MODULE

Fundamentals of
Accountancy, Business,
and Management 2

Acctg2 Mr. Albert B. Martinez, LPT, MBA

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 ANALYSIS AND INTERPRETATION OF
FINANCIAL STATEMENT

LEARNING MODULE IN ACCTG2

A. Course Code – Title : ACCTG2 - Fundamentals of Accountancy, Business, and
Management 2
B. Module No – Title : Module 5 – ANALYSIS AND INTREPRETATION OF FINANCIAL
STATEMENT
C. Time Frame : Week 1 –2 Eight (8) Hours
D. Imperatives : 1,2,3,4,5,6,17,19,20,21,22,26,27,28,29,30,&31
E. Materials : Module 5, Acctg 2 textbook, writing materials, calculator, and
electronic gadgets
1. Overview
This module covers a short review about the different financial statements. It
discusses the different financial analysis tools and financial ratios used by entities in
analyzing their own financial statements. Module 5 also includes questions and activities
designed to test your knowledge and skills in the analysis and interpretation of financial
statement.

2. Desired Learning Outcomes

At the end of the module, you are expected to:
1. recall the different financial statements components by answering the pre-assessment
activity.
2. define the measurement levels, namely, liquidity, solvency and profitability. ABM_FABM12-
Ig-h12
3. perform horizontal and vertical analysis on the financial statements. ABM_FABM12-Ig-h13
4. 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. ABM_FABM12-Ig-h14
5. appreciate the importance of the analysis and interpretation of financial statements as
applied in daily-lives activities.

3. Content/Discussion
Opening prayer

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 Lesson 5: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT

Financial statement (FS) analysis is the process of evaluating risks, performance, financial health,
and future prospects of a business by subjecting financial statement data to computational and
analytical techniques with the objective of making economic decisions (White et.al 1998).There are
three kinds of FS analysis techniques:
- Horizontal analysis
- Vertical analysis
- Financial ratios

Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial
statement data over a period of time with the purpose of determining the increase or decrease that
has taken place (Weygandtet.al 2013). This will reveal the behavior of the account over time. Is it
increasing, decreasing or not moving? What is the magnitude of the change? Also, what is the
relative change in the balances of the account over time?
- Horizontal analysis uses financial statements of two or more periods.
- All line items on the FS may be subjected to horizontal analysis.
- Only the simple year-on-year (Y-o-Y) grow this covered in this lesson.
- Changes can be expressed in monetary value (peso) and percentages computed by using the
following formulas:
• Peso change=Balance of Current Year-Balance of Prior Year
• Percentage change= (Balance of Current Year-Balance of Prior Year)/(Balance of Prior Year)
• Example:

2018 2019
Sales 200,000 250,000

✓Peso change = P250,000 – P200,000 = P50,000

✓Percentage change = (P250,000 – P200,000) / P200,000 = 42.86%
✓This is evaluated as follows: Sales increased by P50,000. This represents growth of 42.86% from
2018 levels.

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Vertical analysis, also called common-size analysis, is a technique that expresses each financial
statement item as a percentage of a base amount (Weygandt et.al. 2013).
- For the Statement of Financial Position, the base amount is Total Assets.
• Balance of Account / Total Assets.
• From the common-size SFP, the analyst can infer the composition of assets and the company’s
financing mix.
• Example:

Account Amount %
Cash 200,000 200,000/1,400,000 = 14.3%
AR 400,000 400,000/1,400,000 = 28.6%
Inventory 250,000 250,000/1,400,000 = 17.9%
Equipment 550,000 550,000/1,400,000 = 39.3%
Total Assets 1,400,000 1,400,000/1,400,000 = 100%

Accounts Payable 300,000 300,000/1,400,000 = 21.4%

Notes Payable 400,000 400,000/1,400,000 = 28.6%
Owner’s Capital 700,000 700,000/1,400,000 = 50.0%
Total Liabilities and Equity 1,400,000 1,400,000/1,400,000 = 100%

✓The above may be evaluated as follows: The largest component of asset is Equipment at 39.3%.
Cash is the smallest component at 14%. On the other hand, 50% of assets are financed by debt and
the other half is financed by equity.

- For the Statement of Comprehensive Income, the base amount is Net Sales.
• Balance of Account / Total Sales.
• This will reveal how “Net Sales” is used up by the various expenses.
• Net income as a percentage of sales is also known as the net profit margin.
• Example
%
Net Sales 900,000 900,000/900,000 = 100%
Cost of Sales 400,00 400,000/900,000 = 44.4%
Gross Profit 250,000 250,000/900,000 = 55.5%
Operating Expenses 500,000 500,000/900,000 = 22.2%
Net Income 300,000 300,000/900,000 = 33.3%
✓The above may be evaluated as follows:
• The cost of sales is 44% of sales.
• The company has a gross profit rate of 55.5%.
• Operating expenses is 22% of sales.
• The company earns income of P 0.33 for every peso of sales. Gross profit generated for every peso
of sale is P 0.555

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Ratio analysis expresses the relationship among selected items of financial statement data. The
relationship is expressed in terms of a percentage, a rate, or a simple proportion (Weygandtet.al.
2013). A financial ratio is composed of a numerator and a denominator. For example, a ratio that
divides sales by assets will find the peso amount of sales generated by every peso of asset invested.
This is an important ratio because it tells us the efficiency of invested asset to create revenue. This
ratio is called asset turnover. There are many ratios used in business. These ratios are generally
grouped into three categories: (a) Liquidity Ratios, (b) Solvency Ratios, and (c) Profitability Ratios.

A. Liquidity is the capacity of a company to pay its currently maturing obligations. These would
require a good amount of cash and other liquid assets like accounts receivable, inventory, trading
securities and prepaid assets. Liquidity ratio is very important to the short term creditors of a
company. These would determine if the borrowing company is in a position to pay the borrowed
principal and interest when they fall due. A good liquidity position would encourage banks or
financial institutions to lend while a bad liquidity position may scare of potential creditors. The
following are the different liquidity ratios:

1. Working Capital is the difference between current assets and current liabilities. This is one of
the simplest liquidity ratios. A positive working capital is preferred because it would mean that
there is enough current assets to pay all the current liabilities at the moment. On the other hand, a
negative working capital is to be avoided because it would mean that the company would surely
default on some of their liabilities. Shown below is an example of working capital.

Year 2018
Current Assets 1,200,000
Less: Current Liabilities 700,000
Working Capital 500,000

Year 2019
Current Assets 1,400,000
Less: Current Liabilities 760,000
Working Capital 640,000

For both periods, the Company has a positive working capital. This is something good but
comparing the two periods together, we can conclude that the company is in better liquidity
positions (working capital wise) in 2019 than in 2018.

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2. Current Ratio is the quotient of current assets divided by the current liabilities of the company.
As much as possible a “whole number” current ratio is preferred. Shown below is an example of
current ratio.
Year 2018
Current Assets 1,200,000
/
Current Liabilities 700,000
Current Ratio 1.71

Year 2019
Current Assets 1,400,000
/
Current Liabilities 760,000
Current Ratio 1.84

It can be seen that the company has whole number current ratios for the two periods. This is
something positive. But comparing the two periods together, the company has a better current ratio
in 2019 than in 2018.

3. Acid Test Ratio is a more strict variation of the current ratio formula. It removes inventory and
prepaid expenses from the numerator components. Only cash, receivables and trading securities
(also known as quick assets) will be left. Generally, the quick assets are more liquid than inventory
and prepaid expenses. As much as possible, a whole number acid test ratio should be desired by
companies. Shown below is an example of acid test ratio.

Year 2018 Cash AR Trading Securities

Quick Assets 1,000,000 ( 500,000 + 300,000 + 200,000)
/
Current Liabilities 700,000
Current Ratio 1.42

Year 2019 Cash AR Trading Securities

Quick Assets 1,100,000 ( 530,000 + 340,000 + 230,000)
/
Current Liabilities 760,000
Current Ratio 1.44

It should be noted that the company has a positive acid test ratios for the two years concerned. It
means that it really has the capacity to pay its currently maturing obligations thru its quick assets.
Comparing both years though would reveal that the company was better off in 2019 than in 2018,
acid test ratio wise.

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4. Accounts Receivable Turnover Ratio measures the frequency of conversion of the company’s
accounts receivable to cash. It measures how many times the company was able to collect its
accounts receivable from its customers. For the numerator, the company should make use of the
total net credit sales. But this data is not usually present in the financial statements of most
companies. As an alternative, the company could make use of the total net sales. For the
denominator, the average accounts receivable can be compared by adding the beginning and ending
balances of the accounts receivable and dividing it by two. In cases where the beginning balance of
the accounts receivable is not present, especially if it is the first year of operations the company can
make use of the ending balance of accounts receivable directly. As much as possible, the goal of
every company is to have a higher accounts receivable turnover ratio. Shown below is an example
of accounts receivable turnover ratio.

Year 2018
Net Sales 6,000,000
/
Average A/R 300,000
A/R Turnover Ratio 20 times

Year 2019
Net Sales 6,800,000
/
Average A/R 320,000 ( 300,000 + 340,000)/ 2
A/R Turnover Ratio 21.25 times

Comparing the computed A/R Turnover Ratios for the two years, it can be seen that the company
has a higher ratio for 2019. This can be attributed to a better performance from its collection
department.

5. Average Collection Period states the usual number of days that it would take before the
company would be able to collect a certain group of receivables. This ratio is usually connected to
the previous accounts receivable turnover ratio. In fact, the AR turnover ratio itself is a component
for the computation of the average collection period. It serves as denominator in the formula. For
the numerator, the company makes use of either 360 or 365 days. This would depend on the policy
of the company. As much as possible, the goal is to have a shorter average collection period. This
would mean that the company is efficient in collecting their outstanding accounts receivables from
their clients. A shorter average collection period would mean that the company would have more
immediate cash that can be used in their operations. Shown below is an example of average
collection period using 365 days.

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Year 2018
Days 365
/
A/R Turnover Ratio 20
Average Collection Period 18.25 days

Year 2019
Days 365
/
A/R Turnover Ratio 21,25
Average Collection Period 17.18 days

By showing a shorter average collection period for 2019, it would mean that the collection
department has increased its efforts to collect the company’s receivables as they fall due. It should
be noted that the conclusion for the AR turnover ratio would be the same for the average collection
period. This is due to the fact that the AR turnover ratio is a component of the formula for the
average collection period. It can be seen in the computation that the company has better AR
turnover ratio and average collection period for the year 2019 than in 2018.

6. Inventory turnover ratio measures the number of times the company was able to sell its entire
inventory to customer during the year. As much as possible, the goal is to have a higher turnover
ratio. By having such, it would mean that the company is being more effective in selling its
inventory to customers. Unsold goods for a long period of time may lead to inventory obselence.
This would also tie up the company’s cash resources to its inventory. This scenario is not favorable
for a company’s liquidity situation. The numerator for this formula would be the company’s cost of
sales. The computation of the average inventory would follow the same concept of computing the
average receivable in the earlier ratio. Shown below is an example of inventory turnover ratio.
Year 2018
COS 1,400,000
/
Average Inventory 100,000
Inventory turnover ratio 14 times

Year 2019
COS 1,700,000
/
Average Inventory 110,000
Inventory turnover ratio 15.45 times
(Assumed that the inventory for 2018 was 100,000 and for 2019 was 120,000)

It can be seen in the computation that the inventory turnover increased for the year 2019. It means
that the sales department was able to push their products more to their customers.

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7. Average Days in Inventory states that the number of days that it would take before a group of
inventory will be entirely sold by the company. This follows the same concept in computing the
average collection period. The company make use of 360 or 365 days as their numerator and will
make use of the inventory turnover ratio for its denominator. The goal is to have shorter average
days in inventory. A shorter amount would mean that the cash of the company is not being tied to
its inventory for a very long period of time. Shown below is an example of average days in inventory.

Year 2018
Days 365
/
Inventory Turnover 14
Average days in inventory 26.07 days

Year 2019
Days 365
/
Inventory Turnover 15.45
Average days in inventory 23.62 days

The average days in inventory of this company improved in 2019. This is due to the fact that the
inventory turnover ratio for 2019 also improved.

8. Number of days in operating cycle measures on how long it would take for the company to
transform its inventory back to cash. This is the combination of the average collection period and
the average days in inventory. The goal is to always have a shorter number of days in operating
cycle. A shorter number would indicate that the company would have additional cash at an earlier
time. Shown below is an example of number of days in operating cycle.

Year 2018
Collection Period 18.25
+
Average age of inventory 26.07
Number of days in operating cycle 44.62 days

Year 2019
Collection Period 17.18
+
Average age of inventory 23.62
Number of days in operating cycle 40.80 days

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A comparison between the two periods will show that there was an improvement of at least 4 days
in their operating cycle. It means that the company improved as a whole when it comes to selling
their products and collecting their receivables.

B. Solvency measures the capability of an entity to pay the long term obligations as they fall due.
Creditors of the company’s long term notes payable and bonds payable will be interested in
knowing its solvency status. There at least three kinds of solvency ratios.

1. Debt to total assets ratio

As the term implies, this is just the proportion between the total liabilities of the company with its
total assets. The debt ratio shows how much of the assets of the company were given by the
creditors. As much as possible, current and prospective creditors would want a very low debt to
total assets ratio. There is a bigger probability of collection in the future if there are fewer liabilities
to pay. To get the debt ratio, the total liabilities is simply divided by the total assets. Shown below is
an example of debt to total assets ratio.

Year 2018
Total Liabilities 1,200,000
/
Total Assets 2,000,000
Debt to total assets ratio .6

Year 2019
Total Liabilities 1,400,000
/
Total Assets 2,400,000
Debt to total assets ratio .58

Comparing the data for two years involved, it can be seen that there is a light decrease in the debt
ratio of the company. It means that the company is more solvent in 2019 than in 2018.

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2. Debt to equity ratio
Instead of assets, the debt to equity ratio compares the liabilities of the company with its equity. A
smaller debt to equity ratio would indicate a healthier solvency position in the company. To get the
debt equity ratio, the total liabilities of the company will be divided by its total shareholders’ equity
of owner’s equity. Shown below is an example of debt to equity ratio.

Year 2018
Total Liabilities 1,200,000
/
Total Equity 800,000
Debt to total assets ratio 1.5

Year 2019
Total Liabilities 1,400,000
/
Total Equity 1,000,000
Debt to total assets ratio 1.4

Comparing the debt equity ratio of the company for the two periods concerned would mean that
the company was more solvent in 2019 than it was in 2015.

3. Times interest earned ratio shows the proportion between the Earning Before Income Taxes
(EBIT) of the company and its interest expense. It is an indicator on how many times can EBIT
covers its finance cost of borrowing. This is related to the solvency situation of the company
because interest expense is always a part of long term borrowing. Creditors will charge interest
during the time that the loan or borrowing is not yet paid. As much as possible, companies would
want to have a higher times interest earned ratio. A small or decimal ratio would indicate that it is
not worthy to borrow money from other if the company would not be able to generate enough
income to cover for it. To compute for this ratio, the EBIT of the company is simply divided by its
interest expense for the year. Shown below is an example of times interest earned ratio.
Year 2018
EBIT 4,000,000
/
Interest Expense 500,000
Times Interest Earned 8

Year 2019
EBIT 6,000,000
/
Interest Expense 2,000,000
Times Interest Earned 3

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It can be seen that the times interest earned decrease for the year 2019. From “8”, it went down to
“3”. This is something negative when it comes to the solvency of the company. Though there was an
increase in EBIT of the company in 2019, there was an ever bigger jump in the interest expense for
the year.

C. Profitability
One of the primary reasons why stockholders invest in a certain company is the change of earning
profits. Investors make use of different profitability ratios in choosing from diverse investment
opportunities available. The absolute value of the net income after tax is not sufficient basis in
determining the earning potential of a certain company. This must be understood in relation to
other item s in the financial statements. There are at least five profitability ratios that can be used.

1. Gross Profit Ratio

As term implies, this is the proportion of the gross profit of the company with its net sales. Gross
profit is the difference between the net sales of the company and its cost of sales. As much as
possible, the company would want to have a bigger gross profit ratio. It means that it was able to
generate more sales from the smaller cost of sales that it has. To compute for the gross profit ratio,
the gross profit is just divided by the net sales of the company. To get the net sales of the company,
the sales return and allowances and the sales discount are both deducted from the gross sales.
Shown below is an example of gross profit ratio.

Year 2018
Gross Profit 5,000,000
/
Net Sales 6, 400,000
Gross Profit Ratio 78.13%

Year 2019
Gross Profit 5,500,000
/
Net Sales 7,200,000
Gross Profit Ratio 76.39%

There was a slight decrease in the gross profit ratio of the company for the year 2019. This is
something to be avoided or at least be minimized. The gross profit ratio can be improved by
continuously finding inventories with lower cost, without sacrificing its equality.

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2. Profit Margin Ratio
The profit being mentioned here is the net income after tax. This ratio measures the proportion
between the net income after tax and the net sales of the company. This is more precise measure of
the company’s profitability because it has already considered the operating expenses and other
expenses of the entity. Like the gross profit ratio, companies would want to have a high profit
margin ratio. This ratio can be computed by dividing the company’s net income after tax with the
company’s net sales. Shown below is an example of profit margin ratio.
Year 2018
Net income after tax 1,800,000
/
Net Sales 6, 400,000
Profit Margin Ratio 28.13%

Year 2019
Net income after tax 1,500,000
/
Net Sales 7, 200,000
Profit Margin Ratio 20.83%

Comparing the ratio for the two year involved, there is an obvious decline in the profit margin ratio
for the second year. This can be attributed to the lower net income after tax coupled by an increase
in net sales.

3. Operating Expenses to Sales Ratio

Operating expenses, aside from the cost of sales, is one of the biggest expenses of every company. It
can be further classified into general and administrative expenses and selling expenses. These
expenses are needed to generate sales for the period. This ratio can be computed by dividing the
operating expenses by the total net sales. This ratio should be minimized as much as possible. The
goal is to generate as much sales with the minimum possible operating expenses. Shown below is
an example of operating expenses to sales ratio.
Year 2018
Operating Expenses 1,500,000
/
Net Sales 6, 400,000
OE to Sales Ratio 23.44%

Year 2019
Operating Expenses 1,100,000
/
Net Sales 7, 200,000
OE to Sales Ratio 15.28%

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Comparing the date for the two years, it can be seen that there was a huge improvement in the
operating expenses to sales ratio. This can be attributed to a lower operating expenses and the
increase in net sales.

4. Return on Investment Ratio

This return on investment ratio has two variations. One is the return on assets and the other is the
return on shareholder’s equity. They only differ on the denominator that will be used in the
computation.

4.1 Return on Assets

Before profits can be realized, certain investments need to be made. In this case, assets will be used
for the different projects of the company. The goal is to generate as much profit bases on the
available assets during the year. Thus, a higher return on assets is to be desired. To compute for the
return on assets, the net income after tax is to be divided by the average total assets for the year.
The average total assets can easily be computed by adding the starting and ending balance of assets
and dividing it by two. Shown below is an example of return on assets.

Year 2018
Profit 1,800,000
/
Avarage Total Assets 2, 000,000
Return on Assets .90

Year 2019
Profit 1,500,000
/
Avarage Total Assets 2, 200,000
Return on Assets .68

It can be seen that there was a decline in the return on assets of the company. This is something
negative. This can be attributed to a lower point and higher average total assets. It means that is
taking more assets to generate the same under of profits for the company.

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4.2 Return on Equity
This is a slight variation of the earlier formula. In this case, it is the average stockholder’s equity
that will be used as a denominator. This is a more specific computation of a company’s profitability
because the denominator being used is the one coming from the stockholders alone. In return on
assets, the average total assets being used may come predominantly from creditors.

Year 2018
Profit 1,800,000
/
Avarage SHE 800,000
Return on Equity 2.25

Year 2019
Profit 1,500,000
/
Avarage SHe 900,000
Return on Equity 1.67

It can be seen that there was a decline in the return on equity for the second year. This is something
negative. This can be attributed to a lower net income after tax for the second year and a larger
return on equity.

5. Asset Turnover Ratio measures the correlation between the assets owned by the company and
the net sales being generated by such properties. It can easily be computed by dividing the net sales
during the period by the average total assets for the year. Like other profitability ratios, the goal is
to have a higher asset turnover ratio.

Year 2018
Net Sales 6,400,000
/
Avarage Total Assets 2, 000,000
Asset Turnover Ratio 3.2

Year 2019
Net Sales 7,200,000
/
Avarage Total Assets 2, 200,000
Asset Turnover Ratio 3.27

It can be seen that there is a slight increase in the asset turnover ratio. This is something positive.
This can be attributed to a bigger net sales generated for the second year.

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 Generalization:
A good way to do some ratio and trend analysis work is to prepare both horizontal and vertical
analyses of the income statement. Both analyses involve comparing income statement accounts to
each other in dollars and in percentages. Moreover, financial ratio analysis helps a business in a
number of ways. The importance and advantages of financial ratios are given below:

(I) Ratios help in analyzing the performance trends over a long period of time.
(II) They also help a business to compare the financial results to those of competitors.
(III) Ratios assist the management in decision making.
(IV) They also point out problem and weak areas along with the strength areas.
(V) Ratios to help to develop relationships between different financial statement items.
(VI) Ratios have the advantage of controlling for differences in size. For example, two businesses
may be quite different in size but can be compared in terms of profitability, liquidity, etc., by the use
of ratios.

In addition, financial ratio analysis is aimed to assess the financial performance and determine the
financial position of an organization through its profitability, liquidity, activity, leverage and other
relevant indicators. There are many groups and individuals with diverse and conflicting interests
but want to know about the business performance or position. In the following table major users of
financial statements with their areas of interest are described.

(1) Bankers and Lenders: Use profitability, liquidity and investment because they want to know
the ability of the borrowing business in regular scheduled interest payments and repayments of
principal loan amount.
(2) Investors: Use profitability and investment because they are more interested in profitability
performance of business and safety & security of their investment and growth potential of their
investment.
(3) Government: Use profitability because government may use profit as a basis for taxation,
grants and subsidies.
(4) Employees: Use profitability, liquidity and activity because employees will be concerned with
job security, bonus and continuance of business and wage bargaining.
(5) Customers: Use liquidity because customers will seek reassurance that the business can
survive in the short term and continue to supply.
(6) Suppliers: Use liquidity because suppliers are more interested in knowing the ability of the
business to settle its short-term obligations as and when they are due.
(7) Management: Use all ratios because management is interested in all aspects i.e., both financial
performance and financial condition of the business.

4. For your assignment, read and review chapter 1-6 on your Acctg2 textbook in preparation
for your first quarterly examination.

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 Closing Prayer

F. References

Beticon, Domingo , and Yabut (2016). Fundamentals of Accountancy, Business and Management 2.
Vibal Group, Inc.

https://www.academia.edu/36828179/Teaching_Guide_for_Senior_High_School_FUNDAMENTALS_
OF_ACCOUNTANCY_BUSINESS_AND_MANAGEMENT_2_SPECIALIZED_SUBJECT

http://www.financialaccountancy.org/financial-ratios/uses-of-financial-ratio-analysis/

https://www.dummies.com/business/accounting/horizontal-and-vertical-analysis/

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Critiqued by:

Comments:

For Senior High School Use:

Identify all imperatives integrated in this modules (Graduate Attributes, SHS Objectives,
Strand Outcomes, Core Values, DepEd Competencies

1,2,3,4,5,6,17,19,20,21,22,26,27,28,29,30,&31

Pilot Tested by:

Name:
Date Started:
Date Finished:

Findings of the Author:

Recommendation of the Academic Chair / Principal:

2nd Pilot Test (after revision):

Name:
Date Started:
Date Finished:

Findings of the Author:

Recommendation of the Academic Chair/ Principal:

Fu n d a m e n t a l s of Ac c o u nt a n c y, B u s i n es s, a n d Ma n a g e m e n t 2 17
MO DU L E 5