Fundamentals of Accountancy, Business, and Management 2

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Analysis and Interpretation of Financial Statements

Module 008 Analysis and Interpretation of

Financial Statements

Different accounting information helps users make decisions depending on

the purpose for which they are reviewing the financials of the company.
These internal and external users depend on the financial analysis in order to
make sound decisions for the business. At the end of this module, you will be
able to:

1. Enumerate the different categories of financial information.

2. Differentiate the different techniques of financial analysis.

3. Apply the concepts of Vertical and Horizontal analysis on the given

financial data.

User of Financial Information

Internal Users – people or entities inside the organization who are interested
in the company’s financial information (ex. Management, Employees, Owner)

External Users – people or entities outside the organization who are

interested in the company’s financial information (ex. Regulatory bodies,
lenders, investors, suppliers, public)

There are different analytical techniques that can be used to review financial
statements. The most common of these are: horizontal analysis, vertical
analysis, and ratio analysis.

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Horizontal Analysis

Horizontal analysis is the comparison of a company’s financial statements from

one period to another (e.g. annually, quarterly). Analysis based on the changes on
the amounts from one period to another are usually expressed either in absolute
numbers or percentages. Let’s look at the tables below for an example:

The first step in coming up with the increase or decrease on the company’s books is
to determine the company’s base year. The company’s base year will be the
denominator in the computation of the changes in the company’s financial
statements. The formula can be computed for either the (1) amount of change or (2)
the percentage change from one period to another. Notice that both figures 1 and 2
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Analysis and Interpretation of Financial Statements

expressed changes by both amounts and percentages in positive (increase) and in

negative (decrease) forms. Formula for changes in the company’s financial amounts
would be the Amount in the New Year minus the Amount in the base year.

By dividing the amount that you arrive at with the amount in the base year, it will
show the percentage change for the item that you are analyzing.

Upon applying the stated formula, the answer shall be 50,000 or 20% increase in
current assets from 2012 to 2013.

Vertical Analysis

Also known as static analysis as it only looks at financial statement information one
period at a time. Vertical analysis makes use of common size financial statements to
convert each financial statement item to its base year.

It analyzes the financial statements of a firm for a given date or period as to the
relative importance of an item in relation to others or to a total as it appears in a
statement (Padilla, 2000).

Vertical analysis, as compared to horizontal, confines itself in a period of time (ex. a

year) and compares its components with a base item in the financial statement. In
Figure 3, the base item is total assets (expressed in the financial statement as the
100%). We then compute how each of the total asset’s components composes the
base item.

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Ratio Analysis

The most commonly- used technique among all three is the analysis. It is the method
of financial evaluation that interprets the relationship among the different accounts
found in the financial statements. It highlights computations that allow the reader to
understand how the company performs and positions itself financially.

Types of Financial Ratios

Liquidity: These ratios will demonstrate a company's ability to pay their

debts and liabilities. If they do not have enough short-term assets to cover
short-term obligations, or they do not generate enough cash flow to cover
costs, they may face financial problems. Liquidity ratios are of extra
importance with penny stocks specifically, since the tinier and newer
companies have tremendous difficulties paying all the bills before their
businesses become established. Some liquidity ratios include the current
ratio, quick ratio, cash ratio, and operating cash flow.

Activity: These demonstrate how efficiently the business operates. There are
a few great activity ratios investors should apply in their research; inventory
turnover; receivables turnover; payables turnover; working capital turnover;
fixed asset turnover; total asset turnover.
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Analysis and Interpretation of Financial Statements

Leverage: These ratios will demonstrate a company's ability to pay their

long-term debt. Leverage ratios are also referred to as debt ratios; debt ratio;
debt to equity; interest coverage.

Performance: Performance ratios are all about profit, which might explain
why they are frequently referred to as profitability ratios. Performance ratios
tell a clear picture of how profitable a business is at various stages of their
operations; gross profit margin; operating profit margin; net profit margin;
return on assets; return on equity.

Valuation: Since valuation ratios are based on the current share price, they
provide a picture of whether or not the penny stock is a compelling
investment at current levels.

There are three (3) main categories of financial information that are mainly assessed when we use
analytic techniques in these financial statements, namely:

1. Liquidity or solvency
2. Profitability
3. Stability

All three of these are being reviewed depending on the user’s perspective. A
lender would be interested as to how liquid the company is, that is, if it is
capable to pay its expenses when it becomes due. On the other hand,
employees and long-term customers are more interested on the stability of
the company. Prospective investors or partners are looking at the
profitability while management or the Board of Directors maybe looking as
to the company’s capacity to expand or grow.

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 <Figure 1.The most widely used basis of fully understanding a company’s financial statements is the ratio
analysis.>

Glossary

Horizontal analysis: the comparison of a company’s financial statements from one period
to another.

Vertical analysis: makes use of common size financial statements to convert each financial
statement item to its base year.

Ratio analysis: the method of financial evaluation that interprets the relationship among
the different accounts found in the financial statements.

Liquidity or solvency: liquidity means having cash, as well as the ability to quickly convert
assets into cash. Solvency is the ability of the business to pay all legal debts, even if it means
converting assets to cash for long term liability coverage.

Profitability: it is the primary goal of all businesses to survive in the long run.

Stability: refers to the ability of the business to pay overhead expenses, pare down debt
and return capital to investors.
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Analysis and Interpretation of Financial Statements

References and Supplementary Materials

Books and Journals

Jimenez, C.E., Palo, R.R, &Ocampo, L.B. (2017). Fundamentals of Accounting 2: Theory and
Practice. Manila: JMS Publishing House

Jimenez, C.E., &Ocampo, L.B. (2015). Fundamentals of Accounting, Quicknotes and

Exercises. Manila: JMS Publishing House

Padilla, Nicanor B. (2014). Financial Statements Preparation, Analysis and Interpretation

Revised and Updated (5th edition). Manila: Padilla Publications.

Online Supplementary Reading Materials

Financial Statement Analysis;https://www.slideshare.net/AnujBhatia3/financial-

statement-analysis-15102101; 10 April 2017

Financial Ratios: https://www.thebalance.com/types-of-financial-ratios-2637034-

January 7,2018

Online Instructional Videos

Overview of Financial Statements Analysis;

https://www.youtube.com/watch?v=4ayqk6g3lGU; 23 March 2017

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