Lecture Guide- Module- 2 - Financial Analysis – Horizontal and Vertical Analysis

FINANCIAL STATEMENT ANALYSIS

Financial Statement analysis is an evaluation of the past and current performance of the firm and its
forecast in the future (Palepu et all ., 1996) . It allows comparison of one company with another, Since
financial statement analysis looks at relationship inside and outside the firm. A firm of one size can be
directly compared with similar firms or with industry averages or norms to determine how the company
is fairing vis-a- vis its competitors (Gitman et al ., 2003)

Financial statement analysis involves calculation. Firms compute by combining accounts coming from an
income statement to the balance sheet or vice-versa or by simply relating an account within the
statement. These calculation help the management assess the deficiencies and take necessary actions to
improve performance.

Users of the financial statement analysis

Investors- forecasting the future of the firms is what financial statement analysis is all about.
Management – that financial statement analysis is an important tool in determining future conditions
and serves as a starting point for undertaking actions to improve the firm future performance.
Creditors – the outcomes of such analysis of the firm financial position and operating result will have an
impact of the firms standing.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

Analysis of financial statements are set to answer a wider-range of questions of users. These users have
common requirements where the very objective of financial statements analysis originate.
The analysis done aims to probe the company’s
 Profitability – this pertains to the ability of the firm to yield a sufficient amount of return on
company sales assets and invested capital.
 Liquidity and stability – Liquidity is also referred to as working capital position or short-term
financial position. It is the ability of the firm to meet or pay its current or short-term maturing
obligations.
 Asset utilization or Activity – this pertains to how efficient the company is in managing its
resources. It also refers to the firm’s speed or pace in turning over accounts receivable,
inventory and long-term assets. This reveals the frequency of the firm in selling its products or in
collecting its receivable. In so far as fixed or long-term assets are concern, it reveals how the
company uses their fixed assets to yield revenue.
 Debt-utilization or leverage – This pertains to the overall debt status of the company. it
measures the degree of how the firm is financed. The debt is evaluated using other variables like
assets, equity and earning power.
LIMITATIONS OF FINANCIAL STATEMENT ANAYSIS

The primary purpose of financial statement analysis is to examine the present, as well as past, financial
position and the results of operations of the firm in order to determine the best suitable estimate and
predict the future state and performance of the company.

The main objective used for the analysis is also subject to limitations. These limitations, if not carefully
considered, can ultimately bring about wrong decisions. The inherent limitations of the financial
statement among other thing may stem from:

1.Its failure reconsider changes in the purchasing power, inconsistencies as well as dissimilarities in the
accounting principle, policies and procedures used by the firms in the industry.

2. the age of the financial statement is a limitation. The older it gets, the less reliable it becomes thus,
considered as a risk management tool.

3.Failure to read and understand the information in the Notes to the financial statements may obscure
managers in evaluating the degree of the risk.

4. Financial statements that have not undergone external auditing procedure may or may not conform
with the Generally Accepted Accounting Principle (GAAP) and standard thus usage of these statements
may lead to erroneous analysis and ultimately erroneous decisions.

5. Financial statements that have not undergone external auditing procedure may prove to be
inaccurate or worse, fraudulent hence do not fairly present the company financial condition. Financial
measurements from the analysis of these companies are not dependable and not conclusive.

6 . Audited statements do not guarantee accuracy.

PRACTICAL STEPS PROPOSED IN ANALYZING FINANCIAL STATEMENTS

1.Determine the objective, Is it to evaluate the profitability, liquidity, asset activity, or debt utilization.?

2.The analysis done may cover not only the subject firm but could involve other firms belonging to the
same industry. It would be wise to learn about the retrospective, current, as well as the prospective
conditions of the industry. Other external variable that may have a bearing or significant effect on the
industry may also be considered. This may include socio-economic and political variables. New laws or
mandates, financial in nature, changing or modifying the industry requirements may also be considered.
Knowledge of average price, or market values of commodities, share of stocks and debts instruments in
the industry may be considered.

3. Get to know the firm you are analyzing. Know the mission and vision. It may prove to have a bearing
on your financial analysis. Know their strategic plans Know where the company wishes to be. Know their
current status in the industry. know the company financial projections. Know all things about the firm
which you consider relevant and may have a bearing on your analysis.
4. ASSESS/ANALYZE the financial statement. The analysis should cover the salient areas namely, the
profitability, liquidity or solvency, stability and operational efficiency of the firm. Using the tools and
techniques in analyzing the financial statement.

5. After finishing the analyzing the financial statement interpret the results of the computations and
ratios.

6. Draw Conclusion from the interpretations made in step five. The conclusions must take into
consideration the objective you have set up in step number 1.

TOOLS AND TECHNIQUES IN FINANCIAL ANALYSIS

The common tools and techniques used In financial analysis are as follows:

1.Horizontal Analysis

This is used to evaluate the trend in the accounts over the years. It is usually shown in comparative
financial statements.

a. Comparative statements Compared are financial data of two years showing the increase
or decrease in the account balances with their corresponding percentages.
It used to evaluate the changes or behavior patterns of the different accounts in the
financial statements for two or more years. In doing the comparison, the earlier year
serve as the base year so that the percentage increase or decrease is determined by
dividing the difference of the base year figure from the latter year figure by the base
year figure.

Later year- Base year

Base year X 100%

Illustrative Example:

ABC COMPANY
Comparative Balance sheet

Increase/(Decrease)
2016 2015 Amount Percent
Assets
Current Assets
Cash & Cash Equivalent 106,789 102,375 4,414 4.31
Trade & Other Receivable 327,611 277,467 50,144 18.07
Inventory 334,863 297,654 37,209 12.50
Prepaid Expenses 101,565 114,813 (13,248) (11.54)
Total Current Asset 870,828 792,309 78,519 9.91
 b. Trend Ratio – A firm’s present ratio is compared with its past and expected future ratio
to determine whether the company’s financial conditions is improving or deteriorating
over time. It is similar to comparative statements except that several consecutive years
were used showing the behavior of financial data
In computing the trend, the base period (oldest year) amount are written as 100%. The
percentage relationship of each account in the statements is then computed by dividing
each amount by the base year figure.
For the year after the base year, it would be
Year 1
Base year x 100 %
Two years after the base year, it would be:
Year 2
Base year X 100%

Illustrative Example:

Dcon Company
Comparative Statement of Financial Position
December 31, 2011 to 2015
In thousand Pesos

2011 2012 2013 2014 2015

Assets
Current Assets
Cash & Cash Equivalent 57 119 120 150 168
Trading Securities 208 75 77 77 91
Trade & other Receivables 530 403 462 535 585
Inventory 390 441 485 542 509
Prepaid Expenses 397 459 479 520 512
Total Current Assets 1,582 1,497 1,623 1,824 1,865

Trend Analysis
Statements of Financial Position
Assets 2011 2012 2013 2014 2015
Current Assets
Cash & Cash Equivalent 100 209 211 263 295
Trading Securities 100 36 37 37 44
Trade & other Receivables 100 76 87 101 110
Inventory 100 113 124 139 131
Prepaid Expenses 100 116 121 131 129
Total Current Assets 100 95 103 115 118
 Learning Resources
 Anastacio, M.F., Dacanay, R., Aliling, L. 2012. Fundamental of financial management.
Manila: Rex Publishing
 Brigham, Eugine F., Houston, Joel 2014. Fundamental of Financial Management,
Cengage Learning
 Cabrera, Ma E. 2015. Financial management principles and application, Manila: GIC E
Enterprises & Co. Inc.
 Timbang, F. 2015. Financial management. Quezon City: C& E Publishing Inc
 Timbang, F. 2016. Financial management II. Quezon City: C& E Publishing Inc

Intellectual Property
This module is for educational purpose only. Under section Sec. 185 of RA 8293, which states,
“The fair use of a copyrighted work for criticism, comment, news reporting, teaching including
multiple copies for classroom use, scholarship, research, and similar purposes is not an
infringement of copyright”.
The unauthorized reproduction, use, and dissemination of this module, without joint consent of
the authors and LSPU, is strictly prohibited and shall be prosecuted to the full extent of the law,
including appropriate administrative sanctions, civil, and criminal.