FINANCIAL STATEMENT ANALYSIS

Financial analysis is designed to determine the relative strengths and weaknesses of a

company. Financial analysis concentrates on financial statement analysis, which highlights
the key aspects of a firm’s operations.

Financial statement analysis involves a study of the relationships between income

statement and balance sheet accounts, how these relationships change over time (trend
analysis or horizontal analysis), and how a particular firm compares with other firms in its
industry (bench-marking or vertical analysis).

Three basic tools in financial statements analysis.

1. Horizontal Analysis or Trend Analysis. 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 either an amount or a percentage.

𝑀𝑜𝑠𝑡 𝑅𝑒𝑐𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒−𝐵𝑎𝑠𝑒 𝑃𝑒𝑟𝑖𝑜𝑑 𝑉𝑎𝑙𝑢𝑒

Percentage Change =
𝐵𝑎𝑠𝑒 𝑃𝑒𝑟𝑖𝑜𝑑 𝑉𝑎𝑙𝑢𝑒

2. Vertical Analysis or Common Size Analysis. It is a technique for evaluating

financial statement data that expresses each item in a financial statement as a percent
of a base amount.

Base amount:
Balance Sheet - Total Assets
Income Statement - Net Sales

3. Ratio Analysis. This technique establishes relationships among financial

statement accounts at given date or period of time. These ratios analyze firm’s
liquidity, the use of leverage, asset management, cost control, profitability, growth,
and valuation.

Basic Rules in Computing Financial Ratios:

- When calculating a ratio using balance sheet amounts only, the numerator and
denominator should be based on amounts as of the same balance sheet date. The
same is true for ratios using only income statement numbers. Exception: calculation of
growth ratios.
- If an income statement amount and a balance sheet amount are sued at the same
time to calculate a ratio, the balance sheet amount should be expressed as an average
for the time period represented by the income statement amount.
 - If the beginning balance of a balance sheet account is not available and cannot be
computed from the given data, the ending balance of the account is sued to represent
the average balance.
- If sales and/or purchases are given without making distinction as to whether made in
cash or on credit, assumptions are made depending on the ratio being calculated:
➢ Turnover ratios: Sales and purchases are made on credit.
➢ Cash flow ratios: Sales and purchases are made in cash.
- As a rule, an operating year is assumed to have 360 days, unless specified otherwise.

Financial Ratios:

Tests of Liquidity:

Current Ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 It is a measure of adequacy of

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑡𝑖𝑒𝑠 working capital. It is the
primary test of liquidity to
meet current obligations from
current assets
Quick Ratio 𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠 It measures the number of
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 times that the current
liabilities could be paid with
the available cash and near-
cash assets (i.e., cash,
current receivables and
marketable securities)

Working Capital Activity Ratios

Receivables Turnover 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 It measures the number of

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 times receivables are
recorded and collected
during the period.
Average Age of Receivables 360 𝑑𝑎𝑦𝑠 It indicates the average
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 number of days during which
the company must wait
before receivables are
collected.
Inventory Turnover 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 It measures the number of
𝐴𝑣𝑒. 𝑀𝑒𝑟𝑐ℎ𝑎𝑛𝑑𝑖𝑠𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 times that the inventory is
replaced during the period.
 Average Age of inventory 360 𝑑𝑎𝑦𝑠 It indicates the average
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 number of days during which
the company must wait
before the inventories are
sold.

Raw Materials Turnover Cost of materials used / average RM inventory

Work In Process Turnover Cost of goods manufactured / average WIP
inventory
Finished Goods Turnover CGS / Average FG inventory
Normal Operating Cycle Ave. Age of Inventory + Ave. Age of
Receivables
Trade Payables Turnover Net Credit Purchases / Average Trade
Payables
Average Age of Trade Payables 360 days / Payables Turnover
Current Assets Turnover (CGS + OPEX) / Ave. Current Assets

Test of Solvency

Times Interest Earned EBIT / Interest Expense It determines the extent to

which operations cover
interest expense.
Debt-Equity Ratio Total Liabilities / Total Equity Proportion of assets provided
by creditors compared that
provided by owners
Debt Ratio Total Liabilities / Total Assets Proportion of total assets
provided by creditors
Equity Ratio Total Equity / Total Assets Proportion of total assets
provided by owners.

Test of Profitability

Return on Sales Income / Net Sales Determines the proportion of

sales that went into
company’s earnings.
Return on Assets Income / Average Assets Efficiency with which assets
are used to operate the
business
Return on Equity Income / Average Equity Measures the amount earned
on the owners’ or
stockholders’ investment.
 Earnings Per Share (Net Income – Preferred Measures the amount of net
Dividends) / Wtd. Ave. income earned by each
Common Shares Outstanding common share.

Market Tests

Price-Earnings Ratio Price Per Share / Earnings It indicates the number of

Per Share pesos required to buy P1 of
earnings.
Dividend Yield Dividend Per Share / Price Measures the rate of return in
Per Share the investor’s common stock
investments.
Dividend Pay-Out Dividend Per Share / It indicates the proportion of
Earnings Per Share earnings distributed as
dividends.

Stability Ratios

Fixed Assets to Total Equity Fixed Assets / Total Equity Measures the proportion of
owners’ equity to fixed assets.
Indicative of over or under
investment by owners and
weakness in trading the
equity.
Fixed Assets to Total Assets Fixed Assets (net) / Total Indicates the possible over-
Assets expansion of plant and
equipment
Sales to Fixed Assets (Plant Net Sales / Fixed Assets (Net) Tests roughly the efficiency of
Turnover) management in keeping plant
properties employed.
Book Value per share – CS Common Shareholders’ Measures recoverable
Equity / Common Shares amount by stockholders in the
Outstanding event of liquidation if assets
are realized at their book
values.
Times Preferred Dividend Net Income After Taxes / It indicates ability to provide
Earned Preferred Dividends dividends to preferred
stockholders.
Capital intensity ratio Total Assets / Net Sales Measures efficiency of the
firm to generate sales through
employment of its resources.
 Times fixed charges earned Net income before taxes & Measures ability to meet fixed
fixed charges / (Fixed charges charges
+ sinking fund payment)

Tests of Over-all Short-Term Solvency or Short-Term Financial Position

Working Capital Turnover Net Sales / Average Working Indicates adequacy of

Capital working capital to support
operation (sales)
Defensive Interval Ratio Current Liabilities / Cash & Measures coverage of
Cash Equivalent current liabilities
Payable Turnover Net Purchases / Average Measures efficiency of the
Accounts Payable company in meeting the
accounts payable.
Fixed assets to long-term Fixed Assets / Long-term Reflects extent of the
liabilities liabilities utilization of resources from
long-term debt. Indicative of
sources of additional funds.

Ratios indicative of income position

Rate of return on average Income / Average Current Measures the profitability of

current assets Assets current assets invested
Operating Profit Margin Operating profit / net sales Measures profit generated
after consideration of
operating costs.
Cash flow margin Operating cash flow / net Measures the ability of the
sales firm to translate sales to cash.