CHAPTER 2

REVIEW OF FINANCIAL STATEMENT

PREPARATION: ANALYSIS AND
INTERPRETATION
LEARNING OBJECTIVES

At the end of this chapter, you will be able to:

1. Understand the process of preparing financial statements for sole proprietorship.
2. Use financial statements in evaluating the financial standing of a business.
3. Perform vertical and horizontal analyses of financial statements for sole
proprietor organization.
4. Interpret financial ratios to evaluate the business financial standing.

ANALYSIS OF FINANCIAL INFORMATION

One final step in understanding business finance is the analysis of financial information. The pre-requisite to this
analysis is knowing and understanding available information and drawing logical conclusions. There are steps to
consider in order to interpret and analyze the financial information. The steps are:
Information must be understood by the user. Data can never be analyzed unless it is fully understood. It is
impossible to interpret financial data if it is only partly understood. At the same time, financial information must be
treated with total honesty – understanding its context, and an understanding of everything that is presented.
Information must be organized. Before an analysis can be made, information must be sorted out. Supposing a data
on profit and loss account for a manufacturing business shows current year data, but if you look back on several
years data, a different analysis can be done. Also, the presentation of changes in investments and their funding set
out in the cash flow statement is very much needed for organizing the data so that we can obtain greater meaning.
Information measurement. Once we have understood and reorganized the financial data needed, then the
measurement can be done using applied common sense and analysis by means of financial ratios. Finally, the data
can then be interpreted.
MANAGERIAL AND FINANCIAL ACCOUNTING
Accounting is the process of collecting, reporting and analyzing the costs associated with operating the business
(Halpern, 2004). There are internal and external users of the accounting information.
External users may include the Bureau of Internal Revenue for tax liability purposes; the Securities and Exchange
Commission for annual reporting for shareholders records; banks for evaluation of financial standing for loan
applications; and private individuals for investment interests. This system is called financial accounting.
Internal users may require different types of data and reports generated by the accounting staff or the firm’s
accountant. These data may guide the organization, particularly the finance executive, to decide on some project to
undertake, financial planning and funding, as well as expenditures. This type is called managerial accounting.

Finance is the process of obtaining and employing assets that allow the firm to continue and expand operations. The
finance manager is responsible for maintaining the steady supply of cash needed to sustain operations while
minimizing the cost of keeping those funds. Accounting data are critical to financial decision making. Accounting is
a system that communicates important information about the company’s operations. Four main accounting
statements are: the balance sheet, income statement, cash flow statement, and statement of changes in ownership.

CHAPTER 2| REVIEW OF FINANCIAL STATEMENT PREPARATION: ANALYSIS AND INTERPRETATION

 THE BASIC FINANCIAL STATEMENTS
BALANCE SHEET – a financial statement that presents all the assets of, and claims against, or the liabilities and
equity, of the firm at a particular period of time. Where assets = liabilities + owner’s equity.
INCOME STATEMENT – measures the profit or loss that an organization has made over a set period of time,
quarterly or a year. For a profit organization, revenue is most often derived from sales, and expenses are the costs
directly involved in acquiring or manufacturing the outputs along with other costs related in operating the business,
including the acquisition and maintenance of facilities, compensation, and distribution or marketing expenses.
Profits occur when the revenue excess expenses. The bottom line of the statement is either a net income or net loss.
Where income = revenue – expenses.
CASH FLOW STATEMENT – is the overview of the company’s financial health. This gives data on the cash
provided or used in operating activities. It starts with a figure from net income, taken from the income statement. It
describes the sources and uses of cash which can be very revealing data for the firm’s wise financial management.
Analyses should be done on the increasing amount of uncollectibles, with rise in sales, may signal good sales but at
the expense of good credit practices. An increase in receivables should also have a counterpart increase in revenue
(Meyer, 2007).
STATEMENT OF CHANGES IN FINANCIAL CONDITION/ STATEMENT OF CHANGES IN OWNER’S
EQUITY/STATEMENT OF STOCKHOLDER’S EQUITY – describes the effect of operations on cash position
of the company, the effect of operations and financing decisions to the change in owner’s equity. This acts as the
link between the income statement and the equity portion of the balance sheet, where the net income in the period is
either added or subtracted, depending if dividends are paid or equity withdrawn by stockholders, leaving and ending
equity balance.

The balance sheet as summary of all the amounts and kinds of assets that the firm’s possesses , as well as the claims
made against those assets by investors and creditors, include the following accounts concepts (Koth):
- The total of the firm’s assets must equal the total value of the claims against the firm.
- The current asset is one that can be converted into cash in the normal operation of the firm within one year.
- The fixed assets are permanent assets that will not normally be converted into cash. On the balance sheet,
fixed assets are shown as historical cost, which is the amount actually paid for the asset.
- The market value of the asset is the price the asset could command in the market, and the replacement cost is
the price that would be required to replace the asset if it had to be acquired today.
- The value of the assets shown on financial reports and the books of the company, the book value, may be
differ from the market value of the assets. Assets that have become obsolete typically have market values below
their book values, while the opposite condition holds for assets, such as land, that have appreciated in value.
- Current liabilities are those that the firm reasonably expects to pay within the next year.
- Accounts payable are obligations that the firm has for that the goods it has received from others.
- Notes payable are short term debt that the firm must pay off within the next year.
- Accruals are debts the firm owes because payment has not yet been made, such as salaries owed to
employees.
- Taxes payable, are taxes that are owed, but that have not been paid yet.

CHAPTER 2| REVIEW OF FINANCIAL STATEMENT PREPARATION: ANALYSIS AND INTERPRETATION

- Long term liabilities are continuing obligations that will not be completely repaid during the next year, such
as long term debt and long term leases.
- The common stock account reflects capital that was contributed by the equity holders of the firm.
- The retained earnings account shows the amount of earnings the firm has accumulated since its inception.
Retained earnings are net income that the firm has not paid out in dividends to its shareholders.

The income statement, which presents the record of the firm’s sales and expenses over a particular period,
identifying the income derived from its operations, and all the changes incurred to generate the income, include the
following accounts concepts (KOTH) :
- The income statement begins with a report of the peso volume of sales.
- From sales, the cost of goods sold (all costs of producing the product for sale) is subtracted to give the gross
profit.
- The firm must recognize its depreciation expense to reflect the consumption of its capital and equipment.
Likewise, the selling and administrative expenses incurred by the firm also affect profit. After all, these costs and
interest expenses subtracted from the sales; the result is the firm’s earnings before tax.
- Subtracting taxes from EBT gives the firm’s earnings after tax or net income.
- One of the most important things to realize about an income statement is that it reflects the firm’s activities
using a technique known as the accrual method of accounting. Under the accrual method, inflows and outflows are
recognized at the time the commitments leading to those inflows and outflows are made, not necessarily at the time
the cash flows inflows and outflows are themselves incurred.
- It should be noted that there is difference between earnings reported in the income statement and the cash
flow that the firm receives. Cash flows refers to the actual payment of cash or cash equivalents. Cash flow is very
important because only cash allows the firm to meet its own obligations.

The statement for the firm’s changes in financial condition, or the resources and uses of funds statement, which
identifies the origin and utilization of funds acquired, considers the following principles:
- For any firm, there are essentially these sources and uses of funds:
a. Sources if funds
. Increase in a liability account
. Increase in a net worth account
. Decrease in an asset account.
b. Uses of funds.
. Decrease in a liability account.
. Decrease in a net worth account.
. Increase in an asset account.

CHAPTER 2| REVIEW OF FINANCIAL STATEMENT PREPARATION: ANALYSIS AND INTERPRETATION

- Working capital is the firm’s current assets. Net working capital is current assets minus current liabilities.
- Some firms construct changes in net working capital statement or cash flow statement instead of a sources
and uses of funds statements.

MAJOR CORPORATE CASH FLOWS

The firm can obtain cash from issuing new stocks to owners, as stockholders: or bonds to creditors, as bondholders.
Cash flows can also be derived from selling plant and equipment or from selling marketable securities. However,
the funds necessary to purchase marketable securities must have originally come from sales of the issuance of stock
or bond. Thus the firm has these possible sources of cash (MEYER,2007)
- Sales
- Capital invested by stock holders
- Debt funds raised from creditors.

CHAPTER 2| REVIEW OF FINANCIAL STATEMENT PREPARATION: ANALYSIS AND INTERPRETATION