FINANCIAL ANALYSIS

Introduction
Financial statements are hot items for all businessmen. These statements are great motivators for
businessmen to move further as it gives them the measurement of business performances (feedback
value) and they can be used to predict the future (predicted value) using financial analysis. These
statements are the following:

1. The Income Statement – the statement that shows the result of the business operations. The
result might be profit, if the revenues exceed the expenses, or loss, if the expenses exceed
revenue.
2. The Statement of Comprehensive Income – the statement that shows the earnings which are
not yet realized during the reporting period.
3. The Statement of Financial Condition – the statement that shows the financial health status of
a business.
4. The Statement of Cash Flows – the statement that shows the sources of a business, cash and
how these cash are spent.
5. The Statement of Changes in Equity – the statement that shows the changes in equity arising
from the additional investment and/or from the operations representing the income or loss
generated during the accounting period.
6. Notes to the Financial Statements – this shows the explanation and details of the various line
items in other statements.

The six financial statements listed above are the bases for making business decisions. Business
decisions related to closure of a business unit or expansion of the business, procurement of new
equipment on account, applying for new loans or issuance of bonds or shares of stocks, etc.

Objectives of Financial Statement Analysis

1. Assessment of past performance – financial statements are historical and therefore a very
good indicator of future operations. Investors are normally interested in trends that can easily
be facilitated in financial statements analysis. Accordingly, past performance is a good indicator
of future performance.
2. Assessment of current position – financial statement analysis will show the current position of
the business and the interpretation of its prime component will certainly tell the user of the
current business status.
3. Prediction of profitability and growth prospects – financial statements have predictive value
once you go deeper and analyze them in relation to other accounts periods.
4. Prediction of bankrupt and business failures – financial analysis can predict bankruptcy using
ratio analysis. For example, the leverage ratio, number of times interest earned, etc.
 5. Assessment of operational efficiency – financial analysis can also assess a company’s operation
through comparison of previous years’ operations and an assessment of potential future
operations using planned operation.

Limitation of Financial Statement Analysis

The financial statements mentioned have feedback value and predictive value. Unless one
performs a deeper analysis, he or she cannot uncover the best elements of the business
operations and the bad elements that can be improved. Although financial analysis is a good
tool in helping business decision makers, there are two noted limitations that decision makers
should consider. These two limitations are:

1. The Lack of comparability with other companies. The differences in accounting

treatments of various accounts sometimes make it very difficult to compare companies.
For example, one company might be using LIFO (last-in-first-out) and the other company
is using FIFO (first-in first out). In the period of rising prices in commodities, FIFO will
result in bigger inventory hence the company’s ending inventory will come from the
latest purchases. Higher ending inventory could result in bigger profits. The exact
opposite is LIFO because in a period of rising prizes in commodities, it can have lower
ending inventory resulting in smaller profits for the company.
2. There is a need to look further beyond financial ratios. Ratios are not conclusive. These
ratios are not to be viewed as an end but rather as a starting point by which the analyst
could be led to a greater depth. The analyst should look at other data in order to make
sound decisions like:

a. Industry trend;
b. Technological changes;
c. Changes in consumer behavior;
d. Changes in the company itself;
e. The economy and the peace and order situation of the country; and
f. The strong political influences of those that are in the administration and in the
opposition.

Comparative Income Statement

Comparative financial statements are achieved if there are consistent treatment of various
transactions and accounts. Consistency happens only when the business enterprise has an
 accounting manual that guides the finance department staff. Basically the contents of the
accounting manual are:

1. The chart of accounts that is a list of account titles which the company may use in all its
transactions;
2. In some instances, it contains journal entries of routinary transactions;
3. Accounting policies and procedures
4. The organizational chart of the finance department including its duties and
responsibilities; and
5. Organizational chart showing the right placement of finance department in the
companywide organizational chart.

Vertical Analysis of Income Statement

The income statement of grand Le’ kasj as shown in figure 5.2 focuses on the major components
of the income statement. Using the vertical analysis, sales are considered as the standard of
comparison at which all other figures are compared. Since sales are the standard of comparison,
sales will be 100%. For year 2011, the percentage of cost of sales is computed by dividing
8,730,000(cost of sales) by 17,270,000 (sales) and the percentage of operating expenses is
 computed by dividing 6,081,325 (total operating expenses) by 17,270,000(sales). As a learner,
try using a calculator in computing percentage for years 2012 and 2013 as shown in figure 5.2.

Year 2013 Year 2012 Year 2011

Sales 20,880,000 100% 17,010,000 100% 17,270,000 100%

Less: Cost of sales 9,720,000 47% 8,490,000 50% 8,730,000 51%

Gross Profit 11,160,000 53% 8,520,000 50% 8,540,000 49%

Less: Operating 6,711,950 32% 6,310,275 37% 6,081,325 35%
Expenses
Net income before tax 4,448,050 21% 2,209,725 13% 2,458,675 14%

Income tax (30%) 1,334,415 6% 662,918 4% 737,603 4%

Net Income After Tax 3,113,635 15% 1,546,808 9% 1,721,073 10%

Interpretation:
After the computational aspect, analyze and observe the rise and fall of percentages from
year to year.

In year 2011, the cost of sales is 51% and its operating expenses is 35%
In year 2012, the cost of sales is 50% and its operating expenses is 37%
In year 2013, the cost of sales is 47% and its operating expenses is 32%

The operating performances of the company showed that it continuously improved its cost of sales
from 51% in year 2011 to 47% in 2013. It is assumed that the qualities of products were not reduced
because sales also increased, neither were the company’s services to their customers because
operating expenses were reduced by 3% in comparison with year 2011 figures. As stated before, these
analyses are not conclusive. These will only be the starting point where the company should consider
non- financial aspects and discover more opportunities for growth.

Manager’s Action

Upon seeing the good operating performance, the manager should work more and may even analyze
the breakdown of the cost of sales and operating performance to look on possibility of improving
more the operating performance. It is only by doing this that new opportunities can be discovered and
 more improvement in operations can be made that in turn will give the owner the best return of his
investment.

Horizontal Analysis of the Income Statement

Year 2013 Year 2012 Increase

(Decrease)
Sales 20,880,000 17,010,000 3,870,000 23%

Less: Cost of sales 9,720,000 8,490,000 1,230,000 14%

Gross Profit 11,160,000 8,520,000 2,640,000 31%

Less: Operating Expenses 6,711,950 6,310,275 401,675 6%

Net income before tax 4,448,050 2,209,725 2,238,325 101%

Income tax (30%) 1,334,415 662,918 671,498 101%

Net Income After Tax 3,113,635 1,546,808 1,566,828 101%

In doing the horizontal analysis of an income statement, two year reports shall be compared and the
increase (decrease) of each account is computed.

Vertical Analysis of the Statement of Financial Condition

Statement of financial condition is restructured for easy computation of ratios.

Year 2013 Year 2012 Year 2011

Current Assets 1,105,500 17% 1,025,500 15% 955,900 14%

Non-Current Assets 5,583,120 83% 5,822,710 85% 6,062,700 86%

Total Assets 6,688,620 100% 6,848,210 100% 7,018,600 100%

Current Liabilities 1,664,415 25% 952,918 14% 1,147,528 16%

Non-Current Liabilities 1,500,000 22% 1,500,000 22% 1,500,000 21%

Stockholders’ Equity 3,524,205 53% 4,395,293 64% 4,371,073 62%

Total Liabilities and Equity 6,688,620 100% 6,848,210 100% 7,018,600 100%

Vertical Analysis of the Statement of Financial Condition

Year 2013 Year 2012 Increase %

(Decrease)
Current Assets 1,105,500 1,025,500 80,000 8%

Non-Current Assets 5,583,120 5,822,710 (239,590) (4%)

Total Assets 6,688,620 6,848,210 (159,590) (2%)

Current Liabilities 1,664,415 952,918 711,497 75%

Non-Current Liabilities 1,500,000 1,500,000 0 0%

Stockholders’ Equity 3,524,205 4,395,293 (871,088) (20%)

Total Liabilities and Equity 6,688,620 6,848,210 (159,591) (2%)