DM 2 223 FINANCIAL MANAGEMENT Lecture 4

THE BASIC FINANCIAL STATEMENTS

Financial Statement and accompanying notes contains a wealth of information regarding the financial position
of a company, the success of its operations, policies and Strategies of management and insights into its future
performance.

A financial statement user can find answers to the following sample questions through analysis of data
presented therein together with other data generated by corporate financial reporting:
➢ How well does the company compete in its operating environment?
➢ Would an investment generate attractive returns?
➢ Should existing investment holdings be continued or liquidated?
➢ Will cash flows be sufficient to meet interest and principal payments?

FOUR BASIC FINANCIAL STATEMENTS

Statement of Financial Position (Balance Sheet) – shows the financial position – assets, liabilities and owner’s
equity of the firm on a particular date.

Statement of Financial Performance (Income Statement) – represents the result of operations – revenues,
expenses, net profit or loss for the accounting period.

Statement of Changes in Equity – summarized the changes in a company’s equity for a period of time (generally
one year).

Cash flow statement – provides information about the cash inflows and outflows from operating, financing and
investing activities during an accounting period.

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

➢ Accountants prepare financial statements by applying set of standard or rules referred to as financial
reporting standards.
➢ Consistent application of these standards permits comparison between companies and between years
of a single company.
➢ Financial reporting standards allow for significant latitude in how certain transactions should be
accounted for.

CONCEPTUAL FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FS

To justify the providing of accounting information, the benefits that will be derived from using this information
should exceed the cost of providing the data.

The following are the cost of providing information:

➢ Cost of collecting, Processing and Disseminating
➢ Cost of Auditing
➢ Costs associated with dangers of litigation and loss of competitive advantage
➢ Cost to the user for analysis and interpretation

Benefits to user and preparer of FS:

➢ Improve access to capital markets
➢ Favorable impact on public relations

STATEMENT OF FINANCIAL PERFORMANCE

Statement of Financial Performance – also known as “Income Statement” or “Profit or Loss Statement”. It shows
the company’s revenues and expenses during a particular period. It indicates how the revenues are transformed
into the net income. The purpose of the income statement is to show managers and investors whether the
company made or lost money during the period being reported.

Net Sales – Total Sales Revenue for each year net of returns and allowance. A sales return is cancellation of sale,
while sales allowance is a deduction from original invoice price. Since sale is the main revenue source for most
companies, the trend of this figure is a key element in performance measurement.

Instructor: Danica M. Almario, CPA 1

DM 2 223 FINANCIAL MANAGEMENT Lecture 4

Cost of Goods Sold – first deduction from sales, this is the cost to the seller of products sold to customers. This
expense is called cost of goods sold or cost of sales. The relationship between cost of goods sold and net sales is
called cost of goods sold percentage.

Gross Profit – also called as gross margin, it is the difference between net sales and cost of goods sold. Gross
profit indicates how much profit the firm is generating after deducting the cost of products.

Operating expenses – includes selling and administrative, advertising, lease payments, depreciation and repairs
and maintenance among others. These are areas which management exercises discretion and which have
considerable impact on the firms current and future profitability.

Selling and Administrative Expense – are expenses that relate to the sale of products or service and to
management of business.

Advertising Cost – major expense in the budgets of companies for which marketing is an important element of
success.

Lease Payments – include cost or rentals of leased facilities for retail outlets.

Depreciation and Amortization – Cost of assets other than land that will benefit a business enterprise for more
than 1 year is allocated over the asset’s service life rather than expensed in the year purchased. Depreciation is
used for the allocation of cost of tangible assets while amortization is the term applied to the cost expiration of
intangible assets.

Repairs and Maintenance – are annual cost of repairing and maintaining the property, plant and equipment.
Expenditure in this should correspond with the level of investment in capital assets and age and condition of
company’s fixed assets.

Operating Profit – also called as EBIT (Earnings Before Interest and Tax). Gross Profit less Operating expenses.
Provide basis for the success of company apart from its financing and investing activities and separate from tax
considerations.

Other Income (Expenses) – this category includes revenues and costs other than from operations, examples are
dividend and interest income, interest expenses, etc.

Earnings Before Tax – profit recognized before deduction of income tax.

Net Earnings – “bottom line” represents the firms profit after consideration of all revenue and expenses
reported during the accounting period.

Earnings per Share – are net earnings for the period divided by average outstanding ordinary shares.

STATEMENT OF CHANGES IN EQUITY

As prescribed in PAS 1, an enterprise should present as a separate component of financial statements, along
with the traditional financial statement showing:

➢ Net profit or loss for the period

➢ Items of income and expenses which are recognized in equity, as required by the standard and the total
of these items
➢ Cumulative effect of changes in accounting policy and correction of fundamental errors
➢ Capital transactions and distributions with/to owners of the enterprise
➢ Balance of accumulated profit or loss at the beginning of the period and at the statement of financial
position date and the movements of the period
➢ Reconciliation between the carrying amount of each class of equity capital share premium and each
reserve at the beginning and end of the period

Instructor: Danica M. Almario, CPA 2

DM 2 223 FINANCIAL MANAGEMENT Lecture 4

STATEMENT OF CASH FLOWS

➢ Provides information about the cash inflows and outflows from operating, financing and investing
activities during an accounting period
➢ Concerned with the flow of cash in and out of the business
➢ Captures both the current operating results and the accompanying changes in the balance sheet
➢ Useful in determining the short-term viability of a company, particularly its ability to pay bills

People and groups interested in cash flow statements include:

➢ Accounting personnel, who need to know whether the organization will be able to cover payroll and
other immediate expenses
➢ Potential lenders or creditors, who want a clear picture of a company's ability to repay
➢ Potential investors, who need to judge whether the company is financially sound
➢ Potential employees or contractors, who need to know whether the company will be able to afford
compensation
➢ Shareholders of the business

The cash flow statement is intended to:

➢ Provide information on a firm's liquidity and solvency and its ability to change cash flows in future
circumstances
➢ Provide additional information for evaluating changes in assets, liabilities and equity
➢ Improve the comparability of different firms' operating performance by eliminating the effects of
different accounting methods
➢ Indicate the amount, timing and probability of future cash flows

The cash flow statement is partitioned into three segments, namely:

1. Cash flow resulting from operating activities;
2. Cash flow resulting from investing activities;
3. Cash flow resulting from financing activities.
➢ The money coming into the business is called cash inflow, and money going out from the business is
called cash outflow.

OPERATING ACTIVITIES
➢ Include the production, sales and delivery of the company's product as well as collecting payment from
its customers. This could include purchasing raw materials, building inventory, advertising, and shipping
the product.

Under IAS 7, operating cash flows include:

➢ Receipts from sales of goods and services
➢ Interest payments
➢ Income tax payments
➢ Payments made to suppliers of goods and services used in production
➢ Salary and wage payments to employees
➢ Rent payments
➢ Any other type of operating expenses.

There are two methods of calculating cash flow: The direct method and the indirect method.

The direct method adds up all the various types of cash payments and receipts, including cash paid to suppliers,
cash receipts from customers and cash paid out in salaries. These figures are calculated by using the beginning
and end balances of a variety of a business accounts and examining the net decrease or increase in the accounts.

With the indirect method, cash flow from operating activities is calculated by first taking the net income off a
company's income statement. Because a company’s income statement is prepared on an accrual basis, revenue
is only recognized when it is earned and not when it is received. Net income is not an accurate representation of
net cash flow from operating activities, so it becomes necessary to adjust earnings before interest and taxes
(EBIT) for items that affect net income, even though no actual cash has yet been received or paid against them.
The indirect method also makes adjustment to add back non-operating activities that do not affect a company's
operating cash flow.

Instructor: Danica M. Almario, CPA 3

DM 2 223 FINANCIAL MANAGEMENT Lecture 4

For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of
an asset that has previously been accounted for. That is why it is added back into net sales for calculating cash
flow. The only time income from an asset is accounted for in CFS calculations is when the asset is sold.

Changes in accounts receivable on the balance sheet from one accounting period to the next must also be
reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company
from customers paying off their credit accounts – the amount by which AR has decreased is then added to net
sales. If accounts receivable increases from one accounting period to the next, the amount of the increase must
be deducted from net sales because, although the amounts represented in AR are revenue, they are not cash.

An increase in inventory, on the other hand, signals that a company has spent more money to purchase more
raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net
sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in
accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other
would be added to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid
off, then the difference in the value owed from one year to the next must be subtracted from net income. If
there is an amount that is still owed, then any differences will have to be added to net earnings.

INVESTING ACTIVITIES
➢ Report the aggregate change in a company's cash position resulting from investment gains or losses and
changes resulting from amounts spent on investments in capital assets, such as plant and equipment.

Examples of Investing activities are:

➢ Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)
➢ Loans made to suppliers or received from customers
➢ Payments related to mergers and acquisition

FINANCING ACTIVITIES
➢ Include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash
to shareholders as dividends as the company generates income. Other activities which impact the long-
term liabilities and equity of the company are also listed in the financing activities section of the cash
flow statement.

Items under the financing activities section include:

➢ Dividends paid
➢ Sale or repurchase of the company's stock
➢ Net borrowings
➢ Repayment of debt principal, including capital leases

Instructor: Danica M. Almario, CPA 4