BSA 4301 Analysis of Financial Statements Mendoza, MV

Financial statements analysis involves the assessment and evaluation of the firm’s past
performance, its present condition, and future business potentials.
Financial statements are analyzed to determine the following:
1. Profitability - the ability of an entity to earn income;
2. Solvency - the ability of the business to meet its obligations at maturity;
3. Stability - safety of investments in the business;
4. Managerial Effectiveness - how well management is
handling the business.
Users of Financial Statement Analysis
a. Managers
1. to evaluate operations
2. for control
3. for planning and budgeting
4. to anticipate future needs and problems
b. Lenders
1. to evaluate credit worthiness
c. Investors
1. to predict future earnings
2. to predict company potential

Limitations of Financial Statements

1. Variation in application of GAAP;
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 the business.

Limitations of ratio analysis

1. Not all companies make use of uniform principles and practices;
2. Some financial ratios provide information about the company and its operations at a point
in time (Not giving allowances to changes );
3. Individual financial ratios should not be used in isolation, rather all ratios of the company
should be taken as a whole;
4. The choice of different generally accepted accounting principles can affect ratios and
harm comparability.

ANALYTICAL TOOLS AND TECHNIQUES:

1. analysis of variation in gross profit and net income
2. cash flow statement
3. vertical analysis (common-size statements) or percentage composition statements
4. horizontal analysis (trend ratios and percentages)
5. financial ratios (ratio analysis)

HORIZONTAL ANALYSIS - involves comparing figures shown in the financial statements of

two or more consecutive periods. The difference between the figures of the two periods is
calculated, and the percentage change from one period to the next is computed, using the
earlier period as the base.
Formula:
Percentage
Change = Most Recent Value – Base Period Value
Base Period Value
Management Advisory Services Mendoza, MV
Analysis of Financial Statements

Comparisons include:
1. Actual to plan or budget
2. Between two versions of a budget
3. Last period to this period

VERTICAL ANALYSIS – the process of comparing figures in the financial statement of a single
period. It involves converting the figures in the statements to a common base. This is accomplished
by converting all the figures in the statements as a percentage of an important item such as total
assets (in the balance sheet) and total or net sales (in the income statement). These converted
statements are called common–size statements or percentage composition statements.

RATIO ANALYSIS – involves the development of mathematical relationships between accounts

in the financial statements. Ratios calculated from theses statements provide users and analysts
with relevant information about the business firm’s liquidity, solvency and profitability.

COMMONLY USED FINANCIAL RATIOS

A. TESTS OF LIQUIDITY. Liquidity refers to the company’s ability to pay its short-term
current liabilities as they fall due.

1. Current Ratio = Current Assets __ - measures the number of times that

(or banker’ ratio Current liabilities the current liabilities could be paid
or working capital with the available current assets.
ratio)

2. Acid Test Ratio =
(or quick ratio)
Quick Assets* - measures the number of times that
Current liabilities the current liabilities could be paid
with the available cash and near
*Cash + marketable cash assets.
securities + receivables

3. Receivables Turnover = Net Credit Sales*
Ave. Receivables
* or Net Sales if Net Credit
Sales is not available
The time required to complete one
collection cycle-from the time
receivables are recorded, then collected,
to the time new receivables are
recorded again.

4. Average age of
receivables = No of working days in a year Indicates the average number of days
Receivables turnover during which the company must wait
before receivables are collected.
or days’ sales in receivables or
average collection period

5. Inventory Turnover:
Merchandising Firm:

Inventory Turnover = Cost of Goods Sold Measures the number of times that
Ave. Mdse. Inventory inventory is replaced during the period.

6. Average Age of Number of Working Days Indicates the average number of

Inventory = Inventory Turnover days during which the company
must wait before inventories are sold.
Management Advisory Services Mendoza, MV
Analysis of Financial Statements

Operating Cycle = Ave. Age of Receivables

+ Average Age of Inventory
Manufacturing Firm:

Raw Materials Turnover = Cost of Materials Used__

Ave. Raw Mat. Inventory

Goods in Process Turnover = Cost of Goods Manufactured_

Ave. Goods in Process Invty.

Finished Goods Turnover = Cost of Goods Sold_

Ave. Finished. Goods Invty.

Average Age = Number of Working Days

Turnover

Operating Cycle = Sum of ave. ages of receivables, raw materials, goods in

goods in process and finished goods inventories.

7. Trade Payables Turnover = Net Credit Purchases

Ave. Trade Payables

Ave. age of trade payables = No. of Working Days Indicates the length of time
Payables Turnover during which payables
are unpaid.

8. Assets Net Sales - Measure the movement and

Turnover = Average Total Assets utilization of assets to meet
operating requirements.

B. TESTS OF SOLVENCY. Solvency refers to the company’s ability to pay all its debts,
whether such liabilities are current or non-current.

1. Times Interest = Income before Tax + Interest Expense -Determines the extent to which
Earned Interest Expense operations cover interest expense.

2. Dept-Equity Ratio = _____Total Liabilities______ -Proportion of assets provided by

Total Owners’ or Stock- creditors compared to that provided
Holders’ Equity by owners.

3. Debt Ratio = _Total Liabilities__ -Proportion of total assets provided

Total Assets by creditors.

4. Equity Ratio = Total Owner’s or Stockholders Equity -Proportion of total assets provided
Total assests by owners.

C. TESTS OF PROFITABILITY. Profitability is the ability of the company to earn income.

1. Return on Sales = __ Income__ -Determines the amount of income

Net Sales earned on each peso sales.

2. Gross Profit Ratio = _Gross Profit_ - indicates percentage of gross income

Net Sales as compared to peso value of sales
Management Advisory Services Mendoza, MV
Analysis of Financial Statements
3. Return on Total = ______Income ______ -Efficiency with which assets are
Assets (ROA) Average Total Assets used to operate the business.

4. Return on Owners’ Equity = ___Net Income___ -Measures the amount earned on the
Ave. Owners’- Equity owners’ or stockholders’ investment.

5. Earnings per Share = Net Income-Pref. Dividends - Measures the amount of net income
_____(if any)___________ earned by each common share.
Weighted Ave. Number of
Common Shares

D. MARKET TESTS:

1. Price-Earnings ratio (P/E) = __Price per share__ - Indicates the number of pesos
Earnings per share required to buy P1 of earnings.

2. Dividend Yield = Dividend Per Share - Measures the rate of return in the
Price Per Share investors’ common stock
investments.

3. Dividend Pay-out = Common Dividend Per Share - Indicates the proportion of earnings
Earnings Per Share distributed as dividends.

E. OTHER RATIOS

1. Working Capital __Working Capital__ Indicates relating liquidity of total

to Total Assets Total Assets assets and distribution of resources
employed.

2. Working Capital ______Net Sales_______ Indicates adequacy and activity of

Turnover Average Working Capital working capital.

3. Fixed Assets to
long-term ____Fixed Assets____ Reflects extent of the utilization of
Liabilities Long-Term Liabilities resources from long-term dept.
Indicative of sources of additional
funds.
4. Fixed assets to ___Fixed Assets___ Measures the proportion of owners’
total equity Total Equity equity to fixed assets. Indicative of
over or under investment by owners;
also weakness in “trading on the equity”.

5. Fixed Assets to ___Fixed Assets (Net)___ Indicates possible over expansions of

total assets Total Assets plant and equipment.

6. Sales to fixed Assets ____Net Sales____ Test roughly the efficiency of

(plant turnover) Fixed Assets (Net) management in keeping plant
properties employed.

7. Book value per share _Common Stock Equity_ Measures recoverable amount
of common stock Number of outstanding in the event of liquidation
shares of common stock if assets are realized at their
book values.
Management Advisory Services Mendoza, MV
Analysis of Financial Statements

8. Times Preferred _Net Income After Taxes_ Indicates ability to provide

Dividend requirements Preferred Dividend dividends to preferred
Requirements stockholders.

9. Times Fixed Net Income before taxes Measures ability to meet fixed
Charges Earned __ and Fixed Charges_______ charges.
Fixed Charges (Rent + Interest)

10. Rate of Return on ____Net Income_____ Measures the profitability

Average Current Average Current Assets of current assets invested.
Asset

11. Rate of Return per Rate of Return on Shows profitability of

Turnover of Current __ Ave. Current Assets__ each turnover of
Assets Current Assets Turnover current assets.

Problem 1. VERTICAL AND HORIZONTAL TECHNIQUES

1. SOLEMN COMPANY financial statements are given below

:
Inc
20-4 20-3 (Dec) %
Sales 360,000 300,000
Cost of sales 240,000 201,000
Gross profit 120,000 99,000
Operating expenses
( includes 20,000 depreciation) 100,000 85,000
Income before taxes 20,000 14,000
Income taxes 8,000 5,600
Net Income 12,000 8,400

Cash 14,000 16,000

Accounts receivables 22,000 28,000
Inventories 65,000 55,000
Property and equipment 85,000 79,000
186,000 178,000

Accounts payable 30,000 15,000

Bonds payable 60,000 75,000
Common stock ( P 10 par ) 60,000 60,000
Retained earnings 36,000 28,000
186,000 178,000
Required :

1. Comparative statement analysis f. debt ratio

2. Common size statements g. equity ratio
3. Financial ratios for 20- 4 h. receivable turnover
a. inventory turnover i. Number of days in receivables
b. average market price of stocks j. Return on total assets
if price earnings ratio is 8 k. working capital
c. current ratio l. quick ratio
d. gross margin percentage m. Asset Turnover
e. debt equity ratio n. Return on stockholders’ equity