Comprehensive Study Notes: Financial Position, SCI, SCE, SCF, and Ratios (ABM-focused)

Statement of Financial Position (Balance Sheet)

• Reports a company's assets, liabilities, and shareholders' equity at a specific point in time; provides a snapshot of what the company owns and owes, and the shareholders’ investment (Hayes, 2020).

• Core equation (basic accounting identity):

  $\text{Assets} = \text{Liabilities} + \text{Owner's Equity}$

• Integrity: In all formats, Assets must equal Liabilities plus Equity (the accounting equation).

Classification of Accounts

• Assets: Resources controlled by the entity from past events with future benefits expected to flow to the entity.

  • Current Assets (realizable within one year):

    • Examples: Cash and Cash Equivalents, short-term investments, Accounts Receivable, Notes Receivable, Merchandise Inventories, Supplies, Prepaid Expenses.

  • Non-Current Assets (not realizable within one year):

    • Examples: Properties, Plant, and Equipment (land, buildings, equipment, furniture, delivery vehicles, etc.), Long-Term Investments, Intangible Assets (trademarks, patents, copyrights).

• Liabilities: Obligations arising from past transactions/events; settlement results in an outflow of resources.

  • Current Liabilities (due within one year):

    • Examples: Accounts Payable, Notes Payable, Accrued Expenses (e.g., Utilities Payable), Unearned Income.

  • Non-current Liabilities (due after one year):

    • Examples: Loans Payable (long-term portions), Mortgage Payable.

• Capital/Owner’s Equity: Represents owner’s investment minus withdrawals plus net income (or minus net loss) since business began; viewed as a residual claim on assets.

  • Naming conventions by business form:

    • Sole Proprietorship: Owner’s Equity

    • Partnership: Partner’s Equity

    • Corporation: Stockholders’ or Shareholder’s Equity

Formats: Report Form vs. Account Form

• Report Form (vertical layout): assets first, then liabilities, then equity; totals line at end of each section; assets balance with liabilities plus equity.

• Account Form (two-column layout): assets on left, liabilities and equity on the right (like the debit/credit balance presentation of accounts).

Structure Example (Summary)

• ASSETS

  • Current Assets: Cash, Accounts Receivable (net of Allowance for Doubtful Accounts), Accrued Income, Inventory, Prepaid Expenses, etc.

  • Non-current Assets: Long-Term Investments, Intangible Assets, Property, Plant and Equipment (Cost minus Accumulated Depreciation).

  • TOTAL ASSETS

• LIABILITIES AND EQUITY

  • Current Liabilities: Accounts Payable, Accrued Expenses, Unearned Income, Notes Payable.

  • Non-current Liabilities: Mortgage Payable, Loans Payable.

  • Equity: Owner/ABMer Equity (or equivalent).

  • TOTAL LIABILITIES AND EQUITY

Formatting Cues

• Single rule used for operations (addition/subtraction).

• Double rule used to denote totals (end of asset side and end of liabilities/equity side).

Practical Notes

• SFP provides the ending balances for the asset, liability, and equity accounts as of a point in time.

• In bankruptcy, liabilities are paid first; hence the importance of understanding assets, liquidity, and gearing.

• The SFP can be presented in either format; both yield the same totals and the same accounting equation must balance.

Statement of Changes in Equity (SCE)

• Purpose: To show changes in the owner's or owners’ equity during a period (usually a year). Prepared before the SFP to obtain ending equity for the SFP.

SCE by Business Organization Type

• Sole Proprietorship (SCE):

  • Beginning Capital

  • Add: Additional Investment (owner’s contributions)

  • Net Income (or minus Net Loss)

  • Less: Drawings (withdrawals)

  • Ending Capital

• Partnership (SCE):

  • Beginning Capital accounts for each partner (e.g., Partner A, Partner B, Partner C)

  • Add: Net Income, Partners’ Contributions

  • Less: Drawings

  • Ending Balances per partner and total

• Corporation (SCE):

  • Equity sections: Paid-In Capital (Capital Stock, Additional Paid-In Capital), Retained Earnings, Total Equity

  • Dividends (distributions) reduce retained earnings; new stock issues increase paid-in capital.

Relationship to Other Statements

• SCE connects to the SFP by providing the ending equity figure used in the Liabilities & Equity side.

• Note: Dividends in corporations are a distribution to owners; drawings in sole proprietorship/partnership are withdrawals by owners.

Statement of Comprehensive Income (SCI) / Income Statement

• Definition and purpose: Reports the results of operations for a period, including components of profit or loss and other comprehensive income (OCI). Also known as the Income Statement; shows net income (positive) or net loss (negative) for the period.

Key Components/Elements

1. Title/Heading: Must identify entity, statement, and period; e.g., ABM Service Company – Statement of Comprehensive Income – For the Year Ended mm/dd/yyyy.

2. Revenue: Gross inflows from ordinary operating activities; can include sales, services, interest, royalties, dividends; varies by entity (e.g., service vs merchandising).

3. Expenses: Decreases in economic benefits during the period; includes cost of sales, wages, depreciation, etc.; includes losses; match with revenues.

4. Gains and Losses: Other items that meet the definition of income/expenses and may arise in ordinary activities or otherwise.

5. Other Items: Income taxes and other comprehensive income items.

SCI Formats by Business Type

• For Service Business (Single-Step SCI):

  • Revenues listed in a single section; expenses listed in another; Net Income = Total Revenues − Total Expenses.

  • Example structure:

    • Service Revenue Php x,xxx,xxx.xx

    • Expenses: Salaries Expense, Rent Expense, Depreciation Expense, Utility Expense, Miscellaneous Expense

    • Total Expenses

    • Net Income Php x,xxx,xxx.xx

  • Note: This approach is commonly used by service companies.

• For Merchandising Business (Multi-Step SCI):

  • Distinguishes between Gross Profit, Operating Expenses, and Net Income; more detailed steps.

  • Key flow:

    • Sales (and contra-revenues: Sales Returns, Sales Discounts) → Net Sales

    • Cost of Goods Sold (COGS) calculation: Beginning Inventory + Net Cost of Purchases − Ending Inventory

    • Gross Profit = Net Sales − COGS

    • Selling Expenses (Salaries, Rent, Depreciation, Utilities, etc.)

    • General and Administrative Expenses (Salaries, Rent, Depreciation, Utilities, Miscellaneous, etc.)

    • Net Income = Gross Profit − (Selling Expenses + G&A Expenses)

  • Important notes:

    • Contra revenues include Sales Returns and Sales Discounts, which reduce gross sales to Net Sales.

    • Freight-In is added to purchases to compute Net Cost of Purchases; freight-out is a selling expense and not included in COGS.

Statement of Cash Flows (SCF)

• Purpose: Tracks changes in cash and cash equivalents; shows cash receipts and payments categorized into operating, investing, and financing activities; reconciles beginning and ending cash.

Three Sections of SCF

• Operating Activities: Cash receipts from customers and cash payments to suppliers/employees; direct method shows gross receipts/payments; indirect method starts with net income and adjusts for non-cash items and changes in working capital.

• Investing Activities: Cash flows from buying/selling long-term assets (property, plant and equipment, intangible assets) and other investments.

• Financing Activities: Cash flows from transactions with owners and lenders (issuance/repayment of debt, issuance of stock, dividends, withdrawals by owners).

Direct vs. Indirect Method

• Direct Method: Presents major cash receipts/payments.

• Indirect Method: Adjusts accrual-based net income to cash from operations.

Relationship to SFP

• The ending cash in the SCF aligns with the cash balance on the SFP.

Financial Statement Analyses

Types of Analysis

• Vertical Analysis (Common-Size): Expresses each item as a percentage of a base amount (e.g., Total Assets for SFP; Net Sales for SCI).

• Horizontal Analysis (Trend Analysis): Compares figures across periods (e.g., 2022 vs 2021) to identify growth rates and trends; uses peso changes and percentage changes.

• Purposes of analysis: Assess liquidity, solvency, profitability; identify trends; compare across periods or with industry benchmarks; support decision-making.

Key Ratios

• Liquidity Analysis: Ability to meet short-term obligations.

  • Working Capital: $\text{Current Assets} - \text{Current Liabilities}$

    • Positive indicates ability to meet short-term obligations; negative suggests potential liquidity risk.

  • Current Ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$

    • >1 indicates healthy liquidity; <1 signals potential liquidity issues; industry norms vary.

  • Acid-Test (Quick) Ratio: $\frac{\text{Cash + Marketable Securities + Accounts Receivable}}{\text{Current Liabilities}}$

    • Stricter measure of immediate liquidity, excluding less liquid current assets (inventory, prepaid expenses).

  • Accounts Receivable Turnover: $\frac{\text{Net Sales}}{\text{Average Accounts Receivable}}$

    • Higher turnover indicates faster collection and better liquidity; very low turnover may indicate collection issues or bad debt risk.

  • Average Collection Period: $\frac{365}{\text{Accounts Receivable Turnover}}$

    • Fewer days to collect means shorter cash conversion cycle.

  • Inventory Turnover: $\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

    • Higher turnover indicates fast-moving inventory; very high turnover could indicate stockouts; very low turnover signals overstocking.

  • Average Days in Inventory: $\frac{365}{\text{Inventory Turnover}}$

  • Number of Days in Operating Cycle: $\text{Average Collection Period} + \text{Average Days in Inventory}$

    • Shorter cycle means faster cash conversion and better liquidity.

• Solvency/Stability Analysis: Ability to meet long-term obligations; evaluates debt levels and leverage.

  • Debt to Total Assets (Debt Ratio): $\frac{\text{Total Liabilities}}{\text{Total Assets}}$

    • Higher values imply higher leverage and risk; values below 1 indicate assets exceed liabilities.

  • Debt to Equity: $\frac{\text{Total Liabilities}}{\text{Total Equity}}$

    • Higher values indicate greater reliance on debt financing; lower values imply more equity financing.

  • Times Interest Earned (TIE): $\frac{\text{EBIT}}{\text{Interest Expense}}$

    • Indicates ability to cover interest obligations; higher is better.

• Profitability Analysis: Ability to generate earnings from sales and assets.

  • Gross Profit Ratio: $\frac{\text{Gross Profit}}{\text{Net Sales}}$

  • Profit Margin: $\frac{\text{Net Income}}{\text{Net Sales}}$

  • Operating Expenses to Sales: $\frac{\text{Operating Expenses}}{\text{Net Sales}}$

  • ROI (Return on Investment): $\frac{\text{Net Profit}}{\text{Investment Cost}}$

  • ROA (Return on Assets): $\frac{\text{Net Income}}{\text{Average Total Assets}}$

  • ROE (Return on Equity): $\frac{\text{Net Income}}{\text{Average Shareholders' Equity}}$

  • Asset Turnover: $\frac{\text{Net Sales}}{\text{Average Total Assets}}$

Quick Reference: Selected Formulas

• Balance Sheet identity:
  $\text{Assets} = \text{Liabilities} + \text{Equity}$

• Current Ratio:
  $\text{Current Ratio} = \dfrac{\text{Current Assets}}{\text{Current Liabilities}}$

• Quick Ratio:
  $\text{Quick Ratio} = \dfrac{\text{Cash + Marketable Securities + Accounts Receivable}}{\text{Current Liabilities}}$

• Accounts Receivable Turnover:
  $\text{AR Turnover} = \dfrac{\text{Net Sales}}{\text{Average Accounts Receivable}}$

• Average Collection Period:
  $\text{Average Collection Period} = \dfrac{365}{\text{Accounts Receivable Turnover}}$

• Inventory Turnover:
  $\text{Inventory Turnover} = \dfrac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

• Average Days in Inventory:
  $\text{Average Days in Inventory} = \dfrac{365}{\text{Inventory Turnover}}$

• Operating Cycle:
  $\text{Operating Cycle} = \text{Average Collection Period} + \text{Average Days in Inventory}$

• Debt to Total Assets:
  $\text{Debt to Assets} = \dfrac{\text{Total Liabilities}}{\text{Total Assets}}$

• Debt to Equity:
  $\text{Debt to Equity} = \dfrac{\text{Total Liabilities}}{\text{Total Equity}}$

• Times Interest Earned (TIE):
  $\text{TIE} = \dfrac{\text{EBIT}}{\text{Interest Expense}}$

• Gross Profit Ratio:
  $\text{GP Ratio} = \dfrac{\text{Gross Profit}}{\text{Net Sales}}$

• Profit Margin:
  $\text{Profit Margin} = \dfrac{\text{Net Income}}{\text{Net Sales}}$

• Operating Expenses to Sales:
  $\text{Operating Expenses to Sales} = \dfrac{\text{Operating Expenses}}{\text{Net Sales}}$

• Return on Assets (ROA):
  $\text{ROA} = \dfrac{\text{Net Income}}{\text{Average Total Assets}}$

• Return on Equity (ROE):
  $\text{ROE} = \dfrac{\text{Net Income}}{\text{Average Shareholders' Equity}}$

• Asset Turnover:
  $\text{Asset Turnover} = \dfrac{\text{Net Sales}}{\text{Average Total Assets}}$

• Net Sales (revenue in SCI):
  $\text{Net Sales} = \text{Sales} - \text{Sales Returns} - \text{Sales Discounts}$

• Cost of Goods Sold (COGS) – Merchandising:
  $\text{COGS} = \text{Beginning Inventory} + \text{Net Purchases} + \text{Freight-In} - \text{Ending Inventory}$

• Net Purchases (Merchandising):
  $\text{Net Purchases} = \text{Purchases} - \text{Purchases Discounts} - \text{Purchases Returns and Allowances}$

• Net Cost of Purchases:
  $\text{Net Cost of Purchases} = \text{Net Purchases} + \text{Freight-In}$

Notes for Exam Preparation

• The SFP is a snapshot as of a specific date; the SCI and SCF cover a period (e.g., year).

• Understand the differences between current and non-current classifications, and why liquidity matters for creditors.

• Be able to convert between formats (Report Form vs Account Form) and explain why both yield the same totals.

• Be able to prepare a basic SCI (single-step) for a service business and a multi-step SCI for a merchandising business, including calculations for net sales, COGS, gross profit, and net income.

• Be able to prepare a basic SCE for sole proprietorships, partnerships, and corporations, and explain how owner contributions, drawings, and retained earnings affect equity.

• Practice calculating key liquidity, solvency, and profitability ratios using given year-end figures, and interpret whether the company has stronger liquidity, solvency, or profitability in the current period.

• Understand vertical analysis (percent of base) and horizontal analysis (growth rates) and their use in comparing firms and track performance over time.