Lesson 2: Financial Statement Analysis

Objectives of Analysis of Financial Statement:

To determine the profitability of the business.
Its liquidity to enable it to meet its obligation.
Safety of investment in the business.
Effectiveness of its management.
Objectives may be ranked as follows:
Management
Creditors
Profitability
Liquidity
Liquidity
Profitability
Managerial effectiveness
Safety
Safety of Investment
Effectiveness

Owners
Safety
Profitability
Effectiveness
Liquidity

Limitations of Financial Statements

1. Variation in application of accounting principles
2. Financial statements are interim in nature although they give an impression
of being accurate
3. Financial statements do not reflect changes in the purchasing power of the
peso
4. Financial statements do not contain all the significant facts about a business
Tools and Techniques
1. Horizontal Analysis The changes or behaviour patterns of the different
items in the financial statements of two or more years are shown and it
involves the use of:
a. Comparative statements
b. Trend ratios and percentages
2. Vertical Analysis the relationships between the different items in the
financial statement for the same year are pointed out with the use of the
following:
a. Common size statements
b. Financial ratios
Comparative Statements

Formula for Percentage Change = Most recent value Base period value
x
Base Period Value
100%
Development of Trends
Comparative figures enhance analysis. However, it would be even much
better if the company could present comparative data for longer periods, such as
from 5 to 10 year, so that the analyst could compute a number of year to year
comparisons. With this, trends could be developed.
Graphic Presentation
These presentations often illustrate financial relationships better that the
usual financial statements.

Vertical Analysis
Vertical analysis is the process of comparing figures in the financial
statements of a single period which involves converting the figures in the
statements to a common base.