Module 2: Financial Statement Analysis

Module Objective:
At the end of the module, you should be able to:
1. Define Financial Statement Analysis and its purpose
2. Identify the different requirements in conducting financial statement analysis
3. Recognize the limitations of Financial Statement Analysis
4. Evaluate a firms progress using trend analysis
5. Distinguish a firms focus through common-size financial statement
6. Assess a firms profitability and risk level using ratio analysis

Financial Statement Analysis

It refers to the evaluation of a firms over-all performance and financial condition through the
examination of the financial statements. Performance refers to a firms result of operation as compared to
a predetermined benchmark while a firms condition is being defined by amount of resources and the
claims to such resources by different parties. Although performance is often being related to net income, a
deeper analysis will result to the determination of how the firm was effective and efficient in achieving its
goals and objectives and if possible, as compared to other firms. Another area in financial statement
analysis is the definition of financial condition, which is usually related to the amount of assets and the
ratio between the liabilities and equity that has a claim on such assets, however, in evaluating the financial
condition of a firm, the ultimate goal is to establish the amount, timing and certainty of future cash flow,
both inflows and outflows. When assessing the financial health of a firm, the main concern is how the
assets of the firm will be able to, either directly or indirectly, contribute to the firms cash inflow in order
to address the spending needs of the firm related to the claims, not only of the firms creditors and
shareholders, but also its operating requirements.
The Financial Statements
As provided by the conceptual framework, the objective of general purpose financial statements is to
provide information about the financial position (resources and claims and the changes on such),
performance (income and expenses), and the changes in the financial position (changes through cash
flows and equity), that is useful in making economic decision. A complete set of financial statement
include a statement of financial position, statement of comprehensive income, statement of cash flows,
statement of changes in equity, and the summary of significant summary and supporting schedules.
The Statement of Financial Position
Formerly known as the balance sheet, the statement of financial position presents the Assets,
Liabilities and Equity of a firm. The statement presents a snapshot of the resources of a firm
(assets) and the claims to those resources (liabilities and shareholders equity). In financial
accounting, assets are resource controlled by a firm that can provide future economic benefit,
however, in financial statement analysis, assets will reflect the past investing decisions of the firm
and this will include the amount tied up to receivables and inventories. Liabilities under financial
accounting are present obligations that will be settled by the firm while equity is the residual
value left to the shareholders after deducting the liabilities. In financial statement analysis,
liabilities and equity will represent the past financing of the firm, meaning, what the firm had
used in acquiring its assets.
The Statement of Comprehensive Income
The income statement presents the amount of income earned by the firm that will be helpful in
assessing the over-all performance of the firm. However, in financial statement analysis, the
income statement will be helpful in assessing how effective and efficient the firm in generating

revenues in order to address all of its financial needs, whether operating, investing or financing in
nature. The only drawback for the statement of comprehensive income is the basis for the
recognition of income and expenses and that is income is recognized when earned or when
services has already been rendered or goods delivered and expense is recognized when incurred
that most of the time, does not coincide with the inflow of cash. Hence, if decision makers will
literally evaluate the result of the operation, they will be misled as to expecting that there will be
cash flowing into the firm when there is net income and vice versa during net loss.
The Statement of Cash Flow
The statement of cash flow presents, for a period of time, the net cash flow (inflows minus
outflow) from the three principal business activities; operating, investing, and financing. The
main goal of the business is to generate a positive cash flow from its operation however; such
operation will be requiring different resources acquired under investing activities which will be
possible if there will be funds provided under financing activities. In providing information about
the cash flow of the firm and reconciling such to the results of operation can permit the
assessment of the certainty, timing and amount of cash that will flow into the firm. As discussed
in the previous section profit does not equal to cash inflows due to the fact that the timing of cash
flow does not coincide with the timing of recognizing revenues and expenses and this sometimes
causes financial difficulties when the retirement of debt or acquisition of properties are done
during times of insufficient cash.
Why interpret financial statements?
In analyzing the financial statements, management will be able to assess the level of an firms success in
the past in conducting its activities, its strengths used to avail of the opportunities and lower, if not
eliminate, any business threats and the areas wherein the firm is weak that causes the business threats.
Also, uncovering the financial condition and performance of the firm will lead to the identification of how
the firm has reacted in relation to changes in the business environment. After ascertaining the strengths
and weaknesses and the firms reaction through financial statement analysis, management can now
project its likely future performance by setting goals, formulate strategies that will eventually lead to the
construction of the financial budget.
Other usages of the result of financial statement analysis are as follows:
1. For investors when determining what firm to be invest in and the amount of the investment to be
made in a firms stocks
2. For the creditors and suppliers when extending credit credit worthiness of the firm being
evaluated.
3. Assessing the operating performance and financial health of suppliers and customers in
determining the level of reliance the firm is going to make and assessing the competitors
performance and financial health could be used in constructing the goals and strategies to be
implemented in the following period.
4. For management consultants and advisers, in terms of valuing another firm being considered as
an acquisition candidate advisers and consultants is likely to consider the income generating
power of the firm to be acquired.
5. Forming a judgment about damages sustained in a lawsuit
6. For auditors when assessing the nature, extent, and timing of the audit tests in rendering an
opinion.
7. Government regulations in as far as to the taxes to be levied and restrictions to be imposed, the
government should evaluate the financial impact to key players in the different industry before
making a regulation.
8. Employee benefits formulation assessing the ability of the firm to provide better remuneration,
retirement benefits and other monthly benefits should be considered when asking for such.

Requirements in conducting financial statement analysis

Before conducting a financial statement analysis, accountants and management consultants should first
identify the economics and current conditions facing the business. Second, identify the strategies that the
firm selects to compete in the business. Third, understand the important concepts and principles
underlying the financial statements used in computing the financial ratios. Through these understanding,
the analyst will be able to develop an expectation of the behavior in account balances and the level of
possible net income. After developing the expectations, we can now perform the analysis. Lastly, after
finishing the analysis, we need to make a judgment or a conclusion and the related recommendation for
the operations primary activities. It is to be described that financial Statements serve as score sheet or the
report card which is the result of the accounting process which are considered to be a system for
measuring the results of a firms business transactions and summarizing them in a form that interested
parties can understand. But the ultimate key concept in this discussion is the effect of business
transactions, which are the key in understanding the financial statements.
Establish the economic and current condition
This aspect refers to both the internal and external business environment of the firm. It require
scrutinizing even the smallest detail in the industry and general economic environment that may
hinder or limit, either directly or indirectly, the firms operation that may prevent it from
achieving its goals and objective. In this aspect, management is required to ascertain the
following:
1. What is the competitive market (output-sales) profile of the industry It is about
identifying the key players in an industry, who are the market leader and challenger and
who are the followers and firms that concentrate on the small portion of the market
(niche market). Aside from the direct competitors, management should also look into the
product and service substitutes and possible threats of foreign competition.
2. What is the production (input) profile of the industry? In as far as production requirement
is concern, the three major production cost, direct materials, direct labor and
manufacturing overhead, should be evaluated as to its proportion, constraints, and
substitutes among other things. Management need to prevent, and if already existing, find
a solution on the following issues:
a. Direct materials its scarcity and depletion. What are the possible substitutes for
the current raw materials being used without affecting the level of quality and
product identity? How is the distribution level of such raw materials?
b. Direct Labor in terms of government regulations on employment such as
minimum wage, benefits, and others. The effects of unionized workforce and the
fast pace changes in technology, looking at how the firms laborer will be able to
keep up.
c. Manufacturing Overhead it is about managements capacity to evaluate on the
different indirect production costs on what are essential and non-essential, what
is value adding and non-value adding; and what can or cannot be eliminated.
3. Evaluating the impact of technologies, how the firms product and/or services should
react on new found technologies, how the firm will be able to maintain the relevance of
its product and/or services to society on the fact of Innovations it is about determining
how the features and details of the firms product and/or services will change.
4. Growth characteristics of the industry this refers to the ability of the industry to expand
and serve new types of market, it is about the products alternative usage and in relation
to the previous item, how altering the products features might lead the way to new
purposes of the product, thus, developing the products market anew.
5. As mentioned in the sections introductory paragraph, government regulations might limit
the firms actions which in turn affect its status in as far as meeting its short and long
term objectives. Government laws and regulations such on taxation, employment,

environmental protection, sanctions, and price control should be considered when

evaluating the firms risk of probable extinction and profitability level despite of
limitations and regulations.
Other factors like demographics (Age group, sex, income brackets, hobbies, lifestyle, etc.) and
microeconomics data (GDP, GNP, interest and foreign currency rates, etc.) should also be
considered in evaluating the past performance and predicting future operations in line with the
result of financial statement analysis.
Corporate Goals, Strategies and Business Activities
As discussed in the previous module, before the operating period began, management will be
conducting its planning activities which include setting the goals and objectives of the firm,
identifying the related strategies required to meet such goals and objectives, and designing an
action plan which contains the time frame, activities to be done, person-in-charge, and the
resources needed which will lead to the construction of a budget. In relation to the conduct of the
financial statement analysis, understanding the goals of management is vital in interpreting why
the result of operation is as such. In analyzing the contents of the financial statement, the analyst
should understand the fact that these information are based on the data extracted from the
different business transactions the firm has undertaken during the operation period. Such business
transactions are executed by management on the basis of the action plan and strategies of the
firm. Diagram 2.1 depicts how the different business transactions are determined by the firms
goal and objective.
Perform Operating, Investing and Financing Activities
Set Goals and Objectives
Formulate the
Construct the Action Plan
Stategy

Financial Statements

Diagram 2.1: Relationship of Goals, Activities and Financial Statements

Goals are the targets or end results toward which a firm directs its energies. The general goals of
firms and businesses are to maximize their profit which will increase their business value that is
the value which is measured through the income-generating capacity of the firm in the succeeding
periods. Goals can be short term or long-term which has been discussed in the previous module.
Other goals of a firm might include contented workforce, supporting the community in which its
operation is based through corporate social responsibility activities and promoting government
policy. Strategies are the means for achieving such goals and it has two levels, Company level
and product level. Under company level, the firm has to decide whether it will concentrate in a
particular industry or to be a diversified firm which offers various products and services. Also,
under company strategy, the decision to maintain a domestic operation or to become a
multinational company would also be included. Under product level, the three generic strategies
are product differentiation, cost leadership, and market focus, which were already discussed in the
previous module.
In as far as business activity is concerned, there are three major activities, financing, investing,
and operating. Operating activities pertains to the Selling of goods and/or services for a higher
price than the cost of the investment made in those goods and services, including the cost of

financing. Investing activities pertains to the acquisition and disposal of properties, intangibles
and other investments and Financing activities refers to obtaining funding from creditors and
owners. Diagram 2.2 depicts the relationship of the three activities.

Financing activities
Investing
Obtaining
activities
Funds Acquisition
Operating Activities
of required
Purchasing
resources & Selling
Repay creditors or declare dividends or acquire additional resources?

Diagram 2.2 Relationships of Business Activities

Financial Statement Concepts and Principles

Financial Statements serve as score sheet or the report card; it shows management stewardship of
the firms resources. It is produced through the accounting system which measures the results of a
firms business transactions and summarizing them in a form that interested parties can
understand. In summarizing the effects of business transactions on the firms resources and claims
to such resources, there are principles and concepts embodied on what is known as the generally
accepted accounting principles (GAAP). In analyzing financial statements, analyst should be
aware of the principles and policies used in the construction of the financial statements to have a
better understanding on the nature of the accounts being used in the analysis. The cost principles
which states that assets are recorded at its cost the cost of acquiring and bringing the assets to
its intended use and will be maintained at cost regardless of the purchasing power of the currency
being used for valuation. Another principle is the Accrual Basis which states that income and
expenses are recognized in the books when earned or incurred regardless whether collected or
paid for. In ascertaining the amount, timing and certainty of cash flows, an analyst might be
misled of the net income being equal to the net cash inflow that a firm will have since income and
expenses are recognized even if there are no cash flows. Another point is the fact that assets are
presented at their cost and not their current market values which most of the time, is higher than
its costs. It is in this context that we see the results of the financial statement analysis as just
rough estimates or a point of reference in the determination of the amount, timing, and certainty
cash flow that a firm can generate.
Developing Expectations, Performance and Conclusion
In performing financial statement analysis, the analyst should have developed some level of
expectations based on the information derived from the preceding discussions in this section of
the module. Such expectations are crucial in a sense that the result of the analysis will either
confirm or deny such will be used in generating the over-all conclusion and evaluation.
Limitations of Financial Statement Analysis
As with the other business and accounting concepts, financial statement analysis has its own limitations.
Aside from the reporting framework policies on valuation and presentation of accounts in the financial
statements which could limit the usefulness of the analysis in reflecting current condition of the firm,
other limitations of analyzing the financial statement in determining the risk and the over-all profitability

of a company that will be used in planning future operating periods will include other environmental
factors.
Strong financial statement analysis does not necessarily mean that the organization has a strong
financial future. Although financial statement analysis can provide a rough estimate on the
amount, timing and certainty of cash flow of the firm, other factors like bankruptcy of major
supplier and customers, or the fast pace change in the products life cycle of the firm or the
sudden breakdown of equipments and machineries requiring immediate replacement, or the
untimely withdrawal of an investor might cause cash flow problems. Hence, in making a
conclusion as to the over-all result of the financial statement analysis, caveats should be given to
readers as to the areas in which possible cash flow crisis might occur.
Financial statement analysis might look good but there may be other factors that can cause an
organization to collapse. In determining the future performance of a firm, the result of the
analysis will present the result of operations and financial condition of the firm within a particular
economic environment and business situations. The problem lies in the constant changes in the
business environment. This would mean that any actions performed in the previous operating
period may not be applicable to the current situations and scenarios. Also, after evaluating the risk
and profitability of a firm, an analyst might conclude that the firm will be able to face the current
business environment in relation to the estimated change in the environment. A change in the
countrys political stability, or bankruptcy of a major financial institution can cause the collapse
of a firm.

Horizontal Analysis
A type of time-series analysis of evaluating what has occurred over a period of time in relation to a
particular starting point. It also called Trend Analysis since the main goal of this analysis is to evaluate the
progress and changes in the firms resources and claims to such resources. It useful in gaining insights
about the changes in the amount and structure of the firms assets, liabilities, equity, revenues, and
expenses which can reveal the firms intended actions in the future. Items are expressed as a percentage of
a base year or the starting point of the evaluation.
Base Year
This is a point in time that will be used as a reference in determining the progress of the firm. It should
represent something of great significance in the firm that was expected to result in its advancement.
Events like hiring of a new management team or execution of a new strategy or business structure or the
introduction of a new product line or business venture, among other things should be the basis in
determining where the firm has been and where it intends to go. In answering the question of how many
periods from the base year should be included in the analysis will depend on the goals set by management
in relation to the particular event that is serving as the basis for determining the progress of the firm. For
example, if the newly hired president of the company promises positive results of operation within five
(5) years, then a five year analysis should be done.
Also, companies may opt to choose period/s before the significant event has occurred for the purpose of
comparing the old and the new situations. Analyst should be cautious in using non-performing years as
the base year since it might result in a wrong connotation as to what is a mediocre performance as
compared to a maximizing-profit-performance.
Performing Horizontal Analysis
In conducting a horizontal analysis, the following formula will be applied in each of the line item in the
face of the financial statement:

Curren YearBase Year

x 100
or
Base Year

2012 Bal .2011 Bal .

x 100
2011 Bal .

In demonstrating the different analysis, Bulacan Corporations financial statements for the past three (3)
periods) will be used and is as follows:
2010
2011
2012
Assets
Cash and Cash Equivalent
Accounts Receivable
Inventory
Other Current Assets
Total Current Assets
Property, Plant & Equipment (net)
TOTAL ASSETS
Liabilities and Equity
Note Payable
Accounts Payable
Accrued Expenses
Total Current Liabilities
Non-Current Liabilities
Total Liabilities
Equity
Total Liabilities and Equity
Net Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Operating Income
Interest Expense
Earnings before tax
Income tax expenses
Earnings after tax
Cash Dividend

148,000
283,000
322,000
10,000
763,000
460,000
1,223,000

100,000
410,000
616,000
14,000
1,140,000
904,000
2,044,000

90,000
394,000
696,000
15,000
1,195,000
974,000
2,169,000

290,000
81,000
28,000
399,000
150,000
549,000
674,000
1,223,000

295,000
94,000
116,000
505,000
453,000
958,000
1,086,000
2,044,000

290,000
94,000
116,000
500,000
530,000
1,030,000
1,139,000
2,169,000

1,235,000
849,000
386,000
180,000
206,000
20,000
186,000
74,000
112,000

2,106,000
1,501,000
605,000
383,000
222,000
51,000
171,000
69,000
103,000

2,211,000
1,599,000
612,000
402,000
210,000
59,000
151,000
60,000
91,000

50,000

50,000

;50,000

For the first three assets, the determination of the trends using 2010 as the base year will be
2011
2012

2011 Bal .2010 Bal .

x 100
2010 Bal .

2012 Bal .2010 Bal .

x 100
2010 Bal .

For the account Cash and Cash Equivalent, the trend analysis will be as follows:
2011
2012

100,000148,000.
x 100
148,000

90,000148,000
x 100
148,000

= - 32%

= -39%

This would mean that the companys cash and cash equivalent balance has been declining since 2010. It
decreases by 32% in 2011 and by 39% in 2012. Although the computations are done for each line item
independent of each other, interpreting the results should be done considering all the results of the
computations. For the account Accounts Receivable, the trend analysis will be as follows:
2011
2012

410,000283,000.
x 100
283,000

394,000283,000
x 100
283,000

= 45%

= 39%

In connection with the previous computation, we can probably connect the decrease in cash to the
increase in receivables which can be connected to the collection policy and processes of the company.
However, over-all conclusion cannot be based on two accounts only, it has to be based on the over-all
results of computation of the different line items. For the account inventories, the trend analysis will be:
2011
2012

616,000322,000.
x 100
322,000

696,000322,000
x 100
322,000

= 91%

= 116%

As we can see, the earlier conclusion may not be accurate since another account that may have been the
cause of the decline in the cash balance is inventory. Further investigation will give the analyst a better
idea on what have causes what. The following table presents the Trend analysis for Bulacan Corporation.
2010

2011

2012

Increase/
(Decrease)
(32%)
45%
91%
40%

Increase/
(Decrease)
-39%
39%
116%
50%

Assets
Cash and Cash Equivalent
Accounts Receivable
Inventory
Other Current Assets

148,000
283,000
322,000
10,000

100,000
410,000
616,000
14,000

Total Current Assets

Property, Plant & Equipment (net)

763,000
460,000

1,140,000
904,000

49%
97%

1,195,000
974,000

57%
112%

1,223,000

2,044,000

67%

2,169,000

77%

Liabilities and Equity

Note Payable
Accounts Payable
Accrued Expenses

290,000
81,000
28,000

295,000
94,000
116,000

2%
16%
314%

290,000
94,000
116,000

0%
16%
314%

Total Current Liabilities

Non-Current Liabilities

399,000
150,000

505,000
453,000

27%
202%

500,000
530,000

25%
253%

Total Liabilities

549,000

958,000

74%

1,030,000

88%

TOTAL ASSETS

90,000
394,000
696,000
15,000

Equity

674,000

1,086,000

61%

1,139,000

69%

Total Liabilities and Equity

1,223,000

2,044,000

67%

2,169,000

77%

Net Sales
Cost of Goods Sold

1,235,000
849,000

2,106,000
1,501,000

71%
77%

2,211,000
1,599,000

79%
88%

Gross Profit
Operating Expenses

386,000
180,000

605,000
383,000

57%
113%

612,000
402,000

59%
123%

Operating Income
Interest Expense

206,000
20,000

222,000
51,000

8%
155%

210,000
59,000

2%
195%

Earnings before tax

Income tax expenses

186,000
74,000

171,000
69,000

(8%)
(7%)

151,000
60,000

(19%)
(19%)

Earnings after tax

112,000

103,000

(8%)

91,000

(19%)

Presenting the Results

Aside from the tabular form that summarizes the computation done with each of the line item, the users of
the analysts report will appreciate trend analysis through a line graph that literally highlight the increase
and decrease of each of the line item. Each set of line graph should show accounts of the same nature. For
example, one set of chart for all assets, then for all liabilities, and then for all income and expenses.
Diagram 2.3 shows the line chart of the trend analysis of the asset account.
140%
120%
100%
80%

Cash and Cash

Equivalent

60%

Accounts Receivable
Inventory

40%

Other Current Assets

20%

Property, Plant &

Equipment (net)

0%
-20%

-40%
-60%
Diagram 2.3: Line Chart of Asset Account Trend Analysis

Interpreting the results

Aside from the stated fact that interpreting trend analysis result should not be done on a per account basis,
another limitation of trend analysis is that a large percentage change in one year for a particular item may
simply reflect relatively small amount from the previous year that serves as a base, referring to the
accrued expense account in the table above, it increases drastically in 2011 but from 2011 to 2012, its
balance did not change but it still reflected an increase since the base year was 2010 and not 2011. Also, a
large percentage change for a particular item may not be significant if that item represents a small

proportion of total assets or total liabilities and equity like the account other current assets which increase
40% during 2011 and 50% during 2012, however this changes will not be that significant since their total
amount is almost immaterial as compared to property, plant and equipment balances.

Vertical Analysis
This analysis is also called Common Size Financial Statements Analysis. It expresses each balances of
account as a percentage of total assets, total liabilities & equity, and total sales. It can be a useful tool for
gaining insight about the structure of a firms assets, liabilities, equity, and expenses. In using this tool,
analyst will be able to ascertain what are the areas of wherein the firm focuses its efforts since it will
reveal what are the majority compositions of a particular account balances.
Performing the Analysis
In constructing the common size financial statement of a firm, the first step will be the selection of the
base amount that will represent the 100% or the item on which other accounts are subject to. Usually for
the statement of financial position, it will be total assets for all assets and total liabilities and equities for
liabilities and equity. For expenses, it will be total sales. The common size financial statement of Bulacan
Corporation follows:

Assets
Cash and Cash Equivalent
Accounts Receivable
Inventory
Other Current Assets
Property, Plant & Equipment (net)
TOTAL ASSETS

Liabilities and Equity

Note Payable
Accounts Payable
Accrued Expenses
Non-Current Liabilities
Equity
Total Liabilities and Equity

Net Sales

2010

2011

148,000 12%
283,000 23%
322,000 26%
10,000 1%
460,000 38%
1,223,00 100%
0

100,000 5%
410,000 20%
616,000 30%
14,000 1%
904,000 44%
2,044,00 100%
0

90,000
394,000
696,000
15,000
974,000
2,169,00
0

290,000
81,000
28,000
150,000
674,000

295,000 14%
94,000 5%
116,000 6%
453,000 22%
1,086,00 53%
0
2,044,00 100%
0

290,000
94,000
116,000
530,000
1,139,00
0
2,169,00
0

2,106,00 100%
0
1,501,00 71%
0
383,000 18%
51,000 2%
69,000 3%

2,211,000

24%
7%
2%
12%
55%

1,223,00 100%
0

Cost of Goods Sold

1,235,00 100%
0
849,000 69%

Operating Expenses
Interest Expense
Income tax expenses

180,000
20,000
74,000

15%
2%
6%

2012
4%
18%
32%
1%
45%
100%

13%
4%
5%
24%
53%
100%

100%
1,599,00
0
402,000
59,000
60,000

72%
18%
3%
3%

Earnings after tax

112,000

9%

103,000

5%

91,000

4%

Presenting the result

Since common size financial statement presents the composition of the base account, the best way to
present such analysis is through the usage of a pie chart that will literally present the portion being
composed of a particular account in as far as the base account is concern which will aid in the immediate
determination of the firms focus. In constructing the pie chart, it should be on a base account per year
basis. But, the annual pie chart having the same base account should be presented side by side to permit
comparison as to the changes in the firms focus. The pie chart of the asset accounts for Bulacan
Corporation for three years are presented below:
Cash and Cash Equivalent
Accounts Receivable
Inventory
Other Current Assets
Property, Plant & Equipment (net)

2010 Total Assets

Cash and Cash

Equivalent

Accounts
Receivable

Inventory

Other Current
Assets

Property, Plant
& Equipment
(net)

2011 Total Assets

Cash and Cash

Equivalent

Accounts
Receivable

Inventory

Other Current
Assets

Property, Plant
& Equipment
(net)

2012 Total Assets

As per the chart, it seems that the companys asset composition has remained constant for the three year
period being analyzed. This could mean that the firm has not been changing its strategies and processes
for the past three years.
Interpreting the results
Just like the horizontal analysis, vertical analysis also has limitations in terms of the interpretation of the
results. The first is that percentages of individual accounts are not independent of the percentages for
other accounts. This means that any changes in one account may or may not be cause in the movement of
such account. For example, the cash account balance may not have change over three years while the
account balance of property, plant and equipment has change drastically over the three period, since both
are assets and their balances will be presented as part of total assets, the share of the cash account as a
percentage of total asset will change due to the movement in property, plant and equipment.
Rationale behind the Common-Size Financial Statement
The horizontal analysis presents a comparative purpose over a period of time by revealing the shift in the
firms focus (strategy formulation) through the determination of changes in the composition of its
resources, claims and expenses. In relation to the results of operation, finding the right mixture of assets
and financing that will result to the highest possible profit will be the aim of such analysis while
determining the expenses that eats up the total revenue of the firm will help management to determine
the focus of its cost reduction effort.
Also, in constructing a common size financial statement, the analyst is actually putting different size
companies at the same level. This is called competitive analysis. It will try to identify where the
competitors, especially the market leader do, focuses their resources and how they are financing such
resources as compared to other players in the industry. In such a way, it can give management an idea on
how to construct their policies in order to address the competition in the market.

Ratio Analysis
In conducting ratio analysis, one is actually presenting the relationships of different accounts with an
objective of evaluating the profitability and risks of a firm. In ratio analysis, what we are uncovering is
whether the proportion of a particular account in relation to another account is within the acceptable level
that can address both the profitability and risks of an enterprise. For example in comparing the amount of
current assets and current liabilities, the analyst is actually comparing the assets that are almost realizable

into cash versus the amount of liabilities that are almost due, hence, we will be able to determine if the
company will be able to pay such maturing liabilities.
There are two areas in ratio analysis; the first area evaluates the firms profitability while the second area
addresses the firms business risks.
Profitability evaluation
In evaluating the firms profitability, some will say to focus on a firms operating activities, however, in
terms of the relationship of business activities, the operation of a firm is highly dependent on its investing
activities the resources available to generate revenues and in connection with investing activities are the
financing activities which presents how the resources were acquired either through debt or investment
of owners. In assessing the firms profitability, we will focus on two areas, the first area will be
determining how effective and efficient the firm in generating income with a given set of resources which
will be represented using the return on asset (ROA) evaluation, and the second area will show how the
firm utilizes the capital provided by the shareholders in generating income by using the Return on Equity
(ROE) computation which indirectly evaluates the effectiveness of the firm in using its debts in its
operation.
Return on Asset (ROA)
This ratio measure the firms effectiveness and efficiency in utilizing its assets to generate income
without reference to the financing tool used in acquiring those assets. In terms of ROA, a lot has
been discussing whether to use net income or operating income, whether to use Total Assets or
Operating Assets. The ratios objective is simple, to present the firms ability to generate income
through its operation operational capabilities, hence, operating income and operating assets
should be used in the analysis, since net income and some assets includes other items that are not
directly related to the firms operations. The formula in computing the return on asset is as
follows:

ROA=

Operating Income
Total Average Operating Assets

In computing the return on assets, and also other ratios involving comparing an income statement
account and a balance sheet account, the average balance of the balance sheet account should be
use. This is so since the income statement account represents transactions that have occurred in a
year while the balance sheet account balance represents a particular day in a year. Computing the
average balance of the balance sheet account, which in this case is the total asset of a firm, is as
follows:

Average Balance=

Beginning Balance+ Ending Balance

2

Computing Bulacan Corporations return on asset for two (2) years 2011 and 2012 will be as
follows:
2011

ROA=

2012

P222,000
P210,000
ROA=
(1,223,000+2,044,000)/ 2
(2,044,000+2,169,000)/ 2

ROA=14

ROA=10

Whether the result of the computation is good or bad for the firm will depend on predetermined
benchmark like industry rates, established objectives at the beginning of the year, and past
computations. In this case, it seems that the companys profitability, in as far as the operation is
concerned were unfavorable in 2012 since its ROA drop to 10% from 14% in 2011.
Analyzing the Return on Assets
In order for a firm to determine how to improve its ROA will require determining the ratios that
can help evaluate how effective and efficient the firm was in generating an income through its
operation. The Asset Turnover represents how effective the firm in generating revenues using a
given set of assets, while Operating Income Margin will show how efficient the firm was in its
operation meaning the ability of the firm to generate operating income at a particular level of
sales.

ROA= Asset Turnover x Operati ng Income Margin

ROA=

Total Sales
Operating Income
x
Total Average Operating Assets
Total Sales

Analyzing the return on asset of Bulacan Corporation for two years:

ROA (2011)=

2,106,000
222,000
x
(1,223,000+2,044,000)/2 2,106,000

ROA ( 2011 )=1.3x 10.5

ROA (2012)=

2,211,000
210,000
x
(2,044,000+2,169,000) /2 2,211,000

ROA ( 2012 )=1.04x 9.5

Although the companys sales increased in 2012, its resulting operating income was lower
resulting in a lower operating income margin, this mean that the company incurred more
expenses in 2012. This could already guide management in formulating a cost reduction policy.
Also, the number of times in a year that the firm was able to use its assets to generate sales was
lower in 2012 that could mean an under-utilization of assets which is not a good sign due to the
fact that the main purpose why an asset is being acquired is to generate revenue. Management
should review its asset composition and should disposed assets if necessary.
Return on Equity (ROE)
This ratio measures the return provided to the firms shareholders. It integrates the result of the
firms three business activities; operating, investing, and financing. In as far as the shareholders

are concerned; the capacity of a company to generate income will be a good source of increasing
the value of their investments. However, the firms earnings will be shared by both the creditors
and the shareholders, the question is, after all the obligations of the firm to its creditors, was it
still able to provide a return to its shareholders? The formula to compute the return on equity is as
follows:

ROE=

Net Income
Total Average Shareholder s ' Equity

Determining the return on equity of Bulacan Corporation for the two year period 2011 and 2012
is as follows:
2011

ROE=

2012

P 103,000
(674,000+1,086,000)/2
ROE=12

ROE=

P 91,000
(1,086,000+1,139,000)/2
ROE=8

In relation to the return on asset, of 14% and 10%, the company was able to return 12% and 8%
to its shareholder in 2011 and 2012, respectively. This figure mean that out of the 14% operating
income generated by the operating assets of the firm, 12% were returned to its shareholders while
2% were provided to its creditors. Generally, this is a good proportion especially on the side of
the shareholders; however, this might impose a problem that since the company did not utilize its
debt capital, its operation suffered.
Analyzing Return on Equity and the Du Pont Analysis
The Du Pont Analysis was developed in 1919 by a finance executive at E.I. du Pont de Nemours
and Co. The analysis focuses on the three types of business activities, the operating activities
represented by the Sales Margin (Net Income/Total Sales), the investing activities represented by
the Asset Turnover (Total Sales/Total Average Assets) and the financing activities represented by
the capital multiplier (Total Average Assets/Total Average Equity).
The Sales Margin
This is just like the Operating Income Margin; the exception is that it will now use the net
income since it is focused on the over-all evaluation of the firm. However, the main
objective of determining how much was a firm able to earn at a particular level of sales
will reflect its efficiency in operation. It is not all about earning an income, more
importantly; it is about earning the maximum income possible. Computing the sales
margin of Bulacan Corporation for the year period follows:
2011

Sales Margin=

2012

103,000
2,106,000

Sales Margin=

91,000
2,211,000

Sales Margin=5

Sales Margin=4

The computation reveals that in 2011, for every P100 of sales that the company is
generating, only P5.00 end up with the firm while the other P95.00 is being spent and/or
paid to other parties.
Asset Turnover
There is no difference in the asset turnover computed under the ROA analysis and the Du
Pont Analysis. Total Asset Turnover reflects how effective the firms investing policies
and strategies are. It is about how the assets acquired by the firm were used in generating
the sales. Re-presenting the computation of Asset turnover of Bulacan Corporation as
follows:
2011

Asset Turnover=

2012

2,106,000
2,044,000+2,169,000
2,211,000
(1,223,000+ 2,044,000)/2
Asset Turnover =
/2

Asset Turnover =1.3

Asset Turnover=1.04

As what has been discussed, there has been an under-utilization of assets during 2012
since the turnover dropped from 1.3 times to 1.04 times.
The Capital Multiplier
Although the formula uses total shareholders equity, the capital multiplier is actually a
method for evaluating how effective a firm used debt in financing its assets. The ratio
shows how much assets per one (1) peso of shareholders equity. If the computation
resulted in a higher amount, it means that the firm is relying more on debt to finance its
assets. To check whether the computation was correct, another way of computing the
capital multiplier is simply the debt to equity ratio (to be discussed later) plus one.
Computation of the capital multiplier of Bulacan Corporation follows:

2011

Capital Multiplier=

2012

(1,223,000+2,044,000) /2
(2,044,000+2,169,000)/2
Capital Multiplier=
(674,000+1,086,000) /2
(1,086,000+1,139,000) /2

Capital Multiplier=1.85:1

Capital Multiplier=1.89:1

This shows that the Bulacan Corporations assets is financed more on equity rather debt
since for every P1.85 of assets it is financed by P1.00 of equity and only P.85 of debt.
Putting it all together
It analyzing the companys profitability using the du Pont analysis, the aim is to have a
deeper understanding of the firms return on equity and in what area the firm is not
performing well, whether is it about the operations, most especially its operating costs, or
its investing or financing activities. The following computation shows the du Pont
analysis for Bulacan Corporation for the years 2011 and 2012.

ROE=Sales Margin x Asset Turnover x Capital Multiplier

2011

2012

ROE=5 x 1.3x 1.85

ROE=4 x 1.04x 1.89

ROE=12

ROE=8

In interpreting the analysis, we can say that the company was very conservative in
utilizing debt in financing its assets, however, its effectiveness in generating revenue
using its assets is pretty low and the efficiency of the company generating revenue at
the lowest possible cost so it can have a higher net income is not that good.
Risk Evaluation
Any firm is always subject to risk that is, there might be events that may or may not result into a
positive outcome for the firm. It might be due to unfounded decisions, competitors action, general market
behavior, or even natural calamities might cause the closure of a firm. However, the main cause of
business closure is bankruptcy which is a legal status of a firm that cannot repay the debts it owes to
creditors and cannot sustain the cash requirement of the operating, investing, and financing activities of
the firm. It usually results from failure to generate sufficient cash internally (through operations selling
goods and providing services) or unable to obtain needed cash from external sources. The next phase of
ratio analysis focuses on evaluating the ability of a firm to meet its cash requirements either in the short
(liquidity) or long (solvency) period of time.
Evaluating Liquidity
There are two ratios that aim to determine a firms liquidity: current ratio and quick ratio. The
current ratio indicates the amount of cash and other current assets that the firm expects to turn
into cash within one year relative to obligations coming due during the same period. It is
computed by dividing total current assets by total current liabilities. Computation of Bulacan
Corporations current ratio for the three periods (2010 2012) follows:
2010

Current Ratio=

2011

763,000
399,000

Current Ratio=

2012

1,140,000
505,000

Current Ratio =

1,195,000
500,000

Current Ratio =1.91:1

Current Ratio=2.26 :1

Current Ratio =2.39: 1

In interpreting the computed ratio, this would simply mean that during 2010, the company has
P1.91 of current assets that are cash or near cash or those that are expected to be converted to
cash in a year for every P1 peso of currently maturing debt. Whether a higher or a lower ratio is
favorable or unfavorable for the firm will generally depend on the industry practice and general
economic conditions. Some limitations of the current ratio includes the following:
1. Inventories are recorded at cost but the cash to be generated will be higher.
2. An increase of equal amount in both current assets and current liabilities results in a
decrease in the current ratio.
3. High current ratio may accompany unsatisfactory business conditions, whereas a falling
ratio may accompany profitable operation.
4. Current ratio is susceptible to window dressing
A variation of the current ratio is the quick ratio or acid-test ratio. It indicates the amount of cash
and other current assets that are near cash relative to obligations coming due during the same
period. It is computed as follows:

Quick Ratio=

Cash+ Accounts Receivable+ Marketable Securities

Current Liabilities

Computation of the quick ratio of Bulacan Corporation for the three year period follows:
2010

Quick Ratio=

2011

2012

148,000+283,000
100,000+ 410,000
90,000+ 394,000
Quick Ratio=
Quick Ratio=
399,000
505,000
500,000

Quick Ratio=1.08:1

Quick Ratio=1.01:1

Quick Ratio=.97 :1

Interpreting the results of the computations shows that Bulacan Corporation is very liquid since it
can meet its currently maturing obligation. However, in interpreting the result of the quick ratio,
the analyst should consider the following:
1. Some businesses can convert their inventory of merchandise into cash more quickly.
2. There could be problems in the collection of receivables.
Evaluating Liquidity additional tools
As part of determining a firms liquidity, an analyst should take a look at how long does it take for
a firm to convert inventory into cash or its operating cycle. A longer cycle generally means that it
requires a firm longer time to convert inventory back into cash which could also be interpreted as
a slower income-generation capabilities while a shorter cycle means shorter time to convert
inventories back into cash. A firms operating cycle is computed as follows:

OperatingCycle=DaysInventory + Average Collection Period

Days in inventory is computed as 360 or 365 days divided by the inventory turnover while
average collection period is 360 or 365 days divided by the receivable turnover. Inventory
turnover gives an indication of how soon inventories were sold. It is computed by dividing Cost
of Goods Sold by the Average Inventory Balances while Receivable turnover is the rate that
indicates how soon does a firm was able to convert receivables into cash. It is determined by
dividing Credit Sales by the Average Receivables. The following table shows the computations of
Bulacan Corporations Operating Cycle for the two year period, 2011 and 2012.
2011
Inventory Turnover (ITO)

ITO=

Cost of Goods Sold

Average Inventory

ITO=

2012

1,501,000
1,599,000
ITO=
(322,000+616,000)/2
(616,000+696,000)/2

ITO=3.2
Days in Inventory

DaysInventory =

360
ITO

DaysInventory =

ITO=2.4

360
3.2

DaysInv .=112.5 days

Receivable Turnover (RTO)

RTO=

Credit Sales
Average Receivable

RTO=

DaysReceivable=

360
RTO

360
2.4

DaysInv .=150 days

2,106,000
2,211,000
RTO=
(283,000+ 410,000)/2
( 410,000+394,000)/2

RTO=6.08
Days in Receivable

DaysInventory =

DaysReceivable=

RTO= 5.5 times

360
6.08

DaysRec .=59 days

Operating Cycle

OperatingCycle=DaysInventory
Op. Cycle=112.5+
+ DaysReceivable
59
Op. Cycle=171.5 days

DaysReceivable=

360
5.5

DaysRec .=65 days

Op. Cycle=150+65
Op. Cycle=215 days

The drop in both operating and net income during 2012 can also be attributed to the longer time
needed to convert inventories into cash since the companys operating cycle is 215 days, of that,
the company needed 150 days just to sell the inventories, equivalent to 5 months then another 2
months just to collect the cash from the customers. In as far as the turnover is concern, during
2012, the company was only able to buy and sell an inventory for 2.4 times in a year which can
already indicate an inefficient usage of its resources since its total assets increased in 2012.
However, in terms of collection, the company was able to collect, on the average, 5.5 times in a
year.
Reconciling the liquidity and activity ratio
It is a good thing that the company is very liquid since it has a high current and quick ratio. The
problem lies with its operations, it is taking them too long to convert inventory back into cash,
which in the long-run can cause cash problems because the company might be tying up too much
of its cash to non-cash items.
Evaluating Solvency
In the previous section, the ability of a firm to meet its current obligations was discussed.
However, another component of risk analysis is to evaluate the firms ability to meet obligations
that will mature in the future. Just like in capital multiplier, an analyst want to ascertain whether
the firm is successful in using its debt in generating cash flow because when a firm is using debt,
it has to understand the fact that the amount borrowed will have to be repaid with the related
interest at a specific time. As a manager, the idea is for the operations should be able to generate
enough cash to meet this kind of obligation. There are four ratios in this section, debt ratio and
equity ratio which will be used to determine the financial structure of a company, the debt to
equity ratio which shows the balance between debt and equity utilized by a company, and lastly,
the times interest earned which shows how many times the firms operation was able to earn the
interest expense the cost of capital for acquiring debt capital. The table below shows the
computation of these ratios for Bulacan Corporation for the two years 2011 and 2012:
2011
Debt Ratio

Total Liabilities
Debt Ratio=
Total Assets

Debt Ratio=

2012

958,000
2,044,000

Debt Ratio=47
Equity Ratio

Total Equity
Equity Ratio=
Total Assets

Equity Ratio=

1,086,000
2,044,000

Equity Ratio= 53%

Debt to Equity Ratio

DtoE=

958,000
1,086,000

Debt Ratio=

1,030,000
2,169,000

Debt Ratio=47

Equity Ratio=

1,139,000
2,169,000

Equity Ratio= 53%

DtoE=

1,030,000
1,139,000

DtoE=

Total Liabilities
Total Equity

DtoE=.88 :1

Times interest earned

Operating Income
TIE=
Interest Expense

TIE=

222,000
51,000

TIE=4.35

DtoE=.90 :1

TIE=

210,000
59,000

TIE=3.56

As what was uncovered using du Pont analysis, the company has not been depending on its debt
capital and relying more on its equity capital. However, concern should be directed towards the
declining rate of times interest earned in 2012 where in the amount of debt capital increased. This
might pose an alarm for management in the ability of the firms operation to meet cost of debt
capital as total debt increases, which could also explain why the firm is not really relying on its
debt capital.
Interpreting Ratios
In generating a general conclusion as to the result of ratio analysis, the firm can compare the different
ratios to earlier period or with other firms. In using earlier period results as the benchmark for evaluating
the over-all performance will permit historical tracking, a type of time-series analysis that will determine
the level of progress the firm was able to achieve over the years. However, such analysis might result in a
wrong interpretation due to the different improvements over the years. Factors like significant changes in
the geographical distribution and operation, product and customer mix, major acquisition and disposal of
properties, and change in accounting practice among other things, might cause a misinterpretation of any
increase or decrease in the ratios.
When comparing the computed ratios of the firm with other firms or the industry statistics in general, the
analyst should consider the firm to use as the comparison whether the firm have similar product, or of the
same size or age, or is utilizing the same strategy. Alternatively, in using industry statistics, the analyst
should be cautious on how an industry was defined, what does it include and exclude, how the averages
were computed and how the mean was distributed, and what are the compositions and variable of a
particular ratio.

Analysis Reporting
A financial statement analysis report should be complete but concise, accurate, logically patterned to
permit understanding of scenarios, but at the same, it has to be objective so as not to influence the
conclusions to be made by the reader of the report. The report should present all, to the point possible and
cost-beneficial, the scenarios that will give logic to what is being presented. The report should start with
the objective of the report to be followed by a company background and analysis of the different business
environment that exists during the period being analyzed. In presenting the analysis, computations and
charts should be included with reference to business situations that have affected such results and if there
are any possible means to improve the situation.
In the last part of the report, the analyst should enumerate the possible events and implications pertaining
to the result of the analysis. It should include assumptions and forecast if such assumptions will occur.
Also, a listing of crucial factors that in the opinion of the analyst will be essential in meeting its objective

should likewise be included. The following table summarizes the different parts of the report and their
contents.
Parts
Report Objectives &
Summary

Content
Purpose
State the purpose of the report. (Why is the report being written and
who can benefit from the report and what benefits can they get from
it?)
Scope.
It is a brief description of what the report covers and what the report
does not cover periods covered, financial statements and concepts
used, companies included, and sources of information.
Executive Summary
This section might also include a description of what is being
emphasized and what is not being emphasized.

Company Background

Basic Information
Name, address, products and/or services, management team profile,
establishment (when, where, who and why was it established)
Operational Details
Major Suppliers and Customers
Number of Headquarters, Branches, Warehouses
Major achievements and set-backs
External Factors
Political
Economic
Social
Technological
Internal Factors
Marketing (Product, Prices, Promotions, Place)
Human Resource
Operations/Production
Finance
Horizontal or Trend Analysis
Vertical or Common Size Financial Statement Analysis
Ratio Analysis
(For each of the computation and charts, if possible, should include the
description, the possible causes for such result in the computation, provide a
benchmark other company or industry statistics and how did the
company faired with the benchmark)
General Evaluation
Positive Results (those that exceeded the benchmark)
Negative Results (those that did not meet the benchmark)
Forecasting
What could happen in the light of the positive and negative results of
the analysis?
Crucial Factors
What are the things that the company should do in order to improve

Business Environment
Analysis

Financial Statement
Analysis

Forecasting, Assumptions
and Crucial Factors

its performance.

Module Summary
1. Define Financial Statement Analysis and its purpose
Financial statement analysis is the evaluation of a firms performance and financial condition
through the examination of its financial statements. Its purpose may range from an investor
evaluating whether the firm can provide return of and on investments, management evaluating
their suppliers, customers, and competitors among other things.
2. Identify the different requirements in conducting financial statement analysis
Before conducting an analysis of financial statements, identify the economics and current
conditions facing the business then identify the strategies that the firm selects to compete in the
business, then, understand the important concepts and principles underlying the financial
statements used in computing the financial ratios.
3. Recognize the limitations of Financial Statement Analysis
Strong financial statement analysis does not necessarily mean that the organization has a strong
financial future. In as far as predicting the future of the firm is concern, the analysis can only
provide an estimate or a point of reference on which path the firm should take.
4. Evaluate a firms progress using trend analysis
Trend analysis or Horizontal analysis is a type of time-series analysis that aims to provide
information about the progress of a firm in relation to a chosen base year that should have
significance with the firm. This analysis is better presented using a line chart to highlight any
increase or decrease in account balances.
5. Distinguish a firms focus through common-size financial statement
Common size financial statement or Vertical Analysis presents how a particular total amount is
composed of different account balances which can reveal the firms focus what is the majority
composition of an amount which in turn can give information as to what type of strategies and
actions the firm is executing or is planning in the future. This type of analysis is best presented
using a pie-chart.
6. Assess a firms profitability and risk level using ratio analysis
In using ratio analysis, there are two aspects, evaluating the risk and profitability of a firm. In
assessing the profitability, there is the return of assets and return on equity. Return on asset can be
analyzed further using the total asset turnover and operating income margin while return on
equity can be analyzed using the du Pont analysis, which requires the computation of the sales
margin, asset turnover, and capital multiplier. In assessing the risk of the company, short-term
risks are measured by the current and quick ratios and the activity ratios like the inventory
turnover and receivable turnover. While, measuring the long-term risk of a firm requires the
computation of debt and equity ratios, debt to equity ratio and the times interest earned.

Practice Problem 1: Basic Ratio Analysis

Name: _______________________________________ Section: __________________ Rating: ______
The comparative statement of financial position and the income statement of Tagaytay Corporation
follow:
2012
2011
2012
2011
Cash and Cash Equivalent
P 90
P100
Notes Payable
P 290
P 295
Accounts Receivable
394
410
Accounts Payable
94
94
Inventories
696
616
Accrued Expenses
116
116
Prepaid Expenses
15
14
Total Current Liabilities
P 500
P 505
Total Current Assets
P 1,195 P 1,140
Long-Term Debt
530
453
Property, Plant & Equipment
1,030
930
Total Liabilities
P 1,030
P 958
Accumulated Depreciation
(329)
(299)
Capital Shares (P1.00 par)
200
200
Investments
50
50
Share Premium
729
729
Other Assets
223
223
Retained Earnings
210
157
Total Assets
P 2,169
2,044
Total Liabilities & Equity
P 2,169 P2,044
2012
Sales
P 2,211
Cost of Goods Sold
1,599
Gross Profit
P 612
Operating expenses
402
Earning Before Interest &
P 210
Taxes
Interest Expense
59
Earnings Before Tax
P 151
Income Taxes
60
Earnings After Tax
P 91
Tagaytay Corporations shares are currently selling at P0.50 per share.
Required: Compute the following ratio: (Use average balances and 360 days whenever possible and
required)
1. Gross Profit
8. Asset Turnover
15. Equity Ratio
2. Return on Sales (Profit Margin) 9. Inventory Turnover
16. Times interest earned
3. Return on Assets
10. Days in Inventory
17. Earnings Per share
4. Return on Equity
11. Receivable Turnover
18. Capital Multiplier
5. Working Capital
12. Days in Receivable
6. Current Ratio
13. Debt to Equity Ratio
7. Quick Ratio (Acid Test)
14. Debt Ratio

Practice Problem 2: Basic Comprehensive Financial Statement Analysis

Name: _______________________________________ Section: __________________ Rating: ______
The three year comparative financial statements of Bataan Corporation follow:
2010

2011

2012

Assets
Cash
Receivables
Trading Securities
Inventories
Other Current Assets
Total Current Assets
Property, Plant and Equipment (Net)
Total Assets

100,000.00
120,000.00
50,000.00
170,000.00
25,000.00
465,000.00
300,000.00
765,000.00

120,000.00
140,000.00
50,000.00
180,000.00
20,000.00
510,000.00
320,000.00
830,000.00

130,000.00
80,000.00
80,000.00
160,000.00
20,000.00
470,000.00
400,000.00
870,000.00

Liabilities and Equity

Accounts Payable
Accrued Expenses
Total Current Liabilities
Non-Current Liabilities
Total Liabilities
Shareholders' Equity
Total Liabilities and Equity

220,000.00
120,000.00
340,000.00
100,000.00
440,000.00
325,000.00
765,000.00

240,000.00
70,000.00
310,000.00
100,000.00
410,000.00
420,000.00
830,000.00

200,000.00
120,000.00
320,000.00
150,000.00
470,000.00
400,000.00
870,000.00

1,200,000.00
800,000.00
400,000.00
150,000.00
250,000.00
12,000.00
238,000.00
71,400.00
166,600.00

1,440,000.00
1,040,000.00
400,000.00
120,000.00
280,000.00
12,000.00
268,000.00
80,400.00
187,600.00

1,584,000.00
1,144,000.00
440,000.00
140,000.00
300,000.00
18,000.00
282,000.00
84,600.00
197,400.00

Sales
Cost of Sales
Gross Profit
Operating Expenses
Operating Income
Interest Expense
Income before taxes
Taxes (30%)
Net Income

Required:
1. Perform a horizontal analysis using 2010 as the base year for the analysis.
2. Construct the companys common size financial statements.
3. Perform ratio analysis to evaluate the companys risks and profitability.

Practice Problem 3: Basic Comprehensive Financial Statement Analysis

Name: _______________________________________ Section: __________________ Rating: ______
Comparative date for Laguna Corporation for the three year period 2010, 2011, and 2012 are presented
below.
2010
2011
2012
Income Statement
Net sales
520,000
480,000
576,000
Cost of goods sold
360,000
315,000
346,500
Gross margin
160,000
165,000
229,500
Operating expenses
128,600
126,000
146,000
Net operating income
31,400
39,000
83,500
Interest expense
6,400
7,000
7,000
Net income before taxes
25,000
32,000
76,500
Less income taxes (30%)
7,500
9,600
22,950
Net income
P 17,500
P 22,400
P 53,550
Assets
Cash
P 12,000
P 23,500
24,000
Accounts receivable, net
60,000
40,000
50,000
Inventory
80,000
100,000
95,000
Prepaid expenses
3,000
1,200
1,200
Total current assets
155,000
164,700
170,200
Land
40,000
40,000
40,000
Buildings and equipment, net
120,000
85,000
100,000
Total property and equipment
160,000
125,000
140,000
Total assets
P 315,000
P 289,700
310,200
Liabilities and Stockholders' Equity
Accounts payable
P 67,000
P 44,000
50000
Notes payable
3,000
6,000
6,000
Total current liabilities
70,000
50,000
56,000
Bonds payable, 8%
75,000
80,000
80,000
Total liabilities
145,000
130,000
136,000
Preferred stock
20,000
20,000
20,000
Common stock
60,000
60,000
60,000
Additional paid-in capital
10,000
10,000
10,000
Retained earnings
80,000
69,700
84,200
Total stockholders' equity
170,000
159,700
174,200
Total liabilities and stockholders' equity
P 315,000
P 289,700
310,200
Required:
1. Perform a horizontal analysis using 2010 as the base year for the analysis.
2. Construct the companys common size financial statements.
3. Perform ratio analysis to evaluate the companys risks and profitability.

Practice Problem 4: Trend Analysis

Name: _______________________________________ Section: __________________ Rating: ______
Part 1: Indicate the peso change and the percentage change for each case below, assuming horizontal
analysis:
2012
2011
2012
2011
a.
45,000
20,000
f.
(30,000)
0
b.
20,000
40,000
g.
5,000
(5,000)
c.
30,000
0
h.
(20,000)
5,000
d.
0
40,000
i.
(10,000)
(10,000)
e.
(30,000)
10,000
j.
20,000
20,000
Part 2: Sales for the Laguna Corporation for a five year period and an industry sales index for this period
are listed below.
2008
2009
2010
2011
2012
Sales of Laguna
4,200
4,515
4,355
4,425
4,265
Industry Sales index
190
212
210
170
158
Required: Convert both series into indexes employing 2008 as the base year. Comment on the companys
performance during the five year period as compared to the industry statistics.
Part 3: The following common size income statements are available for Zamboanga Corporation for the
two years ended December 31, 2011 and 2012.
Sales
Cost of Sales
Gross profit on sales
Operating expenses (including income tax
expense)
Net Income

2012
100%
55%
45%

2011
100%
70%
30%

20%
25%

18%
12%

Trend percentage for sales are as follows:

2012 130%
2011 100%
Required: What should be the trend percentage for gross profit on sales for 2012? Show the computation.

Practice Problem 5: Trend Analysis

Name: _______________________________________ Section: __________________ Rating: ______
1. Condensed balance sheet of three companies is shown below.

Abra Corp.
Assets
Liabilities
Shareholders Equity

6,000,000
2,000,000
4,000,000

Benguet
Corp.
10,000,000
6,000,000
4,000,000

Cagayan
Corp.
15,000,000
5,000,000
10,000,000

Required: Compute for each company:

1. Debt Ratio
2. Equity Ratio
3. Debt to Equity Ratio
2. Give the answer for each by filling in the blank.
1. Debt ratio is 40%, then equity ratio is ________________.
2. Equity ratio is 75%, then debt ratio is ________________.
3. Debt to Equity ratio is 50%; equity to debt ratio is _______________.
4. Debt to Equity ratio is 1/3; equity to debt ratio is ______________.
5. If the debt ratio is 60% and liabilities total P300,000, the shareholders equity amount to
______________.
3. Net income closed to retained earnings was P 240,000 after tax of 40%. The company had an
outstanding loan for the entire year of P 2,000,000 at 9% interest. How many times interest was earned?
4. Below are data supplied by Cebu Corporation:
Sales
Cost of Sales
Gross Profit
Operating Expenses
Net income
Total Assets
Total Liabilities
Shareholders Equity

P 1,000,000
600,000
400,000
300,000
100,000
P 800,000
200,000
600,000

The demand for the product is very strong and the best strategy is to expand its geographical distribution
in order to double its sales. The company has two options,
Option 1: To sell net shares of stocks for P 700,000.
Option 2: Borrow money, P 700,000 @ (a) 12% interest; (b) 30% interest
Required: For the present situation, option 1 and option 2, compute the following:
1. Debt Ratio
2. Equity Ratio
3. Debt to Equity Ratio
4. Return on Assets with analysis (Considering that income statement items will maintain their
ratio)
5. Return on Equity with du Pont Analysis

Practice Problem 6: Ratio Analysis

Name: _______________________________________ Section: __________________ Rating: ______
Part 1: The December 31, 2012 statement of financial position of Cavite Corporation is presented below.
These are the only accounts in Cavites statement of financial position. Amounts indicated by a question
mark can be calculated from the additional information given.
Assets
Cash
P 25,000
Accounts Receivable (net)
?
Inventory
?
Property, Plant, and Equipment
294,000
Total Assets
P 432,000
Liabilities and Shareholders Equity
Accounts Payable
?
Income taxes payable - current
25,000
Non-current Liabilities
?
Paid-In capital
300,000
Retained Earnings
?
Total Liabilities and Shareholders Equity
?
Additional information:
Current ratio at year-end
Debt to Equity Ratio
Inventory turnover based on sales and ending inventory
Inventory turnover based on cost of goods sold and ending inventory
Gross profit for 2012

1.5 to 1
0.8
15 times
10.5 times
P 315,000

Required:
1. What was Cavites December 31, 2012 balance in accounts payable?
2. What was Cavites December 31, 2012 balance in retained earnings?
3. What was Cavites December 31, 2012 balance in the inventory account?
Part 2: Fill in the blank to complete the balance sheet and sales information for Dapitan Corporation,
using the following financial data:
Debt/Net Worth
50%
Average collection period
30 days
Quick Ratio
1.2%
Gross profit margin
30%
Total Asset Turnover
2.0 times
Sales to inventory turnover
5 times
Cash
Accounts Receivable
Inventories
Property, Plant and Equipment
Total Assets

Accounts Payable
Paid-In Capital
Retained Earnings

Sales

Cost of Goods Sold

Total Liabilities and Equity

25,000
35,000

Practice Problem 7: Ratio Analysis

Name: _______________________________________ Section: __________________ Rating: ______
Part 1: The following ratios and other data to the financial statements of Baguio Corporation for the year
ended December 31, 2012.
Current ratio at year-end
1.75 to 1
Quick Ratio
1.27 to 1
Working Capital
P 33,000
Fixed assets to shareholders equity ratio
0.625 to 1
Inventory turnover (based on cost of ending inventory)
4 times
Gross profit percentage
40%
Earnings per share
P0.50
Average age of outstanding accounts receivable (based on calendar
year of 365 days)
73 days
Capital shares outstanding
20,000 no par value shares
Earnings for the year as a percentage of capital shares
25%
The company has no prepaid expenses, deferred charges, intangible assets, or long-term liabilities.
Required: Reconstruct in as much detail as is possible, the companys statement of financial position
and income statement for the year ended December 31, 2012.
Part 2: The following information were contained in the report of a CPA who made an analysis of the
statement of financial position of Pampanga Corporation as of December 31, 2012.
1. Working capital ratio, 2.75:1
2. Ratio of liabilities to assets; 50.5%
3. Ratio of net worth of current assets, 90%
4. Cash was 25% of, while accounts receivable (net) was 1.5 times, the value of merchandise
inventory; the reserve for doubtful accounts being equal to 10% of the outstanding receivables.
5. The land and building are mortgage to secure a loan maturing in 2017, interest on which has been
paid up to financial statement date. Estimated life of the building is 40 years. It was constructed 5
years prior to financial statement date at a cost four times that of the land, and is being
depreciated by the straight-line method without considering any scrap value.
6. Of the current liabilities, 10% covered by non-interest bearing promissory notes issued to trade
creditors; the rest represents balance of purchases on accounts.
7. Capital shares consisting of 10,000 shares were originally issued at par P100 per share and a book
value of P99 per share at financial statement date.
Required: In order to have a clearer picture of the financial position and other matters, reconstruct the
whole statement of financial position considering that there are no other accounts other than those
mentioned or implied in the report.