San Jose Community College

San Jose,Malilipot Albay

College of Business
Administration

FM108-Special Topics in
Financial Management

Mid-Term Hand-outs

What Are Financial Statements?

Financial statements are key tools businesses use to track and provide insights into a company's overall
financial performance and health. These reports provide a snapshot of a business’s financial situation,
results of operations, and cash flows.

While financial statements are used internally to guide management decisions, they are also used by
external stakeholders such as investors, creditors, analysts, and regulators.

Financial statements aid in making decisions about investing in a company, lending money to a company,
or providing other forms of financing.

There are three main types of financial statements: balance sheets, income statements, and cash flow
statements.

Balance Sheet
The balance sheet is a financial statement that provides an overview of a company's assets, liabilities, and
equity. It is used to assess a company's financial situation at a given point in time.

There are two sections on the balance sheet ‒ the left side (assets) and the right side (liabilities and
equity). The balance sheet adheres to the accounting equation:

Accounting Equation
The assets of a company should always equal the combination of its liabilities and shareholders' equity.
Hence, a balance sheet should always balance.

For example, a company purchases equipment on credit for $2,000. This purchase will entail an increase
in assets (equipment) and a liability (credit purchase) for the amount of $2,000. The company's assets
would then equal its liabilities plus shareholders' equity.

Components of a Balance Sheet

Assets, liabilities, and equity comprise the balance sheet.

Assets
Assets are everything a company owns and can be used to generate revenue. They include cash,
investments, inventory, and property, plant, & equipment (PP&E).

Liabilities
Liabilities are everything a company owes to others. These include accounts payables, loans, and notes
payables.

Equity
Equity is the portion of the business that belongs to the owners (i.e., shareholders). Equity is also known
as a company's book value or net worth. It represents the residual value of a company's assets after
liabilities have been paid. It includes retained earnings, paid-in capital, outstanding shares, and treasury
stock.

Balance Sheet Example

The following is an example of a balance sheet from Apple, Inc.:
Source: Apple’s Form 10-k from SEC (Page 34)
From the balance sheet above, we can see that as of September 2021, Apple, Inc.’s total assets amount to
$351,002,000. Its total liabilities are $287,912,000, and total shareholders’ equity is $63,090,000, which,
when lumped together, will equal the total assets of $351,002,000.

Income Statement

The income statement is a financial statement that reports a company's revenue, expenses, and profit (or
loss) over a period of time.
It is also known as the profit and loss (P&L) statement and is important in gauging the profitability of a
business.

Components of an Income Statement

The components of an income statement vary depending on the company but below are some of the most
common items:

Revenue
Revenue pertains to the money a company earns from selling its goods or services. Depending on the
company, revenue can also be called “sales revenue” or “sales.”

Revenue is typically listed as net sales as it would exclude any applicable sales returns, allowances, and
discounts before cost of goods sold is deducted to arrive at gross profit.

Cost of Goods Sold (COGS)

COGS refers to the direct costs associated with the production of a good. This is known as the cost of
sales for businesses that provide services. This includes the cost of direct materials, direct labor, and
direct factory overhead.

Gross Profit
Gross profit is the difference between a company's revenue (net sales) and the cost of goods sold. It
reflects the efficiency of a company in its production and selling process.

Operating Expenses
Operating expenses are the costs associated with managing a business on a day-to-day basis. These are
costs that consist of the direct costs involved in the production of a company’s products and services but
are not included in COGS.

They include things like rent, utilities, and salaries/wages.

Selling, general, and administrative (SG&A) expenses, in other words, all non-production costs, are
usually lumped together with operating expenses. Some companies also choose to put this as a separate
line item from operating expenses.

Operating Profit
Operating profit is a company's income after deducting all operating expenses from the gross profit.

Non-Operating Items
Non-operating items are all the other revenues and expenses that are not part of the business's main
operations. These include interest expenses, interest income, proceeds from sale of extraordinary items,
lawsuit expenses, and taxes.

Net Profit or Loss

This is the amount of money a company has left over after taking into account all non-operating items
from the operating profit. It is the income statement's bottom line and represents the company's total
earnings or losses for a period of time.

Net profit occurs when a company’s revenues exceed its expenses. Net loss occurs when it is the other
way around.

Income Statement Example

Shown below is the income statement from Apple, Inc.

Source: Apple’s Form 10-k from SEC (Page 32)

Per the income statement above, Apple, Inc.’s gross profit as of September 2021 was $152,836,000, the
operating profit was $108,949,000, and the net profit was $94,680,000.
This means the company has a profit margin of 26% which is the percentage of its net profit from total
sales.

Cash Flow Statement

A cash flow statement is another type of financial statement that provides a snapshot of a business's cash inflow and
outflow during a specific period. This statement shows how much cash is being generated or used by a company,
and can be used to assess its financial health.

Components of a Cash Flow Statement

A cash flow statement has these main components:

Cash Flow From Operating Activities (CFO)

This demonstrates the amount of cash generated by the business or used from its ongoing business operations. This
can include salaries paid to employees, payments from customers, and cash paid to suppliers.

A company's operating cash flow is a key metric in assessing the financial viability of its core operations.

Cash Flow From Investing Activities (CFI)

This indicates how much cash the company has generated or used from investing activities. This can include things
like buying property, plant, & equipment or investing in securities.

Companies use CFI to assess their ability to generate cash from their investments and to make decisions about future
investment opportunities.

Cash Flow From Financing Activities (CFF)

This indicates the amount of money the company has generated or used from its financing activities. This can
include issuing new equity, taking out loans, or repaying debt.

Companies use CFF to assess their operations' ability to finance and make decisions about issuing new equity and
debt financing.

Cash Flow Statement Example

The following is an example of a cash flow statement of Apple, Inc.

Source: Apple’s Form 10-k from SEC (Page 36)

Based on the cash flow statement above, Apple, Inc.’s total CFO for September 2021 was $104,038,000.
They used $14,545,000 for their investing activities and $93,353,000 in financing activities.
The total decrease in cash, cash equivalents, and restricted cash was $3,860,000. The total ending balance
was $35,929,000 after deducting the said decrease from its beginning balance.

Limitations of Financial Statements

Financial statements are useful tools for analyzing a company's financial position, performance, and cash
flow. However, several limitations should be considered when interpreting the data.
First, financial statements only provide a snapshot of a company's financial position at a specific point in
time. They do not reveal how the company got to that point or what might happen in the future.
Second, financial statements only include information that can be quantified in monetary terms. This
means the numbers do not reflect vital information like customer satisfaction or employee morale.
Third, management can manipulate financial statements to give a false impression of the company's
financial health. For example, a company might recognize revenue early or delay expenses to make the
financials look better than they actually are.
Fourth, financial statements only provide limited information about a company's competitive position.
They do not reveal things like market share or brand awareness.
Finally, financial statements can be difficult to interpret without a basic understanding of accounting
principles. This makes them inaccessible to many people who could benefit from using them.
Despite their limitations, financial statements are still valuable tools for analyzing a company's financial
situation. When interpreting the data, it is important to consider the limitations of the information and use
other resources to supplement the analysis.
Conclusion
Financial statements are records of a company’s financial activities and are used to reflect its
performance.
The three main financial statements are the balance sheet, income statement, and cash flow statement.
These statements are vital for understanding a company's financial situation, performance, and cash flow.
It is essential to keep in mind that financial statements have limitations. They should be used in
conjunction with other financial information to get a complete picture of a company's financial situation.

Financial statement preparation

How to Prepare Financial Statements

The preparation of financial statements involves the process of aggregating accounting information into a
standardized set of financials. The completed financial statements are then distributed to management,
lenders, creditors, and investors, who use them to evaluate the performance, liquidity, and cash flows of a
business. The preparation of financial statements includes the following steps (the exact order may vary
by company).

Step 1: Verify Receipt of Supplier Invoices

Compare the receiving log to accounts payable to ensure that all supplier invoices have been received.
Accrue the expense for any invoices that have not been received.

Step 2: Verify Issuance of Customer Invoices

Compare the shipping log to accounts receivable to ensure that all customer invoices have been issued.
Issue any invoices that have not yet been prepared.

Step 3: Accrue Unpaid Wages

Accrue an expense for any wages earned but not yet paid as of the end of the reporting period.
Step 4: Calculate Depreciation
Calculate depreciation expense and amortization expense for all fixed assets in the accounting records.

Step 5: Value Inventory

Conduct an ending physical inventory count, or use an alternative method to estimate the ending
inventory balance. Use this information to derive the cost of goods sold, and record the amount in the
accounting records.

Step 6: Reconcile Bank Accounts

Conduct a bank reconciliation, and create journal entries to record all adjustments required to match
the accounting records to the bank statement.

Step 7: Post Account Balances

Post all subsidiary ledger balances to the general ledger.

Step 8: Review Accounts

Review the balance sheet accounts, and use journal entries to adjust account balances to match the
supporting detail.

Step 9: Review Financials

Print a preliminary version of the financial statements and review them for errors. There will likely be
several errors, so create journal entries to correct them, and print the financial statements again. Repeat
until all errors have been corrected.

Step 10: Accrue Income Taxes

Accrue an income tax expense, based on the corrected income statement.

Step 11: Close Accounts

Close all subsidiary ledgers for the period, and open them for the following reporting period.

Step I2: Issue Financial Statements

Print a final version of the financial statements. Based on this information, write footnotes to
accompany the statements. Finally, prepare a cover letter that explains key points in the financial
statements. Then assemble this information into packets and distribute them to the standard list of
recipients.

Activity 2:

Discuss the following.

1. Why are financial statements important?

2. How often should financial statements be prepared?

 3. How accurate are financial statements?

4. How are financial statements used to make business decisions?

5. What is the impact of Generally Accepted Accounting Principles (GAAP) on financial statements?

USERS OF FINANCIAL STATEMENTS

1. Shareholders:
Divorce between ownership and management and broad-based ownership of capital due to dispersal of
shareholdings have made shareholders take more interest in the financial statements with a view to
ascertaining the profitability and financial strength of the company.
2. Debenture Holders:
The debenture holders are interested in the short-term as well as the long-term solvency position of the
company. They have to get their interest payments periodically and at the end the return of the
principal amount.
3. Creditors:
Potential suppliers of goods and materials and others doing business with the company are interested in
the liquidity position of the company.
4. Financial Institutions and Commercial Banks:
These financial institutions are interested in the solvency – short-term as well as long-term – and
profitability position of the company.
5. Prospective Investors:
Prospective Investors are interested in the future prospects and financial strength of the company.
6. Employees and Trade Unions:
Employees and Trade Unions are interested in the profitability position of the company.
7. Important Customers:
Important Customers who want to make long-standing contract with the company are interested in its
financial strength.
8. Tax Authorities:
Tax Authorities are interested in the profits earned by the company.
9. Government Departments:
Government Departments dealing with the industry in which the company is engaged are interested in
the financial information relating to the company.
10. Economists and Investments Analysts:
Economists and Investments Analysts are interested in the financial and other information of the
company.
11. Members of Parliament:
Members of Parliament the Public Accounts Committee and Estimates Committee – are interested in the
financial information of the government companies
12. SEBI and Stock Exchanges:
SEBI and Stock Exchanges are interested in the prospects and performance of listed companies with a
view to protecting the interests of investors.
13. Managers:
Managers are interested in knowing through the financial statements the present position and future
prospects of the company. This is mainly to review the company’s progress and position and take
decisions for the future.

Financial Statement Analysis

Financial statements are the summaries of the operating, financing and investment activities of
business. It must give useful information for investors and creditors in making investment, credit and
other business decisions (Pamela, 1999). Financial statement analysis in accounting arena is effectual
device for different users of financial statements, each having dissimilar objectives to learn about the
financial circumstances of the unit. Financial statements are developed to take wise decisions for
company. Financial statement analysis compares ratios and trends calculated from data found on
financial statements. Financial ratios permit experts to compare output of business to industry averages
or to specific competitors. These comparisons assist recognize financial vigour and flaws. The term
'financial analysis' also termed as 'analysis and interpretation of financial statements', denotes to the
process of determining financial strengths and limitations of the company by establishing strategic
affiliation between the items of the balance sheet, P&L A/c and other operative data. It is the combined
name for the tools and techniques that gives significant information to decision makers.

The main intent of financial analysis is to analyse the information contained in financial
statements in order to review the prosperity and financial reliability of the firm. A financial analyst
appraises the financial statements with various tools of analysis before reporting on the financial
strength or weakness of an enterprise. Basically, it is done to assess the financial status and
performance of entity from the information contained in financial statement.
Financial statement analysis is a noteworthy business movement because financial statements of firms
present helpful information on its financial rank and profit levels. These statements also assist a
shareholder, a regulator or a company's top management executive to recognize operating data, assess
cash receipts and payments during a period and evaluate owners' investments in the company. A good
analysis and explanation of financial statement can offer valuable insights into a firm's performance.

It facilitates investors and creditors to evaluate past performance and financial status and
predict future performance. The principal objective of financial reporting is to give information to
present and potential investors and creditors and others to make rational investment, credit and other
decisions. Successful decision making requires assessment of the past performance of companies and
assessment of their future prospects. Major aim of a company's financial analysis for a specific period is
to consider the financial position of the company, where it views the company's financial balance and
debt performance. The obtained parameters are of great importance, since it is the vital for growth,
development and continued existence of companies, mainly because they determine the ability of its
financing. Financial analysis is also helpful to determinate the proprietary position of the company,
which aims to thoroughly analyse company's assets in terms of manifestations, to analyse the structure
of assets, the satisfactoriness of their goals and objectives, and to find out the degree of capacity
utilization, efficiency of use and speed of their skill. Financial analysis is valuable for firms to determinate
the position of the company yield, based on the determination of earnings power, and to analyse
income statement or to analyse the structure of incomes and expenditures, including analysis of the
lower point of return and quantification of the business, financial and overall business risks.

Financial statements must be realistically presented for quality business and investment
decisions, which indicates that their reliability has to be confirmed through the system of external
control by independent third parties such as auditors. The analysis of financial statements by their users
aims to change the information presented in succinct and accessible forms for certain decisions.
Financial Reporting rocess

Approaches: There are two major approaches for financial statement analysis that include traditional
and modern approach. Traditional approach is based on the financial data contained in financial
statement and considers the statement composed of income statement and balance sheet. Financial
ratios are used to assess the monetary position of firm. Modern approach to financial statement analysis
emphasizes financial and non-financial factors of financial statements.
Table: Differences between traditional and modern approaches of financial statement analysis:

Function
Key function of financial statement analysis is that it enables firms to review operating data and appraise
intermittent business performance. A corporation also may evaluate financial statements to estimate
levels of cash flows and owner investments. On the other hand, a regulator may review a company's
retained earnings statement to evaluate corporate shareholders' accounts.
Different parties involved in financial statement analysis: In this analysis, different users are interested
which are categorized into two parts:
Different users of financial statement

Techniques and tools of financial statement Analysis

Financial statements provide thorough information about assets, liabilities, equity, reserves, expenses
and profit and loss of an enterprise. They are not readily understandable to concerned parties such as
creditors, shareholders, and investors. Therefore numerous techniques are used to analyse and
interpret the financial statements. Techniques of analysis of financial statements are mainly categorized
into three types:

1. Cross-sectional analysis: It is also termed as inter firm comparison. This analysis assists in
analysing financial attributes of an enterprise with financial characteristics of another parallel
enterprise in that accounting period.
2. Time series analysis: It is also known as intra-firm comparison. This procedure indicates the
relationship between different items of financial statement is established, comparisons are
made and results obtained. The basis of comparison may be comparison of the financial
statements of different years of the same business unit, comparison of financial statement of a
particular year of different business units.
3. Cross-sectional cum time series analysis: This analysis is aimed to compare the financial
characteristics of two or more enterprises for a definite accounting period. It is possible to
extend such a comparison over the year. This approach is most successful to appraise financial
statements.
The scrutiny and explanation of financial statements is used to verify the financial status of the firm.
Various tools or methods are used to study the relationship between financial statements.
A. Comparative financial statements
B. Common size statements
C. Trend analysis
D. Ratio analysis
E. Funds flow analysis
F. Cash flow analysis
 A. Comparative financial statements: comparative study of financial statements is the comparison
of the financial statements of the business with the preceding year's financial statements. It
facilitates detection of weak points and applying remedial measures. Practically, two financial
statements (balance sheet and income statement) are prepared in comparative form for
analysis purposes.
1. Comparative Balance Sheet: The comparative balance sheet demonstrates the different
assets and liabilities of the firm on different dates to make comparison of balances from
one date to another. The comparative balance sheet has two columns for the data of
original balance sheets. A third column is used to show change (increase/decrease) in
figures. The fourth column may be added for giving percentages of increase or decrease.
While interpreting comparative Balance sheet the interpreter is accepted to study the
following aspects:
I. Current financial position and Liquidity position
II. Long-term financial position
III. Profitability of the concern
II. For studying current financial position or liquidity position of a concern, interpreter
must investigate the working capital in both the years. Working capital is the excess of
current assets over current liabilities.
III. For studying the long-term financial position of the concern, one should examine the
changes in fixed assets, long-term liabilities and capital.
IV. Another aspect to be understood in a comparative balance sheet is the profitability of
the concern. The study of increase or decrease in profit will help the interpreter to
observe whether the profitability has improved or not.
After studying various assets and liabilities, a judgment should be formed about the financial position of
the concern.
B. Common size statements and trend analysis: The common size statements (Balance Sheet and
Income Statement) are revealed in analytical percentages. The figures of these statements are
shown as percentages of total assets, total liabilities and total sales correspondingly.
Common size balance sheet: A statement where balance sheet items are expressed in the ratio of each
asset to total assets and the ratio of each liability is expressed in the ratio of total liabilities is called
common size balance sheet. Thus the common size statement may be prepared in the following way.
1. The total assets or liabilities are taken as 100.
2. The individual assets are expressed as a percentage of total assets i.e. 100 and different
liabilities are calculated in relation to total liabilities.
Trend analysis: Trend analysis appraises an organization's financial information over a period of time.
Periods may be measured in months, quarters, or years, depending on the circumstances. The objective
is to compute and analyse the amount change and percent change from one period to the next. For
calculating the percentage change between two periods, calculate the amount of the increase (or
decrease) for the period by subtracting the earlier year from the later year. If the difference is negative,
the change is a decrease and if the difference is positive, it is an increase. Divide the change by the
earlier year's balance. The result is the percentage change. To calculate the change over a longer period
of time, select the base year. For each line item, divide the amount in each non base year by the amount
in the base year and multiply by 100.
Figure: Analysis through comparison

C. Ratio analysis: Ratio Analysis is used to get a fast indication of a firm's financial performance in
major areas. It is a process of determining and interpreting numerical relationship based on
financial statement. It is a technique of interpretation of financial statement with the help of
accounting ratios derived from the balance sheet and profit and loss account. The ratios are
categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios,
Profitability Ratios, and Market Value Ratios.
D. Funds flow analysis: Fund flow analysis is associated with more specific information as
compared to the wide range of ratio metrics. Fund flow analysis reveals information about the
inflows and outflows of capital for a specific period of time. Fund flow analysis may disclose why
certain ratio valuations are relatively high or low in a company by digging down into the actual
movement of cash and assets into and out of a company. Fund flow analysis involves creating
fund flow statements that match capital inflows with outflows.
E. Cash flow analysis: Cash flow statement represents inflow and outflow of funds. It is important
tool for short term analysis.
Advantages
Financial statement analysis is an important business practice because it facilitates senior management
to reassess a corporation's balance sheet and income statement to estimate levels of monetary position
and success. Financial statement analysis may be essential for management to recognize levels of cash
receipts and disbursements in business operations. A statement of cash flows lists cash flows related to
operating activities, investments and financing transactions. A statement of owners' equity may
facilitate an investor to recognize a company's shareholders.
Major characteristics to improve the financial statements:
1. Intelligibility which indicates that the information contained in financial statements should be
accessible in such a way that users can comprehend it, so they could communicate the intended
meaning. Will statements be understandable or not depends on how they are compiled by
accountants, and how they are used by the users (decision makers), who should have the basic
knowledge to interpret information and to use them for adoption and implementation of certain
business activities.
2. Comparability: To decide the trend of changes in financial situation and to determine
productivity of business enterprises, it is imperative through consistent adherence to evaluation
and measurement of the effects of business events from period to period. This characteristic
should allow investors, creditors and others to identify and appreciate financial statements of
entities in the flow of time, and to compare the financial statements of different entities
(Stanovcic,. 298). At last, comparability of financial statements is provided if the users are timely
informed about the changes in accounting policy in the same or in different companies.
 3. Timeliness: It entails that if company want that instruments of financial reporting had a great
use value, especially for decision-makers they must be submitted to a reasonable time.
4. Verifiability: This characteristic is a new attribute from 2010 Framework. The information is
confirmable in the sense that it should ensure credibility and objectivity. It necessitates that
independent observers reach the same or similar conclusions that is not biased or contains
material errors and recognition of the chosen method of assessment is applied free from
material error and subjectivity (Škarić, Jovanović, K., 6).
Limitations Of Financial Statement Analysis
1. It is just study of temporary reports.
2. It checks just financial aspect of company's performance and position but it ignores non-
monetary characteristic of company.
3. It does not investigate the changes in price level of different items of financial statements.
4. Many accounting theories and conventions are used to prepare financial statement and these
concepts and conventions are established for analysis. So, analysis is totally affected with these
accounting concepts.
5. Analysis of financial statements is just source but not conclusion or result because reviewer or
evaluator, who writes its analysis, may also affect the analysis. So, different interpretation by
different person may become its restraint.
It can be said that in financial statements, there is lack of Precision, lack of Exactness, Incomplete
Information, hiding of Real Position or Window Dressing, lack of Comparability, and there is historical
cost.
To summarize, financial statement analysis is helpful in appraising the operational competence of the
management of a company. The actual performance of the company which are divulged in the financial
statements can be compared with some standards set earlier and the any difference between standards
and actual performance can be used as the marker of effectiveness of the management. Briefly, financial
statement analysis is the analysis, interpretation and comparison of monetary data in order to
accomplish desired results.