Philippine School of Business Administration

Sampaloc, Manila

Finance 1
Chapter 5 – Understanding Financial
Statements

Prof. Eugene A. Ruano

 FINANCIAL STATEMENTS
• are the product of financial accounting.
• show the results of operation, financial
condition, changes in owner’s equity and
sources and uses of cash
 BASIC FINANCIAL STATEMENTS
• Income Statement or Statement of Comprehensive
Income
• Balance Sheet or Statement of Financial Position or
Statement of Financial Condition
• Statement of Changes in Owner’s Equity (for a sole
proprietorship) or Statement of Changes in
Partners’ Equity (for partnership) or Statement of
Changes in Stockholders’ Equity (for a corporation)
• Cash Flow Statement or Statement of Cash Flows
 INCOME STATEMENT
• now called “Statement of Comprehensive
Income”, details the revenues earned and the
expenses incurred by a company
• shows the results of operation of a company
• the “bottom line” in business parlance is the net
profit or the net loss
• shows profitability of the firm
• covers a certain accounting period, a month, a
quarter, a six-month period, or a year.
 INCOME STATEMENT OF A SERVICE
ENTERPRISE
• very simple.
• simply lists the income from operations, like service
revenue or professional fees and deducts from such
revenue the total operating expenses
• OPERATING PROFIT – if the income is greater than the
operating expenses
• OPERATING LOSS – if the income is less than the operating
expenses
• To the operating profit or loss is added the net of the
other income (interest income, rent income, commission
income, among others) less the other expenses (interest
expense, finance charges, among others).
INCOME STATEMENT OF A TRADING FIRM

• a little complicated
• shows the sales figure and deductions from gross sales
like sales discount and sales return and allowance to
arrive at net sales
• From net sales, the cost of sales is deducted which is
computed by adding the beginning inventory to the
net cost of purchases and deducting the ending
inventory.
• The cost of sales is deducted from the net sales to
arrive at the gross profit.
• From the gross profit, the operating expenses
are deducted to obtain the profit from
operations or operating profit.
• From the operating profit is added the net of
other incomes and other expenses to arrive at
the “bottom line” or profit (or loss, if expenses
are greater than revenue).
 INCOME STATEMENT OF A
MANUFACTURING COMPANY
• more complicated than a trading firm because of the
different costs involved (cost of goods manufactured
and the cost of goods sold) in addition to the
operating expenses.
• Different costs involve direct materials, direct labor
and manufacturing overhead.
• The manufacturing firm’s cost is complicated due to
the fact that its manufacturing operations detail the
cost of goods manufactured first before the cost of
goods sold in computed.
• Manufacturing cost is broken down into direct
materials, direct labor and manufacturing
overhead, the three components of
manufacturing cost. Then there is the work in
process inventories and the finished goods in
inventories.
• Schedule A
1. total manufacturing cost
Direct materials Pxxx
Direct labor xxx
Manufacturing Overhead xxx
TOTAL MANUFACTURING COST Pxxx
To the total manufacturing cost is added the beginning
work in process inventory and from the total thus
obtained is deducted the ending work in process to yield
total cost of goods manufactured.
Thus we have:
2. total cost of goods manufactured
Total Manufacturing Cost Pxxx
Work in Process, Beginning xxx
Work in Process, End (xxx)
TOTAL COST OF GOODS MANUFACTURED Pxxx
To the cost of goods manufactured is added the beginning finished
goods inventory to arrive at the total goods available for sale
and then from the total thus obtained is deducted the ending
finished goods inventory to arrive at the cost of goods sold.
Similarly, we have:
3. total goods available for sale & 4. cost of goods sold
Total Cost of Goods Manufactured Pxxx
Finished Goods Inventory, Beginning xxx
Total Goods Available for Sale xxx
Finished Goods Inventory, End (xxx)
Cost of Goods Sold Pxxx
• Schedule B - shows the details of the selling or
marketing expenses. Expenses related to sales
are grouped under the selling or marketing
expenses
• Schedule C – is the schedule of the general or
administrative expenses. These expenses refer
to those operating expenses related to the
office/general/administrative operations. The
salary of the president and the different vice
presidents and managers are all part of the
general or administrative expenses. The rent
expense for the office space is administrative.
PRODUCT COSTS vs PERIOD COSTS
• Product costs are the costs of direct materials,
direct labor and overhead, also called
manufacturing cost (Schedule A) while
• Period costs refer to the costs incurred during
a particular time period and reported either as
selling or marketing expenses (Schedule B)
and administrative or general expenses
(Schedule C)
 VARIABLE vs FIXED
• Like product costs, they could be variable
(e.g., income taxes, commission expense,
utilities expense, among others) or fixed (e.g.,
officers’ salaries, office rent depreciation for
office building and office equipment, among
others)
 BALANCE SHEET
• or statement of financial condition, sometimes also
called statement of financial position
• shows the assets, liabilities and owner’s equity of a
business
• shows financial condition or financial position of the
business
• details the company’s resources and obligations and the
composition of the owner’s equity
• Assets – Liabilities = Owner’s Equity
• it also shows the liquidity and solvency of the firm
CURRENT AND NON-CURRENT ASSETS
• Total assets are divided into current and non-current
assets
• Current assets are the resources that will be used for
current operations (short term) or within the
operating cycle. Examples: cash, prepaid expenses,
accounts receivable, inventory
• Non-current assets refer to the resources of the firm
that are durable or will last longer than a year like
land, equipment, furniture and fixture and long-term
investments.
CURRENT AND NON-CURRENT LIABILITIES

• Total liabilities are divided into current liabilities

and non-current liabilities or long-term liabilities.
• Current liabilities are obligations of the firm that
will mature or need payment during the
accounting period or accounting year. Examples:
accrued liabilities (accrued property taxes
payable), payroll liabilities (salaries and wages
due within the year), company liabilities
(accounts payable, dividends payable)
• Non-current liabilities are obligations of the
firm that will mature or become due within
more than a year. That portion of the long-
term liability that is due during the current
period is classified as a current liability and the
rest or balance is classified as long-term or
non-current. Examples: long-term loans,
deferred revenues, deferred income taxes,
capital leases
 Account Form and Report Form
• A balance sheet can be reported using the
account form where assets are listed on the
left side and liabilities and owner’s equity on
the right side. The report form lists the assets
followed by the liabilities and the owner’s
equity.
 MARKET VALUE vs BOOK VALUE
• The book value of an asset is its original purchase cost,
adjusted for any subsequent changes, such as for
impairment or depreciation. Market value is the price that
could be obtained by selling an asset on a competitive,
open market.
• For example, a company buys a machine for $100,000 and
subsequently records depreciation of $20,000 for that
machine, resulting in net book value of $80,000. If the
company were to then sell the machine at its current
market price of $90,000, the business would record a gain
on the sale of $10,000.
 STATEMENT OF CHANGES IN OWNERS’
EQUITY
• shows the investments made by the owner
reduced by his withdrawals and increased by
net profit (or reduced by net loss) for a sole
proprietorship or partnership
• For a corporation, the statement of changes in
stockholders’ equity shows the capital stock at
the beginning of the period increased by any
additional issues of shares.
 STATEMENT OF RETAINED EARNINGS

• For a corporation, the accumulated profits of

the company are reflected in the retained
earnings account.
• Retained earnings account details the
beginning retained earnings, the profit/loss of
the corporation, dividends declared, retained
earnings appropriated and the return of
appropriation of retained earnings.
• Retained earnings appropriated are the
appropriation of the company’s accumulated
earnings for such purposes as plant expansion,
building construction, land acquisition, bond
retirement and other purposes as the
corporation sees fit.
• Appropriated retained earnings portion shows
all appropriations of retained earnings at the
beginning of the period and to each respective
appropriation are added additional
appropriations and deducted all reversal of
appropriated retained earnings back to the
unappropriated retained earnings. New
appropriations for the year are also included
in the statement.
 CASH FLOW STATEMENT
• Is sometimes called the funds flow statement
or the statement of the sources and uses of
cash or the statement of sources and uses of
funds.
• Accrual method – recognition of income and
expenses are made when income is earned,
regardless when cash is received and expenses
are recognized when expenses are incurred,
irrespective of when they are paid.
• The profit or net income shown in the income
statement does not show the cash position of
the company. Income in the income statement
can only be “paper profits” if receivables are
not collected and converted into cash. This is
the basic reason why the cash flow is
important to provide additional information as
to the cash position, which is an indication of
the liquidity of the firm.
• Net cash inflow from investing activities shows
purchases and sales of fixed assets.
• Net cash inflow from financing activities shows sales
of capital stock, payment of dividends and
repayment of long-term liabilities.
• Operating activities are all operation-related earning
activities of the company – rendering service for a
firm, selling goods for a trading concern and
manufacturing and selling activities for a
manufacturing company.
• Financing activities involve obtaining
resources from owners (issuances of capital
stock) and paying them dividends as their
share in the profit of the company.
• Investing activities involve all activities related
to non-current assets—disposing of them or
selling them and buying them.