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CHAPTER

THE FINANCIAL STATEMENTS

LEARNING OBJECTIVES

After studying this chapter, you should be able to…

1. describe financial statements;

2. identify the financial standing of the firm
3. prepare financial statements.

FINANCIAL STATEMENTS

Financial statement are those that present financial information to various

interested parties. In as much as finance manager is responsible for managing the
financial activities of the firm, he is naturally one of the most concerned about getting
relevant information through the use of financial statements, but only two of them are
important from the point of view of business finance. These are: (1) the balance sheet;
and (2) the profit and loss statement.

The Balance Sheet

The balance sheet is the statement produced periodically, normally at the end of a
financial year, showing an organization’s assets, liabilities, and the interest of the owners.

Assets. The assets section of the balance sheet shows everything that the firm
owns and which has monetary value. Assets are classified into four items and are
presented in the balance sheet in the order of how quick they can be converted into cash.
The classifications are as follows:

1. Current Assets. These are composed of cash, bank deposits, and other items
readily convertible into cash like accounts receivable, stocks and work-in-
process, and marketable securities;
2. Trade Investment. These are composed of investments in subsidiary or associated
companies;
3. Fixed Assets. These items show the firm’s ownership of property like land,
buildings, plan and machinery, equipment, vehicles, furniture and fixtures, all
valued at cost less depreciation written off; and
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4. Intangible Assets. These items present goodwill, patents, copyright which are
attributed to the firm.

Liabilities. The liabilities section of the balance sheet shows the profile of the debts
of the company. They are classified into several items and are presented first and referred
to as current liabilities. Long-term liabilities are those which are payable after one year.
The following are common liability items:

1. Accounts Payable. These are usually composed of debts payable within a few
days, weeks, or months, like those incurred in the purchase of raw materials
and stocks.
2. Loans and Notes Payable. These are debts evidenced by promissory notes
and oftentimes backed up by collaterals. Creditors of this type of liability are
composed of banks, suppliers, financing companies, and the public.
3. Advances from Customers. Sometimes, customers are required to make down
payments before orders are processed. In as much as this is not yet earned by
the company, they are considered liabilities.
4. Accrued Expenses. These represent obligations, which have been incurred but
not yet paid.
5. Mortgage Payable. This comprises borrowings and other sources of funds.
This item also represents long-term debts and is usually secured by land,
buildings, or equipment.
6. Bonds Payable. When a large amount of long-term debt is sought by the firm
from a large number of creditors, bonds are usually issued. The amount
borrowed is divided in denominations like ₱500, ₱1,000, ₱5,000, and
individual bond certificates are issued in these amounts. Each creditor holds
the bond, or the promise to pay, for his share of the company’s debt.

Net Worth. The net worth section of the balance sheet shows the interest of the
owner or owners in the company.

In a single proprietorship, the owner’s interest usually appears as a single account,

for instance, “Isabelo Musngi, Capital”. This represents sums invested by the owner,
which is increased by profits and decreased by losses and withdrawals.

In a partnership, the interests of the partners are presented separately like the
following:

Francisco Taguinad, Capital ₱10,000,000

Clarita Navarro, Capital ₱20,000,000
Angelita Ballesteros, Capital ₱30,000,000
Total Net Worth ₱60,000,000
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The Net Worth section of a corporation’s balance sheet will appear as follows:

1. When the shares of stock have par value:

Capital Stock ₱50,000,00
2. When the shares of stock have no par value (but with an arbitrary stated value):
Capital stock (stated value at
₱10 per share) ₱20,000,000
Paid-in surplus ₱30,000,000
Total Net Worth ₱50,000,000

Exhibit 1

A SAMPLE BALANCE SHEET

ANDRES NICOLAS CORPORATION

Balance Sheet
December 31, 2006

ASSETS
Cash ₱38,130,000
Accounts Receivable 97,943,000
Inventory 161,351,000
Total Current Assets ₱297,424,000
Fixed Assets 131,067,000
Prepaid Expenses 9,239,000
Cash Value, life Insurance 22,431,000
Total Assets ₱460,161,000
LIABILITIES
Due Banks ₱45,000,000
Notes Payable 24,000,000
Accounts Payable 40,203,000
Accruals 15,332,000
Taxes 5,906,000
Undistributed Earnings 2,109,000
Total Current Liabilities ₱132,604,000
OWNERS’ EQUITY
Common Stock ₱104,500,000
Capital Surplus 0
Earned Surplus 223,057,000
Total Liabilities and Net Worth ₱460,161,000

3. When there is a special class of ownership:

Capital Stock
Preferred (₱500 par, 8% 100,000 shares) ₱ 50,000,000
Common (₱500 par, 200,000 shares) ₱100,000,000
Total Net Worth ₱150,000,000
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The Income Statement

The income statement represents the revenues realized from the sale of
commodities and services produced by the company, as well as the costs and expenses
incurred in connection with the realization of said revenues. The income statement is also
referred to as profit and loss statement, as two possibilities are presented, i.e., net profit
or net loss. Unlike the balance sheet which shows the financial condition of the firm on a
given date, the income statement presents a summary of the transactions for given period.

The income statement is characterized by four distinct items: (1) revenues; (2)
expenses; (3) other income; and (4) net profit or loss.

Revenues. The term refers to the gross income from the production and sale of a
firm’s product or service. Revenues include cash collections and receivables or unpaid
sale. This item does not include trade discounts allowed to distributors of other
middleman. To obtain net income or net sales, returns and allowances are deducted from
the gross revenues.

Expenses. This refers to the monetary values of the goods and services used in
the production and delivery process in order to obtain revenues. Expenses consist of three
items: (1) the cost of goods manufactured and sold; (2) operating expenses; and (3) other
expenses.

1. Cost of Goods Manufactured and Sold. This item presents a summary of the cost
directly involved in the manufacturing process and which represent the
manufacturing cost of goods sold during the period under consideration.
Overhead costs include expenditures like salaries of supervisors, depreciation,
light and water, supplies, and factory rent.

The cost of direct materials is computed by deducting the raw materials inventory at
the end of the period from the total raw materials available for use. In turn, the raw
materials available for use are computed by getting the sum of raw materials inventory at
the beginning of the period and purchases during the period. The formula for determining
the cost of raw materials used is as follows:

Raw Materials Inventory, Beginning of the Period

+ Purchase during the period
= Raw Materials Available for Use
- Raw Materials Inventory, End of the Period
= Cost of Raw Materials Used

The cost of goods manufactured is computed by deducting the work-in-process,

end of the period, from the cost of goods processed. In turn, the cost of goods processed
is the sum of the cost of raw materials used, the direct labor, overhead, and if applicable,
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the work-in-process at the beginning of the period. When the cost of goods manufactured
is determined, the formula will appear as follows:

Cost of Raw Materials

+ Direct Labor
+ Overhead
+ Work-in-Process, beginning
= Cost of Goods Processed
- Work-in-Process, end
= Cost of Goods Manufactured

As some of the goods manufactured may have been added to inventory, the cost of
goods sold may be computed by deducting the finished goods inventory (end) from the
total amount of goods available for sale. The cost of goods manufactured and the finished
goods inventory (beginning) comprises the total amount of goods available for sale. Thus,
the following formula is used in determining the cost of goods manufactured and sold:

Cost of Goods Manufactured

+ Finished Goods, Beginning
= Total Goods Available for Sale
- Finished Goods, End
= Cost of Goods Manufactured and Sold

Exhibit 2

A SAMPLE INCOME STATEMENT

VIRGILIO ILAGAN COMPANY

Income Statement
12 Months to December 31, 2006

Sales ₱150,817,000
Less: Royalties 8,853,000
Net ₱141,964,000
Cost of Goods Sold:
Beginning Inventory 17,161,000
Purchases 79,600,000
Freight 1,179,000
Labor 12,970,000
Indirect Manufacturing Expenses 4,847,000
₱115,757,000
Less: Ending Inventory 53,400,000
₱62,357,000

Gross Profit ₱79,607,000

Operating Expenses:
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Salaries-administrative ₱27,090,000
Salaries-secretarial 5,625,000
General Office 2,120,000
Travel and Entertainment 7,650,000
Auto Expenses 4,374,000
Depreciation and Amortization 1,016,000
Legal and Accounting 4,366,000
Payroll Taxes 4,753,000
Business Taxes 1,749,000
Telephone 1,749,000
Insurance 1,515,000
Management Fee 9,895,000
Research and Development 2,996,000
Miscellaneous 4,990,000
Contributions 2,508,000
Advertising 509,000
Literature 808,000
Interest 2,447,000
Bad Debts 2,580,000
Commission _____ -__
₱88,740,000
Net Loss - ₱ 9,133,000

2. Operating Expenses. These represent marketing, general, and administrative

expenses. Examples are advertising, salaries, and wages.
3. Other Expenses. These include interest expense and sales discounts.

Other Income. This item refers to non-operating income such as interest income and
purchase discounts.

Net Profit or Net Loss. Net profit or net income refers to the difference between
revenues less period expenses and product costs. When expenses and costs are greater
than the revenues, the result is a net loss.

THE BUDGET

Concerning the finance function of the manager, one of the useful tools he could
use is the budget.

The budget is defined as an estimate of income and expenditures for a future

period. The budget is contrasted with the income statement, which is a summary of the
performance of the firm for a past period, and with the balance sheet with presents the
financial condition of the firm at a given date, past or present. The budget completes the
financial picture by referring to the future.
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Budgets are essential elements in the planning and control of the financial affairs
of the business. Large corporations place so much emphasis in the annual budget which is
normally broken down into monthly and weekly periods, and which may take several
months to prepare.

In preparing the budget, an estimate of sales and income for the period is made,
followed by estimates of expenditures in purchasing, administration, production,
distribution, and research. Detailed budgets of cash flows and capital expenditures are
also included.

The Sales Budget

The sales budget is the starting point of company budgets. It shows an estimate of
sales in units and dollars or pesos for each major subdivision of sales.

The Materials and Purchases Budget

This portion of the company budget refers to the estimate of the materials
required by the firm, specified in quantities, costs, timing of purchase, the required
delivery dates, and other requirements.

The Production Budget

The production budget is an estimate of the quantity of products that should be

produced in accordance with the sales budget. It also shows the monthly breakdown of
quantities to be produced for each product depending upon the firm’s seasonal sales
index. The total units to be produced could be derived using the following equation:

Budget Sales
- Starting Finished Goods Inventory (Expected)
+ Ending Finished Goods Inventory (Planned)
= Total Units to be Produced

STATEMENT OF FINANCIAL POSITION

There are five distinct groups interested in knowing the financial standing of the
firm. These are: (1) the owners, (2) the management, (3) the creditors, (4) the
government, and (5) prospective investors. In some cases, customers and employees
require financial data about firm. Financial statements and budgets provide most of the
information required by interested parties.

The owners are primarily concerned with receiving information on the anticipated
financial benefits that will be generated by the firm. They also need to know whether it is
wise or not to continue their relationship with the firm as owners. These information
requirements are provided by the financial statements.
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The management is concerned with effective planning and control of the activities
of the firm. As various financial information is provided by the financial statements will
help them find out the answer.

Financial statements are required by the government for tax and regulatory
purposes. Examples of the areas of concern are income tax assessment and the regulation
of the issuance of securities like stocks and bonds.

Financial statements are also especially important to prospective investors. They

are mainly interested in the protection of their investments and the earnings they require
over a period of years. The balance sheet and the income statement will be very useful in
this regard.

Budgets are especially important to management because they are able to do the
following:

1. Anticipate asset needs;

2. Plan for necessary financing; and
3. Establish standards by which to test current operating performance.

Customers who would want to establish long-term relationship with the firm would
be particularly interested to know how stable the firm is. Financial statements could
provide them with initial information.

Employees who would want to consider long-term employment with the firm would
also want to know the long-term prospects of the firm. Financial statements would be
useful in this regard.

QUESTIONS FOR REVIEW AND DISCUSSION

1. A certain company is offered for sale. You expressed interest in buying the firm.
A document showing that the company made a profit of ₱20,000,000 in the
previous year was handed to you. If you have the money, will you now make a
decision? Explain your answer.
2. Some firms maintain large cash balances instead of investing in other forms of
assets. Discuss the disadvantage of this practice.
3. A prospective investor has three investment choices. In investment proposal A, he
is 50% sure to make ₱100,000 profit. In proposal B, an ₱80,000 profit is 55%
certain, while in proposal C, a ₱120,000 profit is 45% certain. In terms of
expected value, which is the best choice?
4. What are presented in the balance sheet? In the profit and loss statement?
5. What does net worth represent?