Financial Statement

 The end product of the accounting process, which reveals the financial result of

the specified period and financial position as on particular date. It is the basic and

formal annual report through which a business communicates financial information

to its various groups.

 Declaration of information believed to be true communicated in monetary terms.

 Reports which summarize the financial position, operating results and cash flows

of a business.

Objectives of financial Statement

1. To provide reliable financial information about economic resources (assets) and

obligations (liabilities) of a business firm.

2. To provide information about the earning capacity of the business

3. To provide reliable information about the changes in resources and obligations

arising out of business activities

4. To disclose, the various accounting policies followed in preparing the financial

statement to its various groups

5. To disclose, to the external possible, other related information to financial

statement that is relevant to the needs of the users

Components of Final Statement

1. Statement of Performance

 Also called the Statement of Profit and Loss or the Income Statement

 Covers a time frame (a month, a quarter, a year)

2. Statement of Financial Position

  Also called the Balance Sheet

 A snapshot of a point in time, usually period end.

3. Statement of Cash Flows

 Provides supplemental information to other statements

 Covers a time frame

4. Financial Statement Analysis

 An essential part of managing the business and in making investment decision

5. Financial Statement Analysis

 Financial statement analysis helps users make better decisions.

Why Financial Analysis

For financial managers:

 Financial statement analysis allows managers to identify areas to improve

investment value (i.e., what do owners and investors want to see)

 Financial analysis may help managers identify operating problems (slow credit

collections, excessive inventory, etc.)

 Financial analysis may identify areas for financial planning (needed capital

financing, excessive leverage, needed liquidity)

For creditors:

 Financial analysis can provide a significant basis for credit ratings

 Financial analysis can be used to forecast financial

 events (including bankruptcy or liquidity shortage)

 Liquidity and solvency ratios can assess whether

  the company will have difficulty repaying loans

For owners and investors:

 Getting the answers to questions raised in financial decisions. Finding the next

great investment requires an objective assessment of the investment

alternatives

 Analysis may give owners and investors a better insight

 about the company

 Analyzing current investments may help owners and

 investors know when it’s time to sell or close the business.

How to Interpret the Answers

 Some analytics provide answers in themselves. That is, a good portion of the

meaning is in the answer itself.

 However, most analytics have meaning when compared to:

 The “trend” for the corporation or the meaning is clearer if it depicts

a trend.

 Industry averages for other companies in the same business to identify our

performance or under performance

 To budget to discern if objectives are being met.

Standards for Comparison

To help interpret our financial statements, we use several standards of comparison:

 Intracompany

 Competitor

 Industry
  Guidelines

Tools of Analysis

1. Horizontal Analysis - Comparing a company’s financial condition and performance

across time

2. Trend Analysis - is used to reveal patterns in data covering successive periods.

3. Vertical Analysis - Comparing a company’s financial condition and performance to a

base amount

4. Ratio Analysis - Using key relations among financial statement items

The Principles of Statement Presentation

1. The basic statements include the balance sheet, income statement, statement of

retained earnings and statement of cash flows.

2. The balance sheet should be prepared in conformity with GAAP.

3. The income statement should be prepared in accordance with GAAP.

4. The statement of cash flows should properly describe all cash effect of the company’s

operating, financial and investing activities.

5. The basic time period for financial statements is one year

6. Financial information about foreign operations should be translated into Philippine

pesos.

7. Proper classifications are to be made, like sales cost sales, selling expenses,

administrative expenses, current assets, investments, property, plant and equipment,

intangibles, etc.
8. There should be disclosure of significant accounting policies.

9. No particular form of financial statements is presumed better than all other.

10. The earnings per share should be disclosed on the face of the income statement.

Preparing Financial Statements

1. Examine Source Documents

2. Analyze Transactions

3. Record Transactions

4. Post Transactions

5. Prepare Trial Balance

Adjusting the Accounts

Framework for Adjustments

Framework for Adjustments

Adjustments

Prepaid Depreciation Unearned Accrued Accrued

Expenses Revenues Expenses Revenues
1. Prepaid Expenses - Transaction where cash is paid before a related expense is

recognized.

2. Depreciation - Transaction where cash is paid before a related expense is

recognized. Depreciation is the process of computing expense from allocating the cost

of plant and equipment over its expected useful lives.

3. Unearned Revenues - Transaction where cash is received before a related revenue

is recognized.

4. Accrued Expenses - Transaction where cash is paid after a related expense is

recognized.

5. Accrued Revenues - Transaction where cash is received after a related revenue is

recognized.

Foundation of Management Accounting

Types of Accounting Information:

 Financial

 Tax

 Management

Accounting System

An accounting system consists of the personnel, procedures, technology, and records

used by an organization to develop accounting information and to communicate this

information to decision makers.

Determining Information Needs

Although much accounting information clearly is essential to business operations,

management still has many choices as to the types and amount of accounting information

to be developed.

Information System

Information Users Financial Information Decisions Supported

Provided
 Investors  Profitability  Performance

 Creditors  Financial position evaluations

 Managers  Cash flows  Equity investments

 Owners  Tax strategies

 Customers  Labor relations

 Employees  Resource allocations

 Regulators  Lending decisions

 Borrowing

Basic Functions of an Accounting System

1. Interpret and record business transactions.

2. Classify similar transactions into useful reports.

3. Summarize and communicate information to decision makers.

Components of Internal Control

  Control Environment

 Risk Assessment

 Control Activities

 Information and Communication

 Information and Communication

Objectives of External Financial Reporting

1. Provide specific information about assets, liabilities, equity, income and expenses,

including gains and losses, contributions by and distributions to owners in their capacity

as owners, and cash flows.

2. Provide information useful in predicting amount, timing and uncertainty of future cash

flows.

3. Provide general information useful in making economic decisions.

External Users of Accounting Information

 Owners

 Creditors

 Potential investors

 Labor Unions

 Governmental agencies

 Suppliers

 Customers

 Trade associations
  General public

Internal Users of Accounting Information

 Board of directors

 Chief executive officer (CEO)

 Chief financial officer (CFO)

 Vice presidents

 Business unit managers

 Plant managers

 Store managers

 Line supervisors

Qualitative Characteristics of Accounting Information

1. Fundamental (Primary) Qualitative Characteristics

• Relevance

• Representational faithfulness

2. Enhancing (Secondary) Qualitative Characteristics

• Verifiability - The quality of verifiability contributes to the usefulness of accounting

information because the purpose of verification is to provide a significant degree

of assurance that accounting measures represent, what they purport to represent.

• Timeliness - Means providing information's to decision-makers in time to be

capable of influencing their decisions

 • Understandability - Requires financial information to be understandable or

comprehensible.

• Comparability - Means that the information should be comparable with accounting

information about other enterprises.

Tools in Financial Statement Analysis

1. Common Size Statements

 Used to standardize financial statement components by expressing them as a

percentage of a relevant base.

 Can provide useful information as a first step in developing insights into the

economic characteristics of different industries and of different firms in the industry

– Cross Sectional Analysis.

 Can be used to compare the performance of a single company over time – Time

Series Analysis

Tools of Analysis

1. Ratio Analysis - Using key relations among financial statement items

2. Financial Ratios

Current Ratio

 The Current Ratio measures a company's ability to pay their current obligations.

The greater extent to which current assets exceed current liabilities, the easier

a company can meet its short-term obligations.

  A ratio lower than that of the industry average suggests that the company may

have liquidity problems. However, a significantly higher ratio may suggest that

the company is not efficiently using its funds. A satisfactory Current Ratio for a

company will be within close range of the industry average.

Acid Test Ratio

 This ratio is like the current ratio but excludes current assets such as

inventories and prepaid expenses that may be difficult to quickly convert

into cash.

 The acid-test ratio is used to indicate a company’s ability to pay off its

current liabilities without relying on the sale of inventory or on obtaining

additional financing. Inventory is not included in calculating the ratio, as it is

not ordinarily an asset that can be easily and quickly converted into cash.

Compared to the current ratio – a liquidity or debt ratio which does include

inventory value in the calculation – the acid-test ratio is considered a more

conservative estimation of a company’s financial health.

 The higher the ratio, the better the company’s liquidity and overall financial

health. A ratio of 2 implies that the company owns P2 of liquid assets to

cover each P1 of current liabilities. However, it’s important to note that an

extremely high quick ratio (for example, a ratio of 10) is not considered

favorable, as it may indicate that the company has excess cash that is not

being wisely put to use growing its business. A very high ratio may also
 indicate that the company’s accounts receivables are excessively high –

and that may indicate collection problems.

 The optimal acid-test ratio number for a specific company depends on the

industry and marketplaces the company operates in, the exact nature of the

company’s business, and the company’s overall financial stability.

 For example, a relatively low acid-test ratio is less significant for a well-

established business with long-term contract revenues, or for a business

with very solid credit, so that it can easily access short-term financing if the

need arises.

Drawbacks of the Acid-Test Ratio

 As with virtually any financial metric, there are a number of limitations and

potential drawbacks to using the quick ratio:

 The acid-test ratio alone is not sufficient to determine the liquidity position

of the company. Other liquidity ratios such as the current ratio or cash flow

ratio are commonly used in conjunction with the acid-test ratio to provide a

more complete and accurate estimation of a company’s liquidity position.

 The ratio excludes inventory from the calculation because inventory is not

generally considered a liquid asset. However, some businesses are able to

quickly sell their inventory at a fair market price. In such cases, the

company’s inventory does qualify as an asset that can readily be converted

into cash.
  The ratio does not provide information about the timing and level of cash

flows, which are important factors in accurately determining a company’s

ability to pay its obligations when they are due.

 The acid-test ratio assumes that accounts receivable are easily and readily

available for collection, but that may not actually be the case.

3. Cash Ratio - Even more conservative than quick ratio: Cash plus marketable

securities divided by current liabilities

4. Defensive Interval - This measure how long your business could survive without cash

coming in. This should be between 30 and 90 days.

5. Accounts Receivable Turnover - This ratio measures how many times a company

converts its receivables into cash each year. Accounts receivable turnover is

an efficiency ratio or activity ratio that measures how many times a business can turn

its accounts receivable into cash during a period. In other words, the accounts

receivable turnover ratio measures how many times a business can collect its average

accounts receivable during the year.

Analysis

 Since the receivables turnover ratio measures a business’ ability to efficiently

collect its receivables, it only makes sense that a higher ratio would be more

favorable. Higher ratios mean that companies are collecting their receivables

more frequently throughout the year. For instance, a ratio of 2 means that the

company collected its average receivables twice during the year. In other

words, this company is collecting is money from customers every six months.
  Higher efficiency is favorable from a cash flow standpoint as well. If a company

can collect cash from customers sooner, it will be able to use that cash to pay

bills and other obligations sooner.

 Accounts receivable turnover also is and indication of the quality of credit sales

and receivables. A company with a higher ratio shows that credit sales are

more likely to be collected than a company with a lower ratio. Since accounts

receivable are often posted as collateral for loans, quality of receivables is

important.

6. Inventory Turnover - This ratio measures the number of times merchandise is sold

and replaced during the year.

The inventory turnover ratio is an efficiency ratio that shows how effectively

inventory is managed by comparing cost of goods sold with average inventory for a

period. This measures how many times average inventory is “turned” or sold during a

period. In other words, it measures how many times a company sold its total average

inventory peso amount during the year.

This ratio is important because total turnover depends on two main components of

performance.

 The first component is stock purchasing. If larger amounts of inventory are

purchased during the year, the company will have to sell greater amounts

of inventory to improve its turnover. If the company can’t sell these greater

amounts of inventory, it will incur storage costs and other holding costs.
  The second component is sales. Sales have to match inventory purchases

otherwise the inventory will not turn effectively. That’s why the purchasing

and sales departments must be in tune with each other.

Analysis

 Inventory turnover is a measure of how efficiently a company can control its

merchandise, so it is important to have a high turn. This shows the company

does not overspend by buying too much inventory and wastes resources by

storing non-salable inventory. It also shows that the company can effectively

sell the inventory it buys.

 This measurement also shows investors how liquid a company’s inventory

is. Think about it. Inventory is one of the biggest assets a retailer reports on

its balance sheet. If this inventory can’t be sold, it is worthless to the

company. This measurement shows how easily a company can turn its

inventory into cash.

 Creditors are particularly interested in this because inventory is often put up

as collateral for loans. Banks want to know that this inventory will be easy

to sell.

 Inventory turns vary with industry. For instance, the apparel industry will

have higher turns than the exotic car industry.

7. Days’ Sales Uncollected - The days sales outstanding calculation, also called the

average collection period or days’ sales in receivables, measures the number of days

it takes a company to collect cash from its credit sales. This calculation shows the

liquidity and efficiency of a company’s collections department.

 In other words, it shows how well a company can collect cash from its customers.

The sooner cash can be collected, the sooner this cash can be used for other

operations. Both liquidity and cash flows increase with a lower day’s sales outstanding

measurement.

Analysis

 The days sales outstanding formula shows investors and creditors how well

companies’ can collect cash from their customers. Obviously, sales don’t

matter if cash is never collected. This ratio measures the number of days it

takes a company to convert its sales into cash.

 A lower ratio is more favorable because it means companies collect cash earlier

from customers and can use this cash for other operations. It also shows that

the accounts receivables are good and won’t be written off as bad debts.

 A higher ratio indicates a company with poor collection procedures and

customers who are unable or unwilling to pay for their purchases. Companies

with high days sales ratios are unable to convert sales into cash as quickly as

firms with lower ratios.

8. Total Asset Turnover - The asset turnover ratio is an efficiency ratio that measures

a company’s ability to generate sales from its assets by comparing net sales with

average total assets. In other words, this ratio shows how efficiently a company can

use its assets to generate sales.

The total asset turnover ratio calculates net sales as a percentage of assets to

show how many sales are generated from each peso of company assets. For

instance, a ratio of .5 means that each peso of assets generates 50 cents of sales.
 Analysis

 This ratio measures how efficiently a firm uses its assets to generate sales, so

a higher ratio is always more favorable. Higher turnover ratios mean the

company is using its assets more efficiently. Lower ratios mean that the

company isn’t using its assets efficiently and most likely have management or

production problems.

 For instance, a ratio of 1 means that the net sales of a company equals the

average total assets for the year. In other words, the company is generating 1

peso of sales for every peso invested in assets.

 Like with most ratios, the asset turnover ratio is based on industry standards.

Some industries use assets more efficiently than others. To get a true sense of

how well a company’s assets are being used, it must be compared to other

companies in its industry.

 The total asset turnover ratio is a general efficiency ratio that measures how

efficiently a company uses all of its assets. This gives investors and creditors

an idea of how a company is managed and uses its assets to produce products

and sales.

 Sometimes investors also want to see how companies use more specific assets

like fixed assets and current assets. The fixed asset turnover ratio and the

working capital ratio are turnover ratios similar to the asset turnover ratio that

are often used to calculate the efficiency of these asset classes.

9. Solvency - Gearing is a sign of solvency. It is found by dividing loans and bank

overdrafts by equity, long-term loans and bank overdrafts. The higher the gearing, the
 more vulnerable the company is to increasing interest rates. Most lenders will refuse

further finance where gearing exceeds 50 percent.

10. Debt Ratio

 This ratio measures what portion of a company’s assets are contributed by

creditors.

 Debt ratio is a solvency ratio that measures a firm’s total liabilities as a

percentage of its total assets. In a sense, the debt ratio shows a company’s

ability to pay off its liabilities with its assets. In other words, this shows how

many assets the company must sell in order to pay off all of its liabilities.

 This ratio measures the financial leverage of a company. Companies with

higher levels of liabilities compared with assets are considered highly leveraged

and riskier for lenders.

 This helps investors and creditors analysis the overall debt burden on the

company as well as the firm’s ability to pay off the debt in future, uncertain

economic times.

Analysis

 The debt ratio is shown in decimal format because it calculates total liabilities as a

percentage of total assets. As with many solvency ratios, a lower ratio is more

favorable than a higher ratio.

 A lower debt ratio usually implies a more stable business with the potential of

longevity because a company with lower ratio also has lower overall debt. Each

industry has its own benchmarks for debt, but .5 is reasonable ratio.
  A debt ratio of .5 is often considered to be less risky. This means that the company

has twice as many assets as liabilities. Or said a different way, this company’s

liabilities are only 50 percent of its total assets. Essentially, only its creditors own

half of the company’s assets and the shareholders own the remainder of the

assets.

 A ratio of 1 means that total liabilities equals total assets. In other words, the

company would have to sell off all of its assets in order to pay off its liabilities.

Obviously, this is a highly leverage firm. Once its assets are sold off, the business

no longer can operate.

 The debt ratio is a fundamental solvency ratio because creditors are always

concerned about being repaid. When companies borrow more money, their ratio

increases creditors will no longer loan them money. Companies with higher debt

ratios are better off looking to equity financing to grow their operations.

11. Equity Ratio

 This ratio measures what portion of a company’s assets are contributed by owners.

 The equity ratio is an investment leverage or solvency ratio that measures the

amount of assets that are financed by owners’ investments by comparing the total

equity in the company to the total assets.

 The equity ratio highlights two important financial concepts of a solvent and

sustainable business.

1. The first component shows how much of the total company assets are owned

outright by the investors. In other words, after all of the liabilities are paid off, the

investors will end up with the remaining assets.

 2. The second component inversely shows how leveraged the company is with

debt. The equity ratio measures how much of a firm’s assets were financed by

investors. In other words, this is the investors’ stake in the company. This is what

they are on the hook for. The inverse of this calculation shows the amount of assets

that were financed by debt. Companies with higher equity ratios show new

investors and creditors that investors believe in the company and are willing to

finance it with their investments.

Analysis

 In general, higher equity ratios are typically favorable for companies. This is usually

the case for several reasons. Higher investment levels by shareholders shows

potential shareholders that the company is worth investing in since so many investors

are willing to finance the company. A higher ratio also shows potential creditors that

the company is more sustainable and less risky to lend future loans.

 Equity financing in general is much cheaper than debt financing because of the

interest expenses related to debt financing. Companies with higher equity ratios

should have less financing and debt service costs than companies with lower ratios.

 As with all ratios, they are contingent on the industry. Exact ratio performance

depends on industry standards and benchmarks.

Pledged Assets to Secured Liabilities

 This ratio measures the protection to secured creditors.

 Pledged assets to secured liabilities ratio is a financial ratio that compares

the book value of company assets with the book value of secured liabilities.
 This solvency ratio shows creditors and investors what percentage of assets are

secured by creditors. In other words, it shows how many assets the creditors have

claim to in case of a default.

Times Interest Earned

 This is the most common measure of the ability of a firm’s operations to provide

protection to the long-term creditor.

 The times interest earned ratio, sometimes called the interest coverage ratio, is a

coverage ratio that measures the proportionate amount of income that can be used

to cover interest expenses in the future.

 In some respects, the times interest ratio is considered a solvency ratio because it

measures a firm’s ability to make interest and debt service payments. Since these

interest payments are usually made on a long-term basis, they are often treated

as an ongoing, fixed expense. As with most fixed expenses, if the company can’t

make the payments, it could go bankrupt and cease to exist. Thus, this ratio could

be considered a solvency ratio.

Analysis

 The times interest ratio is stated in numbers as opposed to a percentage. The ratio

indicates how many times a company could pay the interest with its before tax

income, so obviously the larger ratios are considered more favorable than smaller

ratios. In other words, a ratio of 4 means that a company makes enough income

to pay for its total interest expense 4 times over. Said another way, this company’s

income is 4 times higher than its interest expense for the year. As you can see,
 creditors would favor a company with a much higher times interest ratio because

it shows the company can afford to pay its interest payments when they come due.

Higher ratios are less risky while lower ratios indicate credit risk.

Profitability

1. Profit Margin - This ratio describes a company’s ability to earn a net income from

sales.

2. Gross Margin - This ratio measures the amount remaining from P1 in sales that is

left to cover operating expenses and a profit after considering cost of sales.

3. Return on Total Assets - This ratio is generally considered the best overall measure

of a company’s profitability.

4. Return on Total Assets

 Also called Return on Investments (ROI), this metric provides the return on assets.

Bear in mind that total assets equals total capital. In other words, how much did

we earn on our investment and borrowed money?

 Many analysts consider EBIT rather than Net Income. Those favoring cash return

use EBITDA (Earnings before Income Tax, Depreciation, Amortization)/ Assets.

 Some analysts use the average of beginning and ending total assets. Others use

assets at year end.

5. Return on Common Stockholders’ Equity

This measure indicates how well the company employed the owners’ investments to earn

income.
6. Basic Earnings per Share - This measure indicates how much income was earned

for each share of common stock outstanding.

7. Price-Earnings Ratio - This measure is often used by investors as a general

guideline in gauging stock values. Generally, the higher the price-earnings ratio, the

more opportunity a company has for growth.

Analyzing the Balance Sheet

Balance Sheet provides information in assessing:

• Liquidity measures how readily assets can be converted to cash relative to how

soon liabilities will have to be paid in cash.

• Solvency refers to the ability of a company to generate sufficient cash flows to

maintain its productive capacity a still meet interest and principal payments on

long-term debt.

• Financial flexibility refers to a company’s ability to adjust to unexpected

downturns in the economic environment in which it operates or to take advantage

of investment opportunity as they arise.

Analyzing Income Statement

Revenues are recorded in the period when they are “earned” and become “measurable.”

 Revenues are “earned” when the seller has performed a service or conveyed an

asset to a buyer.

 Revenues are “measurable” when the value to be received for that service or asset

is reasonably assured and can be measured with a high degree of reliability.

Analyzing Cash Flow Statement

The statement of cash flows is particularly helpful to assess:

 ability to generate positive future cash flows

 ability to meet its obligations and pay dividends

 needs for external financing

 differences between net income and associated cash receipts and payment from

operations

 cash and non-cash aspects of a firm’s investing and financing transactions during

the accounting period

 changes and trends in the balance sheet

 where funds are deployed

Limitations of Ratio Analysis

 A firm’s industry category is often difficult to identify

 Published industry averages are only guidelines

 Accounting practices differ across firms

 Sometimes difficult to interpret deviations in ratios

 Industry ratios may not be desirable targets

 Seasonality affects ratios

Sensitivity Analysis & Risk Analysis

 Sensitivity analysis allows the manipulation of numerators and denominators by

small increments to determine the impact on the ratio

Guide in Analyzing Financial Statements

 Learn the business of the company whose financial statements you are analyzing.

 Get a feel of general industry and economic conditions.

 Learn and understand the intricacies of financial reporting standards particularly

its limitations.

Guide in Analyzing Financial Statements

 In ratio analysis, gather peer data (industry, company) as well as internal financial

information (past, present, actual or planned) to have a basis to compare the

computed ratios with.

 Assess every detail gathered from disclosures as well as outside sources as to its

implication on the company’s past and continuing operations.

Cautions for Doing Ratio Analysis

• Ratios must be considered together; a single ratio by itself means relatively

meaningless.

• Financial statements that are being compared should be dated at the same point

in time.

• Use audited financial statements when possible.