SHS Business Finance Chapter 2

Review of Financial
Statement Preparation,
Analysis and
Interpretation
FINANCIAL STATEMENTS
Financial Statements represents a formal record of the financial
activities of an entity. These are written reports that quantify the
strength, performance and liquidity of a company.
It also reflect the financial effects of business transactions and
events on the entity
Complete Set of Financial Statement
1. Statement of Financial Position – this statement shows the resources of a company (the
asset), the company’s obligations (Liabilities) and net difference between its assets and
liabilities, which represents the equity of the owner.
THREE ELEMENTS OF SFP
a. Asset – these are the resources that are owned and controlled
by the entity. Future economic inflow is expected
with this resources.
b. Liability – It represents the obligation of the entity.
c. Equity – This represents the difference from the assets to its
liabilities.
2. Statement of Other Comprehensive income – this
reflects the net assets generated through business
organizations (revenues), the net assets consumed
(expenses), and the difference which is called net income as
well as other comprehensive income. The Revised
Conceptual framework introduce the new title of this
statement as “Statement of Financial Performance”.
◦ Elements of SFP
◦ Income – this represents what the business has earned over a period of time
◦ Expenses – the cost and expenditures that the entity has incurred over a period of time.
◦ 3. Statement of Cash flows – It represents the movement in cash
and bank balances over a period of time. This statement shows the
amount of cash generated and consumed by a company through
the following three types of activities; operating, investing and
financing.
◦ Operating – it represents the cash flow from primary activities of a
business.
◦ Investing – represents cash flow from the purchase and sale of
assets other than inventories. (mostly, long-assets)
◦ Forecasting – represents cash flow generated or spent on raising
and repaying share capital and debt together with the payments of
interest and dividends.
4. Statement of Changes in Equity – which summarizes the
changes in each item of equity for a period of time.
◦ Net Profit or Loss during the period as reported in the income
statement.
◦ Share Capital issued or repaid during the period
◦ Dividend payments
◦ Gains or losses recognized directly in equity
◦ Effects of a change in accounting policy or correction of accounting
error
5. Notes to financial statements – this contain the supplemental
information as well as information about items not included in the
financial statements such as accounting estimates.
The objective of Financial Statement
“The OBJECTIVE of FINANCIAL STATEMENT is to provide information
about the financial position, performance and changes in financial
position of an enterprise that is useful to a wide range of users in
making economic decision.”
Types of Users of Financial Statements
1. Internal decision makers – it represent people form
the inside of the entity and has direct access to affairs of
the reporting entity.
◦ Example
◦ A. Managers – they are interested in the FS for the management of the
affairs of the business of the company by assessing the financial
performance and position and taking important business decisions.
◦ B. Shareholders – to assess the risk and return of their investments in
the company and take investment decisions based on their analysis.
2. External Decision Makers – they doesn’t have a
direct access in the affairs of the entity.
◦TYPES OF EXTERNAL DECISION MAKERS
a. Prospective Investors – to assess the viability of investing
in a company and assessing the risk of investing in that
company.
b. Financial Institution (lenders) – to decide whether to
grant a loan or credit to a business.
c. Suppliers or trade creditors – to assess the credit
worthiness of a business and ascertain whether to supply
goods on credit.
◦ d. Customers – to assess whether a supplier has the resources to ensure
the steady supply of goods in the future. This is especially vital where a
customer is dependent on a supplier for a specialized component.
◦ e. Employees – to assess the company’s profitability and its consequences
on their future remuneration and job security.
◦ f. Competitors – compare their performance with rival companies to learn
and develop strategies to improve their competitiveness
◦ g. General Public – may be interested in the effects of a company on the
economy, environment and the local community.
◦ h. Government – to determine the correctness of tax declared in the tax
returns. Government also keeps track of economic progress through
analysis of Financial Statements of businesses from different sectors of the
company.
Financial Statement Preparation Process
A set of financial statements is a structured representation
of the financial performance and financial position of a
business and how its financial position changed over time.
It is the ultimate output of an accounting information
system
Accounting Cycle – is the financial process starting with recording
business transactions and leading up to the preparation of financial
statements.
◦ - it is the set of steps that are repeated in the same order
every period. The culmination of these steps is the
preparation of financial statements.
Adjusted trial balance – is a listing of all company accounts that will
appear on the financial statements after year-end adjusting journal
entries have been made.
Accounting Worksheet – is a tool used to help bookkeepers and
accountants complete the accounting cycle and prepare year-end
reports like unadjusted trial balance, adjusting journal entries,
adjusted trial balance, and financial statements.
Methods and tools for Financial
Statement Analysis
Financial Statement Analysis – can be referred as a process of
understanding the risk and profitability of a company by analysing
reported financial info, especially annual and quarterly reports.
◦ - is a study about accounting ratios among various items included in the
balance sheet.
Example of ratios:
a. Profitability ratios
b. Leverage ratio
c. liquidity ratios
d. valuation ratios
Advantages of Financial Statement
Analysis
1. It provides an idea to the investors about deciding on investing
their funds in particular company
2. it is the regulatory authorities like IASB can ensure that the
company follows the required accounting standards.
3. It is helpful to the government agencies in analysing the taxation
owed to the firm
4. The entity analyse its own performance over a specific time
period.
HORIZONTAL vs. VERTICAL ANALYSIS
HORIZONTAL ANALYSIS – Comparison of two or more year’s financial
data.. It is facilitated by showing changes between years in both peso
and percentage form.
VERTICAL ANALYSIS – is the procedure of preparing and presenting

common size statements.
◦ Common Size Statements – is one that shows the items
appearing on it in percentage forms as well as in dollar form.
FINANCIAL RATIO DETERMINATION,
LEVELS, ANALYSIS AND INTERPRETATION
RATIO ANALYSIS – is the most powerful tool of financial statement
analysis.
Accounting Ratios – is used to describe significant relationship

between figures shown on a balance sheet, in a profit and loss
account, in a budgetary control system or in any other part of
accounting organization. It basically shows the relationship between
accounting data.
◦ - “it is an important and age-old technique of financial
analysis.”
ADVANTAGES OF RATIO ANALYSIS
A. Simplifies Financial Statements
B. Facilitates inter-firm comparison
C. Helps in planning
D. Makes inter-firm comparison possible
E. Help in investment decision
LIMITATION OF RATIOS ANALYSIS
A. Comparative study required.
B. Ratios alone are not adequate
C. Problems of price level change
D. Lack of adequate standards
E. Limited use of single ratios
F. Personal bias
G. Incomparable
Classification of Accounting Ratios
A. Traditional Classification or Statement Ratios
B. Functional Classification or Classification According to
Tests
C. Significance Ratios or Ratios According to Importance
A. Traditional Classification or Statement
Ratios
 Profit and loss account ratios or revenue/income statement ratios
Balance sheet ratios or position statement ratios
Composite/mixed ratios or inter statement ratios
B. Functional Classification or
Classification According to Tests
Profitability Ratio - measure the results of business operations or overall performance and
effectiveness of the firm.
Liquidity ratios - measure the short term solvency of financial position of a firm. These ratios
are calculated to comment upon the short term paying capacity of a concern or the firm's ability
to meet its current obligations.
Activity ratios - are calculated to measure the efficiency with which the resources of a firm
have been employed. These ratios are also called turnover ratios because they indicate the
speed with which assets are being turned over into sales
Leverage ratios or long term - convey a firm's ability to meet the interest costs and payment
schedules of its long term obligations.
solvency ratios
C. Significance Ratios or Ratios According
to Importance
Primary ratios
Secondary ratios

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Review of Financial

VERTICAL ANALYSIS – is the procedure of preparing and presenting

Accounting Ratios – is used to describe significant relationship

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