Financial Statement (FS) analysis - is the process of evaluating risks, performance, financial health, and future

prospects of a business by subjecting financial statement data to computational and analytical techniques with
the objective of making economic decisions.
Three kinds of FS Analysis Techniques:
1. Horizontal Analysis – also called trend analysis, is a technique for evaluating series of financial
statement data over a period of time with the purpose of determining the increase or decrease that has
taken place. This will reveal the behavior of the account over time.
Is it increasing, decreasing or not moving? What is the magnitude of the change? Also, what is the relative
change in the balances of the account over time?
Horizontal Analysis uses financial statements of two or more periods. All line items on the FS may be
subjected to horizontal analysis. Only the simple year-on-year (Y-o-Y) grow is covered in this lesson.
Changes can be expressed in monetary value (peso) and the percentages.
Evaluated as follows: Sales increased by ₱75,000. This represents growth of 42.86% from the 2013 levels.
2. Vertical Analysis – also called common-size analysis, is a technique that expresses each financial
statement item as a percentage of a base amount.
From the common-size SFP, the analyst can infer the composition of assets and the company’s financing
mix. SFP may be evaluated as follows: The largest component of asset is equipment at 39.3%. cash is the
smallest component at 14%. On the other hand, 50% of assets are financed by debt and the other half is
financed by equity.
SCI will reveal how “Net Sales” is used up by the various expenses. Net income as a percentage of sales is
also known as the net profit margin. SCI may be evaluated as follows: The cost of goods sold is 44% of the
sales. The company has a gross profit rate of 55.5%. Operating expenses is 22% of sales. The company
earns income of ₱0.33 for every peso of sales. Gross profit generated for every peso of sale is ₱0.555.
The use of common-size financial statements allows the comparison of two companies of different sizes.
This is because the SFP and SCI comparative information are standardized as a percentage of assets and
sales, respectively.
3. Ratio Analysis – expresses the relationship among selected items of financial statement data. The
relationship is expressed in terms of a percentage, a rate, or a simple proportion. A financial ratio is
composed of a numerator and a denominator. There are many ratios used in business. These ratios
are generally grouped into three categories: (a) profitability, (b) efficiency, and (c) financial health.
Profitability Ratios – measure the ability of the company to generate income from the use of its assets and
invested capital as well as control its cost. The following are the commonly used profitability ratios:
Gross profit ratio – reports the peso value of the gross profit earned for every peso of sales. We can infer
the average pricing policy from the gross profit margin.
Operating income ratio – expresses operating income as a percentage of sales. It measures the
percentage of profit earned from each peso of sales in the company’s core business operations. A
company of high operating income ratio may imply a lean operation and have low operating expenses.
Maximizing operating income depends on keeping operating costs as low as possible.
Net profit ratio – relates peso value of the net income earned to every peso of sales. This show how much
profit will go to the owner for every peso of sales made.
Return on asset (ROA) – measures the peso value of income generated by employing the company’s
asset. It is viewed as an interest rate or a form of yield on asset investment. The numerator of ROA is net
income. However, net income is a profit for the shareholders. On the other hand, asset is allocated to both
creditors and shareholders. Some analyst prefers to use denominators for ROA – ending balance of total
assets or average of total assets. An average asset is computed as beginning balance + ending balance
divided by 2.
Return on equity (ROE) – measure the return (net income) generated by the owner’s capital invested in the
business. Similar to ROA, the denominator of ROE may also be total equity or average equity.
Operational efficiency ratio – measures the ability of the company to utilize its assets. Operational
efficiency is measured based on the company’s ability to generate sales from the utilization of its assets, as
a whole or individually. The turnover ratios are primarily used to measure operational efficiency.
Asset turnover – measure the peso value of sales generated for every peso of the company’s assets. The
higher the turnover rate, the more efficient the company is in using its asset.
Fixed asset turnover – is an indicator of the efficiency of fixed assets in generating sales.
Inventory turnover – is measured based on cost of goods sold and not sales. As such both the numerator
and denominator of this ratio are measured at cost. It is an indicator of how fast the company can sell
inventory. An alternative to inventory is “days in inventory. This measures the number of days from
acquisition to sale.
Accounts receivables turnover – measures the number of times the company was able to collect on its
average accounts receivable during the year. An alternative to accounts receivable turnover is “days in
accounts receivable”. This measures the company’s collection period which is the number of days from
sale to collection.
Financial health ratios – look into the company’s solvency and liquidity ratios.
Solvency – refers to the company’s capacity to pay their long term liabilities.
Liquidity ratio – intends to measure the company’s ability to pay debts that are coming due (short term
debt).
Debt ratio – indicates the percentage of the company’s assets that are financed by debt. A high debt to
asset ratio implies a high level of debt.
Equity ratio – indicates the percentage of company’s assets that are financed by capital. A high equity to
asset to ratio implies a high level of capital.
Debt to equity ratio - indicates the company’s reliance to debt or liability as a source of financing relative to
equity. A high ratio suggests a high level of debt that may result in high interest expense.
Interest coverage ratio – measure the company’s ability to cover the interest expense on its liability with its
operating income. Creditors prefer a high coverage ratio to give them protection that interest due to them
can be paid.
Current ratio – is used to evaluate the company’s liquidity. It seeks to measure whether there are sufficient
assets to pay for current liabilities. Creditors normally prefer a current ratio of 2.
Quick ratio – is a stricter measure of liquidity. It does not consider all the current assets, only those that are
easier to liquidate such as cash and accounts receivable that are referred to as quick assets.