Review of Financial Statement
Preparation, Analysis, and
Interpretation Pt.2,3,4
OBJECTIVES
The learners will be able to identify and explain the basic
steps in the accounting process (accounting cycle).
Determine the basic financial statements
Define liquidity and solve liquidity ratios (current and
quick).
Define profitability and solve profitability ratios (return
on equity, return on assets, gross profit margin, operating
profit margin, net profit margin).
WHAT IS ACCOUNTING
CYCLE?
Accounting is all about getting data and putting them into
the accounting equation, the end products are financial
statements such as a balance sheet and income statements,
the process of accounting follows a cycle called the
Accounting Cycle.
It starts with the identification of whether a transaction is
accountable or can be quantified, and ends with a post-
closing trial balance.
STEP 1: Analyze Business Transactions.
Carefully read the description of the transaction to
determine whether an asset, a liability, an owner’s equity,
a revenue, an expense, or a drawing account is affected.
For each account affected by the transaction, determine
whether the account increases or decreases.
Determine whether each increase or decrease should be
recorded as a debit or a credit, following the rules of
debit and credit.
STEP 2: Record This in the Journal.
Using the rules of debit and credit, transactions are initially entered in a
record called a Journal and the entry made is called a Journal Entry.
The journal serves as a record of when transactions occurred and were
recorded.
For repetitive transactions or high volume transactions (e.g. one thousand
sales transactions in one day), Special Journals are made. These special
journals include sales journal, purchases journal, cash receipts journal, and
cash disbursements journal.
STEP 3: Post the Transactions on a
Ledger.
A transaction is first recorded in a journal. Periodically, the journal
entries are transferred to the accounts in the ledger.
The process of transferring the debits and credits from the journal
entries to the accounts is called Posting.
Ledgers provide chronological details as to how transactions affect
individual accounts. There are two types of ledgers: the General
Ledger and Subsidiary Ledger. The general ledger is a summary of the
different Subsidiary Ledgers and can serve as a control account.
For example, a general ledger for accounts receivable summarizes the
balances found in the different subsidiary ledgers for different
customers.
J. Gaya, a CPA, is an independent auditor with only two clients.
The Accounts Receivable ledger account has a balance of
PHP100,000. His two clients are A. Rania, and X. Campos. The
subsidiary ledger of A. Rania has a balance of PHP25,000. X.
Campos’s ledger balance is PHP75,000. The sum of subsidiary
ledgers must total the general ledger or else there must be an
investigation to identify the source of discrepancies.
STEP 4: Prepare an Unadjusted Trial
Balance.
The steps in preparing a trial balance are as follows:
1. List the name of the company, the title of the trial balance, and the date the
trial balance is prepared.
2. List the accounts from the ledger and enter their debit or credit balance in
the Debit or Credit column of the trial balance.
3. Total the Debit and Credit columns of the trial balance.
4. Verify that the total of the Debit column equals the total of the Credit
column.
STEP 5: Make adjustments. Journalize
adjusting entries.
1. Some expenses are not recorded
daily.
2. Some revenues and expenses are
earned as time passes rather than as
separate transactions.
3. Some revenues and expenses may be
unrecorded.
The analysis and updating of accounts at the end of
the period before the financial statements are
prepared is called the Adjusting Process.
The journal entries that bring the accounts up to
date at the end of the accounting period are called
Adjusting Entries.
Accruals. These include unpaid salaries for the accounting
period, unpaid interest expense, or unpaid utility expenses.
Prepayments. If a company has prepaid expenses such as
prepaid rent or prepaid insurance then the correct balances
for these accounts have to be established at the end of each
accounting period to reflect their correct balances.
Depreciation and amortization expenses. Depreciation
expenses are recognized at the end of each accounting
period through adjusting entries. If there are intangible
assets such as franchise, the allocation of their costs which
is called amortization expense, is also recognized at the end
of each accounting period through adjusting entries.
Allowance for uncollectible accounts. Bad debt expense
from accounts receivable is also recognized through
adjusting entries.
STEP 6: Prepare an Adjusted Trial
Balance.
An adjusted trial balance is prepared after taking
into consideration the effects of the adjusting
entries. Again, this is to ensure that the total debit
balances equal the credit balances after posting and
journalizing adjusting entries made.
STEP 7: Prepare the financial
statements.
From the adjusted trial balance, the financial
statements can then be prepared. These are the
statement of financial position, statement of profit
or loss, and the statement of cash flows.
STEP 8: Make the closing entries.
Upon closing:
If the revenues exceed expenses during an accounting period, retained earnings will increase.
The reverse is true which means that if the expenses exceed revenues, the retained earnings
will decrease.
In closing temporary accounts:
Revenue account balances are transferred to an account called Income Summary Account
(sometimes profit or loss summary).
Expense account balances are also transferred to the Income Summary Account.
The balance of the Income Summary (net income or net loss) is transferred to the owner’s
capital account.
The balance of the owner’s drawing account is transferred to the owner’s capital account.
STEP 9: Make a Post-Closing Trial
Balance.
A Post-Closing Trial Balance shows the accounts that
are permanent or real. These are the accounts that
can be seen in your balance sheet. The post-closing
trial balance is prepared to test if the debit
balances equal the credit balances after closing
entries are considered.
BASIC FINANCIAL
STATEMENTS
A financial statement is basically a summary of all
transactions that are carefully recorded and
transformed into meaningful information. It also
shows the company’s permanent and temporary
accounts.
a. Income Statement
These are also known as the Profit/Loss Statement, Statement of Comprehensive Income, or
Statement of Income.
This is a summary of the revenue and expenses of a business entity for a specific period of time,
such as a month or a year.
b. Statement of Owner’s Equity
These are also known as the Statement of Changes in
Equity.
This reports the changes in the owner’s equity over a
period of time.
It is prepared after the income statement because the net
income or net loss for the period must be reported in this
statement.
Similarly, it is prepared before the balance sheet since the
amount of owner’s equity at the end of the period must
be reported on the balance sheet.
c. Balance Sheet
This provides information regarding the liquidity position
and capital structure of a company as of a given date.
It must be noted that the information found in this report
are only true as of a given date.
It shows a list of the assets, liabilities, and owner’s equity
of a business entity as of a specific date, usually at the
close of the last day of a month or a year.
d. Statement of Cash Flows
The statement of cash flows reports a company’s cash
inflows and outflows for a period.
This is used by managers in evaluating past operations and
in planning future investing and financing activities.
It is also used by external users such as investors and
creditors to assess a company’s profit potential and ability
to pay its debt and pay dividends.
LIQUIDITY AND
LIQUIDITY RATIOS
LIQUIDITY
Liquidity refers to the company’s ability to
satisfy its short-term obligations as they
come due. Refer back to the household
example to emphasize the meaning of
liquidity.
Types of Liquidity
Current Ratio is the simplest and least strict. It
measures current assets(those that can reasonably be
converted to cash in one year) against current liabilities.
Quick Ratio is slightly more strict. It excludes
inventories and other current assets, which are not as
liquid as cash and cash equivalents, accounts receivable,
and short-term investments.
Practice:
Current assets is PHP2,000, current liabilities is PHP3,500. What is current
ratio?
Inventory is PHP150. Accounts payable is PHP450. Cash and accounts
receivable total PHP800. What is the current ratio? Quick ratio?
If current ratio is 1.7, what is the total accounts receivable if cash is
PHP20,000, inventory is PHP7,500, and accounts payable is PHP30,000.
Cash is 30% of total current assets. If current ratio is 2.3, what is the new
current ratio if total non-cash current assets grow by 50%?
PROFITABILITY AND
PROFITABILITY RATIOS
Profitability refers to the company’s
ability to generate earnings. It is one of
the most important goals of businesses
Profitability Ratios
Return On Equity
Return On Assets
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Return on equity measures the amount of net income earned
in relation to stockholders’ equity.
ROE (return on equity) = Net income ÷ Stockholders’ equity
Return on assets measures the ability of a company to
generate income out of its resources/assets.
ROA (return on asset) = Operating income ÷ Total assets
Gross profit margin shows how many pesos of gross profit is
earned for every peso of sale. It provides information
regarding the ability of a company to cover its manufacturing
cost from its sales. Remember that gross profit is just sales
less cost of goods or cost of services.
Gross profit margin = Gross profit ÷ Sales
Operating profit margin shows how many pesos of
operating profit is earned for every peso of sale. It
measures the amount of income generated from the core
business of a company.
Operating profit margin =Operating income ÷ Sales
Net profit margin measures how much net profit a
company generates for every peso of sales or revenues
that it generates.
Net profit margin = Net income ÷ Sales
Find the:
Return On Equity
Return On Assets
Gross Profit Margin
Operating Profit
Margin
Net Profit Margin
WHY DO WE NEED TO LEARN HOW TO
COMPUTE THESE RATIOS AND FORMULA?
