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Analysis and Interpretation of Financial Statements 2

The document discusses analyzing financial statements using ratios to assess a company's profitability, efficiency, and financial health. It provides examples of common profitability ratios like gross profit ratio and return on assets. Operational efficiency ratios like asset turnover and inventory turnover are also discussed. Finally, the document covers financial health ratios including debt ratio, current ratio, and interest coverage ratio to evaluate a company's liquidity and solvency. Sample financial statements are provided to demonstrate computing various ratios to interpret the company's performance.

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Alyssa Nikki Versoza
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90 views

Analysis and Interpretation of Financial Statements 2

The document discusses analyzing financial statements using ratios to assess a company's profitability, efficiency, and financial health. It provides examples of common profitability ratios like gross profit ratio and return on assets. Operational efficiency ratios like asset turnover and inventory turnover are also discussed. Finally, the document covers financial health ratios including debt ratio, current ratio, and interest coverage ratio to evaluate a company's liquidity and solvency. Sample financial statements are provided to demonstrate computing various ratios to interpret the company's performance.

Uploaded by

Alyssa Nikki Versoza
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Analysis and Interpretation of

Financial Statements 2
Module 6
Objective
1. Solve exercises and problems that require computation
and interpretation using various financial ratios.
2. Using the downloaded sample financial statements,
learner computes various financial ratios and
interprets the level of profitability, efficiency and
financial health (liquidity and solvency) of the
business.
Terms
Financial Statement (FS) Analysis is the process of
evaluating risks, performance, financial health, and
future prospects of a business by subjecting financial
statement data to computational and analytical
techniques with the objective of making economic
decisions(White et.al 1998).There are three kinds of FS
analysis techniques:
- Horizontal analysis
- Vertical analysis
- Financial ratios
Ratio analysis expresses the relationship among selected
items of financial statement data. The relationship is
expressed in terms of a percentage, a rate, or a simple
proportion (Weygandtet.al. 2013). A financial ratio is
composed of a numerator and a denominator. For
example, a ratio that divides sales by assets will find the
peso amount of sales generated by every peso of asset
invested. This is an
important ratio because it tells us the efficiency of
invested asset to create revenue. This ratio is called asset
turnover. There are many ratios used in business. These
ratios are generally grouped into three categories: (a)
profitability, (b) efficiency, and (c) financial health.
Profitability ratios measure the ability of the company to
generate income from the use of its assets and invested capital as
well as control its cost. The following are the commonly used
profitability ratios:

Gross profit ratio reports the peso value of the gross profit earned
for every peso of sales. We can infer the average pricing policy
from the gross profit margin.

Operating income ratio expresses operating income as a


percentage of sales. It measures the percentage of profit earned
from each peso of sales in the company’s core business
operations (Horngren et.al. 2013). A company with a high
operating income ratio may imply a lean operation and have low
operating expenses. Maximizing operating income depends on
keeping operating costs as low as possible (Horngren et.al. 2013).
Net profit ratio relates the peso value of the net income earned
to every peso of sales. This shows how much profit will go to
the owner for every peso of sales made.

Return on asset(ROA) measures the peso value of income


generated by employing the company’s assets. It is viewed as an
interest rate or a form of yield on asset investment. The
numerator of ROA is net income. However, net income is profit
for the shareholders. On the other hand, asset is allocated to
both creditors and shareholders. Some analyst prefers to use
earnings before interest and taxes instead of net income. There
are also two acceptable denominators for ROA – ending
balance of total assets or average of total assets. Average assets
is computed as beginning balance + ending balance divided by
2
Return on equity(ROE) measures the return (net
income) generated by the owner’s capital invested in
the business. Similar to ROA, the denominator of ROE
may also be total equity or average equity
Sample Financial Statements to be used for the computations:

Cash P 200,000
Accounts Receivable 400,000
Inventory 250,000
Equipment 550,000
Total Assets P 1,400,000

Accounts Payable P 300,000


Notes Payable 400,000
Owner, Capital 700,000
Total Liabilities and equity P 1,400,000

Sales P 900,000.00
Cost of Goods Sold 400,000.00
Gross Profit 500,000.00
Operating Expenses 200,000.00
Operating income 300,000.00
Interest Expense 20,000.00
Net Income 280,000.00
Operational efficiency ratio measures the ability of
the company to utilize its assets. Operational
efficiency is measured based on the company’s ability
to generate sales from the utilization of its assets, as a
whole or individually. The turnover ratios are primarily
used to measure operational efficiency.

Asset turnover measures the peso value of sales


generated for every peso of the company’s assets. The
higher the turnover rate, the more efficient the
company is in using its assets.
Fixed asset turnover is indicator of the efficiency of fixed assets
in generating sales.

Inventory turnover is measured based on cost of goods sold


and not sales. As such both the numerator and denominator of
this ratio are measured at cost. It is an indicator of how fast the
company can sell inventory. An alternative to inventory
turnover is “days in inventory”.

Accounts receivables turnover the measures the number of


times the company was able to collect on its average accounts
receivable during the year. An alternative to accounts
receivable turnover is “days in accounts receivable”. This
measures the company’s collection period
which is the number of days from sale to collection.
Financial Health Ratios look into the company’s
solvency and liquidity ratios. Solvency refers to the
company’s capacity to pay their long term liabilities.
On the other hand, liquidity ratio intends to measure
the company’s ability to pay debts that are coming due
(short term debt).

Debt ratio indicates the percentage of the company’s


assets that are financed by debt. A high debt to asset
ratio implies a high level of debt.
Equity ratio indicates the percentage of the company’s
assets that are financed by capital. A high equity to
asset ratio implies a high level of capital.

Debt to equity ratio indicates the company’s reliance to


debt or liability as a source of financing relative to
equity. A high ratio suggests a high level of debt that
may result in high interest expense.
Interest coverage ratio measures the company’s ability
to cover the interest expense on its liability with its
operating income. Creditors prefer a high coverage
ratio to give them protection that interest due to them
can be paid.
Current ratio is used to evaluate the company’s
liquidity. It seeks to measure whether there are
sufficient current assets to pay for current liabilities.
Creditors normally prefer a current ratio of 2.
Quick ratio is a stricter measure of liquidity. It does not
consider all the current assets, only those that are
easier to liquidate such as cash and accounts receivable
that are referred to as quick assets.

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