ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

CPA Review Batch 44  October 2022 CPA Licensure Examination

MS-44M
MANAGEMENT SERVICES C. LEE  E. ARAÑAS  K. MANUEL

FINANCIAL STATEMENT ANALYSIS

 FINANCIAL STATEMENT (FS) ANALYSIS involves the evaluation of an entity’s past performance, present
condition, and business potentials by way of analyzing the financial statements to obtain information about,
among others, profitability of the business firm, ability to meet company obligations, safety of investment in
the business, and effectiveness of management in running the firm.
 HORIZONTAL ANALYSIS shows changes of corresponding FS items over a period of time. Changes in the
value of a particular FS item can be analyzed in terms of amount or in percentage. The percentage change of
the amounts is calculated using the earlier period as the base period.

Percentage Change (Δ %) = Most Recent Value – Base Period Value

Base Period Value
Comparisons can be made between an actual amount and a budgeted amount, with the latter serving as basis
or pattern of performance. However, if a zero or negative amount appears in the base year, percentage
change cannot be computed. TREND or INDEX ANALYSIS, a subset of horizontal analysis, uses an index
number of 1.00 for the base period and converts all FS items in the subsequent period as percentage of the
base in order to facilitate better understanding of performance over multiple periods.
 VERTICAL ANALYSIS is the process of comparing figures in the FS of a single period. This is accomplished
by expressing all figures in the FS as percentages of a common base 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 FS, often used for comparing multiple years of data from the same
firm, companies of different size, and company-to-industry averages.
 CASH FLOW ANALYSIS is a detailed study in the net change in cash and cash equivalents as a result of
operating, investing and financing activities during the period.
➢ OPERATING ACTIVITIES are principal revenue-producing activities of the entity and generally relate to
changes in current assets and current liabilities involved in company’s normal operations.
➢ INVESTING ACTIVITIES are acquisition and disposal of long-term assets and investments not included in
cash equivalents and generally relate to changes in a company’s non-current assets.
➢ FINANCING ACTIVITIES are result in changes in the size and composition of the contributed equity and
borrowings of the entity and generally relate to changes in long-term liabilities and equity accounts.
 FINANCIAL RATIOS are relationships among accounts found in the FS that provide information about the
firm’s liquidity, solvency, stability, profitability and other aspects of financial situation and potential. Major
categories of financial ratios are: (NOTE: Specific ratios and formulas are found on pages 2 and 3)
➢ LIQUIDITY RATIOS measure an entity’s ability to meet short-term obligations and provide insights on
present cash solvency. Common examples include net working capital, current ratio and quick ratio.
➢ SOLVENCY RATIOS, a.k.a. leverage ratios, measure an entity’s long-term financial viability. Common
examples included debt ratio, debt-equity ratio and times interest earned ratio.
➢ ACTIVITY RATIOS, a.k.a. asset utilization ratios or efficiency ratios, measure an entity’s ability to use its
assets and manage its liabilities effectively in the current period -- how quickly various accounts are
converted into sales or cash. Common examples include turnover ratios and conversions periods.
➢ PROFITABILITY RATIOS, a.k.a. performance ratios, are used to determine how well an entity can generate
profits from its operations. Common examples include margin ratios and return ratios.
➢ MARKET VALUE RATIOS, a.k.a. market prospect ratios, are used to help potential investors make equity
investment decisions through the use of trends in earnings, dividends and stock prices. Common examples
include dividend payout ratio, dividend yield and price-earnings ratio.
These are some of the basic rules in calculating financial ratios:
✓ When calculating a ratio using balance sheet (BS) amounts only, the numerator and denominator should
be based on amounts as of the same BS date. The same is true for ratios using only income statement
(IS) numbers. Exception: calculation of growth ratios.
✓ If an IS amount and a BS amount are used at the same time to calculate a ratio (e.g., turnover ratios),
the BS amount should be expressed as an average for the time period represented by the IS amount.
✓ If the beginning balance of a BS account is not available and cannot be computed from the given data,
the ending balance of the account is used 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.
➢ A 360-day year is preferred as this is consistent with a 12-month year and a 30-day month;
➢ Alternatively, a year may be comprised of 365 calendar days, 300 working days or 270 productive
days. (NOTE: the number of days to be used is specified in most problems).
• FS analysis helps in making FINANCIAL FORECASTS, particularly the required ADDITIONAL FUNDS
NEEDED (AFN), determined based on entity’s capital requirements and from a variety of financial ratios.
Required increase in assets →  in Sales x (Assets ÷ Sales)
- Spontaneous increase in liabilities →  in Sales x (Liabilities ÷ Sales)
- Increase in retained earnings* → Earnings after tax – Dividend payment
ADDITIONAL FUNDS NEEDED from external sources (e.g., creditors, investors)
AFN, a.k.a. External Funds Needed (EFN), may alternatively be computed using the following formulas:
➢ AFN = total changes in equity – internal financing
➢ AFN = (Assets – Liabilities) (% ∆ sales) – (projected sales x profit margin x plowback ratio)
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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY
FINANCIAL STATEMENT ANALYSIS MS-44M
 LIQUIDITY RATIOS
RATIO FORMULA RATIO FORMULA
Current Assets – Quick Ratio Quick Assets
Net Working Capital
Current Liabilities (Acid Test Ratio) Current Liabilities
NOTE: Quick assets are cash items and other current
Current Ratio Current Assets
assets that can be quickly converted into cash (i.e.,
(Working Capital Ratio) Current Liabilities
cash, receivables, marketable securities)

 ACTIVITY RATIOS / EFFICIENCY RATIOS / ASSET UTILIZATIO RATIOS

RATIO FORMULA RATIO FORMULA
Inventory Turnover Cost of Goods Sold Age of Inventory 360 days .
(for merchandisers) Average Inventory (Inventory Conversion Period) Inventory Turnover
Net Credit Sales Age of Receivable 360 days .
Receivable Turnover
Average Receivables (Receivable Collection Period) Receivables Turnover
Net Credit Purchases Age of Payable 360 days .
Payable Turnover
Average Payables (Payable Deferral Period) Payables Turnover
Finished Good Turnover Cost of Goods Sold Sales .
Asset Turnover
(for manufacturers) Ave. FG Inventory Average Total Assets
Work-in-Process Turnover Cost of Goods Manu. Sales .
Fixed Asset Turnover
(for manufacturers) Ave. WIP Inventory Average Fixed Assets
Raw Material Turnover Cost of Materials Used Age of Inventory +
Normal Operating Cycle
(for manufacturers) Ave. RM Inventory Age of Receivables
Inventory Turnover FG Turnover + WIP Normal Operating Cycle
Cash Conversion Cycle
(for manufacturers) Turnover + RM Turnover – Age of Payables
NOTE: ‘Age of Receivable’ is also known as Days Sales Outstanding, Number of Days Sales in Receivable, or
Days Receivable.

 SOLVENCY RATIOS / LEVERAGE RATIOS

RATIO FORMULA RATIO FORMULA
Total Liabilities 1 .
Debt Ratio Equity Multiplier
Total Assets Equity Ratio
Total Equity Times Interest Earned EBIT .
Equity Ratio
Total Assets (Interest Coverage Ratio) Interest Payments
Total Liabilities NOTE: Equity multiplier, a.k.a. equity ratio reciprocal,
Debt-Equity Ratio
Total Equity may be computed based on formula: Assets ÷ Equity

 PROFITABILITY RATIOS / PERFORMANCE RATIOS

RATIO FORMULA RATIO FORMULA
Gross Profit Income .
Gross Profit Margin Return on Sales
Sales Sales
EBIT Income .
Operating Profit Margin Return on Assets
Sales Average Assets
Profit Income .
(Net) Profit Margin Return on Equity
Sales Average Equity
What INCOME figure to use?
 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.
 Expressing income after interest but before tax is now rarely applied in business practice.
 Income should include dividends and interest earned if the said investments are included in asset base.
 If used in the context of “Du Pont” technique, income must be expressed after interests, taxes and
preferred stock dividends. The Du Pont model is based on the following formula:

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

 MARKET VALUE RATIOS / MARKET PROSPECT RATIOS

Market value ratios are anchored on Earnings per Share (EPS), which is also considered a profitability ratio.
Net Income – Preferred Dividends .
EPS =
Weighted Average Common Shares Outstanding
EPS must be distinguished from common shareholder’s Book Value per Share (BVPS), which is based on:
BVPS = Common Shareholders’ Equity ÷ Number of Common Shares Outstanding
RATIO FORMULA RATIO FORMULA
Market Price per Share Dividend Per Share
Price-Earnings Ratio Dividend Payout
EPS EPS
Dividend Per Share Retention Ratio
Dividends Yield 100% - Dividend Payout
Market Price per Share (Plowback Ratio)

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY
FINANCIAL STATEMENT ANALYSIS MS-44M
 OTHER FINANCIAL RATIOS
RATIO FORMULA RATIO FORMULA
Cash_+ Marketable Securities Times Preferred Net Income After Tax
Cash Ratio
Current Liabilities Dividends Earned Preferred Dividends
Quick Assets . Capital Intensity Total Assets
Defensive Interval
Average Capital Expenditures Ratio Net Sales
Operating Cash Flow (CF) . Operating CF + After-Tax
Cash Flow Margin Free Cash Flow
Net Sales Interest – Capital Expenditures

EXERCISES: FINANCIAL STATEMENT ANALYSIS

1. Vertical & Horizontal Analysis
Following are the financial statements of Avengers Company:
Avengers Company
Condensed Statement of Financial Position
December 31, 2022 (In thousands)
ASSETS LIABILITIES AND EQUITY
Cash P 800 Current Liabilities P 500
Non-Cash Current 1,200 Long-term Debts 1,000
Fixed Assets 3,000 Capital Stock 1,500
Retained Earnings 2,000
TOTAL ASSETS P 5,000 TOTAL LIAB. & SHE P 5,000

For 2021: Net sales, P 1,600; CGS, P 1,000; Operating Expenses, P 300; Interests and tax charges, P 200.
For 2022: Net sales, P 2,000; CGS, P 1,300; Operating Expenses, P 300; Interests and tax charges, P 220.
REQUIRED:
1. Prepare 2022 common-size balance sheet and determine:
A) Current ratio B) Debt ratio C) Equity ratio
2. Prepare 2022 common-size income statement and determine:
A) Gross profit margin B) Operating profit margin C) Net profit margin
3. Compute trend percentages for the following:
A) Net sales B) EBIT C) Net income

2. Liquidity Ratios
Thor Company has a current ratio is 1.8 to 1 and an acid-test ratio is 1.2 to 1. Its current assets are composed
of cash, receivables, and inventory with cash and receivables combined amounting to P 300,000.

REQUIRED:
1. Determine: A) Current Liabilities B) Inventory
2. Given that both the current ratio and the acid-test ratio are greater than 1, indicate the effects of
each transaction to both ratios by using (+) for increase, (-) for decrease, and (0) for no effect.
Current Ratio Acid-test Ratio
Example: Sell merchandise for cash + +
A) Buy inventory on account _______ ________
B) Pay an account payable _______ ________
C) Borrow cash on a short-term loan _______ ________
D) Collect an account receivable _______ ________
E) Issue long-term bonds payable _______ ________
F) Sell a plant asset for cash at a loss _______ ________
G) Buy marketable securities for cash _______ ________
H) Sell merchandise on credit _______ ________

3. Activity Ratios/Efficiency Ratios

The receivable collection period is 40 days on the average. Annual sales of P 900,000 are spread evenly
throughout the year. Inventory turnover is 6 times. Cash conversion cycle extends up to 80 days.

REQUIRED: Assuming a 360-day year, determine:

1. Average accounts receivable
2. Operating cycle
3. Payable deferral period

4. Solvency & Profitability Ratios

Net sales total P 100,000. Net profit margin is 12%. Interest charges are earned 6 times. Tax rate is 40%.

REQUIRED:
1. How much is the earnings before interests and taxes?
2. Assuming that inventory age is 45 days and average annual amount of inventory is P 7,500, how
much is the company’s operating expenses?

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY
FINANCIAL STATEMENT ANALYSIS MS-44M
5. Du Pont Technique
➢ Return on sales is 5%.
➢ Return on assets is 10%.
➢ Return on equity is 25%.
➢ There is no preferred stock.
REQUIRED: Using Du Pont technique, determine:
1. Asset turnover
2. Equity ratio
3. Equity multiplier
4. Debt-equity ratio

6. EPS, Dividend & IPO Shares

Hulk Company decided to go public when its net income available to common shareholders amounted to
P300,000 while the number of common shares issued and outstanding is 125,000.

REQUIRED:
1. Assume that the pay-out ratio is 75%, how much of the total dividends shall a shareholder owning
12,500 common shares receive?
2. Assume that the pay-out ratio is 75% and the price per share is P 12, what is the dividend yield?
3. Assume that the price-earnings ratio will be set 12 times and 25,000 new shares will be issued:
A) How much is the initial public offering (IPO) per share of the 25,000 new shares?
B) How much is the net proceeds from issuance if underwriter spread is 5%?

7. Additional Funds Needed

Iron M. Corporation’s sales are expected to increase from P 5,000,000 in 2021 to P 6,000,000 in 2022. Its
assets totaled P 3,000,000 at the end of 2021. Iron M. has full capacity, so its assets must grow in proportion
to projected sales. At the end of 2021, current liabilities are P 1,000,000 (of which P 350,000 are accounts
payable, P 150,000 accruals and P 500,000 notes payable). The after-tax profit margin is projected to be
15%. The forecasted pay-out ratio is 75%.
REQUIRED:
Determine the additional funds needed from external sources.

8. Financial Ratios
Captain A. Merchandising has 1,000,000 common shares outstanding, with each share priced at P 8.00. In
2022, the company declared dividends of P 0.10 per share. The balance sheet at the end of 2022 showed
approximately the same amounts as that at the end of 2021. The financial statements for Long Merchandising
are as follows:
Captain A. Merchandising, Income Statement for 2022 (in thousands)______
Sales P 4,700
Cost of goods sold 2,300
Gross profit P 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 P 700
Income taxes 280
Net income P 420

Captain A. Merchandising, Balance Sheet at December 31, 2022 (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 (RoS) 17. Times interest earned
8. RoA – operational performance 18. Cash flow to total debt
9. RoA – total management effort 19. Cash flow margin
10. Return on equity (RoE) 20. Cash ratio

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY
FINANCIAL STATEMENT ANALYSIS MS-44M
9. Construction of Financial Statements
The following information is available concerning B. Panther Company’s expected results in 2022 (in
thousands of pesos). Turnovers are based on year-end values.
REQUIRED: Fill in the blanks.
1) Return on sales 6%
2) Gross profit percentage 40%
3) Receivables turnover 5 times
4) Inventory turnover 4 times
5) Current ratio 3:1
6) Ratio of total debt to total assets 40%
Condensed Income Statement
Sales P 900
Cost of sales (A) _____
Gross profit (B) _____
Operating expenses (C) _____
Net income (D) _____
Condensed Balance Sheet
Cash P 30 Current liabilities (H) ____
Receivables (E) ____ Long-term debt (I) ____
Inventory (F) ____ Shareholders’ equity (J) ____
Plant and equipment 670
Total (G) ____ Total (K) ____

WRAP-UP EXERCISES (MULTIPLE-CHOICE QUESTIONS)

1. Which type of analysis best facilitates observation of year-to-year trends within a company?
a. Ratio c. Horizontal
b. Vertical d. Intercompany
2. When preparing common-size statements, balance sheet items are generally stated as a percentage of
(1) ______ while income statement items are generally stated as a percentage of (2) ______.
a. (1) total assets (2) net income c. (1) total assets (2) net sales
b. (1) total equity (2) net income d. (1) total liabilities (2) net sales
3. Which one of the following would not be considered a liquidity ratio?
a. Quick ratio c. Return on assets
b. Current ratio d. Inventory turnover
4. How are trade receivables used in the calculations of (1) acid-test ratio and (2) receivable turnover?
a. (1) Denominator (2) Denominator c. (1) Numerator (2) Numerator
b. (1) Numerator (2) Denominator d. (1) Not used (2) Numerator
5. Which ratio is most helpful in appraising profitability?
a. Debt ratio c. Dividend payout
b. Acid-test ratio d. Return on assets
6. Which of the following ratios is most relevant to evaluating solvency?
a. Debt ratio c. Return on assets
b. Dividend yield d. Days’ purchase in accounts payable
7. Return on sales x assets turnover = __________________
a. Return on equity c. Equity ratio
b. Return on assets d. Equity multiplier
8. Dividend yield x price-earnings ratio = ________________
a. Dividend per share c. Earnings per share
b. Market price per share d. Dividend payout ratio
9. When a balance sheet amount is related to an income statement amount in computing a financial ratio
(e.g., turnover),
a. The income statement amount should be converted to an average for the year
b. The balance sheet amount should be converted to an average for the year
c. Comparisons with industry ratios are not meaningful
d. Both amounts should be converted to market value
10. Which one of the following provides a spontaneous source of financing for a firm?
a. Debentures c. Mortgage payable
b. Accounts payable d. Accounts receivable

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