MODULE 4

FINANCIAL STATEMENTS

The Basic Financial Statements

If you can read a nutrition label or a baseball box score, you can learn to read basic

financial statements. If you can follow a recipe or apply for a loan, you can learn basic

accounting. The basics aren’t difficult and they aren’t rocket science.

This brochure is designed to help you gain a basic understanding of how to read financial

statements. Just as a CPR class teaches you how to perform the basics of cardiac pulmonary

resuscitation, this brochure will explain how to read the basic parts of a financial statement. It

will not train you to be an accountant (just as a CPR course will not make you a cardiac doctor),

but it should give you the confidence to be able to look at a set of financial statements and make

sense of them.

Let’s begin by looking at what financial statements do.

“Show me the money!”

We all remember Cuba Gooding Jr.’s immortal line from the movie Jerry Maguire,

“Show me the money!” Well, that’s what financial statements do. They show you the money.

They show you where a company’s money came from, where it went, and where it is now.

There are four main financial statements. They are: (1) balance sheets; (2) income

statements; (3) cash flow statements; and (4) statements of shareholders’ equity. Balance sheets

show what a company owns and what it owes at a fixed point in time. Income statements show

how much money a company made and spent over a period of time. Cash flow statements show

the exchange of money between a company and the outside world also over a period of time. The

fourth financial statement, called a “statement of shareholders’ equity,” shows changes in the

interests of the company’s shareholders over time.

TRIAL BALANCE

A trial balance is a list and total of all the debit and credit accounts for an entity for a

given period – usually a month.   The format of the trial balance is a two-column schedule with

all the debit balances listed in one column and all the credit balances listed in the other.  The trial

balance is prepared after all the transactions for the period have been journalized and posted to

the General Ledger. 

Key to preparing a trial balance is making sure that all the account balances are listed

under the correct column.  The appropriate columns are as follows:

Assets = Debit balanceLiabilities = Credit balanceExpenses = Debit BalanceEquity = Credit balanceRevenue = Credit balanceWithdrawals = Debit

Should an account have a negative balance, it is represented as a negative number in the

appropriate column.  For example, if the company is $500 into the overdraft in the checking

account the balance would be entered as -$500 or ($500) in the debit column.  The $500 negative

balance is NOT listed in the credit column.

Example Trial Balance:

The trial balance ensures that the debits equal the credits.  It is important to note that just

because the trial balance balances, does not mean that the accounts are correct or that mistakes

did not occur.  There might have been transactions missed or items entered in the wrong account

– for example increasing the wrong asset account when a purchase is made or the wrong expense

account when a payment is made.  Another potential error is that a transaction was entered

twice.  Nevertheless, once the trial balance is prepared and the debits and credits balance, the

next step is to prepare the financial statements. 

Let us take a look on how to prepare the three financial statements.

Balance Sheet

A balance sheet provides detailed information about a company’s assets, liabilities and

shareholders’ equity.

Assets are things that a company owns that have value. This typically means they can

either be sold or used by the company to make products or provide services that can be sold.

Assets include physical property, such as plants, trucks, equipment and inventory. It also

includes things that can’t be touched but nevertheless exist and have value, such as trademarks

and patents. And cash itself is an asset. So are investments a company makes.

Liabilities are amounts of money that a company owes to others. This can include all

kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a

building, money owed to suppliers for materials, payroll a company owes to its employees,

environmental cleanup costs, or taxes owed to the government. Liabilities also include

obligations to provide goods or services to customers in the future.

Shareholders’ equity is sometimes called capital or net worth. It’s the money that would

be left if a company sold all of its assets and paid off all of its liabilities. This leftover money

belongs to the shareholders, or the owners, of the company.

The following formula summarizes what a balance sheet shows:

ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY

A company's assets have to equal, or "balance," the sum of its liabilities and

shareholders' equity.

 

A company’s balance sheet is set up like the basic accounting equation shown above.

On the left side of the balance sheet, companies list their assets. On the right side, they list their

liabilities and shareholders’ equity. Sometimes balance sheets show assets at the top, followed by

liabilities, with shareholders’ equity at the bottom.

Assets are generally listed based on how quickly they will be converted into cash.

Current assets are things a company expects to convert to cash within one year. A good example

is inventory. Most companies expect to sell their inventory for cash within one year. Non-current

assets are things a company does not expect to convert to cash within one year or that would take

longer than one year to sell. Noncurrent assets include fixed assets. Fixed assets are those assets

used to operate the business but that are not available for sale, such as trucks, office furniture and

other property.

Liabilities are generally listed based on their due dates. Liabilities are said to be either

current or long-term. Current liabilities are obligations a company expects to pay off within the

year. Long-term liabilities are obligations due more than one year away.

Shareholders’ equity is the amount owners invested in the company’s stock plus or

minus the company’s earnings or losses since inception. Sometimes companies distribute

earnings, instead of retaining them. These distributions are called dividends.

A balance sheet shows a snapshot of a company’s assets, liabilities and shareholders’

equity at the end of the reporting period. It does not show the flows into and out of the accounts

during the period.

Most accounting balance sheets classify a company's assets and liabilities into distinctive

groupings such as Current Assets; Property, Plant, and Equipment; Current Liabilities; etc. These

classifications make the balance sheet more useful. The following balance sheet example is a

classified balance sheet.

Example CompanyBalance Sheet

December 31, 2009

ASSETS LIABILITIESCurrent Assets Current LiabilitiesCash Php   2,100  Notes Payable  Php 5,000 Petty Cash 100  Accounts Payable 35,900 Temporary Investments 10,000  Wages Payable 8,500 Accounts Receivable - net 40,500  Interest Payable 2,900 Inventory 31,000  Taxes Payable 6,100 Supplies 3,800  Warranty Liability 1,100 Prepaid Insurance         1,500   Unearned Revenues         1,500  Total Current Assets       89,000   Total Current Liabilities       61,000  

-Investments       36,000   Long-term Liabilities

Notes Payable 20,000 Property, Plant & Equipment Bonds Payable     400,000  Land 5,500  Total Long-term Liabilities     420,000  Land Improvements  6,500 Buildings 180,000 Equipment 201,000  Total Liabilities     481,000  Less: Accum Depreciation       (56,000) Prop, Plant & Equip - net     337,000  

-Intangible Assets STOCKHOLDERS' EQUITYGoodwill 105,000  Common Stock 110,000 Trade Names     200,000   Retained Earnings 229,000 Total Intangible Assets     305,000   Less: Treasury Stock       (50,000)

Total Stockholders' Equity     289,000  Other Assets         3,000  

-

Total Assets Php770,000  Total Liab. & Stockholders' Equity Php770,000 

The notes to the sample balance sheet have been omitted.

Income Statement

An income statement is a report that shows how much revenue a company earned over a

specific time period (usually for a year or some portion of a year). An income statement also

shows the costs and expenses associated with earning that revenue. The literal “bottom line” of

the statement usually shows the company’s net earnings or losses. This tells you how much the

company earned or lost over the period.

Income statements also report earnings per share (or “EPS”). This calculation tells you

how much money shareholders would receive if the company decided to distribute all of the net

earnings for the period. (Companies almost never distribute all of their earnings. Usually they

reinvest them in the business.)

To understand how income statements are set up, think of them as a set of stairs. You

start at the top with the total amount of sales made during the accounting period. Then you go

down, one step at a time. At each step, you make a deduction for certain costs or other operating

expenses associated with earning the revenue. At the bottom of the stairs, after deducting all of

the expenses, you learn how much the company actually earned or lost during the accounting

period. People often call this “the bottom line.”

At the top of the income statement is the total amount of money brought in from sales of

products or services. This top line is often referred to as gross revenues or sales. It’s called

“gross” because expenses have not been deducted from it yet. So the number is “gross” or

unrefined.

The next line is money the company doesn’t expect to collect on certain sales. This could

be due, for example, to sales discounts or merchandise returns.

When you subtract the returns and allowances from the gross revenues, you arrive at the

company’s net revenues. It’s called “net” because, if you can imagine a net, these revenues are

left in the net after the deductions for returns and allowances have come out.

Moving down the stairs from the net revenue line, there are several lines that represent

various kinds of operating expenses. Although these lines can be reported in various orders, the

next line after net revenues typically shows the costs of the sales. This number tells you the

amount of money the company spent to produce the goods or services it sold during the

accounting period.

The next line subtracts the costs of sales from the net revenues to arrive at a subtotal

called “gross profit” or sometimes “gross margin.” It’s considered “gross” because there are

certain expenses that haven’t been deducted from it yet.

The next section deals with operating expenses. These are expenses that go toward

supporting a company’s operations for a given period – for example, salaries of administrative

personnel and costs of researching new products. Marketing expenses are another example.

Operating expenses are different from “costs of sales,” which were deducted above, because

operating expenses cannot be linked directly to the production of the products or services being

sold.

Depreciation is also deducted from gross profit. Depreciation takes into account the wear

and tear on some assets, such as machinery, tools and furniture, which are used over the long

term. Companies spread the cost of these assets over the periods they are used. This process of

spreading these costs is called depreciation or amortization. The “charge” for using these assets

during the period is a fraction of the original cost of the assets.

After all operating expenses are deducted from gross profit; you arrive at operating profit

before interest and income tax expenses. This is often called “income from operations.”

Next companies must account for interest income and interest expense. Interest income is

the money companies make from keeping their cash in interest-bearing savings accounts, money

market funds and the like. On the other hand, interest expense is the money companies paid in

interest for money they borrow. Some income statements show interest income and interest

expense separately. Some income statements combine the two numbers. The interest income and

expense are then added or subtracted from the operating profits to arrive at operating profit

before income tax.

Finally, income tax is deducted and you arrive at the bottom line: net profit or net losses.

(Net profit is also called net income or net earnings.) This tells you how much the company

actually earned or lost during the accounting period. Did the company make a profit or did it lose

money?

The sample Income Statement below is what is known as the single-step format, and is

the most easily read format.  We will take a look later at the single and multiple step formats, and

how to dissect the different information contained within each one.

SAMPLE STATEMENTS

         Happy Travel Court  

  Income Statement    For the Month Ended March 31, 2005  

           Revenues               Rental Revenue     Php65,000 Operating Expenses           Advertising Php5,310        Wages   30,500        Utilities  1,080        Depreciation 800        Repairs   4,260        Insurance 600        Interest   100        Supplies 3,900          Total Operating Expenses: 46,550   Net Income:     Php18,450            

As you can see, the format, along with the compiled information contained in the

statement is not that complex.  The complexity of the Income Statement lies in the comparison of

the reports, the horizontal and vertical analysis that is often done on the information, and our

ability to absorb that information, and put it into practical application for business assessment

and investment purposes.

LINKING THE INCOME STATEMENT AND BALANCE SHEET

Income Statement

The income statement communicates the inflows and outflows of assets, where inflows

are the revenues generated and outflows are the expenses.  An excess of inflows over outflows is

called net income, and an excess of outflows over inflows is called a net loss.

The income statement can be expressed as an equation:Revenue – Expenses = Net Income (Loss)

The income statement is a summary of the sources of revenues and expenses that result in

a profit or a loss for a specified accounting period.  Typically that period is one year but it can be

a month or a quarter as well.   Income statements are always prepared for a period of time and

the term “for the period ended…” is included in the title.

Revenue:  The sources of revenue for any business depend on the type of business being

operated.  A company that manufactures or resells a product would generate sales revenue.  A

service company on the other hand might generate fees revenue or service revenue.

Expense:  Examples of typical expenses encountered are salaries, utilities, rent,

insurance, and office supplies.  Here again, each entity will have its own unique set of expenses

depending on the type of business being operated.

Net Income (Loss):  The difference between revenues and expenses is expressed as a

positive or negative depending on whether revenues were greater or less than expenses.

If revenues for the month are Php5000 and expenses are Php3500, then the entity has a

net income of Php1500.  If the expenses were instead Php5500, then the entity would have a net

loss of Php500.

Balance Sheet

The balance sheet communicates what the entity owns in terms of assets, what it owes in

terms of liabilities, and the difference between those two which represents what the owners of

the company are entitled to.  The owner’s portion is called equity.   

The balance sheet can be expressed as the fundamental accounting equation:

Assets = Liabilities + Equity

The balance sheet shows a snapshot of an organization’s assets, liabilities, and equity at

one point in time and it demonstrates the accounting equation.  Balance sheets are always

prepared for a point in time and the term “as at …” is included in the title.

Assets:  The assets of a company represent the resources owned by the company.  These

assets can be in the form of cash or things that can be converted to cash like accounts receivable

and they can also be fixed assets like cars and office equipment.

Liabilities:  What a company owes to creditors is reported in the liabilities section of the

balance sheet.  Creditors are banks and other lending institutions as well as suppliers that are

owed money in the form of accounts receivable as well as money that is owed but not yet paid

(accruals).  A common example of an accrued liability is yearly taxes.

Equity:  The difference between what the entity owns and what it owes represents the

owners’ share of the company.  For sole proprietorships this equity is usually called capital and

for public companies it is often referred to as common stock or share capital.   The equity in a

company is the owners’ claim against the assets owned.

The income statement and balance sheet of a company are linked through the net income

for a period and the subsequent increase, or decrease, in equity that results.  The income that an

entity earns over a period of time is transcribed to the equity portion of the balance sheet.   The

income represents an increase in the owners’ claim against the assets:  Income is NOT a cash

asset.   It is through the income and equity accounts that the balance sheet and income statement

reflect the total financial picture of the entity.

Statement Example:

Cashflow Statement

A firm's cash flow is the movement of cash in and out of the firm in the form of payments

to suppliers and collections from customers. Cash flows typically arise from three sources:

operations, investing, and financing.

The following is a list of the various areas of the cash flow statement and what they mean:

Cash flow from operating activities - This section measures the cash used or provided by a company's normal operations. It shows the company's ability to generate consistently positive cash flow from operations. Think of "normal operations" as the core business of the company. For example, Microsoft's normal operating activity is selling software.

Cash flows from investing activities - This area lists all the cash used or provided by the purchase and sale of income-producing assets. If Microsoft, again our example, bought or sold companies for a profit or loss, the resulting figures would be included in this section of the cash flow statement.

Cash flows from financing activities - This section measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt but can also mean the company is making dividend payments and stock repurchases, which investors might be glad to see.

Business firms must file a Statement of Cash Flows as one of their required financial

statements. The Statement of Cash Flows shows the movement of cash through operations

(current assets and liabilities), investing (plant and equipment and investments), and financing

(long-term financing and dividends).

Cash flows are essential to the liquidity or solvency of the business firm. Cash flows are

not the same thing as profit. Profit is arrived at through developing the income statement by

accrual accounting. In order to develop the Statement of Cash Flows, you take the data from the

income statement and use cash accounting to convert profit to cash flows.

Companies need to keep a close eye on their cash flows. To do this, they should develop

cash budgets on at least a monthly basis. Developing a cash budget means comparing cash

receipts or revenues with cash disbursements or payments and determining net cash flow. This is

how the small business owner knows how much cash is available each month.

How to do a Cashflow?

Cash is the gasoline that makes your business run. Cash flow can be defined as the way

money moves into and out of your business; it is the difference between just being able to open a

business and being able to stay in business. A cash flow analysis is a method of checking up on

your firm’s financial health. It is the study of the movement of cash through your business, called

a cash budget, to determine patterns of how you take in and pay out money. The goal is to

maintain sufficient cash for firm operations from month to month. This type of cash flow

analysis is called developing the cash budget.

Here's How:

1. This type of cash flow analysis is called cash budgeting analysis. It is part of your firm's

financial forecasting plan. Determine the amount of cash that will flow into your firm

during the month. If you are just starting your business, you should include the beginning

balance in cash that you want to have available every month. There would also be the

amount of sales you have during the first month. Sales would include both cash sales and

sales that you make to your customers who pay on credit. Here's an example you can

follow to develop your Schedule of Cash Receipts (Sales Receipts).

2. Determine the amount of cash that will flow out of your firm during the month. You will

have expenses. You will probably have to buy office supplies. Other monthly expenses

may include advertising, vehicle expenses, payroll expenses, just to name a few. You will

have some quarterly expenses, such as taxes. You may have expenses that just occur

occasionally, like purchases of computer equipment, vehicles, or other larger expenses.

Here is an example of a Schedule of Cash Payments that is the second step of the cash

budget.

3. You want the cash that will flow into your firm (Step 1) to be greater than the cash that

will flow out of your firm (Step 2). This means that your monthly cash inflow needs to be

greater than your monthly cash outflow so you will have sufficient cash to operate your

firm. Here's a blank worksheet you can use to calculate your cash inflow or cash receipts

and another blank worksheet you can use to calculate your cash payments.

4. Your ending balance for the first month becomes the beginning balance for the second

month. You do the same type of analysis. Each month, you may have to add more items

to your cash flow analysis as your business grows. You need to decide what the minimum

ending cash balance is that you find acceptable for your firm and aim toward that figure

each month.

5. If your cash flow turns negative for any one month, you will have to borrow money for

that month from family or friends, investors, or from a bank or other financial

institutions. Then, if your cash flow is positive the next month, you can repay that loan.

6. Keep on doing this each month for your forecasting period. Try to keep your borrowing

to a minimum and your cash inflow greater than your outflows. Remember that this cash budget

is a financial forecasting document but try to follow it as closely as possible. Here is an example

of a completed Cash Budget, based on the schedules already completed, that you can look at.

When you look at a cash flow statement, the first thing you should look at is the bottom

line item that says something like "net increase/decrease in cash and cash equivalents", since this

line reports the overall change in the company's cash and its equivalents (the assets that can be

immediately converted into cash) over the last period. If you check under current assets on the

balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you take the

difference between the current CCE and last year's or last quarter's, you'll get this same number

found at the bottom of the statement of cash flows.

Sample Cashflow Statement

In the sample Microsoft annual cash flow statement (from June 2004) shown below, we

can see that the company ended up with about $9.5 billion more cash at the end of its 2003/04

fiscal year than it had at the beginning of that fiscal year (see "Net Change in Cash and

Equivalents"). Digging a little deeper, we see that the company had a negative cash outflow of

$2.7 billion from investment activities during the year (see "Net Cash from Investing

Activities"); this is likely from the purchase of long-term investments, which have the potential

to generate a profit in the future. Generally, a negative cash flow from investing activities are

difficult to judge as either good or bad - these cash outflows are investments in future operations

of the company (or another company); the outcome plays out over the long term.

The "Net Cash from Operating Activities" reveals that Microsoft generated $14.6 billion in

positive cash flow from its usual business operations - a good sign. Notice the company has had

similar levels of positive operating cash flow for several years. If this number were to increase or

decrease significantly in the upcoming year, it would be a signal of some underlying change in

the company’s ability to generate cash.

Digging Deeper into Cash Flow

All companies provide cash flow statements as part of their financial statements, but cash

flow (net change in cash and equivalents) can also be calculated as net income plus depreciation

and other non-cash items.

Generally, a company's principal industry of operation determine what is considered

proper cash flow levels; comparing a company's cash flow against its industry peers is a good

way to gauge the health of its cash flow situation. A company not generating the same amount of

cash as competitors is bound to lose out when times get rough.

Even a company that is shown to be profitable according to accounting standards can go

under if there isn't enough cash on hand to pay bills. Comparing amount of cash generated to

outstanding debt, known as the operating cash flow ratio, illustrates the company's ability to

service its loans and interest payments. If a slight drop in a company's quarterly cash flow would

jeopardize its loan payments, that company carries more risk than a company with stronger cash

flow levels.

Unlike reported earnings, cash flow allows little room for manipulation. Every company

filing reports with the Securities and Exchange Commission (SEC) is required to include a cash

flow statement with its quarterly and annual reports. Unless tainted by outright fraud, this

statement tells the whole story of cash flow: either the company has cash or it doesn't.

What Cash Flow Doesn't Tell Us

Cash is one of the major lubricants of business activity, but there are certain things that

cash flow doesn't shed light on. For example, as we explained above, it doesn't tell us the profit

earned or lost during a particular period: profitability is composed also of things that are not cash

based. This is true even for numbers on the cash flow statement like "cash increase from sales

minus expenses", which may sound like they are indication of profit but are not.

As it doesn't tell the whole profitability story, cash flow doesn't do a very good job of

indicating the overall financial well-being of the company. Sure, the statement of cash flow

indicates what the company is doing with its cash and where cash is being generated, but these

do not reflect the company's entire financial condition. The cash flow statement does not account

for liabilities and assets, which are recorded on the balance sheet. Furthermore accounts

receivable and accounts payable, each of which can be very large for a company, are also not

reflected in the cash flow statement.

In other words, the cash flow statement is a compressed version of the company's

checkbook that includes a few other items that affect cash, like the financing section, which

shows how much the company spent or collected from the repurchase or sale of stock, the

amount of issuance or retirement of debt and the amount the company paid out in dividends.

Conclusion

Like so much in the world of finance, the cash flow statement is not straightforward. You

must understand the extent to which a company relies on the capital markets and the extent to

which it relies on the cash it has itself generated. No matter how profitable a company may be, if

it doesn't have the cash to pay its bills, it will be in serious trouble.

At the same time, while investing in a company that shows positive cash flow is desirable,

there are also opportunities in companies that aren't yet cash-flow positive. The cash flow

statement is simply a piece of the puzzle. So, analyzing it together with the other statements can

give you a more overall look at a company' financial health. Remain diligent in your analysis of a

company's cash flow statement and you will be well on your way to removing the risk of one of

your stocks falling victim to a cash flow crunch.

Activity 4

Quite taxing, right? Don’t you worry; I will guide you on how to do it. The most important thing to remember is that you should be able to distinguish each account title – whether they are Asset, Liability, Expense, Owner’s Equity or Revenue. Also, you should know how each account affect the financial statement that you are about to prepare.

Please answer the following questions and submit the same in my emailbox:

1. What is an Asset, Liability, Owner’s Equity, Revenue and Expense.a. Asset

_________________________________________________________________________________________________________________________________

b. Liability _________________________________________________________________________________________________________________________________

c. Owner’s Equity_________________________________________________________________________________________________________________________________

d. Revenue_________________________________________________________________________________________________________________________________

e. Expense_________________________________________________________________________________________________________________________________

2. Differentiate the three financial statements that most business firms prepare.a. Income Statement

_________________________________________________________________________________________________________________________________

b. Balance Sheet_________________________________________________________________________________________________________________________________

c. Cashflow Statement_________________________________________________________________________________________________________________________________

3. The balance sheet of Border Company shows that the total owner’s equity is

P102,000; it is equal to one-third the amount of total assets. What is the amount of

total liabilities?

4. Determine the amount of the missing figure for each of the ff three independent cases:

1. Net income for the year 61,200

Owner’s equity at the beginning of the year 300,000

Owner’s equity at the end of the year

Owner’s drawing during the year 48,500

2. Owner’s drawing during the year

Owner’s equity at the end of the year 130,200

Net income for the year 35,400

Owner’s equity at the beginning of the year 142,500

3. Owner’s equity at the beginning of the year 155,100

Owner’s equity at the end of the year 180,600

Additional investment by owner during the year 30,000

Net income for the year

Owner’s drawing during the year 24,300

5. The assets of Corner Company amounted to P90,000 on December 31 of Year1, but increased

to P126,000 by December of Year2. During this same period, liabilities increased by

P30,000. The owner’s equity at December 31 of Year1 amounted to P60,000. What was the

amount of owner’s equity at December 31 of Year2?

6. Below are the accounts of North Slope Engineering Consultants. Prepare a Trial

Balance, Income Statement and Balance Sheet using the correct format.

NORTH SLOPE ENGINEERING CONSULTANTS

Trial Balance

December 31, 2005

Cash 61,000

Prepaid Office Rent 72,000

Supplies 14,400

Instruments 79,200

Notes Payable 60,000

Unearned Fees 156,000

Ronald Moulton, Capital 131,200

Ronald Moulton, Drawing 51,240

Fees Earned 127,440

Salaries Expense 194,400

Miscellaneous Expense 2,400