BM2313

THE LANGUAGE OF BUSINESS

Understanding Financial Statements
Balance Sheet/Statement of Financial Position
The balance sheet shows the financial position of a business on a certain date (usually the end of the
month or year). It is also called the statement of financial position (or SFP). It is important to note that the
date on the balance sheet is a single date. The balance sheet presents a business view of assets equal to
the sum of liabilities and capital. (Needles, Powers, & Crosson, 2014)
ROLAND CONSULTANCY
Balance Sheet
December 31, 200A

Assets
Cash ₱3,120,000.00
Accounts Receivable 200,000.00
Supplies 100,000.00
Land 2,000,000.00
Building 5,000,000.00
Total Assets ₱10,420,000.00
Liabilities and Owner's Equity
Accounts Payable ₱120,000.00
Total Liabilities ₱120,000.00
R. Tista, Capital ₱10,300,000.00
Total Liabilities and Owner's Equity ₱10,420,000.00
The following are the primary functions of a balance sheet:
• Business funds. The statement of financial position shows the capital contribution of owners and
outside lenders. It also presents the acquired assets of the business.
• Business value. The statement of financial position provides a starting point for assessing a firm's value
since it lists all the assets and business claims.
• Business assets and claims. It can be helpful to look at relationships between various statements of
financial position items, for example, the relationship between how much wealth is tied up in current
assets and how much is owed in the short-term (current liabilities).
• Business performance. The effectiveness of a business in generating wealth can be assessed against
the amount of investment involved. Thus, the relationship between profit earned during a period and
the value of the net assets invested can be helpful to users, particularly owners and managers (Atrill &
McLaney, 2018).

Income Statement
The income statement summarizes the revenues earned and expenses incurred by a business over an
accounting period. It is also called the profit-and-loss (P&L) statement. Many consider it the most
important financial report because it shows whether a business achieved its profitability goal (whether it
earned an acceptable income).

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 1 of 5
 BM2313

ROLAND CONSULTANCY
Income Statement
For the year ended December 31, 200A
Revenue:
Consulting fees earned ₱700,000.00
Expenses:
Equipment rental expense ₱140,000.00
Wages expense 80,000.00
Utility expense 60,000.00
Total expenses 280,000.00
Net Income ₱420,000.00

The income statement may help in providing information on:

• Wealth generation. Assessing how much wealth has been created is vital for businesses. The income
statement reveals the firm's profit for a given period. It provides a measure of the wealth created for
the owners. Gross profit and operating profit are also useful measures of wealth creation.
• Profit derivative. The income statement also provides information needed to gauge business
performance. It reveals the level of sales revenue and the nature and amount of expenses incurred,
which can help understand how profit was derived (Atrill & McLaney, 2018).
Cash Flow Statement
The cash flow statement focuses on liquidity (or balancing the cash inflows and outflows to enable firms
to operate and pay their bills when they are due). Cash flows are the inflows and outflows of cash into
and out of business. Net cash flows are the difference between inflows and outflows.
ROLAND CONSULTANCY
Statement of Cash Flows
December 31, 200A
Cash flows from operating activities
Net income ₱420,000.00
Increase in accounts receivable (₱200,000.00)
Increase in supplies (100,000.00)
Increase in accounts payable 120,000.00 (180,000.00)
Net cash flows from operating activities ₱240,000.00
Cash flows from investing activities
Purchase of land (2,000,000.00)
Purchase of building (5,000,000.00)
Net cash flows used by investing activities (₱7,000,000.00)
Cash flows from financing activities
Investments by owner 10,000,000.00
Withdrawals (120,000.00)
Net cash flows from financing activities ₱9,880,000.00
Net increase (decrease) in cash ₱3,120,000.00
Cash, Beginning 0
Cash, Ending ₱3,120,000.00

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 2 of 5
 BM2313

Financial Ratios
The following are the common types of ratios:

Return on Investments (ROI)

𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
The return on investments (ROI) generally means the return on the owner's equity; hence, it is
sometimes referred to as return on equity (ROE). ROI relates income or profit after income tax to the
total stockholder's equity (preferably on the average stockholder's equity). Average stockholder's
equity is computed by adding the beginning and the ending balances and dividing it by two (2).
Profit Margin/Return on Sales (ROS)
𝐼𝑛𝑐𝑜𝑚𝑒
𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
The profit margin, or return on sales, is the income-to-net sales ratio. On a basic level, a low profit
margin can be interpreted as indicating that a company's profitability is not secure. Suppose a company
with a low profit margin experiences a decline in sales. In that case, its profit margin will decline, leading
to a very low, neutral, or negative profit margin.
Low profit margins may also reveal certain matters about the industry or the broader economic
conditions. For example, suppose a company's profit margin is low. In that case, it may indicate that it
has lower sales than other companies in the industry (a low market share) or that the industry in which
the company operates is suffering. Perhaps because of waning consumer interest (or increasing
popularity and/or availability of alternatives). It could also result from hard economic times
or recession.
The profit margin may also indicate a company's ability to manage expenses. High expenditures relative
to revenue (i.e., a low profit margin) may suggest that a company struggles to keep its costs low,
perhaps due to management problems. It is an indication that costs need to be under better control.
High expenditures may occur for many reasons. These could be expenditures from too
much inventory (relative to the firm's sales), too many employees, and inappropriate operating spaces
(i.e., large offices requiring higher rent pay). On the other hand, a higher profit margin indicates a more
profitable company with better control over its costs than its competitors.
Profit margin can also illuminate certain aspects of a company's pricing strategy. For example, a low
profit margin may indicate a company is underpricing its goods (Segal, 2023).
Return on Assets (ROA)
𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
This profitability measure shows how effectively the company has utilized its assets. In other words, it
is a measure of asset utilization. This time, the operating income is used instead of the income after tax
because the asset utilization pertains to the operations. ROA is equal to operating income divided by
average total assets. The average of total assets is used to better gauge asset utilization.

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 3 of 5
 BM2313

Current Ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The current ratio relates current assets to current liabilities and shows a firm's immediate solvency and
liquidity. Solvency is the ability of a firm to meet long-term obligations, while liquidity refers to an
enterprise's ability to pay short-term bills and debts. The current ratio tells how much current assets
are available to meet the current liabilities. If the current ratio is 2:1, the company has P2 worth of
current assets to meet every peso of current liability. The higher the current ratio, the more solvent or
liquid a company is.
Quick Ratio (Acid-Test Ratio)
𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The quick ratio indicates a company's short-term liquidity and measures its ability to meet its short-
term obligations with its most liquid assets.
While a quick ratio lower than one (1) does not necessarily mean the company is going into default or
bankruptcy, it could rely heavily on inventory or other assets to pay its short-term liabilities. The higher
the quick ratio, the better the company's liquidity position. However, a quick ratio that is too high may
indicate that the company has too much cash sitting in its reserves. It may also mean that the company
has a high accounts receivable, indicating that it may be having problems collecting its account
receivables. (Seth, 2023)
Debt Ratio
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
The debt ratio compares a company's total debt to its total assets. It gives creditors and investors a
general idea of the amount of leverage a company uses. The lower the percentage, the less leverage a
company uses and the stronger its equity position. In general, the higher the ratio, the more risk that
company is considered to have taken on (Hayes, What Is the Debt Ratio?, 2023).
Stockholder's Ratio
𝑇𝑜𝑡𝑎𝑙 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
While the relationship between creditors' claims on total assets is essential for creditors, the total
claims of stockholders on total assets are equally important, as the stockholder's ratio indicates the
firm's financial stability in the long run. It measures how much of a company's assets are funded by
issuing stock rather than borrowing money (Hayes, Investopedia, 2022). Instead of using the formula
above, the stockholder's ratio can be computed alternatively as follows:
𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑅𝑎𝑡𝑖𝑜 = 100% − 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜

Debt-Equity Ratio
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 4 of 5
 BM2313

The debt-equity ratio measures the percentage of the company's balance sheet financed by suppliers,
lenders, creditors, and obligors versus what the shareholders have committed. It provides another
vantage point on a company's leverage position: it compares total liabilities to shareholders' equity
instead of total assets in the debt ratio. Similar to the debt ratio, a lower percentage means that a
company uses less leverage and has a stronger equity position.
Interest Coverage Ratio
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
The interest coverage ratio indicates a company's ability to meet its interest payment obligations. It is
computed by dividing the operating income by the interest expense. It shows how many times the
company earns its annual interest expense. From the creditor's point of view, the higher the ratio, the
better. Generally, it is regarded that an interest coverage ratio of 4:1 or more is desirable. A drop in this
ratio drops the credit rating of the company.

References:
Atrill, P., & McLaney, E. (2018). Accounting and Finance for Non-Specialists (11th ed.). Pearson Education
Limited.

Hayes, A. (2022, July 18). Investopedia. Retrieved from Shareholder Equity Ratio: Definition and Formula
for Calculation: https://www.investopedia.com/terms/s/shareholderequityratio.asp

Hayes, A. (2023, July 7). What Is the Debt Ratio? Retrieved from Investopedia:
https://www.investopedia.com/university/ratios/debt/ratio2.asp

Needles, B. E., Powers, M., & Crosson, S. V. (2014). Principles of Accounting (12th ed.). Mason: South-
Western Cengage Learning.

Segal, T. (2023, May 16). Profit Margin: Definition, Types, Uses in Business and Investing. Retrieved from
Investopedia: https://www.investopedia.com/terms/p/profitmargin.asp

Seth, S. (2023, March 31). Quick Ratio Formula With Examples, Pros and Cons. Retrieved from
Investopedia: https://www.investopedia.com/terms/q/quickratio.asp

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 5 of 5