FINANCIAL STATEMENT ANALYSIS Management Advisory Services

FS ANALYSIS – involves the evaluation of the firm’s past performance, its present condition and business potentials. The
analysis serves to provide information anout the following:
• Profitability of the business firm
• Ability to meet its obligations
• Safety of investment in the business
• Effectiveness of management in running the firm

FINANCIAL STATEMENTS (FS) ANALYSIS TOOLS AND TECHNIQUES

1. Horizontal analysis (trend percentages or index analysis)
2. Vertical analysis (common size statements or percentage composition statements)
3. Financial ratios
4. Gross profit variation analysis
5. Cash flow analysis

HORIZONTAL ANALYSIS
Horizontal or index analysis involves comparison of figures shown in the financial statements of two or more
consecutive periods. The difference of the amount between the two periods is calculated, and the percentage change from
one period to the next is computed using the earlier period as the base.

Most Recent Value – Base period

Percentage Change ( ∆ %) =
Base Period Value
Comparison can be made between an actual amount compared against budgeted amount, with the “budget” serving as the
base or pattern of performance.

LIMITATION: If a negative or a zero amount appears in the base year, percentage change cannot be computed.

VERTICAL ANALYSIS
Vertical analysis is the process of comparing figures in the financial statements of a single period. It involves
conversion of figures in the statements to a common base. This is accomplished by expressing all figures in the statements
as percentages of an important item such as total assets (in the balance sheet) or net sales (in the income statement). These
converted statements are called common-size statements or percentage composition statements.

Percentage of composition statements are used for comparing:

1. Multiple years of data from the same firm
2. Companies that are different in size
3. Company to industry averages

RATIO ANALYSIS
Ratio analysis involves development of mathematical relationships among accounts in the financial statements.
Ratios calculated from these statements provide users and analysts with relevant information about the firm’s liquidity,
solvency, and profitability.

BASIC RULES ON RATIO CALCULATIONS

• When calculating a ratio using balance sheet numbers only, the numerator and the denominator should be from the
same balance sheet. The same is true for ratios using only income statement numbers. Exception: Growth ratios.
• If an income statement account and balance sheet account are both used to calculate ratio, the balance sheet account
should be expressed as a n average for the time period represented by the income statement account.
• If the beginning balance of the balance sheet is not available, the ending balance is normally used to represent the
average balance of the account.
• If sales and/or purchases are given without making distinctions as to whether made in cash or on credit, assumptions
are made depending on the ratio being calculated:
Ø Turnover ratios: Sales and purchases are made on credit
Ø Cash flow ratios: Sales and purchases are made in cash.
• Generally, the number of days in a month or year is not critical to the analysis: a year may have 360 days, 52 weeks,
and 12 months; alternatively, a year may be comprised of 365 calendar years, 300 working days or any appropriate
number of days.

FINANCIAL RATIOS
v TESTS OF LIQUIDITY (Liquidity refers to the company’s ability to pay its current liabilities as they fall due)
It is a measure of adequacy of working
Current Ratio
Current Assets capital. It is the primary test of solvency to
(Banker’s Ratio)
Current Liabilities meet current obligations from current
(Working Capital Ratio)
assets.
It measures the number of times that the
current liabilities could be paid with the
Quick Ratio Quick Assets
available cash and near-cash assets (i.e.,
(Acid Test Ratio) Current Liabilities
cash current receivables and marketable
securities)
Working Capital Activity Ratios (Efficiency Ratios)

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 Income Statement Account No. of days in a year
Turnover Average Age
Average Balance Sheet Account Turnover
It is the time required to complete one
Net (Credit) Sales collections cycle from the time receivables
Receivables Turnover
Average Receivables are recorded, then collected, to the time
new receivables are recorded again.
Average Age of Receivables It indicates the average number of days
360 days
(Average Collection Period) during which the company must wait before
Receivables Turnover
(Days’ Sales in Receivables) receivables are collected.
Cost of Goods Sold It measures the number of times that the
Inventory Turnover inventory is replaced during the period.
Ave. Merchandise Inventory
Average Age of Inventory 360 days It indicates the average number of days
(Inventory Conversion Period) during which the company must wait before
(Days’ Sales in Inventory) Inventory Turnover the inventories are sold.
Cost of Materials Used
Raw Materials Turnover
Average Raw Materials Inventory

Cost of Goods Manufactured

Work in Process Turnover
Average Work in Process Inventory

Cost of Goods Sold

Finished Goods Turnover
Average Finished Goods Inventory

Operating Cycle Average Age of Inventory + Average Age of Receivables

Net Credit Purchased

Trade Payables Turnover
Average Trade Payables
Average Age of Trade It indicates the length of time during which
Payables (Payable Deferral 360 days payables remain unpaid
Period) Payables Turnover
(Days’ Purchases in Payables)
It measures the movement and utilization
Cost of Sales + Operating Expenses*
Current Assets Turnover of current assets to meet operating
Average Current Assets
requirements.
* Operating expenses exclude depreciation, amortization and other expenses related to long-term assets.

v TESTS OF SOLVENCY (Solvency refers to the ability to pay its debts)

These ratios are also called leverage ratios. Leverage refers to how much of company’s resources are financed by debt
and/or preferred equity, both of which require fixed payment of interests and dividends.
EBIT It determines the extent to which
Times interest Earned
Interest Expense operations cover interest expense.

Proportion of assets provided by

Total Liabilities
Debt-Equity Ratio creditors compared to that provided by
Total Stockholders’ Equity
owners.

Total Liabilities Proportion of total assets provided by

Debt-Ratio
Total Assets creditors.

Total Stockholders’ Equity Proportion of total assets provided by

Equity Ratio
Total Assets owners.

v TEST OF PROFITABILITY
Income Determine the portion of sales that
Return On Sales
Net Sales went into company’s earnings.

Income Efficiency with which assets are used

Return on Total Assets
Average Total Assets to operate the business.

What income figure should be used?

• If the intention is to measure operational performance, income is expressed as before interest and tax; Alternatively,
income before after-tax interest may be used to exclude the effect of capital structure.
• If the intention is to evaluate total managerial effort, income is expressed after interest and tax
• The practice of expressing income after interest before tax is being now discouraged
• Income should include dividends and interest earned if the said investments are included in asset base.
• If used in the DuPont technique, income must be after interest, tax and preferred dividends.

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 Return on Equity = Return on Sales x Assets Turnover x Equity Multiplier

Income Measures the amount earned on the

Return On Equity
Average Equity owners’ or stockholders’ investment

Net Income – Preferred Dividends Measures the amount of net income

Earnings Per Share
Wtd Ave. Common Shares Outstanding earned by each common share

v MARKET TESTS
Price per share It indicates the number of pesos
Price Earnings(P/E) Ratio
Earning per share required to buy P 1 of earnings

Dividend per share Measures the rate of return in the

Dividend Yield
Price per share investor’s common stock investments.

Common Dividend per Share It indicates the proportion of earnings

Dividend Pay-Out
Earnings Per Share distributed as dividends.

OTHER MEANINGFUL RATIOS

• RATIOS USED TO EVALUATE LONG-TERM FINANCIAL POSITION OR STABILITY

Measures the proportion of owners’
Fixed Assets equity to fixed assets. Indicative of over
Fixed Assets to Total Equity
Total Equity or under investment by owners and
weakness in trading on the equity.
Fixed Assets (Net) Indicates possible over expansion of
Fixed Assets to Total Assets
Total Assets plant and equipment
Tests roughly the efficiency of
Sales to Fixed Assets Net Sales
management in keeping plant
(Plant turnover) Fixed Assets (Net)
properties employed.
Measures recoverable amount by
Common Stockholder’ Equity common stockholders in the event of
Book Value per Share – CS
Common Shares Outstanding liquidation if assets are realized at their
book values.
Net Income After Taxes It indicates ability to provide dividends
Times Preferred Dividend Earned
Preferred Dividends to preferred stockholders.
Measures efficiency of the firm to
Total Assets
Capital Intensity Ratio generate sales through employment of
Nets Sales
its resources
Net income before taxes & fixed charges
Times Fixed Charges Earned Measures ability to meet fixed charges.
(Fixed charges + sinking fund payment)*
* Fixed charges shall include rent, interests and other relevant fixed expenses; sinking fund payment must be expressed
before tax.

• TESTS OF OVERALL SHORT TERM SOLVENCY OR SHORT-TERM FINANCIAL POSITION

Net Sales Indicates adequacy of working capital
Working Capital Turnover
Average Working Capital to support operation (sales)

Current Liabilities
Defensive Interval Ratio Measures coverage of current liabilities
Cash & Cash Equivalents

Net Purchases Measures efficiency of the company in

Payable Turnover
Average Accounts Payable meeting the accounts payable
Reflects extent of the utilization of
Fixed Assets to Long-Term Fixed Assets resources from long term debt.
Liabilities Long term Liabilities Indicative of sources of additional
funds

• RATIOS INDICATIVE OF INCOME POSITION

Rate of Return on Average Income Measures the profitability of current
Current Assets Average Current Assets assets invested

Operating Profit Measures profit generated after

Operating Profit Margin
Net Sales consideration of operating costs.

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 Operating Cash Flow Measures the ability of firm to translate
Cash Flow Margin
Net Sales sales to cash
A. Ayala has 1,000,000 common shares outstanding. The price of the stock is P8. Ayala declared dividends per share of P
0.10. The balance sheet at the end of 2005 showed approximately the same amounts as that at the end of 2006. The
financial statements for Ayala are as follows:

Ayala Company, Income Statements for 2006 (in thousands)

Sales P 4,700
Cost of goods sold 2,300
Gross profit 2,400
Operating expenses :
Depreciation P 320
Other 1,230 1,550
Income before interest and taxes P 850
Interest expense 150
Income before taxes 700
Income taxes 280
Net income P 420

Ayala Company, Balance Sheet at December 31, 2006 (in thousands)

Assets Liabilities and SHE
Cash P 220 Accounts payable P 190
Accounts receivable 440 Accrued expenses 180
Inventory 410 Total current liabilities P 370
Total current assets P 1,070 Long-term debt 1,960
Plant and equipment 5,600 Common stock 1,810
Accumulated depreciation (2,100) Retained earnings 430
Total assets P 4,570 Total liabilities and SHE P 4,570

REQUIRED: (round off answers to two decimal places)

1. Current ratio 11. EPS
2. Acid-test ratio 12. P/E Ratio
3. Accounts receivable turnover 13. Dividend Yield
4. Inventory turnover 14. Payout ratio
5. Gross profit margin 15. Debt ratio
6. Operating profit margin 16. Debt-Equity ratio
7. Return on Sales 17. Times interest earned
8. RoA – operational performance 18. Defensive interval ratio
9. RoA – total management effort 19. Cash flow to total debt
10. Return on Equity 20. Cash flow margin

B. The following information is available concerning YGC expected results in 2006 (in thousand of pesos). Turnovers are
based on year-end values.

REQUIRED: Fill in the blanks.

Return on sales 6%
Gross profit percentage 40%
Inventory turnover 4 times
Receivable turnover 5 times
Current ratio 3 to 1
Ratio of total debt to total assets 40%

Condensed Income Statement

Sales P 900
Cost of sales ___________
Gross profit ___________
Operating expenses ___________
Net Income P _________

Condensed Balance Sheet

Cash P 30 Current liabilities P ______
Receivables ______ Long-term debt ______
Inventory ______ Stockholders’ equity ______
Plant and equipment 670
Total P ____ Total P ______

C. The current ratio is 2.5 to 1; the acid-test ratio is 0.9 to 1; cash and receivables are P270,000. The only current assets
are cash, receivables, and inventory. Compute:

1) Current liabilities
2) Inventory
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