Preparing, analyzing, and forecasting financial statements quantifying the business plan

1. PREPARING, ANALYZING, AND FORECASTING FINANCIAL STATEMENTS: QUANTIFYING THE BUSINESS
PLAN
Five hundred years ago, the merchants of Venice invented accounting. They wanted to record all of their
business transactions as they imported goods from Asia and exported goods from Europe.
Today, accounting has come a very long way. Professional organizations have established generally
accepted accounting principles.
The intention of this reading is not about teaching entrepreneurs how to be expert accountants. Rather,
it is simply about trying to understand, construct, and interpret financial statements.
More specifically, it is meant to translate the Business Plan into a numerical format composed of
financial statements.
These financial statements summarize what is going to happen to the business if plans are carried out
well.
Let us begin by assuming that an entrepreneur has set up ABC Corporation. A corporation is a separate
legal personality created by law. It can sue and be sued. It can actually own assets. It can owe money
and repay that money.
At the beginning, ABC Corporation has nothing. However, stockholders will be giving cash to the
corporation. In exchange for the cash, equity shares will be given to the stockholders or the owners. The
agreement between the stockholders and ABC Corporation is this: all of the profits and losses of ABC
Corporation will go to the stockholders in exchange for the cash they have given. So, the first transaction
is giving of cash by and issuing of stocks to the stockholders. Second, ABC Corporation may need more
money and goes ahead to borrow this from banks or other financial institutions. The banks provide
loans, which the corporation would have to pay back in terms of principal payments and in terms of
interest expenses. If we assume that ABC Corporation is a manufacturing concern, then there will be a
third source of funds and these are the raw material suppliers. The suppliers would give raw materials
and/or supplies to ABC Corporation and they would be paid later.
From the cash of the corporation, it may want to invest in land, building, machinery, equipment,
furniture, fixtures, and vehicles.
It will then try to activate the factory by converting the raw materials into finished goods. While in the
factory, however, the corporation would need power and water, which they would pay from their cash.
So, cash will be spent to buy power and water, which would be used in the factory. Cash will also be
used to pay for labor and supervisors, which again would be used inside the factory. So what do we have
in the factory? We have the raw materials, the power, the water, the labor, and the supervisors. The raw
materials are then processed in the factory. They would be called work-in-process inventory. When the
goods are completed, they become finished goods inventory. Meanwhile, the accountant will concoct an
account called depreciation. They will assume that the building, machinery, equipment, furniture,
fixtures, and vehicles would last a certain number of years. (For buildings perhaps, 20 years; machinery
and equipment, 10 years; furniture and fixtures perhaps, 5 years; and so on and so forth.) And as they
depreciate, all of these fixed assets, the depreciation of the factory may go to the work-in-process

2. inventory. However, the depreciation of the head office and all the machinery and equipment at the
head office will go directly to the operating expenses.
There are other operating expenses that the corporation would have to pay for in cash. These are the
salaries, the supplies, the electricity, and other expenses (e.g., travel and representation, rental, etc.). •
Notice that there are two types of costs. The cost of making the product becomes the product cost. The
finished goods when sold become the cost of goods sold. Then, there are the period costs, which are the
selling, general, and administrative expenses. Next, ABC Corporation pays, in cash, non-operating
expenses, which are really the interest expenses and other financial charges owed to the banks. Next,
ABC Corporation would have to pay cash to the government for taxes. Once the company sells the
finished goods to the customers, they become cost of goods sold. In exchange, sales or revenues are
gotten from the customers.
Some customers will pay in cash, so the sales and revenues go back to the cash account. Some
customers would want to avail of credit. Unpaid sales become accounts receivable. And when the
customers finally pay, the amount of Accounts Receivables transforms back into cash.
ABC Corporation might have investments in marketable securities, in which case they might have non-
operating income. And this non-operating income comes back in the form of cash.
What does ABC Corporation do with the cash? Most of it circulates back to the operation of the
company. Round and round it goes. However, some cash will be used to pay the principal of the banks.
ABC Corporation already paid for the interest payments in our previous transaction. Some of the cash
will be used to pay the suppliers. And again some of the cash will be used to pay dividends to the
stockholders. Remember, in the beginning, we said that the agreement between the owners and ABC
Corporation is that all profits and losses belong to the stockholders. So a way of repaying the
stockholders is to get a portion or all of the profits and pay dividends to the stockholders. Figure 7.1. (D)
shows the completed flow of funds from the first business transaction to the last (and all the other
subsequent transactions).
Discerning Four Financial Statements
What we have in Figure 7.1. (D) is called funds flow. Funds going from one container or one circle to
another container or another circle comprise the funds flow except for the account called depreciation,
which is a figment of the imagination of the accountant. Depreciation is not really part of the funds flow.
The funds flow is the first financial statement that we have encountered.
The second financial statement is on the right side of Figure 7.1. (D). If you will notice, there are sales
and non-operating income, which actually enter back to the company. However, there are expenses and
costs that permanently exit the company. This entry and exit of funds on the right side of the illustration
will translate to the income statement. If the sales and non-operating income were greater than the cost
of goods sold, operating expenses, non-operating expenses, and taxes, then profit for ABC Corporation
would be generated. If, however, the sales or non-operating income were less than the cost of goods
sold, operating expenses, non-operating expenses, and taxes, then losses would be incurred. So, the
income statement is also called the profit and loss statement. Notice that a summary of the profit and
loss statement is either a profit or a loss. This is the second financial statement that we have
encountered.

3. There is a third financial statement that we can see from Figure 7.1. (D) that is the cash flow. Just focus
on the Cash container or circle. There are arrows pointing to the circle. These are the cash inflows. There
are arrows emanating out of the cash circle. These are the cash outflows. The cash inflows and the cash
outflows constitute the cash flow. If the cash inflows are greater than the cash outflows, we have a net
cash inflow. However, if the cash outflows are greater than the cash inflows, then we will have a net
cash outflow. So, the third financial statement we have encountered is the cash flow.
All three financial statements are flows. There is the overall funds flow, which is all the flows of funds
coming in and out of these circles. There is the operating flow, which is the income statement. And the
third is the cash flow. There is a fourth financial statement. However, it is not a flow. It is a static picture
of the company at one point in time. Let us say December 31 of X year, you may decide to take a picture
of the company. At that very moment, you will find exactly so much cash in the bank or at hand, so
much raw materials and supplies, so much work-in-process inventory, so much finished goods, so much
land, building, machinery, and equipment inside the company at that point in time. These are called the
assets of the corporation at that point in time. You will also find at that point in time a certain amount of
suppliers' credit, a certain amount of bank loans, and a certain amount of stockholders' equity. These
constitute the liabilities of the corporation. Notice that on the right side of Figure 7.1. (D), we have the
assets of the corporation which is everything owned by the corporation. And we have, on the left side,
the liabilities of the corporation or everything that the corporation owes. The assets of the corporation
always equal the liabilities of the corporation. And why is that? It is because the stockholders' equity
takes care of the residual. If the assets generate profits, they get added to the stockholders' equity. If
the company generates losses it gets deducted from stockholders' equity. In the process, assets will
always equal liabilities. So the fourth financial statement that we have encountered is the balance sheet,
as shown in Table 7.1. The assets always balance the liabilities.
Liabilities Suppliers' Credit (all suppliers' credit availed of less what has been paid for) Debt (all debt
incurred less all principal payments paid) Equity (capital put in plus all net profits generated (or net
losses incurred) minus all dividends paid out) Assets Cash (Cash inflows minus cash outflows) Accounts
Receivables (sales not yet collected) Inventories (all merchandise coming in less all merchandise sold)
Fixed Assets Lands Buildings Machinery and Equipment Vehicles, etc. Less: Accumulated Depreciation
Total Liabilities ' Total Assets
Constructing Financial Statements
We have already noted from Figure 7.1. (D) that funds migrate from one container to another. For
example, from the suppliers' credit container, we get raw materials. From the raw materials, we will
convert them into work-in-process. From the work-in-process, we can convert them into finished goods.
From finished goods, they would become cost of goods sold. As the goods are sold, sales are registered.
They come back in the form of cash. From the cash, ABC Corporation may decide to use it for paying
suppliers and the banks. Notice that there is a sourcing of funds from one container and there is a usage
or application of funds to the next container. The sourcing and usage or application of funds is the
financial transaction. So in every accounting entry, there is a source of funds and there is a use of funds.
This is called double entry accounting, which is the basis for the entire construction of the financial
statement. (See Appendix A: An Instructional Guide to Bookkeeping Using an Illustrative Case.) Focusing
on a few accounts of the funds flow statement, specifically loans, cash, and inventory, as examples, we
can follow how these containers of funds relate to one another. Let us begin with the loan. ABC

4. Corporation borrows P1 million from a bank. So, there is an increase in loans of P1 million while at the
same time, ABC Corporation increases its cash by P1 million. There is a source of funds from the loans of
P1 million and a use of funds in cash for the same P1 million. From the P1 million in cash, ABC
Corporation might take out P0.5 million from the cash container and this gets entered into the inventory
container which is again a use of funds.
If we put the infusion of funds into a container on the left side of that container (application or usage of
funds) and we put the extraction of funds out of the same container on the right side of that container
(sourcing of funds), we can construct the famous T account of the accountant.
Note that we have constructed T accounts for each container. The T account divides the left side from
the right side of the fund container. For consistency, the accountant sources funds from a container by
making it exit on the right side of the container. When funds are transformed to another container,
these funds enter on the left side of the container, as shown below.

5. The accountant has made a rule. The right side of each container (exit) is a source of funds. The left side
of each container (entry) is a use of funds. There is also a pattern that we are able to discern. All
increases in liabilities are sources of funds, and all decreases in liabilities are uses of funds. All increases
in assets are uses of funds, and all decreases in assets are sources of funds.
To summarize, all increases in liabilities and all decreases in assets are sources of funds. They are
recorded on the right side of the containers. The technical term given by the accountant for right side
exits are credits. So all entries on the right side are credits. All decreases in liabilities and all increases in
assets are uses of funds. Uses of funds are all recorded on the left side of the container. The technical
term for recording on the left side is debits. Hence, the accountant always has two accounting entries: a
credit followed by a debit or a debit followed by a credit. In Figure 7.2. (A) and Figure 7.2. (B), we see
these three containers. We can divide the containers into two sides: the right side and the left side. This
division creates the accountant's T accounts. On the right side are the sources of funds or the credits. On
the left side are the uses of funds or the debits.
Actually, the accountant prefers the format where the assets are recorded on the left side and the
liabilities are recorded on the right side of the balance sheet contrary to what we have presented
earlier. The accountant will then create a chart of accounts. Each account represents a container of
funds. In this case, the containers are the accounts for cash, accounts receivable, inventory, fixed assets,
and other assets. In the liabilities side, we have the stockholders' equity, short-term debt, long-term
debt, suppliers' credit, and accrued expenses. These accounts may number to more than ten. They may
be twenty, thirty, or more depending on the sophistication of the accounting statement. With this
realization, we can begin to make our financial statements. ABC Corporation will source cash from the
stockholders' equity. This is recorded as source of funds in the stockholders' equity and enters cash as
the use funds. ABC Corporation may also get long-term loans and short terms from the banks. These
loans are sources of funds and put into use in the form of cash.
From the cash, the company may withdraw some cash amount and it exits on the right side as a source
of funds. The company may buy inventory, fixed assets, and other assets with the cash. Cash would be
the source of funds while the purchased assets would be the uses of funds.
The company may also use the cash to pay for suppliers' credit, to pay for short-term debt and to pay for
long-term debt. Again, cash is the source of funds while the payment for the liabilities are the uses of
funds.
In other words, each of the financial transaction will be recorded by the accountant one by one as a
journal entry. Each journal entry is composed of source of funds and use of funds. (This is the double-
entry accounting transaction.) See Table 7.2 for the proper format of the Balance Sheet.

6. Assets Liabilities Cash Accounts Receivable Supplier Accrued Expenses Use I Source Inventory Use
Source Fixed Assets Use I Source Short Term Debt Use Source Long Term Debt Use Source Other Assets
Use I Source Use Source Stockholders' Equity Use I Source Use I Source Use Source
Let us now put some numbers in this financial statement. First, let us source funds from the
stockholders' equity. Let us get P10,000 from the stockholders and this is transaction number one, a
source of fund. This is put into the cash account also for the same P10,000 for the same transaction
number one. This is the first journal entry. The second journal entry is borrowing P20,000 from the bank,
transaction number two. And this gets entered as cash, also as transaction number two for P20,000.
Next we borrow short-term debt of P5,000 from the bank, transaction number three. And we also get
cash for the same transaction of P5,000. If we add the total sources of funds from the past three
transactions, they would amount to exactly the same amount of the uses of funds.
Now let us move on to another transaction. The company decides to buy an inventory of merchandise or
goods worth P10,000. So it reduces cash by P10,000 and puts this in inventory for P10,000 for
transaction four. Again there is a use and there is a source of funds.
For the next transaction, we again reduce cash by another P10,000 and we buy some machinery and
equipment for the same price of P10,000. This is transaction number five. We may actually spend some
money for organizing the company. These are called pre-operating expenses and they will be entered
under other assets. So let us just say we reduce cash by P5,000 (source of funds), transaction number
six, for the purchase of other assets (use of funds) for the same amount. We can now be in business. We
can now start selling goods. So we have an inventory of merchandise goods and we decide to sell half of
it, meaning we will sell P5,000 worth of inventory. We reduce inventory, source of funds, by P5,000;
transaction seven. Since here we have sold the inventory, it will permanently exit the company. Where

7. is the exit point? Remember that the income statement is summarized in a profit or loss under
stockholders' equity. So, what we will do is to record it under stockholders' equity rather than a
separate income statement. (Technically, merchandise sold enters a separate account called Cost of
Goods Sold.) So this P5,000 gets entered as a cost of goods sold as a reduction in stockholders' equity
(debit or use), transaction number seven, for P5,000. (Note: Sales will be recorded as sources of funds
while costs and expenses will be recorded as uses of funds under stockholders' equity) The customer
actually buys our goods for P10,000 and these are recorded as sales. Let us add the sales to the sources
of funds under the stockholders' equity So we will have sales of P10,000; transaction number eight
under stockholders' equity (Again, technically the accountant records this separately under Sales.) If the
customer does not pay in cash, then this gets recorded as accounts receivable or use of funds under the
assets column. So we will now have transaction eight, P10,000 in accounts receivable. Next, we will be
paying cash (source of funds) for operating expenses. Let us just say we will pay P5,000 for operating
expenses on transaction nine. This gets recorded as operating expenses (use of funds) under
stockholders' equity for P5,000. Notice that we now have P5,000 worth of cost of goods sold and P5,000
worth of operating expenses under uses of funds in stockholders' equity. Finally, we decide to pay
P1,000, transaction number ten, in cash (source of funds), to reduce short-term debt by the same
P1,000 (use of funds). Now let us stop there and begin to see if our balance sheet will still balance. But
first, let us summarize. How does the accountant close these accounts? In terms of assets, the right side
must be subtracted from the left side. The left side will always be greater than or equal to the right side
because there is no such thing as a negative asset. So, on the left side of the assets, we have P35,000
cash entries (uses of funds) minus P31,000 of cash exits (sources of funds) on the right side of the assets
or a cash balance of P4,000 on the left side of the assets. That is the balance of the cash account. We will
have a balance of P10,000 in accounts receivable. We will have a balance of P5,000 in inventory, a
balance of P10,000 in fixed assets, and a balance of P5,000 in other assets. In order to get the total
assets, we have to add all of them. So let us add P4,000 in cash plus P10,000 plus P5,000 in inventory
plus P10,000 in fixed assets plus P5,000 in other assets equal P34,000 in total assets. So we have assets
worth P34,000.
Let us look at the liabilities column. Actually, we recorded sales of P10,000 plus recorded cost of goods
sold of P5,000 and operating expenses of P5,000. In effect, we I-. zero profit. Zero profit plus P10,000 in
starting equity gives us P10,000 in stockhold, equity. Add to this the P20,000 in long-term debt. Also add
short-term debt which r have a balance of only P4,000 (that is P5,000 minus P1,000). So let us add all the
liabilii to see if they are equal to the assets. Ten thousand pesos of stockholders' equity p P20,000 of
long-term debt, plus P4,000 of short-term debt, equals P34,000. They balance. Assets still equal
Liabilities. From this presentation, we can also discern the four financial statements. Everyth that was
recorded in all of these containers is part of the funds flow. We see the inco statement below the
stockholders' equity. There is sales of P10,000, cost of goods sole P5,000, and operating expenses of
P5,000 for a profit of zero. That is the income statem( We also have the third financial statement which
is the cash flow composed of the c, inflows of P10,000, P20,000, and P5,000 for a total cash inflow of
P35,000. We subtr the outflows of P10,000 plus P10,000 plus P5,000, plus P5,000 and P1,000 to get a
cash flow of P4,000. This container called cash contains the cash flow statement. far, we have these
three financial statements: the funds flow or all of the transactic the income statement or the operating
flow under the stockholders' equity; and, the c flow under the cash account. The fourth financial

8. statement is the balance sheet, wh was shown earlier. In the balance sheet, we have an ending balance
of P4,000 in she term debt, P20,000 in long-term debt, and P10,000 in stockholders' equity. This is rant
against the assets composed of P4,000 in cash, P10,000 in accounts receivable, P5,00( inventory,
P10,000 in fixed assets, and finally, P5,000 in other assets, for a total of P34,( in assets.
Thus, the four financial statements can be derived from following all these account transactions.