San Carlos College

Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

FINANCIAL STATEMENT ANALYSIS

A financial statement is an official document of the firm, which explores the entire financial information of the firm. The
main aim of the financial statement is to provide information and understand the financial aspects of the firm. Hence,
preparation of the financial statement is important as much as the financial decisions.

Financial statements generally consist of two important statements:

1. Profit and Loss or the Income Statement.
2. Balance Sheet or the Statement of Financial Position.

A part from that, the business concern also prepares some of the other parts of statements, which are very useful to the
internal purpose such as:
1. Statement of Changes in Owner’s equity.
2. Statement of Changes in Financial position or Cash Flow Statement.

Income Statement
Income statement is also called as profit and loss account, which reflects the operational position of the firm
during a particular period. Normally it consists of one accounting year. It determines the entire operational performance of
the concern like total revenue generated and expenses incurred for earning that revenue. Income statement helps to
ascertain the gross profit and net profit of the concern. Gross profit is determined by preparation of trading or
manufacturing account and net profit is determined by preparation of profit and loss account.

Statement of Financial Position

Statement of Financial Position is also called as balance sheet, which reflects the financial position of the firm at
the end of the financial year. Statement of Financial Position helps to ascertain and understand the total assets, liabilities
and capital of the firm. One can understand the strength and weakness of the concern with the help of the position
statement.

Statement of Changes in Owner’s Equity

It is also called as statement of retained earnings. This statement provides information about the changes or
position of owner’s equity in the company. How the retained earnings are employed in the business concern. Nowadays,
preparation of this statement is not popular and nobody is going to prepare the separate statement of changes in owner’s
equity.

Statement of Changes in Financial Position

Income statement and position statement shows only about the position of the finance, hence it can’t measure the
actual position of the financial statement. Statement of changes in financial position or cash flow helps to understand the
changes in financial position from one period to another period. It provides information about the operating, financing,
and investing activities of the company and the effects of those activities on the cash position of the company.

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

Types of Financial Statement Analysis

Analysis of Financial Statement is also necessary to understand the financial positions during a particular period.
According to Myers, “Financial statement analysis is largely a study of the relationship among the various financial
factors in a business as disclosed by a single set of statements and a study of the trend of these factors as shown in a series
of statements”.
Analysis of financial statement may be broadly classified into two important types on the basis of material used
and methods of operations.

1. Based on Material Used

Based on the material used, financial statement analysis may be classified into two major types such as External
analysis and internal analysis.
 External Analysis
Outsiders of the business concern do normally external analyses but they are indirectly involved in the
business concern such as investors, creditors, government organizations and other credit agencies. External
analysis is very much useful to understand the financial and operational position of the business concern. External
analysis mainly depends on the published financial statement of the concern. This analysis provides only limited
information about the business concern.
 Internal Analysis
The company itself does disclose some of the valuable information to the business concern in this type of
analysis. This analysis is used to understand the operational performances of each and every department and unit
of the business concern. Internal analysis helps to take decisions regarding achieving the goals of the business
concern.

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

2. Based on Method of Operation

Based on the methods of operation, financial statement analysis may be classified into two major types such as
horizontal analysis and vertical analysis.
 Horizontal Analysis
Under the horizontal analysis, financial statements are compared with several years and based on that, a
firm may take decisions. Normally, the current year’s figures are compared with the base year (base year is
consider as 100) and how the financial information are changed from one year to another. This analysis is also
called as dynamic analysis.
 Vertical Analysis
Under the vertical analysis, financial statements measure the quantities relationship of the various items in
the financial statement on a particular period. It is also called as static analysis, because, this analysis helps to
determine the relationship with various items appeared in the financial statement.

Techniques of Financial Statement Analysis

Financial statement analysis is interpreted mainly to determine the financial and operational performance of the
business concern. A number of methods or techniques are used to analyze the financial statement of the business concern.
The following are the common methods or techniques, which are widely used by the business concern.

1. Comparative Statement Analysis

Comparative statement analysis is an analysis of financial statement at different period of time. This statement
helps to understand the comparative position of financial and operational performance at different period of time.
Comparative financial statements again classified into two major parts such as comparative balance sheet analysis and
comparative profit and loss account analysis.

 Comparative Balance Sheet Analysis

Comparative balance sheet analysis concentrates only the balance sheet of the concern at different period
of time. Under this analysis the balance sheets are compared with previous year’s figures or one-year balance
sheet figures are compared with other years.

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

Comparative balance sheet analysis may be horizontal or vertical basis. This type of analysis helps to understand
the real financial position of the concern as well as how the assets, liabilities and capitals are placed during a
particular period.

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

 Comparative Profit and Loss Account Analysis

Another comparative financial statement analysis is comparative profit and loss account analysis. Under
this analysis, only profit and loss account is taken to compare with previous year’s figure or compare within the
statement. This analysis helps to understand the operational performance of the business concern in a given
period. It may be analyzed on horizontal basis or vertical basis.

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

2. Trend Analysis
The financial statements may be analysed by computing trends of series of information. It may be upward or
downward directions which involve the percentage relationship of each and every item of the statement with the common
value of 100%. Trend analysis helps to understand the trend relationship with various items, which appear in the financial
statements. These percentages may also be taken as index number showing relative changes in the financial information
resulting with the various period of time. In this analysis, only major items are considered for calculating the trend
percentage.

3. Common Size Analysis

Another important financial statement analysis techniques are common size analysis in which figures reported are
converted into percentage to some common base. In the balance sheet the total assets figures is assumed to be 100 and all
figures are expressed as a percentage of this total. It is one of the simplest methods of financial statement analysis, which
reflects the relationship of each and every item with the base value of 100%.

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

4. Funds flow statement

Funds flow statement is one of the important tools, which is used in many ways. It helps to understand the
changes in the financial position of a business enterprise between the beginning and ending financial statement dates. It is
also called as statement of sources and uses of funds.

5. Cash flow statement

Cash flow statement is a statement which shows the sources of cash inflow and uses of cash out-flow of the
business concern during a particular period of time. It is the statement, which involves only short-term financial position
of the business concern. Cash flow statement provides a summary of operating, investment and financing cash flows and
reconciles them with changes in its cash and cash equivalents such as marketable securities.

6. Ratio analysis
Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a mathematical relationship
between one numbers to another number. Ratio is used as an index for evaluating the financial performance of the
business concern.
An accounting ratio shows the mathematical relationship between two figures, which have meaningful relation
with each other. Ratio can be classified into various types. Financial ratios are often divided up into common type of
categories: liquidity, solvency, efficiency, profitability.

Liquidity Ratios

Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they become due as well
as their long-term liabilities as they become current. In other words, these ratios show the cash levels of a company and
the ability to turn other assets into cash to pay off liabilities and other current obligations.

Liquidity is not only a measure of how much cash a business has. It is also a measure of how easy it will be for
the company to raise enough cash or convert assets into cash. Assets like accounts receivable, trading securities, and
inventory are relatively easy for many companies to convert into cash in the short term. Thus, all of these assets go into
the liquidity calculation of a company.
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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

Here are the most common liquidity ratios.

a) Quick ratio or Acid test ratio

The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay its current
liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within
90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts
receivable are considered quick assets.

Formula:

b) Current Ratio or Working Capital ratio

The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term liabilities
with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within
the next year.

This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities.
Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term.
This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities
when they become due without having to sell off long-term, revenue generating assets.

Formula:

c) Times Interest Earned Ratio or Interest Coverage Ratio

The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that measures the
proportionate amount of income that can be used to cover interest expenses in the future.

Formula:

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

Solvency Ratios

Solvency ratios, also called leverage ratios, measure a company’s ability to sustain operations indefinitely by
comparing debt levels with equity, assets, and earnings. In other words, solvency ratios identify going concern issues and
a firm’s ability to pay its bills in the long term. Many people confuse solvency ratios with liquidity ratios. Although they
both measure the ability of a company to pay off its obligations, solvency ratios focus more on the long-term
sustainability of a company instead of the current liability payments.

Solvency ratios show a company’s ability to make payments and pay off its long-term obligations to creditors,
bondholders, and banks. Better solvency ratios indicate a more creditworthy and financially sound company in the long-
term.

The most common solvency ratios include:

a) Debt to Equity Ratio

The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt
to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to
equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).

Formula:

b) Equity Ratio

The equity ratio is an investment leverage or solvency ratio that measures the amount of assets that are financed
by owners’ investments by comparing the total equity in the company to the total assets.

The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first
component shows how much of the total company assets are owned outright by the investors. In other words, after all of
the liabilities are paid off, the investors will end up with the remaining assets.

Formula:

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

c) Debt Ratio

Debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of its total assets. In a sense,
the debt ratio shows a company’s ability to pay off its liabilities with its assets. In other words, this shows how many
assets the company must sell in order to pay off all of its liabilities.

Formula:

Efficiency Ratios

Efficiency ratios also called activity ratios measure how well companies utilize their assets to generate income.
Efficiency ratios often look at the time it takes companies to collect cash from customer or the time it takes companies to
convert inventory into cash—in other words, make sales. These ratios are used by management to help improve the
company as well as outside investors and creditors looking at the operations of profitability of the company. Here are the
most common efficiency ratios include:

a) Accounts Receivable Turnover Ratio

Accounts receivable turnover is an efficiency ratio or activity ratio that measures how many times a business can
turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how
many times a business can collect its average accounts receivable during the year.

Formula:

b) Asset Turnover Ratio

The asset turnover ratio is an efficiency ratio that measures a company’s ability to generate sales from its assets
by comparing net sales with average total assets. In other words, this ratio shows how efficiently a company can use its
assets to generate sales.

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

Formula:

c) Inventory Turnover Ratio

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing
cost of goods sold with average inventory for a period. This measures how many times average inventory is “turned” or
sold during a period.

Formula:

d) Days Sales in Inventory

The days sales in inventory calculation, also called days inventory outstanding or simply days in inventory,
measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in inventory
ratio shows how many days a company’s current stock of inventory will last.

Formula:

Profitability Ratios

Profitability ratios compare income statement accounts and categories to show a company’s ability to generate
profits from its operations. Profitability ratios focus on a company’s return on investment in inventory and other assets.
These ratios basically show how well companies can achieve profits from their operations. Here are some of the key ratios
that investors and creditors consider when judging how profitable a company should be:

a) Gross Margin Ratio

Gross margin ratio is a profitability ratio that compares the gross margin of a business to the net sales. This ratio
measures how profitable a company sells its inventory or merchandise. In other words, the gross profit ratio is essentially
the percentage markup on merchandise from its cost. This is the pure profit from the sale of inventory that can go to
paying operating expenses.
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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

Formula:

b) Profit Margin Ratio or Return on Sales Ratio

The profit margin ratio, also called the return on sales ratio, is a profitability ratio that measures the amount of net
income earned with sales generated by comparing the net income and net sales of a company. In other words, the profit
margin ratio shows what percentage of sales are left over after all expenses are paid by the business.

Formula:

c) Return on Assets Ratio

The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net
income produced by total assets during a period by comparing net income to the average total assets. In other words, the
return on assets ratio or ROA measures how efficiently a company can manage its assets to produce profits during a
period.

Formula:

d) Return on Capital Employed

Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can generate
profits from its capital employed by comparing net operating profit to capital employed.

Formula:

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San Carlos College
Department: B.E.S.O.
Subject: Financial Management
Professor: Jeffrey M. Peralta, CPA

or

e) Return on Equity Ratio

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from
its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar
of common stockholders’ equity generates.

Formula:

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