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

There are three kinds of FS analysis techniques:

- Horizontal analysis

- Vertical analysis

- Financial ratios

Horizontal analysis
also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time with the
purpose of determining the increase or decrease that has taken .

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 this
covered in this lesson.

- Changes can be expressed in monetary value (peso) and percentages computed by using the following formulas:

• Peso change=Balance of Current Year-Balance of Prior Year

• Percentage change= (Balance of Current Year-Balance of Prior Year)/(Balance of Prior Year)

• Example:

✓Peso change = P250,000 - P175,000 = P75,000

✓Percentage change = (P250,000 - P175,000) / P175,000 = 42.86%

✓This is evaluated as follows: Sales increased by P75,000. This represents growth of 42.86% from 2013 levels.

Vertical analysis,

also called common-size analysis, is a technique that expresses each financial statement item as a percentage of a base
amount

- For the SFP, the base amount is Total Assets.

• Balance of Account / Total Assets.

• From the common-size SFP, the analyst can infer the composition of assets and the company’s financing mix.

• Example:
✓The above 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.
Activity # 6

Prepare Vertical Analysis

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.
For example, a ratio that divides sales by assets will find the peso amount of sales generated by every peso of
asset invested. This is an important ratio because it tells us the efficiency of invested asset to create revenue. This
ratio is called asset turnover. 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 (Horngren et.al. 2013). A
company with a 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 (Horngren et.al. 2013).
- Net profit ratio relates the peso value of the net income earned to every peso of sales. This shows 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 assets. 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 profit for the shareholders. On the other hand, asset is allocated to both creditors and shareholders.
Some analyst prefers to use earnings before interest and taxes instead of net income. There are also two
acceptable denominators for ROA – ending balance of total assets or average of total assets. Average assets is
computed as beginning balance + ending balance divided by 2.
- Return on equity(ROE) measures 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 measures 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 assets. - Fixed asset turnover is 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 turnover is “days in inventory”. This measures the number of days from acquisition to
sale.
- Accounts receivables turnover the 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. On the other hand, 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 the company’s assets that are financed by capital. A high equity to asset
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.
- measures 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
current 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.
Acitvity # 7
a. Compute for the company’s profitability and operating efficiency ratios for 2014.

b. Compute for the financial health ratios of the company in 2014 and 2013.