ANALYSIS AND

INTERPRETATION OF
FINANCIAL STATEMENTS
 AT THE END OF THIS LESSON, YOU ARE EXPECTED TO:

▰ define the measurement levels, namely: liquidity,

solvency, and profitability
▰ perform vertical and horizontal analysis of financial
statements of a single proprietorship
▰ 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.
 FAMILIARIZE THE TERMS:
Financial Statement (FS) Analysis
Horizontal Analysis
Vertical Analysis
Ratio Analysis
With the objective of making an economic decisions, this is a
process of evaluating risks, performance, financial health, and
future prospects of a business by subjecting
financial statement data to computational and analytical
techniques.
Trend analysis is the other name for this. It is a technique for
evaluating a series of financial statement data over a period of
time with the purpose of determining the increase or decrease
that has taken place. This will reveal the behavior of the account
over time. This Horizontal analysis also uses financial statements
of two or more
periods.
This is also known as the common-size analysis, it is a
technique that expresses each financial statement item as a
percentage of a base amount.
It used to express the relationship among selected items of
financial statement data. The relationship is expressed in terms
of percentage, rate, or a simple proportion.
 1
HORIZONTAL ANALYSIS vs.
VERTICAL ANALYSIS
 HORIZONTAL ANALYSIS

One of the most basic tools that could be used by entities

in analyzing their own financial statements is horizontal
analysis. The company compares their own financial
statements for the current period with their financial
statements from the previous period. The amount of the
prior period normally serves as the basis or the starting
point of the comparison. Increases or decreases amounts
are being taken and it will be measured in percentages.
SAMPLE BALANCE SHEET OF XYZ COMPANY FOR THE YEAR
2018 AND 2019:
 To conduct HORIZONTAL ANALYSIS, compare both accounting periods:

To interpret: For example in Cash item

• Peso change = P510,000 – P450,000 = P60,000

• Percentage change = P60,000 / P450,000 = 13.33%
• This is evaluated as follows: Cash increased by P60,000. This represents growth of 13.33% from the year 2018.

The previous period (2018) is the basis or the starting point of the comparison. Through this kind of analysis, the company would easily identify the items that
made substantial movements during the second year (2019).
Aside from the Statement of Financial Position, companies can also make use of horizontal analysis
to analyze Income Statements of companies. Taken, side by side, a horizontal analysis of XYZ
Company’s Income Statement would look like this:

To interpret: For example in Net Sales item

• Peso change = P950,000 – P880,000 = P70,000

• Percentage change = P70,000 / P950,000 = 7.95%
• This is evaluated as follows: Net Sales increased by P70,000. This represents growth of 7.95% from the year 2018.
 VERTICAL ANALYSIS

Another basic tool that could be used by entities in

analyzing their own financial statements is vertical
analysis. The companies express items of a certain
financial statement as a percentage of a given base
amount. For example, items on a Balance Sheet are
normally compared to the total assets of the company for
that given year. Items in an Income Statement are
normally compared to the Net Sales for that given
accounting period.
Let us take as example the Balance sheet and Income Statement of XYZ Company for the year 2018 as
illustrated above. In preparing a vertical analysis of financial statements, the Total Assets and the Net Sales will
serve as the base amount or the 100%. All of the items in the Balance Sheet and in the Income Statement will
be divided using the base amount.

The above may be

evaluated as follows:

• The largest component of

assets is Land at 47.46%
followed by Cash which is
32.61%.
• Patent is the smallest
component at 5.80%.
• On the other hand,
42.75% of assets are
financed by debt and the
remaining 57.25% is
financed by equity.
The above may be
evaluated as follows:

• The cost of goods

sold is 29.55% of
sales. The company
has a gross profit rate
of 70.45%. Operating
expenses are 15.91%
of sales.
• The company earns
income of P 0.33 for
every peso of sales.
• Gross profit
generated for every
peso of sale is P 0.70
 2
DIFFERENT FINANCIAL
RATIOS
Financial ratios in accounting can be
classified into three groups:

1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios
 LIQUIDITY RATIO

Liquidity is the capacity of a company to pay its currently maturing

obligations. These would require a good amount of cash and other
liquid assets such as accounts receivable, inventory, trading
securities, and prepaid assets.

These ratios are very important to the short term creditors of a

company. It will determine if the borrowing company is in a position
to pay the borrowed principal and interest when they fall due.
14
To better understand the financial ratios, let us have an illustrative example of the
computation using the sample Financial Statements of GSM Company shown
below:
 Different ratios under liquidity ratio are shown below:

1. Working Capital
Liquidity capital is the difference between current assets and current liabilities. This is one of the
simplest liquidity ratios. A positive working capital is preferred because it would mean that there are
enough current assets to pay all of the current liabilities at the moment.

Formula: Working Capital = Current Assets – Current Liabilities

Using the GSM Company data, we would be able to compute the company’s working capital for
2018 and 2019.

Analysis: For both periods, the company has a positive working capital. This is something good. However,
comparing the two periods, we can conclude that GSM Company is in a better liquidity position in the year 2019
than in 2018.
2. Current Ratio
Current ratio is the quotient of current assets divided by the current liabilities of the company. As
much as possible, a whole number current ratio is preferred.

Formula: Current Ratio = Current Assets / Current Liabilities

Using the GSM Company data, we would be able to compute the company’s current ratio for
2018 and 2019.

Analysis: GSM Company has P 3.13 worth of current assets for every P 1.00 of current liabilities for the year
2018. This is something positive. However, comparing the two periods, the company has a slightly better current
ratio in 2018 than in 2019. 17
3. Acid Test Ratio
Acid Test Ratio is a more strict variation of the current ratio formula. It removes Inventory and
Prepaid Expenses from the numerator component. Only Cash, Receivables, and Trading Securities
also known as Quick Assets will be left.

Formula: Acid Test Ratio = Quick Assets / Current Liabilities

Using the GSM Company data, we would be able to compute the company’s acid test ratio for
2018 and 2019.

Analysis: GSM Company has P 2.04 worth of quick assets for every P 1.00 of current liabilities for the year
2018. This is something positive. It means that it really has the capability to pay its maturing obligations through
its quick assets. Comparing both years, however, would reveal that the company was better off in 2018 than in 18
2019.
4. Accounts Receivable Turnover Ratio
This ratio measures the frequency of conversion of the company’s Accounts Receivable to Cash. It measures
how many times the company collected its Accounts Receivable from its customers.

Formula: Accounts Receivable Turnover Ratio = Net Sales/Accounts Receivable

Using the GSM Company data, we would be able to compute the company’s accounts receivable turnover
ratio for 2018 and 2019.

Analysis: Comparing the compound Accounts Receivable Turnover Ratios for the two years, it can be seen that
the company has a higher ratio for 2019. This can be attributed to a better performance from its collection
department. 19
5. Average Collection Period
The average collection period states the usual number of days it would take before the company would be
able to collect a certain group of receivables. The Accounts Receivable Turnover itself is a component for the
computation of the average collection period. It serves as the denominator in the formula. For the numerator, the
company makes use of either 360 or 365 days depending on the policy of the company.

Formula: Average Collection Period = 365 days / A/R Turnover Ratio

Using the GSM Company data, we would be able to compute the company’s average collection period for
2018 and 2019.

Analysis: The shorter average collection period in 2019 shows that the collection department increased its efforts
to collect company receivables as they fall due. It can be seen in our computation that the company has a better
Accounts Receivables Turnover Ratio and Average Collection Period in 2019 than in 2018. A shorter average
20
collection period means that the company has more immediate cash that can be used in its operation.
6. Inventory Turnover Ratio
This ratio measures the number of times the company was able to sell its entire inventory to customers during
the year. As much as possible, the goal is to have a high inventory ratio. A high turnover ratio shows how efficient
the company is in selling its inventory to customers.

Formula: Inventory Turnover Ratio = Cost of Goods Sold / Inventory

Using the GSM Company data, we would be able to compute the company’s inventory turnover ratio for 2018
and 2019.

Analysis: It can be seen in our computation that the inventory slightly increased in 2019. It means
that the sales department sold more products to customers in 2019.
7. Average Days in Inventory
This ratio states the number of days that it would take before an inventory would be entirely sold by the
company. This follows the same concept in computing the average collection period. The goal is to have shorter
average days in inventory. A shorter amount would mean that the cash of the company is not being tied to its
inventory for a very long period of time.

Formula: Average Days in Inventory = No. of days / Inventory Turnover Ratio

Using the GSM Company data, we would be able to compute the company’s average days in inventory for
2018 and 2019.

Analysis: This means that the company will take 153 days to sell its entire inventory for the year 2018 while it
would only take 132 days for the year 2019. The average days in inventory of this company improved in 2019.
This is because the inventory turnover in 2019 also improved. 22
8. Number of Days in Operating Cycle
These are the measures on how long it would take for the company to transform its inventory back to cash.
This is the combination of the average collection period and the average age of inventory. The goal is to always
have a shorter number of days of operating cycle.

Formula: No. of Days in Operating Cycle = Average Collection Period + Average Days in Inventory

Using the GSM Company data, we would be able to compute the company’s no. of days in the operating cycle
for 2018 and 2019.

Analysis: A comparison between the two periods shows an improvement of at least 22 days in the operating
cycle. It means that the company improved as a whole when it comes to selling their products and
collecting their receivables.
 SOLVENCY RATIO

Solvency ratios measure the capability of an

entity to pay long term obligations as they fall
due. Creditors of the company’s long term
payable and bond payable will be interested
in knowing its solvency ratios.
 Different ratios under solvency ratio are shown
below:
1. Debt to Total Assets Ratio
This is the proportion between the total liabilities of the company and its total assets. The debt ratio shows how much of the
assets of the company were given by creditors. As much as possible, current and prospective creditors want a very low debt to total
assets ratio.

Formula: Debt to Total Assets Ratio = Total Liabilities / Total Assets

Using the GSM Company data, we would be able to compute the company’s debt to total assets ratio for 2018 and 2019.

Analysis: Comparing the data for the two years involved, it can be seen that there is a minimal change in the
debt ratio of the company. This means that in 2018, out of the total assets of the company, 69% was being
financed 25
by creditors. A high debt to asset ratio implies a high level of debt.
2. Debt to Equity Ratio
Instead of assets, the debt to equity ratio compares the liabilities of the company with its equity.
A smaller debt to equity ratio would indicate a healthier solvency position for the company.

Formula: Debt to Equity Ratio = Total Liabilities / Total Owner’s Equity

Using the GSM Company data, we would be able to compute the company’s debt to equity ratio
for 2018 and 2019.

Analysis: Comparing the debt to equity ratio of the company for two periods concerned showed that the
company was more solvent in 2019 than in 2018. A high ratio suggests a high level of debt that may result in high
interest expense.
3. Times Interest Earned Ratio
The Time Interest Earned Ratio shows the proportion between the Earnings Before Interest and Taxes (EBIT)
of the company and its interest expense. It is an indicator of how many times the company’s EBIT can cover the
finance cost of borrowing. Companies want a high Times Interest Earned Ratio. A small or decimal number ratio
indicates that it is not advisable for a company to borrow money – especially if the company would not be able to
generate enough income to cover it.

Formula: Times Interest Earned Ratio = EBIT / Interest Expense

Using the GSM Company data, we would be able to compute the company’s
times interest earned ratio for 2018 and 2019.

Analysis: Comparing the times interest earned ratio of the company for two periods, it can be seen that the
company is very solvent in the year 2018 compared to that in 2019. It is 10 times more solvent to pay the interest
with its income before tax.
 PROFITABILITY RATIO

Profitability ratios measure the ability of the

company to generate income from the use of
its assets and invested capital as well as
control its cost.
 Different ratios under profitability ratio are shown
below:
1. Gross Profit Ratio
This is the proportion of the gross profit of the company with its net sales. Gross profit is the difference
between the net sales of the company and its cost of goods sold. A company should aim for a bigger gross profit
ratio. A large gross profit ratio shows that a company can generate more sales from the smaller cost of goods
sold
that it has.

Formula: Gross Profit Ratio = Gross Profit / Net Sales

Using the GSM Company data, we would be able to compute the company’s gross profit ratio for 2018 and
2019.

Analysis: This means that for every P 1.00 the company sells, P .80 goes to the gross profit in the year 2018.
The company’s gross profit ratio slightly decreased in 2019. This should be avoided or at least be minimized. The
gross profit ratio can be improved by continuously finding inventories with lower cost, without sacrificing quality.
2. Profit Margin Ratio
The profit mentioned here is the Net Income After Tax (NIAT). This ratio measures the proportion between the
NIAT and the Net Sales of the company. This is a more precise measurement of the company’s profitability
because it has already considered the operating expenses and other expenses of the entity. Companies want a
high profit margin ratio.

Formula: Gross Margin Ratio = Net Income after Tax / Net Sales

Using the GSM Company data, we would be able to compute the company’s gross margin ratio for 2018 and
2019.

Analysis: This means that company earned P .47 for every P 1.00 of sales in the year 2018. The company’s
gross margin ratio shows a decline for the year 2019. This can be attributed to the lower NIAT coupled by an
increase in Net Sales.
3. Operating Expenses to Sale Ratio
Operating expenses are the biggest expenses of every company. It can be further classified into General and
Administrative Expenses and Selling Expenses. These expenses are needed to generate sales. This ratio should
be minimized as much as possible. The goal is to generate as much sales with the minimum operating expenses.

Formula: Operating Expenses to Sale Ratio = Operating Expenses / Net Sales

Using the GSM Company data, we would be able to compute the company’s operating expenses to sale ratio
for 2018 and 2019.

Analysis: Comparing the data for the two years involved shows that there is a huge improvement in
the operating expenses to sales ratio. This can be attributed to lower operating expenses and
increase in net sales.
4. Return on Assets
Before profits can be realized, certain investments should be made. In this case, assets will be
used for the different projects of the company. The goal is to generate profit based on the available
assets during the year. Thus, the company aims for a higher return on assets.

Formula: Return on Assets = NIAT / Total Assets

Using the GSM Company data, we would be able to compute the company’s return on assets
for 2018 and 2019.

Analysis: Comparing the data for the two years involved shows that in the year 2018 the return on assets is very
high compared to the year 2019. This can be attributed to a much higher income compared to the assets of the
company. 32
5. Return on Equity
This is a slight variation of the earlier formula. In this case, it is the averageowner’s/stockholder’s
equity that will be used as a denominator. This is a more specific computation of a company’s
profitability because the denominator being used is the one coming from stockholders/owners
alone.

Formula: Return on Equity = NIAT / Owner’s Equity

Using the GSM Company data, we would be able to compute the company’s return on equity for
2018 and 2019.

Analysis: In 2019, the return on equity decreased. This could be attributed to a lower
net income after tax and a larger owner’s equity.
6. Asset Turnover Ratio
This ratio measures the correlation between the assets owned by the company and the net
sales generated by such properties.

Formula: Assets Turnover Ratio = Net Sales / Total Assets

Using the GSM Company data, we would be able to compute the company’s assets turnover
ratio for 2018 and 2019.

Analysis: The assets turnover ratio slightly decreased in 2019. This is something not good because
the company should aim for a higher assets turnover ratio. This can be attributed to bigger net sales
generated for that year.
 Presented below is the Comparative Financial Statements of Tan General
ACTIVITY Merchandise for the year 2018 and 2019:
Required:

1. Prepare a HORIZONTAL ANALYSIS for the

Comparative Statement of Financial Position.

2. Prepare a VERTICAL ANALYIS for the

Comparative Statement of Comprehensive Income.

37
 3. Compute the following ratios for the comparative periods. The
company used 365 days in its computation for some of the ratios. Show
your solution.

a. Working Capital
b. Current Ratio
c. Acid Test Ratio
d. Accounts Receivable Turnover Ratio
e. Average Collection Period
f. Inventory Turnover Ratio
g. Average Days in Inventory
h. Number of days in Operating Cycle
i. Debt to Total Assets Ratio
j. Debt to Equity Ratio
k. Times Interest Earned Ratio
l. Gross Profit Ratio
m. Profit Margin Ratio
n. Return on Assets
o. Return on Equity
p. Assets Turnover Ratio
THANKS!