MODULE 6– BASICS OF ANALYSIS 1

MODULE 6 – BASICS OF ANALYSIS

INTRODUCTION

The analysis of financial data employs various techniques to emphasize the

comparative and relative importance of the data presented and to evaluate the position
of the firm. These techniques include ratio analysis, common-size analysis, study of
differences in components of financial statements among industries, review of
descriptive material, and comparisons of results with other types of data. The
information derived from these types of analysis should be blended to determine the
overall financial position. No one type of analysis supports overall findings or serves all
types of users. This chapter provides an introduction to different analyses and uses of
financial information. Financial statement analysis is a judgmental process. One of the
primary objectives is identification of major changes (turning points) in trends, amounts,
and relationships and investigation of the reasons underlying those changes. Often, a
turning point may signal an early warning of a significant shift in the future success or
failure of the business. The judgment process can be improved by experience and by
the use of analytical tools.

LEARNING OUTCOMES:

After reading this module, the learner should be able to:

1. Determine the quality of earnings of a company
2. Perform horizontal and vertical analysis of financial statements
3. Compute financial ratios such as liquidity, leverage, turnover, and profitability
ratios
4. Explain the limitations of financial statement analysis

TIME:

The time allotted for this module is three (6) hours.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 2

LEARNER DESCRIPTION

The participants in this module are 3rd year BSBA students

MODULE CONTENTS:

Lesson 6.1: COMMON SIZE ANALYSIS (VERTICAL AND HORIZONTAL)

FINANCIAL STATEMENT ANALYSIS

The preparation of the financial statements is not an end in itself but is a
beginning of a more important process.
There are many ways by which analyses can be done. Two of them are:

LONGITUDINAL EVALUATION OF THE FINANCIAL DATA

– Involves horizontal comparison/contrast of the financial data involving at
least two periods
ANALYSIS OF FINANCIAL RATIOS
– It can be pointed out that the analysis need not be on a PERIOD TO
PERIOD basis only, but could also involve COMPANY TO COMPANY
financial data analysis.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSES

1. PROFITABILITY
 It refers to the ability of the firm to yield a sufficient amount of return on company
sales assets and invested capital. It also refers to the firm’s ability to generate
earnings vis-à-vis its expenses and other relevant costs incurred during a specific
period of time.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 3

2. LIQUIDITY AND STABILITY

 Liquidity is also referred to as WORKING CAPITAL POSITION or SHORT-
TERM FINANCIAL POSITION. It is the ability of the firm to meet or pay its
current or short term maturing obligations.

3. ASSET UTILIZATION OR ACTIVITY

 This pertains to how efficient the company is in managing its resources. It also
refers to the firm’s speed or pace in turning over accounts receivable, inventory,
and long term assets. This reveals the frequency of the firm in selling its products
or in collecting its receivables. IN so far as fixed or long term assets are concern,
it reveals how the company uses their fixed assets to yield revenue.

4. DEBT-UTILIZATION OR LEVERAGE
 This pertains to the overall debt status of the company. It measures the degree of
how the firm is financed. The debt is evaluated using other variables like assets,
equity, and earning power.

PRACTICAL STEPS PROPOSED IN ANALYZING FINANCIAL STATEMENTS

1. Determine which of the following objectives, just discussed, would be the
coverage of the analysis. Is it to evaluate PROFITABILITY? LIQUIDITY?
ASSET ACTIVITY/ OR DEBT-UTILIZATION? Or all of them?
2. The analysis may cover not only the subject firm but could involve other
firms belonging to the same industry. It would be wise to learn about the
RETROSPECTIVE, current, as well as the prospective conditions of the
industry. Other external variables that may have significant effect on the
industry may also be considered. This may include economic and political
variables.
3. Get to know the firm you are analysing. Know their mission and vision.
Know their strategic plans. Know their current status in the industry.
Know their financial projections.
4. ASSESS/ ANALYZE the financial statements. One may employ the
following methods :
Horizontal analysis – also known as dynamic measure or trend ratios.
This involves the comparison and measurement of financial statements of
two or more periods.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 4

Vertical analysis – also known as static measure or structural ratios. This

includes comparison of financial data for only one period. It involves
comparing and establishing the relationship of the components of the
financial statements.
5. After finishing the “dirty” work of computing the trends and ratios, comes
the more important task. INTERPRET the results of the computations and
ratios.
6. Draw conclusions from the interpretations made in step 5. The
conclusions must take into consideration the objectives you have set up in
step number 1.

HORIZONTAL ANALYSIS OF COMPARATIVE STATEMENTS

In the field of accounting, it has been a requirement by the GAAP to present
comparative financial statements for the current year and the previous year. For
obvious reasons, this would facilitate comparison of the company’s financial position
and results of operation. This serves as a sound start for analysing financial
statements by horizontal analysis.
In horizontal analysis, the balance of the accounts, in the financial statements of the
previous years is subtracted from the current year. This would result to a CHANGE,
either GROWTH or REDUCTION.

The percentage of changes is computed as follows:

Percentage of Change = Amount of growth/reduction, or change x 100
Amount in the base year or previous year

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 5

Illustrative Examples:

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 6

Horizontal Analysis using the Statements of Financial Position of VICO Foods

Corporation:

VICO FOODS CORPORATION

Statements of Financial Position
For the Years Ending December 31, 2018-2019

Increase (decrease)
2019 2018 Amount Percent
Assets
Current Assets
Cash 1,062,527 996,904 65,623 7%
Trade Receivables 2,300,500 1,921,799 378,701 20%
Inventories 4,849,304 4,499,998 349,306 8%
Other Current Assets 1,050,000 983,746 66,254 7%
Total 9,262,331 8,402,447 859,884 10%

Non-Current Assets
Property, Plant and Equipment, Net 12,200,000 11,300,000 900,000 8%
Other Noncurrent Assets 835,689 925,681 - 89,992 -10%
Total 13,035,689 12,225,681 810,008 7%

TOTAL ASSETS 22,298,020 20,628,128 1,669,892 8%

Liabilities and Equity

Current Liabilities
Trade Payables 5,050,810 4,746,252 304,558 6%
Income Taxes Payable 433,051 283,705 149,346 53%
Current Portion of Long-term Debt 2,250,000 2,500,000 - 250,000 -10%
Other Current Liabilities 85,600 28,700 56,900 198%
Total 7,819,461 7,558,657 260,804 3%

Noncurrent Liabilities
Long-term Debt, Net of Current Portion 2,000,000 1,250,000 750,000 60%
Total Liabilities 9,819,461 8,808,657 1,010,804 11%

Stockholders' Equity
Capital Stock 8,000,000 8,000,000 - 0%
Retained Earnings 4,478,559 3,819,471 659,088 17%
Total Stockholders' Equity 12,478,559 11,819,471 659,088 6%

TOTAL LIABILITIES AND STOCKHOLDERS'

EQUITY 22,298,020 20,628,128 1,669,892 8%

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 7

Horizontal Analysis using the Statements of Profit and Loss of VICO Foods Corporation:

VICO FOODS CORPORATION

Statements of Profit and Loss
For the Years Ending December 31, 2018-2019

Increase (decrease)
2019 2018 Amount Percent
Net Sales 52,501,085 47,345,223 5,155,862 11%
Cost of Sales 41,954,730 37,988,628 3,966,102 10%
Gross Profit 10,546,355 9,356,595 1,189,760 13%
Operating Expenses 6,497,659 6,196,804 300,855 5%
Operating Income 4,048,696 3,159,791 888,905 28%
Interest Expense 250,000 250,000 - 0%
Income Before Taxes 3,798,696 2,909,791 888,905 31%
Taxes 1,139,609 872,937 266,672 31%
Net Income 2,659,087 2,036,854 622,233 31%

VERTICAL ANALYSIS USING COMMON SIZE STATEMENTS

Vertical analysis uses percentages/ratios that present the relationship of the different
accounts or items in the financial statements. The analyst chooses a base figure or
amount equal to 100 percent and calculates each item’s percentage. For the Staement
of Financial Position the base used is the total assets and the total liabilities and
stockholders’ equity, and for the income statement the net sales or revenue is the
base. In essence, vertical analysis presents the relative size of an account or item in
proportion to the whole (which is the base).
The common size statements are sometimes called component percentage or 100
percent statements.
Through the common size statements, management can have a better understanding of
the changes to the total assets (for Statement of Financial Position) or net sales/net
operating revenue (for income statement) that have transpired from one period to the
next. This statement also aids management to assess their financial position as well as
the results of operation by comparing their statements with other companies belonging
in the same industry.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 8

Vertical Analysis using the Statements of Financial Position of VICO Foods Corporation:

VICO FOODS CORPORATION

Statements of Financial Position
For the Years Ending December 31, 2018-2019

Common Size
Percentages
2019 2018 2019 2018
Assets
Current Assets
Cash 1,062,527 996,904 5% 5%
Trade Receivables 2,300,500 1,921,799 9% 10%
Inventories 4,849,304 4,499,998 22% 22%
Other Current Assets 1,050,000 983,746 5% 5%
Total 9,262,331 8,402,447 41% 42%
Total
Non-Current Assets Assets
Property, Plant and Equipment, Net 12,200,000 11,300,000 55% 55%
Other Noncurrent Assets 835,689 925,681 4% 4%
Total 13,035,689 12,225,681 59% 58%

TOTAL ASSETS 22,298,020 20,628,128 100% 100%

Liabilities and Equity

Current Liabilities
Trade Payables 5,050,810 4,746,252 23% 23%
Income Taxes Payable 433,051 283,705 2% 1%
Current Portion of Long-term Debt 2,250,000 2,500,000 10% 12%
Other Current Liabilities 85,600 28,700 0% 0%
Total 7,819,461 7,558,657 35% 37%

Noncurrent Liabilities
Long-term Debt, Net of Current Portion 2,000,000 1,250,000 9% 6%
Total Liabilities 9,819,461 8,808,657 44% 43%
Total
Liabilities
Stockholders' Equity and
Capital Stock 8,000,000 8,000,000 36% 39% Stockholders
’ Equity
Retained Earnings 4,478,559 3,819,471 20% 19%
Total Stockholders' Equity 12,478,559 11,819,471 56% 57%

TOTAL LIABILITIES AND

STOCKHOLDERS' EQUITY 22,298,020 20,628,128 100% 100%

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 9

Vertical Analysis using the Statements of Profit and Loss of VICO Foods Corporation:

VICO FOODS CORPORATION

Statements of Profit and Loss
For the Years Ending December 31, 2018-2019

Common Size
Percentages
2019 2018 2019 2018
Net Sales 52,501,085 47,345,223 100% 100%
Cost of Sales 41,954,730 37,988,628 80% 80%
Gross Profit 10,546,355 9,356,595 20% 20%
Operating Expenses 6,497,659 6,196,804 12% 13%
Operating Income 4,048,696 3,159,791 8% 7%
Interest Expense 250,000 250,000 0% 1%
Income Before Taxes 3,798,696 2,909,791 7% 6%
Taxes 1,139,609 872,937 2% 2%
Net Income 2,659,087 2,036,854 5% 4%
*** Formula: Item/ Net Sales x 100

Lesson 6.2: TREND ANALYSIS

A more longitudinal and a modification of the horizontal and vertical analysis is the trend
analysis.
 Under this method, the percentage changes are determined for several
successive periods instead of the typical two-year period horizontal
analysis
 This method is more thorough than the garden-variety- two period
horizontal analysis because it presents a view in the –long-run of the
company’s progression or regression as the case maybe.
 In computing the trend, the base period (oldest year) amounts are written
as 100%. The percentage relationship of each account in the statement is
then computed by dividing each amount by the base year figure

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 10

Illustrative Example of Trend Analysis

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 11

Lesson 6.3: FINANCIAL RATIO ANALYSIS

From the previous discussion, it can be noted that there are four objectives of
financial statement analysis: profitability, efficiency/activity, liquidity, and leverage

(1) Profitability ratios

The following ratios are used to measure the profitability of a company:
a. Return on Equity (ROE)
b. Return on Assets (ROA)
c. Gross Profit Margin
d. Operating Profit Margin
e. Net Profit Margin

a. Return on Equity
It is a measure of profitability that should be of interest to stock market investors. It
measures the amount of net income earned in relation to stockholders’ equity.
ROE is computed as follows:
ROE = (Net Income/ Stockholders’ Equity) X 100

In computing ROE, different approaches are observed. There are analysts who use the
average of the stockholders’ equity for two accounting periods while others simply use
the year-end balances. Whichever formula is used, consistency must be applied.

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.

ROE = (Net Income/ Stockholders’ Equity) X 100

ROE= (2,659,087 / 12,478,559) X 100
ROE = 21.31%

Interpretation: The ROE of 21.31% means that for every one peso (Php1) of
stockholders’ equity, Php .2131 was earned in 2019.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 12

b. Return on Assets
It measures the ability of a company to generate income out of its resources.
ROA is computed as follows:
ROA = (Operating Income/ Total Assets) X 100
This ratio can be useful in making investment decisions. For example, if a company has
an opportunity to expand and is not sure how to finance the expansion, the ROA can be
used in making decision. If the interest rate on loan is greater than the ROA, then it
does not make sense to borrow for expansion. However, if the expected ROA with the
expansion is greater than the interest rate on loan, then management may consider
borrowing to finance expansion.
To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
ROE = (Operating Income/ Total Assets) X 100
ROA = (4,048,696/ 22,298,020) X 100
ROA = 18.16%

Interpretation: The 18.61% ROA means that in 2019, the company generated
Php.1816 for every P1.00 asset in the company

c. Gross Profit Margin

It is profitability ratio that measures the ability of a company to cover its cost of goods
sold from its sales.
Gross Profit Margin is computed as follows:
Gross Profit Margin = (Gross Profit/ Sales) x 100

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Gross Profit Margin = (Gross Profit/ Sales) x 100
Gross Profit Margin = (10,546,355/ 52,501,085) x 100
Gross Profit Margin = 20.09%

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 13

Interpretation: This ratio means that for every P1.00 of sale the company generates, it
earns P .2009 in gross profit.
Companies in a very competitive industry have to watch out for this gross profit margin
because stiff competition can substantially bring down this margin. If the manager of a
company wants to improve its gross profit margin, two things can be done:
1. Raise prices.
2. Find ways to bring down production cost. For trading or merchandising
companies, find a supplier which can sell at lower prices.

Both approaches are not easy to do. Raising prices is possible if your company is the
only seller or provider of the product in the area. On the other hand, bringing down
production costs may not also easy to achieve because this may require investment in
technology and cheaper sources of raw materials.
d. Operating Profit Margin
It measures the amount of income generated from the core business of a company. It is
computed as the difference between revenues and the sum of cost of revenues or sales
and operating expenses.
Operating Profit Margin is computed as follows:
Operating Profit Margin = (Operating Income/ Sales) x 100
To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Operating Profit Margin = (Operating Income/ Sales) x 100
Operating Profit Margin = (4,048,696/ 52,501,085) x 100
Operating Profit Margin = 7.71%

Interpretation: The 7.71% operating profit margin means that out of P1.00 sales or
revenues that the company generated in 2019, the company earned P .0771 after
deducing cost of sales and operating expenses.

e. Net Profit Margin

It measures how much net profit a company generates for every peso of sales or
revenues that it generates.
Net Profit Margin is computed as follows:
Net Profit Margin = (Net Income/Sales) x 100

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 14

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Net Profit Margin = (Net Income/Sales) x 100
Net Profit Margin = (2,659,087/ 52,501,085) x 100
Net Profit Margin = 5.06%

Interpretation: In 2019, the company earned P .0506 for every P1.00 of revenues
generated
It is important to compare the operating profit margin and the net profit margin. A
company can have a high OPM but low NPM if the company is heavily indebted. It is
also important to note if the net profit used in computing the ratio is substantially due to
core operations or the main business of the company or is it due to some non-recurring
transactions. An example of nonrecurring transaction is gain from the sale of equipment
where the company is not in the business of selling equipment.

(2) Liquidity Ratios

It measures the ability of a company to pay maturing obligations from its current
assets. There are two liquidity ratios. These are:
a. Current Ratio
b. Acid-test ratio or sometimes called Quick Asset Ratio

a. Current Ratio
Current Ratio is computed as follows:
Current Ratio = Current Ratio/Current Liabilities

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Current Ratio = Current Ratio/Current Liabilities
Current Ratio = 9,262,331 / 7,819,461
Current Ratio = 1.18
Interpretation: The current ratio of 1.18 means that for every P1.00 of current liabilities
that the company has, it has P1.18 current assets to pay for it.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 15

A high current ratio provides comfort that a company will be able to pay its short term
obligations on time, but does not guarantee that no liquidity problems or payment
problems will arise. The ability of a company to pay on time also depends on the quality
of receivables and inventories.

b. Acid Test Ratio or Quick Asset Ratio

Quick Asset Ratio is computed as follows:

Quick Asset Ratio= (Cash + Current Accounts Receivable + Short term Marketable
Securities) / Current Liabilities
The quick asset ratio is a stricter measure of a company’s liquidity position. There are
some books which compute quick assets as current assets less inventories. With this
definition, quick assets can also be computed as follows:
Quick Asset Ratio = (Current Assets – Inventories) / Current Liabilities

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Quick Asset Ratio= (Cash + Current Accounts Receivable + Short term Marketable
Securities) / Current Liabilities
Quick Asset Ratio = (1,062,527 + 2,300,500) / 7,819,461
Quick Asset Ratio = 0.43
Interpretation: This ratio means that for every P1.00 current liability, it has P 0.43 quick
assets. Is this something to be alarmed about? The answer depends on the quality of
accounts receivable which can be determined by its collection period.

(3)Leverage Ratios
Leverage ratios show the capital structure of a company, that is, how much of the
total assets of a company is financed by debt and how much is financed by
stockholders’ equity. It can also be used to measure the company’s ability to meet long-
term obligations.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 16

The following are the leverage ratios:

a. Debt ratio;
b. Debt to Equity Ratio; and
c. Interest Coverage Ratio
a. Debt Ratio
It measures how much of the total assets are financed by liabilities. Below is the
formula:
Debt ratio = Total Liabilities / Total Assets

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.

Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = 9,819,461/ 22,298,020
Debt Ratio = 0.44
Interpretation: The Debt Ratio of less than 0.50 means that the company has less
liabilities as compared to its stockholders’ equity. If the Debt Ratio is 0.50 this means
that the amount of total liabilities is exactly equal to stockholders equity.

b. Debt to Equity Ratio

It is a variation of the debt ratio. A Debt to Equity Ratio of more than one means
that a company has more liabilities as compared to stockholders’ equity. The formula is
shown below:
Debt to Equity Ratio = Total Liabilities/Total Stockholders’ Equity
To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Debt to Equity Ratio = Total Liabilities/Total Stockholders’ Equity
Debt to Equity Ratio = 9,819,461 / 12,478,559
Debt to Equity Ratio = 0.79

Interpretation: Since the company’s debt ratio is less than one, it is expected that the
debt to equity ratio is less than one.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 17

c. Interest Coverage Ratio

It is the ratio that provides information if a company has enough operating
income to cover interest expense. Below is the formula:
Interest Coverage Ratio = EBIT / Interest Expense
***EBIT stands for Earnings before Interest and Taxes

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Interest Coverage Ratio = EBIT / Interest Expense
Interest Coverage Ratio = 4,048,696 / 250,000
Interest Coverage Ratio = 16.19

Interpretation: The interest coverage ratio of 16.19 means that the company has more
than enough operating income or earnings before interest and taxes to cover its interest
expense. It has EBIT which is a little more than 16 times its interest expense in 2019,
This high interest coverage ratio is also a reflection of a more conservative capital
structure of the company.

(4) Efficiency Ratios or Turn over Ratios

Efficiency ratios, otherwise known as turnover ratios, are called such because
they measure the management’s efficiency in utilizing the assets of the company. The
following are the turn over ratios:
a. Total Asset Turnover Ratio;
b. Fixed Asset Turnover Ratio;
c. Accounts Receivable Turnover Ratio;
d. Inventory Turnover Ratio; and

From the accounts receivable turnover ratio, inventory turnover ratio, and accounts
payable turnover ratio, operating cycle and cash conversion cycle can be computed.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 18

a.) Total Asset Turnover Ratio

This ratio measures the company’s ability to generate revenues for every peso of
asset invested. It is an indicator of how productive the company is in utilizing its
resources. The formula is shown below:
Asset Turnover Ratio = Sales / Total Assets
To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Asset Turnover Ratio = Sales / Total Assets
Asset Turnover Ratio = 52,501,085 / 22,298,020
Asset Turnover Ratio = 2.35

Interpretation: The asset turnover ratio of 2.35 means that for every P1.00 of asset the
company has, it is able to generate sales of P2.35
In computing asset turnover ratio, ending balances for total assets or the average of
total assets for the accounting period can be used. Whichever formula is used,
consistency must be applied.

b.) Fixed Asset Turnover Ratio

If a company heavily invested in Property, Plant, and Equipment or fixed assets,
it pays to know how efficient the management of these assets is. This can be applied to
companies which are characterized by high PPE such as utility companies.
The formula for computing fixed asset turnover ratio is shown below:
Fixed Asset Turnover Ratio = Sales/ PPE
To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Fixed Asset Turnover Ratio = Sales/ PPE
Fixed Asset Turnover Ratio = 52,501,085 / 12,200,000
Fixed Asset Turnover Ratio = 4.30

Interpretation: The Company was able to generate P4.30 for every P1.00 of PPE that it
has.
In computing fixed asset turnover ratio, ending balances for PPE or the average of total
PPE for the accounting period can be used. Whichever formula is used, consistency
must be applied.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 19

c.) Accounts Receivable Turnover Ratio

It measures the efficiency by which accounts receivable are managed. A high
accounts receivable turnover ratio means efficient management of receivables.
The formula for computing accounts receivable turnover ratio is shown below:
Accounts Receivable Turnover Ratio = Sales / Accounts Receivable
To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.
Accounts Receivable Turnover Ratio = Sales / Accounts Receivable
Accounts Receivable Turnover Ratio = 52,501,085 / 2,300,500
Accounts Receivable Turnover Ratio = 22.82

Interpretation: This means that the company collects receivable 22.82 times in a year

The Accounts Receivable Turnover Ratio becomes more meaningful when

converted to days’ receivable or average collection period. In our example, this 22.82
ratio can be converted to days by dividing to 360 days.
Average Collection Period = 360 / 22.82
Average Collection Period = 15.78 or 16 days

Interpretation: The Company had an average of 16 days collecting its accounts

receivable. This means that from the day the sales was made, it took the company 16
days, on the average, to collect its accounts receivable

d.) Inventory Turnover Ratio

It measures the company’s efficiency in managing its inventories.
The formula is show below:
Inventory Turnover Ratio = Cost of Sales / Inventories

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 20

Just like computing accounts receivable turnover ratio, ending balances for inventory
turnover ratio or the average of total inventories for the accounting period can be used.
Whichever formula is used, consistency must be applied

To illustrate, let us use the financial statements of VICO Foods Corporation in “2019”.

Inventory Turnover Ratio = 41,954,730 / 4,849,304

Inventory Turnover Ratio = 8.65

Interpretation: This means that the company was able to sell inventories 8.65 times in
a year

The Inventory Turnover Ratio becomes more meaningful when converted to

days’ days’ inventories. In our example, this 8.65 ratio can be converted to days by
dividing to 360 days.
Days’ Inventories = 360 / 8.65
Days’ Inventories = 41.62 or 42 days
Interpretation: The Company had an average of 42 days to sell its inventories. This
means that from the day the inventories were bought, it took the company 42 days, on
the average, to sell them.
Quality of Earnings
In analyzing a statement of profit or loss, how can you tell whether the earnings
are good or not? There are information in the financial statements that should be looked
into. Among these are the following:
1. Is the income coming from the core business? If so, then it is good. But if income
comes from non-recurring transaction such as sale of equipment when the company is
not in the business of selling equipment, then it is not good quality because the income
is not expected to happen again or at least, not in the foreseeable future
2. How much of the net income translates into cash flows? Recognition of revenues
is based on the accrual principle so not all the revenues recognized during the period
are necessarily collected. The same is true for expenses. It is important to know if the
net income reported in the statement translates into cash.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 21

3. Is the income stable? The stability of earnings is influenced by the nature of

business the company is in.

Limitations of Financial Statement Analysis

While financial statement analysis is a very powerful tool in understanding the
financial aspect of the company, it has limitations too.
1. Its failure to consider changes in the purchasing power, inconsistencies as well
as dissimilarities in the accounting principles, policies, and procedures used by
firms in the industry
2. Its failure to consider changes in the purchasing power of currencies.
3. The age of the financial statement is a limitation. The older it gets, the less
reliable it becomes, thus, considered as a risk management tool.
4. Failure to read and understand the information in the Notes to the financial
statements my obscure in evaluating the degree of risk
5. Financial statements that have not undergone external auditing procedures may
or may not conform with the Generally Accepted Accounting Principles (GAAP)
and standards thus, usage of theses financial statements may lead to erroneous
analysis, and ultimately erroneous decisions
6. Financial statements that have not undergone external auditing procedures may
prove to be inaccurate or worse, fraudulent hence, do not fairly present the
company’s financial condition. Financial measurements from the analysis of
these companies are not dependable and not conclusive
7. Audited statements do not guarantee accuracy.

FM6- FINANCIAL REPORTING AND ANALYSIS

 MODULE 6– BASICS OF ANALYSIS 22

MODULE REFERENCES:

Aduana, Nick L. (2015). Financial statements: Preparation, presentation, analysis and

interpretation. C & E Publishing

Ahmad N., Koh E., Gee C, Ramly Z., Abu N. Corporate Finance: An Asian Perspective.
Malaysia: Oxford University Press

Cornett M., Adair T., Nofsinger J. (2018). Finance: Applications and Theory 4th edition.
New York: McGraw-Hill Education

Higgins, Robert C. (2019). Analysis of Financial Statement. McGraw Hill

Pineda A. (2019). Basic Financial Management. Intramuros, Manila: Mindshapers Co.

Inc.

3G E-Learning LLC. Business Finance 2nd edition. 3G E-Learning, USA

https://taxacctgcenter.ph/knowing-basic-business-accounting-non-accountants-
philippines/

https://corporatefinanceinstitute.com/resources/knowledge/accounting/qualitative-
characteristics-of-accounting-information/

FM6- FINANCIAL REPORTING AND ANALYSIS