FINANCIAL STATEMENT ANALYSIS

Financial statement analysis involves the assessment and evaluation of the firm's past performance,
its present condition, and future business potentials. The analysis serves to provide information about
the following:
1. Profitability of the business firm
2. The firm's ability to meet its obligations
3. Safety of the investment in the business
4. Effectiveness of management in running the firm
5. Over-all company marketability

Vertical analysis (Common-size financial statements)

Vertical analysis is a financial statement analysis technique in which each line item is listed as a
percentage of a base figure in the statement. Vertical analysis makes comparing financial statements
from one company to another and across industries much easier.

Converted financial statements are called Common Size Financial Statements. It allows the analyst
to:
1. Comprehend or visualize the changes in individual items
2. Compare statements of two or more companies

ILLUSTRATION:
Sales 5,000,000 100%
Cost of goods sold 1,000,000 20%
Gross profit 4,000,000 80%
General and administrative expenses 2,000,000 40%
Operating income 2,000,000 40%
Taxes (25%) 500,000 10%
Net income 1,500,000 30%

Horizontal analysis (Trend percentages and index analysis)

Horizontal analysis enables investors and analysts to see what has been driving a company's
financial performance over time, as well as identify trends and growth patterns. The statements for
two or more periods are used in horizontal analysis. The study of percentage changes in comparative
statements is called horizontal analysis. It is computed as:

Most recent value – Base period value

Percentage Change = ------------------------------------------------------------
Base period value

Cash flow analysis (Interpretation of cash flows including free cash flow concept)
The cash flow statement (CFS), also known as the statement of cash flows is a financial statement
that summarizes the amount of cash and cash equivalents entering and leaving a company.

The main components of the cash flow statement are:

1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities
4. Disclosure of noncash activities
FREE CASH FLOW
The cash a company generates after accounting for cash outflows to support operations and maintain
capital assets is referred to as free cash flow (FCF). Unlike earnings or net income, free cash flow is a
measure of profitability that excludes non-cash expenses from the income statement and includes
spending on equipment and assets as well as balance-sheet changes in working capital.

Free cash flow can be computed as follows:

If the starting point is Cash Flow from Operating Activities:
Cash Flow from Operating Activities +
Interest Expense +
Tax Shield on Interest Expense -
Capital Expenditures (CAPEX) -
Free Cash Flow =

If the starting point is EBIT:

EBIT x (1- Tax Rate) +
Non-cash Expenses (Depreciation, Amortization, etc) +
Change in (Current Assets - Current Liabilities) -
Capital Expenditures (CAPEX) -
Free Cash Flow =

If the starting point is Net Income

Net Income +
Interest Expense +
Tax Shield on Interest Expense -
Non-cash Expenses (Depreciation, Amortization, etc.) +
Change in (Current Assets - Current Liabilities) -
Capital Expenditures (CAPEX) -
Free Cash Flow =

Interpreting Free Cash Flow

Growing free cash flows are frequently a prelude to increased earnings. Companies that experience
surging FCF due to revenue growth, efficiency improvements, cost reductions, share buybacks,
dividend distributions, or debt elimination can reward investors tomorrow.

Gross profit variance analysis (price, cost and volume factors)

Gross profit analysis is used to determine the reasons why the gross profit margin changes from
period to period, so that management can take steps to bring the gross margin in line with
expectations. The two primary factors that result to revenue variances are the price and the
physical/quantity factors.

The following equations are used to compute the variances:

Sales price variance (SPV)/ Sales Factor
= (Selling price per unit this year - Selling price per unit last year) x Sales units this year
=Total sales this year - Sales this year at last year's price

Cost price variance (CPV) Cost Factor

= (Unit cost this year - Unit cost last year) x Sales units this year
= Cost of sales this year - Cost of sales this year at last year's price
The physical or the quantity variance can be divided into two, the Sales Quantity Variance, and Cost
Quantity Variance. The combined effect of the two quantity variances is the Sales Volume Variance
or Quantity Factor.

The quantity variances are computed as follows:

Sales Quantity Variance (SQV)
= (Sales Qty this year - Sales Qty last year) x Selling price last year

Cost Quantity Variance (CQV)

= (Sales Qty this year - Sales Qty last year) x Unit cost last year

Sales Volume Variance/ Quantity Factor

= (Sales Qty this year - Sales Qty last year) x Gross Profit per unit last year

Breaking down the quantity variance

If a company sells more than one product, the Sales Volume Variance can be further subdivided into
the Sales Mix Variance and Sales Yield Variance/ Sales Quantity Variance. Moreover, the Sales
Quantity Variance can be analyzed further to consider external factors affecting the sales units.
External factors will give rise to the Market Share Variance and Market Size Variance

Financial ratios (liquidity, solvency, activity, profitability, growth and other ratios; Du Pont
model)
Ratio analysis is a quantitative method for gaining insight into a company's liquidity, operational
efficiency, and profitability by examining financial statements such as the balance sheet and income
statement. Ratio analysis is a fundamental component of fundamental equity analysis.

I. TESTS OF LIQUIDITY
Company’s ability to pay its short-term liabilities as they fall due

1. CURRENT-RATIO/BANKER’S CURRENT ASSETS

¿
RATIO/WORKING CAPITAL RATIO CURRENT LIABILITIES

Measures the number of times that the current

liabilities could be paid with available current
assets.

If > 1 = BETTER

Note:
Current assets XX
Current liabilities (XX)
Working capital XX
2. ACID-TEST RATIO QUICK ASSETS
¿
CURRENT LIABILITIES

Quick assets = Cash + Accounts receivable +

Marketable equity securities

If > 1 = BETTER
 Measures the number of times that the current
liabilities could be paid with available cash and
near cash assets.
3. CASH RATIO CASH + MARKETABLE EQUITY SECURITIES
¿
CURRENT LIABILITIES

Absolute test of liquidity without considering

receivables and inventories.
Effects of selected transactions to current ratio,
working capital ratio and quick ratio:
 Purchase of MES for cash - No effect. Reclassification only
 Disposal of MES for cash that resulted to:
 No gain - No effect
 Loss - Decrease
 Gain - Increase
 Collection of accounts receivable - No effect
 Collection of previously written-off AR - No effect
under allowance method
 Collection of previously written-off AR - Increase
under direct write-off method
 Write-off of AR under allowance method - No effect
 Write-off of AR under direct write-off
method - Decrease
 Purchase of inventories for cash - CR and WC = no effect; QR = decrease
 Sale of inventories - At gain = increase

ILLUSTRATION:
Purchase of inventories on account:
Before After
Current asset P10 P11
Current liability 4 5
Current ratio 2.5 2.2
WC P6 P6
QR Decrease

Before After
Current asset P4 P5
Current liability 5 6
Current ratio 0.8 0.83
WC P(1) P(1)
QR Decrease

Before After
Current asset P7 P8
Current liability 7 8
Current ratio 1 1
WC P(0) P(0)
QR Decrease

 Settlement of AP
 Stock dividends - Only WC will not change
 Cash dividends (Declaration date) - No effect
 Cash dividends (Record date) - Decrease
 Cash dividends (Payment date) - No effect
 Disposal of non-current asset (no gain or - Only WC will not change
loss)
 Disposal of non-current asset (at a gain) - Increase
 Disposal of non-current asset (at a loss) Increase
- Increase

4. WORKING CAPITAL ACTIVITY RATIOS

(TURNOVERS)

a. RECEIVABLE TURNOVER NET CREDIT SALES

¿
AVERAGE TRADE RECEIVABLES

This is the time required to complete one

collection cycle – from the time receivables are
recorded, and then collected, to the time new
receivables are recorded again.

TRADITIONAL APPROACH:
AGE OF T/R = *# of working days/Receivable
TO

*Assume 360 days

FINANCIAL MANAGEMENT APPROACH:

**Average daily sales = Net Credit Sales/360
days

Average Trade Receivables

Age of T /R=
¿∗Average daily sales

The number of days during which the company

must wait before receivables are collected.

COST OF GOODS SOLD

¿
b. INVENTORY TURNOVER AVERAGE MDSE INVENTORY

This measures the number of times that inventory

is replaced during the period.

TRADITIONAL APPROACH:
AGE OF INVTY = 360 days/Inventory TO

FINANCIAL MANAGEMENT APPROACH:

Average daily COS = COGS/360 days
 Average Mdse. Inventory
Age of invty=
Average daily COGS

This indicates the average number of days during

which the company must wait before sale.

Note:
Operating cycle = Ave. age of Rec + Ave age of
Invty

NET CREDIT PURCHASES

¿
c. PAYABLES TURNOVER AVERAGE TRADE PAYABLES

Indicates the length of time which payables

remain unpaid.

TRADITIONAL APPROACH:
Age of T/P = 360 days/Payables TO

FINANCIAL MANAGEMENT APPROACH:

Average daily purchases = Net Purchases/360
days

Average Trade Payables

Age of T /P=
Average daily purchases

d. CASH FLOW CYCLE/CASH = OPERATING CYCLE – AVE. AGE OF T/P

CONVERSION CYCLE = Ave age of T/R + Ave. age of Invty – Ave age
of T/P

Test of liquidity that the company is self-

sustaining. As much as possible, this should be
zero or negative. If negative, the company is self-
sustaining from its operating activities and no
need for external financing.

' '
COGS +OPEX (excluding de p n∧amor t n)
e. CURRENT ASSETS TURNOVER CAT =
AVERAGE CURRENT ASSETS

This measures the movement and utilization of

current assets to meet operating requirements.
 5. WORKING CAPITAL TO TOTAL WORKINGCAPITAL
¿
ASSETS TOTAL ASSETS

This indicates relative liquidity of total assets and

distribution of resources employed.
6. WORKING CAPITAL TURNOVER NET SALES
¿
AVERAGE WORKING CAPITAL

This indicates adequacy and activity of working

capital.

II. TESTS OF SOLVENCY

Company’s ability to pay all its debts (Current and Non-current liabilities)

1. TIMES-INTEREST EARNED/INTEREST EARNINGS BEFORE INTEREST ∧TAXES

¿
COVERAGE RATIO INTEREST EXPENSE

Determines the extent to which operations cover

interest expense. This indicates the margin of
safety for payment of fixed interest charges.
2. DEBT RATIO TOTAL LIABILITIES
¿
TOTAL ASSETS

Proportion of total assets provided by creditors.

'
3. EQUITY RATIO TOTALSHAREHOLDE R S EQUITY
¿
TOTAL ASSETS

Proportion of total assets provided by owners.

4. DEBT-EQUITY RATIO TOTAL LIABILITIES
¿ '
TOTALSHAREHOLDE R S EQUITY

Proportion of assets provided by creditors

compared to that provided by owners
5. EQUITY MULTIPLIER/FINANCIAL TOTAL ASSETS
¿
LEVERAGE RATIO '
TOTALSHAREHOLDE R S EQUITY

Opposite of equity ratio. Total assets financed by

equity. The higher the ratio, the higher the
leverage = RISKY.
6. FIXED ASSETS TO TOTAL ASSETS ¿ ASSETS
¿
TOTAL ASSETS

Indicates possible over expansion of PPE.

7. FIXED ASSETS TO LONG-TERM ¿ ASSETS
¿
LIABILITIES LONG−TERM LIABILITIES

Reflects the extent of the utilization of resources

from long-term debt. Indicative sources of
additional funds.
8. FIXED ASSETS TO TOTAL EQUITY ¿ ASSETS
¿
TOTAL EQUITY
 Measures the proportion of owner’s equity to
fixed assets. Indicative of over or under
investment by owners.
9. SALES TO FIXED ASSETS/PLANT NET SALES
¿ ASSETS ¿
TURNOVER AVERAGE ¿

Test roughly the efficiency of management in

keeping plant properties employed.
10. ASSET TURNOVER NET SALES
¿
AVERAGE TOTAL ASSETS

Measures the level of capital investment relative

to sales volume. How efficiently assets are being
used to generate sales.
11. BOOK VALUE PER SHARE (COMMON COMMON SHAREHOLDER ' S EQUITY
¿
SHARES) COMMON SHARES OUTSTANDING

Measures recoverable amount in the event of

liquidation if assets are realized at their book
values.
12. TIMES PREFERRED DIVIDEND EARNINGS BEFORE INTEREST AFTER TAX
¿
REQUIREMENTS PREFERRED DIVIDENDS REQUIREMENTS

Indicates the ability to provide dividends to

preferred shareholders.
13. TIMES FIXED CHARGES EARNED EARNINGS BEFORE INTEREST ∧TAXES
¿
¿CHARGES

FIXED CHARGES = RENT + INTEREST +

**SINKING FUND PAYMENT BEFORE TAXES

**SINKING FUND PAYMENT BEFORE TAXES =

SINKING FUND PAYMENT AFTER TAXES ÷ (1 –
TAX RATE)

Measure the ability to meet fixed charges.

III. TESTS OF PROFITABILITY

1. RETURN ON SALES EARNINGS AFTER INTEREST ∧TAXES

¿
NET SALES

Determines the amount of income on each peso sales.

2. RETURN ON TOTAL ASSETS EARNINGS BEFORE INTEREST BUT AFTER TAXES
¿
AVERAGE TOTAL ASSETS

Efficiency with which managers use total assets to operate

the business.
3. RETURN ON EARNINGS BEFORE INTEREST ∧TAXES
¿
INVESTMENTS/RETURN ON AVERAGE TOTAL ASSETS
INVESTED CAPITAL
 OR
OPERATING INCOME
¿
AVERAGE TOTAL ASSETS

Indicates whether the management is using the fund

wisely.
4. RETURN ON TOTAL EQUITY ¿ NET INCOME−DIVIDEND ON REDEEMABLE PREFERRED STOC
¿ '
AVERAGE TOTAL SHAREHOLDE R SEQUITY

*NET INCOME = EARNINGS AFTER INTEREST AND

TAXES

Measures the amount earned on the owner’s or

stockholder’s investment.
5. RETURN ON COMMON ¿ NET INCOME−PREFERED DIVIDEND
¿
EQUITY '
AVERAGE TOTALCOMMON SHAREHOLDE R SEQUITY

*NET INCOME = EARNINGS AFTER INTEREST AND

TAXES

6. EARNINGS PER SHARE ¿ NET INCOME−PREFERED DIVIDEND

¿ OF COMMON SHARES ¿
WEIGHTED AVE .¿

*NET INCOME = EARNINGS AFTER INTEREST AND

TAXES

Measures the amount of net income earned by each

common share.
7. RATE OF RETURN ON EARNINGS AFTER INTEREST ∧TAXES
¿
CURRENT ASSETS AVERAGE CURRENT ASSETS

Measure the profitability of current assets involved.

8. RATE OF RETURN PER RATE OF RETURN ON AVE . CURRENT ASSETS
¿
TURNOVER OF CURRENT CURRENT ASSET TURNOVER
ASSETS
Measures the profitability of each turnover of current
assets.

IV. TESTS OF MARKETABILITY/GROWTH RATIO

Refers how financial instruments can be quickly converted into cash at a reasonable price.

1. PRICE-EARNINGS RATIO MARKET PRICE PER SHARE

¿
EARNINGS PER SHARE

Indicates the number of pesos required to buy P1

earnings.
2. EARNINGS YIELD RATIO EARNINGS PER SHARE
¿
MARKET PRICE PER SHARE

Determines how much will be earned for every P1

invested. Reciprocal of PRICE-EARNINGS RATIO.
 3. DIVIDEND YIELD RATIO EXPECTED DIVIDENDS PER SHARE (COMMON )
¿
MARKET PRICE PER SHARE

Measures the rate of return in the investor’s

common stock investments.
4. DIVIDEND PAY-OUT RATIO EXPECTED DIVIDENDS PER SHARE (COMMON )
¿
EARNINGS PER SHARE

Indicates the proportion of earnings distributed as

dividends.
5. PLOWBACK/RETENTION RATIO ¿ 1−DIVIDEND PAYOUT RATIO

Determines the portion of earnings used for internal

financing.

Du Pont Equation
DuPont analysis is a useful technique used to decompose the different drivers of return on equity
(ROE). The decomposition of ROE allows investors to focus on the key metrics of financial
performance individually to identify strengths and weaknesses. Du Pont is computed as:

Du Pont = Net Profit Margin X Asset Turnover X Equity Multiplier

= [OPIN/Total Sales] X [Total Sales/Total Assets] X [Total Assets/SHE]

MEASUREMENT OF GROWTH
Growth ratios:
1. Net sale growth
2. EBITDA growth
3. Net profit growth
4. EPS growth

Financial forecasting using additional funds needed (AFN)

AFN is a way of calculating how much new funding will be required, so that the firm can realistically
look at whether or not they will be able to generate the additional funding and therefore be able to
achieve the higher sales level. The simplified formula is:

Projected increase in assets +

Spontaneous increase in liabilities -
Any increase in retained earnings -
Additional Funds Needed =

The more formal equation for AFN is:

AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(RR)

 A - Assets tied directly to sales

 L - Spontaneous liabilities that are affected by sales
 S0 - Last year's sales
 S1 - Total projected sales for next year
 ∆S - The change in sales between S0 and S1
 M - Profit margin
 MS1 - Projected net income
 RR - The retention ratio from net income (equal to 1 minus the dividend payout ratio; disregard
if dividends are not declared)