‘The goal of financial management isto maximize sockholders’ wealth through the current value SPs existing stock (Ross eral, 2008). A common Sake in financial management is the belief that Pe Finance manager should maximize the firm's Bunting profits. Nonetheless, accounting profits BB reid not be discarded as they directly affect the Brock price. Inthe same manner that accounting St emnation is presented in the financial statements it Be imporranc rool to understand why the company performing the way it is and as a forecasting device Beto where ic is going. The financial statement is the summarized SS of a company's assets, liabilities, and equities the balance sheet and its revenue and expenses the income statement. Its objective is to provide SSSemarion about the financial position, result of Bberations, and cash flows of an enterprise that is Fel for decision-making to a wide range of users. Financial managers use these statements in in Sessions. They are concerned primarily with the sta S maximization of stockholders’ wealth. They use At the end of the chapter, students are expected to be able to: * discuss the elements and limitations of financial statements; reconstruct balance sheet and income statement through financial ratios; analyze and interpret trend ratios, evaluate the past performance of the mpany through financial ratios, interpret the changes in the financial structure of the company, Gifferentiate the various activities of the firm—operating, investing, and financing; and Prepare the statement of cash flows ancing, investing, and formulating dividend policy nding of the company and its profitability chat leade financial statements as their firsthand information Ses the company’s performance in the past and its prospects inthe future. Managers une the eon ing the economic progress ofthe firm. In particulat, they fanancil institutions use the Financial statement asa tool in ascertaining the company’s capability co Beesece cash in making payments. Knowing the financial health ofa firm places the eden cn position ifever loans are granted o a company in need of additional capitalre Components of Financial Statements 3. Statem | = ‘There are five basic components of financial statements. They areas follows: cy E 1, Balance Sheet Iris a statement showing the financial position of the company ata particular time. The mi i The balance sheet is composed of the company's assets and liabilities and stockholders’ equity. The ia 8 firs section of the balance sheet list all the assets of the firm, Current assets are presented first. al z These ate the cash and other items such as account receivable and inventories that ean be converted a 5 into cash within one year, Prepaid expenses and accrued income are also included. Next to current a 3 assets are the non-current assets, These assets comprise the company’s land, building, machinery, ag - juipment, furniture and fixture, transportation vehicle, and many more. * 5 quip) Ps y eal dad The liabilities section comprises of current and non-curret liabilities The curren liabilities diy include accounts payable, short-rerm notes payable, acrued expenses, taxes payable, interests payable, eat 30 and other obligations tha are due within one yea. The non-curret liabilities include long-term itd notes payable, bonds payable, and other obligations which are due beyond one year. bo The stockholders’ equity is the net worth or the residual value of the company. Stockholders’ a equity is Further divided ino pa value stock, additional paid-in capital, and retained earnings. The a par value of the stock and the additional paid-in capital are che proceeds from the sale of stock to the public while the retained earnings represent the build-up of equity from profits that are plowed 8 back to the firm, CEE! Balance of FMA Company forthe year 2014 I FMA Company Balance Sheet December 31, 2014 Current Assets Liabilities Cash P 65,000 (Current liabilities P 110,800 ‘Accounts receivable 40,000 Long-term liabilities 160,000 270,800 ‘ Marketable securities 40,000 Inventory 100,000 P 245,000 Stockholder’s Equity Common stock, P'5 par value, 20,000 shares. 100,000 Non-current Assets Retained earnings 74200 174,200 Plants assets 200,000 Total Liabilities and Toral Assets 2.445.000 Stockholders’ Equity £445,000 2. Income Statement. It isa formal statement that shows the result ofthe operations for a certain period of time. Ie presents the revenues generated during the operating period, the expenses incurred, and the company’s net earnings. Ic is used to distinguish four broad clases of expenses: (I) cost of goods sold, which isa direct cost attributable to manufacturing the product sold by the firm; (2) general and administrative expenses, which correspond to overhead expenses, salaries, advertising, and other operating costs that are not directly attributable to production; (3) interest on the firm's debs; and (4) raxes on earnings owed to the government (see Illustration 2).© Seatement of Stockholders’ Equity. The statement of changes in sockholder'equityisa required Basic statement that shows the movements inthe components of the equity. The major elements of the statement equity include Issuance of Stocks, These are the commion or preferred stocks issued duting the year Retained Earnings. Iris the accumulated income or los of the company covering the past years of operations Declaration of Cash Dividends. The dividends declared fo the year are shown asa deduction fiom retained earnings. Distribution of Stock Dividends. Ic discloses the stock dividend rate and the amount of stock dividends distributed to stockholders. This amount is also shown asa deduction from retained earnings. Purchase and Sale of Treasury Stock. It includes the firm's stocks originally isued but were bought back and were not retited. The sale of treasury stock is shown as an addition sa stockholders’ equity while the purchase is shown as a deduction, esumulated Other Comprehensive Income. This category includes unrealized gains and losses on available-forsale investments and foreign-currency translation adjustments Correction of Errors. It list errors in the past but corrected in the current year. FMA Company Income Statement For the Year Ended December 31, 2014 Sales 200,000 Less: Sales returns and allowances 40,000 Nec sales 160,000 Lesé: Cost of goods sold 100,000 Gross profit 60,000 Less: Operating expenses Selling expenses P 22,000 General expenses 8,000 30,000 Income from operations 30,000 ‘Add: Non-operating income 6,000 Income before interest and expe 36,000 Less: Interest expense 4,000 Income before tax expense 32,000 Less: Income taxes (359%) 11,200 Net income 20,800£23 | emrccnanicocar a ‘4 Cash Flow Statement. I is the financial statement that shows the firm's cath receipts and cash Payments during a specified period of time. While the income statement and balance sheet are bated on accrual methods, the statement of cashflow recognizes only transactions in which each changes hands. The balance shect changes could be reviewed to determine the ics, but the coh flow statement has already integrated all chat information. As a result, savvy business people and investors utilize this important financial statement, Here are few ways that the statement of cash flow is used. 2 The cash from operating activities is compared with the company’s net income. Ifthe cash from operating activities is consinenly greater than the net income, the company’s nec incaree or earnings arc said to be of “high quality” If che cash from operating activities i les than nee income, ared flag is raised as vo why the reported net income is not turning imo eah, be Tie cash flow statement identifies the cath thats coming in and going out ofthe company. Xf company is consistently generating more cash chan its using, the company will beable Me eet dividend, buy back some ofits stock, reduce debt, or acquire another company, All of these are perceived to be good for stockholder value & Some financial decisions such as capital budgeting decisions are based on cash flow. Accounting Policies and Notes to Financial Statements. These are the guidelines used in the preparation of the financial statements. Detailed information not appeating in the immacal eramens is lo located in this part for clarification, frinstance, the method used in depreciating the assets traigheline method, sum-ofthe-years' digit method, declining method), valuation oe Jnventory (FIFO, LIFO, moving average), and issuance of capital stocks. Limitations of Financial Statements ‘Though the financial statement isthe most common tol ofthe financial manager in ‘evaluating the firm's performance itis not free from criticisms. Some ofthe limitations of nancial eatements les i ‘There are variations in the application of accounting principles. ‘There ate general sandards followed in the application oF accountng principles, The applications ir because of the different methods and procedure used For instance, in the compaation of deprecation expenses, the frm may use the straight-line method, the sum-of the yea digit metho, ot the replacement method. Financial statements are interim in nature. The financial poston and results of operations ofthe company prepared at every interval, normally one year, are mere estimates of what the performance ofthat firm in that paccular Period Thus, the true performance ofthe company will only be determined upon its liquidation, Ie isavthis time that the final results ofthe operation are determined through the retained ea Financial statements do not reflect changes inthe purchasing power ofthe peso Financial statements are prepared based on historical cost and do not reflect the current market value ofthe asset Financial statements do not contain all the significant facts about the business. {nvestors do not rely only on quantitative factors presented in che financial seatements, They also depend heavily on other pieces of information abour the company such asthe stockholders composition of the board of directors, projects undertaken, and the overall performance of the ‘company relative to the industry, among othersil Statement Analysis Besecial statement analysis is an evaluation of the past and current performance of the firm and fn the furure (Palepu et al, 1996). Ir allows comparison of one company with another, Since Statement analysis looks at relationships inside and outside the firm, a firm of one size can be Sy compared with similar firms or with industry averages or norms to determine how the company is Pea visits competitors (Gieman etal, 2003). SSsecal statement analysis involves calculations. Fiems compute by combining accounts coming iS Secome statement to the balance sheet or vice-versa or by simply relating an account within the ‘These calculations help the management assess the deficiencies and take necessary actions to performance, Pies tools are used by interested parties in making an analysis of che firm's financial statement. Seen: of such analysis ofthe Firms financial position and operating results, as viewed by creditors, ed other uscrs, will have an impact on the firm’s standing. From an investor's standpoine, the future of the firm is what Financial statement analysis is all about. On the other hand, the res view is that financial statement analysis isan important rool in determining future condivions $2 serves asa starting point for undertaking actions to improve the firm's Future performance Phe Role of Financial Statement Analysis in Decision-making Financial ratio is one of the methods used to analyze a company's financial statements It is necessary pees c0 assess whether or not the firm has performed well over a period of time (Samuels etal. 1999) Fisancial analysts, through the help of financial ratios, focus on company's financial strength, liquidity, BS of investment, effectiveness of management, and profitability growth rates to ascertain ies value o¢ Se worthiness. Growth rates ae usually a function of industry growth rates, competitive advantages, sed coxporate straregy ‘he analyst must understand industry practices to properly evaluate a company’s nancial performance. Bi nigh: be unacceptable financial relationships or results in one industry may be perfectly normal in See An analyst mus also understand the company’s business its objectives, the products or services fees and the marker and customers it serves. Reading the annual report, beginning with the CEO's or SSepeson’s letter tothe stockholders, i an excellent stare to understanding a public company’s abjecive Bandits management direction The analyst should then review the pages that discuss the different operations and business environment, SS eersicular, management’ discussion and analysis of operations and financial condition, Next should be g Be of the financial sarement foornoes to understand what accounting practices were used to report the Bei data. The analyst should then examine the financial summary information to get an overview, and SS eve deeply ino the financial satements using financial ratios to evaluate the company’s strength and BSemance, While performing the analysis, the analyst should consider whether or not the CEO’ reports fee the company’s performance and objectives match the financial statements. The financial statereents SS eimarely the “scorecard” of the company’s performance.FINANCIAL MANAGEMENT | Port ww = Tools and Techniques in Financial Analysis The financial analyst's experience, judgment, and temperament affect the evaluation of financial statements (Mejorada, 2000). However, the analyst should be competent enough to use the common tools and techniques used in financial statement analysis. They are as follows: 1, Horizontal Analysis This is used co evaluate the trend in the accounts over the years. It is usually shown in comparative financial statements. Comparative Statements. Compared are financial daca of two yeats showing the increases or decreases in the account balances with their corresponding percentages. b. Trend Ratio. A firm's present ratio is compared with its past and expected future ratios to determine whether the company’s financial condition is improving or deteriorating over time. Icissimila to comparative statements except that several consecutive years were used showing the behavior of financial dara 2. Vertical Analysis T-uses a significant item on the financial statement as a base value, All other financial items con the statements are compared with it Common Size Statement. Each account in the financial statements is expressed by dividing them to a common base account (total asets, liabilities and equity, sales or net sales) Financial Ratios. This is classified into Five groups: + Liquidity ratio ~ is a company’s ability to meet its maturing short-term obligations. A company with poor liquidity may have a poor credit risk, perhaps because itis unable to make timely interest and principal payments + Activity or asset utilization ratio — is used to determine how quickly various accounts are converted into sales or cash Leverage ratio Golvency) ~ is the company’s ability to mect its long tcrm-obligations as they become due. Profitability ratio — shows the profitability of the operations ofthe company. It highlights the firm's effectiveness in handling its operations. Investors will be reluctant co invest in a company that has poor earning capacity Market value ratio ~ relates the firm's stock price to its earnings. Horizontal Analysis Comparative Statements Comparative statements are used to evaluate the changes or behavior patterns ofthe different accounts in the Financial statements for two or more years. In doing the comparison, the earlier year serves as the base year so thatthe percentage increase or decrease is determined by dividing the difference of the base year figure from the later year figure by the base year figure, Later year — Base Base year x 100% = percentage increase or decrease of an account The char The sam Becausea sexes of wide 720. Inthe Smacrial an ASSETS Marketable Total ¢ Toxal Assets UABILITE ct liabi al Libilie‘The change in the account is not limited to a percentage change. Changes in accounts may also be Bessened in peso amounts for better understanding. Using Illustration 3, the percentage of change in total assets of 17.11% for the year 2014 is: = 445,000 P380,000 x 100% 380,000 = IZL% The same procedure is followed for the other accounts in the financial searements. Because a comparative statement stresses the trends ofthe various accounts itis relatively easy to identify azeas of wide divergence that require further attention. Inthe income statement show in Illustration 4, the Serge increase in sales returns and allowances coupled with the dccrease in sales for the period 2013 to 2014 should cause concern. One might compare these results with those of competitors to determine whether she problem is industry-wide or just within a particular company. Ieis important to show both the peso amount of change and the percentage of change because cither ene alone might be misleading. For instance, itis posible that a certain account would increase by 100%, But by looking at the amount, it does not require Further investigation since the amount involved is only 20. In the same manner, the percentage increase or decrease may be insignificant but the amount involved S material and needs further investigation. MEET comparative batance sheet of FMA Company for 2012-2014 FMA Company Comparative Balance Sheet December 31, 2014, 2013, and 2012 Increase or (Decrease) 204-2013. 2013-2012, 2013-2012 ASSETS Cash P 65,000 P 70,000 P 75,000 P (5,000) P 5,000) 6.67% Accounts receivable 40,000 35,000 20,000 5,000 15,000 75.00% Marketable securities 40,000 00 10,000 5,000 25,000 14.29% Inventory 100,000 _80,000 100,000 20,000 (20,000) 25.00% 20.00% Total current assets. 245,000 220,000 205,000 25,000 15,000 11.36% 7.32% Plant assets, 2 160,000 170,000 40,000 10,000) 25.00% 5.88% Toral Assets 380,000? 375,000 P 65.000 P_5.00 11% 1.33% LIABILITIES Cautrent liabilities 110,800 00 104,000 5.800 1,000 0.96% Long-term liabilities 160,000 145,000 140,000 15.000 _5,000 357% Total Liabilities P 270,800 P 250,000 P 244.000 P 20,800 P_6,000 2.46%36 STOCKHOLDERS EQUITY Common stock, P55 pa 100,000 100,000 100,000 20,000 shares Retained earnings P 74200 Total stockholders’ equity 174,200 130,000 131,000 30000 P 31,000 P 44.200 P (,000 14733% 323% 100) 34.00% -0.76%6 Total Liabilities and Stockholders’ Equity 445000 P 380, 900 P.375,000 7.65000 P _5,000 133% entot FMA Company or2012-204 ior Comparative income stat FMA Company Comparative Income Stat December 31, 2014, 2013, and 2012 Increase or Percentage of Increase (Decrease) (or Decrease) 2014-2013 2014-2013 ike iss ania 20S 2012 0132012 Sales 200000 P 210,000 P 100.000 P (10000) P 110,000 -476% —110.00% Sales reqrns and allowances 40,000 25.000 _6,000 15000 19,000 60.00% —316.67% Net sales 160,000 185,000 94,000 25000) 91,000 13.51% 96.81% Cost of goods sold 100,000 115625 50,000 (5.625) 1351% 131.259% Gross prof P 60.000 P 69.375 P 44000 P (375) P 1351% — 57267% Operating expenses Selling expenses P 22,000 P (3.000) P 9,000 -12.00% 56.25% General expenses 8,000 (4.000) _ 4,000 50.00% otal operating expenses 30,000 (7.000) _13,000 54.17% Income from operations 30,000 0.375) 12375 61.88% Non-operating income P __6000 3500 P00) 140.00% 28.57% Income before interest expense and taxes 36000 P 34,875 P Wd P 11375 323% 48.40% Interest expense 4000 _ 3.500 _ 500 _ 500 4.29% 16.67% icone baka ase 32,000 05 199% 53.05% Income axes (35% rat 11200 —_10, 199% 53.05% Net income P 20,800 P 20,394 P 13.325 P L 53.05%FS sestrsscoversa span of many years, comparative financial statements may become unwieldy SBS the result ofa comparative starement may be presented by showing trends relative to a base BB method, the firm has wo choose a year chat represents the firm's activity as its base. Individual the financial statements of the base year are assigned an index of 100. The index for each Scouse in che succeeding years is determined by diving the accounts amount by the base yeat fzad multiplying che quotient by 100, Bie se year after the base year, it would be: Year | Yer! , 100% Base year Bie yas after the base year, it would be: Year 2 Base year x 100% the formula for cash in 2013 and 2014 with 2012 as the base year, the ratio would be a follows. HS cxxio for 2013 is 70,000 9994 75,000 = 93.33% FS cxtio for 2014 is P-65,000 75,000 = 86.67% SP edensed form of the balance sheet tising trend analysis is shown in Illustration 5. Bes comnmon-size statement, a significant item on a financial statement is used as the base value, and s on the financial statement are compared with it. In performing common-size analysis for sheet, total assets are assigned as the base account with a percentage of 100. An individual asset S expressed a5 a percentage of toal assets, Likewise, the total ibliies and stockholders’ equity fsvidual accounts in the lability and equity is also expressed as a percentage of tral liabilities holders’ equity. BBS income statement, net sales are given the value of 100% and all other accounts are evaluated in so netsales. The resulting figures are then given in a common-size statement. The common. size £4 Company's balance sheet is shown in Illustration 6,BEUEENEN tens nays ot tnebatance net of FMA Compas or 2012-7014 ASSETS Current asses Cah ‘Accounts receivable Marketable securities Inventory “Tal current assets Plants assess Total Asses LIABILITIES (Curent ibis ‘Long-term ibis ‘Total Liabilities ‘STOCKHOLDERS’ EQUITY ‘Common stock, 5 pat value, 20,000 shares Rerained earnings Tora stockholders equity ‘Tor Liabilities and ‘Stockholder’ Equity Sales Sale ecars and allowances Netsales Cost of goods sold Gross profit Operating expenses Selling expenses General expenses “Teal operating expenses Income from operations "Non-operating income FMA Company Tend Analysis of Balance Sheet December 31, 2014, 2013, and 2012 Tred rtlo no) 2013/ ni ee OO 65000 F 70000 775000 8667% 93.3% 100% ‘econ 35000 20000 200.00% 175.00% 100% foov 35000 10.000 400.00% 350.00% 100% tooo 80.000 300,000 100.00% 80.00% 1008 asn00 220,000 205,000 11951% 10732% 1008 Joo.o00 360,000 170,000 117.5% 94.2% 100% 5.000 F 380,000 375,000 18.67% 101.3% 100% Pina00 P 105000 #104000 10654% 10096% 1009 1go000 45000 149000 11429% 10357% 100% yao P750000 *244000 11098% 102455 100% 100000 7 100000 # 100900 100.00% 00.00% 100% 74200 30000 31.000 239.35% 96 100% trk00 130000 131,000 13258%% 99.24% 100% 4is00 P mg000 7373000 1867% 10139% 100% FMA‘Company “Tiend Analysis of Income Se December 31,2014, 2013, nd 2012 41013. aos 2013, 2012 2202 0 fron #210000 P 100000 200.008 210,00% — 100.00% voto 25000 600 _ AT AIGG7% 00.00% Sooo TaS.000 34900 I7ORIN.196.81% — 10000% “ooano 115625 sooo _20000% 251.238 100008 _ “F coo00 F 69375 P 4.000 1363636 157.6796 00.00% fe aa00 P 25000 % 16000 13750% 15625% 100.00% 7 Mme 120002000 _10000% 150.0% _10000%_ 5000 S760 2A) 1250 154.17% 10.00% — ~30,000 32,375 20,000 150,00% 161.88% — .100.00% veo 2500—«3800—«7LAS% 71.43% 100.00% Income before and taxes, Inceest expense ome before ¢ income tates (3 Sree al Assets masiTiEs SPOCKHOLDE Kemon sock, |Tncome before interest expense and taxes Interest expense Income before taxes Income taxes (35 Netincome commen ASSETS Cash Accounts receivable Marketable scutces Tora current assets cal Assets MIABILITIES erent labilties oe term lisbilices Toul Liabilities STOCKHOLDERS’ EQUITY mon stock, PS par value, 20,000 shares Besined camings al stockholders equity Feel Lisbiliice and Stockholder? Equity ss and allowances F 36000 F 34875 » 23,500 a0 55 2,000 313 11.200 F230 2054 F 153195 148.407 — 10000% 13339% 11667% 10000 ~156.10% 153.058 Ton ae 156105 153059 10000 136 10% 153.0596 100008 Size analysis ofthe balance sheet of FMA Company for 2012. FMA Company Balance Sheet December 31, 2014, 2013, and 2 Common-size Analysis 2014 2014 20132012 2013 65.000 40,000 35.00 40,000 35,000 400.000 80.000 245.000 220,000 200000 160.000 P 445,000 P 390,000 70000 75.090 20,000 10.000 00.0 205,000 170.000 ¥ 375,000 14.61% 8.999% 8.99% 18.42% 9.21% 9.21% 21.05% 57.89% 42.11% 100.00% 20.00% 5.3386 2.67% 26.67% 54.67% 45.3386 100.0096 F 110800 105,000 160,000 145,000 P 270800 P 250.000 P 104,000 140,000 4,000 27.6346 38.1696 P 100,000 * 100.000 100,000 31.000 16.67% 39.1596 100% 20142013 200.000 P 210,000 40,000 25,000 160.000 185,000 P 100,000 2014 2013 ace 100.00%% 2012 125.00% 106.38% 94,000 100.00%z = | 40 Cost of goods sold 100,000 115,25 50,000 62.50% 62.50% 53.19% Grose profc 60,000 69375 44000 37.50% 37.50% 46.81% Operating expenses Selling expenses 22000 13.51% 17.02% General expenses 3,000 49% _851% Total operating expenses 30,000 20,00% 2 Income From operations 30,000 17.50% 21.28% Non-operating income 5.000 % 372% Income befor interest expense 36,000 18.85% 25.00% and tance Invert expense 4,000 1.99% _3.1986 Income before taxes 32000 31375, 16.96% 21.81% Income taxes (35% rate) 11200 10981 59406 7.63% Netincome 2 14186 ‘Common-size analysis is used to show the internal structure of an enterprise. Ic reflects the existing) relationship of each account in the balance sheet that would help the firm determine possible improvements in the distribution of resources. With the percentage of each account in the income statement in relation to its net sales, the firm can draw berter alternatives in maximizing its profits. Financial Ratios The principal ida in analyzing financial ratios is cha chere ae several major financial ratios obtainable fom che financial statements ofthe firm that reveal its Financial health. Financial statement ratio analysis provides a broader basis for comparison than raw numbers do. However, ratios on their own, without year to-year or other industry/fiem comparative ratios, are of little use in judging che health or future of the industryirm being analyzed In assessing the significance of various financial statement dat, experts engage in financial ratios analysis the process of determining and evaluating financial ratios. A financial statement ratio is a relationship chat indicates something about a company’s activities, such as the ratio between the company’s current asses and current liabilities or berween its accounts receivable and its annual sale, The basic source ofthese ratios is the company’s financial statements that contain figures of assets liabilities, profits, and losses. Financial statement analysis ratios are only meaningful when compared with other information. Since they are most ‘often compared with industry data, ratios help an individual understand a company’s performance relative to that ofits competitors. These are often used to trace performance over time. Ratios analysis can reveal much about a company and its operations. However, there are several points to keep in mind about ratios. First, financial ratios indicate areas of strength or weakness. One or several ratios sight be misleading, but when combined with other knowledge ofa company’s management and economic circumstances, ratio analysis can tell much about a corporation. Second, there is no single correct value for 4 ratio, The observation thatthe value ofa particular ratio is to0 high, roo low, or just right depends on the perspective ofthe analyst and on the company’s competitive strategy. Third, a financial ratio is meaningful ‘only when i is compared with some standard, such as an industry trend, a ratio trend, a ratio trend forthe specific company being analyzed, or a stated management objective Financial 1. Indu: Eebiicies. Some A positive ‘The FMA ¢ 2 245, 0¢ |