TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY

MAS 3: FINANCIAL MANAGEMENT

FINANCIAL STATEMENTS ANALYSIS The difference between the figures of the

two periods is calculated, and the
Involves the assessment and evaluation of
percentage change from one period to the
the firm’s past performance, its present
next is computed using the earlier period
condition, and future business potentials.
as the base.
The data needed for analysis and
VERTICAL ANALYSIS
interpretation come mostly from the
financial statements where key figures are Interchangeably known as common-size
sought and meaningful relationships are statements analysis, involves converting
developed and analyzed. Additional data the figures in the statements to a common
come from other sources such as industry base, such as total assets (in the statement
and economic statistics. of financial position) and net sales (in the
statement of financial performance).
HORIZONTAL ANALYSIS
Illustration 2
Also known as time series analysis, it
involves comparing figures shown in the Hola Company
financial statements of two or more Common-size Statement of Financial Performance
For the years ended December 31, 2019 and 2020
consecutive periods to determine the
increase or decrease from the previous
years.
Illustration 1
Hola Company
Comparative Statement of Financial Performance
For the years ended December 31, 2019 and 2020

Hola Company
Common-size Statement of Financial Position
December 31, 2019 and 2020

Hola Company
Comparative Statement of Financial Position
December 31, 2019 and 2020

With vertical analysis, comparison become

more meaningful, particularly when
analyzing financial statements of different
companies in the industry to evaluate its
own performance vis a vis the performance
of its competitors. If possible, comparison
can be made with the statements of the
leaders in the industry we wish to emulate,
serving as benchmarks.

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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

RATIO ANALYSIS type of credit terms the firm grants

and receives.
Different ratios calculated from financial
statements provide different users of the 3. Receivables Turnover
statements with relevant information about
The number of times the collection
the firm’s liquidity, solvency, profitability,
cycle is completed – from the time
and attractiveness of the stocks. Such
receivables are recorded, then
most commonly used ratios are categorized
collected, to the time new
based on their uses, as follows:
receivables are recorded again.
A. Liquidity Ratios
Net Credit Sales
RECEIVABLES ¿=
Liquidity refers to the company’s ability Average Receivables
to meet currently maturing obligations.
Related to the calculation of
Analysis of liquidity is most important Receivables TO, analysts compute
to short-term creditors. the Average Collection Period. The
formula is:
1. Current Ratio
No. of Working Day
Also called working capital ratio, AVE. COLLECTION PERIOD=
measures the number of times that Receivables ¿
the current liabilities could be paid This indicates the average number
with the available current assets. of days during which the company
Current Assets must wait before receivables are
CURRENT RATIO= collected.
Current Liabilities
An increase in receivables turnover
The current ratio should not be too
or decrease in average collection
low, because the firm would find it
period indicates an effective
difficult to pay its current
collection system. Naturally, the
obligations.
faster the cycle is completed, the
Neither should the ratio be too high, more quickly receivables are
for this means an excessive converted into cash.
investment in current assets that
Simply put, in comparison with the
does not produce much return.
credit terms the firm grants, the
2. Quick Ratio faster the customer pay, the better.

Sometimes called the acid test ratio 4. Inventory Turnover

is similar to the current ratio, except
The number of times inventory is
that the inventories and
replaced during the period.
prepayments are excluded from the
numerator. Merchandising Firm
Current Assets−Inventories−Prepayments Cost of Goods Sold
QUICK RATIO= INVENTORY ¿=
Current Liabilities Average Inventory
Interpretation of the quick ratio is As in the case of receivables, the
the same as in the current ratio. average age of inventory may
However, some analysts believe that likewise be computed. Its formula is:
a quick ratio of at least 1 indicates
an adequate ability to pay its No .of Working Days a Ye
AVE. INVENTORY DAYS=
current obligations. Inventory ¿

Determination of an adequate value Every time merchandise is sold,

of quick ratio depends on many profit is realized. Therefore,
factors, among them are the nature generally, a high inventory turnover
of the company, the type of industry and short average inventory days is
to which the firm belongs and the desirable.

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MAS 3: FINANCIAL MANAGEMENT

But this, as stated, is in general Another tool used to test a

terms. A lot of factors must actually company’s liquidity. Asset turnover
be considered in determining the measures the effectiveness of asset
desirability of inventory turnover utilization towards producing
like the nature of the firm’s revenues.
business.
Net Sales
ATO=
Manufacturing Firm Ave . Total Assets
Cost of RM Used The higher the ATO, the better and
RM ¿=
Average RM Inventory the more effective the management
is in using the company’s resources.
Cost of Goods Manufactured
WIP ¿=
Average WIP Inventory B. Solvency Ratios

Cost of Goods Sold Solvency refers to the company’s ability

FG ¿=
Average FG Inventory
When the raw materials, work in
process and finish goods turnovers
are divided into the number of
working days in a year, the
conversion period or average days of
each type of inventory may be
determined.
to pay all its debts, whether such
liabilities are current or noncurrent.
Solvency therefore is somewhat similar
to liquidity, except that solvency
involves a longer time horizon.
Both long-term creditors and
stockholders are interested in a
company’s solvency.

Naturally, the higher the turnover 1. Times Interest Earned

is, the shorter will be the conversion Determines the extent to which
period. operations cover interest expense.
Operating Cycle EBIT∗¿
¿ INTEREST EARNED= ¿
Ave. Collection Period Interest Expense
+ Ave. Inventory Days* *Earnings Before Interest and Taxes

*For a manufacturing firm, from the As a rule, the higher the times
three inventories. interest earned is, the better, for the
5. Payables Turnover company is considered solvent when
it can afford to pay all its expenses
The trade payables (accounts/notes and it still has a large amount left
payable) turnover. for net income.
Net Credit Purchases 2. Debt to Equity Ratio
PAYABLES ¿=
Average Payables
The total assets of a firm are
No . of Working Days aYear provided by the owners and
AVE. PAYMENT PERIOD= ¿
Payables ¿ creditors. Thus, this ratio
determines the amount provided by
The average payment period creditors relative to that provided by
indicates the number of days during the owners.
which trades payables remain
unpaid. Total Liabilities
DEBT ¿ EQUITY RATIO=
Total Equity
Naturally, the operating cycle must
be shorter than the average
payment period, so the company
may be ensured of cash availability
before the maturity of trade
payables.
6. Asset Turnover (ATO)

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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
As this ratio increases, the amount
of risk assumed by creditors
increases, since this means
decreasing solvency because the
creditors’ contribution to the
company’s total assets is greater
than the amount provided by the
owners.
3. Debt Ratio
Indicates the percentage of total
assets provided by creditors.
Total Liabilities
DEBT RATIO=
Total Assets
4. Equity Ratio
Indicates the percentage of total
assets provided by owners or
shareholders. This ratio is actually
the compliment of the debt ratio,
and therefore can be computed by
subtracting the debt ratio from
100%.
Total Equity
EQUITY RATIO=
Total Assets
The relationship between owners’
equity and liabilities indicates the
company’s use of financial leverage
which means the use a company
makes of borrowed funds to increase
the return on owners’ equity.
Financial leverage is achieved when
borrowed funds can be invested in a
project with a yield higher than the
interest rate paid on the borrowed
money, where the difference
increases the profit or return to
owners.
C. Profitability Ratios
When we express profit as a ratio, we
actually relate profit (or income or
return) to the amount of investment
acquired or used in generating such
return. The basic formula is:
Income
RATE OF RETURN =
Investment
Depending on the users of such ratio
and the purpose for which it is
computed, the above basic ratio may be
modified. In this section, the most
commonly used ways of looking at this
basic relationship are presented.
1. Return on Sales (ROS)
Measures the amount of income
provided by the average peso sales.
The income figure may either be
gross profit or net income.
Gross Profit
GROSS PROFIT RATIO=
Net Sales
The gross profit ratio indicates the
average mark-up obtained on
products sold.
Net Income
ROS=
Net Sales
The net income ratio (ROS) is widely
used as a measure of overall
profitability of operations.
Whether such ratio is considered
satisfactory or not depends on the
nature of the company’s business.
2. Return on Assets (ROA)
A measure of operating efficiency.
ROA indicates how well the firm’s
management has used the assets
under its control to generate
income.
EBIT
ROA=
Ave .Total Assets
A meaningful evaluation of the
firm’s ROA may be done by
comparing the figure with the ROA
of other firms in the same industry,
particularly the leading firm.
For internal analysts, the evaluation
may be done by comparing the ROA
with the target or desired ROA for
the period.
3. Return on Equity (ROE)
Measures the amount earned on the
owners’ (or shareholders’)
investment. ROE determines how
well the company is performing with
the investment contributed by its
owners. The basic formula is:
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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
Net Income
ROE=
Ave . Total Equity
For corporations with preferred
shares aside from the ordinary
shares, the formula is:
Net Income−Preferred Dividends
ROE=
Average Ordinary SHE
4. Basic Earnings per Share (EPS)
Considered as one of the most
important indications of profitability
because investors find it convenient
to see the amount earned for a
single share of stock.
Net Income−Preferred Dividends
EPS=
Weighted Ave . No .of Ord . Shares
No such calculation is done for
preferred shares because preferred
shares have a fixed amount of
earnings per share.
D. Market Ratios
Ratios that indicate the shares’
performance or attractiveness in the
market. Market ratios relate dividend
rate and EPS of shares to the current
market price of such shares.
1. Price to Earnings Ratio (P/E)
Sometimes called times earnings
ratio. P/E ratio indicates how many
pesos are required to buy a peso’s
worth of earnings.
Price per Share
P/ E RATIO=
Earnings per Share
With the calculation of P/E ratio,
financial analysts overcome the
difficulty of comparing differently
priced shares of stock.
2. Dividend Yield
Measure the rate of return in the
investor’s ordinary share
investment.
Dividend per Share
DIVIDEND YIELD =
Price per Share
Investors may compare the dividend
yield with their desired rate of
return on investment to determine
the desirability of investing in the
company.
If the corporation did not declare
dividends, investors cannot use the
dividend yield. Instead, other factors
may be considered such as the
firm’s growth rate, profitability,
liquidity, solvency, etc.
3. Dividend Payout
Measures the rate of dividends
distributed out of the total earnings.
Dividend per Share
DIVIDEND PAYOUT =
Earnings per Share
Normally, growth-oriented
corporations show low dividend
yield and payout ratios.
In this regard, investors must
always keep in mind that investing
in high-growth corporations is
generally riskier than investing in
corporations paying relatively high,
stable dividends.
DUPONT SYSTEM ANALYSIS
Used to dissect the firm’s financial
statements and to assess its
financial condition.
It merges the income statement and
balance sheet into two summary
measures of profitability, return on
total assets (ROA) and return on
common equity (ROE).
DuPont Formula:
Net Income Net Sales Net Income
x =
Net Sales Ave .Total Assets Ave .Total Assets
Or,
ROS x ATO = ROA
Modified Dupont Formula
Net Income Ave .Total Assets Net Inc
x =
Ave . Total Assets Ave . Ordinary SHE Ave .Ordina
Or,
ROA x EM* = ROE
*Equity Multiplier (EM) gives an idea
of how many times the owners’
equity is increased.
It can also be calculated using the
formula, 1 divided by Equity Ratio
or 1 plus Debt to Equity Ratio.
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