REPORT IN BUSINESS FINANCE

Group:2 Review of Financial Statement

Preparation,Analysis,and Interpretation.

Learning Competences
2.1 Prepare Financial Statements.
2.2 Define The Measurement Levels, Namely, Liquidy, Solvency, Stability,
And Profitability.
2.3 Perform Vertical and Horizontal Analyses Of Financial Satatements Of A
Single Proprietorship.
2.4 Compute, Analyze, and Interpret Financial Ratios Such As Current Ratio,
Working Capital ,Gross Profit Ratio, Net Profit Ratio, Receivable Turnover,
Inventory Turn Over, Debtto-Equity Ratio, And The Like.
 PREPARE FINANCIAL STATEMENTS?

2.1 Prepare Financial Statements.

What are financial statements?

Financial statements refer to a collection of reports about an organizations
Financial result, Fiancial condition, and Cash Flows.

Financial statements (or financial report) is a formal record of the financial

activities and position of a business, person, or other entity.

Relevant financial information is presented in a structured manner and in a

form easy to understand. They typically include basic financial statements,
accompanied by a management discussion and analysis

What Comprises A Complete Set Of Financial Statements?

Balance sheet which reports and entitys financial condition.

A balance sheet or statement of financial position, reports on a
company's assets, liabilities, and owners equity at a given point in time.

Income statement which reports and entitys financial result.

An income statement or statement of comprehensive income, statement
of revenue & expense, P&L or profit and loss report, reports on a
company's income, expenses, and profits over a period of time. A profit
and loss statement provides information on the operation of the
enterprise. These include sales and the various expenses incurred
during the stated period.

Statement of cash flows which reports an entitys cash flow.

 cash flow statement, also known as statement of cash flows, is a
financial statement that shows how changes in balance sheet accounts
and income affect cash and cash equivalents, and breaks the analysis
down to operating, investing and financing activities. Essentially, the
cash flow statement is concerned with the flow of cash in and out of the
business. The statement captures both the current operating results and
the accompanying changes in the balance sheet. As an analytical tool,
the statement of cash flows is useful in determining the short-term
viability of a company, particularly its ability to pay bills.

Statement of changes in equity which reports and entitys

movement of equity.
Statement of Changes in Equity, often referred to as Statement of
Retained Earnings in U.S. GAAP, details the change in owners' equity
over an accounting period by presenting the movement in reserves
comprising the shareholders' equity.
A Statement of changes in equity or equity statement or statement of
retained earnings, reports on the changes in equity of the company
during the stated period.
Notes to financial statement or supplementary notes which serves
as supporting details for the above financial statements.
Also referred to as footnotes. These provide additional information
pertaining to a company's operations and financial position and are
considered to be an integral part of the financial statements. The notes
are required by the full disclosure principle.

What are the elements of a balance sheet?

The three major elementsof the balance sheet are assets, liabilities, and
owners equity.
ASSETS: The assets section shows items your company owns that have
tangible value. It includes current assets, along with property and equipment,
investments and intangible assets. The current assets section is compared to
current liabilities to figure out your basic liquidity, or ability to pay off short-
term debt.
LIABILITIES: The liabilities section is simply divided into current and
long-term liabilities. Current liabilities are debts due within the next 12
months. Notes payable and accounts payable are common short-term debt
accounts.
OWNERS EQUITY: Owners' equity is mathematically determined to be
the difference between your assets and liabilities. In essence, whatever you
have left if you were to sell all of your assets and pay off debt is the value of
the company at the present time. Equity actually includes a variety of
accounts, but most commonly it refers to paid-in capital and retained
earnings.

What comprises an income statements?

The income statement consists of revenues and expenses along with the
resulting net income or loss over a period of time due to earning activities.
An income statement is a financial statement that reports a company's
financial performance over a specific accounting period. Financial
performance is assessed by giving a summary of how the business incurs its
revenues and expenses through both operating and non-operating activities. It
also shows the net profit or loss incurred over a specific accounting period.

1.2 Define the measurement levels, namely, liquidity, solvency,

stability, and profitability

Differentiate solvency from profitability

Solvency and profitability are two distinct yet interdependent aspects of
business financial health.
A solvent company has assets that exceed its liabilities sufficiently to provide
for reinvestment in the companys growth.
On the other hand, the standard for profitability requires that income derived
from entitys business activities exceeds the companys expenses.

Differentiate solvency from liquidity.

Solvency and liquidity are both terms that refer to a business state of
financial health, but with some notable differences. Solvency refers to
companys capacity to meet its long-term financial commitments. Liquidity
refers to a companys ability to pay short term obligations; the term also
refers to its capability to sell assets quickly to raise cash.
What is stability?
Stability is the ability of the business to meet its debts and operate into the
long-term period.

What are the goals of finacial statement analysis?

The objectives of financial statements analysis is determine the extent of a
firms success in attaining its financial goals, namely:

To earn maximum profit-The ability for the company to achieve a

maximum profit with low operating expense.

To maintain solvency- in finance or business, is the degree to which

the current assets of an individual or entity exceed the current liabilities
of that individual or entity. Solvency can also be described as the
ability of a corporation to meet its long-term fixed expenses and to
accomplish long-term expansion and growth.

To attain stability- A stable learning algorithm is one for which the

prediction does not change much when the training data is modified
slightly.

2.3 Perform vertical and horizontal analysis of financial statement of a

single proprietorship.

What is a financial statement analysis?

Financial statement analysis is the process of reviewing and evaluating a
companys financial statements.
Financial statement analysis (or financial analysis) is the process of
reviewing and analyzing a company's financial statements to make better
economic decisions. These statements include the income statement, balance
sheet, statement of cash flows, and a statement of changes in equity.

What are the two methods of analyzing financial statement?

Vertical analysis It is a method of performing financial statement

analysis, which shows the relationships of the accounts/items in the
same year.
Vertical analysis in which each entry for each of the three major
categories of accounts, or assets, liabilities and equities, in a balance
sheet is represented as a proportion of the total account.

Horizontal analysis It is a method of performing financial statement

analysis, which shows the changes or tendencies of an item for 2 or
more years.
A horizontal analysis, or trend analysis, is a procedure in fundamental
analysis in which an analyst compares ratios or line items in a
company's financial statements over a certain period of time.

Vertical Analysis

For the For the

Balance sheet Income statement

Percentage = or

What is a common size financial statement?
A common size financial statement displays line items as a percentage of one
selected or common figure.
Common size income statement is an income statement in which each
account is expressed as a percentage of the value of sales. This type of
financial statement can be used to allow for easy analysis between companies
or between time periods of a company.

HORIZONTAL ANALYSIS

Comparing a companys financial condition and performance across time

 Time

2.4 Compute, analyze, and interptret financial ratios such as current

ratio, working capital, gross profit ratio, net profit ratio, receivable
turnover, inventory turnover, debtto- quity ratio, and the like.
Financial Statement Analysis
There are differenct users of financial statements. Financial statement
analysis can be used by managers, equity investors, creditors, regulators,
labor unions, employees, the public, and potential creditors and investors.
Financial statement analysis is used for investment amd credot decisions. It is
also used for regulating companies such as what the Energy Regulatory
Commission does for power distribution companies and other energy
companies.
Financial statement analysis is definitely used by management for monitoring
performance and for identifying strategies to further improve the companys
operations.
For this chapter, the following financial ratios will be discussed:
1. Profitability Ratios
2. Effiiciency Ratios
3. Liquidity Ratios
 4. Leverage Ratios

Profitability Ratios
The following ratios are used to measure the profitability of a company:
1. Return on equity (ROE)
2. Return on assets (ROA)
3. Gross profit margin
4. Operating profit margin
5. Net profit margin

Return on equity (ROE)

Is a profitability measure that should be of interest to stock market investors,
it measures the amount of net income earned in relation to stockholders
equity , ROE is computed as follow:
ROE = Net Income Stockholders Equity

Return on Assets (ROA)

Return on assets measures the ability of a company to generate income out of
its resources. Below is the formula for computing ROA.
ROA = (Operating Income Total Assets) x100%

Gross Profit Margin

Gross profit margin is a financial metric used to assess a company's financial
health and business model by revealing the proportion of money left over
from revenues after accounting for the cost of goods sold (COGS). Gross
profit margin, also known as gross margin, is calculated by dividing gross
profit by revenues.
Gross Profit Margin = (Gross Profit Sales) x100%

Operating Profit Margin

Operating profit margin measures the the amount of income generated from
the core business of a company. It is computed as the deffirence between
revenues and the sum of cost of revenues or sale and operating expense . the
formula for computing operating profit margin ratio is shown below:
Operating Profit Margin = (operating income sales) x100%

Net Profit Margin

Net profit margin measure how net profit a company generates for every peso
of sales or revenues that it generates. The formula for computing net profit
margin is shown below:
Net Profit Margin = (Net Income Sales) x100%

Liquidity Ratios
Liquidity ratios measures the ability of a company to pay maturing
obligations from its current assets. Two commonly used liquidity ratios will
be discussed in this section. These are the current ratio and the acid-test ratio
or sometimes called quick asset ratio.

Current Ratios
current ratio is a liquidity ratio that measures a company's ability to pay
short-term and long-term obligations. To gauge this ability, the current
ratio considers thecurrent total assets of a company (both liquid and illiquid)
relative to that company'scurrent total liabilities.
Current Ratio = Current Assets Current Liabilities

Acid-Test Ratio or Quick Asset Ratio

acid-test or quick ratio or liquidity ratio measures the ability of a company to
use its near cash or quick assets to extinguish or retire its current liabilities
immediately. Quick assets include those current assets that presumably can
be quickly converted to cash at close to their book values.
Quick Asset Ratio = (Cash Current Accounts Receivables Short-term
Marketable Securities) Current Liabilities

Leverage Ratios
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 ised to measure the
companys ability to meet long-term obligations.
1. Nature of business. If a company is in a risky business ant operating
cash flows are uncertain like mining operations. It has to be more
consecutively financed. Conservative financing means there should be
more stockholders equity.
2. Stage of business development. A company which is just startingits
operations may encounter difficulties borrowing from banks. Banks
generally look for the historical performance of a company in making
decisions regarding loan applications. A new company does not have
that historical record.
3. Macroeconomic conditions. If macroeconomic conditions are good as
measured by gross domestic product (GDP) and this trend is expected
to continue in the foreseeable future, then management can take a more
aggressive stance in financing the companys operations to take
advantage of the opportunities.
4. Prosects of the industry and expected growth rutes. If the industry
where the company operates has good prospects and growth rates are
expected to be high, management can consider borrowing more expand
operations.
5. Bond and stock market conditions. The ability of a company to raise
more funds from the stock market and the bond market also depends on
how bullish okayers are in these markets. If both markets are doing
well just like what the Philippines has been experiencing over the last
couple of years where its stock market and bond market are both
 expanding, then it is a good opportunity for the publicly listed
companies and even those which are not listed to tap both markets.
6. Financial flexibility. Refers to the ability of a company to raise funds,
be it the stock market or the bond market, when the needs for cash
arises.
7. Regulatory environment.there are operations which are heavily
regulated such as banks which are monitored by the bangko sentral ng
pilipinas(BSP).
8. Taxes.Interest expense provides tax shield while cash dividends does
not provide tax shield.
9. Management Style.Some managers are aggressive and some are
conservative .

The following leverage ratios will be discussed in this chapter:

1. Debt Ratio
2. Debt To Equity Ratio
3. Interest Coverage Ratio

Debt Ratio
Debt Ratio measure how much of the total assets are financed by liabilities
as compared to its stock holders equity.
Debt Ratio =Total Liabilities Total Assets

Debt to Equity Ratio

Debt to equity ratio is a variation of the debt ratio. A debt to equity ratio of
more than once means that a company has more liabilities as compared to
stockholders equity. The formula for debt to equity ratio is shown below:
Debt Equity Ratio = Totla Liabilities Total Stockholders Equity

Interest Coverage Ratio

Interest coverage ratio provides information if a company has enough
operating income to cover interest expense. Below is the formula for interest
coverage ratio.
Interest Coverage Ratio = EBIT Interest Expense

Efficiency Ratios or Turnover Ratios

Efficiency ratios, otherwise known as turnover ratios, are called as such
because they measure the managements efficiency in utilizing the assets of
the company.
1. Total asset turnover ratio
2. Fixed asset turnover ratio
3. Accounts receivable turnover ratio
4. Inventory turnover ratio
5. Accounts payable turnover ratio
From the accounts receivable turnover ratio, inventory turnover ratio and
accounts payable turnover ratio, operating cycle and cash conversion cycle
can be computed.

Total Asset Turnover Ratio

Total asset turnover ratio measures the companys ability to generate
revenues for every peso of asset invested. It is an indicator of how productive
the company is in utilizing its resources.
Asset Turnover Ratio = Sales Total Assets

Fixed Asset Turnover Ratio

If a company is heavily invested in property, plant, and equipment (PPE) or
fixed asset, it pays to know how efficient the management of these assets
Fixed Asset Turnover Ratio = Sales PPE

Accounts Receivable Turnover Ratio

Accounts receivable turnover ratio measure the efficiencyby which account
receivable are managed.
Accounts Receivable Turnover Ratio = Sales Account Receivables

Inventory Turnover Ratio

Inventory turnover ratio measures the companys efficiency in managing its
inventories
Inventory Turnover Ratio = Cost of sales Inventories

Accounts Payable Turnover Ratio

The accounts payable turnover ratio provides information regarding the rate
with trade payable is paid.
Asset Payable Turnover Ratio = Cost of slaes trade accounts payable

Operating Cycle and Cash Conversion Cycle

By adding the average collection period and days inventories open cycle
Can be computed.
Operating cycle = days inventories days receivable
 REVIEW OF FINANCIAL STATEMENT ANALYSIS
This section is a review of the process taken in preparing financial staements.

1. Analyzing business transactions

In this step, a transaction is analyzed to fine out if it affects the
company and if it needs to be recorded. Personal transactions of the
owners and managers that do not affect the company should not be
recorded in special journals such as sales journal or purchase journal.
2. Recording in the journal
Once a transaction is identified and analyzed, the next step is the
preparation of the journal entry.For repetitive transactions special
journal are made . These special journals include sales journal.The
source documents which will serve as the basis for recordsing must be
Examined .
3.Posting to ledger accounts
After transactions have recorded in the journals, the next step is
 posting the transactions to the ledger. Ledgers provude chronological
details as to how transactions affects individual acount, there are two
types of ledgers: The General Ledger and subsidiary ledger, The
general ledger is a summary of the different subsidiary ledgers and can
serve as a control acount.

4.Preparing the unadjusted trial balance

At the end of each accounting period, unadjusted trial balanced is
prepared from the financial statement account balance found in the
general ledger is done at the end of an accounting period.

5.Making the adjusting entries

Once the unadjusted trial balance is prepared, adjusting entries are
then prepared to account for the following among others:
a. Accruals-These include unpaid salaries for the accounting period,
Unpaid interest expense , or unpaid utility expenses.
b. Prepayments-if a company has prepaid expenses such as prepaid
rent or prepaid insurance.
c. Depreciation and amortization expenses- Depreciation expenses
are recognized at the end of each accounting period through
adjusting entries .
d. Allowance for uncollectible accounts- Bad debt expense from
accounts recievable is also recognized through adjusting entries.
6. Preparing the adjusted trial balance
An adjusted trial balance i prepared after taking into considerat
ion the affects of the adjusting entries.

7. Preparing the financial staements

Income statement accounts such as revenues and expenses are closed
To Prepare the system for the next accounting period.
8.Making the closing entries
Income statement accounts such as revenues and expenses are
Closed to prepare the system for the next accounting period

9.Post-closing trial balance

The post-closing trial balance is prepared to test if the debt
Balance equal the credit balance after closing entries are
Considered