Topic V.

1
Analysis and Interpretation of Financial Statements 1
Learning Outcomes

At the end of the topic, you should be able to:

1. Solve exercises and problems that require computation and interpretation using horizontal
analysis and vertical analysis.
2. Using the downloaded sample financial statements, perform horizontal and vertical analysis

INTRODUCTION

WHAT IS THE FINANCIAL STATEMENTS ANALYSIS?

Financial statement (FS) analysis is the process of evaluating risks, performance, financial health, and
future prospects of a business by subjecting financial statement data to computational and analytical
techniques with the objective of making economic decisions (White et.al 1998).

There are three kinds of FS analysis techniques:

- Horizontal analysis
- Vertical analysis
- Financial ratios

This module will focus on horizontal and vertical analysis. We will discuss financial ratios next chapter.

HORIZONTAL ANALYSIS
Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement
data over a period of time with the purpose of determining the increase or decrease that has taken place
(Weygandtet.al 2013). This will reveal the behavior of the account over time. Is it increasing, decreasing or
not moving? What is the magnitude of the change? Also, what is the relative change in the balances of the
account over time?

The following are important points about the horizontal analysis of financial statements:
- Horizontal analysis uses financial statements of two or more periods.
- All line items on the FS may be subjected to horizontal analysis.
- Only the simple year-on-year (Y-o-Y) growth is covered in this lesson.
 - Changes can be expressed in monetary value (peso) and percentages computed by using the
following formulas:
• Peso change = Balance of Current Year - Balance of Prior Year
• Percentage change = (Balance of Current Year-Balance of Prior Year)/(Balance of Prior
Year)
• For example:

✓Peso change = P250,000 - P175,000 = P75,000

✓Percentage change = (P250,000 - P175,000) / P175,000 = 42.86%

VERTICAL ANALYSIS
Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement
item as a percentage of a base amount (Weygandt et.al. 2013).

- For the Statement of Financial Position, the base amount is Total Assets.
• We use the formula = Balance of Account / Total Assets
• From the common-size SFP, the analyst can infer the composition of assets and the
company’s financing mix.
• For example:

✓The above may be evaluated as follows: The largest component of asset is

Equipment at 39.3%. Cash is the smallest component at 14%. On the other hand,
50% of assets are financed by debt and the other half is financed by equity.
 - For the Statement of Comprehensive Income, the base amount is Net Sales.
• We use the formula = Balance of Account / Total Sales.
• This will reveal how “Net Sales” is used up by the various expenses.
• Net income as a percentage of sales is also known as the net profit margin.
• For example:

✓The above may be evaluated as follows:

• The cost of goods sold is 44% of sales. The company has a gross profit
rate of 55.5%. Operating expenses is 22% of sales.
• The company earns income of P 0.33 for every peso of sales. Gross
profit generated for every peso of sale is P 0.555

- The use of common-size financial statements allows the comparison of two companies of
different sizes. This is because the SFP and SCI comparative information are standardized as a
percentage of assets and sales, respectively.
- A common size financial statement displays entries as a percentage of a common base
figure rather than as absolute numerical figures. Common size statements let analysts
compare companies of different sizes, in different industries, or across time in an apples-
to-apples way.

Now, let us try to apply our knowledge by analyzing the financial statement of a real company.

1. I uploaded the 2020 Audited Consolidated Financial Statements of Jollibee Foods Corporation and
Subsidiaries December 31, 2020 and 2019 on our Google Classroom.

2. Let’s review the components of a complete the set of financial statements. This is a review of
Topics I – IV. Flip through the pages of JFC financial statements and identify and describe each
report. You should be able to find the following:
- The Statement of Financial Position (SFP) which reports the balances of assets, liabilities and
equity of the business as of a point in time;
- The Statement of Comprehensive Income (SCI) which shows the results of operations of the
business by reporting the revenue and expenses for the specific accounting period;
 - The Statement of Cash Flows (SCF) / Cash Flows Statement (CFS) which reports the actual cash
inflows and outflows for the period that are classified into the three main business activities,
namely, operating, investing and financing activities;
- The Statement of Changes in Equity (SCE) which reports all the changes, whether increases or
decreases to the owner’s interest on the company during the period; and
- The Notes to Financial Statements discussed the nature of the company’s operations, its
accounting policies, basis for estimates, components of the accounts and significant transactions.

3. Open the 2020 JFC Consolidated FS and find the SFP and answer the following questions:
a. How much is JFC’s total assets as of December 31, 2020?
b. How much of JFC’s liabilities are due to be paid on or before December 31, 2021?

4. Turn your attention to the Statement of Comprehensive Income and answer the following
questions:
a. What is the amount of JFC’s 2020 advertising expenses?
b. How much revenue did JFC earn in 2020 from royalties and franchise fee?

If you know how to read the financial statements, we would arrive at the same answers:
3. a. Php210,810,130 (in thousand pesos)
3. b. Php58,928,475 (in thousand pesos)
How did we arrive at Php58 billion for the liabilities due to be paid on December
31, 2021? JFC’s current liabilities as of December 31, 2020 is this amount, hence,
these are the liabilities that are due in one year.
4. a. Php2,643,907
4. b. Php6,467,134

These are only examples of information that users of financial statement, both internal and
external, can obtain from reading and studying the financial statements of one company.
Now, let’s practice:

Let’s apply the trend and common-size analysis of FS to the following company:

A. Statement of Financial Position

B. Statement of Comprehensive Income

Here is our answer:

How did we arrive with the answers?

- For the common-size or vertical analysis, we express each financial statement item as a
percentage of a base amount. Thus, for Cash, Balance of the Account / Total Assets or
Php110,000 / Php891,000 = 12% for the 2 014 and Php87,400 / Php874,000 = 10% for
2015. Other accounts are computed for using the same concept.

- For the trend or horizontal analysis, a technique for evaluating a series of financial
statement data over a period of time with the purpose of determining the increase or
decrease that has taken place, we compute for the Year-on-year (YoY) of the Cash
account as Current year balance – Base year balance / Base Year balance or Php110,000
– Php87,400 / Php87,400 = 26%. Other accounts are computed for using the same
concept.