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 Understanding financial statements

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PostSubject: Understanding financial statements   May 23rd 2015, 12:08 pm

You may not be interested in the technicalities of record keeping or the procedures for preparing financial statements, but you should at least understand and know how to use them if you are running your own business.

[related|post]Financial statements are the instrument panel of the business that reports on managerial success or failure, and that flashes warning signals of impending difficulties. To be able to read that panel, you must understand the gauges and their calibrations to make sense out of the data it conveys. In other words, you must understand accounting and financial relationships to interpret the data in the panel.

Financial statements include the balance sheet and the income statement. The balance sheet is a statement of the financial condition of a business at a given time, and it shows the assets, liabilities, and the ownership interest as they are reflected in the accounting records. However, the reported assets or properties of the business do not reflect their current market worth; they are generally entered under the accounting rule of cost.

You must consider the difference between book value and market value when such figures are used as a basis for financial decisions. The ownership interest as it appears in the balance sheet is the net amount after liabilities, or debts, are subtracted from the assets. As a result, any difference between the asset book value and its current worth reflects a corresponding difference between the book value of the ownership interest and what it would be if assets had to be acquired at market value on the date of the balance sheet. The longer an asset is held, the greater the possibility that market prices will have changed.

The assets may be thought of as the uses to which the business has put the funds at its disposal. Liabilities show the sources from which the funds have been drawn, and these sources fall into three main categories:  current liabilities, or debt that will fall due within a year; long-term liabilities, which mature after one year or more from the date of the balance sheet; and the owners’ interest or equity.

Through a careful study of financial statements, it is possible to obtain a fairly complete understanding of the financial position of your business and to become aware of significant changes that have occurred since the date of the preceding balance sheet. Bear in mind, however, that financial statements have their limits. Only those factors that can be reduced to monetary terms appear in the balance sheet.

By studying the amount and kinds of assets in relation to the amount and payment dates of liabilities, you can figure out what your creditor’s opinion will be as to the ability of your business to pay its debts promptly. A creditor pays particular attention to your cash and other assets such as accounts receivable, which will be converted into cash, and then compares these assets with your liabilities falling due in the near future. The creditor is also interested in the amount of the owner’s equity, as this ownership capital serves as a protecting buffer between the banks and any losses that your business may incur.

The financial statements also tell the owners how successful their business has been and summarize its financial position. Their goal is to determine whether your company is gaining or losing ground in the unending struggle for profitability and solvency.

Significant changes in financial data are easy to see when financial statement amounts for two or more years are placed side by side in adjacent columns, with the most recent or current year placed at the leftmost column. Such a statement is called a comparative financial statement.

Analysis techniques
Few figures in a financial statement are highly significant in and of themselves. It is their relationship with other quantities, or the amount and direction of changes since a previous date, which is important. Analysis is largely a matter of establishing significant relationships and pointing up changes and trends.

There are four widely used analytical techniques:
peso and percentage changes
trend  percentages
component percentages

Peso and percentage changes
The peso amount of change from year to year is significant, but expressing the change in percentage terms adds perspective to it. For example, let us assume that your sales have increased by P50, 000. The fact that this is an increase of 10 percent over last year’s sales of P500,000 puts it in a different perspective than if it represents a 1 percent increase over sales of P5, 000, 000 for the prior year.

The peso amount of any change is the difference between the amount for a comparison year and for a base year. You compute the percentage change by dividing the amount of the change between years by the amount for the base year.  

Computing the percentage changes in sales, gross profit, and net income from one year to the next provides insight into your company’s rate of growth. If your company is experiencing growth in economic activities, sales and earnings should increase at more than the rate of inflation.

If, for example, your company’s sales increase by 5 percent while the general price level rises by 10 percent, it is probable that the entire increase in your sales is due to inflation rather than by an increase in your sales volume. In preparing the peso or percentage change in your quarterly sales or earnings, it is customary to compare the results for the current quarter with those of the same quarter of the preceding year to prevent your analysis from being distorted by seasonal fluctuation in business activity.

Percentage changes may create a misleading impression when the peso amount used as a base is unusually small. Assume that your company had a net income of P100, 000 in 2000, P10, 000 in 2001, and P100, 000 in 2002. The net income in 2001 dropped by 90 percent, but increased by 900 percent in 2002. What needs to be emphasized is that the 900 percent increase in 2002 exactly offsets the 90 percent decline in your profits in 2001.

Trend percentages
The changes in financial statement items from a base year to the following years are often expressed as trend percentages to show the extent and direction of the changes. Two steps are necessary to compute trend percentages. First, you select a base year and give each item in the financial statement for the base year a weight of 100 percent. The second step is to express each item in the financial statement for the following years as a percent of your base-year amount. This computation consists of dividing an item in the years after the base year by the amount in the base year.

For example, assume that in the following table, 1998 is selected as the base year.












Net Income






Applying the computation described above, the trend percentages will appear as shown below.












Net Income






The above trend percentages indicate a very modest growth in sales in the early years and accelerated growth in 2001 and 2002. The net income also shows an increasing growth trend with the exception of 2001, when the net income declined despite a solid increase in sales. This variation could have resulted from an unfavorable change in gross profit margin or from unusual expenses. However, the problem was overcome in 2002 with a sharp rise in the net income. Overall, the trend percentages give a picture of a profitable growing enterprise.

As another example, assume that sales are increasing each year, but the cost of goods sold is increasing at a faster rate. This means that the gross profit margin is shrinking. The increases in sales are probably being achieved through excessive price-cutting; as a result, your company’s net income may be declining even though your sales are rising.

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