FUNDAMENTALS OF ACCOUNTANCY, BUSINESS & MANAGEMENT II

Lesson 9: Analysis of
Financial Statements
MELC:
(1) Perform vertical and horizontal analysis of financial statements of a single
proprietorship
(2) Define measurement levels, namely, liquidity, solvency, stability and profitability

JVLEGASPI
• A company’s financial statements provide important information
 about a business enterprise. The analysis helps the user make an
informed decision or judgment rather than rely on guesses and
intuition in the process of decision making by effectively and
systematically using the financial data. It lessens the uncertainty of
outcomes with every decision made because of the use of analytical
tools to financial statements and the related data.

• Different methods and techniques are used in analyzing financial

statements. There are two phases involved, namely, the
COMPUTATION PHASE and the INTERPRETATION PHASE.
• COMPUTATION PHASE
• Here, we compute for differences, percentages, or ratios.

• INTERPRETATION PHASE
 • Here, we interpret the result of the figures we get from the first phase. The
second phase, although more difficult than the first phase, makes the analysis
of financial statements more meaningful because it communicates to the
users the significance of the results.
TOOLS IN ANALYZING THE FINANCIAL DATA PROVIDED BY
THE FINANCIAL STATEMENTS

❑ Horizontal Analysis compares the same account in the financial statements of two periods
(current & past yea) determining the amount of changes and computing its percentage
change using a base year as comparison. It should be noted that for accounts in the base year
with zero or negative balances, the computation of percentage of change will not apply.

❑Vertical Analysis shows the relationship of each part to the whole in a single financial
statement. In the statement of financial position or balance sheet, each item is expressed as a
percentage of total assets or total liabilities and owner’s equity. In the income statement,
each item is presented as a percentage of net sales.
 ❑Trend Analysis compares not only two years but covers three,
four or five years’ financial statements. This is to determine the
trends in the industry.

❑ Financial Ratio Analysis describes the significant relationship

between the numbers presented in the financial statements.
Ratios can be expressed either as a rate, percentage or a
proportion.
Lesson 9-1 HORIZONTAL ANALYSIS
• Horizontal analysis, otherwise known as COMPARATIVE ANALYSIS, helps
management analyze increases and decreases in balance sheet and income
statement accounts.
• For example,

• In the balance sheet, a significant increase in property, plant and

equipment will indicate purchases of land, equipment, machinery or other
plant assets necessary for use in the business.
• For income statement accounts, horizontal analysis also helps
management analyze significant increases or decreases in sales, cost
of sales and expenses. For example, an alarming decrease in net
income may call management’s attention as the generation of net
income is the company’s main goal in doing business. This may lead
management to evaluate other income statement items such as sales,
cost of sales and expenses which are crucial components in arriving at
company’s net income.
 Cash

Accounts Receivable (net)

Inventory

Prepaid Expenses

• 2. Prepare Total Current Assets

comparative financial statements of Property, Plant & Equipment (n

two consecutive years. Total Assets

DELA CRUZ MERCHAN

Statement of Financia

As of December 31, 20 Liabilities & Owner's Equity

(in millions)
Current Liabilities

Non-Current Liabilities

Assets Total Liabilities

Owner's Equity

Current Assets Total Liabilities & Owner'd Equi

 (in millions)

Assets 2017 2016 Increase Amount

Current Assets `
Cash P 222.9 P 330.2 P - 107.3 Accounts Receivable (net) 282.5 172.1 110.4
Inventory 146.3 92.8 53.5 Prepaid Expenses 74.1 70.3 3.8 Total Current
Assets P 725.8 P 665.4 P 60.4 Property, Plant & Equipment (net) 1,866.4
556.2 1,310.2 Total Assets P 2,592.2 P 1,221.6 P 1,370.6

• 2. Add a third Liabilities & Owner's Equity

column for the Current Liabilities

Trade & Other Payables P 551.9 P 620.6 P - 68.7 Non-Current Liabilities
increase and Loan Payable P 1,822.4 P 376.6 1,445.8 Total Liabilities P 2,374.3 997.2 P
1,377.1 Owner's Equity 217.9 224.4 - 6.5 Total Liabilities & Owner'd Equity
decrease in amount and a fourth P 2,592.2 P 1,221.6 P 1,370.6

column for the percentage of the

increase or decrease.
DELA CRUZ MERCHANDISING
Statement of Financial Position
As of December 31, 20____
 Current Assets `
Cash P 222.9 P 330.2 P - 107.3 -32.5 Accounts Receivable (net) 282.5 172.1 110.4 64.1
Inventory 146.3 92.8 53.5 57.7 Prepaid Expenses 74.1 70.3 3.8 5.4
Total Current Assets P 725.8 P 665.4 P 60.4 9.1 Property, Plant & Equipment (net)
1,866.4 556.2 1,310.2 235.6 Total Assets P 2,592.2 P 1,221.6 P 1,370.6 112.2

• 3. Get the Liabilities & Owner's Equity

percent of Current Liabilities

Trade & Other Payables P 551.9 P 620.6 P - 68.7 -11.1 Non-Current Liabilities

increase or Loan Payable P 1,822.4 P 376.6 1,445.8 383.9 Total Liabilities P 2,374.3 997.2 P 1,377.1
138.1 Owner's Equity 217.9 224.4 - 6.5 -2.9

decrease for each account. Total Liabilities & Owner'd Equity P 2,592.2 P 1,221.6 P 1,370.6 112.2
DELA CRUZ MERCHANDISING
Statement of Financial Position
As of December 31, 20____
(in millions)

Assets 2017 2016 Increase Decrease Amount Percentage

Computation of the percent of increase

 • % change = Current year amount-base year amount
x100% • Base year amount

•= P725.8-P665.5 x 100%
• P665.4
•= 9.1%
As of December 31, 20____

(in millions)

2017
Example 2:
DELA CRUZ MERCHANDISING
`
Income Statement
 Net P2,2 Income Before Income Taxes 201.1
Sales
Income Tax Expense 60.3
Cost of Goods Sold 1,0
Net Income P 140.8
Gross Profit 1,

Selling & Admin Expenses 88

Operating Income P29

Interest Expense

Interpretation of Data
• In interpreting the data, it is important to note that the materiality of
increases or decreases depends on the size of the company.

• A material amount in one company may not be material to another.

 Example, a hundred-thousand increase in the receivable of a small
grocery may be considered material to the small grocery but not to
SM considering their size, capitalization and volume of transactions.
Hence, there is not strict rule to follow in determining the
MATERIALITY of an amount.
Analysis
1. Current assets increased by 9.1%. This increase is a result of 64.1% increase in
accounts receivable and a 57.7% increase in inventory. This increase in accounts
receivable entails management to check their credit and collection polity for
prompt collection of accounts especially that increase in net sales was only 27.3%
ad cash decreased by 32.5%. Likewise, the increase in merchandise inventory
necessitates management to check their inventory stocks for obsolescence or slow
moving items comparing their increase in sales and the increase in inventory.
2. Property, Plant and Equipment showed a 235.6% increase. This may be due to
purchases made by the company to invest in plant assets. It is possible for the
owner to invest property and equipment in the business. However, in the case of
Medina Merchandising, owner’s equity showed a decrease of 2.9%. This might not
be possible unless the owner invested non-current assets then afterwards made
large amounts of withdrawals during the year.
3. Current Liabilities and owner’s equity decreased despite increase in total liabilities and
owner’s equity. This can be explained by the 383.9% increase in the company’s non-current
liabilities which means that the company made heavy borrowings during the year. Sources
of business funds are generated either from the investment of the owner or loans from
banks or financial institutions. In the case of Medina Merchandising, the company obtained
additional funds through loan. With the significant increase in non-current assets, it can be
inferred that the loan obtained by the company was used to finance the acquisitions of the
property, plant and equipment.
• 4. Net sales increased by 27.3% during the year. However, despite the
increase in sales, net income decreased by 7.3%. Looking at the other
components of the income statements, cost of goods sold increased by
24.1%. Even with this increase in cost of goods fold, gross margin registered
 a 30.2% increase. Selling and administrative expenses showed a 34.8%
increase. Despite this, income from operations recorded an 18% increase.
The company’s increase in interest expense of 198% resulted in a decrease
in income before taxes despite the increase in net sales. Analyzing the
components of the income statement, we were able to explain the
decrease in net income despite increase in net sales. Hence, management
can now understand that the magnanimous increase in interest expense
caused the decrease in overall net income.
Compute the Increase amount & the MEDINA TRADING
Statement of Financial
Decrease Percentage Position
As of December 31, 20____
LESSON 9 Worksheet No. 1
 2017 2016 Increase Decrease
Assets Amount Percentage Current Assets `

Cash P158,000.0 P 84,000.0 P Short-term Investment 130,000.0 192,000.0

Accounts Receivable, Net 240,000.0 200,000.0

Merchandise Inventory 500,000.0 530,000.0

Total Current Assets 1,028,000.0 1,006,000.0

Property, Plant & Equipment (Net) 2,340,000.0 2,350,000.0

Compute the Increase amount & the
LESSON 9 Worksheet
Decrease Percentage

MEDINA TRADING No. 2

Income Statement
As of December 31, 20____
(in millions)
2017 2016 Increase Decrease
Amount Percentage

Net P 4,972.0 P 4,150.0 P

Sales
Cost of Goods Sold 3,046.0 2,444.0
Gross Profit 1,926.0 1,706.0

Selling & Admin Expenses 1,556.0 1,500.0

Operating Income P 370.0 P 206.0 P

Interest Expense 88.0 92.0

Income Before Income Taxes 282.0 114.0

Income Tax Expense 94.0 42.0

Net Income P 188.0 P 72.0 P
LESSON 9-2 VERTICAL ANALYSIS
• Vertical Analysis in the Income Statement

• In the income statement, vertical analysis helps management analyze the

components of the income statement in relation to its revenue account which
is SALES. It helps management answer certain questions as follows:

• 1. What percentage of net sales is cost of sales or cost of goods sold?

Gross Profit? Operating Expenses?
• 2. If operating expenses were divided between selling and administrative
expenses, what percent of net sales is absorbed by selling expenses? • 3.
What is the percentage of net income to sales?
Steps in Performing Vertical Analysis

• 1. Prepare comparative financial statements of two consecutive

years.

• 2. Add one addition column on the right side of each year.

• 3. For the comparative statement of financial position, express each

account as a percentage of the total assets. The total assets is
automatically 100%. Likewise, total liabilities and owner’s equity is
automatically 200%.
Example
• % of current assets = P725.8 x 100% = 28%
P2,592.2

• % of non-current liabilities = P1,822.4 x 100% = 70.3%

P2,592.2
• 4. For the comparative income statement, express each account as a
percentage of net sales. Net sales is automatically 100%.

• Example:

• % of cost of goods sold = P1,032.1 x 100% = 46.6%

 P2,213.3
DELA CRUZ MERCHANDISING
Statement of Financial Position
As of December 31, 20____
In Millions
2017 Percent 2016 Percent
Assets
Current Assets `
Cash P 222.9 8.6 P 330.20 P 27.03 Accounts Receivable, Net 282.5 10.9 172.10 14.09
Inventory 146.3 5.6 92.80 7.60 Prepaid Expenses 74.1 2.9 70.30 5.75 Total Current Assets P
725.8 28.0 P 665.40 54.47 Property, Plant & 1,866.4 72.0 556.20 45.5 Total Assets P 2,592.2
100.0 P 1,221.60 100

Liabilities & Owner's

Current Liabilities P 551.9 21.3 P 620.6 P 50.8 Non-Current Liabilities

Loan Payable 1,822.4 70.3 376.6 30.8 Total Liabilities P 2,374.3 91.6 997.2 81.6 Owner's Equity
217.9 8.4 224.4 18.4 Total Liabilities & Owner's P 2,592.2 100 P 1,221.6 P 100.0
DELA CRUZ MERCHANDISING

Income Statement

For the Year Endede December 31

____
In Millions

2017 Percent 2016 Percent

Net Sales P 2213.3 100.0 P 1738.7 100.0 Cost of Goods Sold 1032.1 46.6 831.8 47.8 Gross Profit P 1181.2 53.4 P 906.9 52.2 Selling &

Administrative Expenses 889.2 40.2 659.5 37.9 Operating Income P 292 13.2 P 247.4 14.2 Interest Expense 90.9 4.1 30.5 1.8 Income Tax Before

Taxes P 201.1 9.1 P 216.9 12.5 Income Tax Expense 60.3 2.7 65 3.7

Net Income P 140.8 6.4 P 151.9 8.7

Interpretation of Data
ANALYSIS:

1. Current assets was 54.5% of total assets in 2016. However, this percentage
decreased to 28% in 2017. This was due to the significant increase in
property, plant, and equipment. Hence, the dramatic change in total
assets composition.

2. Non-current assets represented by property, plant and equipment was

45.55 of total assets in 2016 and 72% in 2017. This may be due to
purchases made by the company during the year to invest in plant assets.
3. Current liabilities was 50.8% of total liabilities and owner’s equity in
2016 but significantly decreased to 21.3% in 2017. This is opposite to
non-current liabilities which was 30.8% of total liabilities and owner’s
equity in 2016 but increased to 70.3% in 2017. The company made a
loan during the year and might have paid its current liabilities. Hence,
the opposite change in the two liabilities. Percentage of owner’s equity
to total liabilities and owner’s equity was 18.4% in 2016 and 8.4 in
2017. This means that the equity financed by creditors represented by
total liabilities was 81.6 in 2016 and 91.6 in 2017. This is not a good
sign as the company’s business funds are heavily provided by creditors.
4. From the income statement, the percentage of net income to sales
decreased form 8.7% to 6.4%. This decrease has been explained by the
onerous interest expense in the horizontal analysis. The percentage
cost of goods of sold in relation to net sales indicated a minimal
decrease from 47.8% to 46.6% while selling and administrative
expenses indicated a minimal increase form 38% to 40.2%. Th relation
of interest expense to net sales during the year increased more than
double from 1.8% to 4.1%. Finally, net income in relation to net sales
 decreased form 8.7% to 6.4% despite the company’s acquisition of
property, plant and equipment.
• Based on the information given, Accounts Receivable, Net 240,000 200,000 Merchandise Inventory 500,000
530,000 Total Current Assets P 1,028,000 P 1,006,000 Non-Current Assets
Property, Plant & Equipment (Net) 2,340,000 2,350,000 Total Assets P
perform a vertical analysis for Lucky 3,368,000 P 3,356,000
boy Trading Liabilities & Owner's Equity
LUCKY BOY TRADING
Current Liabilities P 530,000 P 584,000 P Non-Current Liabilities 800,000
Statement of Financial Position
840,000 Total Liabilities P 1,330,000 1,424,000 Owner's Equity 2,038,000
As of December 31, 20____
1,932,000 Total Liabilities & Owner's Equity P 3,368,000 P 3,356,000 P
2017 Percent 2016 Percent
Assets
LESSON 9 Worksheet No. 3
Current Assets `
Cash P 158,000 P 84,000 P Short-term Investments 130,000 192,000
LESSON 9
Worksheet
No. 4
LUCKY BOY TRADING
Income Statement
For the Year Ended December 31 ____
In Millions
 2,017 Percent 2,016 Percent

Net Sales P 4,972 P 4,150

Cost of Goods Sold 3,046 2,444
Gross Profit P 1926 P 1706
Selling & Administrative Expenses 1556 1500
Operating Income P 370 P 206
Interest Expense 88 92
Income Tax Before Taxes P 282 P 114
Income Tax Expense 94 42
Net Income P 188 P 72

Lesson 3 – Trend Analysis

• In Trend Analysis, a base year is established which is labeled as the

100% thereby expressing figures of all other years as a percentage of
the base year. The amount under each year is divided by the amount
 in base year thereby determining the amount of the other years in
relation to the base year.
Steps in Performing a Trend Analysis
1. Prepare comparative financial statements for three, four or five
consecutive years.

2. Choose a base year. USUALLY, the FIRST YEAR is the base year.

3. Calculate the trend percentage for each item by DIVIDING the

amount of each item by the BASE YEAR. The base year is
automatically 100%
Formula:
• Trend % = chosen year x 100%
base year

Example: Current Assets Trend % 2016 = P665.40 x 100% = 111.3%

P597.60