ANALYSIS OF

FINANCIAL
STATEMENTS
FINANCIAL STATEMENTS
ANALYSIS

It involves careful selection of data from financial

statements for the primary purpose of forecasting the
financial health of the company.
FINANCIAL STATEMENTS
ANALYSIS

It is the comparison of actual conditions with expected

financial conditions…
LEARNING OBJECTIVES
After studying this unit, you should be able to…

1. Define a common-size statement.

2. State the purposes of common-size statements.
3. Apply the guidelines in the preparation and interpretation of common-
size statements.
4. Define financial ratio
5. State the purpose and limitations of financial ratios.
6. Discuss the nature of liquidity ratios, solvency ratios, profitability ratios,
and efficiency ratios.
7. Apply the financial ratios in evaluating the company’s financial position
(short-term and long-term) and operating performance.
Common-Size Financial
Statements
It translates peso amounts to percentages, which
indicate the relative size of an item in proportion to
the whole.
COMMON-SIZE FINANCIAL STATEMENTS
Nature:
 Year-to-yearcomparisons and
trend analyses are useful in
understanding an organization’s
performance
 Butas the size of an organization
changes, year-to-year
comparisons of peso amounts
can be misleading.
 Common-size statements of financial
position shows assets, liabilities and
owners’ equity as percentage of total
assets.
 Common-size income statements
express revenue and expenses as a
percentage of sales revenues
 The preparation of common size
statements is known as vertical
analysis.
COMMON-SIZE FINANCIAL STATEMENTS
Purposes:
 Common-size statements which
are also known as “component
percentage” or “100 percent”
statements enable the analyst to:
(1.) Comprehend or visualize the changes
in individual items that have taken place
from year to year in relation to the total
assets, total liabilities, and owners’ equity
or total net sales.
(2) Compare statements of two or more
companies or statement of one company
with the statements for an entire industry
and evaluate their current financial
position and operating results.
(3) Point out efficiencies and
inefficiencies that might otherwise go
unnoticed.
COMMON-SIZE FINANCIAL STATEMENTS
Conversion Procedures:

A. For the Statement of Financial Position, each item therein is

converted to percent by dividing it by total assets.

B. In the Income Statement, each item is restated as a percentage of net

sales or net operating revenue by dividing the former by the latter.
Guidelines in the Interpretation of Common-Size
Statements
Statement of Financial Position

1. A common-size statement of financial position shows the percent of

total assets that has been invested in each type or kind of asset.
2. The common-size statement will also show the distribution of
liabilities and equity, i.e., the sources of the capital invested in the
assets.
3. The percentage of current assets may also be related to the percentage
of current liabilities to determine debt-paying capacity of the
company.
Guidelines in the Interpretation of Common-Size
Statements
Income Statement

1. The common-size income statement shows the amount or percentage of the

sales that has been absorbed by each individual cost or expense item and the
percentage that remains as net income.
2. A comparison of year-to-year income statement common-size ratios will show
whether a larger or smaller relative amount of net sales was used to meet
particular costs or expenses. These percentages may also be compared with a
competitors’ statements to determine in order effect a higher profit margin.
3. Comparison of the gross profit percentage from year may also reveal success
or failure in the company’s effort to increase efficiency in the procurement
and merchandising policies, etc.
Illustrative Problem. Financial Position Statement
Illustrative Problem. Financial Statement Analysis Using
Common-Size Statement
Illustrative Problem. Income Statement
Illustrative Problem. Financial Statement Analysis Using
Common-Size Statement
FINANCIAL RATIO ANALYSIS
FINANCIAL RATIO
It is a comparison in fraction, proportion, decimal or
percentage form of two significant figures taken from
financial statements.
Financial Ratio Analysis
Purpose:

Through ratio analysis, the financial statements user comes into possession
of measures which provide insight into the profitability of operations, the
soundness of the firm’s short-term and long-term financial condition and the
efficiency with which management has utilized the resources entrusted to it.
Financial Ratio Analysis
Limitations of Financial Ratios:
1. Ratios must be used only as financial tools, that is, as indicators of weakness or strength
and not to be regarded as good or bad per se.
2. Financial ratios are generally computed directly from the company’s financial statements,
without adjustment.
3. Ratios are a composite of many different figures– some covering a time period, others an
instant time and still others representing averages.
4. Ratios to be meaningful should be evaluated with the use of certain yardsticks. The most
common of these are:
a. Company’s own experience (prior years)
b. Other companies in the same industry (industry averages)
c. A standard set by management (a budget)
d. Rules of thumb
Financial Ratio Analysis
Uses:
1. LIQUIDITY RATIOS are ratios that measures the firm’s ability to meet
cash needs as they arise (e.g. payment of accounts payable, bank loans
and operating costs).
2. ACTIVITY RATIOS are ratios that measure the liquidity of specific assets
and efficiency in managing assets such as accounts receivables, inventory
and fixed assets.
3. LEVERAGE RATIOS are ratios that measure the extent of a firm’s
financing, with debt relative to equity and its ability to cover interest and
other fixed charges such as rent and sinking fund payments.
4. PROFITABILITY RATIOS are ratios that measure the overall performance
of the firm and its efficiency managing assets, liabilities and equity.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
I. Ratios Used to Evaluate Short-Term Financial Position (Short-Term Solvency & Liquidity
Name Formula Significance
1. Current Ratio Total Current Assets ___ Primary test of solvency to meet
Total Current Liabilities current obligations from current
assets as a going concern;
measure of adequacy of working
capital

2. Acid Test ratio or Total Quick Assets A more severe test of immediate
(Cash+Marketable Securities+ solvency; test of ability to meet
Quick Ratio Accounts Receivables) demands from current assets.
Total Current Liabilities

3. a.) Working Capital to Working Capital Indicates relative liquidity of

Total Assets total assets and distribution of
Total Assets resources employed.
Current Assets – Current
b.)Working Capital Liabilities
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
I. Ratios Used to Evaluate Short-Term Financial Position (Short-Term Solvency & Liquidity
Name Formula
4. Cash Flow Liquidity Cash + Marketable Securities +
Cash Flow from Operating
Ratio Activities
Current Liabilities
5. Defensive Interval Quick Assets
Projected Daily Operational
Ratio Expenses
Significance
Measures short term liquidity by
considering as cash resources
(numerator) cash plus cash
equivalents plus cash flow from
operating activities
Measures length of time in days
the firm can operate on its
present liquid resources.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency
Name Formula Significance
1. a.) Trade Receivable Net Credit Sales *__ Velocity of collection of trade
Average Trade Receivable (net) accounts and notes; test of
Turnover efficiency of collection.

b.) Average ______360 days_______ Evaluates the liquidity of

Collection period or
number of days’ sales
uncollected
Receivable Turnover accounts receivables and the
Or firm’s credit policies..
Accounts Receivable
Net Sales/ 360
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency
Name Formula Significance
2. Inventory Turnover
___Cost of Goods Sold__ Measures efficiency of the firm in
a.) Merchandise Turnover Average Merchandise managing and selling inventories
Inventory

b.) Finished Goods Inventory ___Cost of Goods Sold___ -do-

Average Finished Goods
Inventory

c.) Goods in Process Turnover Cost of Goods Manufactured Measures efficiency of the firm in
Average Goods-In Process managing and selling inventories.
Inventory
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency
Name Formula Significance
2. Inventory Turnover

d.) Raw Materials Turnover __Raw Materials Used__ Numbers of times raw materials
Average Raw Materials inventory was used and
Inventory replenished during the period.

e.) Days Supply in Inventory _______360 Days______ Measures average number of

Inventory Turnover days to sell or consume the
average inventory.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency
Name Formula Significance
3. Working Capital __________Net Sales_________ Indicates adequacy and activity
Average Working Capital of working Capital.
Turnover

4. Percent of Each Current Amount of Each Current Asset Indicates relative investment in
Asset to Total Current ____________Item______________ each current asset.
Assets Total Currents Assets

5. Current Assets Cost of Sales+ Operating Measures movement and

Expenses + Income Taxes + utilization of current resources to
Turnover Other Expenses (net) meet operating requirements.
(excluding depreciation and
________amortization)_______
Average Current Assets
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency
Name Formula Significance
6. Payable Turnover __________Net Purchases_________ Measure efficiency of the
Average Accounts Payable company in meeting trade
payable.

7. Operating Cyle Average Conversion Period of Measures the length of time

Inventories required to convert cash to
+ finished goods; then to recievable
Average Collection Period of and then back to cash.
Recievable
+
Days Cash
8. Days Cash __________Ave. Cash Balance_____ Measures availability of cash to
Cash Operating Cost + 360 days meet average daily cash
requirement..
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency
Name Formula Significance
9. Free Cash Flow Net Cash from Operating Activities Excess of operating cash flow over
-- basic needs.
Cash Used for Investing Activities
and Dividends

10. Investment or assets __________Net Sales_______ Measures efficiency of the firm in

turnover Ave. Total Investment managing all assets.
Or
Total Assets

11. Sales to fixed assets __________Net Sales____ Tests roughly the efficiency of
Ave. Fixed Assets (net) management in keeping plant
properties employed.

12. Capital Intensity Ratio ____Total Assets___ Measures efficiency of the firm to
Net Sales generate sales through
employment of its resources.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
III. Ratios Used to Evaluate Long-Term Financial Position or Stability/ Leverage
Name Formula Significance
1. DEBT RATIO __Total Liabilities__ Shows proportion of all assets that are
Total Assets financed with debt.

2. EQUITY RATIO __________Total Equity______ Indicates proportion of assets provided

Total Assets by owners. Reflects financial strength
and caution to creditors.

3. DEBT TO EQUITY RATIO ________Total Liabilities____ Measures debt relative to amounts of

Total Equity resources provided by owners.

4. FIXED ASSETS TO LONG- ____Fixed Assets (net)__ Reflects extent of investment in

TERM LIABILITIES Total Long-term Liabilities long-term assets financed from
long-term debt.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
III. Ratios Used to Evaluate Long-Term Financial Position or Stability/ Leverage
Name Formula Significance
5. FIXED ASSETS TO TOTAL __Total Assets (net)__ Measures the proportion of owners
EQUITY Total Equity capital invested in fixed assets.

6. FIXED ASSETS TO TOTAL ______Fixed Assets_(net)____ Measures investment in long-term

ASSETS Total Assets capital assets.

7. BOOK VALUE PER SHARE OF Ordinary Sharesholders Equity_ Measures recoverable amount in the
ORDINARY SHARES No.of Outstanding ordinary event of liquidation if assets are
shares realized at their book values.

8. TIMES INTEREST EARNED Net Income before Measures how many times interest
Interest and Taxes__ expense is covered by operating
Annual Interest Charges profit.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
III. Ratios Used to Evaluate Long-Term Financial Position or Stability/ Leverage
Name Formula Significance

9. TIMES PREFERRED __Net Income After Taxes__ Indicates ability to provide dividends
DIVIDEND REQUIREMENT Preferred Dividends for preference shareholders.
EARNED Requirement

10. TIMES FIXED CHARGES Net Income Before Taxes Measures coverage capability more
EARNED ____and Fixed Chareges____ broadly than times interest earned by
Fixed Charges including other fixed charges.
(Rent+Interest+Sinking Fund
Payment before Taxes)
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
IV. Ratios Used to Measure Profitability and Returns to Investors
Name Formula Significance
1. GROSS PROFIT MARGIN __Gross Profit__ Measures profit generated after
Net Sales consideration of cost of product sold.

2. OPERATING PROFIT MARGIN ______Operating Profit____ Measures profit generated after

Net Sales consideration of operating costs.

3. NET PROFIT MARGING (Rate __Net Profit__ Measures profit generated after
of Return on Net Sales) Net Sales consideration of all expenses and
revenues.

4. CASH FLOW MARGIN Cash Flow for Measures ability of the firm to
__Operating Activities__ translate sales to cash.
Net Sales
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
IV. Ratios Used to Measure Profitability and Returns to Investors
Name Formula Significance
5. RATE OF RETURN ON ASSETS __Net Profit__ Measures overall efficiency of the firm
(ROA) Ave. Total Assets in managing assets and generating
profits.

6. RATE OF RETURN ON ______Net Income____ Measures rate of return on resources

EQUITY Ave. Ordinary Equity provided by owners.

7. EARNINGS PER SHARE Net Income less preference Peso return on each ordinary share.
__dividends requirement__ Indicative of ability to pay dividends.
Ave. Ordinary Shares Outstanding

8. PRICE/EARNINGS RATIO Market Value per Share Measures relationship between

__of Ordinary Shares__ price of ordinary shares in the
Earnings per Share of open market and profit earned on
Ordinary Shares a per share basis.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
IV. Ratios Used to Measure Profitability and Returns to Investors
Name Formula Significance
9. DIVIDEND PAYOUT __Dividend per Share__ Shows percentage of earnings paid to
Earnings per Share shareholders.

10. DIVIDEND YIELD ___Annual Dividends per Share_ Shows the rate earned by shareholders
Market Value per Share of from dividends relative to current
Ordinary Shares price of stock.

11. DIVIDENDS PER SHARE __Dividends Paid/ Declared__ Shows portion of income distributed to
Ordinary Shares Outstanding shareholders on a per share basis.
Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
IV. Ratios Used to Measure Profitability and Returns to Investors
Name Formula Significance

12. RATE OF RETURN ON __Net Income__ Measures the profitability of current

AERAGE CURRENT ASSETS Ave. Current Assets assets invested.

13. RATE OF RETURN ON Rate of Return on Shows profitability of each turnover of

AVERAGE CURRENT ASSETS Ave. Current Assets_ current assets.
Current Assets
Turnover
 LIFE IS LIKE
ACCOUNTING….
Everything must
be BALANCED.