ADVANCE ACCOUNTING

PRINCIPLE – AP 127
UNIT 4: ANALYSIS OF
FINANCIAL STATEMENT
Name: ________________________Course &Year: __________
Set: ___Contact #: _______________ Email Add: ____________
Home Address: ______________________________________

GADTC-INSTITUTE OF BUSINESS AND FINANCIAL SERVICES

| MALORO, TANGUB CITY, MIS.OCC.
GRADING SYSTEM:
Written Tasks
Performance Tasks
Final Exam
Total

Passing Rate 65%

CONSULTATION SCHEDULE:

UNIT 4: ANALYSIS OF FINANCIAL

STATEMENTS
Unit Intended Learning Outcomes:
At the end of this module, you will be able to:
1. Explain the basics of financial statements
analysis.
2. Describe the standards of comparisons in
financial statements analysis.
3. Explain and apply horizontal analysis.
4. Describe and apply vertical analysis.
5. Use ratio analysis to assess liquidity,
profitability and solvency of a business.

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We are going know the basics of financial statement
analysis, analyze its important contributions to
individuals, to the companies, firms and at the end of this
unit, you should be able to describe what are the basics of
financial statements, should be able to explain the
terminology associated with financial statements and
should be able to discuss its components.
Student’s let’s bring it on!

Week: ______________Deadline: ______

Pre-Assessment: This test is required but not graded.
1. In your own idea, what is a financial statement?
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2. What are the tools of financial statement

analysis?
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3. How important financial statements is in the

business? Why?

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4. In your own idea, what are ratio analysis?

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5. How important it is to know the kinds of ratio
analysis? Why?
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You made it! You are ready to our next destination!

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Ta-da! Read and carefully understand the discussion as activities/quizzes
u’reng
will follow afterwards. Rubric is attached
great! asgood!
So far, so your basis of assessment.
Should you have any questions or topics that isn’t clear to you, you may
write it down at the discussion part below. Rest assured that it will be
addressed, and feedbacks will be given afterwards.

Discussion Begins!

Lesson 1: Basics of Financial

Statements

For us to understand every single step of our journey, it is

very important to know the basic terminologies and
concepts of financial statement, itself.
What is one thing that creditors, investors, management,
and regulatory authorities all have in common? In order
to do their job well, all of them rely in one way or another
on financial statement analysis.

Creditors rely on financial statements to evaluate whether

a company or organization will be able to pay back a debt.
Regulatory authorities, like the US Securities and
Exchange Commission (SEC), rely on financial
statements to determine whether a company meets the
accounting standards required of a publicly traded

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company. Investors rely on financial statements in order
to understand whether investing in a company would be
profitable. And management relies on financial
statements to make intelligent business decisions and
communicate with investors and key stakeholders.

“Accounting is the language of business, and a company’s

financial statements are its way of communicating
accounting information to its owners and the taxing
government,” says Thomas R. Ittelson, author
of Financial Statement: A Step-by-Step Guide to
Understanding and Creating Financial Reports and Visual
Guide to Financial Statements: Overview for Non-
Financial Managers & Investors. “This includes sales,
costs, expenses, profits, and assets.”

Simply put, the business world could not exist in its

current form without financial statements.

But what is financial statement analysis? What are the

most common types of financial statements? And how do
you conduct an analysis?

What is Financial Statements?

Financial statements are written records that convey the
business activities and the financial performance of a
company. Financial statements are often audited by
government agencies, accountants, firms, etc. to ensure
accuracy and for tax, financing or investing purposes.
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Analyzing financial statements involves evaluating three
characteristics of an entity: it’s liquidity, it’s
profitability and its solvency. For example, a short-term
creditor such as a bank, is primarily interested in the
ability of the borrower to pay obligations when they come
due. The liquidity of the borrower in such a case is
extremely important in evaluating the safety of a loan. A
long-term creditor, such as a bondholder, however, looks
to indicators such as profitability and solvency that
indicate the firm’s ability to survive over a long period.
Long-term creditors consider such measures as the
amount of debt in the entity’s capital structure and the
ability to meet interest payments. Similarly, shareholders
are interested in the profitability and solvency of the
enterprise when they assess the likelihood of dividends
and the growth potential of the share.

Advantages and Disadvantages of

Financial Statements

Financial Statements are useful for the following reasons;

• To determine the ability of a business to

generate cash, and the sources and uses of that
cash.

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 • To determine whether a business has the
capability to pay back its debts.

• To track financial results on a trend line to spot

any looming profitability issues.

• To derive financial ratios from the statements

that can indicate the condition of the business.

• To investigate the details of certain business

transactions, as outlined in the disclosures that
accompany the statements.

• To use as the basis for an annual report, which

is distributed to a company’s investors and the
investment community.

There are few downsides to issuing financial

statements. A possible concern is that they can be
fraudulently manipulated, leading investors to believe
that the issuing entity has produced better results than
was really the case. Such manipulation can also lead a
lender to issue debt to a business that cannot
realistically repay it.

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Standards for Comparative Analysis
Every item reported in a financial statement has
significance. For example, when L. Victorino Corporation
reports cash for P35,000,000 on its statement of financial
position, it is known that the entity had that amount of
cash on the statement of financial position reporting date.
However, it is not known whether the amount represented
an increase over the prior year or whether the amount is
adequate in relation to the entity’s need for cash. To obtain
this information, it is necessary to compare the amount of
cash with other financial statement data. Comparisons can
be made on a number of different bases;

• Intracompany basis. This basis compares an

item or financial relationship within an entity in
the current year with the same item or relationship
in one or more prior years. For example, a
comparison of L. Victorino’s cash balance at the
end of the current year with last year’s balance will
show the amount of the increase or decrease.
Likewise, L Victorino can compare the percentage
in one or more prior years. Intracompany
comparisons are useful in detecting changes in
financial relationships and significant trends.
• Industry averages. This basis compares an
item or financial relationship of an entity with
industry averages or norms published by financial
ratings organizations. For example, L Victorino’s
profit can be compared with the average profit of
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 all entities in the same industry. Comparisons with
industry averages provide information as to an
entity’s relative performance within the industry.
• Intercompany basis. This basis compares an
item or financial relationship of one entity with the
same item or relationship in one or more
competing entities. The comparisons are made on
the basis of the published financial statement of
the individual entities. For example, L.
Victorino’s total sales for the year can be
compared with the total sales of its major
competitors. Intercompany comparisons are
useful in determining an entity’s competitive
position.

Three Major Financial Statements

Reports
• Balance Sheet
• Income Statement
• Statement of cash flows

Balance Sheet. It provides an overview of a company's

assets, liabilities, and stockholders' equity as a snapshot
in time. The date at the top of the balance sheet tells you
when the snapshot was taken, which is generally the end
of the fiscal year.

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The balance sheet totals will be calculated already, but
here's how you identify them by;

1. Locate total assets on the balance sheet for the

period.
2. Total all liabilities, which should be a separate
listing on the balance sheet. It may not
include contingent liabilities.
3. Locate total shareholder's equity and add the
number to total liabilities.
4. Total assets should equal the total of liabilities
and total equity.

The balance sheet identifies how assets are funded, either

with liabilities, such as debt, or stockholders' equity, such
as retained earnings and additional paid-in capital. Assets
are listed on the balance sheet in order of liquidity.

Liabilities are listed in the order in which they will be

paid. Short-term or current liabilities are expected to be
paid within the year, while long-term or non-current
liabilities are debts expected to be paid in over one year.

FORMULA:

Assets= (Liabilities + Owner’s Equity)

Below are examples of items listed on the balance sheet:

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Assets

• Cash and cash equivalents are liquid assets,

which may include Treasury bills and certificates
of deposit.
• Accounts receivables are the amount of
money owed to the company by its customers for
the sale of its product and service.
• Inventory

Liabilities

• Debt including long-term debt

• Wages payable
• Dividends payable

Shareholders' Equity

• Shareholders' equity is a company's total

assets minus its total liabilities. Shareholders'
equity represents the amount of money that would
be returned to shareholders if all of the assets
were liquidated and all of the company's debt
was paid off.
• Retained earnings are part of
shareholders' equity and are the amount of net
earnings that were not paid to
shareholders as dividends.

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 Below is a portion of Exxon Mobil
Corporation's (XOM) balance sheet as of September
30, 2018.

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Income Statement. Unlike the balance sheet, the
income statement covers a range of time, which is a year
for annual financial statements and a quarter for quarterly
financial statements. The income statement provides an
overview of revenues, expenses, net income and earnings
per share. It usually provides two to three years of data
for comparison.

FORMULA:

Net Income= (Revenue − Expenses)

1. Total all revenue or sales for the period.

2. Total all expenses and costs of operating the
business.
3. Subtract total expenses from revenue to achieve
net income or the profit for the period.

An income statement is one of the three

important financial statements used for reporting a
company's financial performance over a specific
accounting period. Also known as the profit and loss
statement or the statement of revenue and expense, the
income statement primarily focuses on a company’s
revenues and expenses during a particular period.

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Once expenses are subtracted from revenues, the
statement produces a company's profit figure called net
income.

Revenue. Operating revenue is the revenue earned by

selling a company's products or services. The operating
revenue for an auto manufacturer would be realized
through the production and sale of autos. Operating
revenue is generated from the core business activities of
a company.

Non-operating revenue is the income earned from non-

core business activities. These revenues fall outside the
primary function of the business. Some non-operating
revenue examples include:

• Interest earned on cash in the bank

• Rental income from a property
• Income from strategic partnerships
like royalty payment receipts
• Income from an advertisement display located on
the company's property

Other income is the revenue earned from other activities.

Other income could include gains from the sale of long-
term assets such as land, vehicles, or a subsidiary.

Expenses. Primary expenses are incurred during the

process of earning revenue from the primary activity of
the business. Expenses include the cost of goods sold
(COGS), selling, general and administrative expenses
(SG&A), depreciation or amortization, and research and
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development (R&D). Typical expenses include employee
wages, sales commissions, and utilities such as electricity
and transportation.

Expenses that are linked to secondary activities include

interest paid on loans or debt. Losses from the sale of an
asset are also recorded as expenses.

The main purpose of the income statement is to convey

details of profitability and the financial results of
business activities. However, it can be very effective in
showing whether sales or revenue is increasing when
compared over multiple periods. Investors can also see
how well a company's management is controlling
expenses to determine whether a company's efforts in
reducing the cost of sales might boost profits over time.

Below is a portion of Exxon Mobil

Corporation's (XOM) income statement as of September
30, 2018.

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Cash Flow Statement. It provides an overview of the
company's cash flows from operating activities, investing
activities, and financing activities. Net income is carried
over to the cash flow statement where it is included as the
top line item for operating activities. Like its title,
investing activities include cash flows involved with firm
wide investments. The financing activities section
includes cash flow from both debt and equity financing.

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The bottom line shows how much cash a company has
available.
There is no formula, per se, for calculating a cash flow
statement. Instead, it contains three sections that report
cash flow for the various activities for which a company
uses its cash. Those three components of the CFS are
listed below.

Operating Activities. It includes any sources and uses

of cash from running the business and selling its products
or services. Cash from operations includes any changes
made in cash, accounts receivable, depreciation,
inventory and accounts payable. These transactions also
include wages, income tax payments, interest payments,
rent and cash receipts from the sale of a product or
service.

Investing Activities. It includes any sources and uses

of cash from a company's investments into the long-term
future of the company. A purchase or sale of an asset,
loans made to vendors or received from customers or any
payments related to a merger or acquisition is included in
this category.

Also, purchases of fixed assets such as property, plant,

and equipment (PPE) are included in this section. In
short, changes in equipment, assets, or investments relate
to cash from investing.

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Financing Activities. It includes the sources of cash
from investors or banks, as well as the uses of cash paid
to shareholders. Financing activities include debt
issuance, equity issuance, stock repurchases, loans,
dividends paid, and repayments of debt.

The cash flow statement reconciles the income statement

with the balance sheet in three major business activities.

Below is a portion of Exxon Mobil

Corporation's (XOM) cash flow statement as of
September 30, 2018. We can see the three areas of the
cash flow statement and their results.

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Limitations
Although financial statements provide a wealth of
information on a company, they do have limitations. The
statements are open to interpretation, and as a result,
investors often draw vastly different conclusions about a
company's financial performance.

For example, some investors might want stock

repurchases while other investors might prefer to see that
money invested in long-term assets. A company's debt
level might be fine for one investor while another might
have concerns about the level of debt for the company.
When analyzing financial statements, it's important to
compare multiple periods to determine if there are any
trends as well as compare the company's results its peers
in the same industry.

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 • Financial statements are written records that
convey the business activities and the
financial performance of a company.
• Financial statement analysis is used by
internal and external stakeholders to
evaluate business performance and value.
• Financial accounting calls for all companies
to create a balance sheet, income statement,
and cash flow statement which form the
basis for financial statement analysis.
• The balance sheet provides an overview of
assets, liabilities, and stockholders' equity
as a snapshot in time.
• The income statement primarily focuses on
a company’s revenues and expenses during
a particular period. Once expenses are
subtracted from revenues, the statement
produces a company's profit figure called
net income.
• The cash flow statement (CFS) measures
how well a company generates cash to pay
its debt obligations, fund its operating
expenses, and fund investments.
We have discussed the first lesson in this
module. So far, so good! Do you have any
concerns and questions that you would want to

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discuss? Write it down below. Let me hear from you.
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If this space is not enough for you, don’t worry, you can
write it in a sheet of paper and don’t forget to staple it in
your module.
We have provided you a link for your additional
readings and references.

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Further Readings:
https://www.investopedia.com/terms/f/financial-
statement-analysis.asp
https://www.cfainstitute.org/en/membership/professio
nal-development/refresher-readings/introduction-
financial-statement-analysis
https://www.accountingtools.com/articles/2017/5/14/fi
nancial-statement-analysis
https://online.hbs.edu/blog/post/financial-statement-
analysis

YouTube Video:
https://www.youtube.com/watch?v=_F6a0ddbjtI
https://www.youtube.com/watch?v=cKRo5AZbT_s

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Week: __________ Score:
Deadline: _______
Essay: Write down your answers on the space
provided below. Avoid unnecessary erasures and
write clearly and legibly.
1. Why are financial statements important to
internal users, such as employees, managers, and
directors?
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2. What is the purpose and importance of financial
analysis?
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3. A company's financial statements consist of the
balance sheet, income statement, and statement
of cash flows. Describe what each statement tells
us and their limitations.
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You made it! You are ready to our next
destination!

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 Discussion Begins

Lesson 2: Tools of Financial

Statements

For us to understand every single step of our journey, it is

very important to know the basic terminologies and
concepts of analyzing financial statements.
Financial statement analysis is an exceptionally
powerful tool for a variety of users of financial
statements, each having different objectives in learning
about the financial circumstances of the entity.
The information obtained from this analysis can benefit
decision-making for internal and external stakeholders
and can give a company valuable information on overall
performance and specific areas for improvement. The
analysis can help them with budgeting, deciding where to
cut costs, how to increase revenues, and future capital
investments opportunities.

Users of Financial Statement Analysis

There are a number of users of financial statement
analysis. They are:

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 • Creditors. Anyone who has lent funds to a
company is interested in its ability to pay back
the debt, and so will focus on various cash flow
measures.

• Investors. Both current and prospective

investors examine financial statements to learn
about a company's ability to continue issuing
dividends, or to generate cash flow, or to
continue growing at its historical rate
(depending upon their investment
philosophies).

• Management. The company controller

prepares an ongoing analysis of the company's
financial results, particularly in relation to a
number of operational metrics that are not seen
by outside entities (such as the cost per delivery,
cost per distribution channel, profit by product,
and so forth).

• Regulatory authorities. If a company is

publicly held, its financial statements are
examined by the Securities and Exchange
Commission (if the company files in the United
States) to see if its statements conform to the
various accounting standards and the rules of
the SEC.

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Tools of Financial Statement Analysis
Various tools are used to evaluate the significance of
financial statement data. Three commonly used tools are
the following:

• Horizontal Analysis. It is a technique for

evaluating a series of financial statement data over
a period of time.
• Vertical Analysis. It is a technique for
evaluating financial statement data that expresses
each item in a financial statement in terms of a
percent of a base amount.
• Ratio Analysis. It expresses the relationship
among selected items of financial statement data.

What is Horizontal Analysis?

Horizontal Analysis is also called trend analysis. It is a
technique for evaluating a series of financial statement
data over a period of time. Its purpose is to determine the
increase or decrease that has taken place, expressed as
either an amount or a percentage.
You can use this method to compare trends over time of
any financial statement line items. For example, managers
often want to track changes on the statement of
comprehensive income in net sales and profit over time.
If in a particular reporting period, net sales increased by

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8% and profit rose by 12% over the prior year, you can
learn much information from this. First, compare the
performance of the line items with forecasts to determine
the level of entity performance. Some entities would
consider an 8% increase in net sales a dramatic failure
while others would consider it a tremendous success; the
relationship of performance to forecast is the key. Further,
the relationship between distinct line items can give you a
lot of insight into the health of the entity. In this example,
it is likely a very positive indication that profit rose at a
much higher rate (12%) than did net sales (8%). When you
use horizontal analysis over time, you can spot positive or
negative trends.
For example, the recent net sales figures of L. Victorino
Corporation are as follows:

Assume that 2014 is the base year, percentage increases

or decreases from this base period amount is computed as
follows:

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For example, net sales for L. Victorino Corporation,
increased approximately 11.7% [(P5,786.6 – P5,181.4) /
P5,181.4] from 2014 to 2015. Similarly, net sales
increased over 26.7% [((P6,562.8 – P5,181.4) / P5,181.4)
from 2014 to 2018. The percentage of the base period for
each of the 5 years, assuming 2014 as the base period, is
shown in the following illustration.

What is Vertical Analysis?

Vertical Analysis is a method of analyzing financial
statements in which you can compare individual line
items to a baseline item such as net sales from the
statement of comprehensive income, total assets from the
asset section of the statement of financial position and
total liabilities and owner’s equity in the liabilities and
owner’s equity section of the statement of financial

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position. The word vertical is used to describe this
analysis method because the method generates a vertical
column of ratios next to the individual items on the
financial statements.
Vertical analysis makes it much easier to compare the
financial statements of one company with another, and
across industries. This is because one can see the relative
proportions of account balances. It also makes it easier to
compare previous periods for time series analysis, in
which quarterly and annual figures are compared over a
number of years, in order to gain a picture of whether
performance metrics are improving or deteriorating.
You can use vertical analysis to compare trends in the
relative performance of financial statement line items
over time. For example, from the statement of
comprehensive income you may want to track the cost of
goods sold and the profit as a percentage of sales. These
two indicators let you know whether year-to-year costs
are becoming unreasonable and whether profit trends are
as desired. By tracking ratios over time, you can observe
positive or negative trends so that you can begin any
required corrective actions. You can also use vertical
analysis to compare an entity’s performance.
Given the consistent sales growth from year 1 to year 3, it
is not surprising that salaries and the marketing expenses
of the company have also risen as personnel and
marketing spend generally supports sales growth.
However, these expenses at the first glance, don’t seem to
be significant enough to account for the large fall in net
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income in year 3. This is where vertical analysis proves to
be useful.

The first step of vertical analysis is to make a new income

statement, such as the common size income statement
stated below. Here, we have divided each item by the
company’s total sales and shown each category as a
percentage of total sales for year 1-3 respectively.

We can discern through vertical analysis that the main

problem area vis-à-vis the decline in net income in year 3
is the cost of goods sold. This rose sharply to 52% of sales
in year 3 (from 41% and 44% in year 2 and year 1

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respectively). As a result, there was a significant fall in
gross profits in year 3.

As noted before, we can see that salaries increased to 22%

as a percentage of total sales in Year 3, compared to 20%
in year 2. We can also view from this table that marketing
expenses as a percentage of total sales increased to 8% as
a percentage of total sales in year 3, compared to 6% in
year 2. However, these two types of expenses did not
really rise substantially and only account for a relatively
small proportion of revenue.

We must also consider that there may be another factor

responsible for the significant rise in total sales in year 3
– such as a robust economy driving significantly higher
sales in this year. This may be due to higher demand or
some other factor that needs to be investigated.

By using vertical analysis, we can look at the proportional

contribution of each cost (COGS, marketing, salaries etc.)
and analyze which are having a significant impact on
profitability. It is a simple and consistent method that can
be used year on year and also compare different
companies. By being able to measure which cost areas of
the business are rising (falling) as a proportion of sales,
one can then look at the contributing factors in more
detail.

35 | P a g e
Statement of Financial Position

The following illustration is the comparative statement of

financial position of L. Victorino Corporation for 2018
and 2017, analyzed vertically. The base, for the asset
items is total assets and the base for the liability and equity
items is total liabilities and equity.

In addition to showing the relative size of each category

on the statement of financial position, vertical analysis
may show the percentage change in the individual asset,
liability and equity items. In this case, even though current
assets increased by P75,000 from 2017 to 2018, they
decreased from 59.2% to 55.6% of total assets. Property
and Equipment-Net have increased from 39.7% to 43.6%
of total assets, and retained earnings have increased from
32.9% to 39.7% of liabilities and equity. These results
36 | P a g e
may signify that L. Victorino Corporation is choosing to
finance its growth through retention of earnings rather
than through the incurrence of additional debt.

Statement of Comprehensive Income

Vertical analysis of the comparative statement of
comprehensive incomes of L. Victorino Corporation
revealed that cost of goods sold as a percentage of net
sales declined by 1% (62.1% vs. 61.1%) and total
operating expenses declined by 0.4% (17.4% vs. 17.0%).
Consequently, profit as a percent of net sales increased
from 12.3% to 13.4%.

Common-Size Statements
The percentages in the statement of financial position and
statement of comprehensive income of L. Victorino
37 | P a g e
Corporation can be presented as a separate statement that
reports only percentages. Such a statement is called a
common-size statement.
On a common-size statement of comprehensive income,
each item is expressed as a percentage of the net sales
amount. Net sales is the “common size” to which we relate
the statement’s other amounts. In the statement of
financial position, the “common size” is the total on each
side of the accounting equation – total assets or the sum
of the total liabilities and equity. Common-size statements
can be used to compare entities of different sizes.

What is Ratio Analysis?

Ratio analysis is a quantitative method of gaining insight
into a company's liquidity, operational efficiency, and
profitability by studying its financial statements such as
the balance sheet and income statement. Ratio analysis is
a cornerstone of fundamental equity analysis.
Investors and analysts employ ratio analysis to evaluate
the financial health of companies by scrutinizing past and
current financial statements. Comparative data can
demonstrate how a company is performing over time and
can be used to estimate likely future performance. This
data can also compare a company's financial standing
with industry averages while measuring how a company
stacks up against others within the same sector.

38 | P a g e
Investors can use ratio analysis easily, and every figure
needed to calculate the ratios is found on a company's
financial statements.

Financial statement ratios can be classified into three

major groupings:

• Liquidity
• Profitability
• Solvency ratios

What are Liquidity Ratios?

Liquidity ratios measure a company's ability to pay off
its short-term debts as they become due, using the
company's current or quick assets. Liquidity ratios
include the current ratio, quick ratio, and working capital
ratio.

Types of Liquidity Ratio

Working Capital. It represents a company's ability to
pay its current liabilities with its current assets. Working
capital is an important measure of financial health
since creditors can measure a company's ability to pay
off its debts within a year.

Working capital represents the difference between a

firm’s current assets and current liabilities. The challenge
39 | P a g e
can be determining the proper category for the vast array
of assets and liabilities on a corporate balance sheet and
deciphering the overall health of a firm in meeting its
short-term commitments.

Example:

W. Blanche Corp.’s working capital for 2017 follows:

The formula and the calculation of W. Blanche Corp.’s

working capital for 2017 follows:

Working capital for 2016 was P53,189,000 (current

assets of P94,104,00 minus current liabilities of
P40,915,000). During 2017, working capital increased by

40 | P a g e
P17,070,000 (P70,259,000 – P53,189,000). The increase
indicates that more liquid resources were created than
were used during the year. A decrease in working capital
would have indicated that the entity was using more
liquid resources than it was creating. The current ratio
and the acid-test ratio are decision-making tools based on
working capital.

Current Ratio. The current ratio is the simplest

liquidity ratio to calculate and interpret. It describes the
ability of an entity to meet current debt obligations with
assets that are readily available. It is used to evaluate an
entity’s liquidity and short-term debt paying capacity.

The formula and the 2017 current ratio for W. Blanche

Corp. follow:

This means that for every peso of current liabilities, W.

Blanche Corp. has P2.80 of current assets. The acceptable
current ratio depends on the nature of the industry.

41 | P a g e
Higher ratios indicate an increased ability to pay short-
term debt obligations such as accounts payable and
interest payments on debt. Lower ratios can indicate an
inability to meet short-term debt obligations, which could
lead to insolvency and bankruptcy. A historic rule of
thumb is that healthy current ratios equal or exceed the
value of 2.0. However, very high current ratios much in
excess of 2.0, can indicate an entity is not using its assets
in an ideal manner. This is because current assets seldom
yield returns as large as long-term assets such as
investments in equipment and subsidiaries.

Quick Ratio. Quick ratio or acid-test ratio tells whether

the entity could pay all its current liabilities even if none
of the inventory is sold. It is a stricter test of liquidity than
the current ratio. Both are similar in the sense that current
assets is the numerator and current asset is the
denominator.
Quick assets are those that may be converted directly into
cash within a short period of time. These include cash,
trading investments and receivables.
This account titles should be omitted in preparing quick
ratio;
• Merchandise inventory is omitted because
merchandise is normally sold on credit and then
the receivable must be collected before cash is
realized.

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 • Prepaid expenses are also omitted because they
are usually relatively small in amount and because
they are used up in operations rather than
converted into cash.
W. Blanche Corp.’s quick ratio on Dec 31, 2017 is
calculated as follows:

Creditors generally use the rule of thumb that a quick ratio

of at least 1:1 is satisfactory. W. Blanche Corporation’s
quick ratio appears to be acceptable.
The quick ratio, when considered with the current ratio,
gives an idea of the influence of merchandise inventory
and prepaid expenses. Looking at the Corporation A and
Corporation B illustration, by using quick ratios, it is
shown that Corporation A’s current ratio may be
misleading. Current ratio should not be used as the sole
indicator of short-term liquidity.

43 | P a g e
Corporation B has the stronger quick ratio though with a
weaker current ratio, indicating that merchandise
inventory and prepaid expenses play a less important
role in its current position than these assets do in
Corporation A’s.

Accounts Receivable Turnover. It is described as a

ratio of average accounts receivable for a period divided
by the net credit sales for that same period. It measures
the entity’s ability to collect from credit customers.
In general, the higher the ratio, the more successfully the
business collects cash. However, a turnover that is too
high may indicate that credit is too high causing the loss
of sales to good customers. Assuming that substantially
all of W. Blanche’s sales are on credit, the 2017
receivables turnover is as follows:

44 | P a g e
You can increase accounts receivable turnover by
tightening credit policies and by more proactively seeking
payment of outstanding accounts. Note that tighter credit
policies may have the undesirable effect of reducing sales
since some customers are likely to seek other suppliers
with more liberal credit.

Average Age of Receivables. It refers to the amount

of time it takes for a business to receive payments owed
by its clients in terms of accounts receivable. It is an
indicator of the effectiveness of a firm’s AR management
practices and is an important metric for companies that
rely heavily on receivables for their cash flows.

W. Blanche Corporation takes an average of 14 days to

collect its receivables. If W. Blanche’s credit terms are net
10 days, its collection efforts should be improved. If the
credit terms are 15 or 30 days, W. Blanche’s collection
efforts appear to be excellent. The general rule is that the
collection period should not materially exceed the credit
period.

45 | P a g e
Inventory Turnover. It is a measure of the number of
times an entity sold its average level of inventory during
the period. A high rate of turnover indicates relative ease
in selling inventory. However, a high value can mean that
the business is not keeping enough inventories on hand
and thus may result to lost sales. Inventory turnover is
calculated by dividing cost of goods sold by average
merchandise inventory. Cost of goods sold is used instead
of net sales because both cost of goods sold and
merchandise inventory are stated at cost. The formula and
the 2017 W. Blanche’s inventory turnover are as follows:

Since W. Blanche’s inventory turned over about 10 times

this period, the ending inventory should be about 10% of
cost of goods sold. W. Blanche’s ending inventory of
P62,582,000 is a little above this amount (10% x
P564,346,000). This excess is probably in anticipation of
increasing sales volume.
Higher inventory turnover ratios generally increase entity
profitability since an entity can use the cash normally tied

46 | P a g e
up in inventory for higher return investments. Higher
turnover is easier to accommodate by improving a number
of factors. These include production planning, scheduling,
capacity planning, product quality, equipment quality,
relations with raw materials suppliers and inventory
planning. Simply increasing inventory turnover without
improvement in these critical areas can lead to disastrous
results.

Average Age of Inventory. It is the average number

of days it takes for a firm to sell off inventory. It is a metric
that analysts use to determine the efficiency of sales.

Operating Cycle. This measures the average time

period between buying the inventory and receiving cash
proceeds from its sales. It is determined by adding the
average age of inventory and the average age of
receivables.

What are Profitability Ratios?

Profitability Ratio. are a class of financial metrics that
are used to assess a business's ability to generate earnings
relative to its revenue, operating costs, balance sheet

47 | P a g e
assets, or shareholders' equity over time, using data from
a specific point in time.

Return on Total Assets. It is a measure of

management’s efficiency in using its assets to earn
profits. It is defined as the ratio between net income and
total average assets, or the amount of financial and
operational income a company receives in a financial
year as compared to the average of that company's total

assets.

W. Blanche Corporation’s return on total assets for 2017

is calculated as follows:

W. Blanche’s management earned an average of 12.57%

on every peso asset invested.

48 | P a g e
Return on Ordinary Equity. It is a measure of
financial performance calculated by dividing net income
by shareholders’ equity. This rate may be higher or lower
than the return on total assets, depending on how
judiciously management has combined debt and
preference share with ordinary share in financing the
entity’s resources.
The formula for computing this ratio is:

The numerator yields the profit available to the ordinary

shareholders and is the net amount earned on the equity of
the ordinary shareholders. Average ordinary equity is an
approximation of the amount invested by this group of
owners throughout the year.

49 | P a g e
The return on W. Blanche Corporation’s ordinary equity
for 2017 is:

Since the 18.45% return on ordinary equity exceeded the

12.57% return on total assets, management has made
effective use of leverage or trading on the equity. This
difference resulted from borrowing at a lower rate and
investing the funds to earn a higher rate of return on
ordinary equity. This practice is directly related to the debt
ratio; the higher the debt ratio, the higher the leverage.
Trading on the equity does not always guarantee
improved profitability; it is because when revenues drop
and operations resulted to losses, interest on debts must
still be paid.

Basic Earnings Per Ordinary Share. It is a

measure of the profit earned on each ordinary share. The
formula for a simple capital structure and the calculation
of 2017 earnings per share for W. Blanche Corporation
follows:

50 | P a g e
Increasing profit can directly increase earnings per share.
You can achieve this by providing highly demanded
products or services in a cost-effective manner. Highly
demanded products or services can increase net sales by
causing sales of larger volumes of products or services at
premium prices. By producing the product or service in a
cost-effective manner, you can increase profit margins to
strengthen earnings.
Corporations can also improve their earnings per share
figures by repurchasing outstanding shares. This will
decrease the amount of shares outstanding and for a fixed
amount of earnings, inflate earnings on per-share basis. If
an entity sells additional shares, dilution occurs and the
opposite effect results; earnings per share decline.

Price-Earnings Ratio. It is the measure of the share

price relative to the annual net income earned by the firm
per share. This ratio reflects investor’s assessments of the
entity’s future earnings.

51 | P a g e
The formula for calculating the price-earnings ratio is:

The higher an entity’s P/E ratio, the more potential

investors typically see in the particular entity. Generally,
corporations with higher P/E ratios tend to have higher
growth rates and deliver products or services that will
probably be in demand for a significant time into the
future. Because of such positive projections, investors are
willing to pay a higher share price in the hope that sales
and earnings growth will fuel further increases in share
price.
Assuming a current market price of P27 for W. Blanche
Corporation’s ordinary share, the price-earnings ratio for
2017 would be calculated as follows:

W. Blanche’s share is currently selling at 15 times

earnings. Investors are generally willing to buy a share for
as many as 15 to 20 times the current per-share earnings
because they feel that the future profit growth of the firm
will be sufficient to provide an adequate return on this
investment. This return is normally received through a
combination of dividends and an increased market value

52 | P a g e
of the share. Many investors interpret a sharp increase in
a share’s price-earnings ratio as a signal to sell a share.
You can increase P/E ratios by increasing net sales and
profit growth rates. Increasingly larger profit margins also
tend to increase P/E ratios. You can increase profit
margins by controlling costs and by maintaining optimum
pricing by offering competitive, highly desirable products
or services.

Dividend Yield. It is the ratio of dividends per share to

the share’s market price. This ratio measures the
percentage of a share’s market value that is returned
annually as dividends. This indication of the cash payout
rate on an investment allows shareholders and potential
shareholders to compare interest rates on certificates of
deposit, corporate bonds and other securities with this
measure of return on ordinary share.
The formula for calculating 2017 dividend yield for W.
Blanche Corporation assuming that P8,000,000 cash
dividends were paid to ordinary shareholders follows:

53 | P a g e
This relatively low dividend yield rate of about 3% on W.
Blanche Corp. ordinary share would not attract investors
who count on cash flow from dividends to pay their living
expenses. A potential W. Blanche Corp. shareholder
would probably be more interested in speculating on the
growth in the market value of the share. This type of
investor would rely more heavily on growth in earnings
per share and recent trends in the market price of the share
than on the dividend yield.

Solvency Ratios. It is a key metric used to measure

an enterprise’s ability to meet its long-term debt
obligations and is used often by prospective business
lenders. It measures the ability of the entity to survive over
a long period of time. It indicates whether a company’s
cash flow is sufficient to meet its long-term liabilities and
thus is a measure of its financial health.

Times Interest Earned Ratio. It is a measure of a

company’s ability to meet its debt obligations based on its
current income. The times interest earned ratio indicates
the margin of safety provided by current earnings in
meeting the entity’s interest responsibilities.
The formula for calculating this ratio is:

54 | P a g e
The ratio uses profit before interest expense and income
taxes because this amount represents the amount available
to cover interest. Times interest earned for W. Blanche
Corp. in 2017 is:

Thus, W. Blanche Corp.’s profit available to meet its

interest responsibilities was way over 9 times the amount
of its interest expense. Usually, if interest is covered
several times, long-term creditors consider this an
acceptable margin of safety.
Higher ratios indicate healthy entities that generate high
income streams from operations and/or entities that
employ little or no debt. As the times interest earned ratios
increase, there is typically less risk to creditors that debt
payment schedules will not be met.
Lower ratios indicate highly leveraged firms with
significant interest expense and/or those firms that
55 | P a g e
generate small income streams from operations. While
creditor risk increases as times interest earned ratios
decrease, there is the potential that the leverage gained
with the financed debt may allow enhanced future returns.
Less mature entities, especially start-ups, will tend to
exhibit lower ratios. This is because these entities
typically require larger amounts of debt because profit
generation has not yet reached optimum levels and
because growth generally requires cash investments for
assets such as inventories and accounts receivable. You
can achieve higher ratios by paying off debt and reducing
interest expense and/or increasing operations profitability.

Debt to Total Assets Ratio. It is a leverage ratio that

defines the total amount of debt relative to assets owned
by a company. Higher ratios indicate that an entity has
financed a large portion of assets with debt. As debt-to-
asset ratios climb, creditor risk increases because there is
less margin available if the entity must liquidate assets.
Creditors may require higher interest rates or refuse to
issue additional debt under these circumstances.
However, a certain degree of debt is generally quite
acceptable; especially in the view of investors because the
leverage gained with debt financing may yield higher
returns on equity investments.
You can determine an acceptable level of debt by
examining the ratio of interest payments to operating
profit. In the case of start-ups or entities experiencing
special situations, compare all sources of income
including additional debt financing with interest payments
56 | P a g e
to ascertain the acceptability of current debt levels. The
higher this percentage is, the greater the risk that the entity
will be unable to meet its obligations when due. Thus, if
the debt ratio is 100%, then debt has been used to finance
all the assets. The debt ratio for W. Blanche Corporation
follows:

Thus, 40% of W. Blanche Corp.’s total assets were

financed by debt.

Equity to Total Assets Ratio. Equity to total assets

ratio or equity ratio, shows the percentage of the firm’s
assets financed by shareholders. The higher this ratio is,
the smaller the risk that the entity will be unable to meet
its obligations when due. Observe that debt ratio and
equity ratio are complementary; that is, the two
percentages should always add up to 100%. This is true
because all assets are financed by either debt or equity
funds. The equity to total assets ratio may be found by
subtracting the debt to total assets ratio from 100%:

57 | P a g e
This ratio may also be calculated by the following
formula:

Thus, 60% of W. Blanche Corp.’s assets came from the

shareholders and 40% from creditors. This ratio should
be satisfactory to long-term creditors.

58 | P a g e
 • Vertical analysis makes it easier to
understand the correlation between single
items on a balance sheet and the bottom line,
expressed in a percentage.
• Vertical analysis can become a more potent
tool when used in conjunction with horizontal
analysis, which considers the finances of a
certain period of time.
• Horizontal analysis is used in the review of a
company's financial statements over multiple
periods.
• It is usually depicted as percentage growth
over the same line item in the base year.
• Horizontal analysis allows financial statement
users to easily spot trends and growth
patterns.
• Horizontal analysis shows a company's
growth and financial position
versus competitors.
• Horizontal analysis can be manipulated to
make the current period look better if specific
historical periods of poor performance are
chosen as a comparison.

59 | P a g e
 • Ratio analysis compares line-item data from a
company's financial statements to reveal insights
regarding profitability, liquidity, operational
efficiency, and solvency.
• Ratio analysis can mark how a company is
performing over time, while comparing a company
to another within the same industry or sector.
• While ratios offer useful insight into a company,
they should be paired with other metrics, to obtain
a broader picture of a company's financial health.
• The average collection period refers to the length of
time a business needs to collect its accounts
receivables.
• The accounts receivable turnover ratio is an
accounting measure used to quantify a company's
effectiveness in collecting its receivables or money
owed by clients.
• A high receivables turnover ratio may indicate that
a company’s collection of accounts receivable is
efficient and that the company has a high
proportion of quality customers that pay their debts
quickly.
• A low receivables turnover ratio could be the result
of inefficient collection, inadequate credit policies,
or customers who are not financially viable or
creditworthy.
• Inventory turnover measures how many times in a
given period a company is able to replace the
inventories that it has sold.
60 |• P a g e
 We have discussed the second lesson in this
module. So far, so good! Do you have any
concerns and questions that you would want
to discuss? Write it down below. Let me hear
from you.
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If this space is not enough for you, don’t worry, you can
write it in a sheet of paper and don’t forget to staple it in
your module.

61 | P a g e
We have provided you a link for your additional
readings and references.

Further Readings:
https://www.fe.training/free-
resources/accounting/vertical-
analysis/#:~:text=Vertical%20analysis%20is%20a%20m
ethod,percentage%20of%20the%20base%20figure.&text
=Each%20item%20in%20the%20income,a%20common
%20size%20income%20statement).
https://www.investopedia.com/terms/v/vertical_analysis.
asp
https://www.investopedia.com/terms/h/horizontalanalysi
s.asp
https://www.investopedia.com/terms/r/ratioanalysis.asp#
:~:text=Ratio%20analysis%20compares%20line%2Dite
m,the%20same%20industry%20or%20sector.
YouTube Video:
https://www.youtube.com/watch?v=fehWwjOe8FI
https://www.youtube.com/watch?v=h9Blw1-g_lc
https://www.youtube.com/watch?v=D7ELfN6emS4

62 | P a g e
Week: __________ Score:
Deadline: _______
Directions: Comply the necessary requirements given in
the problems. Write your answer in a short bond paper.

Problem #1
Horizontal Analysis
Estrada, Inc. is concerned about the level of its
advertising and office salaries expense. Selected
statement of comprehensive income data from 2016 to
2018 appear below:

Required:
Calculate trend percentages for sales, advertising
expense and office salaries expense. Use 2016 as the
base year. Round to the nearest percent.

63 | P a g e
Problem #5
Liquidity Ratios

You have been asked to evaluate the liquidity position of

Burgos Fitness Center. The following data are from
Burgos’ annual report:

Required: Using these data, calculate Burgos’

1. Working Capital
2. Current Ratio
3. Quick Ratio
4. Inventory Turnover
5. Accounts receivable turnover
6. Average age of receivables

64 | P a g e
Problem #6
Solvency Ratios

The president of Rodriguez, Inc., has asked you to gather

some statistics about his corporation’s solvency. You
have compiled the following data:

Using these data, calculate:

1. Times interest earned ratio
2. Debt ratio
3. Equity ratio

Problem #7
Profitability Ratios
The following data are from the financial statements of
Parada, Inc.:

65 | P a g e
Calculate the following ratios:
1. Return on total assets
2. Return on ordinary equity

Problem #8
Profitability Ratios
Gonzales is analyzing the earnings performance of the
Bobadilla Transport Corporation. He has gathered the
following data from Bobadilla’s financial statements and
from a report of the closing market prices of shares:

Calculate the following ratios relating to the Bobadilla

share:

66 | P a g e
 1. Basic earnings per ordinary share
2. Price-earnings ratio
3. Dividend yield on ordinary share

You made it! You are ready to our

next destination!

Congratulations for
Finishing Unit 4!
67 | P a g e