Philippine School of Business Administration

Sampaloc, Manila

Finance 1
Chapter 6 – Financial Statements: Tools for
Decision-making

Prof. Eugene A. Ruano

 FINANCIAL STATEMENTS
• are indispensable tools in making financial decisions
• shows performance of the company (income
statements), financial condition of the company
(balance sheet), where the cash came from and
where it was spent (cash flow statement),
investments, withdrawals by owners and any profit
earned or loss incurred by the company (statement
of changes in owners’ equity)
• helps both internal and external users
 FINANCIAL ANALYSIS
• deals with the understanding of the
relationship between financial concepts and
daily decision-making.
• it is both an analytical and a judgmental
process which helps answer questions in a
managerial context.
BASIC DECISION AREAS
• Operation
• Investment
• Finance
 OPERATING DECISION
• deals with the day-to-day operations/activities of the firm.
• includes decisions that are relevant to pricing, selecting
markets, choosing appropriate production processes and
technology, outsourcing payroll, outsourcing maintenance
and janitorial services among others.
• Operating leverage involves the determination of the
profitable level and the proportion of fixed costs of
operation versus the amount and nature of variable costs
incurred in manufacturing, trading and service operations.
• Breakeven analysis is used to determine the
volume of business a company needs to reach
where the income equals expenses. It means
the company needs to go over this point to
earn a profit. This analysis enables the
manager to set target sales figures that will
guide the sales personnel in their sales effort
to earn the desired profit.
 INVESTMENT DECISION
• refers to deciding what assets to acquire, be
they current assets as marketable securities or
non-current assets as property, plant or
equipment and long-term investments in
stocks and bonds.
• it includes decisions relative to projects to
undertake or business to enter to.
• Current available resources and new funding obtained can
be utilized to fund:
a. Working capital - working capital budget for operating
expenses and payment for current liabilities
b. Property, Plant and Equipment - capital budgeting – capital
expenditure intended for long-term assets and projects
c. Major Spending Programs – e.g. research and development,
product or service development, promotional and
advertising programs or long-term investment alternatives
for excess funds so that cash can be converted into an
earning asset
 FINANCING DECISION
• Refers to decision that involves funding
investments and operations over the long run.
• Includes decisions that relate to the
company’s capital structure, debt-equity mix,
funding sources, dividend policies, cost of
capital, among others
 STEPS IN ANALYZING THE FINANCIAL
STATEMENTS
• Understanding the information provided in
the financial statements – any reader of the
financial statements, especially the manager,
who is to make decisions to benefit the
enterprise, needs to have a basic knowledge
of finance in its contextual meaning to avoid
confusion and misleading or wrong decisions,
which are sometimes, fatal to the business.
• Drawing logical conclusion based on the data
presented – i.e., financial statements for two or
more periods are necessary before one can
make a decision on how the business is
performing or how the condition of the
company is changing. Comparative analysis of
sales or revenue and expenses can help the
manager decide on where the company needs
improvement-sales, manufacturing or expenses.
• Making the appropriate decision on the
course of action to take – After drawing
logical conclusion, the manager or user of the
financial statements is now able to determine
the course of action to take to correct what
needs correction and the steps necessary to
redirect company efforts toward the goals that
the company has set to achieve.
 HORIZONTAL ANALYSIS
• Refers to comparative analysis of the financial
statements.
• This reveals if the profitability and the
financial condition of the firm are improving
or not.
• This comparison usually reveals trend; the
reason why it is sometimes referred to as
trend analysis.
• Trend analysis involves analysis of significant
changes in absolute amounts and
percentages, including an analysis of changes
in ratios used in ration analysis.
• Ratios in prior years are compared to ratios in
the current year.
• Comparative Income Statement shows the
changes that occur in the different elements
of the income statement in absolute money
value and percentage of increase/(decrease)
to see if the performance of the company is
improving or not.
 VERTICAL ANALYSIS
• Refers to the type of analysis where one
number is compared to another to identify
significant relationships.
TWO TYPES OF VERTICAL ANALYSIS:
1. Common-Size Statements or Percentage
Analysis
2. Ratio Analysis
• Common-size statements show the
relationship between items in a single
statement, either in the balance sheet or in
the income statement. It shows the
percentage relationship of an element of the
financial statement to a significant total
amount in the financial statement.
• Ratio analysis compares one figure to another.
Also, it compares one period with another
period.
• Profitability ratios indicate whether the
company is earning or not.
• Liquidity ratio indicates if the company is able to
pay its maturing obligations.
• Long-term debt ratio indicates the ability of a
firm to pay its liabilities in the long run.
 PROFITABILITY RATIOS
• Return on Owners’ Investment (ROI) –
sometimes referred to as ROE. It relates
income or profit after income tax to the total
stockholders’ equity, preferably on the
average of stockholders’ equity. The average is
computed by adding the beginning and the
ending balances and dividing it by two.
• Profit margin – also known as return on sales,
(ROS) is the ratio of income to net sales.
• Return on Assets – is a measure of asset
utilization.
LIQUIDITY/SHORT-TERM SOLVENCY RATIOS

• Current ration – relates current assets to current

liabilities and shows the immediate solvency and
liquidity of a firm. It tells how much current assets is
available to meet the current liabilities.
• Quick ratio – also called acid-test ratio, is a more
stringent measure of liquidity and solvency. It uses
only the “quick assets” that can be readily converted
into cash.
• Working capital – is not a ratio but is the difference
between current assets and current liabilities.
 LONG-TERM DEBT RATIOS
• Debt ratio – relates total liabilities to total assets.
• Stockholders’ ratio – relates total stockholders’
equity to total assets
• Debt-equity ratio – relates the total liabilities to
total stockholders’ equity
• Interest coverage ratio – indicates the
company’s ability to pay its interest on its
obligations
 LIMITATIONS OF FINANCIAL STATEMENTS
ANALYSIS
1. Data are reported at historical costs.
2. Data are all in monetary terms.
3. Financial statements use estimates.
4. Financial statements use judgments.
5. Financial statements are interim in nature.
6. Financial statements assume stable monetary
unit.