UNIVERSIDAD DE DAGUPAN

SCHOOL OF BUSINESS AND ACCOUNTANCY

Financial Management Hand Outs

FINANCIAL STATEMENT
ANALYSIS
Semi-Finals Topic

Contents:
I. Financial Statements
II. Components of Financial Statements
III. Limitations of Financial Statements
IV. Free Cash Flow
V. Market Value Added (MVA)
VI. Economic Value Added (EVA)
VII. Financial Statement Analysis
VIII. The Role of a Financial Statement Analysis in Decision-Making
IX. Tools and Techniques in Financial Analysis
X. Summary of Financial Ratios
XI. Limitations of Financial Ratios
XII. Limitations of Ratio Ratios
XIII. Statement of Cash Flow
XIV. Exercises

“An investment in knowledge pays the best interest."

- Benjamin Franklin

FINANCIAL STATEMENT ANALYSIS

Prepared by:
Jessaira R. Alvarez
SBA Instructor
I. Financial Statements

Definition:

Financial statements are formal records that present the financial activities and
condition of a business or individual. They help users understand a company’s
financial performance and position over a specific period.

Major Types of Financial Statements:

1. Balance Sheet/ Statement of Financial Position

 It presents the company’s assets, liabilities and equity, which show the basic
accounting equation (assets = liabilities + equity), where total assets must always be
balanced with the sum of the total liabilities and total equity.
Sample Balance Sheet: (Report Form)

How to Prepare a Balance Sheet (Statement of Financial Position)

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In the accounting cycle, the balance sheet and other financial statements are prepared after
the adjusted trial balance is done. Preparing the balance sheet without doing the previous
steps of the accounting cycle will give the preparer troubles in coming up a fair balance
sheet statement.
Here’s the sample of adjusted trial balance:

1. Start with the heading.

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The heading includes the name of entity (individual or company), name of the statement
(balance sheet), and the reporting period (ex. as of December 31, 2011). Some complex
forms of businesses may include a more detailed heading, such as when reporting a
consolidated balance sheet and or when presenting comparative years.
Sample balance sheet heading:

2. Present your assets.

Classify you assets into current and noncurrent assets. Current assets are cash; cash
equivalent; assets held for collection, sale, or consumption within the entity’s normal
operating cycle; or assets held for trading within the next 12 months. The rest are considered
noncurrent assets. From our adjusted trial balance, our current assets include cash,
accounts receivables and prepaid expenses. Take note that we have grouped the prepaid
rent (P15,000), prepaid insurance (P11,000) and unused computer supplies (P45,000) into
one account, that is, prepaid expenses totaling P 71,000. On the other hand, our noncurrent
assets only consist of computer equipment and its accumulated depreciation. This results to
a net carrying amount of P98,333 for the computer equipment.

3. Present your liabilities.

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After we’re done with the total assets, next are the liabilities. Liabilities should also be
classified as current and noncurrent. But in our example, we only have current liabilities. Our
current liabilities include accrued expenses, loans, and income tax payable. After presenting
our total assets and liabilities, our balance sheet already looks like this.

After adding liabilities in the balance sheet:

4. Add the owner’s equity.

The balance sheet is an equation of “Assets = liabilities + equity”. Thus, we need to add the
owner’s equity in the “liabilities and equity” section of our balance sheet. The owner’s equity
presented may only show the ending balance, that is, the ending balance amount shown in
the statement of changes in owner’s equity. This amount is already the result after adjusting
the investments, withdrawals, net income (loss) for the year, and other adjustments from the
beginning balance of the owner’s equity. After, presenting the owner’s equity, our balance
sheet will already look like this.

Sample balance sheet or statement of financial position:

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Note that the “total assets” and the “total liabilities and owner’s equity” must be balanced.
Also remember that this is only an example of a balance sheet for a single proprietorship
business. Other forms of businesses, such as partnership and corporation, may have
different presentation in the equity section of the balance sheet. Furthermore, the term
balance sheet is amended to statement of financial position by IAS 1 (International
Accounting Standard) in 2007.

2. Income Statement

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  Reports the company’s revenues and expenses over a period. It is also called profit
and loss statement or statement of financial performance. It reports the net
income or net loss for the accounting period.
*Note: If the balance sheet tells us the financial condition of a business as at the end of
reporting period (e.g., as of December 31, 201X), the income statement tells us the financial
performance of a business for a certain reporting period (e.g., for the year ended December
31, 201X).

How to Prepare a Balance Sheet (Statement of Financial Position)

We will also use the same sample of adjusted trial balance:

1. Put the heading.

The heading includes the name of the entity (individual or company), name of the financial
statement (income statement), and the reporting period (e.g., for the year ended December
31, 2011).

Sample heading of an income statement:

2. Present the revenues or sales.

Since our example represents a service entity, we use the term revenues. Merchandising
companies that sell goods use the term sales instead of revenues. In our sample adjusted
trial balance, our revenues include Internet services (P65,000) and printing services
(P54,000), with a total of P119,000.

3. Present your expenses.

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The next step is to present our expenses and subtract their total to the total revenues to get
our income before income tax. From the sample adjusted trial balance, our expenses with a
total of P67,511 (excluding income tax), consist of salaries and wages, internet
communication, water and power, rents, computer supplies, depreciation, insurance,
interest, and taxes and licenses. Our income before income tax equals to P51,489
(P119,000 – P67,511).

4. Compute the net income.

To arrive at the net income, we need to subtract our income tax expense from our income
before tax. Based on our adjusted trial balance, our income tax expense amounted to P75.
Hence, our net income is equal to P51,414 (P51,489 – 75). After doing the steps above our
simple income statement will already look like this.

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Things to remember:
1. The income statement and balance sheet can also initially be prepared directly from a
worksheet with the adjusted trial balance. Thus, in our sample adjusted trial balance, you
can add columns for balance sheet and income statement balances. All you need to do is
to forward the account titles’ balances that should be presented in the balance sheet and
in the income statement.
2. The net income amount at the bottom of our income statement is what we will forward
in the “income for the year” in the statement of changes in owner’s equity.
3. After the amendment of International Accounting Standard (IAS) 1 in 2007, the term
statement of comprehensive income is used instead of the income statement. However,
income statement is retained in case of a two-statement approach.
4. When a business results in a loss, the statement is sometimes called “statement of
loss”.
5. For corporations, the earnings per share may also be required to be presented in the
statement of income.

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 3. Statement of Cash Flows
 Shows the cash inflows and outflows categorized into operating, investing, and
financing activities.
*Kindly refer to your book page 63-66

4. Statement of Changes in Equity

 Displays changes in owner’s equity including additional investments or withdrawals. It
presents how the capital shown in the balance sheet equity section changes over a
period of time. It also shows the effects on the capital account of the various
business transactions that occurred during that period. This statement normally
presents first the owner’s beginning capital balance. Then, it summarizes the net
increase or changes in the owner’s equity by presenting the additional investments
during the period plus net income (loss) for the period, and subtracted by the owner’s
withdrawals during that period. The net changes in owner’s equity is then added to
the beginning capital balance to arrive at the ending capital balance, which is also
what is forwarded and presented in the balance sheet. Other forms of businesses,
such as partnership and stock corporations have different presentations of statement
in changes in equity.

This is how our statement of changes in owner’s equity looks like using the
adjusted trial balance in previous example:

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I. Components of Financial Statements
 Assets - Economic resources owned by the business.
 Liabilities - Obligations to outsiders (e.g., loans).
 Equity - Owner’s share in the business.
 Revenue - Earnings from sales or services.
 Expenses - Costs incurred to earn revenue.

II. Limitations of Financial Statements

 Do not reflect inflation-adjusted values.
 Do not include intangible factors like employee morale.
 Can be manipulated through accounting choices.

IV. Free Cash Flow (FCF)

Definition: Indicates the cash that a company generates after spending on capital
expenditures.

V. Market Value Added (MVA)

Definition: Measures how much value a firm has created for its shareholders.

VI. Economic Value Added (EVA)

Definition: Measures the company’s financial performance based on residual wealth.

VII. Financial Statement Analysis

Purpose: To evaluate a business's financial health, identify trends, and support decision-
making.

VIII. Role of Financial Analysis in Decision-Making

 Helps managers make informed operational and investment decisions.
 Assists investors in evaluating company performance.
 Aids lenders in assessing credit risk.

IX. Tools and Techniques in Financial Analysis

 Horizontal Analysis - Comparison across time periods.
 Vertical Analysis - Line items as a percentage of a base item (e.g., sales).

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  Ratio Analysis - Focuses on key financial indicators.

X. Summary of Financial Ratios

Liquidity Ratios:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Profitability Ratios:
Net Profit Margin = Net Income / Sales
ROA = Net Income / Total Assets
ROE = Net Income / Equity
Efficiency Ratios:
Inventory Turnover = COGS / Average Inventory
Receivables Turnover = Credit Sales / Avg. Accounts Receivable
Solvency Ratios:
Debt to Equity = Total Liabilities / Equity
Interest Coverage = EBIT / Interest Expense

XI. Limitations of Financial Ratios

 May not consider external conditions.
 One ratio alone may not be conclusive.
 Affected by different accounting policies.

XII. Limitations of Ratio Analysis

 Ignores qualitative factors.
 Seasonal business patterns can distort data.
 Can be manipulated by window dressing.

XIII. Statement of Cash Flows

Sections:
 Operating Activities - Cash from normal operations.
 Investing Activities - Buying/selling assets.
 Financing Activities - Loans, stock issuance, dividends.

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References:
Vic, & Vic. (2012b, March 14). Sample Balance Sheet and income Statement | Business
Tips Philippines. Business Tips Philippines: Business Owners and Entrepreneurs’ Guide.
https://businesstips.ph/sample-balance-sheet-and-income-statement/

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