MODULE 2: FINANCIAL STATEMENTS ANALYSES AND THEIR IMPLICATIONS TO

MANAGEMENT
R.O. MARAMBA

OBJECTIVES:

At the end of this topic, the students will be able to:

1. Know and explain the various ways financial statements are analyzed
2. Know and explain the objectives of financial statement analyses
3. Know the steps in doing financial statement analyses
4. Know and explain the limitations of financial statement analyses
5. Perform the steps in doing financial statement analyses by applying the different
techniques, interpretations, conclusions, and draw the implications based on the
results of the applications.

Objectives of Financial Statement Analyses

Fundamentally, analyses of financial statements are set to answer a wide-range of
questions of users. These users have diverse concerns, and objectives. Hence, they
have different priorities. However, all these users have common requirements where the
very objective of financial statements analyses originate.

1. Profitability. This pertains to the ability of the firm to yield a sufficient amount of
return on company sales assets and invested capital. It also refers to the firm's
capacity to generate earnings vis-à-vis its expenses and other relevant costs
incurred during a specific period.
2. Liquidity and Stability. Liquidity is also referred to as working capital position or
short-term financial position. It is the ability of the firm to meet or pay its current
or short-term maturing obligations.
3. Asset utilization or Activity. This pertains to how efficient the company is in
managing its resources. It also refers to the firm's speed or pace in turning over
accounts receivable, inventory and long-term assets. This reveals the frequency
of the firm in selling its products or in collecting its receivable. As far as fixed or
long-term assets are concern, it reveals how the company uses their fixed assets
to yield revenue.
4. Debt-utilization or Leverage. This pertains to the overall debt status of the
company. It measures the degree of how the firm is financed. The debt is
evaluated using other variables like assets, equity and earning power.

Limitations of Financial Statement Analysis

The primary purpose of financial statement analysis is to examine the present, as
well as past, financial position (SFP) and results of operations (Income Statement) of
the firm in order to determine the best suitable estimate and predict the future state and
performance of the company. With this in mind, it would be fair to state that
interpretations of financial ratios are not ultimately conclusive. Results from the analysis
are refutable.
 In addition to this, the main object (the financial statement) used for the analysis is
also subject to limitations. These limitations, if not carefully considered, can ultimately
bring about wrong decisions. The inherent limitations of the financial statements among
other things may stem from:

1. Its failure to consider changes in the purchasing power, inconsistencies as

well as dissimilarities in the accounting principles, policies and procedures
used by the firms in the industry.
2. Its failure to consider changes in the purchasing power of currencies.
3. The age of the financial statements is a limitation. The older it gets, the less
reliable it becomes thus, considered as a risk management tool.
4. Failure to read and understand the information in the Notes to the financial
statements may obscure managers in evaluating the degree of risk.
5. Financial statements that have not undergone external auditing procedures
may or may not conform with the Generally Accepted Accounting Principles
(GAAP) and standards thus; usage of these statements may lead to
erroneous analysis, and ultimately erroneous decisions.
6. Financial statements that have not undergone external auditing procedures
may prove to be inaccurate or worse, fraudulent hence, do not fairly present
the company's financial condition. Financial measurements from the analysis
of these companies are not dependable and not conclusive.
7. Audited statements do not guarantee accuracy.

Lastly, the reality that a firm is trading in the stock exchange and that its financial
statements are readily available does not guarantee that the company in question is
financially stable and credit-worthy.

Practical Steps Proposed in Analyzing Financial Statements:

There are various ways by which the analysis of financial statements can be done.
The following proposed steps in carrying òut the analysis may be used:
1. Determine which of the following objectives, just discussed, would be the
coverage of the analysis. Is it to evaluate profitability, liquidity, asset activity,
or debt-utilization? Alternatively, are you going to evaluate all of them?
2. The analysis done may cover not only the subject firm but could involve other
firms belonging to the same industry. It would be wise to learn about the
retrospective, current, as well as the prospective conditions of the industry.
Other external variables that may have a bearing or significant effect on the
industry may also be considered. This may include socio-economic and
political variables. New laws or mandates, financial in nature, changing or
modifying the industry requirements may also be considered. Knowledge of
average prices or market values of commodities, shares of stocks and debt
instruments in the industry may be considered.
3. Get to know the firm you are analyzing. Know their mission and vision. It may
prove to have a bearing on your financial analysis. Know their strategic plans.
Know where the company wishes to be. Know their status in the industry.
 Know company financial projections. Know all things about the firm which you
consider relevant and may have a bearing on your analysis.
4. ASSESS/ANALYZE the financial statements. The analyses should cover the
salient areas namely, the profitability, liquidity or solvency, stability, and
operational efficiency of the firm. One may employ the following methods:
5. After finishing the “dirty” work of computing the trends and ratios, comes the
more important task. INTERPRET the results of the computations and ratios.
6. Draw CONCLUSIONS from the interpretations made in step five. The
conclusions must take into consideration the objectives you have set up in
step number 1.

HORIZONTAL ANALYSIS OF COMPARATIVE STATEMENTS

In the field of accounting, it has been a requirement by the Generally Accepted

Accounting Principles to present comparative financial statements for the current year
and the previous year. For obvious reasons, this would facilitate comparison of the
company's financial position and results of operation. This serves as a sound start for
analyzing financial statements by horizontal analysis.
In horizontal analysis, the balance of the accounts in the financial statements of the
previous year is subtracted from the current year. This would result to a change, either a
growth or a reduction. The percentage of change is then computed as follows:

Percentage of change = Amount of growth/reduction or change x 100

Amount in the base year or previous year

The concept is better presented in the illustrative example of Riel Corporation.

Financial Statement Analyses, Interpretations and Conclusions-Riel Corporation
The following analyses, interpretations and conclusions are made in terms of:

Liquidity and Solvency:

To measure liquidity you can focus more closely on the working capital items of
the statements of financial position (SFP). In doing the analysis, salient changes must
be given due consideration and must be accounted for. One must be able to explain to
management the cause(s) of such change. Part of being thorough with the analysis is
by establishing links between related accounts across financial statements. For
instance, the increase or decrease in accounts receivable may have a bearing on the
sales or the increase/decrease in inventory may have a bearing on the cost of sales.

In our example, it can be noted that there is an increase in the current assets
(9.91%)and current liabilities (16.17%).However, we can see that the increase in the
current assets is less than the increase in the current liabilities. The increase in the
current assets is mainly due to the increase in the trade and other receivables (18%)
and inventory of (12.5%). This could be related to the increase in sales (10.07%). Note
that the increase in receivables and inventory is much higher than the increase in sales.
This can be interpreted to mean that the inventory and receivables had a slow
conversion into cash.

It is also worth noting that the increase in inventory could be related to the marked
increase in the cost of goods sold or 12.40%. It implies that the purchase cost of
inventories have increased. This must be investigated. Along with this, you may want to
consider accounting for the notable increase of unearned revenues by 30.38%. The
increase in trade & other payables (14.04%) can also be accounted for by considering
its bearing on the cost of good sold. You may want to relate this to Riel's purchases.

Based on the surface findings and analysis, you can infer that there is a drop in
the liquidity status of Riel Corporation as of period ending 2015 vis-à-vis 2014.

Stability or Long-term Financial Position:

Under this position, you can focus your analysis by considering Riel's capital
structure. It can be noted that the growth in total liabilities (1.57%) is much lower than
the growth of the firm's total shareholders' equity (10.23%). This can be accounted for
by the marked increase in the firm's retained earnings, which caused the notable growth
of the total shareholders' equity. The growth in the retained earnings could be attributed
to the firm's net income growth of 7.57%.

Riel's property, plant and equipment's carry a value diminished by 18.46%. This
could be accounted for by considering depreciation of the fixed assets.

Based on the results of the analysis it could be inferred that Riel Corporation has
stabilized its long-term financial position.

Operating Efficiency and Profitability:

In analyzing the firm's profitability the income statement is used. There is a

marked favorable increase in sales (10.07%), however this is negated by the greater
increase in the cost of goods sold (CGS) (12.40%). This occurrence could be accounted
for by looking at elements that made up the sales revenue and the cost of goods sold.
The sales revenue consists of a good mixture of two elements namely, selling price and
sales volume. The cost of good sold is made up mainly of current purchases and
inventories. The relatively lower sales growth vis-a-vis CGS growth may be interpreted
to mean that the company is failing to adequately adjust their selling price to cover the
CGS. The higher growth rate of the GS may be interpreted that the company may have
acquired inventories at higher prices and may have failed to consider other suppliers
who may offer much lower or more reasonable prices.
 The decrease in administrative expenses (-2.82%) is noteworthy; this may be
interpreted to mean that the company has efficiently and successfully controlled its
expenses. In presenting your report to management, disclose the reason for this
marked decrease in administrative expenses. Management may need it to further
improve their cost controlling systems and use the same system to lower selling
expenses for the succeeding periods. The decrease in the notes payable (17.78%) may
indicate early payment of the debt, which resulted in a decrease interest expense (-
4.66%).

In general, it can be inferred that the operating performance of Riel Corporation

has
proven to be favorable as supported by the increase in net income of 7.57%.

VERTICAL ANALYSIS using COMMON SIZE STATEMENTS

Vertical analysis uses percentages/ratios that present the relationship of the

different accounts or items in the financial statements. The analyst chooses a base
figure or amount equal to 100 percent and calculates each item's percentage. For the
statement of financial position, the base used is the total assets, and for the income
statement, the net sales or net revenue is the base. In essence, vertical analysis
presents the relative size of an account or item in proportion to the whole (which is the
base). The outcome of the percentages is presented in the common-size statement.

The common-size statements are sometimes called component percentage or

100
percent statements.

Through the common-size statements, management can have a better

understanding of the changes to the total assets (for SFP) or net sales/net operating
revenue (for income statement) that have transpired from one period to the next. This
statement also aids management to assess their financial position as well as the results
of operation by comparing their statements with other companies belonging in the same
industry.

Practical Tips in Assessing the Financial Statements (Vertical Analysis):

1. The distribution or allocation of assets stated in percentage form is disclosed

in the common-size statement of financial position. The percentages, which
show the relationship of an account to another (base), may also so compared
with competitors belonging to the same industry. This would help the analyst
determine whether or not the firm has over or under-invested in an item in the
SFP.
2. This method would also show the firm's capital structure by presenting the
percentage allocation of assets in terms of how much percent was borrowed
and how much percent the owners invested.
3. For working capital analysis, the current asset percentage may be compared
with current liabilities percentage to ascertain the firm's liquidity or solvency.
4. This method would also present the percentage relationship of sales to all the
other items in the income statement. The cost of good sold ratio, the gross
profit ratio and net profit ratio are among the salient ratios revealed using the
common-size statement. Doing a longitudinal analysis of these ratios can help
management improve efficiency in terms of controlling cost and expenses and
improving revenue.

Illustrative Example: Using Riel Corporation financial statements

Financial Statement Analyses - Riel Corporation (Vertical Analysis)

The assessment of the statement of financial position using vertical analysis reveals the
following:

Statement of Financial Position

The common-size statement reveals that for both periods, the company's current
assets represent a great bulk of the firm's assets. This is good as it indicates liquidity.
However, deeper analysis of the statement shows that majority of the current assets is
made up of inventory (33.02%) and seconded by receivables (32.31%). Inventory is one
of the least liquid of all assets under the current assets category. Again, the analyst
must be able to account for this proportion. Why are inventory and receivables so high?
The growth in receivable percentage can be accounted for by the sales revenue
increase. Another item worth accounting for is the decrease in the percentage of cash.
What caused such decrease?

The decrease in the percentage allocation for property plant and equipment must
also be noted. Although this can be caused by depreciation, it is worth mentioning to
management, if the circumstances call for it.
 The total liability percentage (59.06%) is higher than the total shareholders'
equity percentage (40.94%), which means that most assets were financed by
borrowings. The decrease of liabilities in 2014 (61.02%) to 2015 (59.06%) indicates that
the firm is shifting its dependence of financing from borrowing to using more of the
owners' investment. If this continues, this would be a good indication of long-term
financial position.

The owners' equity is considered as the margin of safety by the creditors.

Creditors are happy when the owners' equity is high. This is because the owners' equity
is the amount can absorb any decline in the assets. In other words, in case the assets
of the company decline the owners' equity is the amount that can be used to pay the
creditors.

Income Statement

The noticeable high percentage of the CGS (73.42%) to sales is not favorable.
This indicates that most of the sales revenue is used to cover the cost of selling. As
mentioned in the horizontal analysis, management must determine what caused this
and establish measures to remedy this. The gross profit ratio (26.58%) in 2015 has
decreased comparing it with the gross profit ratio (28.10%). This is due to the marked
increase of the cost of good sold ratio.

The decreases in the operating expense ratios are favorable for the firm. This
indicates the firm's efficiency in controlling operating expenses. The net income ratio
(3.86%) is favorable as this indicates that the company earned during the year.
However, deeper analysis would indicate that there was a decrease in the net income
ratio. Again this could be accounted for by the unfavorable increase in the CGS ratio,
which was too high to be offset by the favorable results from the decrease in the
operating expense ratio.

Implications to Financial Management

1. The slow movement of the company's operating cycle due to the slow
conversion of inventory and receivable needs to be addressed. New policies
that would speed up the operating cycle must be designed. Improved cash
discount policies to encourage quick and prompt payment of receivables must
be put in place. Strict and assertive measures for receivable collection must
also be established. New marketing strategies to increase sales of inventories
are also needed.
2. The firm's capital structure leaning towards equity due to company's favorable
results of operation is to be maintained. However, it would still be wise to
strike a balance between liabilities and owners' equity, as this would favor
both potential creditors and owners.
3. Consistent measures to lower the cost of goods sold and/or to increase sales
revenue to cover CGS issues must be drawn as soon as possible. This would
help improve the 7.57% growth of net income for the succeeding periods.
 Control measures on cost and expense reduction must be improved and
make sure that the measures are strictly implemented.
4. There is a need to consistently monitor implementation of measures and
policies to assure continuous improvements of said measures and
implementation procedures.

TREND ANALYSES

A more longitudinal and a modification of the horizontal and vertical analysis is

the trend analysis. Under this method, the percentage changes are determined for
several successive periods instead of the typical two-year period horizontal analysis.
This method is more thorough than the garden-variety two-period horizontal analysis
because it presents a view in the long-run of the company's progression or regression
as the case maybe. Items not seen in two-period analysis may surface in a longer
based study such as the trend analysis.

In computing the trend, the base period (oldest year) amounts are written as
100%.
The percentage relationship of each account in the statements is then computed by
dividing each amount by the base year figure. A trend is then determined by comparing
percentage relationships. Based on the trends, interpretation, conclusions, and
implications are drawn.
Trend Analyses - Nico Corporation

The following analyses, interpretations and conclusions are made in terms of:

Liquidity and Solvency:

The trend analysis matrix shows the improving net working capital (current
assets - current liabilities) status of Nico Corporation. The upward trend of the firm's
current asset and the downward trend of the current liabilities evidence this. Closer look
at the matrix also reveals that cash as well as the other current assets showed an
upward trend. The consistent increase of the trade and other receivables is supported
by the upward trend of sales revenue.

The trading securities from the base year (208) to the next (75) and succeeding
figures may indicate the company's strict concern about using their funds wisely by
diverting cash to higher yielding assets. These results could be accounted for by a
number of factors, namely efficient use of assets that lead to consistently improving
sales, better collection of receivables, quicker conversion of inventories and receivables
to cash. Based on the results, it may be inferred that the firm has been efficient in
managing their working capital components.

Stability and Long-term Financial Position

For long-term financial position, the analysis should focus on total liabilities as
well as shareholders' equity. The property plant and equipment also displays an upward
trend. The analysis matrix purports that the acquisition of these fixed assets were
financed by issuance of non-current notes payable (note increase in borrowing in year
2012), issuance of shares above par value (note increase in amount in year 2012), and
from earnings from operation. It is noticeable that the liabilities exhibit a downward
trend. Inversely the shareholders' equity exhibits an upward trend. This indicates an
improving margin of safety for creditors.

Operating Efficiency and Profitability

In analyzing profitability, the trend matrix disclosed a favorable upward trend in

sales. However, notice that there is also an unfavorable upward trend in the cost of
good sold. Deeper analysis shows that the rate of increase for sales is more rapid than
the increase of the cost of goods sold. The fast upward trend in sales and slower
upward trend in the cost of sales may be a result of efficient pricing policies, pricing
strategies, and efficient cost control systems in acquiring inventories.

Note the unfavorable upward trends in the operating expenses. More unfavorable
is the noticeable fact that rate of increase of the operating expenses is faster than that
of sales revenue. Based on these, it can be inferred that the firm would have yielded
more income if it were able to have better control of their operating expenses.
 Implications to Management

1. As evidenced by the analysis, efficient working capital management should

be an essential concern of the firm, as this would assure fortified solvency
position.
2. To secure the firm's stability or a favorable long-term financial position,
management should be mindful of the creditor's margin of safety. This can be
done by financing acquisitions of fixed assets mainly from the owner's
investments and from company's profits rather than from borrowings.
3. The firm would be able to consistently improve financial yields by adopt
innovative and efficient marketing and distribution policies and strategies
ensure increase in sales revenue. Instilling stringent cost control or cost-
cutting measures would decelerate growth of the cost of sales and operating
expense. A fine mixture of these two would maximize or bring about
consistently increasing company profits.