MODULE 7

FINANCIAL STATEMENT
ANALYSIS
 INTRODUCTION

There are two key factors for business survival:

 Profitability
 Solvency

Profitability the business ability to produce a return. A measure of

efficiency. It is important if the business is to generate revenue
(income) in excess of the expenses incurred in operating that business.
Solvency of a business is important because it looks at the ability of
the business in meeting its financial obligations over long term.
Learning Objectives

At the end of the module students shall be able to

1. To use financial statements to evaluate an organization’s
 Financial performance
 Financial position.
2. To have a means of comparative analysis across time in terms of
 Intracompany basis (within the company itself)
 Intercompany basis (between companies)
 Industry Averages (against that particular industry’s averages)

3. To apply analytical tools and techniques to financial statements to obtain useful

information to aid decision making
What is Financial Statement Analysis?

Financial statement analysis involves analyzing the information

provided in the financial statements and evaluating a firm’s
financial performance to:
 Provide information about the organization’s:
 Past performance
 Present condition
 Future performance

 Assess the organization’s:

 Earnings in terms of power, persistence, quality and growth
 Solvency
Financial Statement Analysis

Defined as-
the calculation of a set of financial ratios designed to reveal the relative
strengths and weaknesses of a company as compared with other companies
in the same industry and to show whether its financial position is improving
or deteriorating overtime.
 It involves separating the components of the financial statements, to
determine their relationship to each other and to the past performance of
the business and to the industry as a whole.
 Two phases : Computation and Interpretation
Continued…

The computation phase determines the relationship between parts of the FS through the tools
used .
Whereas the interpretation phase gives meaning to the relationship of the parts to the base
figure. It shows the meaning of the business’ status in terms of operating results (IS) and
financial condition (BS). Knowing the relationship between parts is important for decision-
making purposes.
Objectives of Financial Statement Analysis

 Understand reported financial data

 Better manage a business
Provide a base for rational decision making (though the major focus of separate analyses
and types of decision under consideration will vary)
Make a reasonable assessment of future financial condition based on present and past
financial conditions and on best available estimate of future economic occurrences.

Decisions made on basis of financial analysis are important and accepting presented
financial data at face value is poor policy, the very reason why prepared financial statements
require some analysis as first step toward extracting information from presented data
Effective Financial Statement Analysis

❑ To perform an effective financial statement analysis, you need to be aware of the

so called organization’s individual factors such as:
▪ business strategy
▪ objectives
▪ annual report and other documents like articles about the organization in
newspapers and business reviews.
 Understand the nature of the industry in which the organization works called
the industry factor.
 Understand that the overall state of the economy may also have an impact on
the performance of the organization
 Effective…
 Benchmark is needed which means that in analyzing there must be some point of reference or criteria to
compare to.
A single year Financial Statement tells you very little. Say, we don’t have revenue of P1,000,000 is that good or
bad? A benchmark to compare it to is needed.

Last year revenue was only P800,000. I’m better than last year OR our competitor has P12,000,000 in revenue.
Our company don’t have his kind of market share we always miss the target/ projected Sales or Budget for the
year was P1,200,000, we are not as good as the budget, we are over the budget.

**Market share- is the percentage of total sales in an Industry generated by a particular company calculated by
taking the company's sales over the period and dividing it by the total sales of the industry over the same period.
This metric is used to give a general idea of the size of a company in relation to its market and its competitors.
The Market leader in an industry is the company with the largest market share.
Tools of Financial Statement Analysis
 Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader
picture of the organization in order to evaluate appropriately how that organization is performing.
The commonly used tools for financial statement analysis are:
❖ Financial Ratio Analysis-diagnostic tool that tells whether plans are properly executed.
Financial ratios play two roles in credit analysis:
▪ They help quantify the borrower’s credit risk before the loan is granted.
▪ Once granted, they serve as an early warning device for increased credit risk
❖ Comparative financial statements analysis:
 Horizontal analysis/Trend analysis-comparison of financial statements from one
period to another period of the same items. It predicts the growth and the degree of
growth for certain accounts.
 Vertical analysis –shows the relationships of all items to some base items within the
FS. For IS the base is Sales and for SFP, the base is Total Assets. Vertical Analysis
creates what is called a “Common-Size” analysis.
TOOLS…

Vertical analysis use SALES as the base figure (100%) because of the importance of sales to
operations.
In vertical analysis of Balance Sheet or Statement of Financial Position (SFP) use TOTAL
ASSETS as the base figure(100%) because the amount of total assets is the largest item which
also mean that percentages of Liabilities and Equity when added should equal to total assets
percentage which is 100%.
Formula:
Percentage of Base = Individual amount/ Amount of Base Item
TOOLS…

 Horizontal Analysis shows a comparison of the same line item in the Balance Sheet from
previous periods to current period.
 This method is useful for discovering trends in financial statement relationships, hence it
is commonly called trend analysis.
 While this method may not predict the future perfectly, understanding their implications
can provide useful insights for future operations of the business.
Formula:
Percentage of Change = (Current period amount – Base Year Amount) / Base Year Amount
 Sample Vertical Analysis of
Statement of Comprehensive Income
BSA Corporation
Comparative Income Statements
For the Periods Ended December 31, 2018 and 2019
Vertical Analysis
Year 2019 Year 2018 2019 2018
Net Sales (80% on credit) P800,000 P650,000 100% 100%
Cost of Goods Sold (320,000) (292,500) 40% 45%
Gross Profit 480,000 357,500 60% 55%
Operating Expenses:
Selling Expenses (120,000) (80,000) 15% 12.3%
General & Administrative Expenses (180,000) (87,500) 22.5% 13.5%
Total Operating Expenses (300,000) (167,500) 37.5% 25.8%
Net Operating Income 180,000 150,000 22.5% 23.1%
Finance Charges-Interest Expense (8,000) (5,000) 1% .8%
Net Income before Income taxes 172,000 145,000 21.5% 22.3%
Income Tax Expense (32%) (55,040) (46,400) 6.9% 7.1%
Net Income P116,960 P98,600 14.6% 15.2%
Earnings per Ordinary shares (10,000shares) P11.70 P10.96
 Sample Horizontal Analysis on the
Statement of Financial Position
BSA Corporation
Comparative Statements of Financial Position
As of December 31, 2018 and 2019
ASSETS 2019 2018 Horizontal Analysis LIABILITIES & EQUITY 2019 2018 Horizontal Analysis
Increase (Decrease) Increase (Decrease)
Current Assets Amount Percent Current Liabilities Amount Percent
Cash P20,000 P25,000 (5,000) (20%) Accounts Payable P20,000 P30,000 (10,000) (33.3%)
Accounts Receivable 40,000 28,000 12,000 42.9% Accrued Expenses 40,000 38,000 2,000 5.3%
Supplies 30,000 20,000 10,000 50% Income Tax Payable 10,000 12,000 (2,000) 16.7%
Merchandise Inventory 80,000 72,000 8,000 11.1% Total Current Liabilities P70,000 P80,000 (10,000) (12.5%)
Prepaid Expenses 10,000 15,000 (5,000) (33.3%) Non-Current Liabilities
Total Current Assets P180,000 P160,000 P20,000 12.5% 10% Mortgage Payable 20,000 50,000 (30,000) 60%
Non-Current Assets 10% Bonds Payable 60,000 0 60,000 0
Investment in Common Stocks 50,000 65,000 (15,000) (23.01%) Total Non-Current Liabilities 80,000 P50,000 30,000 60%
Land 100,000 75,000 25,000 33.3% Total Liabilities 150,000 130,000 20,000 15.4%
Building 200,000 200,000 0 0 SHAREHOLDERS’ EQUITY
Less: Accum. Depreciation-Bldg. (50,000) (40,000) (10,000) 25% Ordinary Shares, 10,000 issued, par P20 P200,000 180,000 20,000 11.1%
Total Non-Current Assets P300,000 P300,000 0 0 Share Premium-Ordinary 50,000 40,000 10,000 25%
Retained Earnings 80,000 110,000 (30,000) (27.3%)
Total Shareholders’ Equity P330,000 P330,000 0 0

Total Assets P480,000 P460,000 P20,000 4.3% Total Liabilities & Shareholders’ P480,000 P460,000 P20,000 4.3%
Equity
Continued…

Financial ratio analysis involves calculating and analysing ratios that use data from one, two
or more financial statements. The four categories of financial ratios are :
❖ Profitability Ratios—ability of the firm to earn an adequate return and control costs.
❖ Asset Utilization Ratios—How efficiently the firm’s assets are being utilized.
❖ Liquidity Ratios—focus on short term risk management. Liquidity is the ability of the firm
to meet its short term obligations when they falls due, an important ingredient to a smoothen
the continuous operation of the firm.
❖ Debt Utilization Ratios—focus on the capital structure and long-term risk management
 CLASSIFICATION SYSTEM

A. Profitability Ratios-It show how B. Asset utilization ratios-it show how effectively
profitable a company is. the company uses its Assets
1. Receivable turnover - In a 360 day year, how
1. Profit margin or Return on Sales – many times do our receivables turn over in terms
measures what fraction of sales goes to of sales. (times)
the bottom line.(%) 2. Average collection period-shows how many
2. Return on assets (investment)- what days in a year do we collect our receivables.
percent are we earning on the assets we (Days)
have invested in the firm (%). 3. Inventory turnover-how many times must we
replenish inventory to achieve this level of sales—
3. Return on equity-percent of return often, COGS is used instead of sales. (times)
the investor get from their 4. Fixed asset turnover. how many times would
investments.(%) our fixed assets turnover to represent this level of
sales (times)
5. Total asset turnover – no. of times total assets
is used.(times)
Ratios…

C. Liquidity ratios-it show how liquid a D. Debt utilization ratios –show how a
company is and how much money it has to meet company is managing or using debt
short-term needs.
1. Debt to total assets-debt as a percent of
1. Current ratio- how many times our current total assets—what part of assets is financed
assets, if liquidated, pay our current liabilities?
(times). Also known as “working capital ratio” with long-term debt. (%)
2. Times interest earned-a measure of
safety—how many times will our EBIT
2. Quick ratio or Acid-test ratio- excluding cover interest expenses? (times)
inventory, how many times will our current
assets, if liquidated, cover our current
liabilities?(times)
**inventory and prepayments are removed from
CA
ILLUSTRATION using 2019 DATA
A.PROFITABILITY RATIOS Industry Average

1. Profit Margin= Net Income / Net Sales = P116,960/P800,000 = 14.6% 6.7%

2. Return on Assets (ROA)= Net Income/Total Assets = 116,960/480,000 = 24.4% 10%

3. Return on Equity (ROE):

a. Net Income /Shareholder’s Equity=116,960/ 330,000=35.4% 15%

b. ROA/1-Debt/Total Assets=.244/1-150,000/480,000=.244/1-.3125=.244/.6875=35.4%

B. ASSET UTILIZATION RATIOS

10 times
1. Receivable Turnover = Credit Sales / Receivables = 640,000/40,000 = 16 times
2. Average collection period = Accounts Receivable/ Average Daily Credit Sales (ADCS)
36days
=40,000/1778= 22 days. ADCS= Credit Sales or Net Credit Sales/360 days
3. Inventory turnover= Sales / Inventory = P800,000/80,000 = 10 times 7 times

4. Fixed Asset turnover = Sales/ Fixed Assets = 800,000/250,000 = 3.2 times 5.4 times

5. Total Asset turnover = Sales / Total assets = 800,000/480,000 = 1.7 times 1.5 times
ILLUSTRATION using 2019 DATA
C. LIQUIDITY RATIOS Industry Average

1. Current ratio- = Current Assets / Current Liabilities = P180,000/ 70,000 = 2.6 : 1 2:1

2. Quick Ratio or Acid-test ratio = Current Assets-Inventory-Prepayments/Current Liabilities

1:1
=180,000-90,000=90,000/70,000=1.3:1

D. DEBT UTILIZATION RATIOS

33%
1. Debt to Total Assets= Total Debt/ Total Assets = P150,000/ 480,000 = 31%
2. Times Interest Earned = Earnings Before Interest & Taxes (EBIT)/ Interest Expense
7 times
=180,000/8,000 = 22.5times
 Interpreting Ratios

 Below are some points to consider in doing financial analysis:

1. Understand the strategic plan of the firm.
2. Compare ratios of other similar firms, be sure to compensate for firm size and other
differences.
3. Don’t jump to conclusions—ratios are only a starting point—you must figure out WHY
the ratio is what it is.

NOTE: BIGGER ISN’T NECESSARILY ALWAYS BETTER OR WORSE

PLS. DO 2018 FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION