COMPETENCY BASED LEARNING MATERIAL

Sector : Health, Social and Other Community

Development Service

Qualification Title : BOOKKEEPING NC III

Unit of Competency : Prepare Financial Reports

Module Title : Preparing Financial Reports

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 ST. NICHOLE’S TECHNICAL SCHOOL, INC.

BOOKKEEPING NC III
COMPETENCY-BASED LEARNING MATERIALS

List of Competencies

No. Unit of Competency Module Title Code

Journalize Journalizing HCS412301

1.
transactions transactions

HCS412302
2. Post transactions Posting transactions

HCS412303
3. Prepare trial balance Preparing trial balance

Prepare financial Preparing financial

HCS412304
4.
reports reports

Review internal control Reviewing internal

HCS412305
5.
system control system

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 MODULE CONTENT

UNIT OF COMPETENCY PREPARE FINANCIAL REPORTS

MODULE TITLE PREPARING FINANCIAL REPORTS FOR

SINGLE PROPRIETORSHIP

MODULE DESCRIPTOR: This module covers the knowledge, skills, and

attitudes in preparing financial reports manually for Single
Proprietorship.

NOMINAL DURATION: 24 hours

LEARNING OUTCOMES:
At the end of this module you MUST be able to:
1. Prepare financial statements
2. Analyze financial statements

ASSESSMENT CRITERIA:
1. Income statement is prepared in accordance with generally accepted
accounting principles/Philippine Financial Reporting
Standards/Philippine Financial Reporting Standards
2. Statement of Changes in Equity is prepared in accordance with
generally accepted accounting principles/Philippine Financial
Reporting Standards/Philippine Financial Reporting Standards
3. Balance Sheet is prepared in accordance with generally accepted
accounting principles/Philippine Financial Reporting
Standards/Philippine Financial Reporting Standards

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 4. Statement of Cash Flow is prepared in accordance with generally
accepted accounting principles/Philippine Financial Reporting
Standards/Philippine Financial Reporting Standards
5. Financial Statements are analyzed in accordance with prescribed
format.
6. Report on financial analysis is prepared in accordance with industry
requirements.

LEARNING OUTCOME NO. 1

Prepare financial statements
Contents:

1. Financial Statements for Single Proprietorship

Assessment Criteria

1. Income statement is prepared in accordance with generally accepted

accounting principles/Philippine Financial Reporting
Standards/Philippine Financial Reporting Standards
2. Statement of Changes in Equity is prepared in accordance with
generally accepted accounting principles/Philippine Financial
Reporting Standards/Philippine Financial Reporting Standards
3. Balance Sheet is prepared in accordance with generally accepted
accounting principles/Philippine Financial Reporting
Standards/Philippine Financial Reporting Standards
4. Statement of Cash Flow is prepared in accordance with generally
accepted accounting principles/Philippine Financial Reporting
Standards/Philippine Financial Reporting Standards

Conditions

The participants will have access to:

1. Calculator
2. Paper
3. Learning Materials
4. Pencil
5. Eraser
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 6. Ruler
7. Worksheet
Assessment Method:

1. Written test
2. Practical/performance test

Learning Experiences
Learning Outcome 1

PREPARE FINANCIAL STATEMENTS

Learning Activities Special Instructions

Read Information Sheet 4.1-1
Internal Control Fundamentals
Answer Self-check 4.1-1
Compare and check the answers You must answer all questions
with the answer keys in correctly before proceeding to the
information sheet 4.1-1
Read and understand the
Information Sheets and check
yourself by answering the Self-check.
next activity.
Perform the Task Sheet and Job
Sheet to help you practice your
skills.
You may refer to the Information
Sheets to determine if you are doing
the right procedures.
The Performance Criteria Checklist
will guide you and help you evaluate
your work as you are practicing your
skill.
Evaluate your own work using the
Performance Criteria. When you are
ready, present your work to your
trainer for final evaluation and

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 recording.
If you have questions about the Task
Sheet and Job Sheet, please ask your
trainer.
After doing all activities of this

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 INFORMATION SHEET 4.1-1
The Income Statement
The income statement is one of the major financial statements used by accountants and business
owners. (The other major financial statements are the balance sheet, statement of cash flows, and
the statement of stockholders' equity.) The income statement is sometimes referred to as the profit
and loss statement (P&L), statement of operations, or statement of income. We will use income
statement and profit and loss statement throughout this explanation.
The income statement is important because it shows the profitability of a company during the
time interval specified in its heading. The period of time that the statement covers is chosen by
the business and will vary. For example, the heading may state:
"For the Three Months Ended December 31, 2018" (The period of October 1 through December 31,
2018.)
"The Four Weeks Ended December 27, 2018" (The period of November 29 through December 27,
2018.)
"The Fiscal Year Ended June 30, 2018" (The period of July 1, 2017 through June 30, 2018.)
Keep in mind that the income statement shows revenues, expenses, gains, and losses; it does
not show cash receipts (money you receive) nor cash disbursements (money you pay out).

People pay attention to the profitability of a company for many reasons. For example, if a
company was not able to operate profitably—the bottom line of the income statement indicates
a net loss—a banker/lender/creditor may be hesitant to extend additional credit to the company.
On the other hand, a company that has operated profitably—the bottom line of the income
statement indicates a net income—demonstrated its ability to use borrowed and invested funds in
a successful manner. A company's ability to operate profitably is important to current lenders and
investors, potential lenders and investors, company management, competitors, government
agencies, labor unions, and others.
The format of the income statement or the profit and loss statement will vary according to the
complexity of the business activities. However, most companies will have the following elements
in their income statements:

A. Revenues and Gains

1. Revenues from primary activities
2. Revenues or income from secondary activities
3. Gains (e.g., gain on the sale of long-term assets, gain on lawsuits)
B. Expenses and Losses
1. Expenses involved in primary activities
2. Expenses from secondary activities
3. Losses (e.g., loss on the sale of long-term assets, loss on lawsuits)
If the net amount of revenues and gains minus expenses and losses is positive, the bottom line
of the profit and loss statement is labeled as net income. If the net amount (or bottom line) is
negative, there is a net loss.

A. Revenues and Gains

1. Revenues from primary activities are often referred to as operating revenues. The primary
activities of a retailer are purchasing merchandise and selling the merchandise. The primary
activities of a manufacturer are producing the products and selling them. For retailers,
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manufacturers, wholesalers, and distributors the revenues resulting from their primary activities
are referred to as sales revenues or sales. The primary activities of a company that provides
services involve acquiring expertise and selling that expertise to clients. For companies providing
services, the revenues from their primary services are referred to as service revenues or fees
earned. (Some people use the word income interchangeably with revenues.)
It's critical that you don't confuse revenues with receipts. Under the accrual basis of
accounting, service revenues and sales revenues are shown at the top of the income statement in
the period they are earned or delivered, not in the period when the cash is collected. Put
simply, revenues occur when money is earned, receipts occur when cash is received.
For example, if a retailer gives customers 30 days to pay, revenues occur (and are reported)
when the merchandise is sold to the buyer, not when the cash is received 30 days later. If
merchandise is sold in December, the sale is reported on the December income statement.
When the retailer receives the check in January for the December sale, the retailer has a
January receipt—not January revenues.
Similarly, if a consulting company asks clients to pay within 30 days of receiving their service,
revenues occur (and are reported) when the service is performed (earned), not 30 days later
when the consulting company receives the cash from the client.
If an attorney requires a client to prepay $1,000 before beginning to research the client's case,
the attorney has a receipt, but does not have revenues until some of the research is done.
If a company sells an item to a buyer who immediately pays for it with cash, the company has
both a receipt and revenues for that day—it has a cash receipt because it received cash; it has
sales revenues because it sold merchandise.
By knowing the difference between receipts and revenues, we make certain that revenues from a
transaction are reported only once—when the primary activities have been completed (and not
necessarily when the cash is collected).

Let's reinforce the distinction between revenues and receipts with a few more examples. (Keep in
mind that all of the examples below assume the accrual basis of accounting.)

 A company borrows $10,000 from its bank by signing a promissory note due in 90 days.
The company will have a receipt of $10,000 at the time of the loan, but it does not have
revenues because it did not earn the money from performing a service or from a sale of
merchandise.
 If a company provided a $1,000 service on January 31 and gave the customer until
March 10 to pay for the service, the company's January income statement will show
revenues of $1,000. When the money is actually received in March, the March income
statement will not show revenues for this transaction. (In March the company will report a
receipt of cash and a reduction/collection of an accounts receivable.)
 A company performs a $400 service on December 31 and receives the $400 on the very
same day (December 31). This company will report $400 in revenues on December 31—
not because the company had a cash receipt on December 31, but because the service
was performed (earned) on that day.
 On December 10, a new client asks your consulting company to provide a $2,500 service
in January. You are uncertain as to whether or not this client is credit worthy, so to be on
the safe side you ask for an immediate partial payment of $1,000 before you agree to
schedule the work for January. Although your consulting company has a receipt of
$1,000 in December, it does not have revenues in December. (In December your
company will record a liability of $1,000.) Your consulting company will report the $1,000
of revenues when it performs $1,000 of services in January.

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2. Revenues from secondary activities are often referred to as nonoperating revenues. These are
the amounts a business earns outside of purchasing and selling goods and services. For
example, when a retail business earns interest on some of its idle cash, or earns rent from some
vacant space, these revenues result from an activity outside of buying and selling merchandise.
As a result the revenues are reported on the income statement separate from its primary activity
of sales or service revenues.
As is true with operating revenues, nonoperating revenues are reported on the profit and loss
statement during the period when they are earned, not when the cash is collected.

3. Gains such as the gain on the sale of long-term assets, or lawsuits result from a transaction
that is outside of the primary activities of most businesses. A gain is reported on the income
statement as the net of two amounts: the proceeds received from the sale of a long-term asset
minus the amount listed for that item on the company's books (book value). A gain occurs when
the proceeds are more than the book value.
Consider this example: Assume that a clothing retailer decides to dispose of the company's car
and sells it for $6,000. The $6,000 received for the car (the proceeds from the disposal of the car)
will not be included with sales revenues since the account Sales is used only for the sale
of merchandise. Since this retailer is not in the business of buying and selling cars, the sale of the
car is outside of the retailer's primary activities. Over the years, the cost of the car was being
depreciated on the company's accounting records and as a result, the money received for the car
($6,000) was greater than the net amount shown for the car on the accounting records ($3,500).
This means that the company must report a gain equal to the amount of the difference—in this
case, the gain is reported as $2,500. This gain should not be reported as sales revenues, nor
should it be shown as part of the merchandiser's primary activities. Instead, the gain will appear
in a section on the income statement labeled as "nonoperating gains" or "other income". The
gain is reported in the period when the disposal occurred.

Single-Step Income Statement

A single-step income statement is one of two commonly used formats for the income statement or
profit and loss statement. The single-step format uses only one subtraction to arrive at net
income.

An extremely condensed income statement in the single-step format would look like this:

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The heading of the income statement conveys critical information. The name of the company
appears first, followed by the title "Income Statement." The third line tells the reader the time
interval reported on the profit and loss statement. Since income statements can be prepared for
any period of time, you must inform the reader of the precise period of time being covered. (For
example, an income statement may cover any one of the following time periods: Year Ended
May 31, Five Months Ended May 31, Quarter Ended May 31, Month Ended May 31, or Five
Weeks Ended May 31.)
A sample income statement in the single-step format would look like this:

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 INFO SHEET 4.1-2
The Statement of Changes in Equity and the Statement of Cash Flows
The statement of stockholders' (or shareholders') equity lists the changes in stockholders' equity
for the same period as the income statement and the cash flow statement. The changes will
include items such as net income, other comprehensive income, dividends, the repurchase of
common stock, and the exercise of stock options.
The official name for the cash flow statement is the statement of cash flows. We will use both
names throughout AccountingCoach.com.

The statement of cash flows is one of the main financial statements. (The other financial
statements are the balance sheet, income statement, and statement of stockholders' equity.)

The cash flow statement reports the cash generated and used during the time interval specified in
its heading. The period of time that the statement covers is chosen by the company. For
example, the heading may state "For the Three Months Ended December 31, 2018" or "The
Fiscal Year Ended September 30, 2018".
The cash flow statement organizes and reports the cash generated and used in the following
categories:

Confused? Send Feedback

What Can The Statement of Cash

Flows Tell Us?
Because the income statement is prepared under the accrual basis of accounting, the revenues
reported may not have been collected. Similarly, the expenses reported on the income statement
might not have been paid. You could review the balance sheet changes to determine the facts,
but the cash flow statement already has integrated all that information. As a result, savvy
business people and investors utilize this important financial statement.
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Here are a few ways the statement of cash flows is used.

1. The cash from operating activities is compared to the company's net income. If the cash
from operating activities is consistently greater than the net income, the company's net
income or earnings are said to be of a "high quality". If the cash from operating activities
is less than net income, a red flag is raised as to why the reported net income is not
turning into cash.
2. Some investors believe that "cash is king". The cash flow statement identifies the cash
that is flowing in and out of the company. If a company is consistently generating more
cash than it is using, the company will be able to increase its dividend, buy back some of
its stock, reduce debt, or acquire another company. All of these are perceived to be good
for stockholder value.
3. Some financial models are based upon cash flow.
Based on what you learned, you can make the following general assumptions:

 When an asset (other than cash) increases, the Cash account decreases.

 When an asset (other than cash) decreases, the Cash account increases.
 When a liability increases, the Cash account increases.
 When a liability decreases, the Cash account decreases.
 When owner's equity increases, the Cash account increases.
 When owner's equity decreases, the Cash account decreases.

Where To Enter The Balance Sheet

Changes
Take a look at the summary below—it shows where the changes in balance sheet accounts
should be entered on your statement of cash flows:

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 SELF-CHECK 4.1-1

Multiple Choice: Choose the most correct answer. Show your work where appropriate.
1. The correct order to present current assets is
A) cash, accounts receivable, prepaid items, inventories.

B) cash, accounts receivable, inventories, prepaid items.

C) cash, inventories, accounts receivable, prepaid items.

D) cash, inventories, prepaid items, accounts receivable.

2. The stockholders' equity section is usually divided into what three parts?
A) Preferred stock, common stock, treasury stock

B) Preferred stock, common stock, retained earnings

C) Capital stock, additional paid-in capital, retained earnings

D) Capital stock, appropriated retained earnings, unappropriated retained earnings

3. The financial statement which summarizes operating, investing, and financing activities of an entity for a period of time is the
A) retained earnings statement.

B) income statement.

C) statement of cash flows.

D) statement of financial position.

4. Making and collecting loans and disposing of property, plant, and equipment are
A) operating activities.

B) investing activities.

C) financing activities.

D) liquidity activities.

5. In preparing a statement of cash flows, cash flows from operating activities

A) are always equal to accrual accounting income.

B) are calculated as the difference between revenues and expenses.

C) can be calculated by appropriately adding to or deducting from net income those items in the income statement that do not
affect cash.
D) can be calculated by appropriately adding to or deducting from net income those items in the income statement that do affect
cash.

6. Which of the following balance sheet classifications would normally require the greatest amount of supplementary disclosure?
A) Current assets

B) Current liabilities

C) Plant assets

D) Long-term liabilities

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 7. The following trial balance of Reese Corp. at December 31, 2012 has been properly adjusted except for the income tax expense
adjustment.

Other financial data for the year ended December 31, 2012:
• Included in accounts receivable is $1,200,000 due from a customer and payable in quarterly installments of
$150,000. The last payment is due December 29, 2014.
• The balance in the Deferred Income Tax Liability account pertains to a temporary difference that arose in a prior
year, of which $20,000 is classified as a current liability.
• During the year, estimated tax payments of $525,000 were charged to income tax expense. The current and
future tax rate on all types of income is 30%.

In Reese's December 31, 2012 balance sheet, the current assets total is
A) $6,280,000.

B) $5,755,000.

C) $5,605,000.

D) $5,155,000.

8. Which of the following is not an acceptable major asset classification?

A) Current assets
B) Long-term investments
C) Property, plant, and equipment
D) Deferred charges

9. Lohmeyer Corporation reports:

Cash provided by operating activities $220,000
Cash used by investing activities 110,000
Cash provided by financing activities 140,000
Beginning cash balance 70,000

What is Lohmeyer's ending cash balance?

A) $250,000.

B) $320,000.

C) $470,000.

D) $540,000.

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10. Which of the following is a limitation of the balance sheet?
A) Many items that are of financial value are omitted.

B) Judgments and estimates are used.

C) Current fair value is not reported.

D) All of these

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 ANSWER KEY 4.1-1
1. B
2. C
3. C
4. B
5. C
6. D
7. D
8. D
9. B
10. D

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LEARNING OUTCOME NO. 2
Analyze financial statements
Contents:

1. Financial analysis
Assessment Criteria

1. Financial Statements are analyzed in accordance with prescribed

format.
2. Report on financial analysis is prepared in accordance with industry
requirements.

Conditions

The participants will have access to:

1. Calculator
2. Paper
3. Learning Materials
4. Pencil
5. Eraser
6. Ruler
7. Worksheet
Assessment Method:

1. Written test
2. Practical/performance test

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 Learning Experiences
Learning Outcome 2

ANALYZE FINANCIAL STATEMENTS

Learning Activities Special Instructions

Read Information Sheet 4.1-1
Internal Control Fundamentals
Answer Self-check 4.1-1
Compare and check the answers You must answer all questions
with the answer keys in correctly before proceeding to the
information sheet 4.1-1
Read and understand the
Information Sheets and check
yourself by answering the Self-check.
next activity.
Perform the Task Sheet and Job
Sheet to help you practice your
skills.
You may refer to the Information
Sheets to determine if you are doing
the right procedures.
The Performance Criteria Checklist
will guide you and help you evaluate
your work as you are practicing your
skill.
Evaluate your own work using the
Performance Criteria. When you are
ready, present your work to your
trainer for final evaluation and
recording.
If you have questions about the Task
Sheet and Job Sheet, please ask your
trainer.
After doing all activities of this
Leaning Outcome, you are ready to
proceed to Preparing internal policy
compliance report.

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 INFO SHEET 4.2-1
Analyizing Financial Statements
How to Analyze a Financial Statement
There are a couple of steps, and a caution to observe, when you analyze financial statements.
And after you've done an analysis you still have to interpret the meaning of your analysis, and
the significance of your analysis. First, the caution...

Several ratios use an average. When an average is used it is a simple average. In all these
ratios you will take the balance in an account at the start and end of year, add them together
and divide by 2. That's a simple average. For instance, the Receivable Turnover Rate is:

    Net Sales    
Average Accounts Receivable

Average accounts receivable is:

AR start of year balance + AR end of year balance

2

Some people calculate these using the end of year balance, rather than an average. The
textbook shows one possible set of formulae. If you search the Internet you will find many other
formulae that can be used to evaluate financial information.

Steps to Financial Statement Analysis

All financial ratios and measures use information from the balance sheet and/or income
statement. Many of the use either an average, discussed above, or a significant subtotal, such as
current assets, quick assets or current liabilities. You should be able to identify and calculate
these amounts before beginning.

Current Assets
Current assets are those that will be available to conduct business and pay bills in the near
future, within the coming year. Long term assets are those that will benefit the company beyond
the current year. In a classified balance sheet, the current assets will be subtotaled already.

Current assets consist of:

 Cash
 Accounts Receivable
 Notes Receivable

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  Short Term Investments
 Inventory
 Prepaid Expenses

Quick Assets are used to calculate the Quick Ratio. Cash, Accounts and Notes Receivable,
and Short Term Investments are quick assets.

Current Liabilities
Current liabilities are those that will come due within the next year. They are matched to current
assets, because the money generated from current assets will pay the current liabilities.

Current liabilities consist of:

 Current portion of Notes Payable

 Accounts Payable
 Accrued Expenses Payable (taxes, interest, payroll)
 Unearned Revenue

In order to calculate ratios you should be able to identify the current and quick assets, and
current liabilities in any balance sheet.

Measures of Liquidity
Liquidity refers to how quickly a company can turn its assets into cash, and its ability to pay it's
current debts on time. Highly liquid assets can be turned into cash very quickly. Some of these
are called cash equivalents, because they are very liquid. For instance, a US Treasury bill or
note can be converted into cash immediately at almost any bank, so it is considered equivalent
to cash.

Other assets can be turned into cash, but more slowly. The company expects to collect its
accounts and notes receivable, but that may take 30-60 days, or longer. Inventory takes even
longer to turn into money. It could take six months or more to convert inventory into cash,
depending on the type of merchandise. Automobiles and jewelry sell slower than eggs and milk.

Inventory Turnover Rate

Turnover refers to how often a sales or collection cycle happens in a given year. Let's think
about grocery store inventory for a minute. Milk spoils quickly and a grocery store will only stock
enough milk to meet its demand for a short period of time, perhaps one week. If they store sells
its entire stock of milk each week, we would say that their milk inventory turns over 52 times
each year. The number of days sales in inventory for milk would be 7. Let's recap:

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Milk inventory:
Turnover = 52 times
Days in Inventory = 7 days

A company may analyze a single product, like milk, because they have detailed inventory
records. The information contained in financial statements relates to the entire inventory. So
you, and other investors, can only draw some large, general inferences. However, a few rules of
thumb hold true:

 A higher turnover rate is better

 Fewer days in inventory is better

These would indicate better inventory management.

Financial statements don't tell the whole story. A high turnover rate is a good thing, but empty
shelves can mean lost sales, and that's a bad thing. Good inventory management means
stocking an adequate supply of merchandise to meet demand, but not too much excess.

Inventory is an asset with it's own problems. It must be stored and protected until it is sold. It
must often be paid for before it is sold. It can be damaged, stolen or become spoiled or
obsolete. These are all risks associated with inventory and the cost of these losses have to be
made up from revenues.

Ratios tell part of a story, but not the whole story. How can you answer some of these
questions? You would probably have to visit the store on a regular basis, and observe how they
handle inventory, note the condition of merchandise, how well the shelves are stocked and
tended, and check the dumpsters to see how much spoiled or damaged goods are being thrown
away each week.

Accounts Receivable Turnover Rate

AR turnover is similar to inventory turnover. It is the other end of the sales cycle - the collections
side. The AR turnover tells us how good a job management is doing collecting accounts
receivable. If the company has a 30 day payment policy, their AR turnover rate should be about
12 (once a month), and their number of days in AR should be around 30.

If the turnover rate is too low (days in AR too high), the company is having problems enforcing
its credit policies. This is the credit manager's responsibility. The company needs to review its
credit policy and start enforcing it. They might also have too many old, uncollectible accounts
receivable that need to be turned over to a collection agency.
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EBIT means Earnings Before Interest and Taxes. It is also referred to as Operating Income,
and is used in these ratios:

 Interest coverage ratio,

 Operating expense ratio, and
 Return on assets

Stock Pricing and P/E Ratio

Stock price is a difficult thing to predict. Many subtle factors can effect a stock's price, but they
all have one thing in common. They all have to do with the future. A stock investment give the
stockholder rights to future earnings, not past earnings. As a matter of fact, the entire financial
market is about the future.

The P/E ratio is integral to stock pricing. It's so important to investors that the Wall Street
Journal publishes the P/E ratio for every stock, on a daily basis. If you check the Journal, the P/E
ratio is right next to the stock price.

The P/E ratio is also called the Price-Earnings ratio. It is the market price divided by the most
current earnings per share (EPS). A P/E ratio from 12 to 20 is about average. What are we really
saying here? If the P/E is 12, that means the investor is willing to pay 12 times the current DPS
to buy one share of stock. That's the same as paying forward for 12 years of future earnings,
just to get on the ride.

An Example of Financial Statement Analysis

Let's say a company has 10,000,000 shares of stock outstanding, and a P/E ratio of 15. If EPS is
$2.00 then the price of the stock is $2.00 x 15 = $30.00 per share. To make it easier, let's also
assume that the company expects to have the same earnings in the coming year.

Assume the company loses a lawsuit and must pay $1,000,000 in damages. What
effect will this have on stock price? There are a couple of ways to calculate this. Previous
earnings must have been $20,000,000 (10,000,000 shares x $2.00 EPS).

We can recalculate current earnings as follows:

Expected earnings $20,000,000 

Less: loss from lawsuit ( $1,000,000)

Revised earnings $19,000,000 

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The revised EPS is $19,000,000 / 10,000,000 shares = $1.90.

The revised stock price is $1.90 x 15 = $28.50 per share.

What happened to EPS?

The lawsuit had the following impact on earnings per share:

Lawsuit $1,000,000 / 10,000,000 shares = $0.10 per share.

Original EPS  $2.00

Less: loss from lawsuit ($0.10)

Revised EPS  $1.90

Here's another way we can use the PE ratio to calculate the effect of the lawsuit on
stock price:

Effect of lawsuit on EPS = $0.10 x 15 P/E = $1.50 per share

Original stock price per share  $30.00

Less: effect of lawsuit on stock price ($1.50)

Revised stock price per share $28.50

If you look over the calculations above, you will see there are several ways to arrive at the
solution. They all reflect the relationships between a company's earnings, the number of shares
outstanding, and investors' perception of the company's future earnings potential (P/E ratio).

If investors think the company's earning potential is improving they are willing to pay more for
the stock, which is reflected in a higher P/E ratio. The opposite is also true. If they think the
company's earnings are impaired the P/E ratio will go down. That is a much more complex
discussion that we have time for here, but investors look at a large variety of things to determine
P/E ratio - strength of the market for the company's product, the quality of the company's
management, likelihood of continued business success, etc.

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 SELF-CHECK 4.2-1
The company has made a profit of £13,587 in the year 31st August 2012,
yet has generated a operating cash OUTFLOW of £109,690. a) Explain,
using both facts and figures, how Three Quarter Time Ltd has made a profit
yet has suffered a significant negative operating cashflow. (10 marks) b)
Evaluate the significance of the cashflow statement when making credit
decisions. (6 marks) c) If the adjustment outlined in the auditor’s opinion
was put in place what effect would this have on the Profit and Loss Account
and on the Cashflow Statement. (ignore any tax effect). (4 marks) Total 20
marks a) Suggested answer Note to the cashflow statement Reconciliation of
operating profit to net cash outflow from operating activities Operating profit
13,587 Depreciation charges 99,966 Profit on sale of tangible fixed assets
(83) Decrease in stocks 21,769 Increase in debtors (162,222) Decrease in
creditors (82,707) Net cash outflow from operating activities (109,690) If
non- cash items such as depreciation are added back to profit, and then the
company should have had a net cash inflow of over £100,000. The fact that
they have a net operating cash outflow is entirely due to their management
of working capital. Stock has decreased which should improve the cashflow
Creditors have decreased significantly which could be a concern for potential
lenders as it could signify a reluctance for suppliers to provide credit. The
main issue appears to be a large increase in debtors, people owing the
company money. This could be a concern as it may signal significant
disputes with companies or an under provision for bad debt. The notes to
the accounts will need to be examined to gain more detail
The creditor note shows that although there is a fall in trade creditors, the
majority of the decrease is due to the repayment of leases. An examination
of the debtor note (below) tells the user that although debtors have
increased as a whole, trade debtors have decreased and have offset the new
debt of £197,202 from a related company, and also an increase in
prepayments.

Therefore overall the reason why there is a ne

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 Document No. NTTA-TM1-07
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 ANSWER KEY 4.2-1
Suggested Answers:
Is the information reliable? The cashflow statement of large companies is
included in the statutory audit and therefore shows a ‘true and fair view’ of
the company’s cashflows. Additionally it is prepared according to accounting
standards, either FRS1 or IAS 7, and therefore is comparable from company
to company and consistent in its underlying assumptions and presentation.
As previously stated, cash based accounting is not subject to accounting
policies or adjustments and therefore is more objective than other
statements. Indeed cash itself is easily verified by the banks, which are
independent of the company. Compare this to the value of stock/inventory,
which is subjective.
Is the information relevant? As the credit manager is concerned principally
with the ability of a customer to pay its short term debts, i.e. its short term
liquidity, then both the company’s cash position and its ability to generate
cash from trading is highly relevant information. Additionally a credit
manager can ensure that the cash that is generated is being fairly
distributed and not being taken by the owners as dividend or ‘management
fees’ in a group situation. Conversely it must be acknowledged that the
information is untimely in its publication and by the time the credit
manager receives it, it may be too late to be useful. However the cashflow
when analysed with other figures such as debt can offer a warning of
potential future cashflow problems, particularly when considered with the
company’s debt repayment schedule (found in the notes to the accounts).
Is the information understandable? It could be argued that the concept of
the ‘indirect method’ is confusing for non-finance professionals; however the
absence of underlying accounting policies makes the information more
understandable for the non-accountant. The majority of adults manage a
bank account and this statement is merely an analysed form of bank
statement. It details where cash has been generated and where it has been
spent.

Document No. NTTA-TM1-07

Date Developed: Issued by:
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 Document No. NTTA-TM1-07
Date Developed: Issued by:
September 2019 NTTA
Bookkeeping NC III Date Revised:

Preparing Financial Developed by:

Reports Vangie D. Manguil
Revision #
00