1

FINANCIAL STATEMENT ANALYSIS

Statement readers must know what the figures on the financial statements mean and how to analyze and interpret the
data in a logical and systematic manner. Financial analysis is necessary for intelligent decision making. It must serve
the needs of those for whom it is made. Sound conclusions can be drawn from financial statements only when the
contents are completely understood. Financial analysts constantly search for some standard of comparison against
which to judge whether the relationships found are favorable or not.

The objective of FINANCIAL STATEMENT ANALYSIS is to determine the extent of a firm's success in attaining
its financial goals namely:

1. LIQUIDITY - (also known as Working Capital Position or Short-Term Financial Position)

refers to the ability of an enterprise to pay its short-term debts as they mature. Financial statements are
analyzed to determine whether a business is currently liquid and whether it could retain its liquidity even in
times of adversity. A company with excellent long-term prospects could fail to realize them because it was
forced into bankruptcy when it could not pay its debts in the near term.

2. STABILITY - (also known as Long-Term Financial Position)

is measured by the ability of a business to make interest and principal payments on outstanding debt
and to pay dividends regularly to its stockholders.

3. PROFITABILITY - is measured by the ability to increase its ownership equity from its operations. The nature
and amount of income as well as its regularity and trend are significant factors affecting profitability.

4. GROWTH POTENTIAL - is measured by the expansion and growth into new markets, the rate of growth in
existing markets, the rate of growth in EPS and the amount of expenditures for Research & Development.

PURPOSES OF FINANCIAL PERFORMANCE ANALYSIS:

1. To set goals and targets.

2. To compare the firm's performance to others.
3. To measure financial strength for credit granting purposes.
4. To measure profitability for return-on-investment purposes.
5. To spot trends, weaknesses and potential problem areas.
6. To evaluate alternative courses of action.
7. To understand interactions that financial changes have on a firm's financial position.

PHASES OF FINANCIAL STATEMENT ANALYSIS:

1. Computation Phase - considers both the absolute & relative changes.

2. Interpretation Phase - is more difficult as it requires considerable experience to become proficient at

interpreting financial statement data. There could be guidelines for interpretation
but there is no substitute for practice and experience.

Expert financial analysts have an amazing feel for financial statement relationships and underlying issues as they are
able to read "between the lines".

TYPES OF FS ANALYSIS

Financial analysts examine FS data in every manner possible to gain insight.

1. HORIZONTAL ANALYSIS - Data for 2 or more time periods are compared. Current year's data are compared
with that of the base year and this comparison technique is called HORIZONTAL ANALYSIS.

2. VERTICAL ANALYSIS (or common - size analysis) - It is customary to express each item on the income
statement as a % of Net Sales and each item on the balance sheet as a percentage of Total Assets. It is used for
comparing multiple years of data, companies of various sizes and comparing with industry averages.

Component percentages indicate the relative size of each item included in a total. Expressing the relationship of items
within a single period or the preparation of common-size statements is known as vertical analysis (also referred to as
static measure or structural ratios) which helps the analyst to spot trends.
 2

3. TREND ANALYSIS - Base year comparisons fix a base period at 100% and express amounts in other periods as
percentage of the base. The index-number trend series technique is a type of horizontal analysis. It can give
statement users a long-range view of a firm's financial position, earnings and cash flow. Index numbers can only
be computed when amounts are positive. The set of percentages for several years may be interpreted as trend
values or as a series of index numbers relating to a particular item.

4. RATIO ANALYSIS - Two individual items on the FS can be compared with one another and the relationship
expressed as a ratio. A ratio is a mathematical expression of the relationship of one item to another. These ratios
are compared with those of prior years and with those of other companies to make them more meaningful. Ratios
are an aid to analysis and interpretation; they are not a substitute for sound thinking. Ratios should be viewed as
a starting point for analysis rather than as an end in themselves. They indicate what should be pursued in greater
depth. Comparison of a firm's financial ratios and percentages with those of its competitors often reveals
important differences or similarities. Such comparisons are based on published reports of other companies in the
industry or on the industry averages made available by trade associations , private financial services or
government agencies.

Rules in Calculating Ratios

1. In calculating a ratio using balance sheet numbers only, the numerator and denominator should be from the same
balance sheet, not from balance sheets of different dates.

2. When a BS # and an IS # are used in a ratio, the BS # should be an average for the time period; at least an
average of the beginning and ending BS #s.

3. Generally, the # of days in a month or year is simplified to ease calculation and analysis. For example, a year is
360 days/52 weeks/12months. A month is 30 days.

Consistency in ratio analysis must be observed to avoid distortion of information. This means that if there are
different acceptable bases in the computation of a given ratio, see to it that whatever was used in arriving at ratios
used as standard, it is also the one being used in the current computation.

Need for Comparative Analysis

Every item reported in the FS has significance. For example, a company reports cash of P10M on its balance sheet.
We know that the company had that amount of cash on the balance sheet date. However, we do not know whether the
amount represents an increase over prior years or whether the amount is adequate in relation to the company's need
for cash. To obtain this information, it is necessary to compare the amount of cash with the other financial statement
data.

3 Types of Comparisons:

1. Intra-company Comparisons are useful in detecting changes in financial relationships and significant trends.
2. Intercompany Comparisons are useful in determining a company's competitive position.
3. Comparisons with Industry Averages provide information as to the company's relative performance
within the industry.

Exercise # 1:
Indicate the peso change, percentage change, and also the ratio that would be reported for each case below, assuming
horizontal analysis is used:
2017 2016 2017 2016
a) P 90,000 P 40,000 f) P(30,000) 0
b) 10,000 40,000 g) 15,000 P( 5,000)
c) 30,000 0 h) (20,000) 5,000
d) 0 20,000 i) (10,000) (10,000)
e) (15,000) 5,000 j) 25,000 25,000

Major Types of Ratios:

1. LIQUIDITY RATIO (or short-term solvency ratio)

* Measures the firm's capacity to cover its short-term obligation using only its liquid asset.

2. ACTIVITY RATIO (or Asset Management Ratio, Turnover Ratio or Efficiency Ratio)
 3

* A set of ratios that measure how effectively a firm is managing its assets.
* Measures the speed with which accounts are converted into cash

3. PROFITABILITY RATIO
* Shows the company's operating efficiency & overall returns on asset & capital.

4. LEVERAGE RATIO (or Long-term Solvency Ratio; Coverage Ratio or Capital Structure Ratio)
* Measures the degree of protection for long-term creditors & investors;
* Indicates the overall dependence of the company on external financing;
* Measures the relative level of debts & the capacity of the company to service debts.

5. MARKET TEST RATIO

* Used to evaluate the stock's performance & attractiveness in the stock market.

Definition of Terms

A standard ratio represents the average of individual ratios of a number of companies in an industry. It is the
representative accomplishment of the industry.

An ideal ratio is one that a company should attempt to accomplish; it is the ratio that the average company within an
industry will not experience. The ideal ratio is the result of the most desirable level of efficiency and one which
should be attained if operating and financial efficiency are sound and most favorable.

Turnover refers to the number of times an item is used or disposed of.

Solvency refers to the company's ability to meet its liabilities as they mature. It refers to long-term safety, the
likelihood that the company will be able to pay its long-term liabilities. It is similar to liquidity but has a much longer
time horizon.

Permanent working capital represents a fixed sum equal to the minimum working capital requirements at any time of
the year.

Temporary working capital consists of the variable amount of working capital, the sum depending upon the seasonal
activity and the emergency and extraordinary needs of the business.

That portion of the current assets which flows recurringly in the normal and regular course of current operations
through a sequential series of cash, cost of production and operation, inventories, receivables and cash may be
referred to as circulating capital.

LIQUIDITY RATIOS
(TEST OF OVERALL SHORT-TERM SOLVENCY)

RATIO FORMULAS SIGNIFICANCE

1. Current Ratio Current Assets Primary test of solvency; measures ability to meet
or Working Capital Current Liabilities currently maturing obligation from current assets; a
Ratio or Banker's Ratio measure of adequacy of working capital.

2. Acid- test ratio or Quick Assets A more severe test of immediate solvency; measures
Quick ratio Current Liabilities the instant debt paying ability of the firm.

3. Working Capital to Working Capital Indicates relative liquidity of total assets & distribution
Total Assets ratio Total Assets of resources employed.

Working Capital CA - CL Represents current assets financed from long-term

capital sources that don't require near-term repayment.

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

5. Cash Debt Coverage Cash Flow from Operations This will overcome the deficiency of DTER which
 4

Ratio (CDCR) Average Total Liabilities do not consider the availability of cash to cover
various level of debt.

6. Cash Flow Adequacy Cash Flow from Operations Measures the ability to generate
Ratio (Purchase of long-term assets + sufficient cash to satisfy predictable cash
repayments of long-term debt requirements.
+ cash dividend payments)

ACTIVITY RATIOS

1. Accounts Receivable Net Credit Sales Measures the velocity of collection of trade
Turnover (ART) Average Receivables (net) accounts & notes; a test of efficiency of
collection; measures how many times A/R
have been turned into cash during the year.

2. No.of Day Sales Annual Business Days Also known as average collection period;
Uncollected or Age Receivable Turnover indicates the average age of A/R; gives a
of Receivable or rough measure of the length of time the A/R
NDSR have been outstanding.

Average A/R
Ave. Daily Credit Sales

Days Sales Outstanding

(DSO) or Recble Receivables
Collection Pd. Sales/360 days

3. Inventory Turnover (IT)

a) Merchandise Cost of Goods Sold Indicates liquidity of inventory; number
 5

Inventory Turn- Ave. Merchandise Inventory of times the inventory was sold and
 6

over (MIT) replenished on the average during the

period.

b) Finished Goods Cost of Goods Sold Indicates the efficiency with which a firm
Inventory Turnover Average Finished Goods uses its inventory.

c) WIP Turnover Cost of Goods Manufactured

Ave.Work in Process Inventory

d) Raw Materials Raw Materials Used # of times raw materials inventory was
Inventory Turnover Ave. Raw Materials Inventory used and replenished during the period.

4. No. of Day's Sales in Average Inventory Measures appropriateness of inventory

Inventories (NDSI) Ave.Daily Cost of Goods Sold levels in terms of time required to sell or
"turnover" goods.
or

Inventory Determines the holding period of inventory

Sales per day for sale

5. Day's Supply of Annual Business Days Measures average number of days to sell
Inventory or No. of Inventory Turnover or consume the average inventory;
Days Sales in Average estimates the company's average inventory
Period (turnover in days) replenishment cycle.

6. Working Capital Net Sales Indicates adequacy and activity of average

Turnover (WCT) Average Working Capital working capital; also a profitability ratio.

7. Current Assets Cost of Sales + Operating Expenses Measures movement & utilization of
Turnover (CAT) (excluding depreciation & current resources to meet operating
amortization) requirements; also a profitability ratio.
Average Current Assets
or

Net Sales
Average Current Assets

8. Accounts Payable Net Purchases Measures efficiency of the firm in

Turnover (APT) Ave. Accounts Payable meeting trade payables; indicate the
# of times the amount of average
payables is paid during the period.

9. Operating Cycle:
a) For Trading Average Collection Measures the length of time required to
Business Period of Receivables convert cash to finished goods then to
+ receivables back to cash.
Averages Conversion
Period of Inventories

b) For Manufacturing # of Days' Usage in RMI

Firm + No. of Days to Process
+ NDSI + NDSR

c) Cash Conversion Is the length of time bet. paying for

Cycle (CCC) = Invty + Recbles - Deferral materials, labor & collecting receivables
Conversion Collection Period
Period

10. No. of Days' Opera- 365 Indicates the number of days' operations
tions covered by ---------------------------- covered by cash and its equivalent
Cash & Marketable Cash and Marketable
Securities Securities Turnover
 7

11. Accounts Payable Measures the credit period taken by the

# of Days' Purchases ---------------------------------- company.
in Accounts Payable Credit Purchases per Day
or NDPAP or Ave. Daily Purchases

12. Sales to Fixed Assets Net Sales Shows the efficiency of fixed assets in
ratio (plant turnover ----------------------------------- generating sales.
or fixed assets Average Fixed Assets (net)
turnover)

13. Investment or Asset Net Sales Measures effectiveness of asset

Turnover ratio (AT) ---------------------------------- utilization.
Total Investment or
Average Total Assets

14. Sales to Owners' Net Sales Number of times net worth is turned over
Equity ratio or ---------------------------------- in sales; indicative of the utilization of
Invested Capital Average Owners' Equity owner’s capital
Turnover (ICT)

STABILITY OR SOLVENCY RATIOS

(RATIOS USED TO EVALUATE LONG-TERM SOLVENCY)

1. Owners' Equity to Owners' Equity or SE Indicate proportion of assets provided by

Total Assets ratio ------------------------------ owners. Reflects financial strength and
or Equity ratio (ER) Total Assets caution to creditors; also a profitability ratio.

2. Fixed Assets to Fixed Assets Reflects extent of the utilization of

Long-term Liabilities -------------------------- resources from long-term debt; indicative of
Ratio Long-term Liabilities sources of additional funds.

3. Fixed Assets to Fixed Assets Measures the proportion of owners’ equity to

Total Owners' Equity ------------------------------- fixed assets; indicative of over or under
ratio Owners' Equity investment by owners.

4. Fixed Assets to Fixed Assets (net) Indicates possible expansion of plant and
Total Equity ratio ----------------------------- equipment.
Total Assets

5. Times Preferred Net Income after Taxes Indicates ability to provide dividends to
Dividend Require- -------------------------------- preferred stockholders.
ment is Earned Preferred dividend requirements

6. Times Fixed Charges Net Income before Taxes Measures ability to meet fixed charges.
Earned -------------------------------------
Fixed charges (rent + interest +
sinking fund payment before taxes)

7. Sinking Fund Payment Sinking Fund Payment after Taxes

Before Taxes 1 - Income Tax Rate

8. Preferred Dividend Net Income before Measures assurance for the preferred
Coverage Interest Expense, Taxes and E.O.items stockholders that dividends will
------------------------------------------------------ continue to be received.
Preferred Dividend Requirement

LEVERAGE OR COVERAGE RATIOS

1. Debt to Equity Ratio Total Liabilities Measures use of debt to finance

(DTER) ---------------------------- operation; measures leverage
 8

Total Stockholders' Equity which is the use of Ltd to finance

the company’s requirements.

2. Total Liabilities to Total Total Liabilities Is the proportion of assets provided

Assets Ratio or Debt Total Assets by creditor; it shows the percentage
Ratio (DR) or Total Debt of assets financed by the creditors.
to Asset ratio
(DTAR)

3. Book Value per Share Common Stock Equity Measures recoverable amount in the
of Common Stock (BVS) ------------------------------ event of liquidation if assets are
# of Outstanding shares realized at their book values.
of common stock

Book Value per Share Preferred Stockholders' Equity

of Preferred Stock # of Preferred Shares Outstanding

4. Times Interest Net Income before Interest & Taxes Measures ability to meet interest
Earned (TIE) or EBIT payments
---------------------------------------------------
Annual Interest Charges or Interest Expense

5. Equity to Debt ratio Total Stockholders' Equity Indicates the margin of safety to
(ETDR) Total Liabilities creditors.

6. Leverage ratio Average Total Assets Measures the relation between

-------------------------------------- investment in total assets to
Average Shareholders' Equity investment share of owners.

7. Financial Leverage ROE - ROA Reflect the advantage gained by borrowing

at an interest rate that is lower than
the rate earned on total assets.

8. Net Income Earned Net Income less Peso return on each share of common
per Share of Common Preferred Dividends stock;
Stock or Earnings Ave. # of common shares
per Share (EPS) outstanding

9. Dividends per Share Dividends Payable or Declared Shows portion of income distribution
(DPS) Common Shares Outstanding to stockholders on a per share basis.

MARKET TEST RATIOS

1. Price-Earnings Ratio Market Price per Share of CS An index of whether a stock is relatively cheap
(PER) Earnings per Share or expensive in relation to earnings.

2. Yield on Common Dividend per Share of CS__ Measures cash yield on investment
Stock or Dividend Market Value per Share of CS in common stocks
Yield (DY)

3. Pay Out ratio or Common Dividends Measures portion of net income to

Dividend Pay Out -------------------------------- common shareholders paid out in
ratio (DPR) Preferred Dividends dividends; an index showing whether
a company pays out most of its
or earnings in dividends or reinvests the
earnings internally.
Dividends per Share
Earnings per Share

4. Capitalization Rate Earnings per Share Indicates the rate at which the stock market
or Earnings Price Market Price per Share is apparently capitalizing the value of current
Ratio (EPR) earnings.
 9

5. Market Price to Book Market Price per Share Indicates whether the stock is
Value per Share ratio Book Value per Share undervalued or not; it supplements PER

PROFITABILITY RATIOS
(RATIOS INDICATIVE OF INCOME POSITION)

1. Turnover of Operating Sales Used for comparing companies that

and Leased Assets Operating and Leased Assets differ as to ownership of fixed assets.

or

Operating Asset Sales Segregates assets used in operation

Turnover Rate ---------------------- from those which benefit future sales
Operating Assets or which were acquired for the purpose
other than to increase sales.

2. Return of Operating Income Indicates the efficiency in the utilization

Assets (ROA) --------------------------- of assets and disregards the effects of the
Total Operating Assets source of financing.

Net Income to Total Net Income Measures overall asset productivity;

Assets or Rate of Total Assets a measure of how well assets have been
Return on Assets employed by management.
(ROA or ROI)

Rate Earned on Net Income

Total Assets or Average Total Assets
Return on Total or
Assets or Asset ROS x Asset Turnover
Productivity Rate

3. Defensive Interval Defensive or Quick Assets Measures the no. of days a firm could
ratio (DIR) ---------------------------------- carry on with normal operations by
Average Daily Expenditures using its most liquid assets to finance
for Operations operating expenses.

4. Tax ratio or Income Tax Expense Indicates the corporate tax charges as a
Tax Rate Profit before Tax proportion of profit

5. Stock ratio Cost of Sales Indicates how quickly goods move through
Stock the business

6. Net Income to Net Net Income Indicates the amount of net income per
Sales ratio (profit Net Sales or peso of sales or the profitability based on
margin or ROS sales.
ROA
AT

7. Net Income to Owners' Net Income Earnings rate on resources provided

Equity ratio or Rate Ave.Owners' Equity by owners; indicates profitability in the
of Return on Owners' use of invested capital.
Equity (ROE) or
Invested
ROS x Capital Turnover

Rate Earned or Net Income Measures rate of return on average

Return on SE Ave. Stockholders' Equity stockholders' equity.

or
Dividends on Common Stock
 10

Ave.# of Common Shares Outstanding

8. Gross Profit ratio Gross Profit Measures the margin per peso of sales
(GPr) Net Sales that will absorb operating expenses.

9. Operating ratio Cost of Sales + Operating Expenses Reflects the margin per peso of sales that
Net Sales will absorb costs and expenses.

10. Rate of Return on Net Income Measures the profitability of current

Average Current Average Current Asset assets invested; indicates profitability in
Asset the use of current assets.

11. Rate of Return per Rate of Return on Shows profitability of each turnover
Turnover of Current Average Current Assets of current assets; indicates the % of
Assets --------------------------------- profit everytime current assets are
Current Assets Turnover used.

12. Rate Earned on Net _ Preferred Shows how many peso of net income
Common Stockholders' Income Dividends were earned for every peso invested
Equity or Return on Average Common SE by the owners.
Common Equity

13.Retained Earnings to Retained Earnings Indicates the profitability of dividend

Capital Stock ratio Capital Stock declaration.

14. Rate of Return on Net Income Indicates the profitability in the use of
WC ratio Ave. Working Capital working capital.

15. Rate of Return per Rate of Return on Indicates the % of profit earned everytime
Working Capital Working Capital working capital is used.
Turnover Working Capital Turnover

16. Capital Employed Sales

Turnover Rate (CETR) Capital Employed

17. Rate of Return on CETR x NP% or

Capital Employed
(RORCE) Profit
Capital Employed

18. Economic Value After-tax Operating Profit Context of divisional performance

Added (EVA) - (Cost of Capital x Investment) evaluation & compare it with
residual income.

19. Cash Return on Net Cash Provided by OA Is the cash basis counterpart of NP %
Sales ratio Net Sales

20. Retained Earnings to Retained Earnings Designates cumulative profitability.

Total Asset Ratio Total Assets
(RETAR)

“Be thankful that you don’t have everything,

for if you did, what is there to look forward to?”