Financial Modelling

Financial Statements and Analysis - Types of Financial Statements

After completing a course or module on Financial Statements and Analysis, students will
possess the skills and knowledge necessary to comprehensively analyze financial statements,
interpret financial data, and make informed financial decisions, enabling them to assess the
financial health and performance of businesses and organizations effectively.

1. True or False: Financial statements provide a snapshot of a company's financial health

and performance at a specific point in time.
2. True or False: The three primary types of financial statements are the income statement,
the balance sheet, and the sales statement.
3. True or False: Ratio analysis involves evaluating relationships between different financial
data points to assess various aspects of a company's financial performance.
4. True or False: Profitability ratios assess a company's ability to meet short-term
obligations.
5. True or False: Building historical financial models involves creating future financial
projections.

2.1 Financial Statements and Analysis

Financial statements are essential documents that provide a snapshot of a company's
financial health and performance. They are critical for various stakeholders, including investors,
creditors, management, and regulators, to assess a company's financial condition and make
informed decisions. Here are key points to understand about financial statements:
2.1.1 Types of Financial Statements:
There are three primary types of financial statements:
a) Income Statement: Also known as the profit and loss statement (P&L), it shows a
company's revenues, expenses, and net income or loss over a specific period, typically a
quarter or a year.
a.1 How to Interpret an Income Statement

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An income statement provides a breakdown of your business's expenditures and
earnings during a specific financial reporting period. It enables you to compute your net
profit, which is often referred to as the 'bottom line.'
The term 'bottom line' is used because the net profit figure appears at the bottom
of your income statement. As you progress through your income statement, additional
expenses are deducted from your revenue, making your income line item progressively
more detailed.
Sample Income Statement
John's Aquarium Supply Corporation
Income Statement As of Jan 1, 2023

Sales Revenue ₱9,000.00

Cost of Goods Sold
(COGS) ₱4000.00
Gross Profit ₱5000.00

General Expenses ₱2250.00

- Rent ₱2000.00
- Utilities ₱200.00
- Office Supplies ₱50.00

Operating Earnings
(EBIT) ₱2750.00

Income Tax Expense ₱900.00

Net Profit ₱1850.00

a.2 Components of an Income Statement

The income statement comprises several key elements:
1. Sales Revenue (Top Line): This represents the total income generated by the
business during the month, before considering any expenses.
2. Cost of Goods Sold (COGS): COGS is the expenditure incurred to earn the sales
revenue. For businesses like John's retail store, this typically includes the wholesale
cost of products.
3. Gross Profit: Gross profit is the income left after subtracting COGS but before
considering general expenses.
4. General Expenses: General expenses encompass the regular monthly expenditures
John incurs to operate her business and maintain sales. Some, like rent, remain
consistent each month, while others, such as utilities and office supplies, may vary.
5. Operating Earnings (or EBITDA - Expenses Before Interest, Taxes,
Depreciation, and Amortization): This figure represents the total amount John

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retains after deducting expenses from her revenue, excluding taxes and interest on
debt.
6. Income Tax Expense: This accounts for the estimated income tax paid or owed for
the reporting period. Together with interest payments (which John doesn't have), it
forms the 'IT' in EBITDA.
7. Net Profit: Net profit signifies the overall earnings of the business after factoring in
all expenses, including taxes and interest.

a.3 Analyzing an Income Statement Using Financial Ratios

When examining an income statement, you can employ three essential financial
ratios, each of which assesses different profit margins—highlighting the relationship
between revenue and expenses.
1. Gross Profit Margin:
The gross profit margin reveals how much profit your business generates per peso of
revenue, solely considering the Cost of Goods Sold (COGS).
This margin can be increased by reducing COGS (e.g., by cutting wholesale costs) or
by raising prices.
To compute the gross profit margin, use this formula:
 Gross Profit Margin = (Sales Revenue – COGS) / Sales Revenue
In John's case, the calculation results in:
 Gross Profit Margin = (9,000 – 4,000) / 9,000 = 0.55, or 55%
John's gross profit margin of 55% means she retains ₱0.55 of every peso earned as
gross profit.
2. Operating Profit Margin:
The operating profit margin is similar to the gross profit margin but factors in general
expenses along with COGS.
To boost this margin, you can consider raising prices, reducing COGS, or lowering
operating expenses.
The formula for calculating the operating profit margin is as follows:
o Operating Profit Margin = Operating Earnings (EBITDA) / Sales Revenue
For John, the calculation looks like this:
o Operating Profit Margin = 2,750 / 9,000 = 0.31, or 31%
John takes home ₱0.31 for every peso earned, accounting for EBITDA.
3. Net Profit Margin:
The net profit margin measures the relationship between your bottom line (net
income) and your sales revenue, representing the total amount left after considering
all expenses.
You can compute the net profit margin using this formula:
o Net Profit Margin = Net Income / Sales Revenue
For John, the calculation is as follows:
o Net Profit Margin = 1,850 / 9,000 = 0.21, or 21%
John takes home ₱0.21 for each peso earned.
Typically, businesses focus on increasing their operating profit margin, as it offers
greater control over profitability. While interest and tax expenses are often beyond direct
control, EBITDA, influenced by day-to-day operations, plays a pivotal role in
determining the operating profit margin."

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b) Balance Sheet: This statement presents a company's assets, liabilities, and shareholders'
equity at a specific point in time, providing insights into its financial position.

Interpreting a Company's Balance Sheet

When reviewing a company's balance sheet, you'll focus on understanding the
following components:
1. Assets: These are categorized into current assets and long-term assets.
2. Liabilities: These are divided into current liabilities and long-term liabilities.
3. Stockholders' (or Owner's) Equity: This section comprises common stock and
retained earnings."

Fundamental Balance Sheet Equation: Assets = Liabilities + Shareholders' Equity

This equation is central to understanding the balance sheet. Now, let's explore the
breakdown of the Assets section, which encompasses everything a company owns and
items that fulfill four key attributes: future, probable, economic, and beneficial. The
Assets section is further categorized into Current Assets and Long-Term Assets."
Current Assets

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Here are several items typically found in this category:

1. Cash: This represents the company's cash holdings, encompassing both physical
currency and bank balances.

2. Marketable Securities: Marketable securities include short-term investments

made by the company, such as bonds or stocks of other companies. These
investments offer high liquidity and can be easily converted into cash, serving as a
valuable resource when additional capital is needed.

3. Accounts Receivables: Accounts receivables represent sales made by the

company on credit. While the sale has occurred, the company is yet to receive the
payment, making it an asset.

4. Inventory: Inventory refers to the stock of goods held by the company.

Long Term Assets

5. Prepaid Expenses and Accrued Income: Prepaid expenses are payments made
for future services or benefits, like advance payments for advertising. The benefit
from prepaid expenses will be realized over time. Similarly, accrued income
represents earnings that have been generated but not yet received. These items are
recognized in the current fiscal year, ensuring that the company anticipates future
income even if it hasn't been received."

Long Term Assets

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Plant & Equipment: It shows all the machinery the company owns to make its
products. We also charge depreciation on it to reduce its value over some time.
Depreciation helps us show the true value of these assets in our business.
Then we can have other assets like land, furniture, vehicles, computers, etc.

Interpreting Balance Sheet Liabilities

This section encompasses the total obligations that the business owes to
external parties. Many businesses commonly employ leverage as a strategy to
enhance their profit margins. Leverage involves utilizing debt as a means to
finance the business, thereby reducing the reliance on the owner's capital for
funding the company's day-to-day operations. Within this section, liabilities are
further categorized into Current Liabilities and Long-Term Liabilities.
Current Liabilities

This category encompasses the following elements:

1. Accounts Payables: Accounts payable represents the cumulative amount owed by the
company to its suppliers for the provision of raw materials or goods. Many industries
operate on a system of trade credit, granting buyers time to secure funds before payment.

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This practice facilitates increased business sales, allowing transactions with customers
who may not have immediate upfront payment but will settle their dues shortly.
2. Unearned Revenue: Unearned revenue stands in contrast to accrued income. In this
scenario, the company has received payment from customers but has not yet delivered the
goods or services. Consequently, it is classified as a short-term liability until the goods
are delivered.
3. Current Portion of Long-Term Debt (CPLTD): CPLTD encompasses all debt
payments due within one year."

Long Term Liabilities

Long-term debt comprises the funds raised for an extended period, serving as a
significant component of our overall capital structure.
Understanding Balance Sheet Equity

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This category encompasses the entire amount contributed by the owner to the
business, along with two primary components:
This category encompasses the total capital injected by the owner into the business and
comprises two primary elements:
1. Paid-up Capital: Paid-up capital represents the essential capital base of the business. In
larger enterprises, it can be further categorized into common stock and preferred stock.
Preferred stockholders typically receive preferential treatment in terms of dividend
payments but lack voting rights. Conversely, common equity serves as the foundational
component of the company's capital structure.
2. Retained Earnings: Retained earnings offer a snapshot of the entire sum earned by the
owners and subsequently reinvested in the business, rather than distributed as dividends.
Take note that the items mentioned above are not exhaustive, and additional elements
may fall under these three categories. The primary purpose is to underscore the key items
that can be classified within them.
Analyzing the Balance Sheet
Furthermore, there are two primary formats for presenting this financial statement, as
outlined below:
#1 - Vertical Analysis Balance Sheet

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In this form of vertical analysis, we assess each item on the balance sheet as a percentage
of the total assets. This approach offers a more visual representation of the overall asset
base.
#2 - Horizontal Analysis Balance Sheet
Horizontal analysis involves a detailed examination of all items on the balance
sheet presented in absolute numerical values over a specific period. Consequently, it is
also referred to as trend analysis. The aim is to evaluate the company's performance and
growth over an extended timeframe.
Additionally, there is the common-size balance sheet, which provides a more
comprehensive view by presenting items in both absolute and percentage terms over an
extended duration.

c) Cash Flow Statement: It outlines a company's cash inflows and outflows, categorizing
them into operating, investing, and financing activities. This statement helps assess a
company's cash management.
c.1 How to Interpret a Cash Flow Statement
While not every small business utilizes cash flow statements, they become
indispensable when applying the accrual method of accounting to gauge financial well-
being.
Under the accrual method, expenses and income are logged in financial records
when they are incurred, regardless of the actual exchange of money. For example, if you
place a Php1,000 order with a vendor, it is promptly recorded as a Php1,000 expense,
even if the payment to the vendor is deferred until later, upon receipt of an invoice.
Similarly, when you invoice a client for Php1,000, it is recorded as Php1,000 in
accounts receivable—an asset. However, the actual funds are not immediately available.
Thus, if you intend to use that Php 1,000 for a purchase, the cash may not be on hand.
A cash flow statement reconciles such transactions in which cash is not instantly
available. It provides a clear depiction of the actual cash resources at your disposal during
a specific time frame, allowing for a more accurate assessment of your financial liquidity.

SAMPLE CASH FLOW STATEMENT

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John's Puppets
Cash Flow Statement
For Month Ending March 31, 2023

Cash, Beginning of Period PHP 2,000

Cash Flow from Operating Activities
Net Income PHP 1,000
Additions to Cash
Depreciation PHP 200
Increase in Accounts Payable PHP 500
Subtractions from Cash
Increase in Accounts Receivable (PHP 1,000)
Net Cash from Operating Activities PHP 700
Cash Flow from Investing Activities
Purchase of Equipment (PHP 500)
Cash Flow from Financing Activities
NIA
Cash Flow for the Month Ending March 31, 2023 PHP 200
Cash, End of Period PHP 2,200

c.2 Components of a Cash Flow Statement

It's important to note that figures enclosed in brackets denote cash deductions and can be
interpreted as negative amounts, while figures without brackets represent cash inflows.
1. Cash, Beginning of Period: This signifies the cash John had on hand at the
commencement of the month.
2. Net Income: Net income represents John's total earnings for the month. On the cash flow
statement, some or all of this income may be subtracted, depending on how much of it is
in accounts receivable (unpaid) or held in the bank (paid).
3. Additions to Cash: Additions to cash reverse expenses that are recorded on the books
but have not yet been disbursed. For instance, the Php500 listed in accounts payable
represents money John owes but has not yet paid. Similarly, the Php200 depreciation is
an accounting measure, as she has already paid this amount as part of the total asset cost
she's depreciating.
4. Subtractions from Cash: Subtractions from cash reverse transactions that were recorded
as revenue for the month but have not been physically received. In this case, it's Php1,000
in accounts receivable.
5. Net Cash from Operating Activities: John's net cash from operating activities amounts
to Php700, signifying that Php700 in cash flowed into her business during the month.
6. Cash Flow from Investing Activities: This category encompasses expenditures related
to assets like real estate, equipment, or securities. For instance, John purchased a Php500
sewing machine this month—an investment. While the books record this as a Php500
increase to her equipment account, she actually disbursed Php500 in cash, necessitating a
subtraction.

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7. Cash Flow from Financing Activities: This section lists income generated from
collecting interest on loans, credit, and other debt. It may also incorporate draws or
additional capital contributions from the business owner.
8. Cash Flow for Month Ending March 31, 2020: John's cash flow for this period
amounts to Php200, calculated by subtracting the cash spent on equipment (Php500) from
the total cash flow from operations (Php700). In total, her business received Php200 in
cash during this month.
9. Cash at End of Period: This figure stands at Php2,200, representing John's initial cash
amount plus the earnings she accumulated during the month.
c.3 Analyzing a Cash Flow Statement Using Financial Ratios
Financial ratios related to cash flow can provide valuable insights into your cash reserves
to cover debt and the portion of your monthly income that comes in the form of cash. Here are
three formulas to help you achieve this.
1. Current Liability Coverage Ratio:
 The current liability coverage ratio assesses your cash flow available for a specific
period relative to the upcoming debt payments, typically within the next year.
 To calculate this ratio, you first need to determine your average current liability, which
considers variations due to debt repayments. Here's how to find it:
 Add your current liabilities at the beginning and end of an accounting period, then
divide by 2.
 For instance, if John's balance sheet shows Php1,000 in current liabilities at the
beginning of March and Php900 at the end:
 (1,000 + 900) / 2 = 950
 Her average current liability is Php950.
 The formula for calculating the current liability coverage ratio is as follows:
 Current Liability Coverage Ratio = Net Cash from Operating Activities / Average
Current Liabilities
 For John, it would be:
 Current Liability Coverage Ratio = 200 / 950 = 0.21, or 21%
 A current liability coverage ratio below 1:1 indicates insufficient cash to meet
immediate obligations.
2. Cash Flow Coverage Ratio:
 Similar to the current liability coverage ratio, this ratio assesses your ability to settle
debts with cash. However, it considers all debt, both short and long term.

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 This ratio is typically calculated annually. John would sum up her monthly cash flow
from operations to get her yearly cash flow.
 For example, if John's monthly cash flow from operations was consistently Php700, her
total annual cash flow would be Php8,400.
 The formula is:
 Cash Flow Coverage Ratio = Net Cash Flow from Operations / Total Debt
 If John had Php1,200 in credit card debt and Php5,000 in business loan debt, her total
debt is Php6,200.
 For her, the calculation would be:
 Cash Flow Coverage Ratio = 8,400 / 6,200 = 1.35
 Generally, a cash flow coverage ratio above 1.0 is recommended to attract investors.
3. Cash Flow Margin Ratio:
 The cash flow margin ratio indicates how much cash you earned for every peso in sales
revenue during a reporting period.
 You can calculate it using this formula:
Cash Flow Margin = Net Cash from Operating Activities / Net Sales
 For instance, if John generated Php1,200 in net sales for the month of March, her cash
flow margin ratio would be:
Cash Flow Margin = 700 / 1,200 = 0.58, or 58%
 This means that for every peso in sales revenue earned in March, she retained Php0.58 in
cash."

Activity: Analyzing Financial Statements Using Excel

Objective: In this activity, you will use Microsoft Excel to create and analyze financial
statements, specifically an Income Statement and a Cash Flow Statement. You will also calculate
and interpret various financial ratios to assess the company's financial performance.
Instructions:
1. Income Statement Creation:
 Open a new Excel worksheet.
 Create a table similar to the sample Income Statement provided in the discussion.

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 Input your own data for Sales Revenue, Cost of Goods Sold (COGS), General
Expenses, and Income Tax Expense. You can use any values you like.
 Use Excel formulas to calculate Gross Profit, Operating Earnings (EBIT), and Net
Profit.
 Create a new worksheet tab and name it "Income Statement."
 TAKE NOTE: Every student must not have the same entry in the Income
Statement
2. Income Statement Analysis:
 Calculate the Gross Profit Margin, Operating Profit Margin, and Net Profit
Margin using Excel formulas.
 Interpret these ratios to assess the company's profitability.
3. Cash Flow Statement Creation:
 On a new worksheet tab, create a table for a Cash Flow Statement similar to the
sample provided in the discussion.
 Input data for Cash at the Beginning of the Period, Net Income, Additions to
Cash, Subtractions from Cash, and Cash Flow for the Month Ending.
 Calculate Cash at the End of the Period using Excel formulas.
 Create another worksheet tab and name it "Cash Flow Statement."
4. Cash Flow Statement Analysis:
 Calculate the Current Liability Coverage Ratio, Cash Flow Coverage Ratio, and
Cash Flow Margin Ratio using Excel formulas.
 Interpret these ratios to assess the company's liquidity and ability to cover its
debts.
5. Optional: Common-Size Balance Sheet
 If you want to challenge yourself further, you can create a Common-Size Balance
Sheet that presents items as both absolute values and percentages of total assets.
 Create a new worksheet tab for the Common-Size Balance Sheet and input data
for Assets, Liabilities, and Shareholders' Equity.
 Calculate the percentages for each line item and interpret the results.
6. Conclusion:
 Write a brief summary of your analysis, including any insights you gained from
calculating and interpreting the financial ratios.

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Remember to use Excel's built-in functions and formulas to perform calculations and
format your financial statements neatly. This activity will help you gain practical experience in
financial statement analysis using Excel.

Multiple-Choice Questions:

1. Which of the following financial statements provides information about a company's revenues,
expenses, and net income or loss over a specific period?
a) Balance Sheet
b) Cash Flow Statement
c) Income Statement
d) Statement of Retained Earnings

2. What is another name for the Income Statement?

a) Statement of Cash Flows
b) Balance Sheet
c) Profit and Loss Statement (P&L)
d) Statement of Stockholders' Equity

3. What term is often used to refer to the net profit figure on an Income Statement?
a) Top line
b) Middle line
c) Bottom line
d) Center line

4. Which component of an Income Statement represents the total income generated by a business
before considering any expenses?
a) Cost of Goods Sold (COGS)
b) Gross Profit
c) Sales Revenue
d) Operating Earnings (EBITDA)

5. What financial ratio reveals how much profit a business generates per peso of revenue,
considering only the Cost of Goods Sold (COGS)?
a) Gross Profit Margin
b) Operating Profit Margin
c) Net Profit Margin
d) Expense Ratio

6. If a company's Gross Profit Margin is 55%, what does this mean?

a) The company earns 55% of its revenue from interest income.
b) The company retains 55% of every peso earned as gross profit.
c) The company's expenses are 55% of its total revenue.
d) The company's net profit is 55% of its gross profit.

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7. Which financial statement presents a company's assets, liabilities, and shareholders' equity at a
specific point in time?
a) Income Statement
b) Cash Flow Statement
c) Balance Sheet
d) Statement of Retained Earnings

8. What is the fundamental balance sheet equation?

a) Assets = Liabilities
b) Assets = Shareholders' Equity
c) Liabilities = Shareholders' Equity
d) Assets = Liabilities + Shareholders' Equity

9. Which of the following is categorized as a current asset on a Balance Sheet?

a) Land
b) Accounts Receivables
c) Plant & Equipment
d) Long-term Debt

10. What category on a Balance Sheet includes the total obligations that a business owes to
external parties?
a) Assets
b) Liabilities
c) Stockholders' Equity
d) Current Assets

11. Accounts Payables is an example of which category of liabilities on a Balance Sheet?

a) Long-Term Liabilities
b) Current Liabilities
c) Shareholders' Equity
d) Long-Term Assets

12. Which financial statement outlines a company's cash inflows and outflows, categorized into
operating, investing, and financing activities?
a) Income Statement
b) Balance Sheet
c) Cash Flow Statement
d) Statement of Stockholders' Equity

13. Under which accounting method are expenses and income recorded when they are incurred,
regardless of the actual exchange of money?
a) Cash Basis Accounting
b) Accrual Basis Accounting
c) Modified Cash Basis Accounting
d) Tax Basis Accounting

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14. What does the Cash Flow Statement reconcile for transactions where cash is not instantly
available?
a) Assets and Liabilities
b) Income and Expenses
c) Revenue and Costs
d) Cash and Non-Cash Transactions

15. Which component of a Cash Flow Statement represents the cash a business had on hand at
the beginning of a specific period?
a) Net Income
b) Net Cash from Operating Activities
c) Cash, Beginning of Period
d) Cash at End of Period

16. What does the Cash Flow Coverage Ratio assess?

a) Cash available for a specific period relative to upcoming debt payments
b) Cash available for a specific period relative to total debt
c) Cash available for a specific period relative to sales revenue
d) Cash available for a specific period relative to operating expenses

17. What does the Cash Flow Margin Ratio indicate?

a) How much cash a business has on hand
b) How much cash a business earns for every peso in sales revenue
c) How much cash a business owes to external parties
d) How much cash a business spends on operating activities

18. If a company's Cash Flow Coverage Ratio is 1.35, what does this indicate?
a) The company has insufficient cash to meet immediate obligations.
b) The company has more cash available than its total debt.
c) The company is not generating enough cash to cover its debt payments.
d) The company has a healthy cash position.

19. What is the primary purpose of the common-size balance sheet?

a) To present items in both absolute and percentage terms over an extended duration.
b) To evaluate a company's performance and growth over an extended timeframe.
c) To assess a company's financial liquidity.
d) To assess a company's ability to meet long-term obligations.

20. In the Cash Flow Statement, what do figures enclosed in brackets typically denote?
a) Positive cash inflows
b) Negative cash outflows
c) Assets
d) Liabilities

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