Understanding Financial Statements Creditors’ point of view

1. Liquidity ratios (short term solvency) – measure a

Financial Statements (FS) - the means by which the information
accumulated and processed in financial accounting is periodically
communicated to the users
Stated differently, the FS are the end product or main output of
the financial accounting process.
FS are the structured financial representation of the financial
position and financial performance of and entity
Complete set of FS
1. Statement of Financial Position
2. Statement of Financial Performance
a. Income Statement =
b. Statement of Comprehensive Income
3. Statement of Changes in Equity
4. Statement of Cash Flows
5. Notes to the Financial Statements
FS Analysis
FS Analysis is the process of interpreting or giving meaning to the
financial statements. It involves a careful selection of data from
the financial statements in order to assess the firms past
performance, present condition and future business potentials
FS Analysis Techniques
A. Common Size Analysis
1. Vertical analysis (Common Size FS) – comparison
between FS elements of a single period. Each FS
element is expressed as a percent of a common
base:
a. Total asset for balance sheet
b. Net sales for income statement
𝑙𝑖𝑛𝑒 𝑖𝑡𝑒𝑚
=
𝑐𝑜𝑚𝑚𝑜𝑛 𝑏𝑎𝑠𝑒
2. Horizontal analysis (Comparative FS) – comparison
between FS element of 2 or more consecutive
periods.
a. Increase-decrease method
1. Absolute peso amount
= 𝑦𝑒𝑎𝑟 2 − 𝑦𝑒𝑎𝑟 1
2. Percentage
𝑦𝑒𝑎𝑟 2 − 𝑦𝑒𝑎𝑟 1
= =
𝑦𝑒𝑎𝑟 1
b. Trend Percentage or index numbers – analyzes
a firm’s financial ratios over time and can be
used to estimate the likelihood of
improvement or deterioration in operating and
financial conditions.
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟/𝑠
=
𝑐𝑜𝑚𝑚𝑜𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
B. Ratio Analysis – the use of percentages, turnovers or
ratios to express relationships between selected items
form balance sheet or income statement
firm’s ability to pay its currently maturing
obligations
a. Current ratio – measures the number of times
the current liabilities could be paid by current
assets
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
=
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
b. Acid test (quick) ratio – measures the number
of times that the current liabilities could be
paid by available cash and near cash assets. It
is a more severe test of liquidity
𝑐𝑎𝑠ℎ + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
2. Stability ratios (long term solvency) – measure a
firm’s ability to pay its long term obligation and the
firm’s overall long-term financial health.
a. Times-interest-earned ratio – determine the
extent to which operations cover fixed interest
charges
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥 (𝐸𝐵𝐼𝑇)
=
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
b. Debt ratio – indicates the proportion of
creditor’s claims against assets or the
percentage of funds provided by creditors
𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
=
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
c. Equity ratio – indicates the proportion of
shareholders’ claims against assets or the
percentage of funds provided by shareholders
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
=
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
d. Debt to equity ratio – indicates the proportion
of assets provided by creditors to that of
owners
𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
=
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
Owners’ point of view
1. Profitability analysis – return achieved on the funds
invested
a. Return on equity (ROE) – indicates the percent
return for every peso of owners’ equity
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑞𝑢𝑖𝑡𝑦
b. Earnings per share (EPS) – measures the
amount earned by each common share
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
=
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠
2. Disposition of earnings – measures the change in
economic status of a company over a period of time
a. Earnings yield – approximates the return on
investment per ordinary share
𝐸𝑃𝑆
=
𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
 b. Dividend yield – measures the return on e.Average age of accounts receivable – indicates
investment from cash dividend the average number of days before receivables
𝑐𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 are collected
=
𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 360 𝑜𝑟 365 𝑑𝑎𝑦𝑠
=
c. Dividend payout – indicated the portion of 𝐴𝑅 𝑇𝑂
earnings issued as dividends f. Accounts payable turnover – indicates the
𝑐𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 number of times of payment cycles made over
= the period
𝐸𝑃𝑆
3. Market indicators – measure of shareholder value 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
=
as reflected in the price of the firm’s ordinary 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
shares g. Average age of accounts payable – indicates
a. Price earnings – amount required to buy P1 of the average number of days before payables
earnings are paid
𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 360 𝑜𝑟 365 𝑑𝑎𝑦𝑠
= =
𝐸𝑃𝑆 𝐴𝑃 𝑇𝑂
b. Book value per share – measures the amount 3. Profitability – measures the efficiency of the
of assets available to shareholders in the event management in the use of the firm’s assets
of liquidation a. Return on asset (ROA) – measures the income
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 generated by every P1 of asset
= 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
=
Management’s point of view 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
1. Operational analysis *Du Pont Analysis for profitability ratios – disaggregates
a. Gross margin – indicates the ability of the elements of ROE. It gives an alternative for computing
company to recover cost of product and to ROE and ROA
absorb operating expense and other expense 𝑅𝑂𝐴 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝑔𝑟𝑜𝑠𝑠 𝑚𝑎𝑟𝑔𝑖𝑛 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
= 𝑅𝑂𝐴 = ×
𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
b. Profit margin (return on sale) – indicates the
ability of the company to recover all expenses 𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 𝑒𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
and provide profit to owners 𝑅𝑂𝐸 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝑒𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
= 𝑅𝑂𝐴 = × ×
𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
2. Resource management – measures how a firm uses
its assets to generate income
a. Asset turnover – indicates the size of assets
commitment required to support a particular
level of sales
𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
=
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
b. Inventory turnover – measures the number of
times that inventory was replaces during the
period. It indicates if a firm holds excessive
stocks of inventory
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
=
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑡𝑜𝑟𝑦
c. Average age of inventory – indicates the
average number of days before inventories are
sold
360 𝑜𝑟 365 𝑑𝑎𝑦𝑠
=
𝑖𝑛𝑣𝑡𝑦 𝑇𝑂
d. Accounts receivable turnover – indicates the
number of times of collection cycles made over
the period
𝑛𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒
=
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑖𝑣𝑎𝑏𝑙𝑒