TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY

MAS 3: FINANCIAL MANAGEMENT

FINANCIAL STATEMENTS ANALYSIS The difference between the figures of the two
periods is calculated, and the percentage
Involves the assessment and evaluation of
change from one period to the next is
the firm’s past performance, its present
computed using the earlier period as the
condition, and future business potentials.
base.
The data needed for analysis and
VERTICAL ANALYSIS
interpretation come mostly from the
financial statements where key figures are Interchangeably known as common-size
sought and meaningful relationships are statements analysis, involves converting the
developed and analyzed. Additional data figures in the statements to a common base,
come from other sources such as industry such as total assets (in the statement of
and economic statistics. financial position) and net sales (in the
statement of financial performance).
HORIZONTAL ANALYSIS
Illustration 2
Also known as time series analysis, it
involves comparing figures shown in the Hola Company
financial statements of two or more Common-size Statement of Financial Performance
For the years ended December 31, 2019 and 2020
consecutive periods to determine the
increase or decrease from the previous
years.
Illustration 1
Hola Company
Comparative Statement of Financial Performance
For the years ended December 31, 2019 and 2020

Hola Company
Common-size Statement of Financial Position
December 31, 2019 and 2020

Hola Company
Comparative Statement of Financial Position
December 31, 2019 and 2020

With vertical analysis, comparison become

more meaningful, particularly when
analyzing financial statements of different
companies in the industry to evaluate its
own performance vis a vis the performance
of its competitors. If possible, comparison
can be made with the statements of the
leaders in the industry we wish to emulate,
serving as benchmarks.

Page 1 of 5
 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

RATIO ANALYSIS 3. Receivables Turnover

Different ratios calculated from financial The number of times the collection
statements provide different users of the cycle is completed – from the time
statements with relevant information about receivables are recorded, then
the firm’s liquidity, solvency, profitability, collected, to the time new receivables
and attractiveness of the stocks. Such most are recorded again.
commonly used ratios are categorized based
Net Credit Sales
on their uses, as follows: RECEIVABLES TO =
Average Receivables
A. Liquidity Ratios
Related to the calculation of
Liquidity refers to the company’s ability Receivables TO, analysts compute
to meet currently maturing obligations. the Average Collection Period. The
formula is:
Analysis of liquidity is most important to
short-term creditors. AVE. COLLECTION PERIOD =
No. of Working Days a Year
Receivables TO
1. Current Ratio
This indicates the average number of
Also called working capital ratio, days during which the company
measures the number of times that must wait before receivables are
the current liabilities could be paid collected.
with the available current assets.
An increase in receivables turnover
Current Assets or decrease in average collection
CURRENT RATIO = period indicates an effective
Current Liabilities
collection system. Naturally, the
The current ratio should not be too
faster the cycle is completed, the
low, because the firm would find it
more quickly receivables are
difficult to pay its current converted into cash.
obligations.
Simply put, in comparison with the
Neither should the ratio be too high, credit terms the firm grants, the
for this means an excessive faster the customer pay, the better.
investment in current assets that
does not produce much return. 4. Inventory Turnover

2. Quick Ratio The number of times inventory is

replaced during the period.
Sometimes called the acid test ratio
is similar to the current ratio, except Merchandising Firm
that the inventories and
Cost of Goods Sold
prepayments are excluded from the INVENTORY TO =
Average Inventory
numerator.
Current Assets − Inventories − Prepayments As in the case of receivables, the
QUICK RATIO =
Current Liabilities average age of inventory may likewise
Interpretation of the quick ratio is the be computed. Its formula is:
same as in the current ratio. No. of Working Days a Year
AVE. INVENTORY DAYS =
However, some analysts believe that Inventory TO
a quick ratio of at least 1 indicates an
Every time merchandise is sold,
adequate ability to pay its current
profit is realized. Therefore,
obligations.
generally, a high inventory turnover
Determination of an adequate value and short average inventory days is
of quick ratio depends on many desirable.
factors, among them are the nature
But this, as stated, is in general
of the company, the type of industry
terms. A lot of factors must actually
to which the firm belongs and the
be considered in determining the
type of credit terms the firm grants
desirability of inventory turnover like
and receives.
the nature of the firm’s business.

Page 2 of 5
 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

Manufacturing Firm The higher the ATO, the better and

the more effective the management is
Cost of RM Used
RM TO = in using the company’s resources.
Average RM Inventory
B. Solvency Ratios
Cost of Goods Manufactured
WIP TO =
Average WIP Inventory Solvency refers to the company’s ability
to pay all its debts, whether such
Cost of Goods Sold
FG TO = liabilities are current or noncurrent.
Average FG Inventory Solvency therefore is somewhat similar
When the raw materials, work in to liquidity, except that solvency involves
process and finish goods turnovers a longer time horizon.
are divided into the number of Both long-term creditors and
working days in a year, the stockholders are interested in a
conversion period or average days of company’s solvency.
each type of inventory may be
determined. 1. Times Interest Earned

Naturally, the higher the turnover is, Determines the extent to which
the shorter will be the conversion operations cover interest expense.
period. EBIT ∗
TIMES INTEREST EARNED =
Operating Cycle Interest Expense
*Earnings Before Interest and Taxes
Ave. Collection Period
+ Ave. Inventory Days* As a rule, the higher the times
interest earned is, the better, for the
*For a manufacturing firm, from the company is considered solvent when
three inventories. it can afford to pay all its expenses
5. Payables Turnover and it still has a large amount left for
net income.
The trade payables (accounts/notes
payable) turnover. 2. Debt to Equity Ratio

Net Credit Purchases The total assets of a firm are provided

PAYABLES TO = by the owners and creditors. Thus,
Average Payables
this ratio determines the amount
No. of Working Days a Year
AVE. PAYMENT PERIOD = provided by creditors relative to that
Payables TO
provided by the owners.
The average payment period
Total Liabilities
indicates the number of days during DEBT TO EQUITY RATIO =
Total Equity
which trades payables remain
unpaid. As this ratio increases, the amount of
risk assumed by creditors increases,
Naturally, the operating cycle must
since this means decreasing solvency
be shorter than the average payment
because the creditors’ contribution to
period, so the company may be
the company’s total assets is greater
ensured of cash availability before
than the amount provided by the
the maturity of trade payables.
owners.
6. Asset Turnover (ATO)
3. Debt Ratio
Another tool used to test a company’s
Indicates the percentage of total
liquidity. Asset turnover measures
assets provided by creditors.
the effectiveness of asset utilization
towards producing revenues. Total Liabilities
DEBT RATIO =
Net Sales Total Assets
ATO =
Ave. Total Assets

Page 3 of 5
 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
4. Equity Ratio
Indicates the percentage of total
assets provided by owners or
shareholders. This ratio is actually
the compliment of the debt ratio, and
therefore can be computed by
subtracting the debt ratio from
100%.
Total Equity
EQUITY RATIO =
Total Assets
The relationship between owners’
equity and liabilities indicates the
company’s use of financial leverage
which means the use a company
makes of borrowed funds to increase
the return on owners’ equity.
Financial leverage is achieved when
borrowed funds can be invested in a
project with a yield higher than the
interest rate paid on the borrowed
money, where the difference
increases the profit or return to
owners.
C. Profitability Ratios
When we express profit as a ratio, we
actually relate profit (or income or
return) to the amount of investment
acquired or used in generating such
return. The basic formula is:
Income
RATE OF RETURN =
Investment
Depending on the users of such ratio
and the purpose for which it is
computed, the above basic ratio may be
modified. In this section, the most
commonly used ways of looking at this
basic relationship are presented.
1. Return on Sales (ROS)
Measures the amount of income
provided by the average peso sales.
The income figure may either be
gross profit or net income.
Gross Profit
GROSS PROFIT RATIO =
Net Sales
The gross profit ratio indicates the
average mark-up obtained on
products sold.
Net Income
ROS =
Net Sales
The net income ratio (ROS) is widely
used as a measure of overall
profitability of operations.
Whether such ratio is considered
satisfactory or not depends on the
nature of the company’s business.
2. Return on Assets (ROA)
A measure of operating efficiency.
ROA indicates how well the firm’s
management has used the assets
under its control to generate income.
EBIT
ROA =
Ave. Total Assets
A meaningful evaluation of the firm’s
ROA may be done by comparing the
figure with the ROA of other firms in
the same industry, particularly the
leading firm.
For internal analysts, the evaluation
may be done by comparing the ROA
with the target or desired ROA for the
period.
3. Return on Equity (ROE)
Measures the amount earned on the
owners’ (or shareholders’)
investment. ROE determines how
well the company is performing with
the investment contributed by its
owners. The basic formula is:
Net Income
ROE =
Ave. Total Equity
For corporations with preferred
shares aside from the ordinary
shares, the formula is:
Net Income − Preferred Dividends
ROE =
Average Ordinary SHE
4. Basic Earnings per Share (EPS)
Considered as one of the most
important indications of profitability
because investors find it convenient
to see the amount earned for a single
share of stock.
Net Income − Preferred Dividends
EPS =
Weighted Ave. No. of Ord. Shares
No such calculation is done for
preferred shares because preferred
shares have a fixed amount of
earnings per share.
Page 4 of 5
 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

D. Market Ratios DUPONT SYSTEM ANALYSIS

Ratios that indicate the shares’ Used to dissect the firm’s financial
performance or attractiveness in the statements and to assess its financial
market. Market ratios relate dividend condition.
rate and EPS of shares to the current
It merges the income statement and
market price of such shares.
balance sheet into two summary
1. Price to Earnings Ratio (P/E) measures of profitability, return on
total assets (ROA) and return on
Sometimes called times earnings
common equity (ROE).
ratio. P/E ratio indicates how many
pesos are required to buy a peso’s DuPont Formula:
worth of earnings. Net Income Net Sales Net Income
x =
Price per Share Net Sales Ave. Total Assets Ave. Total Assets
P/E RATIO =
Earnings per Share Or,

With the calculation of P/E ratio, ROS x ATO = ROA

financial analysts overcome the
Modified Dupont Formula
difficulty of comparing differently
priced shares of stock. Net Income
x
Ave. Total Assets
=
Net Income
Ave. Total Assets Ave. Ordinary SHE Ave. Ordinary SHE
2. Dividend Yield
Or,
Measure the rate of return in the
ROA x EM* = ROE
investor’s ordinary share investment.
*Equity Multiplier (EM) gives an idea
Dividend per Share
DIVIDEND YIELD = of how many times the owners’ equity
Price per Share
is increased.
Investors may compare the dividend
It can also be calculated using the
yield with their desired rate of return
formula, 1 divided by Equity Ratio or
on investment to determine the
1 plus Debt to Equity Ratio.
desirability of investing in the
company.
If the corporation did not declare
dividends, investors cannot use the
dividend yield. Instead, other factors
may be considered such as the firm’s
growth rate, profitability, liquidity,
solvency, etc.
3. Dividend Payout
Measures the rate of dividends
distributed out of the total earnings.
Dividend per Share
DIVIDEND PAYOUT =
Earnings per Share

Normally, growth-oriented
corporations show low dividend yield
and payout ratios.
In this regard, investors must always
keep in mind that investing in high-
growth corporations is generally
riskier than investing in corporations
paying relatively high, stable
dividends.

Page 5 of 5