Basic Financial Statements

• Financial statement- are considered the final product of the whole accounting process.
Complete set of Financial Statements
1. Statement of financial position
2. Statement of financial condition
3. Statement of changes in equity
4. Cash flow statement
5. Notes to the financial statement
• FRSC (FINANCIAL REPORTING STANDARD COUNCIL) - in the Philippines the preparation of the financial
statement is based on the guidelines issued by FRSC.
• The guidelines issued by the FRSC is called Philippine Financial Reporting Standards (PFRSs), or referred to,
inshort as STANDARDS.
• The users of financial statement are broadly classified as follows:
1. External users
2. Internal Users
• EXTERNAL USERS - are individuals or parties that are not directly involved in the operation of the business.
 SEC suppliers
 BSP customers
 BIR prospective investors
 CREDITORS
• INTERNAL USERS - are individuals who have direct and active participations in various quantifiable transactions
of the business.
 Employees
 Management
Basic Guideline in the preparation of Financial Statement
1. fair presentation
2. going concern assumption
3. accrual basis of accounting
4. consistency of presentation

The Statement of Financial Position

 The Statement of Financial Position provides information regarding the liquidity position and capital structure of
a company as of a given date.
 It must be noted that the pieces of information found in this report are only true as of a given date.
 Liquidity refers to the ability of a company to pay maturing obligations.
 Capital structure provides information regarding the amount of assets financed by debt or liabilities and equity.
 Statement of Financial Position is previously referred to as Balance Sheet. It was renamed as such since 2009 to
better reflect the kind of information found in the financial report.
 New title for balance sheet
 Is a structured financial statement that shows the assets, liabilities and equity of a business entity as of a given
date.
 As of a given date indicates that the statement of sfp can be prepared anytime of the year and the information is
considered true and correct as of the date indicated in the statement.
Assets- resources controlled by the entity as a result of past events and from which future benefits are expected to flow
in the entity.
Liabilities- are present obligation of the entity arising from past events, the settlement of which is expected to result in
an outflow from the entity.
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
• Financial position of a business entity is usually expressed in terms of its
Liquidity- refers to the ability of a business entity to settle its currently maturing financial obligations.
Solvency- is the ability of a business to pay its long term financial obligations.
Obligations are currently maturing if they become due within one year.
 • Financial structure- indicates the amount of capital resources financed by creditors and amount provided by the
owners.
• Capacity for adaptation- refers to the ability of a business to invest excess available resources or raise needed
funds through borrowings without difficulty in times of need.
The Statement of Profit or Loss
 The Statement of Profit or Loss provides information regarding the revenues or sales, expenses, and net income
of a company over a given accounting period, a period which may be for a month, a quarter, or a year.
 In analyzing earnings performance, a comparison with the previous periods and with other companies,
especially those coming from the same industry, is a must. Such comparison will not be made possible without
knowing the accounting periods covered in the statement of profit or loss.
 Statement of Profit or Loss is also known as Income Statement.
 The income reported by a company is not that useful if the accounting period is not stated.
 Statement of comprehensive income (income statement) –is a structured financial statement that shows the
financial performance of a business entity for a given period.
 Period indicates- covers a month, a quarter six months or a year.
Income- is the summary of increase in economic benefits during the accounting period in the form of inflows or
enhancement of assets or decrease in liabilities that result in increase in equity other than those relating to
contributions from equity participants.
Expenses- are decrease in economic benefit during the accounting period in the form of outflows or depletion of
assets or incurrences of liabilities that result in decrease in equity, other than those relating to distribution to equity
participants.

• The standards mention two methods of presenting the statement of comprehensive income
1. Nature of expense method
2. Function of expense method
The choice between these two methods depends on historical cost and industrial factors and nature of entity.

 In analyzing Statement of Profit or Loss, it is important to identify how much of the income comes from core
business (the main business of the company) and how much comes from the non-core business.
 There are two options in presenting the Statement of Profit or Loss:
 The first option is to present it as a separate financial statement; and
 The second option is to present it together with other comprehensive income (OCI), which represents
transactions that are not reported in the profit or loss statement but affects the stockholders’ equity.

The Statement of Cash Flows

 The Statement of Cash Flows provides an explanation regarding the change in cash balance from one accounting
period to another.
 The Cash Flows are classified into three main categories:
1. Operating;
2. Investing; and
3. Financing.
 The Cash Flows are classified into three main categories:
 Operating. In the cash flows from operating activities, the income reported from the statement of profit
or loss which is based on accrual principle is converted to cash.
- the principal revenue producing activities of the entity and
other activities that are neither investing nor financing
 Investing. The cash flows from investing activities provide information regarding the future direction of
the company; it shows how much investment the company is making over a given accounting period.
Are the acquisition of long term assets and other investments not included in cash equivalents.
 Financing. The cash flows from financing activities provide information whether there is a proper
matching of investing and financing activities.
 Operating activities include the production, sales, and delivery of the company’s product as well as collecting
payments from its customers.
  Investing activities are purchases or sales of assets (land, building, equipment, marketable securities, etc.), loans
made to suppliers or received from customers, and payments related to mergers and acquisitions.
 Financing activities include the inflow of cash from investors, such as banks and shareholders, and the outflow
of cash to shareholders as dividends as the company generates income.
 Non-cash investing and financing activities are disclosed in footnotes in the financial statements.
 Financing Activities
One of the three main components of the cash flow statement is cash flow from financing. In this context,
financing concerns the borrowing, repaying, or raising of money. This could be from the issuance of shares,
buying back shares, paying dividends, or borrowing cash. Financing activities can be seen in changes in non-
current liabilities and in changes in equity in the change-in-equity statement.
 non-cash financing activities: Non-cash financing activities may include leasing to purchase an asset, converting
debt to equity, exchanging non-cash assets or liabilities for other non-cash assets or liabilities, and issuing shares
in exchange for assets.

OPERATING ACTIVITIES
• CASH RECEIVED FROM CUSTOMERS
• CASH PAID TO SUPPLIERS
• CASH PAID TO EMPLOYEES
• TAXES AND INTEREST PAID
• CASH RECEIPTS FROM GOODS SOLD
INVESTING ACTIVITIES
• PROPERTY, PLANT AND EQUIPMENT
• CAPITALIZED SOFTWARE EXPENSES
• CASH PAID IN MERGERS AND ACQUISITION
• PURCHASE OF MARKETABLE SECURITIES
• PROCEEDS FROM SALE OF ASSETS
• ALL PURCHASES OF CAPITAL ASSETS
• INVESTMENT IN OTHER VENTURES
• INVESTMENT IN STOCKS
FINANCING ACTIVITIES
• ISSUE NEW SHARES
• DIVIDENDS ARE PAID
• PAYMENT OF BANK LOAN
• DEBT PRINCIPAL IS REPAID
• REPAYMENT OF SHORT TERM FINANCING
• REPAYMENT OF LONG TERM FINANCING
• RAISING CAPITAL
• BORROWING CAPITAL
• REPAYING CAPITAL

The Statement of Changes in Stockholders’ Equity

 The Statement of Changes in Stockholders’ Equity provides information that explains the changes in the
stockholders’ equity account from one accounting period to another.
 The changes may be due to the following:
1. Profit or loss for the accounting period;
2. Cash dividend declaration;
3. Issuance of new shares of stocks; and
4. Other transactions that affect the stockholders’ equity such as other comprehensive income,
treasury stocks, and revaluation of assets.

Notes to Financial Statements – are integral part of the financial statements.

1. Brief Description of the Company
Information may include the nature of business of the company and the owners behind the company.
 2. Summary of Significant Accounting Policies
This is very important because the existing generally accepted accounting principles provide alternative
accounting policies to companies. It is therefore important to find out what specific accounting policies are used
by the company.
3. Breakdown of Amounts Found in the Financial Statements
The company’s property, plant, and equipment (PPE) account may have too many components. Putting all the
details on the face of the balance sheet may make the balance sheet too long. An alternative presentation is to
provide a single amount on the face of the balance sheet for PPE but the breakdown of PPE can be presented in
the notes to financial statements.
What Is Financial Statement Analysis?
Financial statement analysis is the process of selecting related data from financial statement to evaluate the entity past
financial position and operating performance and predict the outcome of future operations.
1. horizontal or comparative approach
2. vertical or common size approach
3. trend approach
Horizontal Analysis
 Horizontal analysis is also known as comparative analysis.
 Is an analytical tool that evaluates the present performance of an entity compared to last years. The analysis
reflects the differences in absolute amount and in percentage between two periods only, namely the present
year and the previous year.
 The technique borrowed its name from the horizontal direction of the analysis.
 The objective of the analysis is to answer the following questions:
 What is the behavior of the account over time? Is it increasing, decreasing or not moving?
 What is the relative or the percentage change in the balances of the account over time?
 Horizontal analysis uses financial statements of two or more periods.
 Horizontal analysis may be performed on all financial statements, specifically for both the SFP and SCI.
 Changes can be expressed in monetary value (peso) or percentages computed by using the following formulas:
Peso change = Balance of Current Year – Balance of Prior Year

Two methods of performing horizontal/ comparative analysis

1. absolute amount comparison
2. percentage comparison

Vertical Analysis
 Vertical analysis is the preparation of common-size financial statements. It is a technique that expresses each
financial statement line item as a percentage of a base amount. For the SFP, the base amount used is total
assets. On the other hand, sales or net sales is used as base amount for the SCI.
 Is an analytical tool that determine the size or proportion of an item in the financial statements in relation to the
total.
 A common-size SFP shows each line account as a percentage of total assets. From the asset side, we can infer
the composition of assets. On the other side, we can determine the company’s financing mix – the percentage of
asset financed by liability and equity.
Guidelines in the preparation of common size financial statement
1. convert the absolute amount of the items into percentage by dividing each item in the base year. the base
shall be equal to 100%.
2. use the following as the base:
a. Total assets for sfp
b. Total or net sales for comprehensive income
c. Total cash available for cash flows
Trend percentage approach
• Is used to analyze the financial statements that extend beyond two years through the use of index numbers or
percentage. It converts the absolute peso into percentages.
The following guidelines may be followed in conducting trend analysis
1. Present in tabular format the financial statement covering several years. The arrangement is usually in
ascending order of the dates.
2. Select a base year that is purely judgemental, normally the base year is the earliest year used in the analysis and
has an index of 100 or 100%.
3. Divide each absolute amount by the base year in order to determine the relationship of each item with the base
year. Multiply the result by 100 in order to express the data in percentage.

Uses of Financial Statement Analysis

 It is used for investment and credit decisions
 It is also used for regulating companies.
 It used by management for monitoring performance
 It is used in identifying strategies to further improve the company’s operations.
 Can be used by managers, equity investors, creditors, regulators, labor unions, employees, the public, and
potential investors and creditors.
Financial mix ratio analysis is an analytical tool employing the ratio or proportion of certain item in the financial
statement.
Financial Ratios
1. liquidity ratios – measure the ability of a company to pay maturing obligations from its current assets
2. solvency ratios
3. profitability ratios
Different Liquidity Ratios
1. Current Ratio
2. Acid-Test Ratio
3. Receivable turnover
4. Inventory turnover
Liquidity Ratio: Current Ratio

Current assets include cash and other assets which are expected to be converted to cash within 12 months such as
accounts receivable and inventories.
Current assets also include prepayments such as prepaid rent and prepaid insurance.
Current liabilities include obligations that are expected to be settled or paid within 12 months such as accounts payable,
accrued expenses payable such as accrued salaries, and current portion of long-term debt.
• current portion of long-term debt is the principal amount of a long-term loan expected to be paid within the
next 12 months from the balance sheet date.
Liquidity Ratio: Acid-Test Ratio
 Acid-Test Ratio is sometimes referred to as Quick Asset Ratio.
 The quick asset ratio is a stricter measure of a company’s liquidity position.
QUICK ASSETS = CASH+ TRADING SECURITIES+ TRADE
QUICK RATIO OR ACID TEST RATIO= QUICK ASSETS/ CURRENT LIABILITIES
Liquidity Ratio: Receivable Turnover
 Measures the velocity of conversion of trade receivable into cash during the year.
 In computing ROE, different approaches are observed. There are analysts who use the average of the
stockholders’ equity for two accounting periods while others simply use the year-end balances. Whichever
formula is used, consistency must be applied.
receivable turn over = net credit sales
average trade receivable
Liquidity Ratio: Inventory Turnover
 Measures the number of times inventories are acquired and sold during the year.
inventory turnover = cost of goods sold
average inventory
Different Solvency Ratios
1. Debt Ratio
2. Equity ratio
3. Debt to Equity Ratio
4. Time interest earned
 leverage ratios show the capital structure of a company, that is, how much of the total assets of a company is
financed by debt and how much is financed by stockholders’ equity. Leverage ratios can also be used to measure the
company’s ability to meet long-term obligations.
Solvency Ratio: Debt Ratio
 Debt Ratio measures how much of the total assets are financed by liabilities.

Solvency Ratio: equity Ratio

 equity Ratio determines the proportion of resources provided by the owner or owners of the business
Equity ratio= total equity/ total assets

Solvency Ratio: Debt to Equity Ratio

 Debt to Equity Ratio is a variation of the Debt Ratio.
 A Debt to Equity Ratio of more than one means that a company has more liabilities as compared to stockholders’
equity.

Solvency Ratio: times interest earned

 Is a tool that measures the debt paying ability of the business.
Tie = income before interest and taxes/ interest expense
Different Profitability Ratios
1. Gross profit rate
2. Operating profit margin
3. Net profit margin
4. Return on investment
Profitability Ratio: Gross profit rate
 Measures the percentage of gross profit to sales.
GROSS PROFIT RATE= GROSS PROFIT
NET SALES
Profitability Ratio: Operating Profit Margin
 operating Profit Margin is measures the percentage of profit available after deducting the cost of sales and
operating expenses from sales.
Operating profit margin= Operating profit/ net sales
Profitability Ratio: Net Profit Margin
 Net Profit Margin measures how much net profit a company generates for every peso of sales or revenues that
it generates.

Net income is the amount left after all expenses including income taxes are deducted from sales or revenues.
Profitability Ratio: RETURN ON INVESTMENT
 RETURN ON INVESTMENT (ROI), ALSO called return on assets measures the amount of net income per peso of
investment in a business.
RETURN ON INVESTMENTS = NET INCOME/ AVERAGE TOTAL ASSETS
Financial Ratios
 It is composed of a numerator and a denominator.
 It expresses the relationship between specific financial statement data.
 The resulting ratio may be interpreted as a percentage, a rate, or a proportion.
Profitability Ratios
 Profitability ratios measure the ability of the company to generate income from the use of its assets and
invested capital.
 The company’s ability to control its cost is also inferred from profitability ratios.
 Net Profit Margin
 Return on Assets
 Return on Equity
Profitability Ratio: Gross Profit Margin
1. Gross Profit Margin
 It expresses gross profit as a percentage of sales.
 It can be interpreted as the peso value of the gross profit earned for every peso of sales.
 We can infer the average pricing policy from the gross profit margin.

Profitability Ratio: Operating Profit Margin

2. Operating Profit Margin
 It operating income as a percentage of sales.
 It is the peso value of the operating income earned for every peso of sales.
 Operating Income = Gross Profit – Operating Expenses

Note: Operating income is computed as gross profit less operating expenses. Therefore, between two companies with
the same gross profit margin, the company with the better operating income margin has leaner operations.
• In business, leaner operations imply lower operating expenses.
Profitability Ratio: Net Profit Margin
3. Net Profit Margin
 It expresses net income as a percentage of sales.
 It can be interpreted as the peso value of the net income earned for every peso of sales.
 A company with a higher net profit margin is considered more profitable.

Profitability Ratio: Return on Assets

4. Return on Assets or ROA
 It is computed as net income divided by average total assets.
 It can also be computed using the ending balance of total assets instead of average total assets.
 It measures the peso value of income generated by employing the company’s assets.
 It is a popular measure of the profitability of the company’s assets.
 In comparing companies, the company with a higher ROA is judged to be more profitable.
Profitability Ratio: Return on Equity
5. Return on Equity or ROE
 It is computed as net income divided by average total equity.
 Like return on assets, it can also be computed using the ending balance of equity.
 It measures the return (net income) generated by the capital invested by the owner in the business.
 Like ROA, the company with a higher ROE is judged to be more profitable.

Average Assets = Asset,Beginning + Asset, Ending

2
Average Equity = Capital beginning + Capital ending
2
Operational Efficiency
 It measures the ability of the company to utilize its assets.
 It is measured based on the company’s ability to generate sales from the utilization of its assets, as a whole or
individually.
 The turnover ratios are primarily used to measure operational efficiency.
Operational Efficiency: Asset Turnover
1. Asset Turnover
 It is an indicator of the efficiency with which the company is utilizing all of its assets.
 It measures the peso value of sales generated for every peso of the company’s assets.
 The higher the turnover rate, the more efficient the company is in using its assets.

Operational Efficiency: Inventory Turnover

2. Inventory Turnover
 It is measured based on cost of goods sold and not sales because inventory, upon sale, is transferred to
cost of goods sold. It makes both the numerator and denominator measured at cost. This ratio is an
indicator of how fast the company can sell its inventory.
 Inventory turnover measures the number of times the company restock inventory.

Operational Efficiency: Days in Inventory

3. Days in Inventory
 This ratio computes the average number of days that inventories are held until sold. Days in inventory
can be easily derived from inventory turnover by multiplying 365 days by 1/Inventory Turnover.

Operational Efficiency: Accounts Receivable Turnover/Days in Receivable

4. Accounts Receivable Turnover / Days in Receivable
 Accounts Receivable Turnover measures the number of times the company can convert accounts
receivable to cash during the year. Basically, the ratio asks how many times the company was able to
collect on its average accounts receivable during the year.
  Days in Receivable is another measure of the company’s collection effectiveness. It can be computed
from the turnover ratio or computed on its own. Days in receivable is a more visual indicator as
compared to accounts receivable turnover. It computes for the average number of days from date of sale
to date of collection.

Financial Health
SOLVENCY LIQUIDITY
• Debt to Equity Ratio • Current Ratio
• Debt Ratio • Quick Ratio
• Interest Coverage Ratio
• Solvency refers to the company’s capacity to pay their long term liabilities. On the other hand, liquidity ratio intends
to measure the company’s ability to pay debts that are coming due (current liabilities).
• Liquidity is a more urgent issue as compared to solvency. Creditors look at both solvency and liquidity ratios to
evaluate the company’s ability to pay back their debts as well as pay interests.
Financial Health: Solvency Measures
SOLVENCY
1. Debt to Equity Ratio
 Debt to equity ratio indicates the company’s reliance to debt or liability as a source of financing relative
to equity.
 A high ratio suggests a high level of debt that may result in high interest expense.
 A debt to equity ratio of greater than 1 implies that the company’s debt exceeds its capital.

2. Debt Ratio
 This is a ratio similar to debt to equity ratio.
 It indicates the percentage of the company’s assets that are financed by debt.
 A high debt to asset ratio implies a high level of debt.
 3. Interest Coverage Ratio
 This ratio measures the company’s ability to cover the interest expense on its liability with its operating
income.
 A ratio greater than 1 means the company’s operating income can meet its interest expense.
 But 1 is a very low ratio. Creditors prefer a high coverage ratio to give them protection that interest can
be repaid from income.

Financial Health: Liquidity

LIQUIDITY
1. Current Ratio
 This ratio is used to evaluate the company’s liquidity.
 Basically, we want to know whether there are sufficient current assets to pay for current liabilities.
 A ratio of 1 means current assets can fully cover current liabilities. However, creditors want a margin of
safety. Some creditors require a current ratio of 2.
 An alternative measure of liquidity is the net working capital, which refers to current assets less current
liabilities.
 A positive net working capital means that not only is current liabilities fully covered by current assets,
there are excess current assets that the company can use for other purposes.
 A negative net working capital means that current assets are not sufficient to pay liabilities that are
coming due.

2. Quick Ratio
 This ratio is stricter than current ratio.
 It suggests that not all current assets can be easily liquidated to pay for the short term liabilities.
 Quick assets include only current assets that can be quickly turned into cash such as cash and cash
equivalents, accounts receivable, and marketable securities.