UNDERSTANDING FINANCIAL STATEMENT

Learning Objectives Chapter:

-Describe the financial statement and its element;
-Analyze balance sheet and income statement through financial ratio;
-Determine and evaluate the past performance of the company through financial ratio;
-Identify how to interpret the changes in the company's financial structure;
-Discuss the different activities of the company operating, investing, and financing
and;
-Construct the cash flow statement.

Introduction

The financial manager aims to optimize the funds of the investors by

maintaining the present value of the existing stock. The misconception of believing
that financial managers should increase the firm's fund by presenting an impressive
report. It should not be discarded as it directly affects the firm's stock price. The
accounting information is presented in the financial statements. It is a vital tool to
analyze the company's performance from the previous report and how it will going to
be in the future.

What is the financial statement?

It is the presentation of data in the company assets, liabilities, and equities.

Including the balance sheet and its revenue and expense in the income statement. Its
goal is to provide substantial information about the financial position, result of the
operation, and cash flow of the firm that is beneficial for decision making to a greater
range of recipients.

Financial managers use this statement in financing and investing funds. Also,
it greatly affects in formulating dividend policy decision. They are primarily
concerned with the standing of the company. It is profitably that leads to the
maximization of stockholders to wealth. Managers should use the financial statement
as vital information on the company's performance from the previous and future
information. They are concerned with the profitability of the investment. The listing
of various assets of the firm and proper usage of resources.

Financial institutions present the financial statement as a way of establishing

the firm capability to produce cash in making payments. Considering that financial
status depends on the creditors. It is in a safer position that loans are granted to a firm
if in need of additional capital.

Component of Financial Statements

The following are the components:

1. Balance sheet
It shows the financial position of the firm at a particular time and is composed
of assets, liabilities, and stockholder's equity. The balance sheet includes the list of all
the assets of the firm.
 The current asset includes cash and other items such as account receivable and
inventories that can be converted into cash within one year. Aside from that, prepaid
expenses and accurate income are also included. Next is the non-current assets which
comprise the company's land, buildings, machinery, equipment, furniture and fixture,
vehicle, and many more.
The liability section is comprised of the current and non-current liabilities. The
current liability includes accounts payable, short-term notes payable, expense, tax
payable, interest payable, any other obligation that is due within one year. The non-
current liability includes long term notes payable, bonds payable, and other
obligations which do beyond one year.
Stockholders' equity is the sum of the net worth of the residual value of the
company. It is divided into par value stock which is the additional paid-in capital and
retained earnings. It includes the par value of the stocks and the additional paid-in
capital or the proceeds from the sales of stocks to the public Meanwhile, the retained
earnings represent the build-up of equity from the profit that is plowed back to the
firm.

2. Income statement is a formal statement that indicates the output of the operation
for a certain period. It shows the revenue gathered during the operating period, the
expenses incurred, and the firm's net earnings. This is also used to distinguish for
broad classes of expense:
a. Cost of Goods Sold, which is direct cause attribute to manufacturing the products
sold by the firm:
b. General and Administrative expenses, which correspond to overhead expenses,
salaries, advertising, and other operating costs that are not directly attributable to
production;
c. the interest of the firm debt; and
d. d. taxes of earning owned by the government.

3. Statement of stockholders' equity is a required basic statement that shows the

movements in the component of equity.

The major elements of the statement equity include:

a. Issuance of stocks. It is common for preferred stocks issued during the year.
b. Retained earnings. It is the accumulated income or loss of the company covering
the past year of operation.
c.Declaration of cash dividends. It is the declaration for the year that is indicated as a
deduction from retained earnings.
d. Distribution of stock dividends. It discloses the stock dividend rate and the number
of stock dividends distributed to stockholders. This amount is also shown as a
deduction from retained earnings.
e. Purchase and sale of treasury stock. It includes the originally issued both were
brought back and we do not retain. This sale of treasury stock is shown as an addition
to stockholders' equity while the purchase is shown as a deduction.
f.The accumulated other comprehensive income. It includes unrealized gains and
losses on available-for-sale investment and foreign currency transportation
adjustments.
g.Correction of errors. It includes at least errors in the past but corrected in the current
year.
 MGM Enterprises
Income Statement
For the Year Ended December 31, 2019
Sales P300,000
Less: sales return and allowances 40,000
Net sales 160,000
Less: cost of goods sold 100,000
gross profit 60,000
Less Operating expense
Selling expense 22,000
General expense P8,000
Income from operations 30,000
Add: non-operating income 6,000
Income before interest and expenses 36,000
Less: expense 4,000
Income before tax expense 32,000
Less: income taxes (35%) 11,200
Net income P30,800

Financial Statement Analysis

It is the comparison of one firm of the past and present activities of the firm
and forecast in the future. It involves computations and calculations of figures. Firms
compute by combining accounts coming from an income statement and balance sheet.
It simply relating an account within the statement. This calculation helps the
management assess the deficiencies and take necessary action to improve
performance.
Various tools are used by interested parties in analyzing the firm financial
statement. The outcome of such an analysis of the firm financial position or operating
results, as viewed by creditors, investors, another user can have an impact on the firm
standing. In determining future condition and services, the management view in
starting point for undertaking activities to improve the firm's future performance.

The Role in Decision Making

Financial analysis helps in financial ratios on the firm financial strength,
liquidity, safety of investment, effectiveness of management, and profitability growth
rates. It ascertains the value or creditworthiness. Growth rate or usually a function of
industry growth rates, competitive advantages, and corporate strategy. The financial
statement analysis properly evaluates a company's financial performance.

The analysis must also understand the company businesses, its objectives, the
product or services it provides, the market, and the customer. The analysis should
review the pages that discuss the different operations and businesses environment. It
reviews the financial statement footnotes to understand what accounting practices
were used to report the financial data. The analysis should examine the financial
summary information to get an overview. It is to evaluate the company's strength and
performance. While performing the analysis, it should consider whether or not the
CEO's report about the firm's performance and objectives. It is considered the
scorecard of the company's performance.
Common Tools and Techniques used in Financial Statement Analysis
1. Horizontal Analysis
Comparative statements are comparing financial data of two years showing
the increase or decrease in the account balance with their corresponding percentages.
The trend ratio is compared with its past and expected future ratio to
determine whether the firm's financial condition is improving or deteriorating over
time. It is similar to a comparative statement except for several consecutive years
where it shows the behavior of financial data.
2. Vertical Analysis
It uses a significant item on the financial statement as a base value. All other
financial items on the statement are compared with it.
a. Common size statement. Each account in the financial statement is expressed by
dividing them into a common paste account (total assets, liabilities, and equity, sales,
or net sales).
b. Financial ratio. It gives meaningful information about the performance of the
company through numerical values from financial statements.

Five classifications:
1. Liquidity ratio shows the firm's ability to meet its maturing short-term obligations.
A company with poor liquidity may have a poor credit risk that may cause its
inability to make timely interest and principal payments.
2. Activity or Asset Utilization ratio shows to determine how quickly various
accounts are converted into sales or cash.
3. Leverage ratio(solvency) shows the company's ability to meet its long-term
obligation as they become due.
4. Profitability ratio shows the earnings of the operation of the company. It highlights
the firm effectiveness in handling its operation. Investors will not invest in a firm that
may lead to low earning capacity.
5. Market value ratio shows the firm's stock price to its earnings

Horizontal Analysis

Comparative statement
It is used to compare the changes or behavior patterns of the different accounts
in the financial statement for two or more years. In doing the comparison, their early
years served as the base year so that the percentage changes (increase or decrease) by
dividing the difference of the base year figure from the later year figure from the base
year figure.
(Later year-Base /year Base year)* 100%
= percentage increase or decrease of an account
445,000-380,000 /380,000) * 100%
= 17.11%

The same procedure is followed for the other account in the financial
statement.
Because a comparative statement stresses the trends of the various account, it
is related easily to identify areas of wide divergence that require further attention. In
the income statement shown in illustration 4, the large increase in the sales return and
allowances coupled with the decrease in the sales for the period 2013 to 2014 should
cost concerning. One might compare these results with those of competitors to
determine whether the problem is industry-wide or just within a particular company.
 It is important to show both the peso amount of change and the percentage of
the change because either one alone might be misleading. For instance, if a certain
account would increase by 100%, but by looking at the amount, it does not require
further investigation since the account involved is only 20 pesos. In the same manner,
the percentage increase or decrease may be insignificant but the amount involved is
material and needs further investigation.

Vertical Analysis

Common-size statement

According to Cabrera, M. (2013) in a common size statement, a significant

item on the financial statement is used as the base value, and all other items on the
financial statement are compared with it. In performing common-size analysis for the
balance sheet, total assets, or assigns as the base account with a percentage of 100. An
individual asset account is expressed as a percentage of total assets. Likewise, the
total liability and stockholders' equity is 100%. The individual account in liability and
equity is also expressed as a percentage of total liabilities and stockholders' equity.
In the income statement, net sales are given the value of 100% and all other
accounts are evaluated in comparison to net sales. The result figures or then given in
the common size statement. Common size analysis is used to show the internal
structure of an enterprise. It reflects the existing relationship of each account and the
balance sheet that would help determine possible improvements and the distribution
of resources. Where the percentage of each account and the income statement and
relation to its net sales, the firm can grow better alternatives and maximizing its profit.