CHAPTER 4: ANALYSIS OF FINANCIAL STATEMENTS

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).
A company`s financial statements provide important information about a business
enterprise. The analysis helps the user make an informed decision or judgement rather than rely on
guesses and intuition in the process of decision making by effectively and systematically using the
financial data. It lessens the uncertainly of outcomes with every decision made because of the use of
analytical tools to financial statements and the related data.

In order to evaluate a company, one-year data or a one year`s financial statement is not
sufficient. One needs at least two periods to make an evaluation or even three to five years if one is
to make a trend analysis. Financial statements are analyzed to evaluate a company`s present
financial position and operating performance in relation to its past. Using these figures, the company
can predict or forecast future operations.

FINANCIAL STATEMENT ANALYSIS

Different methods and techniques are used in analyzing financial statements. There are two
phases involved, namely the computation phase and the interpretation phase. In the first phase, we
compute of differences, percentages, or ratios. In the second stage, we interpret the results of the
figures we get from the first phase. The second phase, although more difficult than the first phase,
makes the analysis financial statements more meaningful because it communicates to the users the
significance of the results.

Using the statement of financial position and the income statement, financial statements
can be analyzed using the following techniques. There are considered the tools in analyzing the
financial data provided by the financial statements.

Horizontal Analysis compares the same account in the financial statements of two periods (current
and past year) determining the amount of changes and computing its percentage change using a
base year as comparison. It should be noted that for accounts in the base year with zero or negative
balances, the computation of percentage of change will not apply.

Vertical Analysis shows the relationship of each part to the whole in a single financial statement. In
the statement of financial position or balance sheet, each item is expressed as a percentage of total
assets or total liabilities and owner`s equity. In the income statement, each item is presented as a
percentage of net sales.

Trend Analysis compares not only two years but covers three, four, or five years` financial
statements. This is to determine the trends in the industry.

Financial Ratio Analysis describes the significant relationship between the numbers presented in the
financial statements. Ratios can be expressed either as a rate, percentage, or a proposition.
HORIZONTAL ANALYSIS IN FINANCIAL STATEMENTS

Horizontal Analysis, otherwise known as comparative analysis, helps management analyze

increases and decreases in balance sheet and income statement accounts. For examples, in the
balance sheet, a significant increase in property, plant, and equipment will indicate purchases of
land equipment, machinery or other plant assets necessary for use in the business. On the other
hand, a significant decrease will reveal disposal of such assets as management may have deemed
necessary. Comparing two consecutive years and noting magnanimous increases or decreases in
other balance sheet items may also be used by management for decision making purposes.

For income statement accounts, horizontal analysis also helps management analyze
significant increases or decreases in sales, cost of sales and expenses. For example, an alarming
decrease in net income may call management`s attention as the generation of net income is the
company`s main goal in doing business. This may lead management to evaluate other income
statement items such as sales, cost of sales, and expenses which are crucial component is arriving at
a company`s net income.

The conclusion, getting the amount of increases and decreases and their percentage, is just
the first step of the analysis. The difficult part is the interpretation of the results. In the real world,
this is subjective as there are no strict and fast rules to follow. Experience and industry trends are
considered in the picture.

INTERPRETATION OF DATA

In interpreting the data, it is important to note that the materiality of increase or decreases
depends on the size of the company. A material amount in one company may not be material to
another. For example, a hundred-thousand increase in the receivable of a small grocery may be
considered material to the small grocery but not to SM`s Hyper Mart considering their size,
capitalization, and volume of transactions. Hence, there is no strict rule to follow in determining the
materiality of an amount.

In analyzing the significance of a percent change in value, the analysis should not only enter
on internal factors controllable by management. An examples is the drop in sales of plastic bags. A
25% drop in the sales of a plastic bag company may be significant to the company but because of the
plastic ban issued by the Philippines government in some areas in Metro Manila, other company`s
plastic bag sales may have dropped by 30% to 50% considering the trend in the industry. This is an
outside factor over which management has no control. Hence, internal factors are not the only
factors considered in data analysis and interpretation but external factors as well. Management
should be well informed on the latest trends affecting their industry.

ANALYSIS

1. Current assets increased by 9.1%. This increase is a result of a 64.1% increase in accounts
receivable and a 57.7% increase in inventory. This increase in accounts receivable entails
management to check their credit and collection policy for prompt collection of accounts especially
that increase in net sales was only 27.3% and cash decreased by 32.5%. Likewise, the increase in
merchandise inventory necessitates management to check their inventory stocks for obsolescence
or slow moving items comparing their increase in sales and the increase in inventory.
2. Property, Plant, and Equipment showed a 235.6% increase. This may be due to purchases made by
the company to invest in plant assets. It is possible for the owner to invest property and equipment
in the business. However, in the case of Fidas Merchandising, owner`s equity showed a decrease of
2.9%. This might not be possible unless the owner invested non-current assets then afterwards
made large amounts of withdrawals during the year.

3. Current liabilities and owner`s equity decreased despite increase in total liabilities and owner`s
equity. This can be explained by the 383.9% increase in the company`s non-current liabilities which
means that the company made heavenly borrowings during the year. Sources of business funds are
generated either from the investment of the owner or loans from banks of financial institutions. In
the case of Fidas Merchandising, the company obtained additional funds through loan. With the
significant increase in non-current assets, it can be inferred that the loan obtained by the company
was used to finance the acquisitions of the property, plant, and equipment.

4. Net sales increased by 27.3% during the year. However, despite the increase in sales, net income
decreased by 7.3%. Looking at the other components of the income statement, cost of goods sold
increased by 24.1%. Even with this increase in cost of goods sold, gross margin registered a 30.2%
increase. Selling and administrative expenses showed a 34% increase. Despite this, income from
operations recorded as 18% increase. The company`s increase in interest expense of 198% resulted
in a decrease in income before taxes despite the increase in net sales. Analyzing the components of
the income statement, we were able to explain the decrease in net income despite increase in net
sales. Hence, management can now understand that the magnanimous increase in interest expense
caused the decrease in overall net income.

VERTICAL ANALYSIS

VERTICAL ANALYSIS IN THE STATEMENT OF FINANCIAL POSITION

In the statement of financial position, vertical analysis, otherwise knowns as common-size

analysis, help management analyze the components of the total assets as well as the components of
the total liabilities and owner`s equity. It helps management answer certain question as follows:

1. Of the total assets, what percent is classified as current? Non-Current?

2. Of the total assets, what percent is account receivable? Merchandise Inventory?
3. Of the total liabilities, what percent is classified as current? Non-Current?
4. Of the total liabilities and owner` equity, what percent is liabilities? What percent is owner`
equity?

The answer to the above questions may lead to other questions such as when accounts
receivable occupy a big percentage of current assets, are these receivables collectible? This may
reflect on the company`s credit and collection policy. This indicate the leniency of a company in
extending credit to its customers and the terms and policies for collection. If a big percentage of the
total assets is allotted to merchandise inventory, this raises a question as to the whether the
inventory is saleable or obsolete. For the percentage of total liabilities versus owner`s equity, this
indicates the part of the company financed by creditors and the part of the company financed by the
owner. In short, what part of total assets is financed by the creditors and what part of the total
assets is financed by the owner?

VERTICAL ANALYSIS IN THE INCOME STATEMENT

 In the income statement, vertical analysis helps management analyze the component of the
income statement in relation to its revenue account which is sales. It helps management answer
certain questions as follows:

1. What percentage of net sales is cost of sales or cost of goods sold? Gross Profit? Operating
Expenses?
2. If operating expenses were divided between selling and administrative expenses, what
percent of net sales is absorbed by selling expenses? Administrative expenses?
3. What is the percentage of net income to sales?

The following are the steps in performing a vertical analysis

1. Prepare comparative financial statements of two consecutive years.

2. Add one addition column on the right side of each year.
3. For the comparative statement of financial position, express each account as a percentage
of the total assets. The total assets is automatically 100%. Likewise, total liabilities and
owner`s equity is automatically 100%. Likewise, total liabilities and owner`s equity is
automatically 100%.

Example

% of current assets = ₱ 725.8 x 100% = 28%

₱2,592.2

% of non-current liabilities = ₱ 1,822.4 x 100% = 70.3%

₱ 2,592.2

4. For the comparative income statement, express each account as a percentage of net
sales. Net sales is automatically 100%.

Example

% of cost of goods sold = ₱ 1,032.1 x 100% = 46.6%

₱ 2,213.3

INTERPRETATION OF DATA

Analysis

1. Current assets was 54.5% of total assets in 2016. However, this percentage decreased to 28% in
2017. This was due to the significant increase in property, plant, and equipment. Hence, the
dramatic change in total assets composition.

2. Non-current assets represented by property, plant, and equipment was 45.5% of total assets in
2016 and 72% in 2017. This may be due to purchases made by the company during the year to invest
in plant assets.
3. Current liabilities was 50.8% of total liabilities and owner`s equity in 2016 but significantly
decreased to 21.3% in 2017. This is opposite to non-current liabilities which was 30.8% of total
liabilities and owner`s equity in 2016 but increased to 70.3% in 2017. The company made a loan
during the year and might have paid its current liabilities. Hence, the opposite change in the two
liabilities. Hence, the opposite change in the two liabilities. Percentage of owner`s equity to total
liabilities and owner`s equity was 18.4% in 2016 and 8.4 in 2017. This means that the equity financed
by creditors represented by total liabilities was 81.6 in 2016 and 91.6 in 2017. This is not a good sign
as the company`s business funds are heavily provided by creditors

4. From the income statement, the percentage of net income to sales decreased from 8.7% to 6.4%.
This decrease has been explained by the onerous interest expense in the horizontal analysis
discussed in the previous lesson. The percentage of cost of goods sold in relation to net sales
indicated a minimal decrease from 47.8% to 46.6% while selling and administrative expenses
indicated a minimal increase from 38% to 40.2%. The relation of interest expense to net sales during
the year increased more than double from 1.8% to 4.1%. Finally, net income in relation to net sales
decreased from 8.7% to 6.4% despite the company`s acquisition of property, plant, and equipment.

TREND ANALYSIS

In trend analysis, a base year is established which is labeled as the 100% thereby expressing
figures of all other years as a percentage of the base year. The amount under each year is divided by
the amount in base year thereby determining the amount

STEPS IN PERFORMING A TREND ANALYSIS

1. Prepare comparative financial statements for three, four or five consecutive years.

2. Choose a base year. Usually the first year is the base year.

3. Calculate the trend percentage for each item by dividing the amount of each item by the base
year. The base year is automatically 100%.

Trend % = Chosen Year x 100%

Base Year
Example

Current Assets Trend % 2016 = ₱665.40 x 100% = 111.3%

₱597.60

INTERPRETATION OF DATA

Analysis

1. Cash increased in 2016 but significantly decreased in 2017. Accounts Receivable and Inventory
continued its upward trend for three years. Although net sales has an upward trend, its increase is
not on a par with the increased in accounts receivable and inventory from 2017. The company`s
credit and collection policy should be reviewed and inventory should be checked for obsolete and
slow moving items.
2. Property, Plant, and Equipment decreased in 2016 but dramatically increased in 2017 due to
acquisitions made by the company. Likewise, non-current liabilities significantly increased in 2017
which means that the company used the loan to acquire the property, plant, and equipment.

3. Total liabilities has an upward trend while owner`s equity has a downward trend indicating that
the company heavily relied on outside funds from creditors.

4. Net sales had an upward trend from three years while property, plant, and equipment decreased
in 2016 but significantly increased in 2017. This may indicate that the company is benefitting from
the use of the newly acquired non-current assets as evidenced by the increase in sales.

5. Cost of sales has an upward trend but despite this, gross profit managed to follow with an upward
trend. Selling and administrative expenses has an upward trend, income from operations decreased
in 2016 but increased in 2017.

6. Interest expense has the most significant increasing trend in three years culminating to more than
300 percent increase in 2017. With cost of sales and all expenses going up, income understandably
went on a downward trend despite an upward trend in net sales.

Tools used in the analysis of financial statements

1. Horizontal Analysis – compares the same account in the financial statements of two periods
(current and past year) determining the amount of changes and computing its percentage
change using a base year as comparison.
2. Vertical Analysis – shows the relationship of each part to the whole in a single financial
statement. In the statement of financial position, each item is expressed as a percentage of
total assets or total liabilities and owner’s equity. In the income statement, each item is
presented as a percentage of net sales.
3. Trend Analysis – analyzes not only two years in comparison but covers, three, four or five
years’ financial statement.