Management

Accounting

Mike Darryl N. Viray,CPA

 Chapter 5
Analysis and Interpretation of Financial Statements

Learning Objectives
1. Define the measurement levels, namely,
liquidity, solvency, stability, and profitability.
2. Perform vertical and horizontal analyses of
financial statements of a single proprietorship.
3. Compute and interpret financial ratios such as
current ratio, working capital, gross profit ratio,
net profit ratio, receivable turnover, inventory
turnover, debt-to-equity ratio, and the like.

Fundamentals of ABM 2 by: Ferrer & Millan

Financial Statement Analysis
• Financial statement analysis is a process of
evaluating and interpreting an entity’s
financial statements to assess its financial
health for the purpose of making better
economic decisions.

Fundamentals of ABM 2 by: Ferrer & Millan

Methods of Financial Statement Analysis
• The two methods used in analyzing
financial statements are as follows:
1. Horizontal and Vertical Analyses
2. Financial ratio analysis

Fundamentals of ABM 2 by: Ferrer & Millan

 Horizontal Analysis
• Horizontal analysis is the comparison of financial
information over two or more reporting periods.
The purpose is to analyze if changes in amounts
are unusually high or low, which may entail
investigation of the reason for the unusual change.

• Steps in Horizontal Analysis

1. Compute for the change in the amounts in a
baseline year (earlier period) and a later period.
2. Divide the change by the amount in the baseline
year.

Fundamentals of ABM 2 by: Ferrer & Millan

Examples of Horizontal Analysis

Fundamentals of ABM 2 by: Ferrer & Millan

 Vertical Analysis
• Vertical analysis involves the analysis of the
financial statements of one reporting
period. It is a proportional analysis whereby
each amount in the financial statements is
shown as a percentage of another item.

Fundamentals of ABM 2 by: Ferrer & Millan

Example of Vertical Analysis

Fundamentals of ABM 2 by: Ferrer & Millan

Summary:

Fundamentals of ABM 2 by: Ferrer & Millan

 Financial Ratio Analysis
• Financial ratio analysis involves the
computation of percentages, fractions or
proportions using certain formulas.

• Financial ratios are broadly classified into the

following:
1. Liquidity ratios
2. Activity ratios (Asset management ratios)
3. Leverage ratios (Debt management ratios)
4. Profitability ratios
Fundamentals of ABM 2 by: Ferrer & Millan
 Liquidity ratios
• Liquidity ratios provide a measure of the
ability of a business to pay its liabilities.
Examples include:

a. Current ratio – the most commonly used

ratio in measuring the ability of a business to
pay its short-term debts.

Fundamentals of ABM 2 by: Ferrer & Millan

Liquidity ratios (continuation)
b. Quick ratio (Acid-test ratio) – a much
stricter ratio used to measure the ability of a
business to pay its short-term debts.

Fundamentals of ABM 2 by: Ferrer & Millan

Liquidity ratios (continuation)
c. Working capital – similar to current ratio
but measures the ability of a business to pay
its short-term debts by the excess or
deficiency of current assets over current
liabilities.

Fundamentals of ABM 2 by: Ferrer & Millan

Activity ratios (Asset management ratios)
• Activity ratios provide a measure of how
efficient a business is utilizing its resources.

a. Inventory turnover – is a measure of the

number of times inventory is sold and
replenished during a period.

Fundamentals of ABM 2 by: Ferrer & Millan

Activity ratios (continuation)
b. Days of inventory (Average sale period) –
is a measure of the number of days inventory
is held before it is sold.

Fundamentals of ABM 2 by: Ferrer & Millan

Activity ratios (continuation)
c. Accounts receivable turnover – is a
measure of the number of times accounts
receivable have been collected during a
period. It is an indication of the efficiency in
collection.

Fundamentals of ABM 2 by: Ferrer & Millan

Activity ratios (continuation)
d. Days of receivable (Average collection
period) – is a measure of the average time to
collect a receivable.

Fundamentals of ABM 2 by: Ferrer & Millan

Leverage ratios (Debt management ratios)
• Leverage ratios (Debt management ratios)
provide a measure of the extent a business
uses debt financing or “leverage.”

a. Debt ratio (Debt-to-asset ratio) –

measures the proportion of assets
financed through debt.

Fundamentals of ABM 2 by: Ferrer & Millan

Leverage ratios (continuation)
b. Equity ratio – measures the proportion of
assets financed through equity.

Fundamentals of ABM 2 by: Ferrer & Millan

Leverage ratios (continuation)
c. Debt-to-equity ratio – indicates how much
debt is used to finance the assets relative to
the amount pertaining to the owner(s).

Fundamentals of ABM 2 by: Ferrer & Millan

 Profitability ratios
• Profitability ratios provide a measure of the
performance of a business in terms of its
ability to generate profit from its resources.

a. Gross profit ratio – shows the relationship

between sales and cost of goods sold.

Fundamentals of ABM 2 by: Ferrer & Millan

Profitability ratios (continuation)
b. Net profit ratio – measures profitability
after considering all income and expenses.

Fundamentals of ABM 2 by: Ferrer & Millan

Profitability ratios (continuation)
c. Return on assets – measures the profit
generated in relation to the total resources
available to the business.

Fundamentals of ABM 2 by: Ferrer & Millan

Profitability ratios (continuation)
d. Return on equity (Return on net assets) –
measures the profit generated in relation to
the resources invested by (or attributable to)
the owner(s) of the business.

Fundamentals of ABM 2 by: Ferrer & Millan

Summary: Financial Ratio Analysis

Fundamentals of ABM 2 by: Ferrer & Millan

Summary: Financial Ratio Analysis

Fundamentals of ABM 2 by: Ferrer & Millan

Summary: Financial Ratio Analysis

Fundamentals of ABM 2 by: Ferrer & Millan

Summary: Financial Ratio Analysis

Fundamentals of ABM 2 by: Ferrer & Millan

OPEN FORUM
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Fundamentals of ABM 2 by: Ferrer & Millan

 END

Fundamentals of ABM 2 by: Ferrer & Millan