Bato Institute of Science and Technology
Dolho, Bato, Leyte
Business Finance
ABM 4
Student’s Name:____________________________________ Year & Section: ________________
Date Submitted:_________________
Module 4 (Week 4)
Financial Statement
Preparation, Analysis and
Interpretation Part 1
Introduction
Financial management deals with the ways in which
an organization can raise funds for the various projects,
allocation of those funds in the most productive and efficient
way, how to exercise control over those funds, and how to
distribute the returns of those funds to the various
stakeholders. It generally deals with planning, controlling,
organizing, and directing the financial activities of a firm.
Financial Management ensures that the organization
meets its primary objectives such as maximizing the
shareholders’ wealth, cutting down the finance cost, and other
non-financial objectives which are to other stakeholders such
as the government, employees, and suppliers.
Learning Outcomes
At the end of this module, you should be able to:
1. Prepared financial statements; and
2. Defined the measurement levels, namely:
liquidity, solvency, valuation, and profitability.
Core Content
Lesson 7 – Financial Statements
Financial statements are how companies
communicate their story. Thanks to GAAP, there are
four basic financial statements everyone must prepare.
Together they represent the profitability and strength of
a company. The financial statement that reflects a
company’s profitability is the income statement.
The statement of retained earnings – also called
statement of owners’ equity shows the change in retained
earnings between the beginning and end of a period (e.g.,
a month or a year). The balance sheet reflects a
company’s solvency and financial
position. The statement of cash flows shows the cash
inflows and outflows for a company over a period of
time.
There are several accounting activities that
happen before financial statements are prepared.
Financial statements are prepared in the following order:
✓ Income Statement
✓ Statement of Retained Earnings – also called
Statement of Owners’ Equity
✓ The Balance Sheet
✓ The Statement of Cash Flows
Income Statement
The income statement, sometimes called an
earnings statement or profit and loss statement, reports
the profitability of a business organization for a stated
period of time. In accounting, we measure profitability
for a period, such as a month or year, by comparing the
revenues earned with the expenses incurred to produce
these revenues. This is the first financial statement
prepared as you will need the information from this
statement for the remaining statements. The income
statement contains:
✓ Revenues are the inflows of cash resulting from
the sale of products or the rendering of services
to customers. We measure revenues by the prices
agreed on in the exchanges in which a business
delivers goods or renders services.
✓ Expenses are the costs incurred to produce
revenues. Expenses are costs of doing business
(typically identified as accounts ending in the
word “expense”).
REVENUES – EXPENSES = NET INCOME.
Net income is often called the earnings of the
company. When expenses exceed revenues, the business
has a net loss.
The net income from the income statement will
be used in the Statement of Equity.
Statement of Retained Earnings (or Owner’s Equity)
The statement of retained earnings, explains the
changes in retained earnings between two balance sheet
dates. We start with beginning retained earnings (in our
example, the business began in January so we start with
a zero balance) and add any net income (or subtract net
loss) from the income statement. Next, we subtract any
dividends declared (or any owner withdrawals in a
partnership or sole-proprietor) to get the Ending balance
in Retained Earnings (or capital for non-corporations)
The Ending balance we calculated for retained
earnings (or capital) is reported on the balance sheet.
Balance Sheet
The balance sheet, lists the company’s assets,
liabilities, and equity (including dollar amounts) as of a
specific moment in time. That specific moment is the
close of business on the date of the balance sheet. Notice
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how the heading of the balance sheet differs from the
headings on the income statement and statement of
retained earnings. A balance sheet is like a photograph;
it captures the financial position of a company at a
particular point in time. The other two statements are for
a period of time. As you study about the assets,
liabilities, and stockholders’ equity contained in a
balance sheet, you will understand why this financial
statement provides information about the solvency of the
business.
Statement of Cash Flows
The statement of cash flows shows the cash
inflows and cash outflows from operating, investing, and
financing activities. Operating activities generally
include the cash effects of transactions and other events
that enter into the determination of net income.
Management is interested in the cash inflows to the
company and the cash outflows from the company
because these determine the company’s cash it has
available to pay its bills when due. We will examine the
statement of cash flows in more detail later but for now
understand it is a required financial statement and is
prepared last. The statement of cash flows uses
information from all previous financial statements.
Lesson 8 – Measurement Levels
Ratio can be invaluable tools for making
decisions about companies you might want to invest in.
they are used by individual investors and professional
analysts, and there are a variety of ratios to use. Financial
ratios are typically cast into four categories:
1. PROFITABILITY RATIOS
Profitability is a key aspect to analyze
when considering an investment in a company.
This is because high revenues alone don’t
necessarily translate into high earnings or high
dividends.
In general, profitability analysis seeks to
analyze business productivity from multiple
angles using a few different scenarios.
Profitability ratios help provide insight into
how much profit a company generates and how
that profit relates to other important information
about the company. These are used to assess a
business's ability to generate earnings relative to
its revenue, operating costs, balance sheet assets,
and shareholders' equity over time, using data
from a specific point in time.
Some key profitability ratios include:
✓ Gross margin (and adjusted gross
margin)
✓ Operating margin
✓ Net profit margin
✓ EBITDA margin
✓ Operating cash flow margin
✓ Return on assets (ROA)
✓ Return on equity (ROE)
✓ Return on invested capital (ROIC)
✓ Return on investment (ROI)
One of the leading ratios used by
investors for a quick check of profitability is the
net profit margin.
Example: Net Profit Margin
This ratio compares a company’s net
income to its revenue. In general, the higher
a company's profit margin, the better. A net profit
margin of 1, or 100%, means a company is
converting all of its revenue to net income.
Profit margin levels vary across
industries and time periods as this ratio can be
affected by several factors. Thus, it is also helpful
to look at a company's net profit margin versus
the industry and the company’s historical
average.
With net profit margin, there can be a
few red flags you should watch out for,
especially if the company sees decreasing profit
margins year-over-year. Oftentimes, this
suggests changing market conditions, increasing
competition, or rising costs.
If a company has a very low-profit
margin, it may need to focus on decreasing
expenses through wide-scale strategic initiatives.
A high-profit margin relative to the industry may
indicate a significant advantage in economies of
scale, or potentially some accounting schemes
that may not be sustainable for the long term.
2. LIQUIDITY RATIOS
Liquidity measures how quickly a
company can repay its debts. It also shows how
well company assets cover expenses.
Liquidity ratios give investors an idea of
a company’s operational efficiency. They also
show how quickly and easily a company
generates cash to purchase additional assets or to
repay creditors quickly, either in an emergency
situation or in the course of normal business.
Some of the key liquidity ratios include:
✓ Current ratio
✓ Quick ratio
✓ Cash ratio
✓ Cash conversion cycle (CCC)
✓ Operating cash flow ratio
✓ Receivables turnover
✓ Inventory turnover
✓ Working capital turnover
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 Example: Quick & Current Ratios
The current and quick ratios are great
ways to assess the liquidity of a firm. Both ratios
are very similar.
The current ratio is calculated by
dividing current assets by current liabilities.
Since current assets and current liabilities
represent activity in the upcoming 12 months,
this ratio can provide insight into the firm’s short-
term liquidity. A higher current ratio is favorable
as it represents the number of times current assets
can cover current liabilities.
The quick ratio is nearly the same;
however, it subtracts inventory from current
assets. This gives better insight into the short-
term liquidity of the firm by narrowing the
current assets to exclude inventory. Again, a
higher quick ratio is better.
3. SOLVENCY RATIOS
Solvency ratios, also known as leverage
ratios, are used by investors to get a picture of
how well a company can deal with its long-term
financial obligations. As you might expect, a
company weighed down with debt is probably a
less favorable investment than one with a
minimal amount of debt on its books.
Some of the most popular solvency
ratios include:
✓ Debt to total assets
✓ Debt to equity
✓ Time interest earned
✓ Interest coverage ratio
✓ Net income to liabilities
✓ Times interest earned
Debt to assets and debt to equity are two
top ratios often used for a quick check of a
company’s debt levels. Both reviews how debt
stacks up against other categories on the balance
sheet.
Example: Debt to Assets
The total-debt-to-total-assets ratio is used
to determine how much of a company's assets are
tied up by debt.
It is calculated as follows:
As a general rule, a number closer to zero is
generally better because it means that a company carries
less debt compared to its total assets. The more solvent
the assets, the better. Remember, lenders typically have
the first claim on a company's assets when required
to liquidate; therefore, a lower debt/assets ratio typically
indicates less risk.
When using this ratio to analyze a company, it
can help to look at both the company growth phase and
the industry as a whole. It's not unrealistic for a younger
company to have a debt-to-total-assets ratio closer to one
(with more of its assets financed by debt) as it hasn't had
a chance to eliminate its debt.
4. VALUATION RATIOS
Valuation ratios are some of the most
commonly quoted and easily used ratios for
analyzing the attractiveness of an investment in a
company. These measures primarily integrate a
company’s publicly traded stock price to give
investors an understanding of how inexpensive or
expensive the company is in the market.
In general, the lower the ratio level, the more
attractive an investment in a company becomes.
Often, analysts will take the reciprocal of a valuation
ratio, or its multiple, as a measure of relative value.
Popular valuation multiples include:
✓ Price-to-earnings (P/E)
✓ Price-to-book (P/B)
✓ Price-to-sales (P/S)
✓ Price-to-cash flow (P/CF)
Example: Price-to-Earnings
The price-to-earnings (P/E) ratio is one of
the most well-known valuation ratios. It
compares a company's stock price to
its earnings on a per-share basis. Like other
valuation ratio analyses, the price to earnings
shows the premium that the market is willing to
pay.
The P/E ratio is calculated as follows:
This ratio transforms any company's
earnings into an easily comparable measure.
Basically, it tells you how much investors are
willing to pay for $1 of earnings in that company.
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 The higher the ratio, the more investors are
willing to spend.
But don't think a higher P/E ratio for one
company necessarily suggests that its stock is
overpriced. Different industries have
substantially different P/E ratios; so, it is
important to compare a company's P/E ratio to
that of its industry.
In-text Activity 1
? How measurement levels determined the status of the
business or company? Do these levels justify the
success of the business or company?
? When revenue exceeds expenses, company will be?
What will you do to increase your revenue and
decrease your expense?
Summary & Key Takeaways
❖ There are four financial statements produced by
accountants, including:
o The income statement reports the revenues
and expenses of a company and shows the
profitability of that business organization for
a stated period of time. The net income (or
loss) calculated is used in the statement of
retained earnings.
o The statement of retained earnings shows the
change in retained earnings between the
beginning of the period (e.g., a month) and its
end. The ending retained earnings is used by
the balance sheet.
o The balance sheet lists the assets, liabilities,
and equity (including dollar amounts) of a
business organization at a specific moment in
time and proves the accounting equation.
o The statement of cash flows which shows the
cash inflows and cash outflows for a
company for a stated period of time. The
statement of cash flows uses information
from all previous financial statements.
❖ Ratios – one variable divided by another – are used
widely in financial analysis to understand how
companies are doing internally and relative to one
another.
❖ Financial ratios can be computed using data found in
financial statements, such as the balance sheet and
income statement, and form the basis of fundamental
analysis.
❖ In general, there are four common types of measures
used in ratio analysis: profitability, liquidity,
solvency, and valuation.
❖ Common examples of ratios include the price-to-
earnings (P/E) ratio, net profit margin, debt-to-equity
(D/E)
❖ Ratios are comparison points for companies.
They evaluate stocks within an industry.
Likewise, they measure a company today against
its historical numbers.
❖ In most cases, it is also important to understand
the variables driving ratios as management has
the flexibility to, at times, alter its strategy to
make the company's stock and ratios more
attractive. Generally, ratios are typically not used
in isolation but rather in combination with other
ratios. Having a good idea of the ratios in each of
the four previously mentioned categories will
give you a comprehensive view of the company
from different angles and help you spot potential
red flags.
❖ The information you need for calculating ratios is
easy to come by as every single number or figure
can be found in a company's financial statements.
Once you have the raw data, you can plug it right
into your financial analysis tools and put those
numbers to work for you.
❖ Everyone wants an edge in investing, but one of
the best tools is frequently misunderstood and
avoided by new investors. Understanding what
ratios tell you, as well as where to find all the
information you need to calculate them, can give
you greater confidence in your investment
decisions and potentially help you avoid large
losses.
Self-Assessment Questions
Posted separately as quiz assignment or assignment in your
google classroom.
References
Timbang, Ferdinand L.; “Financial Management, Part
1”;2015; C & E Publishing, Inc...
Brigham, Eugene F. and Ehrhardt, Michael C.;
“Financial Management: Theory and Practice”; 12th
Edition
https://courses.lumenlearning.com/sac-
finaccounting/chapter/financial-statements/
https://www.investopedia.com/articles/stocks/06/ratios.
asp
ARGENE B. ABELLANOSA
Instructor
0995-852-3831
argene.abellanosa@gmail.com