ANALYSIS OF FINANCIAL STATEMENTS

Financial statement analysis is the process of extracting information from financial statements to better
understand a company’s current and future performance and financial condition.

ANALYZING THE BROADER BUSINESS ENVIRONMENT

Quality analysis depends on an effective business analysis. The broader business context in which a
company operates must be assessed as its financial statements are read and interpreted. A review of
financial statements which reflect business activities is contextual and can only be effectively
undertaken within the framework of a thorough understanding of the broader forces that impact
company performance. Some of these questions about a company’s business environment are:

Life cycle. At what stage in its life is this company? Is it a startup, experiencing growing pains? Is it strong
and mature, reaping the benefits of competitive advantages? Is it nearing the end of its life, trying to
milk what it can from stagnant product lines?

Outputs. What products does it sell? Are its products new, established or dated? Do its products have
substitutes? How complicated are its products to produce?

Buyers. Who are its buyers? Are buyers in good financial condition? Do buyers have substantial
purchasing power? Can the seller dictate sales terms to buyers?

Inputs. Who are its suppliers? Are there many supply sources? Does the company depend on a few
supply sources with potential for high input costs?

Competition. In what kind of markets does it operate? Are markets open? Is the market competitive?
Does the company have competitive advantages? Can it protect itself from new entrants? At what cost?
How must it compete to survive?

Financing. Must is it seek financing from public markets? Is it going public? Is it seeking to use its stock
to acquire another company? Is it in danger of defaulting on debt covenants? Are there incentives to tell
an overly optimistic story to attract lower cost financing or to avoid default on debt?

Labor. Who are its managers? What are their backgrounds? Can they be trusted? Are they competent?
What is the state of employee relations? Is labor unionized?

Governance. How effective is its corporate governance? Does it have a strong independent board of
directors? Does a strong audit committee of the board exist, and is it populated with outsiders? Does
management have large portion of its wealth tied to the company’s stock?

Risk. Is it subject to lawsuits from competitors or shareholders? Is it under investigation by regulators?

Has it changed auditors? If so, why? Are its auditors independent? Does it face environmental and/or
political risks?

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

Although financial statement analysis is a highly useful tool, the analyst should consider its limitations.
The limitations involve the comparability if financial data between companies and the need to look
beyond ratios. These limitations are:

1. Information derived by the analysis are not absolute measures of performance in any and all of
the areas of business operations. They are only indicators of degrees of profitability and financial
strength of the firm.
2. Limitations inherent in the accounting data the analyst work with. These are brought about by
among others: (a) variation and lack of consistency in the application of accounting principles,
policies and procedures, (b) too-condensed presentation of data, and (c) failure to reflect
change in purchasing power.
3. Limitations of the performance measures or tools and techniques used in the analysis.
Quantitative requirements are not absolute measures but should be interpreted relative to the
nature of the business and in the light of past, current and future operations. Timing of
transactions and the use of averages can also affect the results obtained in applying the
techniques in financial analysis.
4. Analysts should be alert to the potential for management to influence the outcome of financial
statements in order to appeal to creditors, investors and others.

Limitations of analysis may be overcome to some extent by finding appropriate benchmarks used by
most analysts such as the performance of comparable components and the average performance of
several companies in the same industry.

FINANCIAL RATIO ANALYSIS

There are numbers of different ways to analyze the financial statements. The most applied is the
financial ratio. Financial Ratio is a comparison in fraction, proportion, decimal or percentage of two
significant figures taken from financial statements. It expresses the direct relationship between two or
more quantities in the statement of financial position and the statement of comprehensive income of a
business firm.

The ratio can be categorized as follows:

1. Liquidity Ratios. These ratios give us an idea of the firm’s ability to pay off debts that are
maturing within a year or within the next operating cycle. Satisfactorily, liquidity ratios are
necessary if the firm is to continue operating.
2. Asset Management Ratios. These ratios give us an idea of how efficiently the firm is using its
assets. Good asset management ratios are necessary for the firm to keep its costs low and thus,
its net income high.
3. Debt Management Ratios. The ratios would tell us how the firm has financed its assets as well
as the firm’s ability to repay its long-term debt. Debt management ratios indicate how risky the
firm is and how much of its operating income must be paid to bondholders rather than
stockholders.
 4. Profitability Ratios. These ratios give us an idea of how profitable the firm is operating and
utilizing its assets. Profitability ratios combine the asset and debt management categories and
show their effects on return on equity.
5. Market Book Ratios. These ratios which consider the stock price give us an idea of what
investors think about the firm and its future prospects. Market book ratios tell us what investors
think about the company and its prospects.

I. Ratios used to Evaluate Short-term Financial Position (Short-Term Solvency and Liquidity)
NAME Formula Significance
1. Current Ratio Total Current Assets___ Primary test of solvency to meet
Total Current Liabilities current obligations from current
assets as a going concern;
measure of adequacy of working
capital.
2. Acid-test Ratio or Quick Total Quick Assets A more severe test of immediate
Ratio (Cash + Marketable Securities + solvency; test of ability to meet
Accounts receivable)_________ demands from current assets
Total Current Liabilities

3. A. Working Capital to Working Capital Indicates relative liquidity of

Total Assets Total Assets
b. Working Capital Current Assets less Current
Liabilities
4. Cash Flow Liquidity Ratio Cash + Marketable Securities +
Cash Flow from Operating
Activities
Current Liabilities
5. Defensive Interval Ratio Quick assets
Prohjected Daily Operational
Expenses
II. Ratios Used To Evaluate Asset Liquidity and Management Efficiency
1. A. Trade receivable Net Credit Sales / Net Sales if net Velocity of collection of trade
turnover credit sales is not available
b. Average collection 360 days (or 365 days)
period or number of Receivable Turnover
days’ sales outstanding Or
Accounts Receivable
Net Sales/360 (or 365)
2. Inventory Turnover Cost of goods sold
a. Merchandise Average Merchandise Inventory in managing and selling
turnover (MI, Beg. + MI, end / 2)
b. Finished goods Cost of goods sold
total assets and distribution of
resources employed.
Measures short-term liquidity by
considering as cash resources
(numerator) cash plus cash
equivalents plus cash flow from
operating activities.
Measures length of time in days
the firm can operate on its
present liquid resources.
accounts and notes; test of
efficiency of collection
Evaluates the liquidity of
accounts receivable and the
firm’s credit policies.
Measures efficiency of the firm
inventories.
Measures efficiency of the firm
 inventory Average Finished Goods
Inventory (FG, beg. + FG, end / 2)
c. Work in process Cost of goods manufactured
turnover Average Work in Process
Inventory (WIP, beg. + WIP,
end /2)
d. Raw materials Raw materials used
turnover Average raw materials inventory
( RM, beg. + RM, end / 2)
e. Days supply in 360 days (or 365 days)
inventory Inventory Turnover
3. Working Capital Net sales
Turnover Average Woking Capital
4. Percent of each current Amount of each current asset
asset to total current item
assets Total current assets
5. Current assets turnover Cost of sales + Operating
Expenses + Income Taxes +
Other Expenses (net) [excluding
depreciation and amortization]
Average current assets
6. Accounts payable Net purchases ( Purchases less
turnover purchase returns and
allowances)
Average accounts payable ( AP,
beg + AP, end / 2)
7. Operating cycle Average conversion period of
inventories + Average collection
period of receivbales + days cash
8. Days cash Average cash balance ( Cash, beg
+ Cash end / 2)
Cash operating costs + 360 days
9. Free cash flow Net cash from operating
activities – Cash used for
investing activities and dividends
10. Investment or asset Net sales
turnover Ave. Total Investments or Total
Assets
11. Sales to fixed assets Net Sales (Sales less sales returns
(plant assets turnover) and allowances)
Ave. Fixed Assets (net)
12. Capital intensity ratio Total assets
Net Sales
in managing and selling
inventories.
Measures efficiency of the firm
in managing and selling
inventories.
Number of times raw materials
inventory was used and
replenished during the period.
Measures average number of
days to sell or consume the
average inventory.
Indicates adequacy and activity
of working capital.
Indicates relative investment in
each current asset.
Measures movement and
utilization of current resources
to meet operating requirements.
Measure efficiency of the
company in meeting trade
payable.
Measures the length of time
required to convert cash to
finished goods; then to
receivable and then back to
cash.
Measures of availability of cash
to meet average daily cash
requirement.
Excess of operating cash flow
over basic needs.
Measures efficiency of the firm
in managing all assets
Tests roughly the efficiency of
management in keeping plant
properties employed.
Measures efficiency of the firm
to generate sales through
employment of its resources.
III. Ratios Used to Evaluate Long-Term Financial Position or Stability / Leverage
1. Debt Ratio
2. Equity Ratio
3. Debt to equity Ratio
4. Fixed Assets to Long-
term Liabilities
5. Fixed Assets to Total
Equity
6. Fixed Assets to Total
Assets
7. Book value per share of
ordinary shares
8. Times interest earned
9. Times preferred
dividend requirement
earned
10. Times fixed charges
earned
IV. Ratios Used to Measure Profitability and Returns to Investors
1. Gross Profit Margin
2. Operating Profit Margin
3. Net profit Margin (Rate
of return on net sales)
Total Liabilities Shows proportion of all assets
Total Assets that are financed with debt
Total Equity Indicates proportion of assets
Total Assets provided by owners. Reflects
financial strength and caution to
creditors.
Total Liabilities Measures debt relative to
Total equity amounts of resources provided
by owners.
Fixed Assets (net) Reflects extent of investment in
Total Long-term Liabilities long-term assets financed from
long-term debt.
Fixed Assets (net) Measures the proportion of
Total Equity owner’s capital invested in fixed
assets.
Fixed Assets (net) Measures investment in long-
Total Assets term capital assets.
Ordinary shareholder’s Measures recoverable amount in
equity the event of liquidation if assets
No. of outstanding ordinary are realized at their book value.
shares
Net Income before Interest Measures how many times
and Taxes interest expense is covered by
Annual Interest Charges operating profit.
Net Income after Taxes Indicates ability to provide
Preferred Dividends dividends for preference
Requirement shareholders.
Net Income before Taxes and Measures coverage capability
Fixed Charges more broadly than times interest
Fixed Charges (Rent + earned by including other fixed
Interest + Sinking Fund charges.
payment before taxes*)
*Sinking fund payment
before taxes =
Sinking fund payment after
taxes / 1 – Tax Rate
Gross profit Measures profit generated after
Net Sales consideration of cost of product
sold.
Operating Profit Measures profit generated after
Net Sales consideration of operating costs.
Net Profit Measures profit generated after
Net Sales consideration of all expenses and
revenues.
 4. Cash Flow Margin
5. Rate of Return on Assets
(ROA)*
6. Rate of Return on Equity
(ROE)**
7. Earnings per share
8. Price/earnings ratio
9. Dividend payout
10. Dividend Yield
11. Dividends per share
12. Rate of return on
average current assets
13. Rate of return per
turnover of current
assets
*If there is interest-bearing debt, Rate of return on assets is computed as follows:
Net income + [Interest expense (1-Tax Rate)]
Average Total Assets
**May also be computed as follows:
ROE = Return on Asset x Equity Multiplier (1/Equity Ratio)
Cash Flow for operating
activities
Net Sales
Net profit
Ave. Total Assets
Alternative formula:
Asset Turnover x Net Profit
Margin
Net Income
Ave. Ordinary Equity (OE, beg. +
OE, end / 2)
Net income less preference
dividends requirement
Average ordinary shares
Market Value per Share of
Ordinary Shares
Earnings per share of Ordinary
Shares
Dividends per share
Earnings per share
Annual Dividends per Share
Market Value per share of
Ordinary Shares
Dividends paid/declared
Ordinary Shares outstanding
Net Income
Ave. Current Assets
Rate of return on Ave. Current
Assets
Current Assets Turnover
A measure of the productivity if assets regardless of
how the assets are financed.
Measures ability of the firm to
translate sales to cash.
Measures overall efficiency if the
firm in managing assets and
generating profits.
Measures rate of return on
resources provided by owners
Peso return on each ordinary
share. Indicative of ability to pay
dividends.
Measures relationship between
price of ordinary shares in the
open market and profit earned
on a per share basis.
Shows percentage of earnings
paid to shareholders.
Shows the rate earned by
shareholders from dividends
relative to current price of stock.
Shows portion of income
distributed to shareholders on a
per share basis.
Measures the profitability of
current assets invested.
Shows profitability of each
turnover of current assets.
ILLUSTRATIVE CASE - ACTIVITY

EBC Enterprise, Inc.

Statement of Financial Position at December 31, 2014 and 2013

2014 2013
ASSETS
Current Assets
Cash P2,030.5 P1,191.0
Marketable securities 2,636.0 4,002.0
Accounts receivable 4,704.0 4,383.5
Allowance for doubtful accounts (224.0) (208.5)
Inventories 23,520.5 18,384.5
Prepaid expenses 256.0 379.5
Total current assets P32,923.0 P28,132.0

Property, Plant and Equipment

Land 405.5 405.5
Buildings and leasehold improvements 9,136.5 5,964.0
Equipment 10,761.5 6,884.0
P20,303.5 P13,253.5
Less: Accumulated depreciation and
amortization (5,764.0) (3,765.0)
Net property, plant and equipment 14,539.5 9,488.5

Other Assets 186.5 334.0

Total Assets P47,649.0 P37,954.5

LIABILITIES AND EQUITY

Current Liabilities
Accounts payable P7,147.0 P3,795.5
Notes payable – banks 2,807.0 3,006.0
Current maturities of long-term debt 942.0 758.0
Accrued liability 2,834.5 2656.5
Total current liabilities P13,730.5 P10,216.0
Deferred Income taxes 421.5 317.5
Long-Term Debt 10,529.5 8,487.5
Total liabilities P24,681.5 P19,021.0

Equity
Ordinary shares, par value P1, authorized
10,000,000 shares; issued 2,297,000
shares in 2014 and 2,401, 500 shares in P2,401.5 P2,297.0
2013 478.5 455.0
Additional paid-in capital 20,087.5 16,181.5
Retained earnings 22,967.5 18,933.5
Total Equity
P47,649.0 P37,954.5
Total Liabilities and Equity
EBC Enterprises, Inc.
Income Statements and Retained Earnings
For the Years Ended December 31, 2014, 2013 and 2012

2014 2013
Net Sales Php 107,800.00 Php 76,500.00 Php
Cost of goods sold 64,682.00 45,939.50
Gross Profit 43,118.00 30,560.50

Selling and administrative expenses 16,332.00 13,191.00

Advertising 7,129.00 5,396.00
Lease payments 6,529.00 3,555.50
Depreciation and amortization 1,999.00 1,492.00
Repairs and maintenance 1,507.50 1,023.00
Total 33,496.50 24,657.50
Operating profit 9,621.50 5,903.00
Other income (expenses)
Interest income 211.00 419.00
Interest expense (1,292.50) (1,138.50)
Earnings before income taxes 8,540.00 5,183.50
Income taxes 3,843.00 2,228.50
Net Income 4,697.00 2,955.00

Earnings per common share Php 2.00 Php 1.29 Php

Statements of Retained Earnings

Retained earnings at beginning of
year 16,181.50 14,157.50
Net income 4,697.00 2,955.00
Cash dividends (2014-P0.33 per
share;
2013-P0.41 per share) (791.00) (931.00)
Retained earnings at end of year Php 20,087.50 Php 16,181.50 Php

EBC Enterprises, Inc.

Statements of Cash Flows for the Years Ended December 31, 2014 and 2013
(in thousands)
 2014 2013
Cash Flow from Operating Activities - Direct
Method

Cash received from customers Php 107,495.00 Php 74,830.50

Interest received 211.00 419.00

Cash paid to suppliers for inventory (66,466.50) (49,968.00)

Cash paid to employees (S&A
expenses) (16,332.00) (13,191.00)
Cash paid for other operating
expenses (14,864.00) (10,675.00)

Interest paid (1,292.50) (1,138.50)

Taxes Paid (3,739.00) (2,160.50)

Net cash provided (used) by operating
activities 5,012.00 (1,883.50)
Cash Flow from Investing Activities
Additions to property, plant and
equipment (7,050.00) (2,386.50)

Other investing activities 147.50 -

Net cash provided (used) by investing
activities (6,902.50) (2,386.50)
Cash Flow from Financing Activities

Sales of ordinary shares 128.00 91.50

Increase (decrease) in short-term
borrowings (includes current
maturities of long-term debt) (15.00) 927.00

Additions to long-term borrowings 2,800.00 3,941.00

Reductions of long-term borrowings (758.00) (796.50)

Dividends paid (791.00) (931.00)

Net cash provided (used) by financing
activities 1,364.00 3,232.00
Increase (decrease) in cash & marketable
securities (526.50) (1,038.00)

Supplementary Schedule
Cash flow from Operating Activities-Indirect
Method
 Net Income 4,697.00 2,955.00
Noncash revenue and expense
included in net income:

depreciation 1,999.00 1,492.00

Deferred income taxes 104.00 68.00

Cash provided (used) by current
assets and liabilities:

Accounts receivable (305.00) (1,669.50)

Inventories (5,136.00) (3,503.00)

Prepaid expenses 123.50 147.50

Accounts payable 3,351.50 (525.50)

Accrued liabilities 178.00 (848.00)

Net cash provided (used) by
operations Php 5,012.00 Php (1,883.50)

Additional Information
Market price per share - 2014: P30;
2013: P17