FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is defined as the process of identifying financial strengths and
weaknesses of the firm by properly establishing relationship between the items of the balance
sheet and the profit and loss account. (Analyze finance data)

There are various methods or techniques that are used in analyzing financial statements, such
as comparative statements, schedule of changes in working capital, common size percentages,
funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision
making purposes. They play a dominant role in setting the framework of managerial decisions.
But the information provided in the financial statements is not an end in itself as no meaningful
conclusions can be drawn from these statements alone. However, the information provided in
the financial statements is of immense use in making decisions through analysis and
interpretation of financial statements.

Financial statement analysis involves careful selection of data from financial statements in order
to assess and evaluate the firm's past performance, its present condition, and future business
potentials.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

The primary purpose of FS analysis is to evaluate and forecast the company's financial health.
Interested parties, such as the managers, investors, and creditors, can identify the company's
financial strengths and weaknesses and know about the:
1. Profitability of the business firm;
2. Firm's ability to meet its obligations;
3. Safety of the investment in the business; and
4. Effectiveness of management in running the firm.

TOOLS AND TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS:

Following are the most important tools and techniques of financial statement analysis:
1. Horizontal and Vertical Analysis
2. Ratios Analysis
1. HORIZONTAL AND VERTICAL ANALYSIS:

Horizontal Analysis or Trend Analysis:

Comparison of two or more year’s financial data is known as horizontal analysis, or trend
analysis.
Horizontal analysis is facilitated by showing changes between years in both dollar and
percentage form.

Trend Percentage:
Horizontal analysis of financial statements can also be carried out by computing trend
percentages. Trend percentage states several years’ financial data in terms of a base year. The
base year equals 100%, with all other years stated in some percentage of this base.

Formula:

Most Recent Value - Base Period

Percentage Change Value
=
Base Period Value

Increase
Example:
(Decrease)
2020 2019 Pesos Percent
P8,00
Sales P10, 000 P2,000 25% *
0

P10,000- P8,000
Percentage Change= x 100 25% *
P8,000

Vertical Analysis:
Vertical analysis is the procedure of preparing and presenting common size statements.
Common size statement is one that shows the items appearing on it in percentage form as well
as in peso form. Each item is stated as a percentage of some total of which that item is a part.
Key financial changes and trends can be highlighted by the use of common size statements.

Example:
EXCELLENT CORPORATION
Income Statement
For the year Ended December 31, 2019
2020 Percent
Sales P10,000 100%
Less Cost of Sales 6,000 60%
Gross Income P4,000 40%
Less operating expenses: Selling 510 5.10%
Administrative 210 2.10%
Total operating expenses 720 7.20%
Income from Operations 3,280 32.80%
Less interest expense 28 0.28%
Income before tax 3,252 32.52%
Less income tax 975 9.75%
Net Income P2,277 22.77%

ILLUSTRATIVE PROBLEM 1
The financial position of Generous Company at the end of 2019 and 2020 is as follows:

2019 2020
ASSETS
Cash P3000 P5000
Accounts receivable 40,000 25000
Inventory 27,000 30000
Long-term investments 15000 0
Land, Building and equipment (net) 100000 75000
Intangible assets 10000
Other assets P5000 P20000
Total assets P200000 P165000

LIABILITIES
Current liabilities 30000 47000
Long-term liabilities 88000 74000
Total liabilities P118000 P121000
 OWNER’S EQUITY
Jenny Rose Mapagbigay, Equity 12/31 P82000 P44000
Total liabilities and shareholder’s equity P200000 P165000

Sales and cost of goods sold insignificantly change in 2020 in relation with 2019.
Required:
1. Prepare a comparative balance sheet showing peso and percentage changes for 2020
as compared with 2019.
2. Prepare a common-size balance sheet as of December 31, 2019 and 2020.

SOLUTION:
1. HORIZONTAL ANALYSIS
Generous Company
Comparative Balance Sheet
December 31, 2019 and 2020

Increase / Decrease
2020 2019 AMOUNT PERCENTAGE
ASSETS
Cash P3000 P5000 (P2000) -40%
Accounts Receivable 40000 25000 15000 60%
Inventory 27000 30000 (P3000) -10%
Long-term investments 15000 0 15000 0
PPP net 100000 75000 25000 33.3
Intangibles 10000 10000 0 0
Other Assets 5000 20000 (P15000) -75%
TOTAL ASSETS P200000 P165000 P35000 21.20%

LIABILITIES AND OWNER'S EQUITY

Current Liabilities P30000 P47000 (P17000) -36.20%
Long-term Liabilities 88000 74000 14000 18.90%
Total Liabilities 118000 121000 (P3000) -2.50%
Total Owner's Equity 82000 44000 38000 86.40%
 TOTAL LIABILITIES AND OWNER'S EQUITY P20000 P165000 P35000 21.20%

1.2 VERTICAL ANALYSIS

Generous Company
Common Size Balance Sheet
December 31, 2019 and 2020

2020 2019
ASSETS
Cash 1.50% 3.03%
Accounts Receivable 20 15.15
Inventory 13.5 18.18
Long-term investments 35 36.36
PPP net 7.5 0
Intangibles 50 45.46
Other Assets 5 6.06
TOTAL ASSETS 2.50% 100%

LIABILITIES AND OWNER'S EQUITY

Current Liabilities 15% 28.48
Long-term Liabilities 44 44.85
Total Liabilities 59% 73.33%
Total Owner's Equity 41 26.67
TOTAL LIABILITIES AND OWNER'S EQUITY 100% 100%

2. RATIO ANALYSIS:
The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply
means one number expressed in terms of another. A ratio is a statistical yardstick by means of
which relationship between two or various figures can be compared or measured. Ratios can
be found out by dividing one number by another number. Ratios show how one number is
related to another.

PROFITABILITY RATIOS:
Profitability ratios measure the results of business operations or overall performance and
effectiveness of the firm.

RATIO FORMULA SIGNIFICANCE

1. Profit Margin on Sales Measures the
Net Income
or percentage of net
Net Profit percentage Net Sales income to sales.
2. Net Operating Income
EBIT*
to Measures the
Sales Net Sales percentage of
operating income to
*Earnings before sales.
interest and taxes
3. Return on Investment
Net Income
or Indicates whether
Return on Total Assets or Average Total management is using
Return on Invested funds wisely.
Assets
Capital
4. Net Operating Income A variation of the
EBIT Return on Total
to
Assets that excludes
Equity + Interest non-interest bearing
Total Capital debt from total assets.
bearing Debt
5. Marginal Profitability A variation of the Net
Change in EBIT
Operating Income to
Change in Capital
Rate Total Capital Ratio.
Measures the return
6. Return on Equity Net Income
on the
Carrying amount of
Average Total Equity
equity.

LIQUIDITY RATIOS:
Liquidity ratios measure the short term solvency of financial position of a firm. These
ratios are calculated to comment upon the short term paying capacity of a concern or
the firm’s ability to meet its current obligations. Following are the most important liquidity
ratios.

RATIO FORMULA SIGNIFICANCE

 1. Current Ratio or
Current Assets Current Test of short-term debt
Working Capital Ratio or
Liabilities paying ability
Banker's Ratio
2. Acid Test or Quick Quick Assets*
Ratio Current Liabilities Measures the firm's
ability to pay its short-
*Quick Assets = Cash
term debts from its
+ Cash
most liquid assets
Equivalents + Net without having to rely
Receivables + on inventory
Marketable Securities

WORKING CAPITAL ACTIVITY RATIOS (EFFICIENCY RATIOS)

Income statement account No. of days in a year

Turnover Average age
Average balance sheet account Turnover

NOTE: Working capital = Current assets – Current liabilities

ILLUSTRATIVE PROBLEM 2
The following are taken from the balance sheet of Star Company as of December 31, 2020:

Current Assets:
Cash on hand and in
P220,000
banks
Accounts receivable 300,000
Merchandise inventory 330,000 P850,000
Liabilities:
Accounts payable P400,200
Notes payable 662,300 P1,062,500
Long term liabilities 2,500,000

What are the company’s current ratio and quick (acid test) ratio?

SOLUTION:
Current Assets /
Current
Current Ratio= Liabilities
P850,000 0.8
 P 1,062,500

Quick Assets /
Current
Liabilities
Quick Ratio =
P341,600 +
P200,000
0.51
P 1,062,500

ASSET MANAGEMENT RATIOS:

Measure how the firm uses its assets to generate revenue and income.
RATIO FORMULA SIGNIFICANCE

Cost of Sales Indicates if a

Average Inventory firm holds
excessive
1. Finished
stocks of
Goods or inventories
Merchandise that are
Inventory unproductive
and that
Turnover
lessen the
company's
profitability.

2. Average Number of Days in a Year Measures

Age of the average
Inventory Turnover Ratio number of
Inventories or
days that
Number of
inventory is
Days of or held before
Inventory Average Inventory sale.
Average Daily Cost of Sales
 Net Credit Sales Average Measures
3. Receivables Accounts Receivable the average
Turnover number of
days to
Ratio collect a
receivable

4. Average Age
of Receivables Number of Days in a Year
or Number of Receivables Turnover Ratio Measures
the average
Days of number of
Receivable or or days to
collect a
Average receivable.
Collection Average Accounts Receivable
Period Average Daily Sales

Average Age of Inventories + Measure the

5. Operating Average Age of average
Cycle or number of
Receivables
days to
Conversion convert
Period inventories
to cash.

Determines
6. Average whether the
Age of Average Accounts Payable firm is
Accounts Average Daily Purchases paying its
Payable invoices on a
timely basis.

Net Sales Measures

7. Fixed the level of
Assets Average Net Fixed Assets
use of
Turnover property,
Ratio plant, and
equipment.

Net Sales Average Measures the

8. Total Assets Total Assets level of capital
Turnover investment
Ratio relative to sales
volume.
 Net Sales Measures
the level of
9. Total Total Capital *
total assets
Capital having
Turnover explicit costs
*Total Capital = total assets
Ratio relative to
having explicit costs (equity +
sales
interest-bearing debt)
volume.

Measures
the
10. Investment Total Capital, 200B - Total Capital, percentage
Rate 200A change in

Total Capital, 200A Total capital.

LONG TERM SOLVENCY OR LEVERAGE RATIOS:

Long term solvency or leverage ratios convey a firm’s ability to meet the interest costs and
payment schedules of its long-term obligations. Following are some of the most important long
term solvency or leverage ratios.
RATIO FORMULA SIGNIFICANCE

Interest Bearing
Debt Measures the extent to which
1. Interest-bearing the assets having explicit cost
Equity + Interest
Debt Ratio (total capital) are financed by
-
interest bearing debt.
Bearing Debt

Total Liabilities
Total Assets Measures the percentage of
2. Total Debt Ratio
(Capital) funds provided by creditors.

Total Liabilities Compares the resources

3. Debt to Equity provided by creditors with
Equity
Ratio resources provided by
shareholders.
 Total Liabilities

4. Debt to Tangible Equity - A more conservative measure

Net Worth Intangible of a long-term debt-payment
Assets ability than the debt ratio or
Ratio debt to equity ratio.

ILLUSTRATIVE PROBLEM 3
The data were taken from the financial records of Left Company and Right Company on
December 31, 2020 (in thousands):
Left Company Right Company
Debt P 200,000 P 300,000
Owners’ equity 300,000 200,000
Total liabilities and equity P 500,000 P 500,000

Required: Calculate the following ratios for East Company and West Company for 2019:
1. Debt ratio.
2. Equity ratio.
3. Debt equity ratio.

SOLUTION:
Left Company Right Company

P P
200,000 300,000
1. Debt ratio = =
40% 60%
=
P P
500,000 500,000

P P
300,000 200,000
2. Equity = =
60% 40%
ratio =
P P
500,000 500,000

3. Debt- P 66.67% P 133.33%

 equity ratio = 200,000 300,000
= =

P P
300,000 200,000

Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it has two limitations. These two
limitations involve the comparability of financial data between companies and the need to look
beyond ratios.

ADVANTAGES OF FINANCIAL STATEMENT ANALYSIS:

There are various advantages of financial statements analysis. The major benefit is that the
investors get enough idea to decide about the investments of their funds in the specific
company. Secondly, regulatory authorities like International Accounting Standards Board can
ensure whether the company is following accounting standards or not. Thirdly, financial
statements analysis can help the government agencies to analyze the taxation due to the
company. Moreover, company can analyze its own performance over the period of time through
financial statements analysis.