ANALYSIS OF FINANCIAL STATEMENTS THEORIES

TOOLS AND TECHNIQUES:

Horizontal Analysis – The changes or behavior patterns of the different items in the fs of two or more
years are shown and it involves the use of
1. Comparative statements
2. Trend ratios and percentages

Vertical Analysis – The relationships between the different items in the fs for the same year are pointed
out with the use of the following:
1. Common size statements
2. Financial ratios

Comparative Statements
Increase (Decrease)
2017 2016 Amount %
Sales 240,000 200,000 40,000 20
Less Cost of sales 182,000 140,000 42,000 30
Gross profit 58,000 60,000 (2,000) (3 1/3)

Trend Ratios and Percentages

Assuming the SOCI are as follows:
2014 2015 2016 2017
Sales 200,000 220,000 210,000 180,000
Less Cost of sales 120,000 126,000 114,000 116,400

2014 2015 2016 2017

Sales 100 110 105 90
Cost of sales 100 105 95 97

Common Size Statements

%
Sales 153,000 102
Less SRA 3,000 2
Net sales 150,000 100
Less cost of sales 90,000 60

Current Assets
Cash 20,000 10
A/R 30,000 15
Total Current Assets 50,000 25

Property & equipment 150,000 75

Total Assets 200,000 100

Financial Ratios
Measures of Profitability
Formula Significance
1. Rate or return on sales Net income Indicates profitability based on sales
Net sales

2. ROR on total assets Net income Indicates profitability in the use of

Average Total Assets total assets

3. Asset turnover Net sales Indicates efficiency in the use of total

Average total assets resources

4. Gross profit ratio Gross profit Adequacy of gross profit to cover operating
Net sales expenses and desired profit
 5. Operating ratio COS + operating exp Indicates the portion of sales absorbed by
Net sales operating expenses

6. Rate of return on CA Net income Indicates profitability in the use of CA

Average current assets

7. Invested capital Net sales Indicates the rate at which owner’s equity
Turnover Average owner’s equity is being used

8. ROR on owner’s equity Net income Indicates profitability in the use of invested
Average owner’s equity capital

Measures of Liquidity or Short-term Solvency

Liquidity is the ability of a business to meet its current obligations. This is based on the availability of
cash or the convertibility of other current assets into cash in the normal course of operations

1. Current ratio Current assets Indicates ability to pay current obligations

Current liabilities

2. Acid test ratio Quick assets Ability to pay current obligations from the
Current liabilities more liquid current assets

3. CA to total assets Current assets Indicates the liquidity of total assets

Total assets

4. Receivable turnover Net credit sales Indicates the number of times average recbls
Average receivables is collected during the period

5. Average collection period 360 Indicates the number of days to collect

Receivables turnover average receivables

6. Inventory turnover Cost of sales Indicates the number of time average invty
Average inventory was sold during the period

7. Number of days’ supply 360 Indicates the number of days required to sell
In inventory Inventory turnover average inventory

8. Payables turnover Net credit purchases Indicates the number of times average
Average payables payables ia paid during the period

9. Number of days in No. of days’ sales in invty The interval from the time purchases are made
Operating cycle + average collection period to the time it is converted to back to cash

Measures of Long-term Solvency

The long-term solvency of a company depends on the management of assets and long-term debts.

1. Debt/Equity ratio Total Liabilities Measures the proportion of borrowed

Owner’s equity capital to invested capital

2. Equity/Debt ratio Owner’s Equity Indicates the margin of safety to creditors

Total liabilities

3. Proprietary ratio Owner’s equity Indicates what portion of total assets is

Total assets provided by owners

4. Debt ratio Total liabilities Indicates what portion of total assets is

Total assets provided by creditors

5. Property turnover Property & eqpt Indicates efficiency in the use of property
Total long-term liab