MODULE 2

Review of Financial
Statement Preparation,
Analysis and
Interpretation
This module will enable us to recall the financial
statements that you have learned in your
Content Course Competencies previous Business courses such as
At the end of the module, you should be able to: Fundamentals of Accounting and Business
Demonstrate an understanding of the process of preparing
Management 1& financial
2. Asidestatements as
from preparing the
well as the methods or tools of analysis of financial
financial statements,
statements, including
we will have an in-depth
horizontal analysis, vertical analysis, and financialofratios
discussion to test the
the financial level and
methods of tools
liquidity, solvency, profitability, and stability of the business
that you can employ in determining the financial
performance of a business in terms of the level
of liquidity, solvency, profitability, and stability of
its operation. As such, this module will help you
Performance Course Competencies solve business problems that require financial
At the end of the module the learner shall be all to: statement preparation, analysis and
Solve exercises and problems that require financial
interpretation statement
using preparation,
comparative analysis such
analysis, and interpretation using horizontal and vertical
as vertical analyses, analysis
and horizontal and various
as well as
financial ratios. various financial ratios for sound business
decisions.

COURSE LEARNING OUTCOMES

After completing this course, you are expected
to demonstrate understanding of...
COURSE LEARNING OUTCOMES Demonstrate an understanding of the process of
preparing financial statements
After completing this course, you are expected to:Understand the methods and tools of analysis of
financial statements
a. Demonstrate an understanding of the process
Distinguishof preparing
horizontal financial statements
and vertical analysis of
b. Understand the methods and tools of analysis
financialof financial statements
statements
c. Distinguish horizontal and vertical analysis of financial
Compute statements
the financial ratios
d. Compute the financial ratios Interpret the methods of analysis in determining
e. Interpret the methods of analysis in determining
the liquidity,the liquidity,profitability
solvency, solvency, and
profitability
stability and
of
stability of the business. the business.
 Most essential learning outcomes

a. Prepare financial statement

b. Compute for financial ratios
c. Interpret financial statement and ratios
d. Use the information generated for decision-making.

At the end of this module, you should have achieved the following topic or unit learning
outcomes.

UNIT LEARNING OUTCOMES

Discuss the elements, preparation, and limitation of financial statements;

Reconstruct balance sheet & income statement given the accounting accounts;
Analyze & interpret the trend using comparative statement analysis.
Evaluate the past performance of the company through financial ratios; and,
Interpret the changes in the financial structure of the company.

Formation outcomes
Based on the principles learned in this course, the student should be able
prepare and analyze financial statement and use it in their day to day decision-making .

There are two topics to be tackled in this module. These are:

1.Review of Financial Statement Preparation
a. Definition of terms related to Financial Statements and user of financial
information
b. Basic Financial statements
c. Interrelationship of the different financial statements
2.The Financial Analysis tools
a. Common-size Analysis (Horizontal and Vertical Analysis)
b. Financial Ratios

Given your prior knowledge about financial statements and the elements that it is made
up of as learned in your Fundamentals of Accounting and Business Management subject, let us
we begin our discussion the activity below.

Activity 1: Review of Accounts

 Classify the following accounts if it will fall under income statement or balance sheet.
Put a checkmark under the column income statement if you think the account is found on
income statement or a checkmark under balance sheet if the account falls under such
statement.

LIST OF ACCOUNTS INCOME BALANCE

STATEMENT SHEET

1. Accounts Payable

2. Building

3. Miscellaneous expense

4. Cash

5. Insurance expense

6. Prepaid rent

7. Accrued salaries

8. Unearned rent

9. Allowance for bad debts

10. Drawing account

11. Loans payable

12. Interest receivable

13. Mortgage payable

14. Salaries expense

15. Portion of Bonds payable within one year

16. Accrued income

17. Interest income

18. Utilities expense

19. Furnitures and fixtures

20. Office supplies

Let’s explore: Affluent millennials are economically optimistic, but afraid to invest
Investopedia’s Affluent Millennial Investing Survey has revealed that nearly half of
affluent millennials say they'll be forced to work beyond retirement age, yet nearly all said their
personal or family financial situation will improve over the next decade, making them more
optimistic than both their Gen X and Gen Z counterparts. 

The survey asked 1,405 respondents to share how they view investing, who taught them,
and how that education influences where they spend, save and invest.

The results also revealed that despite their

greater than average income, affluent millennials
are still surprisingly reluctant to enter the stock
market. According to the survey, almost 40% of this
well-off cohort stated they believe investing is
“risky,” with nearly a quarter labeling it
“overwhelming.” 

The Majority of Affluent Millennials Don’t

Feel Knowledgeable About Investing Why are
affluent millennials so wary of the stock market,
despite decades of evidence that investing pays off
in the long term? Trepidation about stocks and a lack of knowledge about investing are major
factors propelling the investment jitters of the wealthy millennials in our study, despite their
median income of $132,000. (Median HHI for millennials as a whole is $69,000, according to the
Pew Research Center).1 Our survey revealed that less than half of affluent millennials feel
confident about investing and retirement planning. In fact, only 37% of affluent millennials feel
knowledgeable about investing at all.

High-income millennials who feel knowledgeable about investing are 5X more likely (73% vs.
14%) to feel very confident in their ability to make their own financial decisions. 
Further, affluent millennials who consider themselves financially knowledgeable are more likely
to associate investing with positive emotions, and less likely to find it intimidating, risky or
overwhelming.

Early Financial Education Incites Greater Confidence in Adulthood

The way affluent millennials feel about managing their finances often reflects how effectively
their parents managed money. Only 9% of those who said their parents were good at managing
finances said they feel “very anxious” about managing their own money as adults, compared to
24% of those who said their parents were not good at managing finances. 

Conversely, among respondents who said their

parents successfully managed their money, 46%
have high confidence in managing their finances,
compared to only 30% of those who said their
parents were ineffective at managing finances. 

What motivated one affluent millennials’s first

investment was "a life lesson from my pops."
Another respondent explained: "I was told that I
have to start thinking beyond myself and think
about my future family.” The takeaway? Modeling
responsible financial behavior and talking about
money with your kids may make them better
investors. Data backs up common sense.

Why Affluent Millennials? 

Investopedia sought to examine what motivated investment decisions for a generation that
came into adulthood during the great recession and has notoriously encountered a variety of
challenging economic factors. In order to understand attitudes around investment, we studied
those who should have disposable income to invest, referred to as “affluent millennials.” By
examining a segment of the population that makes a greater than average yearly income for
their age group, we hoped to eliminate financial hardship from the reasons they may not invest. 

The Bottom Line 

The Investopedia Affluent Millennials Survey reveals the importance of financial education, as
evidenced by those who learned about investing as a teenager feeling confident enough to
invest as an adult. Further, observing how their parents managed finances has shaped many
affluent millennials’ confidence as adults as well. Earning a good income alone doesn’t always
go hand-in-hand with knowing how to invest or feeling comfortable managing money.

Based on these findings, here are four ways affluent millennials can plan more effectively for
their financial future:

1. Affluent millennials should contribute to a retirement account, even if they’re not

concerned about their finances: 12% of respondents said they don’t yet, despite their
income.
2. For those that do invest already, they should save even more for retirement: 46% of
respondents said they didn’t feel they were saving enough, even though nearly 8 in 10
affluent millennials said that saving for retirement is a top priority. Time value of
 money and compounding demonstrate how investing more, earlier, can add hundreds of
thousands of dollars over the course of a lifetime.
3. Investing less conservatively is also key — affluent millennials can afford to take more
calculated risks with the goal of earning higher returns, as they have both the
advantages of time and more money to work with.
4. Finally, working with a financial professional can alleviate economic anxieties. Affluent
millennials report substantially better investment performance when they work with an
advisor, and having expert advice can help avoid missteps and missed opportunities.

According to Scott A. Bishop, CFP®, executive vice president of financial planning at STA
Wealth Management in Houston, “Not investing is what is risky. If you don’t save or invest, the
true risk is that you will never have any level of financial independence." 

Discussion guide:
1. What do you think is the main reason why millennials are afraid to invest?
2. Given you knowledge of financial statements, do you think this will help you come up
with better decision when it comes to investment?
3. What is your take away or learning from this case in relation to your personal finances?

UNIT 1 Review of Financial

Statements

Knowing how to work with the numbers in a

company's financial statements is an essential skill for
stock investors. The meaningful interpretation and analysis
of balance sheets, income statements, and cash flow
statements to discern a company's investment qualities is
the basis for smart investment choices. However, the
diversity of financial reporting requires that we first
become familiar with certain financial
statement characteristics before focusing on individual
corporate financials. In this lesson, we'll show you what
the financial statements have to offer and how to use them
to your advantage.

Financial statements contain summarized information about the financial affairs of a firm,
organized systematically as per the accounting principles. It is considered as the product of the
whole accounting transactions within specified period. Moreover, it shows the company’s
permanent and temporary accounts. The financial statements used in investment analysis are
the balance sheet, the income statement, and the cash flow statement with additional
analysis
of a company's shareholders' equity and retained earnings. Although the income statement
and the balance sheet typically receive the majority of the attention from investors and analysts,
it's important to include in your analysis the often overlooked cash flow statement. We normally
follow a guideline in preparing the financial statement. In the Philippines, we make use of
Generally Accepted Accounting Principle (GAAP) and follow the mandate of Financial Reporting
Standard Council (FRSC) as well as Philippine Financial Reporting Standards (PFRS).

Now you might be wondering why does an organization need a financial statement? This
question can be addressed by the objectives of financial statements written below.

Why are Financial Statements Important? 

Financial statements are important because they

contain significant information about a
company's financial health. Financial statements help
companies make informed decisions since they highlight
which areas of the company provide the best ROI (return
on investment).

Hence: 1. Assess the risk (i.e. credit risk, asset risk)

2. Provide the
comprehensive economic
history of a business entity;
3. Can be used for various
purposes such
as:
a. analytical tool
b. management report card (Financial
performance and Cash flow of the
business)
c. an early warning signal
d. basis of prediction
e. a measure of
accountability
(Stewardship of investors’resources)

4. Financial position of the firm

Though accounting records and reports a company’s transactions, many different parties
benefit from this information. These individuals — called financial statement users — often
review the information for decision-making purposes. Financial accounting information also
helps users measure a company’s profitability and performance. Interested parties include
owners, lenders, employees, suppliers and government agencies. We generally classify
these users into two, namely:

1. External users- people that are not directly involved in the operation of the
business
2. Internal users- has direct participation in various quantifiable transaction of the
business
USERS OF FINANCIAL INFORMATION

Government Employee

Supplier
Suppliers

Owners/Managers . Owners are typically the most interested user of financial statements. Not
only do owners have an interest in profits, but also in the amount of money they retain for
personal income. This information comes from the income statement. Owners want to know
how much capital the business consumed in order to generate sales revenue.

Lenders/Creditors. Lenders have an interest in both a company’s profit and cash flow. These
users may have given loans to the business. Companies with an inability to repay the loans
increase the lender’s risk. Lenders often require several months of financial statements for
review before lending money. Periodic updates are also necessary to ensure borrowers still
have the ability to repay loans

Employees. Employees have an interest in financial statements because they need assurances
for job retention. Employees can also have an interest in their company’s stock price, which has
a close relationship to the company’s accounting information. Employee stock options may
increase or decrease precipitously based on the company’s financial health. Employees need
this information to determine if they should buy more or hold their current investment level.
Suppliers. Suppliers often open trade accounts with many companies in the business
environment. This allows businesses to pay off purchases over a stated period of time rather
than all at once. Suppliers prefer to work with financially healthy companies when selling goods.
This often ensures payment in the future. Suppliers looking for new clients may also review
financial statements to find profitable and stable clients.

Government Agencies. Government agencies — primarily those that assess business taxes
— review financial information to ensure companies pay their fair share of tax revenue.
Federal, state and local government agencies may have a stake in a company. Oversight
agencies may also review a company’s financial statements. Inappropriate or material
financial misstatement may result in a fine against a company. These agencies attempt to
protect a company’s shareholders

THE BASIC FINANCIAL STATEMENTS

Financial statements are summaries of the operating, financing, and investment activities of
a business. Financial statements should provide information useful to both investors and
creditors in making credit, investment, and other business decisions. And this usefulness means
that investors and creditors can use these statements to predict, compare, and evaluate the
amount, timing, and uncertainty of future cash flows. In other words, financial statements
provide the information needed to assess a company’s future earnings and, therefore, the cash
flows expected to result from those earnings. In this chapter, we discuss the four basic financial
statements: the balance sheet, the income statement, the statement of cash flows, and the
statement of shareholders’ equity.

A. The Balance Sheet

The balance sheet is a

report of the assets, liabilities,
and equity of a company at a
point in time, generally at the
end of a fiscal quarter or fiscal
year. Assets are resources of
the business enterprise, which
are comprised of current or long-
lived assets. How did the
company finance these
resources? It did so with
liabilities and equity. Liabilities
are obligations of the business
enterprise that must be repaid at
a future point in time, whereas
equity is the ownership interest
of the business enterprise. The
relation between assets ,
liabilities and equity is simple, as
 reflected in the balance of what is owned and how it is financed, referred to as the
accounting identity:

ASSETS = LIABILITIES + CAPITAL

B. The Income Statement

These are also known as the

Profit/Loss Statement, Statement of
Comprehensive Income, or Statement of
Income. It is a summary of the revenue
and expenses of a business entity for a
specific period of time, such as a month
or a year. Income statement is viewed
as statement of profitability of a business
since it reflects if the firm earned
something during its entire year of
operation. We start with the revenue of
the company over a period of time and
then subtract the costs and expenses
related to that revenue. The bottom line
of the income statement consists of the
owners’ earnings for the period. To
arrive at this “bottom line,” we need to
compare revenues and expenses.

C. The Cash Flow Statement

The statement of cash flows is the

summary of a company’s cash flows,
summarized by operations, investment
activities, and financing activities. Cash
flow from operations is cash flow from
day-to-day operations. Cash flow from
operating activities is basically net income
adjusted for (1) noncash expenditures,
and (2) changes in working capital
accounts. Cash flow for/from investing
is the cash flows related to the acquisition
(purchase) of plant, equipment, and other
assets, as well as the proceeds from the
sale of assets. Cash flow for/from
 financing activities is the cash flow from activities related to the sources of capital
funds (e.g., buyback common stock, pay dividends, issue bonds).

D. The Statement of Stockholders’ Equity

The statement of stockholders’ equity (also referred to as the statement of shareholders’

equity) is a summary of the changes in the equity accounts, including information on
stock options exercised, repurchases of shares, and Treasury shares. The basic
structure is to include a reconciliation of the balance in each component of equity from
the beginning of the fiscal year with the end of the fiscal year, detailing changes
attributed to net income, dividends, purchases or sales of Treasury stock. The
components are common stock, additional paid-in capital, retained earnings, and
Treasury stock.

HOW ARE THE STATEMENTS RELATED?

The four basic statements are the result of transactions that record each activity of the
company. As a result, the financial statements are inter-related. For example, the change in
cash, the bottom line of the statement cash flows, is equal to the change in the cash balance
from the previous fiscal period to the current fiscal period.

1. Net income, the bottom line of the income statement, is the starting point of the
statement of cash flows, and contributes to retained earnings in the balance sheet
and the statement of shareholders’ equity.

2. The changes in the working capital accounts are adjustments to the arrive at the
cash flow from operating activities in the statement of cash flows, the changes in the
asset accounts contribute to changes in cash flows from investing activities, and debt
issuances and repayments, as well as issuance or repurchase of stock contribute to
the change in cash flows for financing activities.
WHY BOTHER ABOUT THE FOOTNOTES?

Footnotes to the financial statements contain additional information, supplementing or

explaining financial statement data. These notes are presented in both the annual report and
the filing with the Securities and Exchange Commission (SEC), though the latter usually
provides a greater depth of information. The footnotes to the financial statements provide
information pertaining to: The significant accounting policies and practices that the company
uses. This helps the analyst with the interpretation of the results, comparability of the results to
other companies and to other years for the same company, and in assessing the quality of the
reported information.

1. Income taxes. The footnotes tell us about the company’s current and deferred
income taxes, breakdowns by the type of tax (e.g., federal versus state), and the
effective tax rate that the company is paying.
2. Pension plans and other retirement programs. The detail about pension plans,
including the pension assets and the pension liability, is important in determining
whether a company’s pension plan is overfunded or underfunded.
3. Leases. You can learn about both the capital leases, which are the long-term lease
obligations that are reported on the balance sheet, and about the future
commitments under operating leases, which are not reflected on the balance sheet.
4. Long-term debt. You can find detailed information about the maturity dates and
interest rates on the company’s debt obligations.
5. Stock-based compensation. You can find detailed information about stock options
granted to officers and employees. This footnote also includes company’s accounting
method for stock-based compensation and the impact of the method on the reported
results.
6. Derivative instruments. This describes accounting policies for certain derivative
instruments (financial and commodity derivative instruments), as well as the types of
derivative instruments. The phrase “the devil is in the details” applies aptly to the
footnotes of a company’s financial statement. Through the footnotes, a company is
providing information that is crucial in analyzing a company’s financial health and
performance. If footnotes are vague or confusing, as they were in the case of Enron
prior to the break in the scandal, the analyst must ask questions to help understand
this information.

PERFORMANCE TASK 1: LET’S PIECE IT TOGETHER!

In relation to the lessons tackled in this unit, kindly perform the tasks
assigned found at the appendix of module (Financial Statement
Reconstruction)
 INTERRELATEDNESS OF THE FOUR FINANCIAL STATEMENTS

The diagram above reflects the interrelatedness of the four financial statements that we
tackled today. Guided by such illustration, explain in your own words and understanding how
are these statements connected with each other. You may cite your own example in each
connection for you to be able to elaborate further on the concept. Kindly write your answer at
the space provided below. Let’s check how well did you comprehend the topic?
 Revisit lesson in Fundamentals of Accounting and Business Management. Recall the
basic terminologies used as they are also used here in this course. After which, match the letter
from the choices written below with the definition that corresponds to the following terms. Write
your answers on the space provided for beside each term.

TERMS

______1. Accounting System

______2. Debit
______3. Credit
______4. Transactions
______5. Double-Entry Accounting
______6. Journal Entry
______7. Journals
______8. Accounting Process (or cycle)
______9. Special Journals
______10. General Journal
______11. Account
______12. Ledger
______13. Posting
______14. General Ledger
______15. Subsidiary Ledgers

CHOICES

A. Exchanges of goods or services between/among two or more entities or some other event
having an economic impact on a business enterprise.
B. An accounting record used to list a particular type of frequently recurring transaction.
C. A record used to classify and summarize the effects of transactions.
D. An entry on the right side of an account.
E. A record used as the basis for analyzing and recording transactions. Examples include
invoices, check stubs, and receipts.
F. A collection of accounts maintained by a business.
G. Procedures used for analyzing, recording, classifying, and summarizing the information to be
presented in accounting reports.
H. An entry on the left side of an account.
I. Procedures and methods used, including data processing equipment, to collect and report
accounting data.
J. An accounting record used to record all business activities for which a special journal is not
maintained.
K. The process of summarizing transactions by transferring amounts from the journals to the
ledger accounts.
L. The grouping of supporting accounts that in total equal the balance of a control account in the
general ledger.
M. The general ledger account that summarizes the detailed information in a subsidiary ledge
N. A collection of all the accounts used by a business that could appear on the financial
statements.

O. A system of recording transactions in a way that maintains the equality of the accounting
equation.
P. Records in which transactions are first entered, providing a chronological record of business
activity.
Q. The recording of a transaction in which debits equal credits. It usually includes a date and an
explanation of the transaction.

References:

www.investopedia.com Affluent millennials are economically optimistic, but afraid to invest

McLaney,E.,Business Finance: Theory and Practice,8th ed.,2009, Pearson Education,Ltd
Fabozzi, F., The Basics of Finance: An Introduction to Financial Market, Business Finance and
Portfolio Management, 2010, Wiley and Sons

UNIT 2 Financial Analysis Tools

Unit learning outcomes

 Understand the different financial mix ratio in analyzing the financial
statement
 Explain the different ratio analysis
 Evaluate the business using profitability measure
 Apply the concept of financial mix ratio analysis in analyzing the financial

Message from the CFOs (Chief Finance Officers)

The following quotes are from the Chief Financial Officers (CFOs) of the respective
corporations. Reflect on the quotes cited and mention how financial statements are important to
your financial position in the future. Write your idea on the space provided for below.

1. Unilever: “Finance plays a critical role across every aspect of our business. We
enable the business to turn our ambition and strategy into sustainable, consistent
and superior performance” - Jean-Marc Huët (Unilever)
2. Jollibee: “It’s very exciting because you are not just thinking of today but what
the company will need in the future” - Ysmael V. Baysa (Morales, 2013)
3. SM Corporation: “Now, we don’t go out because we need funds. We go out
because it’s an opportunity.” – Jose T. Sio (Montealegre, 2015) Reflect on the
quotes cited and mention how financial statements are important to your financial
position in the future.

REFLECTION
THE CASE OF CREATIVE ACCOUNTING

In the previous section we considered the problems that the accounting conventions
raise for those trying to interpret financial statements. In addition, there can be other concerns
about financial statements. There is evidence that the directors of some companies have used
particular accounting policies or structured particular transactions in a way that portrays a
picture of financial health that is in line with what they would like users to see rather than what is
a true and fair view of financial position and performance. This practice is referred to as
creative accounting and it poses a major problem for accounting rule makers and for society
generally.

There seem to be various reasons for the existence of creative accounting, including:
1. getting around restrictions (for example, to report sufficient profit to be able to pay a
dividend); l
2. avoiding government action (for example, the taxation of excessive profits); l hiding
poor management decisions;
3. achieving sales revenue or profit targets, thereby ensuring that performance bonuses
are paid to the directors;
4. attracting new share capital or loan capital by showing a healthy financial position;
and,
5. satisfying the demands of major investors concerning levels of return.

Creative accounting methods

There are several approaches that unscrupulous directors have
adopted with the aim of manipulating the financial statements. Some of
these methods concern the (1) overstatement of revenue which involves
early recognition of sales revenue or the reporting of sales transactions
that have no real substance, that is said to have been carried out by the
Xerox Corporation, a large US business and a leading player in the
photocopying industry. It is alleged that Xerox brought forward revenues
in order to improve reported profits as its fortunes declined in the late
1990s. These revenues related to copier equipment sales, particularly in Latin America.
Following the uncovering of the overstatement of revenues, Xerox had to restate its equipment
sales revenue figures for a five-year period. The result was a reversal in reported revenues of a
staggering $6.4 billion, although $5.1 billion was reallocated to other revenues as a result. This
restatement was one of the largest in US corporate history.
Another example of this creative accounting approach of
revenue overstatement involved Dell Inc, the US computer
business. In August 2007, Dell admitted that some unnamed
‘senior executives’ had been involved in a scheme to
overstate sales revenue figures during the period 2003 to
2007. This was done in an attempt to make it appear that
quarterly sales targets had been met, when in fact this was
not the case. The overstatement of sales revenue was
estimated to amount to $92 million; this represented about 1
per cent of total profit over the period concerned.
Another creative accounting methods focus on the (2)
manipulation of expenses, also known as capitalization of
expenses, and certain types of expenses are particularly
vulnerable. These are expenses that rely heavily on the
judgement of directors concerning estimates of the future or
concerning the most suitable accounting policy to adopt.
Capitalisation is treating expenses as if they are part of the cost of a non-current asset.. As
such, the capitalisation of expenses is falsely to boost both profit
and the balance sheet value of non-current assets. One particularly
notorious case of capitalising expenses is alleged to have occurred
in the financial statements of WorldCom (now renamed MCI), a
large US telecommunications business. WorldCom is alleged to
have overstated profits by treating certain operating expenses,
such as basic network maintenance, as if they were the acquisition of a non-current asset. This
happened over a fifteen-month period during 2001 and 2002, hence, when this was revealed,
operating profits had to be reduced by a massive $3.8 billion. Some creative accounting
methods focus on the (3) concealment of losses or liabilities. The financial statements can look
much healthier if these can somehow be eliminated. One way of doing this is to create a
‘separate’ entity that will take over the losses or liabilities. Perhaps the most well-known case of
concealment of losses and liabilities concerned the Enron Corporation. Special Purpose Entities
or SPEs were used by Enron to rid itself of problem assets that were falling in value, such as its
broadband operations. In addition, liabilities were transferred to
these entities to help Enron’s balance sheet look healthier. The
business had to keep its gearing ratios (the relationship
between borrowings and equity) within particular limits in order
to satisfy credit-rating agencies, and SPEs were used to
achieve this. The SPEs used for concealment purposes were
not independent of the business and should have been
included in the balance sheet of Enron, along with their losses
This Photo by Unknown Author is
and liabilities. When these, and other accounting irregularities,
licensed under CC BY-SA were discovered in 2001, there was a restatement of Enron’s
financial performance and position toreflect the consolidation of
the SPEs, which had previously been omitted. As a result of this restatement, the business
recognised $591 million in losses over the preceding four years and an additional $628 million
of liabilities at the end of 2000. The business collapsed at the end of 2001. Finally, creative
accounting may involve the (4) overstatement of
asset values. This could be done by revaluing the assets, using figures that do not correspond
to their fair market values. It may also, as we have seen, involve the capitalising of costs that
should have been written off as expenses, as described earlier. Parmalat SpA, a large Italian
dairy-and-food business, provided an example of overstatement of an asset. Parmalat
announced in December 2003 that a bank balance of a3.95 billion with the Cayman Islands
branch of the Bank of America did not, in fact, exist.

Discussion Questions: write your answer in the box provided.

1. If you are the potential investor in the above example companies, what are the checks
that you need to perform to determine the reliability of their financial statements?
2. Do you think creative accounting can be resolved? Or do you think it is a permanent
problem?
 Financial statement analysis is very important in every enterprise, big or small, because
aside from gaining information about the firm’s performance, it will also try to summarize a more
complex accounting information into a relatively small number of key indicators. As such, it will
also enable us to compare the performance of one business with another or even enable us to
benchmark the business’ performance with the rest of other businesses within same industry.
Moreover, we may want to compare the current performance of the firm with its past
performance so as to establish a pattern or trend that may help us come up with better plans or
improved decisions.

So what is Financial Statement Analysis?

Financial analysis involves the selection, evaluation, and interpretation of financial data
and other pertinent information to assist in evaluating the operating performance and financial
condition of a company. It helps in understanding the information contained in the financial
statement in better manner hence, it helps in knowing the strengths and weaknesses of the firm.
Furthermore, it enables the firm to make decisions and forecasts.

There are three methods in doing the financial analysis, namely:

 Vertical Analysis (also

called Common Size
Statements Analysis) – It
compares each item of to the
base case of the financial
statements. All income
 statement items are expressed as a percentage of Sales. Balance Sheet Items
are expressed as a percentage of Total Assets or Total Liabilities (please note Total
Assets = Total Liabilities)

 Horizontal Analysis – It

percentage changes.

 Ratio Analysis –
provides a meaningful relationship
between individual values in the
financial statements.

For both vertical and horizontal analysis,

the ratios are computed and compared with
their past performance, and hence, a powerful tool to ascertain what actions should be
undertaken in the future.

So you might ask “Why in the world to we need to know about financial ratios?”. Let me
tell you why.

IMPORTANCE OF FINANCIAL RATIOS

1. It allows us to compare one’s company’s performance with that of the other.

2. It lets us identify the differences of the risks faced by each organization, hence, different
expectations of what returns these organizations should make.
3. Companies can evaluate their past performance as against their targets.
4. It will give the managers and the owners whether the company has the ability to survive
and to prosper.
5. Users of information will have a better idea about the financial condition and health of
the company.

COMMON-SIZE ANALYSIS
 An investor can evaluate a company’s operating performance and financial condition
through ratios that relate various items of information contained in the financial statements.
Another way to analyze a company is to look at its financial data more comprehensively.

Common-size analysis is a method of analysis in which the components of a financial

statement are compared. Common-size financial statements are particularly useful when
comparing data from different companies.
In the vertical common-size analysis, each financial statement item is compared to a
benchmark item for that same year. The first step in this form of common-size analysis is to
break down a financial statement—either the balance sheet or the income statement—into its
parts. The next step is to calculate the proportion that each item represents relative to some
benchmark. In the case of a vertical common size analysis of the balance sheet, the benchmark
is total assets; in the case of the income statement, the benchmark is revenues. Vertical
analysis focuses on the relationships among financial statement items at a given point in time.
A common-size financial statement is a vertical analysis in which each financial statement item
is expressed as a percentage.
Another form of common-size analysis is horizontal common-size analysis, in which
we use either an income statement or a balance sheet in a fiscal year and compare accounts to
the corresponding items in another year. Trend percentages (Horizontal analysis) state several
years’ financial data in terms of a base year, which equals 100 percent.

Trend Percentage
Percentage
= Current Year Amount
Base Year Amount × 100%

Let us see how it works by doing some common-size financial analysis for the Clover
Corporation. In the income statement, as with the balance sheet, the items may be restated as a
proportion of sales; this statement is referred to as the common-size income statement. We
provide the common-size income statements for Clover Corporation for the two years below.
Looking at gross profit, EBIT, and net income, these proportions are the profit margins we
calculated earlier. Using the common-size income statement, we learn about the profitability of
different aspects of the company’s business. Again, the picture is not yet complete. For a more
complete picture, the investor must look at trends over time and make comparisons with other
companies in the same industry. We restate the company’s balance sheet. This statement does
not look precisely like the balance sheet we have seen before. Nevertheless, the data are the
same but reorganized. Each item in the original balance sheet has been restated as a
proportion of total assets for that year. Hence, we refer to this as the common-size balance
sheet. We can see, in very general terms, how Clover has raised capital and where this capital
has been invested. As with financial ratios, however, the picture is not complete until trends are
examined and compared with those of other companies in the same industry. We provide a
horizontal common-size analysis for Clover balance sheet . In this analysis, we see that current
and total assets have declined since FY20X1, the company is using less long-term debt, and
equity has increased. If we wanted to look at relative trends, we could carry this out over 5 or 10
fiscal periods.

VERTICAL ANALYSIS
 Sales is usually
the base and is
expressed as
100%.

2005 Cost ÷ 2005 Sales × 100%

( $360,000 ÷ $520,000 ) × 100% = 69.2%
2004 Cost ÷ 2004 Sales × 100%
( $315,000 ÷ $480,000 ) × 100% = 65.6%

HORIZONTAL ANALYSIS
 CLOVER CORPORAT ION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Sales increased by 8.3% yet

net income decreased by 21.9%.

There were increases in both cost of goods sold (14.3%)

and operating expenses (2.1%). These increased costs
more than offset the increase in sales, yielding an overall
decrease in net income.

FINANCIAL RATIOS

A financial ratio is a comparison between one bit of financial information and another.
Consider the ratio of current assets to current liabilities, which we refer to as the current ratio.
This ratio is a comparison between assets that can be readily turned into cash—current assets
—and the obligations that are due in the near future—current liabilities. A current ratio of 2, or
2:1, means that we have twice as much in current assets as we need to satisfy obligations due
in the near future.
We can classify ratios according to the way they are constructed and the financial characteristic
they are describing. For example, we will see that the current ratio is constructed as a coverage
ratio (i.e., the ratio of current assets—available funds—to current liabilities, i.e., the obligation)
that we use to describe a company’s liquidity (its ability to meet its immediate needs).
We can also classify ratios according to the dimension of the company’s performance or
condition. For example, a current ratio provides information on a company’s liquidity, whereas a
turnover ratio provides information on the effectiveness to which the company puts its asset to
use. There are as many different financial ratios as there are possible combinations of items
appearing on the income statement, balance sheet, and statement of cash flows. We can
classify ratios according to the financial characteristic that they capture. When we assess a
company’s operating performance, a concern is whether the company is applying its assets in
an efficient and profitable When an investor assesses a company’s financial condition, a
concern is whether the company is able to meet its financial obligations.

The investor can use financial ratios to evaluate five aspects of operating performance
and financial condition:
1. Liquidity
2. Profitability
 3. Activity
4. Financial leverage
5. Return on investment

LIQUIDITY RATIOS

- reflects the ability of a company to meet

its short-term obligations using those
assets that are most readily converted
into cash. Assets that may be converted
into cash in a short period of time are
referred to as liquid assets; they are
listed in financial statements as current
assets. We often refer to current assets
as working capital, because they
represent the resources needed for the
day-to-day operations of the company’s
long-term capital investments. Current
assets are used to satisfy short-term
obligations, or current liabilities. The
amount by which current assets exceed
current liabilities is referred to as the net
working capital.

Measures of Liquidity

1. Current ratio (CR)

the ratio between Current assets (CA) & Current liabilities(CL)
The current ratio is an indication of how many times the company can cover its
current liabilities, using its current assets.

Example:

Charlie's Skate Shop sells ice-skating equipment to local hockey teams. Charlie is
applying for loans to help fund his dream of building an indoor skate rink. Charlie's bank
asks for his balance sheet so they can analyze his current debt levels. According to
Charlie's balance sheet he reported P100,000 of current liabilities and only P25,000 of
current assets.

Solution: CR = CA/CL = 25,000/100,000=0.25

2. Quick ratio or Acid Test Ratio

liquidity ratio that measures the ability of a company to pay its current liabilities
when they come due with only quick assets.
It is similar to the current ratio, except we remove the least liquid of the current
assets from the numerator.
Quick assets are current assets that can be converted to cash within 90 days or
in the short-term. The following the quick assets included:
1. Cash/cash equivalents
2. short-term investments or marketable securities
3. current accounts receivable
 Quick ratio = Quick assets / Current Liabilities
= (cash +marketable securities +accounts receivable)
Current liabilities

= Total current assets – inventory – prepaid expenses

Current liabilities

Example

Let's assume Carole's Clothing Store is applying for a loan to remodel the storefront.
The bank asks Carole for a detailed balance sheet, so it can compute the quick ratio.
Carole's balance sheet included the following accounts:
• Cash: P10,000
• Accounts Receivable: 5,000
• Inventory: 5,000
• Stock Investments: 1,000
• Prepaid taxes: 500
• Current Liabilities: 15,000

SOLUTION

QAR = P10,000+ P5,000+ P1,000

P15,000

Carole's quick ratio is 1.07.

This means that Carole can pay off all of her current liabilities with quick assets and
still have some quick assets left over.

3. Working Capital
means the firm is able to meet its current maturing obligations with safety
cushion to meet other unexpected or unrecorded current liabilities
Working Capital(WC) = difference between current assets(CA) and current
liabilities(CL)

Using the information provided in the first ratio for Charlie's Skate Shop where he
reported P100,000 of current liabilities and only P25,000 of current assets, then, working
capital of Charlie can be computed as:

SOLUTION: WC = CA-CL
= 100,000- 25,000
= 75,000

TRY IT OUT! LIQUIDITY RATIOS

Complete the following using Clover Corporation’s financial statements:

Current Ratio
Quick Ratio
Working capital
PROFITABILITY RATIOS

Measures the managements’ effectiveness in terms of satisfactory profit and return on

investment.

Profitability ratios are concerned with the effectiveness of the business in generating
profit. It helps the investor gauge how well a company is managing its expenses.
Profit margin ratios compare components of income with sales. They give the investor
an idea of which factors make up a company’s income and are usually expressed as a
portion of each dollar of sales. For example, the profit margin ratios we discuss here
differ only in the numerator. It is in the numerator that we can evaluate performance for
different aspects of the business.

Measures of Profitability

1. Gross Profit Margin (GPM)

evaluates how well production facilities are managed. To do so, the investor
would focus on gross profit (revenues less cost of goods sold), a measure of
income that is the direct result of production management. Comparing gross
profit with sales produces the gross profit margin:
Gross profit margin = Gross profit /Revenues, or
GPM= ( Gross profit / Net sales ) x 100
This ratio tells us the portion of each dollar of sales that remains after deducting
production expenses.
Looking at sales and cost of goods sold, we can see that the gross profit margin
is affected by:
1. Changes in sales volume, which affect cost of goods sold and sales.
2. Changes in sales price, which affect revenues.
3. Changes in the cost of production, which affect cost of goods sold.

This means that any change in gross profit margin from one period to the next is
caused by one or more of those three factors. Similarly, differences in gross margin
ratios among companies are the result of differences in those factors.

Formula:
GPR= ( Gross profit / Net sales ) x 100

EXAMPLE:
Total sales = P260,000; Sales returns = P10,000; Cost of goods sold P200,000

Calculation:
Gross Profit = [ (260,000 – 10,000) – 200,000] = 50,000
GPR= (50,000 / 250,000) x 100
GPR = 20%
 2. OPERATING PROFIT MARGIN (OPM)

This ratio shows what is left of sales revenue after all of the expenses of running
the business for the period have been met. Once again it should be as large as
possible, provided that high profit margins are not being earned at the expense of
some other aspect.
Shows the operational efficiency of the business.
Lower operating ratio shows higher operating ratio shows higher operating profit
and vice versa. An operating ratio ranging between 75% and 80% is generally
considered as standard for manufacturing concerns.
To do this, remove operating expenses (e.g., selling and general administrative
expenses) from gross profit, leaving operating profit, also referred to as earnings
before interest and taxes.

FORMULA: Operating profit margin = Operating profit /Revenues, OR

OPM = [ ( Cost of goods sold + Operating expenses) / Net Sales ] x 100
OPM = [(COGS+OE)/NS] X 100

EXAMPLE:
Cost of goods sold = P90,000; Other operating expenses = P15,000; Net Sales = P150,000

Calculation:
Operating Ratio = [(90,000 + 15,000) / 150,000] x 100
OPM = [115,000 / 150,000] x 100 = 70%

3. NET PROFIT MARGIN (NPM)

The net profit margin is the net income generated from each dollar of revenues; it
considers financing costs that the operating profit margin does not consider.
Measures the overall profitability and very useful to proprietorship or owners of
the company.
This ratio also indicates the firm’s capacity to face adverse economic conditions
such as price competition, low demand, and similar situations.

FORMULA: Net profit margin = Net profit

Revenues

NPR= Net profit/Net sales x 100

EXAMPLE:
Total sales = P260,000; Sales returns = P10,000;
Cost of goods sold P200,000; operating expenses = 20,000; taxes=5% of cogs

SOLUTION:
Net Sales = [ (260,000 – 10,000) = 250,000
NPR = (20,000 / 250,000) x 100 = 8%
 TRY IT OUT! PROFITABILITY RATIOS

Complete the following using Clover Corporation’s financial statements:

Gross Profit Margin

Operating Profit Margin
Net profit margin

ACTIVITY RATIOS

We use activity ratios—for the most part, turnover ratios—to

evaluate the benefits produced by specific assets, such as
inventory or accounts receivable, or to evaluate the benefits
produced by the totality of the company’s assets.
Activity ratios are used to try to assess the effectiveness of a
business in using its assets.
Turnover is often used in the calculation for assessing activity
of:
o accounts receivable
inventories
plant and equipment
total operating assets
total assets.

MEASURES OF ACTIVITY

1. Accounts Receivable Turnover(ARTO)

A measure of how many times a company converts its receivables into cash
each year.
a measure of how effectively a company is using credit extended to customers.
The reason for extending credit is to increase sales.
 The downside to extending credit is the possibility of default—customers not
paying when promised. The benefit obtained from extending credit is referred to
as net credit sales—sales on credit less returns and refunds.

FORMULA
Accounts receivable turnover (ARTO) = _Credit sales
Average Accounts receivable

Velocity of conversion of trade receivables into cash during a year.

How many times during a year a receivable been converted into cash.
Note: High turnover ratio- favorable
Low turnover ratio- unfavorable
EXAMPLE

Accounts receivable turnover (ARTO) = _Credit sales

Average Accounts receivable
= 500,000
(17,000 + $20,000) ÷ 2
= 27.03
Or average collection period(ACP) of 13.5 days.
NB. ACP = 365 days/ARTO

INVENTORY TURNOVER (ITO)

measures how many times average inventory is "turned" or sold during a period.
it measures how many times a company sold its total average inventory amount
during the year.
It shows how fast the company replenishes its inventory.
This ratio is important because total turnover depends on
1. Stock Purchasing.
- larger amounts of inventory, sell greater amounts of inventory OTHERWISE, it
will incur storage costs and other holding costs.
2. Sales.
- match inventory purchases otherwise the inventory will not turn effectively.
The inventory turnover ratio is a measure of how quickly a company has used
inventory to generate the goods and services that are sold. The inventory
turnover is the ratio of the cost of goods sold to inventory:

Inventory turnover = Cost of goods sold / Average Inventory

EXAMPLE
 2. TOTAL ASSETS TURNOVER (TATO)

simply the asset turnover, which is how many times during the year the value of a
company’s total assets is generated in revenues:

Total asset turnover = Revenues

Total assets
EXAMPLE

Given the revenue of $2,000 million and total assets of $1,175.

SOLUTION
Total Assets Turnover ratio= 2,000million / 1,175 = 1.159

indicated that in the current year, every dollar invested in total assets generates
$1.159 of revenues. Because total assets include both tangible and intangible
assets, this turnover indicates how efficiently all assets were used.

TRY IT OUT! ACTIVITY RATIOS

Complete the following using Clover Corporation’s financial statements:

Account Receivable Turnover

Inventory Turnover
Average Collection Period
Total Assets Turnover Ratio

LEVERAGE RATIOS

A company can finance its assets with equity or with debt. Financing with debt legally
obligates the company to pay interest and to repay the principal as
promised. Equity financing does not obligate the company to pay
anything because dividends are paid at the discretion of the board
of directors. There is always some risk, which we refer to as
business risk, inherent in any business enterprise. But how a company chooses to finance its
operations—the particular mix of debt and equity—may add financial risk on top of business
risk. Financial risk is risk associated with a company’s ability to satisfy its debt obligations, and
is often measured using the extent to which debt financing is used relative to equity.
Use to assess how much financial risk the company has taken on.
two types of financial leverage ratios:
1. component percentages, and
2. coverage ratios.

MEASURES OF LEVERAGE

A. Component Percentage Ratios

o The ratios that compare debt to equity or debt to assets indicate the amount of
financial leverage, which enables an investor to assess the financial condition of
a company.

1. Debt-to-Assets Ratio (DA)

A ratio that indicates the proportion of assets financed with debt, which
compares total liabilities (Short-term debt + Longterm debt) with total assets:
=
Formula: Debt to Assets Ratio
Total liabilities
Total Assets
For Example, in the current year, the debt of ABC Corporation amounted to
20,000 and the total assets is equal to 15,000. Hence,

DAR = TL /TA = 15,000,000/20,000,000 = 0.75 = 75%

This ratio indicates that 75% of the company’s assets are financed with debt
(both short term and long term).

2. Debt-to-Equity Ratio or Debt Ratio

measures how the company finances its operations with debt relative to the
book value of its shareholders’ equity.
Measures the relative proportion of contribution from owner’s and creditor’s.
FORMULA

Debt to equity = Total liabilities / Shareholders’ equity

Debt Ratio
=
Total liabilities
Total liabilities + Owners’Equity
Shareholders’ equity is the book value, or carrying value, of shareholders’
equity as reported on the company’s balance sheet.

EXAMPLE
 Total owners' equity 60,000
Total liabilities 40,000
Total liabilities plus
owners' equity 100,000
SOLUTION

Debt Ratio = 40,000/ (40,000 + 60,000) = 0.4 or 40%

This means that for every one dollar of book value of shareholders’ equity,
the company uses 0.40 cents of debt.

B. COVERAGE RATIOS
o Another way of looking at the financial condition and the amount of financial
leverage used by the company is to see how well it can handle the financial
burdens associated with its debt or other fixed commitments.

1. Time interest-covered ratio

This ratio tells us how well the company can cover or meet the interest
payments associated with debt.
The ratio compares the funds available to pay interest (that is, earnings
before interest and taxes) with the interest expense.
The interest coverage ratio provides information about a company’s ability to
cover the interest related to its debt financing.
The greater the interest coverage ratio, the better able the company is to pay
its interest expense.

FORMULA

Times interest earned = Earnings before interest and taxes

Interest expense

EXAMPLE

SOLUTION

Times Interest earned = 6586

3378
= 1.95 times

TRY IT OUT! LEVERAGE RATIOS

Complete the following using Clover Corporation’s financial statements:

Debt to Assets
Debt to Equity
Time interest earned ratio
RETURN ON INVESTMENT

Return-on-investment ratios compare measures of benefits, such as earnings or net

income, with measures of investment.
One of the most important ratios used for measuring the overall efficiency of a firm.
The ratio reveals how well the resources of the firm are being used and the higher the
ratio, the better the results.
COMMON USED ROIs ratios are:
1. Basic Earning power
2. Return On Assets
3. Return On Equity

1. Basic Power Earning Ratio

to evaluate how well the company uses its assets in its operations, he could
calculate the return on assets
the ratio of earnings before interest and taxes (also known as operating earnings)
to total assets

FORMULA:
Basic earning power = Earnings before interest and taxes

Total assets

For Example, ABC Corporation, for the current year, the basic earning power ratio is
$110 million ÷ $1,725 million = 11.594%. This means that for every dollar invested in
assets, Exemplar earned about 11.6 cents in the current year. This measure deals with
earnings from operations; it does not consider how these operations are financed.

2. Return on Assets
Another return-on-assets ratio uses net income—operating earnings less interest
and taxes—instead of earnings before interest and taxes.

FORMULA
Return on assets = Net income / Total assets

For Example, in the current year, the net income realized by ABC Corporation is
110M and the total assets amounted to 1,725M, hence:
Return on assets = $110 million ÷ $1,725 million = 6.358

3. Return on Equity
the ratio of the net income shareholders receive to their equity in the stock
 This ratio is used when investors may not be interested in the return the
company gets from its total investment (debt plus equity), but rather shareholders
are interested in the return the company can generate on their investment.

FORMULA

Return on equity = Net income

Shareholders’ equity

For Exemplar Corporation, there is only one type of shareholder: common. For
the current year, the return on equity is $110 million ÷ $1,725 million = 7.656%.

TRY IT OUT! RETURN ON INVESTMENT RATIOS

Complete the following using Clover Corporation’s financial statements:

Basic Earning power

Return to Assets
Return to Equity

1. Prepare a creative concept map that will reflect your own summary or conclusion about
the different financial ratios that we have discussed in this module. Make your
conclusion as specific as possible for each financial ratio. Write your answer on the
space provided for or use a separate sheet of paper, preferably bond paper to do this
activity.
 PERFORMANCE TASK 2: Analysis of Norton Corporations’Financial performance

Apply the lessons you have learned from this unit and generate the financial
analysis for Norton Corporation which is found on the appendix of this module.

References:

Bernstein, Leopold. Financial Statement Analysis, 4th Ed. Illinois: Irwin, 2014.

Cabrera, Elenita B. Management Advisory Services. Manila: Conanan, 2015.

Gitman, Lawrence J. Principles of Financial Management. New York: Pearson 2014

http://suppscentral.aw.com

Padilla, Nicanor B. Jr. How to Analyze Financial Statements. Manila: Conanan, 2007.
White, Gerald I., Sondhi, Ashwinpaul C., and Fried, Dov. The Analysis and Use of Financial
Statements, New Jersey: Wiley, 2012.