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ACFrOgBfkBoiRJszOmdFhuS8P6k4A cO98JX2vRe4126n8qkQ 55MrwphGFcPDfwkNMXQoQ - 79H 3AybOD0Zw6MH17zIh h9b3u2CWDF4691W6dWpUdLUkpW5jZq60rrVjTzln29bnexP0mQThOP PDF
ACFrOgBfkBoiRJszOmdFhuS8P6k4A cO98JX2vRe4126n8qkQ 55MrwphGFcPDfwkNMXQoQ - 79H 3AybOD0Zw6MH17zIh h9b3u2CWDF4691W6dWpUdLUkpW5jZq60rrVjTzln29bnexP0mQThOP PDF
management, and to other interested parties. After completing the financial statements,
accountants need to fulfill the last accounting function, interpretation. Interpretation needs
analysis tools. Despite the use of accounts recommended by PAS guidelines, readers may still
find difficulty in understanding the financial statements. Hence, financial analysis can be a big
help to users.
OBJECTIVE OF ANALYSIS
Primarily, the objective in analyzing the financial statements is to assess the over-all
performance of the business for a given period of time. This can serve as the basis for the owner
or management in making present and future plans or decisions. The results of the analysis can
also be used to evaluate the performance of the managers of the different departments or units of
the company.
Financial analysis can uncover the strengths and weaknesses of the business. The analysis
should likewise be able to determine the liquidity, solvency, stability, profitability, and
Several rules are suggested by academicians to be observed when conducting analysis and
interpretation. If these rules are ignored, misleading interpretation or conclusion may be made.
First, develop a group of related financial ratios. A single ratio is meaningless because it is an
isolated ratio. It only becomes meaningful if related to other allied ratios. Next, make
comparison. In the analysis and the interpretation of financial statements, comparison is a must.
No interpretation can or should be made without first making a comparison. The financial ratios
developed can be compared with the past (this is called time-series analysis)
After developing a group of financial ratios and making comparisons, the analyst must
also take into consideration the limitations of the financial statements being analyzed before
financial analysis: The financial statements are not exact in the sense that there are estimated
figures incorporated in the statements. (Examples are depreciation, impairment loss, etc.) The
financial statements are not yet final. The amounts are subject to change from period to period.
They are merely interim financial statements. The final statements are the statements on the date
the business will be liquidated. The effect of inflation is ignored. The financial statements are
historical in nature. They are the results of past activities and the past may not resemble the
Analytical tools
Foremost among the financial ratio is the ratio of one item in the financial statement to
another item in the same financial statement. There are four kinds of financial ratios: statement
of comprehensive income ratio; statement of financial position ratio; inter-statement ratio; and
trend ratio.
Statement of Comprehensive Income Ratio is the ratio of one item in the Statement of
Comprehensive Income to another item in the same SCI. An example is Return on Sales (ROS)
in the same SFP. An example is the Current Ratio which is the ratio of the total current assets to
Inter-Statement Ratio is the ratio of one item in the SCI to another item in the SFP. An
example is Accounts Receivable Turnover which is the ratio of net credit sales to the average
accounts receivable. The SFP item must be the average of the beginning and ending balances.
Trend Ratio is the ratio of one item to the same item of different periods. An example is
As mentioned earlier, the results of the analysis of the financial statements should also be
The focus of this module is the measure of performance of a business based on the
financial statements. Aside from the profit or loss and the growth in the proprietor’s capital,
liquidity, solvency, stability, and profitability of a business can be assessed. Liquidity pertains
to the capability of the business to meet payments for its short-term debts. It also means the
ability to convert non-cash current asset into cash. On the other hand, solvency is the ability to
pay liabilities on time. A business which cannot pay on time is said to be “technically insolvent”.
Solvency is of two types, short-term solvency which is the ability to pay current liabilities on
time and long-term solvency which is the ability to pay the amortization of the long-term
abilities plus the interest. Long-term solvency is the ability of the company to continue as a
going concern over a long period of time. It is concerned with the track record of the company
in handling its long-term loans. Meanwhile, profitability refers to the efficiency of the business
in generating profits from its assets, which are funded by both creditors and the proprietor. It
also refers to the ability of the management to generate adequate profits to sustain the operations
of the business and earn satisfactory return for the owners. On the other side, stability is the
ability to withstand financial reverses. It can also be equated with survivability in the event of
financial crisis.
To understand financial analysis, you must understand how to compute and interpret
financial ratios. Among the financial ratios, liquidity is the simplest ratio. It is measured using
working capital and four ratios: current ratio, acid test or quick assets ratio, accounts receivable
turnover and inventory turnover. Working capital is the difference between current assets and
current liabilities. It shows the cycle from accounts payable /receivable to cash. Current ratio
refers to the capability of the entity to settle its current liabilities by using its current assets.
Another liquidity ratio is the acid test or quick assets ratio. The acid test or quick assets ratio
involves the ability to pay current liabilities with the assets that are most readily convertible into
cash. Accounts receivable turnover is the number of times that receivables on credit sales are
collected. It measures the efficiency of credit and collection procedures. Inventory turnover is
the number of times that inventory is sold during the accounting period. It indicates whether the
whether the entity can survive over a long period of time. The questions asked here, by the long-
term creditors and the proprietor; pertain to the ability of the company to pay the regular
assessed through the times interest earned ratio, debt ratio, equity ratio, and debt-equity ratio.
Times interest earned ratio is the ability to source interest payments from net profits in regular
business operations. It is computed by dividing net profit before interest expense and income
taxes by annual interest expense. Debt ratio shows the percentage of assets provided by
creditors. Equity ratio indicates the percentage of assets coming from the owner. Debt-to-equity
ratio shows the proportion of liabilities to owner’s equity in financing company resources.
Another ratio that may be applicable to stability is the ratio of total debt to total capitalization
(i.e. long-term debt + equity). This ratio gives the degree of significance of long-term debt as
Profitability ratios assess the efficiency of the business in generating profits from its
assets. The proprietor must benchmark its profit ratios with rival companies in its industry to
better assess its performance. Different profit ratios are used to assess the various components of
the company’s net income or loss. These are gross profit margin, net profit margin, return on
assets and return on equity. Gross Profit Margin refers to the ratio of Gross Profit to Net Sales.
setting up the selling price of its products. Focusing downward in the SCI, gross profit margin is
the remaining proportion of net sales that can absorb operating expenses of the business.
Another measure of profitability is the net profit margin. Net Profit Margin is equal to the ratio
of Net Profit after Taxes to Net Sales or Revenues. It gives the remaining profits of the firm
after deducting all expenses and income taxes. This ratio is crucial to a business for its
continuity as a going concern. Another helpful ratio is Return on Assets. Return on Assets is
computed as the ratio of Net Profit after Taxes to Total Assets. Similar to Net Profit Margin, the
numerator here is net profit after all expenses and taxes; however, the denominator is Total
Assets. Return on Assets measures net profit generated from total assets. Last among the
profitability ratios is the Return on Equity. Return on Equity is equal to the ratio of Net Profit
after Taxes to Owner’s Equity. Return on Equity shows the profits accruing to the owner of the
business (after all expenses and taxes). Thus the owner should focus on this ratio in order to
current period and previous period allows the user or reader to compare and analyze the changes
Horizontal Analysis. Horizontal analysis refers to getting the growth trend over several
periods, of certain items or ratios in the financial statements. An example of a line item is
accounts receivable. You may get the increase or decrease in accounts receivable for three
succeeding years, say 2013, 2014, and 2015. In a similar way, you may compare the gross profit
ratio of a company for the past three years. Horizontal analysis can be better appreciated when
Vertical Analysis. Under the technique, the ratio of each item in the financial statement
Comprehensive Income, the base item is the net sales. In the Statement of Financial Position, the
base item is the total assets. The resulting statement expressed in percentages is called a
common-size statement. Vertical analysis highlights the components of the statement which
Given the following financial statements, prepare an analysis using financial ratios.
2018 2017
A. Liquidity ratios:
Quick assets are items under current assets that are easily converted into cash, such as
Average accounts receivable refers to the average of beginning and ending balances of
accounts receivable.
Remark: There is a high receivable turnover which increases the profits of the company.
B. Solvency ratios
5. Times interest earned ratio = net profit before interest and income taxes / annual interest
exp.
Remark: The interest coverage ratio is high. It assures long-term creditors that interest and
Interest
Note: To be more useful, the computed stability ratios can be compared with industry ratios
(average financial ratios for companies comprising a specific industry e.g. toiletries industry and
Remark: To be more useful, the above stability ratios can be compared to industry ratios.
C. Profitability ratios:
1. Gross profit margin ratio = Gross profit / Net Revenues or Net Sales
2. Net profit margin ratio = Net Profit after taxes / Revenues or Net Sales
4. Return on Sales or Net Profit Margin Ratio = Net Profit after Taxes / Net Revenues or
Net Sales
whether the resulting ratios are weak, strong or within industry average. They may also be
compared with market interest rates (prevailing interest rates on bank deposits or on loans). For
instance, if offered rates to investors averaged at 15%, then the return on equity of 26% in 2018
is quite rewarding.
Using the same data for Kleene Car Park, presented below is the horizontal analysis.
Increase (Decrease)
2018 2017 Amount Percent
Current Assets:
Cash P 394,500 P 460,500 P(66,000) (14%)
Accounts Receivable 38,000 29,000 9,000 31%
Prepaid Expenses 65,000 35,000 30,000 86%
497,500 524,500 (27,000) (5%)
Non-Current Assets 1,211,000 1,315,500 (104,500) (8%)
Total Assets P 1,708,500 P1,840,000 (131,500) (7%)
Note: Decrease in loans payable was significant at 34% and contributed to the 7% decline in
total assets.
Remark: The decrease in revenues by 0.9% and increase in expenses by 1% plus the interest
expense of P130,500 contributed to the 38% decrease in net income.
Remarks: As a service business, a major portion (71% in both 2018 and 2017) of the company’s
assets are non-current assets - property and equipment. In 2018, after payment of a huge portion
of long-term liability, the owner’s equity rose to 59% from 48% in 2017.
2018 2017
Revenues:
Parking Fees 95% 97%
Car Wash and Cleaning 5% 3%
100% 100%
Expenses:
Rent 33% 33%
Salaries 16% 15%
Depreciation 6% 6%
Utilities 6% 6%
Supplies 4% 5%
Insurance 3% 4%
Advertising 3% 3%
Taxes & Licenses 4% 5%
Repairs and Maintenance 1% 0.20%
76% 77.2%
Operating income. 24% 22.8%
Interest expense 7%
Net income 17% 22.8%
Note: For 2018, a sizeable portion of expenses is rent at 33%. Interest expense is substantial at 7%. Net
income declined to 17% of total revenues due to the huge interest expense.
The proprietor of a doll shop wants to evaluate its task on inventory management. To assist the
proprietor, you gathered the following information from his accounting records:
To determine whether the inventory turnover is high, it must be compared with the