FINANCIAL STATEMENT ANALYSIS

 Primary purpose: evaluate and forecast the company's financial health

 
ANALYSIS AND INTERPRETATION
 
Users try to find answers to the following when analyzing fs:
1. profitability of the business
2. the firm's ability to meet its obligations
3. safety of the investment in the business
4. effectiveness of management in running the firm
 
 
ANALYTICAL TOOLS AND TECHNIQUES
 
1. Analysis of variation in Gross profit and net income
2. Statement of changes in Financial Position
3. Cash flow statement
4. Vertical Analysis (Common Size Statements)
5. Horizontal Analysis (Trend Ratios and Percentages)
6. Financial Ratios
 
 
HORIZONTAL ANALYSIS aka TREND ANALYSIS
 Comparing figures shown in the FS of two or more consecutive periods
 The difference between the figures of the two periods is calculated
o The percentage change from one period to the next is computed- using the earlier period as
base
 Note: The absolute change (in pesos) and percentage changes between the values being
compared should be carefully interpreted because a percentage change may be extremely large,
but the absolute change is not necessarily significant. For instance, a 200% change in the amount
of 30,000- this may not be significant by some analysts, particularly if the securities are related to
cash balance and total assets.
 If base year amount is zero, there shouldn't be a percentage shown.
 
VERTICAL ANALYSIS aka COMMON SIZE STATEMENTS/ 100 PERCENT STATEMENTS/ COMPONENT
STATEMENTS
 Process of comparing the figures in the financial statements of a single period
 Converting the figures in the statements to a common base
o Expressing all the figures in the statements as a percentage of an important item such as
total assets and total sales
 As a result, all figures in the statements would be expressed in PERCENTAGE TERMS.
 More MEANINGFUL when we are analyzing fs of different companies
 Comparing two amounts of two accounts from different companies is unfair. Therefore, items are
reduced to a common unit.
 For instance:
o Company A: 1,800,000 total assets; 120,000 total cash
 Percentage of cash is 6.67%
  It is helpful for companies to compare its own financial statements to other firms to evaluate its
own performance in relation to their competitors.
 
RATIO ANALYSIS
 MOST WIDELY KNOWN and most commonly used tool for financial statement analysis (financial
condition and performance)
 Mathematical relationship between two numbers
o Proportion, fraction, percentage, decimal
 Through this, we'll be able to know the liquidity, solvency, and profitability
 DIFFERENT RATIOS ARE USEFUL TO DIFFERENT USERS
o Long term creditors- solvency
o Short term creditors- liquidity
o Potential investors/ stockholders- profitability; behavior of shares of stocks in the market
(attractiveness of stocks)
o Managers- all aspects
 
A. TESTS OF LIQUIDITY- CTA
 To test the company's ability to pay it short-term current liabilities as they fall due
 
 Current Ratio
 Working capital ratio/ Banker's ratio
 Measures the number of times that the current liabilities could be paid with the
available current assets.
 Formula:
 Current Ratio= Current Assets/ Current Liabilities
 2.07 to 1= 605/292 (1990)
 1.88 to 1=1 519/276 (1989)
 This indicates that the company has enough current assets to pay its
current liabilities twice.
 Too low ratio is bad like 1.2 to 1 because it would be difficult to pay
current liabilities
 Too high ratio is also bad like 5 to 1 because an excessive
investments in current assets= does not produce much return for
the company
 
 Acid test ratio
 Quick Ratio
 Refined version of current ratio
 Solves the problems of using total figures of total current assets which conceals
important information; for instance, how much inventories and accounts receivable;
and how soon are they converted to cash?
 Inventories and prepayments are EXCLUDED
 Only NEAR CASH are included
 Formula:
 Quick Ratio= Quick Assets/Current Liabilities
 Quick Ratio= Cash + Marketable securities + Receivables /Current Liabilities
  Some analysts say that an acid test ratio of at least 1 indicates an
adequate ability to pay. However this does not apply to all companies. It
depends on what nature the company belongs to, type of credit terms the
company grants and receives.
 For instance:
 Acid ratio A company sells a 30 day credit term and buys at a 60 day
credit term can be lower than the acid ratio of the a company that
sells at a 60 day credit term and buys at a 30 day credit term.
 Cash Ratio
 Formula
 Cash ratio= Cash + Cash Equivalents + Marketable Securities/ Current Liabilities
 Tests short-term liquidity without relying on receivables and inventories.
 Higher than 1 ratio- very liquid
 
 Cash to Current Assets Ratio
 Measures liquidity of current assets
 Formula
 Cash to Current Assets Ratio= Cash + cash equivalents + Marketable Securities/
Current Assets
 
 Cash Flow Ratio
 Tests the significance of cash flow for settling current obligations as they become due
 Formula
 Cash Flow Ratio= Operating cash flow (net income+ depreciation +income tax+ non-
cash expenses- changes in working capital)/ Current Liabilities
 
 Defense Interval
 Reflects the percentage of near cash items to the daily operating cash flow
 Formula:
 Defensive Interval= Cash Equivalents + Net Receivables + Marketable Securities/ Daily
Operating Cash flow
 Daily Operating Cash Flow= Operating Cash Flow/ 360- if silent
 
 Net Working Capital
 Indicates the amount invested by the business to operate its normal activities
 Formula:
 Net Working Capital= Current Assets- Current Liabilities
 
ASSET MANAGEEMENT RATIOS
 Turnovers
 This is formulated because the acid ratio and the current ratio cannot give answers to
the following:
 How long can the firm expect to realize cash from its receivables and
inventories?
 When should the firm pay its various current liabilities?
 
A. RECEIVABLES TURNOVER
  Time required to complete one collection cycle- from the time receivables are recorded,
then collected, to the time new receivables are recorded again.
 Measures the efficiency in credit and collection policies
 The faster the cycle is completed, the more quickly the receivables are converted to
cash.
 Formula:
 Receivables Turnover= Net Credit Sales/ Average Receivables
 The higher the turnover, the better.
 RI= 3,280/ 180+210/2=123.2222 16.82 turnovers
 Sometimes, the net credit sales cannot be obtained especially for
someone who does not belong to the firm. Hence, the net sales figure
may be used.
 Average receivables are used because balance sheet data like
receivables are for a point in time. They do not represent the whole
period. Therefore, an average should be computed to represent the
entire accounting period.
 Formula:
 Average of Receivables= Beg Balance+ Ending Balance/ 2
 
 However, year end balances may not be a representative
during most of the year. Therefore, year's monthly or
quarterly balances should be used.
 For example: Monthly balances
 January 1 balance plus February to December month
end balances divided by 13 months
 If beginning balances are not available, some analysts
just use the ending balance if the average figure cannot
be determined.
 Through this, analysts can compute the average age of receivables or
days' sales in receivables. (how long the company must wait before
receivables are collected)
 Formula:
 Average age of receivables= number of working days in a year/
receivables turnover
 Measures the number of days to collect a receivable
 The lower the better
 
 360/16.82=21.40 days
 Say the credit term given by a Company is 30 days, then 21.40
days is the collection period, the performance of the
company's credit and collection department is satisfactory
enough.
 
B. INVENTORY TURNOVER
 Measures the number of times that inventory is replaced during the period.
 Indicates if a firm holds excessive stocks of inventories that are unproductive and that lessen
the company's profitability.
 
  MERCHANDISING FIRM
 Formula:
 Inventory Turnover= COGS/ Average Merchandise Inventory
 Average Merchandise Inventory= Beg Balance+ Ending Balance/2
 If the inventory balances fluctuate due to seasonal variations, the monthly
or quarterly balances if available must be used.
 2,640,000/190,000+250,000/2=12 times
 Average age of inventories= number of working days in a year/ inventory
turnover
 Measures the average number of days that inventory is held before sale
 360/12=30 days
 A high turnover and short average age is desirable. = every time
merchandise is sold, profit is realized
 However, some things should be considered. If turnover is very
high, the possibility of running out of stock is great= which then
result to losing customers.
 If turnover is very low, stocks are kept for too long which entails
additional costs such as storage costs, insurance, maintenance,
interest on funds tied up in inventory.
 Nature of the firm's business must also be considered in determining
whether the turnover is satisfactory or not.
 Companies selling at a MINIMAL MARK UP and relies heavily on high
volume of sales to earn high profit require high turnover.
(perishable goods, change in fads or styles)
 HIGH MARK UP companies like jewelry stores don't need a high
turnover.
 MANUFACTURING FIRM
 Raw Materials Turnover= Cost of Raw Materials Used/ Average Raw
Merchandise Inventory
 Goods in Process Turnover= Cost of Goods Manufactured/ Average Goods in
Process Inventory
 Finished Goods Turnover= COGS/ Average Finished Goods Inventory
 Working days/ turnover= conversion period or average age of each type
of inventory
 
 
Operating Cycle- begins from the time raw materials are acquired through production, sale of
finished goods, until the time when receivables are collected or converted into cash which may in
turn be used again to acquire raw materials.
 Formula:
 Operating Cycle/ CONVERSION PERIOD = Sum of average ages of
receivables and the three inventories
 Measured the average number of days to convert inventories to
cash
 The lower the better
 Basehan kung mag purchase ug accounts
 
C. TRADE PAYABLES TURNOVER
  ACCOUNTS/NOTES PAYABLE TURNOVER
 Formula
 Payables Turnover= Net Credit Purchases/ Average Trade Payables
 Average Age of Trade Payables= Number of Working days/ Payables Turnover
 Or Average Age of Trade Payables= Average Accounts Payable/ Average Daily
Purchases
 Determines whether the firm is paying its invoices on a timely basis
 Number of days during which trade payables remain unpaid
 From the purchase of materials up to the payment of accounts payable arising
from such a purchase
 IT WOULD BE MEANINGFUL to compare the conversion period for trade
payables and the firm's operating cycle.
 Naturally, the operating cycle must be shorter than the average age of the
payables to ensure that cash is available before the maturity of the trade
payables.
 
FIXED ASSETS TURNOVER
 Measures the level of use of PPE
 Formula:
 Fixed Assets Turnover= Net Sales/ Average Net Fixed Assets
 Sample: 6.57 turnovers
 For every net fixed asset used, they were able to generate a revenue of 6.57.
 
TOTAL ASSETS TURNOVER
 Measures the effectiveness of asset utilization
 Formula:
 Total Assets Turnover= Net Sales/ Average Total Assets
 Sample: 3.62 turnovers
 For every peso of total assets, we were able to generate 3.62 sales.
 Compare this to your competitors
 
 
D. CURRENT ASSETS TURNOVER
 Measures the movement and utilization of current assets to meet operating requirements
such as payment of salaries, supplies
 Formula:
 Current assets turnover= Cost of Sales+ Operating expenses (Except depreciation and
amortization)/ Average Current assets
 Depreciation and amortization are not included as they don’t need utilization of
current assets.
 Satisfactory figure for the turnover is SUBJECTIVE
 However, if we compare the company to other companies:
 Much higher turnover rate than others, the firm's current assets is
inadequate to meet current operating requirements.
 Much lower turnover rate means the business is sluggish; keeping
too much current assets for current operations, thereby losing the
opportunity of investing idle resources in other profitable ventures.
 
B. TESTS OF SOLVENCY- NDDE (LEVERAGE)
 Number of times interest earned ratio
Measures the ability of the firm to
satisfy interest payments given the
amount of EBIT.
 FORMULA= EBIT (Operating Profit)/Interest expense
 
 Debt-equity ratio
Measures the resources provided by
creditors with resources provided by
shareholders.
 FORMULA=
Total liabilities/Total shareholders’
Equity
 
 Debt-to-asset ratio or Debt ratio
Measures the amount of funds
provided by the creditors.
 FORMULA= Total liabilities/Total asset
 
 
 Equity Ratio
 
 Financial leverage index
If the index exceeds 1.0, it is
favorable and the use of financial
leverage is successful.
 FORMULA= Return on common equity/Return on
assets
 
 Equity multiplier
Measure the amount of assets
financed by equity. The higher the
ratio, the greater is the leverage.
 FORMULA= Average total assets/Average common equity
 
 Operating cash flow to total debt ratio
Measures the portion of total
liabilities that can be paid out of the
cash flows from operations.
 FORMULA= Operating cash flow/Total debt
 
C. TEST OF PROFITABILITY- RCUBE E
- Measures the ability of the firm to earn profits given their amount of sales, assets, and equity
 
 Return on Sales
 Measures the amount of net income generated per peso of sales
 RETURN ON SALES= NET INCOME/ NET SALES
  For ex: If ROS is 10%, the profit is able to have a return of 10 cents from every peso of a
sale.
 The higher the ratio, the better
 
 GROSS PROFIT RATE
Measures gross profit percentage
on sales to recover operating
expenses.
 GPR= Gross Profit/ Net Sales
 The higher the better
 Generate a higher income if expenses were properly maintained
 
 Return on total assets
Measures the overall asset profitability.
 FORMULA= Net income/Average total assets
 
 Return on TOTAL owners' equity
Measures percentage of profit derived per peso of owners’ equity
 FORMULA= Net income/Average total equity
 
 Earnings per share/ Return on Common Equity
Measures percentage of profit
derived per peso of ordinary shares.
 FORMULA= Earnings available to ordinary
Shareholders (Total net income- Preferred Dividends)/Average ordinary
Equity (includes RE)
 
D. MARKET TESTS - PDD or GROWTH AND VALUATION RATIOS
 BASIC EARNINGS PER SHARE
Measures the amount of earnings
for ordinary shareholders per share
outstanding.
 FORMULA= Earnings available to ordinary
shareholders/Average ordinary
shares outstanding
 
 Price-earnings ratio
Measures the confidence of the
inventors in the company’s stock.
 FORMULA= Market price per share/Earnings per
Share
 
 Dividend yield
Measures the rate of cash return to
investment in stock
 FORMULA=
Cash dividend per ordinary
share/Market price per share
  
 Dividend payout
Measures if a firm pays out its
earnings in dividends.
 FORMULA=
Cash dividend per ordinary
share/Earnings per share
 
 BOOK VALUE PER SHARE
Measures the amount of net assets
available to the shareholders of a
given type of stock.
 FORMULA=
Shareholders’ equity/Average shares
Outstanding
 
 
 MARKET TO BOOK RATIO
Measures how high is the shares’
market price in relation to book
value.
 FORMULA=
Market price per share/Book value
per shar e