Financial Analysis and Reporting Notes PDF

FINANCIAL ANALYSIS AND REPORTING NOTES WEEK 1 1. Accounting vs. Finance Accounting is defined as the systematic process of recording, classifying, summarizing, and interpreting financial transactions and events to provide relevant information for decision-making. It serves as a tool for business...

FINANCIAL ANALYSIS AND REPORTING NOTES WEEK 1 1. Accounting vs. Finance Accounting is defined as the systematic process of recording, classifying, summarizing, and interpreting financial transactions and events to provide relevant information for decision-making. It serves as a tool for businesses and other entities to maintain accurate financial records, prepare financial statements, and comply with regulatory requirements. Finance refers to the management of an organization's financial resources, including the planning, acquisition, allocation, and utilization of funds, with the aim of maximizing value and ensuring financial stability. It involves key areas such as investment decisions, funding strategies, risk management, and financial forecasting. Accounting Focuses on the systematic recording, classifying, summarizing, and reporting of financial transactions. Provides information through financial statements such as balance sheets, income statements, and cash flow statements. Backward-looking: primarily concerned with past financial performance. Finance Focuses on managing an organization’s assets, liabilities, and investments to maximize value. Includes decision-making in areas such as investments, funding, and risk management. Forward-looking: emphasizes forecasting, budgeting, and strategizing for future growth. Key Difference: Accounting ensures accurate financial records, while finance uses those records for decision-making and strategy. 2. Users of Financial Statements Internal Users: 1. Management – To make informed operational, tactical, and strategic decisions. 2. Employees – To assess job security and potential for salary increases or bonuses. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 1 External Users: 1. Investors – To evaluate the profitability and risk of their investments. 2. Creditors – To assess an organization's ability to repay debts. 3. Government Agencies – For tax purposes and regulatory compliance. 4. Customers – To ensure the company’s financial stability. 5. Suppliers – To determine the organization's creditworthiness. Purpose of Financial Statements: Provide transparent and standardized information to aid in decision-making for various stakeholders. 3. Development of GAAP (Generally Accepted Accounting Principles) Traditional Assumptions in GAAP Development: In the Philippines, Generally Accepted Accounting Principles (GAAP) refer to the framework of accounting standards, principles, and procedures that guide the preparation and presentation of financial statements. These principles are primarily based on the Philippine Financial Reporting Standards (PFRS), which align closely with the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). The Financial Reporting Standards Council (FRSC), under the supervision of the Board of Accountancy (BOA) and the Professional Regulation Commission (PRC), oversees the development and enforcement of these standards. This ensures that financial reporting in the Philippines meets global benchmarks for transparency, consistency, and comparability. Philippine GAAP applies to various entities, from large corporations to small and medium- sized enterprises (SMEs), with specific provisions under PFRS for SMEs. It emphasizes principles such as accrual accounting, the historical cost principle, and full disclosure to provide clear and reliable financial information to stakeholders. By adhering to these standards, businesses in the Philippines build trust and credibility, both locally and internationally, enabling investors, creditors, and regulators to make informed financial decisions. 1. Economic Entity Assumption: o The business is distinct from its owners or other entities. 2. Monetary Unit Assumption: o Financial transactions are recorded in a stable currency (e.g., USD, PHP). 3. Time Period Assumption: o Financial reporting is done over standard intervals (monthly, quarterly, annually). 4. Going Concern Assumption: o The business is expected to operate indefinitely unless stated otherwise. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 2 Key Objectives of GAAP: Standardize accounting practices for consistency. Ensure reliability and comparability of financial statements. Global Perspective: In many countries, GAAP has evolved to align with International Financial Reporting Standards (IFRS) to enhance global consistency. 4. Financial Accounting Concepts Key Concepts: 1. Accrual Accounting: o Revenue is recognized when earned, and expenses are recorded when incurred, regardless of cash flow. 2. Matching Principle: o Expenses should be recognized in the same period as the revenues they help generate. 3. Historical Cost Principle: o Assets are recorded at their original purchase price. 4. Revenue Recognition Principle: o Revenue is recognized when it is earned and realizable. 5. Materiality Concept: o Financial information should include all items that could influence decisions by users. 6. Conservatism Principle: o When in doubt, record expenses and liabilities sooner and income later to avoid overstating financial position. Purpose of Financial Accounting Concepts: Ensure that financial reports are accurate, comparable, and reflective of the true financial state of the entity. Summary Accounting is the foundation for financial reporting, while finance focuses on using that data for strategic decision-making. Financial statements serve diverse users, each with unique information needs. GAAP and financial accounting concepts standardize practices to ensure transparency, reliability, and consistency in financial reporting. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 3 Presentation of Financial Statements Forms of Business Enterprises Forms of business enterprises refer to the legal structures businesses can adopt. The choice of form influences operations, liabilities, taxes, and financial reporting. Types of Business Enterprises 1. Sole Proprietorship o Characteristics: Owned and managed by one person. o Advantages: ▪ Simple to set up and operate. ▪ Full control by the owner. ▪ Profits are not shared. o Disadvantages: ▪ Unlimited liability. ▪ Limited resources and capital. o Example: A sari-sari store in the Philippines. Where do you register your Sole Proprietorship business? - Department of Trade and Industry (DTI) 2. Partnership o Characteristics: Owned by two or more individuals. o Advantages: ▪ Shared responsibility and resources. ▪ Easier access to funding compared to sole proprietorship. o Disadvantages: ▪ Disputes among partners. ▪ Unlimited liability for general partners. o Example: Law or accounting firms in the Philippines. Where do you register? - Securities and Exchange Commission (SEC) 3. Corporation o Characteristics: Separate legal entity owned by shareholders. o Advantages: ▪ Limited liability for shareholders. ▪ Easier access to large-scale funding. ▪ Perpetual existence. o Disadvantages: ▪ More regulations and paperwork. ▪ Double taxation in some cases. o Example: Jollibee Foods Corporation. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 4  Where do you register? - Securities and Exchange Commission (SEC) 4. Cooperative o Characteristics: Member-owned organization focusing on benefits for members. o Advantages: ▪ Democratic control (one member, one vote). ▪ Tax exemptions under Philippine law. o Example: Farmers' cooperatives in rural areas. Where do you register? - Cooperative Development Authority (CDA) The Financial Statements Definition: Financial statements provide a structured representation of a business’s financial position, performance, and cash flows, aiding stakeholders in decision-making. Key Financial Statements [according to Philippine Financial Reporting Standards (PFRS)] 1. Balance Sheet (Statement of Financial Position) o Shows the company’s financial position at a specific point in time. o Key Equation: Assets = Liabilities + Equity. 2. Income Statement (Statement of Comprehensive Income) o Reports the company's financial performance over a specific period, detailing revenues and expenses to determine net income. 3. Statement of Cash Flows o Provides insights into cash inflows and outflows from operating, investing, and financing activities. 4. Statement of Changes in Equity (or Statement of Stockholders’ Equity) o Details changes in equity accounts (e.g., retained earnings, share capital) during a reporting period. 5. Notes to Financial Statements o While not a "statement" in the traditional sense, Notes to Financial Statements are an integral part of financial reporting. o These provide detailed disclosures, assumptions, accounting policies, and additional context for the numbers presented in the primary statements. Note: If discussing traditional core statements. The correct answer is 4 kinds of financial statements. If considering the complete financial report: The correct answer is 5 kinds of financial statements, including the Notes. Under the Philippine Financial Reporting Standards (PFRS), all five are required for complete financial reporting. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 5 Balance Sheet Definition: A balance sheet is a snapshot of a business's financial position at a specific date. Key Equation: Assets = Liabilities + Equity Components 1. Assets: Resources controlled by the business. o Current Assets: Cash, accounts receivable, inventory. o Non-Current Assets: Property, plant, and equipment (PPE). o Philippine Context Example: Real estate properties owned by SM Prime Holdings. 2. Liabilities: Obligations to creditors. o Current Liabilities: Accounts payable, short-term loans. o Non-Current Liabilities: Long-term debt, bonds payable. o Philippine Context Example: Loans availed by Ayala Corporation. 3. Equity: Owner’s claims on the assets. o Includes share capital and retained earnings. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 6 Key Summary: Total Assets = Total Liabilities + Equity. PHP 755,000 = PHP 335,000 + PHP 420,000. What are the basic financial ratios related to a Balance Sheet? BFFINARX NOTES BY MR. A. V. CLARIN PAGE 7 Interpretation: The company has 1.74 in current assets for every 1 of current liabilities. A ratio above 1 indicates good liquidity. Interpretation: The company has 1.19 in liquid assets (excluding inventory) for every 1 of current liabilities. This is a stricter measure of liquidity. The Quick Ratio (also known as the Acid-Test Ratio) is considered a stricter measure of liquidity because it excludes inventory and other less liquid current assets from the calculation. Inventory is Less Liquid Liquidity Definition: Liquidity refers to how quickly and easily an asset can be converted into cash to pay off liabilities. Inventory's Limitations: o Inventory might not sell quickly, especially if it’s slow-moving or obsolete. o Even if it sells, the sale might be on credit, delaying cash inflow. o The value of inventory is often uncertain, as it depends on demand and market conditions. Greater Accuracy in Crisis Situations BFFINARX NOTES BY MR. A. V. CLARIN PAGE 8  During financial distress or urgent situations, a company may not have time to sell inventory or may need to sell it at a significant discount. The Quick Ratio highlights the company’s ability to meet immediate obligations without relying on potentially illiquid assets. By excluding inventory, the Quick Ratio focuses on assets that are almost as liquid as cash, such as: Cash Accounts Receivable Short-term investments Greater Accuracy in Crisis Situations During financial distress or urgent situations, a company may not have time to sell inventory or may need to sell it at a significant discount. The Quick Ratio highlights the company’s ability to meet immediate obligations without relying on potentially illiquid assets. Interpretation: The company uses PHP 0.80 of debt for every PHP 1 of equity, indicating a moderate level of financial leverage. A Debt-to-Equity Ratio of 0.80 is considered a moderate level of financial leverage because it indicates the company uses PHP 0.80 of debt for every PHP 1 of equity, reflecting a balanced approach to financing. This means the company relies slightly more on equity than debt, reducing the risk of over-leveraging while still benefiting from the advantages of debt, such as tax-deductible interest and additional funds for growth. A ratio below 1.0 generally suggests that the company is not overly dependent on borrowing, providing a cushion to manage financial obligations even in challenging times, while maintaining financial flexibility to pursue growth opportunities. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 9 Interpretation: 44% of the company’s assets are financed through liabilities. A lower ratio indicates less reliance on debt. Income Statements Definition: An income statement details the revenues, expenses, and profits of a business over a specific period. Key Equation: Net Income = Revenues – Expenses Components BFFINARX NOTES BY MR. A. V. CLARIN PAGE 10  1. Revenues: Income earned from operations. o Examples: Sales income, service income. 2. Expenses: Costs incurred to earn revenue. o Includes COGS, salaries, utilities, depreciation. 3. Net Income: The profit or loss after expenses. Key Points: BFFINARX NOTES BY MR. A. V. CLARIN PAGE 11  1. Net Sales = Sales Revenue - Sales Returns and Allowances. 2. Gross Profit = Net Sales - Cost of Goods Sold. 3. Operating Income = Gross Profit - Operating Expenses. 4. Net Income = Operating Income + Other Income/Expenses - Income Tax. What are the basic financial ratios related to an income statement? BFFINARX NOTES BY MR. A. V. CLARIN PAGE 12 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 13 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 14 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 15 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 16 Statement of Stockholders’ Equity Definition: This statement shows the changes in a company’s equity over a reporting period. The Statement of Stockholders' Equity is a financial statement that summarizes the changes in a company's equity during a specific accounting period. It reflects how the components of equity, such as share capital, retained earnings, and other reserves, evolve due to business activities. Key Components of Stockholders’ Equity 1. Share Capital: o Funds raised by issuing shares to investors. o Includes: ▪ Common Stock (ordinary shares). ▪ Preferred Stock (if applicable). 2. Additional Paid-In Capital (APIC): o The excess amount received over the par value of shares issued. 3. Retained Earnings: o Cumulative net income that has been retained by the company instead of being distributed as dividends. 4. Treasury Stock: o Shares repurchased by the company, reducing equity. 5. Other Comprehensive Income (OCI): o Gains or losses not included in net income, such as foreign currency adjustments or unrealized gains/losses on securities. 6. Dividends: o Payments distributed to shareholders, reducing retained earnings. Importance Tracks the impact of net income and other changes on shareholders’ equity. Purpose of the Statement 1. Transparency: Provides detailed insights into equity changes, helping stakeholders understand how the company is managing its resources. 2. Shows Shareholder Value: Reflects the company's profitability and financial decisions impacting shareholders' investments. 3. Tracks Growth: Indicates whether the company is reinvesting profits or returning value to shareholders. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 17 Explanation of Components 1. Common Stock: Increased by PHP 50,000 due to new share issuance. 2. Additional Paid-In Capital (APIC): Reflects a PHP 20,000 premium on the issuance of shares. 3. Retained Earnings: Increased by net income of PHP 164,500, reduced by dividends of PHP 50,000. 4. Treasury Stock: Reduced equity by PHP 30,000 due to the repurchase of shares. 5. Other Comprehensive Income (OCI): Increased by PHP 10,000 from unrealized gains. The Ending Balance of Stockholders’ Equity is the sum of all components after accounting for additions and deductions. This format provides a clear view of the changes in equity over the accounting period. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 18 What are the basic financial ratios related to Statement of Stockholders’ Equity. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 19 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 20 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 21 Statement of Cash Flows Definition: This statement outlines cash inflows and outflows, categorized into three activities. The Statement of Cash Flows is a financial statement that summarizes the cash inflows and outflows of a business over a specific period. It shows how a company generates and uses cash from its operating, investing, and financing activities, helping stakeholders assess the company’s liquidity, solvency, and financial flexibility. Purpose of the Statement of Cash Flows 1. Evaluate Cash Liquidity: o Determines if the company can generate sufficient cash to meet its obligations. 2. Understand Cash Flow Sources: o Identifies where cash is coming from (operations, investments, or financing). 3. Track Financial Health: o Helps investors and creditors assess how cash is managed and whether the business is sustainable. Components of the Statement of Cash Flows 1. Operating Activities: o Represents cash flows from the company's primary business operations. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 22  o Includes: ▪ Cash received from customers. ▪ Cash paid to suppliers, employees, and for other operating expenses. ▪ Adjustments for non-cash items (e.g., depreciation, changes in working capital). 2. Investing Activities: o Reflects cash flows from the purchase or sale of long-term assets. o Includes: ▪ Purchase or sale of property, plant, and equipment. ▪ Investments in securities or other businesses. 3. Financing Activities: o Represents cash flows related to the company's capital structure. o Includes: ▪ Issuance or repurchase of shares. ▪ Borrowing or repayment of loans. ▪ Dividend payments to shareholders. Importance Helps assess cash availability for operations and obligations. Differentiates between cash and profit. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 23 Explanation of Components 1. Operating Activities: Reflects cash flows from core business operations, adjusting net income for non-cash expenses and changes in working capital. 2. Investing Activities: Captures cash flows from the purchase or sale of long-term assets, like equipment. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 24  3. Financing Activities: Includes activities that change the equity or debt structure, such as issuing shares, paying dividends, or borrowing funds. This format provides a clear overview of how the company generated and used cash during the year. What are the basic financial ratios related to Statement of Cashflows? BFFINARX NOTES BY MR. A. V. CLARIN PAGE 25 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 26 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 27 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 28 Interrelationship of Financial Statements 1. How They Connect o Income Statement: Determines net income, which impacts retained earnings in the Statement of Stockholders’ Equity. o Statement of Stockholders’ Equity: Updates the equity section of the Balance Sheet. o Statement of Cash Flows: Explains changes in cash balances reflected in the Balance Sheet. 2. Case Study (Ready for a Seatwork 1 - Midterm): o A Filipino retail store: Walkthrough of how a sales transaction affects all financial statements. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 29 WEEK 4 & 5 Introduction The Statement of Financial Position, commonly known as the Balance Sheet, provides a snapshot of a company's financial standing at a specific point in time. It outlines the company's resources (assets), obligations (liabilities), and the residual interest of the owners (equity). Maximizing the Use of a Balance Sheet by Financial Professionals 1. Financial Advisers Wealth Planning: Financial advisers use the balance sheet to evaluate a company\u2019s financial health and stability, helping clients make informed decisions about investments, mergers, or acquisitions. Risk Assessment: By analyzing the liabilities and debt structure, they assess the financial risks associated with investing in or working with a company. Asset Management: The classification of assets helps advisers recommend optimal strategies for asset utilization and diversification. 2. Financial Analysts Liquidity Analysis: Analysts assess current assets and liabilities to evaluate the company's ability to meet short-term obligations (current ratio, quick ratio). Profitability and Solvency: They examine non-current liabilities and equity to understand how well a company can sustain operations and grow over the long term. Valuation: By analyzing equity and retained earnings, analysts estimate a companys book value and market potential, supporting investment decisions. Trend Analysis: Comparing balance sheets over time helps analysts identify trends in financial performance, such as asset growth, debt accumulation, or equity returns. 3. Accountants Compliance and Reporting: Accountants ensure the balance sheet complies with accounting standards like GAAP or IFRS, maintaining its accuracy for stakeholders. Financial Controls: They use the balance sheet to monitor internal controls over cash, inventory, and other assets, minimizing financial risks. Tax Planning: By reviewing liabilities and assets, accountants identify opportunities for tax deductions and credits. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 30 Why the Balance Sheet is a Basis for Judging a Company’s Performance 1. Snapshot of Financial Position: o The balance sheet provides a comprehensive view of what the company owns (assets), owes (liabilities), and the net worth (equity) at a specific point in time. o Stakeholders can determine if the company has sufficient resources to meet its obligations. 2. Liquidity Indicators: o Ratios derived from balance sheet components, such as the current ratio or quick ratio, indicate whether the company can handle short-term financial demands. 3. Solvency and Financial Health: o High levels of debt relative to equity might signal financial instability, while a strong equity base often indicates good financial health and a lower risk profile. 4. Investment Potential: o The balance sheet highlights areas of growth, such as increasing assets or retained earnings, which signal a company\u2019s capacity for expansion and profitability. 5. Operational Efficiency: o Comparing assets to liabilities helps assess whether the company is effectively using its resources to generate income. Limitations to Keep in Mind The balance sheet alone does not provide a complete picture; it must be analyzed alongside the income statement and cash flow statement. It reflects financial data at a single point in time and might not capture fluctuations or seasonal trends. Some values, like intangible assets, are subjective and may not represent their true market value. By leveraging the balance sheet effectively, financial advisers, analysts, and accountants can provide actionable insights, enabling businesses and investors to make strategic decisions. Example Recommendations from Financial Analyst using a Balance Sheet as a point of reference. 1. Improving Liquidity Observation from Balance Sheet: The company has a current ratio of 0.8, indicating that current liabilities exceed current assets. This could signal a risk in meeting short-term obligations. Recommendation: o Increase cash reserves by negotiating faster payment terms with customers or liquidating non-essential assets. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 31  o Reduce short-term debt by refinancing into longer-term liabilities. o Defer discretionary expenses or negotiate extended payment terms with suppliers. 2. Reducing Debt Levels Observation from Balance Sheet: The debt-to-equity ratio is 2.5, which is above the industry average of 1.5. High leverage increases the company's financial risk and reduces flexibility. Recommendation: o Focus on debt reduction by allocating a portion of profits to repay high-interest loans. o Consider equity financing options to reduce reliance on debt. o Renegotiate loan terms to secure lower interest rates or extend maturities. 3. Enhancing Asset Utilization Observation from Balance Sheet: Non-current assets, particularly machinery, show signs of underutilization, with no corresponding increase in production or revenue. Recommendation: o Conduct a cost-benefit analysis to determine whether to sell underperforming assets. o Invest in automation or upgrades to improve productivity if existing equipment is outdated. o Lease unused capacity to generate additional income. 4. Improving Return on Equity (ROE) Observation from Balance Sheet: Retained earnings have grown significantly, but there is no noticeable improvement in net income. Recommendation: o Invest retained earnings in high-return projects or expansion opportunities. o Consider a share buyback program to reduce the number of outstanding shares and increase ROE. o Pay higher dividends to shareholders if reinvestment opportunities are limited. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 32 5. Addressing Inventory Issues Observation from Balance Sheet: Inventory levels have increased by 30% compared to the previous period, but sales growth remains stagnant. Recommendation: o Implement inventory management strategies, such as just-in-time (JIT) to reduce holding costs. o Analyze market demand to adjust production levels and avoid overstocking. o Discount excess inventory to free up cash for other operational needs. 6. Strengthening Equity Position Observation from Balance Sheet: Shareholder equity has declined due to accumulated losses and dividend payouts exceeding net income. Recommendation: o Temporarily suspend dividend payments to rebuild equity reserves. o Explore strategic partnerships or additional equity investment to inject capital into the company. o Focus on cost reduction and revenue generation initiatives to improve profitability. 7. Preparing for Expansion Observation from Balance Sheet: The company has a low debt-to-equity ratio of 0.3, indicating untapped borrowing capacity. Additionally, there is a significant cash reserve. Recommendation: o Leverage the strong financial position to fund expansion projects or acquisitions. o Use debt financing at favorable terms to maintain a balance between growth and equity stability. o Allocate cash reserves to invest in new markets or diversify product lines. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 33 1. Elements of the Balance Sheet The Balance Sheet is composed of three main elements: a. Assets These are resources owned or controlled by the business that are expected to provide future economic benefits. Examples include cash, accounts receivable, inventory, and property. b. Liabilities These are obligations the company owes to external parties, which are expected to be settled through the transfer of assets or services. Examples include accounts payable, loans, and taxes payable. c. Equity This represents the owners' residual interest in the assets of the business after deducting liabilities. It includes contributed capital (e.g., common stock) and retained earnings. The fundamental equation for the Balance Sheet is: 3. Classification of Assets Assets are classified based on their liquidity (how quickly they can be converted to cash) into the following categories: a. Current Assets These are assets expected to be converted to cash or used up within one year or the business's operating cycle, whichever is longer. Examples: Cash and cash equivalents Accounts receivable Inventory Prepaid expenses b. Non-Current Assets BFFINARX NOTES BY MR. A. V. CLARIN PAGE 34 These are assets not expected to be converted to cash or consumed within one year. Examples: Property, Plant, and Equipment (PPE) Intangible assets (e.g., patents, trademarks) Long-term investments Deferred tax assets 4. Classification of Liabilities Liabilities are classified based on their maturity (when they are due) into the following categories: a. Current Liabilities These are obligations expected to be settled within one year or the operating cycle, whichever is longer. Examples: Accounts payable Short-term loans Accrued expenses Taxes payable b. Non-Current Liabilities These are obligations not due within one year. Examples: Long-term debt Deferred tax liabilities Lease obligations 5. Capital and Retained Earnings a. Capital This refers to the funds contributed by owners or shareholders to the business. It can be in the form of common stock, preferred stock, or additional paid-in capital. b. Retained Earnings This represents the cumulative net income of the business that has been retained (not distributed as dividends) for reinvestment or to cover future expenses. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 35 How Retained Earnings are Derived: 1. From the Income Statement: o Retained earnings accumulate from the net income reported in the income statement after accounting for expenses, taxes, and costs. o If the company incurs a net loss, it reduces retained earnings. 2. Adjustments: o Retained earnings are updated by adding the current period's net income (or subtracting a net loss) and deducting any dividends paid out to shareholders. Connection Between Statements: The income statement flows into the retained earnings statement, which in turn connects to the balance sheet. This linkage ensures that financial statements are integrated and consistent. 6. Forms of Balance Sheet The Balance Sheet can be presented in the following formats: BFFINARX NOTES BY MR. A. V. CLARIN PAGE 36 a. Account Form This format lists assets on the left side and liabilities and equity on the right side, resembling a "T-account" structure. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 37 b. Report Form BFFINARX NOTES BY MR. A. V. CLARIN PAGE 38 This format presents assets, liabilities, and equity in a vertical sequence, commonly used in financial statements today. The Statement of Financial Position is a crucial financial statement that provides insights into a company's financial health. By understanding the components and classifications of the Balance Sheet, stakeholders can assess the company's liquidity, solvency, and overall financial stability. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 39 WEEK 5 The Income Statement BFFINARX NOTES BY MR. A. V. CLARIN PAGE 40  1. Elements of the Income Statement The Income Statement, also known as the Profit and Loss Statement, provides a summary of a company’s revenues and expenses over a specific period. Its main elements include: Revenues: Inflows of economic benefits from ordinary operations, such as sales revenue, service income, and interest income. Expenses: Outflows or consumption of resources incurred to generate revenues, such as cost of goods sold (COGS), salaries, and rent. Beginning Inventory: Value of inventory at the start of the year. Purchases: Total cost of materials or goods purchased during the year. Direct Labor Costs: Salaries/wages for workers directly involved in production. Manufacturing Overhead: Indirect costs related to production (e.g., utilities, maintenance). Goods Available for Sale: Sum of the beginning inventory, purchases, and other costs. Ending Inventory: Value of inventory remaining at the end of the year. Gains: Increases in equity from peripheral or incidental transactions. Losses: Decreases in equity arising from peripheral or incidental transactions. Net Income (or Loss): The difference between total revenues and total expenses. 2. Accounting Equation for Income Statement BFFINARX NOTES BY MR. A. V. CLARIN PAGE 41 The accounting equation applicable to the Income Statement focuses on the relationship between revenue and expense accounts: Net Income (or Loss) = Revenues – Expenses If revenues exceed expenses, the result is net income; if expenses exceed revenues, the result is a net loss. 3. Importance of Income Statement and Approaches to Income Measurement Importance: Performance Evaluation: It shows how well a business has performed during a specific period. Decision-Making: Stakeholders use it to make informed decisions regarding investments, lending, and management. Compliance: It ensures financial reporting adheres to accounting standards. Profitability Analysis: It helps in evaluating profitability and operational efficiency. Approaches to Income Measurement: Transaction Approach: Focuses on recording all revenue and expense transactions during the period. Capital Maintenance Approach: Measures income as the amount that can be distributed while maintaining the capital of the business. 4. Revenue Definition: Revenue is the income earned from normal business operations and is often the primary source of income for a company. Recognition Criteria: According to accounting standards, revenue is recognized when: 1. The entity has transferred control of goods or services to the customer. 2. The amount of revenue can be reliably measured. 3. It is probable that the economic benefits will flow to the entity. 5. Expenses Definition: Expenses represent the costs incurred in the process of earning revenue. They reduce the net income of the business. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 42  Types of Expenses: o Operating Expenses: Costs directly related to core operations (e.g., salaries, utilities). o Non-Operating Expenses: Costs not directly tied to core operations (e.g., interest expenses, losses from asset sales). 6. Concepts in the Preparation of the Income Statement Accrual Basis of Accounting: Revenues are recognized when earned, and expenses are recognized when incurred, regardless of cash flow. Consistency Principle: The company should consistently use the same accounting methods and principles to ensure comparability. Matching Principle: Expenses should be matched with the revenues they helped to generate during the same accounting period. Materiality Concept: Only significant items that could influence decision-making are included in the Income Statement. Periodicity Assumption: Financial performance is measured over a specific time period (e.g., monthly, quarterly, annually). 7. Forms of Income Statements Single-Step Income Statement: Groups all revenues together and subtracts all expenses in one step to calculate net income. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 43 Multi-Step Income Statement: Separates operating revenues and expenses from non-operating items and provides a more detailed analysis: o Gross Profit: Revenues minus cost of goods sold (COGS). o Operating Income: Gross profit minus operating expenses. o Net Income: Operating income adjusted for non-operating items like taxes and interest. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 44 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 45 8. Reporting Comprehensive Income Definition: Comprehensive income includes all changes in equity during a period except those resulting from investments by or distributions to owners. It encompasses both net income and other comprehensive income (OCI). Components of Comprehensive Income: Net Income: The result of the Income Statement (revenues minus expenses). Other Comprehensive Income (OCI): Items not included in net income, such as: o Unrealized gains or losses on available-for-sale securities. o Foreign currency translation adjustments. o Changes in revaluation surplus for property, plant, and equipment. Common Financial Ratios for the Income Statement Financial analysts use these ratios to evaluate a company’s performance based on its income statement. Here are key ratios, their calculations, interpretations, and potential recommendations. Purpose: Measures profitability after covering the cost of goods sold (COGS). Example Observation: Gross Profit Margin = 58.33% (based on Example Corporation’s data). BFFINARX NOTES BY MR. A. V. CLARIN PAGE 46  Indicates that PHP 58.33 of every PHP 100 in revenue remains after covering production costs. Recommendation: Positive Margin: Maintain efficiency in production and consider negotiating lower material costs. Low Margin: Review pricing strategies and focus on cost control in manufacturing. Purpose: Shows profitability from core operations before interest and taxes. Example Observation: Operating Profit Margin = 32.5%. Reflects strong operational efficiency and cost management. Recommendation: High Margin: Reinvest in expanding operations, marketing, or R&D. Low Margin: Assess operational expenses (e.g., salaries, utilities) and streamline processes. Purpose: Indicates the percentage of revenue retained as profit after all expenses. Example Observation: Net Profit Margin = 24.25%. The company retains PHP 24.25 from every PHP 100 in revenue after expenses and taxes. Recommendation: Positive Margin: Focus on maintaining profitability while seeking growth opportunities. Low Margin: Identify high-impact expenses to reduce, such as interest payments or non- essential costs. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 47 Purpose: Measures the company’s operational efficiency in generating income. Example Observation: ROS = 32.5%. Indicates efficient conversion of revenue into operating income. Recommendation: High ROS: Capitalize on operational strengths by scaling production or expanding product lines. Low ROS: Reassess operational workflows and invest in automation to reduce inefficiencies. Purpose: Highlights the proportion of expenses relative to revenue. Example Observation: Expense-to-Revenue Ratio = 77.08% (calculated as 4,625,000/6,000,000×1004,625,000 / 6,000,000 \times 1004,625,000/6,000,000×100). For every PHP 100 in revenue, PHP 77.08 is consumed by expenses. Recommendation: High Ratio: Reduce discretionary expenses, negotiate better supplier contracts, or improve production efficiency. Low Ratio: Reinvest in growth initiatives without compromising profitability. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 48 Purpose: Assesses the company’s ability to cover interest expenses with its operating income. Example Observation: Interest Coverage Ratio = 26 times. The company earns 26 times its interest expense, indicating strong financial stability. Recommendation: High Ratio: Consider strategic investments or debt for expansion. Low Ratio: Pay down high-interest debt or refinance to reduce interest costs. Purpose: Measures profitability on a per-share basis, important for shareholders. Example Observation: Assume Net Income = PHP 1,455,000 and Total Shares Outstanding = 500,000. EPS = PHP 2.91. Recommendation: Strong EPS: Use profits to declare dividends or reinvest in business growth. Low EPS: Focus on boosting revenue and managing expenses effectively. Purpose: Shows the percentage of profits distributed to shareholders as dividends. Example Observation: Assume Dividends Declared = PHP 500,000 and Net Income = PHP 1,455,000. Dividend Payout Ratio = 34.36%. Recommendation: High Payout Ratio: Ensure sufficient retained earnings for reinvestment. Low Payout Ratio: Consider increasing dividends to attract or retain investors. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 49 BFFINARX NOTES BY MR. A. V. CLARIN PAGE 50 REFERENCES: Accounting Standards Council. (2017). Philippine Financial Reporting Standards (PFRS). Accounting Standards Council. Financial Accounting Standards Board. (2020). Concepts statement no. 8: Conceptual framework for financial reporting (Chapter 1). Financial Accounting Standards Board. https://www.fasb.org International Financial Reporting Standards Foundation. (2019). International Financial Reporting Standards (IFRS). IFRS Foundation. https://www.ifrs.org Philippine Institute of Certified Public Accountants. (2018). Code of ethics for professional accountants in the Philippines. PICPA. Glautier, M. W. E., & Underdown, B. (2017). Accounting theory and practice (10th ed.). Pearson Education. Higgins, R. C. (2012). Analysis for financial management (10th ed.). McGraw-Hill Education. Mollah, M. A. (2017). Accounting for management: A practical approach (2nd ed.). Asia- Pacific Business Press. Scott, W. R. (2015). Financial accounting theory (7th ed.). Pearson. Van Horne, J. C., & Wachowicz, J. M. (2013). Fundamentals of financial management (13th ed.). Pearson. Zahirul, A. A., & Choudhury, M. (2016). Financial management: Theory and practice. McGraw-Hill. BFFINARX NOTES BY MR. A. V. CLARIN PAGE 51