CHAPTER 2

Review of Financial Statement Preparation, Analysis, and

Interpretation
Can you tell if a company is healthy or unhealthy? Before the end of this chapter, you should be able
to answer this question.

Below are excerpts of a news article from the business section of the The Philippine Star about
Universal Robina Corporation (URC), one of the biggest food conglomerates in the country and the
company behind popular brands such as Chippy, C2, Nova, and Blend 45, among others. 1

"...URC said its net income from October 2013 to September 2014 jumped 15.1 percent to
P11.56 billion from P10.05 billion during the same period the previous year."

"Net sales also rose 14.1 percent year-on-year to P92.38 billion on the back of robust sales in its
branded consumer food group (BCFG)."

These excerpts seem to indicate that URC did well in 2014. But financial health is not limited to
profitability. An analyst of a company should not just look at how much profits a company generates,
but should also pay attention to its capital structure, that is, how much of the total assets are financed
by debt. The drivers of the revenues and net income must also be looked into. In the case of URC, the
increase in revenues in 2014 must have come from its core business as the robust sales in its branded
consumer food group was cited as the reason for its improved revenues in 2014.

In determining the financial health of a company, the different financial statements have to be
analyzed. These are the statement of financial position or balance sheet, income statement or
statement of profit or loss, and the statement of cash flows. There is a fourth financial statement, the
statement of changes in stockholders’ equity. For purposes of this chapter, focus will be on the
statement of financial position, statement of profit or loss, and the statement of cash flows.

Objectives

1. Know the information found in the different financial statements.

2. Be familiar with the preparation of financial statements.
3. Determine the quality of earnings of a company.
4. Know how to compute different financial ratios such as liquidity, leverage, efficiency or
turnover, and profitability ratios.
5. Know how to use horizontal and vertical analysis in analyzing a company.
6. Apply the different financial statement analysis tools in assessing the financial 1‘ position and
operating performance of a company.
7. Understand the limitations of financial statement analysis.

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‘Mercurio. Richmond 8. “URC beefs up capex to PQB." Philstancom. Posted on January 15, 2015.
http://www.philstar. com/business/2015/01/15/1412931/urc-beefs-capex-p9b. Date Accessed: March 17. 2015.

Basic Financial Statements

This section discusses the four basic financial statements and the kind of information that can be
found and generated from each report.

Statement of Financial Position or Balance Sheet

The statement of financial position is the new name that the international Accounting Standards Board
(IASB)2 suggested for the "balance sheet" since 2009 to better reflect the kind of information found in
the financial report. This financial report provides information regarding the liquidity position and
capital structure of a company as of a given date. It must be noted that the information found in this
report are only true as of a given date. For example, if a company reported a cash of P1 500 000 as of
December 31, 2014, this cash balance is only true as of the end of December 31, 2014. By January 1,
2015, that cash balance may no longer be the same. More cash may have been received from sales or
interest income or some cash may have been spent for operating expenses on January 1, 2015.

Liquidity refers to the ability of a company to pay maturing obligations. The current assets of a
company are compared with its current liabilities to determine its paying capacity. Generally, assets
which are expected to be converted to cash within one year such as accounts receivable and
inventories are classified as current assets. Liabilities which are expected to be settled or paid within
one year are classified as current liabilities.

Capital structure provides information regarding the amount of assets financed by debt or liabilities
and equity. For example, if a company has P1 million assets and has liabilities of P400,000, its capital
structure is 40% liabilities (P400,000 / P1,000,000) and 60% equity (P1,000,000 - P400 000) /
(P1,000,000). While debt or liabilities are not necessarily bad in business; too much of it is not also
good as it exposes the company to higher probability of bankruptcy.

Statement of Profit or Loss or Income Statement

The statement of profit or loss or otherwise known as income statement provides information
regarding the revenues or sales, expenses, and net income of a company over a given accounting
period. This accounting period may be for a month, a quarter, or a year. The income reported by a
company is not that useful if the accounting period is not stated. in analyzing earnings performance, a
comparison with the previous periods and with other companies, especially those coming from the
same industry, is a must. Such comparison will not be made possible without knowing the accounting
periods covered in the statement of profit or loss.

in analyzing statement of profit or loss, it is important to identify how much of the income comes from
core business and how much comes from the non-core business. Core business refers to the main
business of a company. For example, sales of products such as C2, Blend 45, and its other branded
products should be the core business of

Universal Robina Corporation (URC). However, it can also generate interest income from its deposits
or other investments. In analyzing URC’s statement of profit or loss, more emphasis should be made
on its core business because if something goes wrong with this main operation, uncertainties may
arise regarding the ability of the company to continue operating in the future.‘

If an actual statement of profit or loss ofa company is examined, one will realize that this financial
statement is not easily found. This is because the international Accounting Standards Board (lASB)
which serves as the source of our generally accepted accounting principles gives the preparers of
financial statements two options on how to present their statements of profit or loss. The first option is
to present it as a separate financial statement. The second option is to present it together with other
comprehensive income (0C1). 0C1 represents transactions that are not reported in the profit or loss
statement but affects the stockholders' equity. Transactions of this nature are better discussed in
more advanced accounting courses. While the transactions related to the statement of profit or loss
and 00 can be combined with the second option, information for each have to be distinctly presented
in the financial statement. Most listed companies in the Philippines follow the second option.

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2
IASB is an independent, private-sector body that develops and approves International Financial Reporting
Standards (IFRS).

Statement of Cash Flows

The statement of cash flows provides an explanation regarding the change in cash balance from one
accounting period to another. The cash flows are also classified into three main categories: operating,
investing, and financing.

The statement of cash flows is a very important financial statement because it provides information
regarding the quality of earnings of a company as shown in the cash flows from operating activities. In
this section, the income reported from the statement of profit or loss which is based on accrual
principle is converted to cash. This is a very important piece of information found in this financial
report because a company may have so much reported net income, but if such income is not
translated into cash, then that income is useless. One cannot use net income to pay debt or to pay the
salaries of employees. Cash is needed.

The cash flows from investing activities provide information regarding the future direction of the
company. This section shows how much investment the company is making over a given accounting
period. Expansions allow companies to grow. Note, however, that expansions or investments are not
always good especially when management has undertaken them too aggressively and are also
financed aggressively.

To find out if a company, which is undergoing expansion, will potentially encounter liquidity problems
in the future, an examination of the third section of the statement of cash flows has to be made. The
cash flows from financing activities provide information whether there is a proper matching of
investing and financing activities. An expansion which will take a longer period of time to realize the
benefits warrants a more patient source of financing such as equity. If loan is to be incurred to
partially finance this kind of expansion, the tenor of the loan has to be studied properly and a
reasonable amount of equity must also be provided to minimize the probability of liquidity problems in
the future.

Statement of Changes in Stockholders’ Equity

This financial statement provides information that explains the changes in the Stockholders' equity
account from one accounting period to another. The changes may be due to the following:

1. Profit or loss for the accounting period.

2. Cash dividend declaration
3. Issuance of new shares of stocks
4. Other transactions that affect the Stockholders' equity such as other comprehensive income,
treasury stocks, and revaluation of assets.3

Notes to Financial Statements

The notes to financial statements are integral part of the financial statements. Among the additional
information that the notes to financial statements provide are the following:

1. Brief description of the company. Information may include the nature of business of the
company and the owners behind the company.

2. Summary of significant accounting policies. This is very important because the existing
generally accepted accounting principles provide alternative accounting policies to companies.
It is therefore important to find out what specific accounting policies are used by the company.

3. Breakdown of amounts found in the financial statements. The company's property, plant, and
equipment (PPE) account may have too many components. Putting all the details on the face
of the balance sheet may make the balance sheet too long. An alternative presentation is to
 provide a single amount on the face of the balance sheet for PPE but the breakdown of PPE
can be presented in the notes to financial statements.

This breakdown may be provided for other financial statement accounts such as accounts
receivable, inventories, loans, operating expenses, among others.

Self-Test Questions

Identify and describe the financial information that can be found in the following financial statements:

a. Statement of Financial Position

b. Statement of Profit or Loss
c. Statement of Cash Flows
d. Statement of Changes in Stockholders' Equity

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3
These other transactions are more advanced in nature and are not covered in this worktext.

Review of the Financial Statement Preparation

This section is a review of the process taken in preparing financial statements.

1. Analyzing business transactions

in this step, a transaction is analyzed to find out if it affects the company and if it needs to be
recorded. Personal transactions of the owners and managers that do not affect the company
should not be recorded. In this step, a decision may have to be made to identify if a transaction
needs to be recorded in special journals such as sales journal or purchases journal.

2. Recording in the journals

Once a transaction is identified and analyzed, the next step is the preparation of the journal entry.
For repetitive transactions, special journals are made. These special journals include sales journal,
purchases journal, cash receipts journal, and cash disbursements journal. Transactions which do
not fall under any of these four may be recorded in general journal.

The source documents which will serve as the basis for recording must be examined. For example,
sales invoice and acknowledged delivery receipt from customers must be present to support the
recording of a sales transaction in the sales journal. Official receipts may be needed to support a
recording in the cash receipts journal.

3. Posting to ledger accounts

After transactions have been recorded in the journals, the next step is posting the transactions to
the ledgers. Ledgers provide chronological details as to how transactions affect individual
accounts. There are two types of ledgers: the general ledger and subsidiary ledger. The general
ledger is a summary of the different subsidiary ledgers and can serve as a control account. For
example, a general ledger" for accounts receivable summarizes the balances found in the different
subsidiary ledgers for different customers.

To illustrate, assume that there are three customers. As of December 31, 2014, customer 1 has
accounts receivable balance of P10 000, customer 2 has accounts receivable balance of P15 000,
and customer 3 has accounts receivable balance of P25 000. The general ledger balance for
accounts receivable as of December 31, 2014 must be P50 000 which is the sum of the three
subsidiary ledgers. If the sum of the three subsidiary ledgers does not tally with the amount in the
general ledger, an investigation has to be made to identify the source of discrepancies.
 Posting in the subsidiary ledgers can be done anytime and the balances are summarized at the
end of an accounting period. Posting in the general ledger is done at the end of an accounting
period.

4. Preparing the Unadjusted trial balance

At the end of ‘each accounting period, unadjusted trial balance is prepared from the financial
statement account balances found in the general ledgers. Accounts with debit balances and credit
balances are then added. The sum for the debit balances must exactly equal that of the credit
balances. If there are discrepancies, steps have to be taken to identify the sources of
discrepancies. Possible sources of discrepancies can be erroneous posting and additions or
improper recording of a transaction.

5. Making the adjusting entries

Once the unadjusted trial balance is prepared, adjusting entries are then prepared to account for
the following, among others:

a. Accruals. These include unpaid salaries for the accounting period, unpaid interest expense, or
unpaid utility expenses.

b. Prepayments. If a company has prepaid expenses such as prepaid rent or prepaid insurance,
then the correct balances for these accounts have to be established at the end of each
accounting period to reflect their correct balances. ‘

c. Depreciation and amortization expenses. Depreciation expenses are recognized at the end of
each accounting period through adjusting entries. if there are intangible assets such as
franchise, the allocation of their costs, which is called amortization expense, is also recognized
at the end of each accounting period through adjusting entries.

d. Allowance for uncollectible accounts. Bad debt expense from accounts receivable is also
recognized through adjusting entries.

6. Preparing the adjusted trial balance

An adjusted trial balance is prepared after taking into consideration the effects of the adjusting
entries. Again, this is to ensure that the total debit balances equal the credit balances.

7. Preparing the financial statements

Once the adjusted trial balance is available, the financial statements can then be prepared. These
are the statement of financial position, statement of profit or loss, and the statement of cash
flows.

8. Making the closing entries

Income statement accounts such as revenues and expenses are closed to prepare the system for
the next accounting period. These income statement accounts are closed to the retained earnings.
If the revenues exceed expenses during an accounting period, retained earnings will increase. The
reverse is true which means that if the expenses exceed revenues, the retained earnings will
decrease.

9. Post-closing trial balance

The post-closing trial balance is prepared to test if the debit balances equal the credit balances
after closing entries are considered. This is to ensure that the accounting system is working.
Self-Test Questions

1. Name the different steps in preparing financial statements.

2. Give examples of financial statement accounts that will require adjusting entries when
financial statements are prepared
3. What are closing entries?
4. What is a post-closing trial balance?

Taken from: Cayanan, Arthur S. and Borja, Daniel Vincent H., Page 17, BUSINESS FINANCE, 1 st
Edition. Manila: Rex Bookstore