FINMAN 301 –

FINANCIAL
MANAGEMENT

CHAPTER 2

Prepared by:

WILFREDO P. MONDIDO JR.

Instructor

Page 1 of 12
 CHAPTER 2 – REVIEW ON
FINANCIAL STATEMENTS

LECTURE NOTES

What Are Financial Statements?

Financial statements are written records that convey the business activities and the financial
performance of a company. Financial statements are structured representation of financial position,
financial performance, and cash flows of an entity that is useful to a wide range of users in making sound
economic decisions. Financial statements also show the results of the management’s stewardship of the
resources entrusted to it.
The financial statements are used by investors, market analysts, and creditors to evaluate a
company's financial health and earnings potential. Investors and financial analysts rely on financial data
to analyze the performance of a company and make predictions about its future direction of the
company's stock price. One of the most important resources of reliable and audited financial data is the
annual report, which contains the firm's financial statements.

Complete Set of Financial Statements as stated in Philippine Accounting Standards (PAS) 1:

There are six (6) financial statements as Per Revised PAS No. 1. They are as follows:
1. Statement of Financial Position (Balance Sheet)
2. Statement of Comprehensive Income:
1. Income Statement
2. Other Comprehensive Income
3. Statement of Changes in Equity
4. Statement of Cash Flows
5. Notes to Financial Statements
6. Third Balance Sheet (Statement of Financial Position at the earliest Comparative period)

1. Statement of Financial Position (Balance Sheet)

Statement of Financial Position is a financial statement that shows the financial position of an
enterprise as of a particular date. It is a financial statement that provides a snapshot of what a company
owns and owes, as well as the amount invested by shareholders. It reports a company's assets, liabilities
and shareholders' equity at a specific point in time, and provides a basis for computing rates of return
and evaluating its capital structure. It measures and evaluates in terms of the enterprise’ liquidity,
solvency, financial structure and capacity for adaptation. The balance sheet is used alongside other
important financial statements such as the income statement and statement of cash flows in conducting
fundamental analysis or calculating financial ratios.

Page 2 of 12
 The balance sheet adheres to the following accounting equation, where assets on one side, and
liabilities plus shareholders' equity on the other, balance out:
Assets = Liabilities + Shareholders’ Equity
This formula is intuitive: a company has to pay for all the things it owns (assets) by either borrowing
money (taking on liabilities) or taking it from investors (issuing shareholders' equity).
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.

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.

Non-current 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. In general, intangible assets are only listed on the balance sheet if they are
acquired, rather than developed in-house. Their value may thus be wildly understated – by
not including a globally recognized logo, for example – or just as wildly overstated.

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:

• accounts payable
• interest payable
• wages payable and other accrued expenses
• customer prepayments
• dividends payable and others
• bank indebtedness
• current portion of long-term debt

Long-term liabilities can include:

• Long-term debt: interest and principal on bonds issued
Page 3 of 12
 • 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
(Besides timing, this figure reconciles differences between requirements for financial
reporting and the way tax is assessed, such as depreciation calculations.)

Some liabilities are considered off the balance sheet, meaning that they will not appear on the
balance sheet.

SHAREHOLDERS' 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.

Some companies issue preferred stock, which will be listed separately from common stock under
shareholders' equity. Common Stock and Preferred Stock are assigned an arbitrary par value that has no
bearing on the market value of the shares. 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.

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.

2. Statement of Comprehensive Income (Income Statement)

Statement of Comprehensive Income is a financial statement that shows the “results of
operations” of the business for a given period of time. Also known as the profit and loss statement or the
statement of revenue and expense, the income statement primarily focuses on the company’s revenues
and expenses during a particular period.

The income statement focuses on four key items—revenue, expenses, gains, and losses. It
does not differentiate between cash and non-cash receipts (sales in cash versus sales on credit) or the
cash versus non-cash payments/disbursements (purchases in cash versus purchases on credit). It starts
with the details of sales, and then works down to compute the net income and eventually the earnings
per share (EPS). Essentially, it gives an account of how the net revenue realized by the company gets
transformed into net earnings (profit or loss).

Page 4 of 12
REVENUES AND GAINS
The following are covered in the income statement, though its format may vary depending
upon the local regulatory requirements, the diversified scope of the business and the associated
operating activities:

Operating Revenue
Revenue realized through primary activities is often referred to as operating revenue. For a company
manufacturing a product, or for a wholesaler, distributor or retailer involved in the business of selling that
product, the revenue from primary activities refers to revenue achieved from the sale of the product.
Similarly, for a company (or its franchisees) in the business of offering services, revenue from primary
activities refers to the revenue or fees earned in exchange of offering those services.

Non-Operating Revenue
Revenues realized through secondary, non-core business activities are often referred to as non-
operating recurring revenues. These revenues are sourced from the earnings which are outside of the
purchase and sale of goods and services and may include income from interest earned on business
capital lying in the bank, rental income from business property, income from strategic partnerships like
royalty payment receipts or income from an advertisement display placed on business property.

Gains
Also called other income, gains indicate the net money made from other activities, like the sale of
long-term assets. These include the net income realized from one-time non-business activities, like a
company selling its old transportation van, unused land, or a subsidiary company.

Revenue should not be confused with receipts. Revenue is usually accounted for in the period when
sales are made or services are delivered. Receipts are the cash received and are accounted for when
the money is actually received. For instance, a customer may take goods/services from a company on
28 September, which will lead to the revenue being accounted for in the month of September. Owing to
his good reputation, the customer may be given a 30-day payment window. It will give him time till 28
October to make the payment, which is when the receipts are accounted for.

EXPENSES AND LOSSES

The cost for a business to continue operation and turn a profit is known as an expense.

Primary Activity Expenses

All expenses incurred for earning the normal operating revenue linked to the primary activity of the
business. They include the cost of goods sold (COGS), selling, general and administrative expenses
(SG&A), depreciation or amortization, and research and development (R&D) expenses. Typical items that
make up the list are employee wages, sales commissions, and expenses for utilities like electricity and
transportation.

Secondary Activity Expenses

All expenses linked to non-core business activities, like interest paid on loan money.

Losses as Expenses
All expenses that go towards a loss-making sale of long-term assets, one-time or any other unusual
costs, or expenses towards lawsuits.

While primary revenue and expenses offer insights into how well the company’s core business is
performing, the secondary revenue and expenses account for the company’s involvement and its
expertise in managing the ad-hoc, non-core activities. Compared to the income from the sale of
manufactured goods, a substantially high-interest income from money lying in the bank indicates that
the business may not be utilizing the available cash to its full potential by expanding the production
capacity, or it is facing challenges in increasing its market share amid competition. Recurring rental
income gained by hosting billboards at the company factory situated along a highway indicates that
the management is capitalizing upon the available resources and assets for additional profitability.

Page 5 of 12
INCOME STATEMENT STRUCTURE
Mathematically, the Net Income is calculated based on the following:
Net Income = (Revenue + Gains) – (Expenses + Losses)
However, real-world companies often operate on a global scale, have diversified business
segments offering a mix of products and services, and frequently get involved in mergers, acquisitions,
and strategic partnerships. Such wide array of operations, diversified set of expenses, various business
activities, and the need for reporting in a standard format as per regulatory compliance leads to multiple
and complex accounting entries in the income statement.
Listed companies follow the Multiple-Step Income Statement which segregates the
operating revenues, operating expenses, and gains from the non-operating revenues, non-operating
expenses, and losses, and offer many more details through the income statement. Essentially, the different
measures of profitability in a multiple-step income statement are reported at four different levels in a
business' operations – gross, operating, pre-tax and after-tax.

Uses of Income Statements

Though the main purpose of an income statement is to convey details of profitability and
business activities of the company to the stakeholders, it also provides detailed insights into the
company’s internals for comparison across different businesses and sectors. Such statements are also
prepared more frequently at the department- and segment-levels to gain deeper insights by the
company management for checking the progress of various operations throughout the year, though such
interim reports may remain internal to the company.
Based on income statements, management can make decisions like expanding to new
geographies, pushing sales, increasing production capacity, increased utilization or outright sale of assets,
or shutting down a department or product line. Competitors may also use them to gain insights about the
success parameters of a company and focus areas as increasing R&D spends.
An income statement provides valuable insights into various aspects of a business. It includes
a company’s operations, the efficiency of its management, the possible leaky areas that may be eroding
profits, and whether the company is performing in line with industry peers.

3. Statement of Changes in Shareholders’ Equity

A statement of changes in shareholders equity presents a summary of the changes in
shareholders’ equity accounts over the reporting period. It highlights the changes in value to stockholders'
or shareholders' equity, or ownership interest in a company, from the beginning of a given accounting
period to the end of that period. Typically, the statement of shareholders' equity measures changes from
the beginning of the year through the end of the year. Thus, it reconciles the opening balances of equity
accounts with their closing balances.

There are two types of changes in shareholders’ equity:

• changes that originate from transactions with shareholders such as issue of new shares, payment
of dividends, etc. and
• changes that result from changes in total comprehensive income, such as net income for the
period, revaluation of fixed assets, changes in fair value of certain investments, etc.

The statement of shareholders' equity highlights the business activities that contribute to
whether the value of shareholders' equity goes up or down.
The statement of shareholders' equity typically includes the following components:
• Common stock. This is a type of stock, or ownership stake in a company, that comes with voting
rights on corporate decisions. Common stockholders are lower down on the list of priorities when
it comes to paying equity holders. If a company needs to liquidate, holders of common stock will
get paid after preferred stockholders and bondholders. Like preferred stock, common stock is
typically listed on the statement of shareholders' equity at par value.
• Preferred stock. This is a special type of stock, or ownership stake in a company, that offers holders
a higher claim on a company's earnings and assets than those who own the company's common
stock. Preferred stockholders will typically be entitled to dividends before holders of common stock
can receive theirs. Preferred stock is usually listed on the statement of shareholders' equity at par
value, or face value, which is the amount at which it is issued or redeemable. Holders of preferred
stock do not have voting rights in the issuing company.

Page 6 of 12
 • Additional paid-in capital. Also known as contributed capital, additional paid-in capital is the
excess amount investors pay over the par value of a company's stock.
• Treasury stock. Treasury stock is stock that the issuing company repurchases. A company might
repurchase its own stock in an attempt to avoid a hostile takeover or boost its stock price.
Shareholders' equity is reduced by the amount of money spent to repurchase the shares in
question.
• Retained earnings. Retained earnings are the total earnings a company has brought in that have
not yet been distributed to shareholders. This figure is calculated by subtracting the amount paid
out in shareholder dividends from the company's total earnings since inception. A company that's
been profitable for quite some time will probably show a large amount of retained earnings.

The statement of shareholders' equity enables shareholders to see how their investments are faring.
It's also a useful tool for companies in helping them make decisions about future issuances of stock shares.

4. Statement of Cash Flows

Statement of Cash Flows is a financial statement that provides information about the causes
if change in an entity’s cash balance from the beginning to the end of a given period of time. It 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.

Page 7 of 12
 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 operations, investment, and financing. The sum of these three
segments is called net cash flow.
There are two different branches of accounting—accrual and cash. Most public companies
use accrual accounting, which means the income statement is not the same as the company's cash
position. The cash flow statement, though, is focused on cash accounting.
Profitable companies can fail to adequately manage cash flow, which is why the cash flow
statement is a critical tool for companies, analysts, and investors. The cash flow statement is broken down
into three different business activities: operations, investing, and financing.

Cash Flows from Operating Activities

This is the first section of the cash flow statement covers cash flows from operating activities
(CFO) and includes transactions from all operational business activities. The cash flows from operations
section begins with net income, then reconciles all noncash items to cash items involving operational
activities. So, in other words, it is the company's net income, but in a cash version.
This section reports cash flows and outflows that stem directly from a company's main
business activities. These activities may include buying and selling inventory and supplies, along with
paying its employees their salaries. Any other forms of in and outflows such as investments, debts, and
dividends are not included.
Companies are able to generate sufficient positive cash flow for operational growth. If there
is not enough generated, they may need to secure financing for external growth in order to expand. For
example, accounts receivable is a noncash account. If accounts receivable go up during a period, it
means sales are up, but no cash was received at the time of sale. The cash flow statement deducts
receivables from net income because it is not cash. The cash flows from the operations section can also
include accounts payable, depreciation, amortization, and numerous prepaid items booked as revenue
or expenses, but with no associated cash flow.

Cash Flows from Investing Activities

This is the second section of the cash flow statement looks at cash flows from investing (CFI)
and is the result of investment gains and losses. This section also includes cash spent on property, plant,
and equipment. This section is where analysts look to find changes in capital expenditures (capex).
When capex increases, it generally means there is a reduction in cash flow. But that's not
always a bad thing, as it may indicate that a company is making investment into its future operations.
Companies with high capex tend to be those that are growing.
While positive cash flows within this section can be considered good, investors would prefer
companies that generate cash flow from business operations—not through investing and financing
activities. Companies can generate cash flow within this section by selling equipment or property.

Cash Flows from Financing Activities

Cash flows from financing (CFF) is the last section of the cash flow statement. The section
provides an overview of cash used in business financing. It measures cash flow between a company and
its owners and its creditors, and its source is normally from debt or equity. These figures are generally
reported annually on a company's 10-K report to shareholders.
Analysts use the cash flows from financing section to determine how much money the
company has paid out via dividends or share buybacks. It is also useful to help determine how a company
raises cash for operational growth.
Cash obtained or paid back from capital fundraising efforts, such as equity or debt, is listed
here, as are loans taken out or paid back.
When the cash flow from financing is a positive number, it means there is more money
coming into the company than flowing out. When the number is negative, it may mean the company is
paying off debt, or is making dividend payments and/or stock buybacks.

Page 8 of 12
 ILLUSTRATIVE PROBLEM

On January 1, 2021, you are hired as the new controller of FINMAN COMPANY. As your first job,
you are asked by the firm’s VP-Finance to submit to him comparative financial statements of the
company for the years ended December 31, 2019 and 2020. Upon inspection of the company’s book of
accounts, you have gathered the following information:

Income Balance Sheet

Account Title 2019 2020
Statement Items Items

Accounts Payable 150,000 200,000

Accounts Receivable 300,000 200,000
Accrued Expenses 80,000 70,000
Accumulated Depreciation - Building 800,000 880,000
Accumulated Depreciation – Mach & Equ 400,000 400,000
Additional Paid-In Capital 500,000 ?
Advertising Expense 10,000 20,000
Allowance for Doubtful Accounts 30,000 20,000
Bank Loan Payable 0 ?
Bonds Payable 1,200,000 ?
Building 2,000,000 2,500,000
Cash and Cash Equivalents 400,000 550,000
Common Stock, P10 par value 2,000,000 ?
Cost of Goods Sold ? 1,100,000
Depreciation Expense-Building 80,000 80,000
Depreciation Expense-Mach & Eq 40,000 50,000
Dividends Paid 100,000 210,000
Doubtful Accounts Expense 20,000 30,000
Freight In 30,000 100,000
Freight Out 30,000 50,000
Income Taxes ? ?
Intangible Assets 200,000 170,000
Interest Expense 30,000 50,000
Land 1,500,000 1,500,000
Long-term Investments 600,000 1,500,000
Machinery & Equipment 800,000 1,300,000
Marketable Securities 120,000 300,000
Merchandise Inventory, Dec 31 300,000 200,000
Merchandise Inventory, Jan 1 200,000 ?
Preferred Stock, P50 par value 1,000,000 ?
Prepaid Expenses 180,000 120,000
Purchase Discount 10,000 30,000
Purchase Returns & Allowances 20,000 70,000
Purchases 400,000 ?
Retained Earnings, Dec. 31 ? ?

Page 9 of 12
 Retained Earnings, Jan 1 200,000 ?
Salaries Expense 50,000 60,000
Sales 850,000 2,200,000
Sales Discount 10,000 80,000
Sales Returns & Allowances 40,000 120,000
Supplies Expense 20,000 30,000
Taxes & Licenses 20,000 30,000
Treasury Stock 0 ?

Additional Information:
• The applicable corporate income tax rate is 30%.
• During 2020, the company borrowed P500,000 money from the bank (Bank Loan Payable).
• The company also paid the P200,000 portion of its Bonds Payable that is due in 2020.
• During 2020, the company issued 50,000 shares of its common stock for P15 and issued 10,000
shares of its preferred stock for P70.
• During 2020, the company reacquired 5,000 shares of its common stock for P12.

Requirement: Prepare the following financial statements.

1. Comparative Income Statement for the years ended December 31, 2019 and 2020.
2. Comparative Statement of Changes in Retained Earnings for the years ended December 31, 2019 and 2020.
3. Statement of Changes in Shareholder’s Equity for the year ended December 31, 2020.
4. Comparative Statement of Financial Position as of the years ended December 31, 2019 and 2020.
5. Interpret and evaluate the overall financial condition and financial performance of the company
based on the financial statements.

REQUIREMENT

On January 1, 2021, you are hired as the new controller of COVID-19 COMPANY. As your first job,
you are asked by the firm’s VP-Finance to submit to him comparative financial statements of the
company for the years ended December 31, 2019 and 2020. Upon inspection of the company’s book of
accounts, you have gathered the following information:

Income Balance Sheet

Account Title 2019 2020
Statement Items Items
Accounts Payable 700,000 1,000,000
Accounts Receivable 500,000 700,000
Accumulated Depreciation - Building 800,000 1,200,000
Accumulated Depreciation – Furn & Fixt 300,000 400,000
Accumulated Depreciation – Mach & Equ 400,000 500,000
Additional Paid-In Capital 2,000,000 ?
Advertising Expense 250,000 300,000
Allowance for Doubtful Accounts 50,000 100,000
Bonds Payable 6,000,000 ?
Building 8,000,000 8,000,000
Cash and Cash Equivalents 1,000,000 1,200,000

Page 10 of 12
Common Stock, P100 par value 10,000,000 ?
Cost of Goods Sold 3,500,000 ?
Deferred Tax Liability 0 850,000
Depreciation Expense-Building 400,000 400,000
Depreciation Expense-Furn & Fix 100,000 100,000
Depreciation Expense-Mach & Eq 200,000 250,000
Dividends Paid 500,000 700,000
Doubtful Accounts Expense 50,000 50,000
Freight In 200,000 300,000
Freight Out 300,000 350,000
Furniture & Fixtures 1,500,000 1,500,000
Income Taxes ? ?
Insurance Expense 100,000 100,000
Interest Expense 300,000 400,000
Interest Payable 200,000 500,000
Land 10,000,000 ?
Long-term Investments 2,000,000 4,000,000
Long-term Notes Payable 3,000,000 ?
Machinery & Equipment 4,000,000 5,000,000
Marketable Securities 600,000 1,600,000
Merchandise Inventory, Dec 31 700,000 500,000
Merchandise Inventory, Jan 1 500,000 ?
Mortgage Payable 0 ?
Patent 500,000 450,000
Preferred Stock, P200 par value 5,000,000 ?
Prepaid Insurance 500,000 400,000
Prepaid Rent 250,000 300,000
Purchase Discount 100,000 400,000
Purchase Returns & Allowances 400,000 600,000
Purchases ? 4,500,000
Rent Expense 100,000 100,000
Retained Earnings, Dec. 31 ? ?
Retained Earnings, Jan 1 850,000 ?
Salaries Expense 900,000 1,200,000
Sales 8,000,000 10,000,000
Sales Discount 200,000 300,000
Sales Returns & Allowances 300,000 500,000
Supplies Expense 300,000 350,000
Trademark 300,000 350,000
Treasury Stock 0 ?
Unearned Income 300,000 0

Additional Information:
• The applicable corporate income tax rate is 25%.
• During 2020, the company acquired another land at a cost of P500,000.
• During 2020, the company paid its P1,000,00 Long-term Notes Payable but later on borrowed
another P500,000 Long-term Notes Payable from the same bank.
Page 11 of 12
 • During 2020, the company borrowed P2,000,000 money from another bank with the building as
collateral.
• The company also paid the P1,000,000 portion of its Bonds Payable that is due in 2020.
• During 2020, the company issued 10,000 shares of its common stock for P120.
• During 2020, the company also issued 5,000 shares of its preferred stock for P240.
• During 2020, the company reacquired 5,000 shares of its common stock for P110.

Requirement: Prepare the following financial statements.

1. Comparative Income Statement for the years ended December 31, 2019 and 2020.
2. Comparative Statement of Changes in Retained Earnings for the years ended December 31, 2019 and 2020.
3. Statement of Changes in Shareholder’s Equity for the year ended December 31, 2020.
4. Comparative Statement of Financial Position as of the years ended December 31, 2019 and 2020.
5. Interpret and evaluate the overall financial condition and financial performance of the company
based on the financial statements.

---END---

Page 12 of 12