GE1715

THE LANGUAGE OF BUSINESS

Understanding Financial Statements
Balance Sheet/Statement of Financial Position
The purpose of a balance sheet is to show the financial position of a business on a certain date, usually
the end of the month or year. For this reason, it is often called the statement of financial position. It is
important to note that the date on the balance sheet is a single date, whereas the dates on the other three
(3) statements cover a period of time, such as a month, quarter, or year. The balance sheet presents a
view of the business as the holder of resources, or assets, that are equal to the claims against those
assets (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

• It provides insights about how the business is financed and how its funds are deployed. The
statement of financial position shows how much finance is contributed by the owners and how much is
contributed by outside lenders. It also shows the different kinds of assets acquired and how much is
invested in each kind.

• It can provide a basis for assessing the value of the business. Since the statement of financial
position lists, and places a value on, the various assets and claims, it can provide a starting point for
assessing the value of the business.

• Relationships between assets and claims can be assessed. It can be useful to look at relationships
between various statement 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).

• Performance can be assessed. The effectiveness of a business in generating wealth can usefully be
assessed against the amount of investment that was involved. Thus, the relationship between profit
earned during a period and the value of the net assets invested can be helpful to many users, particularly
owners and managers (Atrill & McLaney, 2017).

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Income Statement
The income statement summarizes the revenues earned and expenses incurred by a business over an
accounting period. Many people consider it the most important financial report because it shows whether
a business achieved its profitability goal – that is, whether it earned an acceptable income.

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
Utilities expense 60,000.00
Total expenses 280,000.00
Net Income ₱420,000.00

The income statement may help in providing information on the following:

• How effective the business has been in generating wealth. Since wealth generation is the primary
reason for most businesses to exist, assessing how much wealth has been created is an important
issue. The income statement reveals the profit for the period, or bottom line as it is sometimes called.
This provides a measure of the wealth created for the owners. Gross profit and operating profit are
also useful measures of wealth creation.

• How profit was derived. In addition to providing various measures of profit, the income statement
provides other information needed for a proper understanding of business performance. It reveals
the level of sales revenue and the nature and amount of expenses incurred, which can help in
understanding how profit was derived (Atrill & McLaney, 2017).

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Cash Flow Statement

The statement of cash flow focuses on liquidity, that is, balancing the inflows and outflows of cash to
enable it to operate and pay its bills when they are due. Cash flows are the inflows and outflows of cash
into and out of a business. Net cash flows are the difference between the 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 from 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

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Financial Ratios

Return on Investments

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇

𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝒐𝒐𝒐𝒐 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑟𝑟 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
ROI generally means return on owner’s equity; hence it is sometimes referred to as ROE. This is to avoid
confusion because the word investment may connote investment or funding by both stockholders and
creditors. It relates income or profit after income tax to the total stockholder’s equity, preferably on the
average stockholder’s equity. The average is computed by adding the beginning and the ending balances
and dividing it by two (2).

Profit Margin/Return on Sales (ROS)

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
The profit margin, also known as return on sales, is the ratio of income to net sales. On a rudimentary
level, a low profit margin can be interpreted as indicating that a company’s profitability is not very secure.
If a company with a low profit margin experiences a decline in sales, its profit margin will decline even
further, leading to a very low, neutral, or even negative profit margin.
Low profit margins may also reveal certain things about the industry in which a company operates or
about broader economic conditions. For example, if a company’s profit margin is low, 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 itself suffering, perhaps because of waning consumer interest (or increasing
popularity and/or availability of alternatives). This could also result from hard economic times
or recession.
Profit margin may also indicate certain things about a company’s ability to manage its expenses. High
expenditures relative to revenue (i.e. a low profit margin) may indicate that a company is struggling to
keep its costs low, perhaps due to management problems. This is an indication that costs need to be
under better control. High expenditures may occur for many reasons, including that the company has too
much inventory (relative to its sales), that it has too many employees, and that it is operating in spaces
that are too large and thus is paying too much in rent. On the other hand, a higher profit margin indicates
a more profitable company that has better control over its costs, compared with its competitors.
Profit margin can also illuminate certain aspects of a company’s pricing strategy. For example, a low profit
margin may indicate that a company is underpricing its goods.

Return on Assets (ROA)

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝒐𝒐𝒐𝒐 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 =
𝐴𝐴𝐴𝐴𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Another profitability measure is the return on average total assets to show how effectively the company
has utilized its assets. In other words, it is a measure of asset utilization. This time, however, the operating
income is used instead of the income after income tax because the asset utilization pertains to the
operations. As such, ROA is equal to operating income divided by average total assets. Again, the
average is used for a better gauge.

Current Ratio
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑪𝑪𝑪𝑪𝑪𝑪𝒓𝒓𝒆𝒆𝒆𝒆𝒆𝒆 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿

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The current ratio relates current assets to current liabilities and shows the immediate solvency and
liquidity of a firm. Solvency is the ability of a firm to meet or pay maturing obligations as they come due.
It tells how much current assets is available to meet the current liabilities. If the current ratio is 2:1, it
means the company has P2 worth of current assets to meet every peso of current liability. The higher the
current ratio, the more solvent a company is.

Quick Ratio (Acid-Test Ratio)

𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
The quick ratio is an indicator of a company’s short-term liquidity, and measures a company’s ability to
meet its short-term obligations with its most liquid assets.
While a quick ratio lower than 1 does not necessarily mean the company is going into default or
bankruptcy, it could mean that the company is relying 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, too high a
quick ratio 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 the company may be having problems
collecting on its account receivables.

Debt Ratio
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
The debt ratio compares a company’s total debt to its total assets. This provides creditors and investors
with a general idea as to the amount of leverage being used by a company. The lower the percentage,
the less leverage a company is using and the stronger its equity position. In general, the higher the ratio,
the more risk that company is considered to have taken on.

Stockholder’s Ratio
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑟𝑟 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝒓𝒓′ 𝒔𝒔 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
While the relationship of creditors’ claims on total assets is important for creditors, the total claims of
stockholders on total assets is equally important to the stockholders. As such, the total stockholder’s
equity to total assets ratio is often computed. Instead of using the formula dividing total stockholder’s
equity by total assets, it can be simply:
𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝒓𝒓′ 𝒔𝒔 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 = 100% − 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅

Debt-Equity Ratio
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 − 𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑟𝑟 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
The debt-equity ratio is a measurement of the percentage of the company’s balance sheet that is financed
by suppliers, lenders, creditors, and obligors versus what the shareholders have committed. It provides
another vantage point on a company’s leverage position, in that it compares total liabilities to
shareholders’ equity as opposed to total assets in the debt ratio. Similar to debt ratio, a lower percentage
means that a company is using less leverage and has a stronger equity position.

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Interest Coverage Ratio

𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
Interest coverage ratio is the indicator of 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 creditors’ 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. (2017). Accounting and finance for non-Specialists (10th ed.). Harlow: Pearson
Education Limited.
Investopedia. (2017, June 13). Debt ratios: The debt ratio. Retrieved May 16, 2018, from
https://www.investopedia.com/university/ratios/debt/ratio2.asp
Investopedia. (2017, June 13). Debt ratios: Debt-equity ratio. Retrieved May 16, 2018, from
https://www.investopedia.com/university/ratios/debt/ratio3.asp
Investopedia. (2018, April 04). Profit margin. Retrieved May 16, 2018, from
https://www.investopedia.com/terms/p/profitmargin.asp
Momoh, O. (2017, November 21). Quick ratio. Retrieved May 16, 2018, from
https://www.investopedia.com/terms/q/quickratio.asp

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

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