FINANCIAL STATEMENTS ANALYSIS – I a) Maintain a well-balanced relationship between borrowed funds and
equity.
Financial Statement Analysis involves careful selection of data from FS for the primary purpose
of forecasting the financial health of the company.
 Accomplished by examining trends in key financial data, comparing financial data
across companies, and analyzing key financial ratios.
 Important aspect is the comparison of actual financial conditions with expected
financial conditions.
 Expected Conditions may be represented by:
1) Predetermined Standards
2) Past Performance
3) Competitor’s Performance or industry average
 Managers, investors, and lenders analyze FS to identify an organization’s financial
strengths and weaknesses.
Current Shareholders or Owners are concerned about their investment income as well as about
the company’s overall profitability, stability, and sound capital structure necessary for
continued successful operations.
Potential Investors are interested in “sold” companies, ones whose FS indicate stable earnings
and dividends with limited or moderate growth.
Others prefer companies whose FS indicate a trend of financial flexibility, rapid
growth, and diversification into different lines of business.
Short-term Creditors are interested in a firm’s short-run liquidity, its ability to pay current
obligations as they mature.
Long-term Creditors are concerned about the long-term security of their interest income and the
company’s ability to maintain successful earnings and cash flows to meet continuing financial
commitments.
General Approach to Financial Statements Analysis
1. Background Study and Evaluation of Firm Industry, Economy and Outlook
 It is necessary to start the analysis of a firm’s FS with an evaluation of the
environment in which the firm conducts business, since economic
developments and the actions of competitors affect the ability of any
business enterprise to perform successfully.
2. Short-term Solvency Analysis
 An analysis of the company’s ability to meet near-term demand for cash
and normal operating requirements.
 Indicators that a company enjoys a satisfactory short-term solvency position
a) Favorable credit position
b) Satisfactory proportion of cash to the requirements of the current
volume
c) Ability to pay current debt in the regular course of business
d) Ability to extend more credit to customers
e) Ability to replenish inventory promptly
3. Capital structure and long-term solvency analysis
 Pertains to the evaluation of the amount and proportion of debt in a firm’s
capital structure to assess its ability to service debt.
 Cover the analysis of the use of financial leverage to maximize the returns
to the owners.
 A company is generally considered enjoying a satisfactory long-term
financial position if it is able to:
b) Effectively employ borrowed funds and equity
c) Declare satisfactorily amount of dividends to shareholders
d) Withstand adverse business conditions
e) Engage in research and development to provide new products or
improve old products, method or processes
f) Meet their commitment to borrowers and owners
4. Operating efficiency and profitability analysis
 Involves the evaluation of how well assets have been employed by
management in terms of generating revenues and maximizing returns of
such sources.
 Indicators of managerial efficiency is the use of the resources:
a) Ability to earn a satisfactorily return on its investment of borrowed
funds and equity
b) Ability to control operating costs within reasonable limits
c) Optimum level of investments in assets
5. Other Considerations
 Quality of Earnings. Critical in the analysis of financial statements.
o Reasons that push managers to manipulate reported earnings:
a) Meet Internal Earning Target
b) Meet External Expectations
c) To Even-out Income
- Income Smoothing the practice of carefully timing the
recognition of revenues and expenses to even-out the
amount of reported earnings from year to the next.
 Income smoothing can make it easier for a
company to obtain a loan or favorable terms
and easier to attract investors.
d) Provide “window dressing” for an IPO or a Loan
- Window Dressing are measures taken by management
to make the company appear as strong and profitable
as possible in its statement of financial position, income
statement, and cash flow statement.
- Reverse Window Dressing enterprise who would want
to obtain government subsidiaries or exemptions from
tariff and taxes.
 Techniques to Manage Earnings
a) Strategic Matching
 Involves timing its transactions so that large one-time gains
and losses occurs in the same period resulting in a smooth
upward trend in reported earnings.
 Could involve extra efforts to ensure certain transactions are
completed quickly or delayed so that they are recognized in
the most advantageous quarter.
b) Change in Methods or Estimated with little or no disclosure
c) Departure from Accounting Standards
 Fraudulent Reporting or Deliberate Violation of
Accounting Rules is one of the often-used techniques in
managing earnings to show more favorable results.
 Examples:
i) Intentional capitalization or deferent of
expenditures that should have been expensed
 ii) Non-provision of losses due to uncollectibility of
receivables, or
iii) Failure to recognize impairment losses on PPE
d) Fictitious Transactions
 It could involve deliberate recording of non-existent revenue
transactions and customers or reporting sales when contracts
are not fully completed and goods not yet delivered.
 The exercise of judgment inherent in the actual process
gives desperate managers the ability to accelerate or defer
the reporting of profit to best suit their purpose.
Ultimate Objective in the Analysis of the Earning Quality: to arrive at a performance measure
which best reflects both financial reality and the future operating potential of the company.
To arrive at the appropriate earnings for an entity, starting from the bottom line net income, at a
minimum the following adjustments should be considered:
Start with total income before taxes P xx
Add (Deduct)
Gain on disposal of assets (if any) (xx)
Excess of share in equity income over dividends receive (xx)
Unrealized gains on investors in trading/available for sale securities (xx)
Provision for estimated shutdown costs (xx)
Research and development costs xx
Impairment loss on fixed assets xx
Gain on early extinguishments of debt (xx)
Adjusted income from normal operations P xx
 Quality of Assets and Relative Amount of Debt
o Analyst must also look at the composition of assets, their conditions and
liquidity, the timing of repayment of liabilities and the total amount of debt
outstanding.
 Transparent Financial Reporting the Best Practice
o The more reliable the economic information provided by a company
through the FS, the more confidence potential investors can place in that
information.
o Allows better decision making that reduces the risk to potential investors
and creditors thereby lowering the company’s cost of capital
o Transparent financial reporting even in a scenario in which there are great
motivations for managers to manipulate earnings in the short run,
represents the best business practice for the long run.
Steps in Financial Statement Analysis
1) Establish objective of the analysis
2) Study the industry in which firm operates and relate industry climate to current and
projected economic development
3) Develop knowledge of the fir and the quality of management
4) Evaluate financial statements using any of the techniques below:
i) Horizontal analysis of Comparative Statements (Increase-Decrease Method)
 A good place to begin in FS analysis is to put statements in
comparative form.
 Horizontal Analysis is the study of percentage changes in
comparative statements.
 Two Steps in computing a percentage change:
a) Compute the peso amount of the change from the base
(earlier) period to the later period, and
b) Divide the peso amount of change by the base-period
amount.
ii) Trend Percentages
 These are index numbers showing relative changes in financial
data resulting with the passage of time.
 Trend % state several years’ financial data in terms of a base year.
 Trend percentage or relatives to the base year emphasize changes
in the Financial and operating data between specific dates or
period and makes possible a horizontal analysis and study of
comparative FS data.
 Computation and Evaluation:
a. In the comparative statements that choose the year to be
used as the base and convert the amount of each item to
100%. The “base year” may be the earliest year involve in the
comparison, the latest year or any intervening year.
Generally, the base year should be representative of the
normal operating activity of the firm.
b. Compute the percentage relationship that each statement
items bears to the same item in the base year by simply
dividing each value by the base year.
c. Compare the trends of related financial and operating data
to form an opinion as to whether favorable or unfavorable
tendencies are reflected by the data.
iii) Common Size Financial Statements
iv) Financial Ratios
The major areas that may be covered in the analysis are:
i) Short-term Solvency
ii) Capital Structure and long-term solvency
iii) Operating efficiency and profitability
iv) Segmented analysis (when relevant)
5) Summarize findings based on analysis and reach conclusions about firm relevant to
the established objectives.
Limitations of Financial Statement Analysis
The limitations involve the comparability of financial data between companies and the
need to look beyond ratios. These limitations are:
a) Information derived by the analysis are not absolute measures of performance in any
and all of the areas of business operations. They are only indicators of degrees of
profitability and financial strength of the firm.
b) Limitations inherent in the accounting data the analyst works with. These are brought
about by among other:
a. Variation and lack of consistency in the application of accounting principles,
policies and procedures
b. Too condensed presentation of data
c. Failure to reflect change in purchasing power
c) Limitations of the performance measure or tools and techniques used in analysis.
  Quantitative measurements are not absolute measures but should be
interpreted relative to the nature of the business and in the light of past,
current and future operations.
 Timing of transactions and the use of averaged can also affect the results
obtained in applying the techniques in financial analysis.
d) Analysis should be alert to the potential for management to influence the outcome of
financial statements in order to appeal to creditors, investors, and others.

Limitations of analysis may be overcome to some extent by finding appropriate benchmarks

against which to measure a company’s performance.