Analysis of Financial Statements

1. Vertical, Static, and Common Size Analysis

2. Horizontal, Dynamic, and Index Analysis
3. Financial Ratio Analysis

Vertical Analysis
➔ Focuses on a specific distribution of resources within a financial statement (like a balance
sheet/income statement), to see how each part compares to the whole.
◆ Example: in the balance sheet, you’ll express each item as a percentage of the total
assets/total liabilities and equity of a company
◆ Example: in the income statement, you’ll express each expense or revenue item as a
percentage of the net sales. This reveals the items that place extra burden on the
company’s operations

Horizontal Analysis
➔ Compares financial statements from different periods to see how things changed over time. It
helps spot trends and patterns by looking at year-to-year fluctuations in various account
items.
➔ Expresses a balance sheet and income statement account as a percentage of the figure/value
in the chosen year.
◆ For example: let’s say you have financial statements from 2023 and 2024. With
horizontal analysis, you’d express each item on the 2024 statement as a percentage of
the corresponding item on the 2023 statement. This allows you to see if accounts have
grown or shrunk relative to a base year, which indicates possible areas of
improvement or concern.

Financial Ratios
➔ Relates two pieces of financial data to each other that is used as a measuring tool in
evaluating the financial condition and performance of a company

Two Types of Financial Ratios:

1. Trend Analysis
➔ Compares a present ratio with past and expected future of ratios of the same company
2. Comparison with Others
➔ Compares with industry averages/standards or ratios of similar firms

Uses of Financial Ratios:

1. Internal Management
➔ For purposes of internal control
2. Creditors
➔ To evaluate the firm’s cash flow ability during the short and long-run
3. Investors/Owners
➔ To assess the company’s present and future earnings and stability of these earnings
about a trend

Ratios Relevant on Management’s Viewpoint

1. Operational Analysis
a. Gross Profit Margin Ratio
 ➔ Indicates the margin of “raw profit” from operations.
➔ Can be changed by: selling price of product, level of manufacturing costs/purchase
costs for product, variations in product mix of the business volume of operations
b. Net Profit Margin
➔ Indicates management’s ability to successfully operate business to leave a margin of
reasonable compensation to the owners for putting their capital at risk
➔ Overall cost/price effectiveness of the operation
c. Operating Expense Analysis
➔ Various expense categories (administrative, selling and promotional, etc.) are routinely
related to net sales
d. Contribution Analysis
➔ Relates net sales to the contribution margin of individual product groups or of the
total business
2. Resource Management
a. Asset Turnover
➔ Relates net sales to gross assets / net sales to total capital
➔ How a company uses its assets to make revenue
➔ Limitations: crude measure because it does not account for the quality or age of
assets
b. Inventory Turnover Ratio
➔ How efficiently a company manages its inventory
c. Account Receivable Ratio
➔ How efficiently a company manages its accounts receivable by comparing the amount
of credit sales during a period compared to the average AR balance.
➔ Based on net sales made on credit (separate cash and credit sales)
i. Receivable Turnover Ratio
ii. Average Collection Period/Days Sales Outstanding
● Indicates the average length of time the firm must wait after making a
sale before it receives cash
3. Profitability
a. Return on Assets
➔ How efficiently a company utilizes its assets to make a profit

Ratios Relevant on Owners’ Viewpoint

1. Profitability
a. Return on Net Worth
➔ Use average net worth if profitable operations build up shareholder’s equity during the
year
b. Return on Common Equity
➔ Measures a company’s profitability relative to its common equity
c. Earnings per Share
➔ Measures proportional participation of each unit of investment in corporate earnings
for the period
➔ Used in the valuation of common stocks
d. Cash Flow per Share
➔ Very rough indicator of the company’s ability to pay cash dividends
2. Disposition of Earnings
a. Dividend Yield
 ➔ Measure of the return on the owner’s investment from cash dividends alone
b. Payout/Retention Ratio
➔ Represents the proportion of earnings paid out to shareholders in the form of cash
during any given year
c. Dividend to Assets
➔ Indication of how much of the company’s assets are used to pay dividends
3. Market Indicators
a. Price/Earnings Ratio (aka Earnings Multiple)
➔ Used to indicate how the stock market is judging the company’s earnings
performance and prospects
b. Market to Book Ratio
➔ Relates current market value on a per share basis to the stated book value of owner’s
equity on a per share basis
➔ Though, it is not an economic measure of performance because it relates accounting
earnings to stated historical accounting values
4. Summary
➔ Ratios here are the measures of the return owners have earned on their stake and the cash
rewards they received in the form of dividends.

Ratios Relevant on Lenders’ Viewpoint

1. Liquidity Ratios
➔ Focuses on short-term credit extended to a business for funding its operations and if current
assets that can readily be converted to cash can form a cushion against default
➔ Measure a company’s ability to meet its short-term financial obligations with its available
current assets
a. Current Ratio
➔ Most commonly used to appraise the debt exposure represented on balance sheet
➔ Weakness: the current ratio’s lies in its static assessment, as it only offers a
momentary snapshot of liquidity without considering operational dynamics. It fails to
reflect the ongoing viability of a company as a going concern, which should be
management’s top priority.
b. Quick Ratio/Acid Test Ratio
➔ Measure of liquidity
➔ Tests the collectibility of current liabilities in the case of real crisis on the assumption
that inventories would have no value at all
2. Financial Leverage
➔ Use of debt in the business
a. Debt to Assets/Debt Ratio
➔ Describes the proportion of “other people’s money” to the total claims against the
assets of the business
b. Debt to Capitalization
c. Debt to Equity
➔ Attempt to show in another format the relative proportions of all lenders’ claims to
ownership claims
3. Debt Service
a. Interest Coverage/Times Interest Earned (TIE) Ratio
➔ Ratio is developed with the expectation that annual operating earnings are considered
as a basic source of funds. Any significant change here may signal difficulty
 ➔ Variant: Cash-Flow Interest Coverage
b. Burden Coverage
➔ Company’s ability to cover its fixed costs or financial obligations, often in the context
of debt service or operating expenses
➔ Assesses whether a company’s earnings/cash flow can pay off its fixed expenses
➔ Variant: Cash Flow Coverage of Interest and Principal Repayment

Merchandising
➔ Selling goods in the same condition as when they were bought
➔ Inventory Account: Merchandise Inventory
➔ Cost of Sales Account: Cost of Goods Sold

Manufacturing
➔ Converting raw materials into finished goods
➔ Inventory Accounts: Materials, Work-in-Process, and Finished Goods Inventories
➔ Cost of Sales Account: Cost of Goods Sold

Servicing
➔ Furnishing intangible services rather than tangible goods
➔ Inventory Accounts: Materials Inventory, Job-in-Progress or Unbilled Cost
➔ Cost of Sales Account: usually includes the materials used to complete a service as well as
labor and other related costs
➔ 3 types of service organization:
1. Personal Service
2. Building Trade Firms and Repair Businesses
3. Professional Service Firms

Inventories
➔ Supplies inventory refer to physical items a company will use during regular operations. Unlike
merchandise, which is bought and sold, supplies are not sold as products themselves.
Additionally, supplies differ from materials because they are not included in the COGM
separately.
➔ What costs are included in inventory?
◆ Purchase price of merchandise (material)
◆ Cost incurred in acquiring it (transportation, custom duties, insurance)
◆ Conversion costs (if any)

Inventory Measurement Methods

➔ Periodic Inventory
◆ Used by small businesses wherein they can take into account any unsold inventories
◆ Only revenue is recorded each time a sale is made
◆ Ending Inventory = physical inventory count
◆ COGS = amount of goods available for sale - ending inventory amount
➔ Perpetual Inventory
◆ Mostly used by large companies where they have a point of sale (POS) system to track
inventory
 ◆ Amount of inventory sold to customers is recorded as it happens. It keeps a detailed
record of each item in inventory, similar to how changes in cash are tracked, ensuring
that all increases and decreases are accurately recorded
◆ Ending Inventory = total goods available for sale - cost of goods sold

Periodic Perpetual

Given, Unknown Ending Inventory = physical Solve for Cogs

inventory count
Ending Inventory = total goods
Solve for COGS available for sale - cost of goods
sold

Adjusting Entries DR COGS DR COGS

CR Inventory (Beg) CR Inventory
CR Purchases

DR Inventory (Beg)
CR COGSS

Closing Entries DR Expense and Income Summary

CR Cash

Comparison For items that can be easily counted Requires record keeping, good for
at the end of the period few items
*Beg Inventory + Purchases = Cost of Goods Avail. For Sale = COGS + Ending Inventory

Advantage of Perpetual Inventory

➔ Detailed record is useful when deciding when/how much to reorder. Also useful for analyzing
customer demand
➔ Provides a self-check feature where records can be compared to actual inventory counts,
helping to track missing items due to theft, loss, or disposal. This is not possible with the
periodic method.
➔ Physical count is not needed to prepare an income statement

Variations in Perpetual Method

➔ Does not need physical inventory count to get COGS
➔ Retail Method
◆ Purchases are recorded at both their cost and retail selling price. The gross margin
percentage of available goods is calculated, and the complement of this percentage is
used to estimate the COGS from sales
➔ Gross-Profit Method
◆ Applies a normal gross margin percentage directly to sales figures to estimate the
COGS, typically on a per department basis
COGS For Manufacturing Companies
➔ Direct Materials
◆ Materials that are essential parts of the product
◆ Raw materials used in its manufacturing process.
◆ Materials dedicated to the operation of the business and become an integral part of
the end product
➔ Direct Labor
◆ Labor applied to convert direct materials into finished products
◆ Includes wages, related costs of workers who assemble inputs into finished goods,
those who operate equipment integral to the production process, etc.
➔ Factory Overhead (all costs incurred in direct support of product manufacturing operations)
◆ Indirect Materials
● Supplies consumed in operations but not directly part of end product
◆ Indirect Labor
● Wages/Salaries earned by employees who do not directly work on the product
but whose services are related to the production process (e.h. Supervisors,
operations support engineers, material handlers, storeroom personnel, etc.)
◆ Fixed and Misc. Expenses
● Depreciation, taxes, rent, warranties, and insurance
➔ Note:
◆ Prime Cost = direct material + direct labor
◆ Conversion Cost = direct labor + factory overhead

COGS For Manufacturing Companies: Inventory Account Categories

1. Materials Inventory
➔ Costed at acquisition cost with adjustments for freight-in and returns
2. Work-in-Process Inventory
➔ Costed as the sum of:
a. Cost of materials that have been issued and used in the production process up to that
point
b. Cost of labor and other manufacturing costs incurred on these partially completed
items up to the end of the accounting period.
3. Finished Goods Inventory
Inventory Costing Method
➔ Determine how the cost of inventory is allocated when identical units of a commodity are
acquired at different unit costs within a period
1. Specific Identification Method
➔ Used when a specific purchase can be directly matched with the units sold. However, this is
only practical when each unit can be accurately identified, which may not always be possible
2. Average Cost Method
➔ Calculates the weighted average cost of all goods available for sale, and the units in both cost
of goods sold and ending inventory cost at this average.
➔ Gives result in between the LIFO and FIFO method, as such, it is a compromise between those
two methods
3. First In First Out (FIFO)
➔ Oldest goods are sold first. Most recent purchased goods are in ending inventory
➔ When inflation occurs, COGS is lower and gross profit is higher. Opposite when deflation
occurs.
4. Last In First Out (LIFO)
➔ COGS is based on most recent purchases, and ending inventory is costed at the cost of the
oldest units available
➔ When inflation occurs, COGS is higher and gross profit is lower (as well as net income).
Opposite when deflation occurs.

FIFO LIFO

Advantage/s COGS approximates the physical Usage under inflationary periods

flow of goods because companies
sell old goods first
Ending inventory reflects the
current cost since it is costed at
the amounts of most recent
purchases
Maximizes the near-term amount
of income reported to
shareholders under inflationary
periods
provide for income-tax savings and
thus, a better cash flow for the
company
Tendency to minimize the effect of
price trends on gross profits, giving
a more current gross margin value.
Lower reported profits and taxes
provides a more current and
accurate representation of the
gross margin value.

Disadvantage/s Tends to pass through the effects
of inflationary and deflationary
trends to gross profit. In periods of
inflation, FIFO results in lower
COGS and higher gross profit, while
in periods of deflation, FIFO results
in higher COGS and lower gross
profit
Potential mismatch between
revenue and COGS. Might not
accurately reflect the difference
between sales revenue which are
necessarily current and the current
COGS may not reflect the usual
physical flow of merchandise. Since
LIFO assumes newest items are sold
first, the COGS may not represent the
actual flow of merchandise. This is
problematic for businesses that
experience fluctuations in inventory
costs or changes in the types of
products they sell.
Ending inventory cost not
reflecting current costs. Since LIFO
values the cost of oldest items, the
ending inventory tends to be valued
COGS. If the cost of newer
inventory items increased, the
COGS calculated using FIFO may
be lower than the current market
value of the goods sold. This can
result in an over/understatement
of revenue.
at historical costs rather than
current market prices. This can
distort financial statements by not
accurately reflecting the true value
of inventory on hand.