ANALYSIS & INTERPRETATION OF

FINANCIAL STATEMENTS 5
______________________________________________________________________________ MODULE
Learning Objectives:

1. To define the measurement levels of Financial Statements, namely, liquidity, solvency, stability, and
profitability.
2. To perform vertical and horizontal analyses of financial statements of a single proprietorship.
3. To compute and interpret financial ratios such as current ratio, working capital, gross profit ratio, net
profit ratio, receivable turnover, inventory turnover, debt-to-equity ratio, and the like.

FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is a process of evaluating and interpreting an entity's financial statements to assess
its financial health for the purpose of making better economic decisions.

Depending on the objective of the analysis, a financial statement analysis may involve analyzing one or more
of the following:

1. Industry and economic trend

2. Solvency and Capital structure
3. Operational efficiency
4. Profitability

Industry and economic trend

This involves the analysis of the economic environment where the business operates. This is necessary because
the ability of a business to thrive is affected by various external factors, such as economic climate, competition,
demand and supply, market rates, government regulations, technological changes, and the like.

The financial statements of a business do not provide all the necessary information needed in analyzing the
industry and economic trend. Other, information from external sources is needed, for example, published
industry averages, current events, statistical data, research papers, financial data from key players in the
industry, and the like. The financial statements of the business are only one of the many inputs needed in this
analysis.

Solvency and Capital structure

Solvency refers to the ability of the business to pay its debts and remain as a going concern. Solvency can be
short-term (liquidity) or long-term (solvency).

Capital structure refers to how a business efficiently finances its operations using different sources of funds,
such as debt or equity. Solvency and capital structure relates to the stability of a business.

Page 1 of 10
Operational efficiency
Operational efficiency refers to how well a business is managing its resources to maximize earnings.

Profitability
Profitability refers to the ability of the business to generate profit.

Methods of Financial Statement Analysis

The two methods used in analyzing financial statements are as follows:

1. Horizontal and Vertical Analyses
2. Financial ratio analysis

Horizontal Analysis
Horizontal analysis is the comparison of financial information over two or more reporting periods. The purpose
is to analyze if changes in amounts are unusually high or low, which may entail investigation of the reason for
the unusual change. It is also called trend analysis.

Steps in Horizontal Analysis

1. Compute for the change in the amounts in a baseline year (earlier period) and a later period.
2. Divide the change by the amount in the baseline year.

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑒𝑠𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 − 𝑃𝑟𝑖𝑜𝑟 𝑦𝑒𝑎𝑟 𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 − 𝑃𝑟𝑖𝑜𝑟 𝑦𝑒𝑎𝑟 𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 =
𝑃𝑟𝑖𝑜𝑟 𝑦𝑒𝑎𝑟′𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

Example:
2020 2021
Net Income 655,000.00 932,000.00

Change in Peso = 932,000.00 – 655,000.00 = 277,000.00

Change in Percentage = (932,000.00 – 655,000.00)

655,000.00
= 42.29%

Interpretation: Net income for year 2021 has increased by P277,000.00, with a percentage of 42.29% as
compared to year 2020.

Page 2 of 10
ABC Company
Comparative Balance Sheets
As of December 31, 2021 and 2020

2021 2020 Increase(Decrease) Percent

ASSETS
Cash and Cash Equivalents 30,000 80,000 (50,000) -62.50%
Accounts Receivable - net 1,672,000 304,000 1,368,000 450.00%
Inventory 500,000 300,000 200,000 66.67%
Prepaid Assets 48,000 50,000 (2,000) -4.00%
Total Current Assets 2,250,000 734,000 1,516,000 206.54%

Property, Plant, & Equipment 780,000 720,000 60,000 8.33%

Total Noncurrent Assets 780,000 720,000 60,000 8.33%

TOTAL ASSETS 3,030,000 1,454,000 1,576,000 108.39%

LIABILITIES
Accounts Payable - net 980,000 420,000 560,000 133.33%
Notes Payable (current portion) 180,000 180,000 - 0.00%
Total Current Liabilities 1,160,000 600,000 560,000 93.33%

Notes Payable (noncurrent portion) 180000 360000 (180,000) -50.00%

Total Noncurrent Liabilities 180,000 360,000 (180,000) -50.00%
TOTAL LIABILITIES 1,340,000 960,000 380,000 39.58%

EQUITY
Owner's Capital 1,690,000 494,000 1,196,000 242.11%
TOTAL LIABILITIES & EQUITY 3,030,000 1,454,000 1,576,000 108.39%

ABC Company
Comparative Income Statements
For the years ended December 31, 2021 and 2020

2021 2020 Increase(Decrease) Percent

Sales 4,000,000 2,400,000 1,600,000 66.67%

Cost of Sales (1,400,000) (900,000) (500,000) 55.56%
GROSS PROFIT 2,600,000 1,500,000 1,100,000 73.33%
Salaries Expense (780,000) (780,000) - 0.00%
Utilities Expense (120,000) (120,000) - 0.00%
Rent Expense (156,000) (156,000) - 0.00%
Depreciation Expense (240,000) (180,000) (60,000) 33.33%
Bad Debts Expense (72,000) (16,000) (56,000) 350.00%
Interest Expense (36,000) (54,000) 18,000 -33.33%
PROFIT FOR THE YEAR 1,196,000 194,000 1,002,000 516.49%

Page 3 of 10
Analyses and interpretations:

Solvency and Capital structure

 Liquidity (Short-term solvency): The liquidity of the business has improved in 2021. This is reflected by
the increase in total current assets at a higher percentage compared to the increase in total current
liabilities (206.54% vs. 93.33%).

However, the main cause of the increase in total current assets is the increase in accounts receivable
(450.00%). This means that the ability of the business to pay its current liabilities is dependent on its
ability to collect the accounts receivable. This is because despite the increase in total current assets,
cash has decreased (-62.50%).

 Solvency (Long-term solvency): The solvency of the business has also improved in 2021. This is reflected
by the decrease in noncurrent liabilities (-50.00%). The business was able to settle in 2021 the currently
maturing loan of P180,000 from 2020.

This is further analyzed below:

2021 2020 (Decrease) Percent

Current portion 180,000 180,000 - 0.00%
Noncurrent portion 180,000 360,000 (180,000) -50.00%
Total Notes Payable 360,000 540,000 (180,000) -33.33%

 Capital structure: The main source of business financing in 2021 is equity, primarily from retained
profits. These are reflected by the following:

a. The increase in equity is higher compared to the increase in total liabilities (242.11% vs. 39.58%).
b. The main cause of the increase in equity is retained profit, rather than additional contribution by the
owner.

2021 2020 Increase Percent

TOTAL ASSETS 3,030,000 1,454,000 1,576,000 108.39%
TOTAL LIABILITIES 1,340,000 960,000 380,000 39.58%
TOTAL EQUITY 1,690,000 494,000 1,196,000 242.11%

PROFIT FOR THE YEAR 1,196,000 194,000 1,002,000 516.49%

Profitability
The profitability of the business has greatly improved in 2021 (increase of 516.49%).
a. Sales have increased at a higher rate than cost of goods sold (66.67% vs. 55.56%). This could mean that
unit costs have either decreased or sale prices have increased.
b. Depreciation expense increased, which could have been brought about by the acquisition of additional
depreciable assets during 2021, (PPE increased by 8.33%).
c. Bad debts expense increased with the increase in accounts receivable. This reflects the higher risk that
the business assumes as a consequence of extending more credit to customers.
Page 4 of 10
 d. Interest expense decreased mainly because of the decrease in notes payable.

Trend Analysis
A variation to the horizontal analysis is trend analysis. Under a trend analysis, the comparison of financial
information extends beyond two periods, normally five or more. The computational procedures in a trend
analysis are similar to a horizontal analysis.

Vertical Analysis
Vertical analysis involves the analysis of the financial statements of one reporting period. It is a proportional
analysis whereby each amount in the financial statements is shown as a percentage of another item.

For example, each amount in the balance sheet is stated as a percentage of total assets; each amount in the
income statement is stated as a percentage of gross sales. Financial statements stated in this manner are also
called "common-size financial statements."

ABD Company
Balance Sheet
As of December 31, 2020
2020 % of Assets
Cash 500,000 30.30%
Accounts Receivable 150,000 9.09%
Inventory 200,000 12.12%
Equipment 800,000 48.48%
TOTAL ASSETS 1,650,000

Accounts Payable 400,000 24.24%

Notes Payable 150,000 9.09%
Owner's Capital 1,100,000 66.67%
TOTAL LIABILITIES & OWNER'S EQUITY 1,650,000

Interpretations: The largest component of asset is Equipment with 48.48%. Accounts Receivable is the smallest
component at 9.09%. 33.33% of assets are financed by debt and the rest is financed by equity.

Page 5 of 10
 ABD Company
Income Statement
For the year ended December 31, 2020
2020 % of Sales
Sales 5,300,000
Cost of Goods Sold 3,850,000 72.64%
Gross Profit 1,450,000 27.36%
Operating Expenses
Rent 120,000 2.26%
Salaries 385,000 7.26%
Utilities 155,000 2.92%
Admin Expenses 545,000 10.28%
NET PROFIT 245,000 4.62%

Interpretations: Cost of Goods Sold is 72.64% of Sales. Gross Profit rate is 27.36% of Sales. Total Expenses is
22.72% of Sales. For every peso of Sales, the business earns P0.046. Gross Profit generates P0.274 for every
peso of Sales.

FINANCIAL RATIO ANALYSIS

Financial ratio analysis involves the computation of percentages, fractions or proportions using certain
formulas. This analysis is designed to emphasize the meaningful relationships between financial data.

Financial ratios are broadly classified into the following:

1. Liquidity ratios
2. Activity ratios (Asset management ratios)
3. Leverage ratios (Debt management ratios)
4. Profitability ratios

Liquidity ratios
Liquidity ratios provide a measure of the ability of a business to pay its liabilities, Examples include:
a. Current ratio - the most commonly used ratio in measuring the ability of a business to pay its short-
term debts.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

b. Quick ratio (Acid-test ratio) - a much stricter ratio used to measure the ability of a business to pay its
short-term debts.

𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒, 𝑛𝑒𝑡

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Page 6 of 10
 c. Working capital - similar to current ratio but measures the ability of a business to pay its short-term
debts by the excess or deficiency of current assets over current liabilities.

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Activity ratios (Asset management ratios)

Activity ratios provide a measure of how efficient a business is utilizing its resources. Examples include:
a. Inventory turnover - is a measure of the number of times inventory is sold and replenished during a
period. Generally, the higher the ratio, the better. However, an unusually high inventory turnover could
also indicate inventory shortages due to shortage in raw materials, production inefficiency,
underinvestment, poor inventory planning, and loss of sales.

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Where:
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐸𝑛𝑑𝑖𝑛𝑔
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
2

b. Days of inventory (Average sale period) - is a measure of the number of days inventory is held before
it is sold.

365 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

𝐷𝑎𝑦𝑠 𝑜𝑓 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

c. Accounts receivable turnover - is a measure of the number of times accounts receivable have been
collected during a period. It is an indication of the efficiency in collection.

𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

Where:

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒, 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 + 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒, 𝐸𝑛𝑑𝑖𝑛𝑔

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 =
2

d. Days of receivable (Average collection period) - is a measure of the average time to collect a receivable.

365 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

𝐷𝑎𝑦𝑠 𝑜𝑓 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 =
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Page 7 of 10
Leverage ratios (Debt management ratios)

Leverage ratios (Debt management ratios) provide a measure of the extent a business uses debt financing or
"leverage."

a. Debt ratio (Debt-to-asset ratio) - measures the proportion of assets financed through debt.

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

b. Equity ratio - measures the proportion of assets finance through equity.

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

c. Debt-to-equity ratio - indicates how much debt is used to finance the assets relative to the amount
pertaining to the owner(s).

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 − 𝑡𝑜 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Profitability ratios

Profitability ratios provide a measure of the performance of a business in terms of its ability to generate profit
from its resources.

a. Gross profit ratio - shows the relationship between sales and cost of goods sold.

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

b. Net profit ratio - measures profitability after considering all income and expenses.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

c. Return on assets - measures the profit generated in relation to the total resources available to the
business.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Page 8 of 10
 d. Return on equity (Return on net assets) - measures the profit generated in relation to the resources
invested by (or attributable to) the owners) of the business.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

PRACTICE:

Given the financial statements below, compute for the following Financial Ratios in 20x1 and write a short
interpretation of your answer.

1. Current Ratio
2. Quick Ratio
3. Working Capital
4. Inventory Turnover
5. Days of Inventory
6. Accounts Receivable Turnover
7. Days of Receivable
8. Debt Ratio
9. Equity Ratio
10. Debt-to-Equity Ratio
11. Gross Profit Ratio
12. Net Profit Ratio
13. Return on Assets
14. Return on Equity

Page 9 of 10
Practice Company
Balance Sheet
As of December 31, 20x0 and 20x1

ASSETS 20x1 20x0

Cash and Cash Equivalents 30,000 80,000
Accounts Receivable - net 1,672,000 304,000
Inventory 500,000 300,000
Prepaid Assets 48,000 50,000
Total Current Assets 2,250,000 734,000

Property, Plant, & Equipment 780,000 720,000

Total Noncurrent Assets 780,000 720,000

TOTAL ASSETS 3,030,000 1,454,000

LIABILITIES
Accounts Payable - net 980,000 420,000
Notes Payable (current portion) 180,000 180,000
Total Current Liabilities 1,160,000 600,000

Notes Payable (noncurrent portion) 180,000 360,000

Total Noncurrent Liabilities 180,000 360,000
TOTAL LIABILITIES 1,340,000 960,000

EQUITY
Owner's Capital 1,690,000 494,000
TOTAL LIABILITIES & EQUITY 3,030,000 1,454,000

Practice Company
Income Statements
For the year ended December 31, 20x1

2021
Sales (Credit sales amount to P3,200,000) 4,000,000
Cost of Sales (1,400,000)
GROSS PROFIT 2,600,000
Salaries Expense (780,000)
Utilities Expense (120,000)
Rent Expense (156,000)
Depreciation Expense (240,000)
Bad Debts Expense (72,000)
Interest Expense (36,000) Page 10 of 10
PROFIT FOR THE YEAR 1,196,000