working capital is used to designate current assets only as the
amount intended for day-to-day operations of the business. Thus, the use
of the term net working capital is more appropriate. The bigger the net
working capital, the better, as it would mean more current assets are
available for operations.

2. Current Asset Ratio = Current assets divided by current liabilities

This is the basic test of liquidity of the firm. This will determine the adequacy
of working capital or the ability to meet current obligations. The higher the
current asset ratio, the better, as this would mean there are more current
assets available for paying its current obligations.

3. Quick (Acid) Test Ratio = Quick assets divided by current liabilities

Quick or acid test ratio is a more stringent test of ability to pay current
obligations as they come due. Quick assets are: Cash and cash
equivalents, marketable securities, short-term notes and accounts
receivables. The higher the quick asset ratio, the better liquidity position of
the firm.

 Asset Management Ratios – measures how effectively a firm is managing its

assets. These ratios are also called utilization ratio, which pertains to how
effectively the firm utilized its assets to earn profits. One of the questions answered
by these ratios is: will too high or too low current assets in relation to the projected
or actual operating levels affect profitability? Normally, companies borrow or obtain
capital from other sources to acquire assets. If a company has too many assets
acquired through borrowings, the interest expenses will be too high, hence the
profits will be lower. On the other hand, if assets are too low, profitable sales may
be lost. Therefore, managing these assets, particularly current assets will help the
firm avoid borrowing funds to finance operations.

1. Account Receivable Turnover = Net sales on account ÷ Average A/R

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 This will measure the efficiency of collections. How fast collections are being
made. The higher the turnover, the better, this would mean a greater
number of times receivable is reinvested for more profit.

2. Average collection period = 365 days ÷ A/R Turnover

This measures the number of days the firm invests in accounts receivable.
The shorter the collection period, the better for the company, as it could
present reinvestment opportunities, which mean additional income.

3. Inventory Turnover = Cost of Sales ÷ Average Inventory

Similar with accounts receivable, inventory turnovers are used to determine
how fast inventory were converted into sales. The higher the inventory
turnover, the better, as this would mean a greater number of times inventory
is reinvested and more profit will be realized.

4. Average Selling Period = 365 days ÷ Inventory Turnover

This determines the number of days an inventory is held as stock before it
will be sold. The shorter the number of days it is held on stock, the better it
will be as it means a greater number of times it is reinvested by the firm.

5. Fixed Assets Turnover or Fixed Assets Utilization Ratio = Sales ÷ Net Fixed
Assets

6. Total Assets Turnover = Sales ÷ Total Assets

These two determine the number of times investments in assets are
reinvested in sales. The higher the turnover, the higher profit the company
gets by utilizing its assets.

 Debt Management Ratios or Financial Leverage – These ratios will measure

the extent to which firm uses its debt financing or the so-called financial leverage.
Some important implications could be raised in managing financial leverage, these
are:
o By raising funds through debt, the owners can maintain control of the firm
with the limited investment.
o Creditors look to the equity, or owner-supplied funds, to provide a margin of
safety, that is, if the owners have provided only a small proportion of the
total financing, the risks of the enterprise are borne mainly by its creditors.

Financial leverage raises the expected rate of return to stockholders for two
reasons:
o Since interest is deductible, the use of debt financing lowers the tax and
leaves more the firm’s operating income available to its investors.

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 o If the rate of return on assets (income before tax divided by the total assets)
exceeds the interest rate on debt, as it generally does, then a company can
use debt to finance asset, pay the interest on the debt, and have something
left over for its stockholders.

Normally, firms with relatively high debt ratios are exposed to more risk of losses
when the economy is in a recession, but they also have higher expected returns
when the economy booms.

1. Debt to Total Asset Ratio = Total Debt ÷ Total Assets

This is the ratio of total liabilities to total assets. It measures to what extent
that portion of the total assets provided by the creditors.

2. Debt to Equity Ratio = Total Liabilities ÷ Total Stockholders’ Equity

It measures the resources provided by the owners in the business. It
provides information on the equivalent amount provided by creditors for
every P1 provided by the owners.

3. Times-Interest-Earned Ratio = Earnings Before Interest and Taxes (EBIT)

÷ Interest Charges
This measures the ability of the firm to meet its annual interest payments. It
will also measure the extent to which operating income can decline before
the firm is unable to meet is annual interest costs.

4. Fixed Charge Coverage = (EBIT + Fixed Charges) ÷ (Interest Charges +

Fixed Charges)
This ratio is like the “times interest earned ratio”, but it is more inclusive in
that it recognizes that many firms incur many fixed charges.

5. Book Value of Securities = Value of each security* ÷ Each number of shares

outstanding
*Securities are bonds, preferred stocks and common stocks

Analyzing the Income Statement

 Profitability Ratios – These ratios would show the net result of the policies and
decisions the management did in the current period. The combined effects of
liquidity, asset management and debt management on operating results will be
analyzed using these ratios.

1. Profit Margin = Net Income Available to Common Stock ÷ Sales

2. Return on Sales = Net Income ÷ Net Sales

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 3. Return on Total Assets (ROA) = Net Income Available to Common Stock ÷
Average Total Assets

4. Return on Common Equity (ROE) = Net Income Available to Common Stock

÷ Average Common Stock Equity

5. Basic Earning Power = EBIT ÷ Average Total Assets

This ratio indicates the ability of the firm’s assets to generate operating
income. This ratio shows the raw earning power of the firm’s assets, before
the influence of taxes and leverage, and it is useful for comparing firms with
different tax situations and different degrees of financial leverage.

6. Earnings per Share (EPS) = Net Income Available to Common Stock ÷

Weighted Average Number of Shares Outstanding

7. Dividend per Share = Dividends Paid to Common Stock ÷ Common Shares

Outstanding

8. Dividend Pay-Out Ratio = Dividends per Share of Common Stock ÷

Earnings per Share

Notes to Financial Statements

Published financial statements are accompanied by notes. These narratives provide
greater detail of information that is included very concisely in the financial statements.
Information typically disclosed in the notes includes:
 Details of the inventory costing and depreciation method used
 Contingent liabilities and pending lawsuits
 Long-term leases, if any
 Terms of executive employment contracts, profit sharing programs, pension plans
and stock options granted to employees.

Note: Financial statements and the financial ratios derived from them are
but a single source of information about a company. Like any
management accounting information, financial ratios serve only as an
attention-directing device. The ratios raise questions more often than they
answer them. An analyst must follow-up the financial statement analysis
with in-depth research on a company’s management styles, its history and
trends, the industry, and the national and international economies in which
the firm operates.

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 COST-VOLUME-PROFIT ANALYSIS

CVP analysis is the analysis of three variable viz. cost, volume and profit. Cost-volume-
profit (CVP) analysis is a powerful and vital tool in many business decisions because it
helps managers understand the relationships among cost, volume and profit. CVP
analysis focused on how profits are affected by the following elements: selling prices,
sales volume, unit variable cost, total fixed costs and mix of products sold.
This model is used to answer a variety of critical questions such as:
 What is the company’s breakeven volume?
 What is its margin of safety?
 What is likely to happen if specific changes are made in prices, costs and volume?
Financial managers need to know the costs that are likely to be incurred under normal
operating conditions and how they might vary if conditions change. They need to
understand which costs would stay the same and which costs would follow the movement
of volume and so on.
Fixed Costs are the costs which incurred for a period and which within certain output and
turnover limits, tend to be unaffected by fluctuations in the levels of activity (Output or
turnover).
Variable Costs tend to vary with the volume of activity. Any increase in activity results in
an increase in the variable cost and vice versa.
Semi-Variable Costs contain both fixed and variable components and thus partly
affected by fluctuation in the level of activity.
CVP analysis takes into account
 the total costs (fixed and variable)
 the total sales revenues
 desired profits vis-a-vis the sales volume
It is used for forecasting or predicting how the changes in costs and sales volume affect
profit. It is also known as 'Break-Even Analysis'.
CVP analysis could be helpful in the following situations:
 Budget planning: for forecasting profit by considering cost and profit relation, and
volume of production volume. This will help in determining the sales volume
required to make a profit.
 To make decisions regarding pricing and sales volume
 Determining the sales mix of different products, in what proportions each of the
products can be sold.
 Preparing flexible budget considering costs at different levels of production.
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Profit Equation and Contribution Margin
 Profit = Sales -Total costs
 Profit = Sales -Total variable costs - Total Fixed costs
 Contribution margin = Total revenue – Total variable costs

Sales xxxx
Less: Variable Cost xxxx
Contribution Margin xxxx
Less: Fixed Cost xxxx
Profit xxxx

 Profit = (S-V) *Q – FC
 Q = (FC + Expected Profit) ÷ (S - VC)
Note:
Q is the number of units required to be sold to obtain target profit.
S is the Selling Price per unit
VC is the Variable Cost per unit
FC is the Fixed Cost
Illustration:
Suppose that Super Bikes wants to produce a new mountain bike called Hero1 and has
forecast the following information.

 Price per bike = 800

 Variable cost per bike = 300
 Fixed costs related to bike production = 5,500,000
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  Target profit = 200,000
 Estimated sales = 12,000 bikes
We determine the quantity of bikes needed for the target profit as follows.
Solution:
Q = (FC + Expected Profit) ÷ (S - VC)
Q = (5,500,000 + 200,000) ÷ (800 - 300)
Q = 5,700,000 ÷ 500
Q = 11,400

Profit Volume Ratio (PV)

The contribution margin ratio (CMR) i.e., PV ratio is the percentage by which the selling
price (or revenue) per unit exceeds the variable cost per unit, or contribution margin as a
percentage of revenue.
Illustration: (Still using the above data for Hero1)
For Hero1, we could use the forecast information about volume (12,000 bikes) to
determine the contribution margin ratio.
Solution:
Total revenue = 800 x 12,000 = 9,600,000
Total variable cost = 300 x 12,000 = 3,600,000
Total contribution margin = 9,600,000 - 3,600,000 = 6,000,000
Contribution margin ratio = 6,000,000 / 9,600,000 = 0.625

Break-even Point (BEP)

A CVP analysis can be used to determine the BEP, or level of operating activity at which
revenues cover all fixed and variable costs, resulting in zero profit. In other words, this is
the point where no profit or losses have been made.

BEP analysis
Breakeven analysis is used to find the minimum level of production required. It Evaluates
both fixed and variable costs. It is used to:
 find a suitable product mix.
 find the sales required to reach a desired revenue.
 find the profits at certain price level and sales.

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Break even Applications
 New product decisions - Enables to determine the sale volume required for a firm
(or an individual product) to breakeven, given expected sales price and expected
costs.
 Pricing decisions - Enables to study the effect of changing price and volume
relationship on total profits.
 Modernizations or automation decisions - Analysis of the profit in implication of a
modernization or automation program.
 Expansion Decisions - studies the aggregate effect of a general expansion in
production and sales.

BEP Formulae

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Illustration:
 Sales 5,000 units
 Sales price per unit P50
 Variable cost per unit P30
 Fixed cost 35,000
Solution:
 BEP in units = 35,000 ÷ (P50 – P30)
BEP in units = 35,000 ÷ P 20
BEP in units = 1,750

 BEP in sales value = 1,750 x P50 = P87,500

Margin of safety
Represents the strength of the business.

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