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Module 2
Financial Statement Analysis

After you have learned the basics of financial statements in your

accounting course, you must now learn how to analyze the basic types
of financial statements.

After going over this chapter, you should be able to:

1. Know the classification of financial statement analysis

2. Analyze financial statements using financial statement analysis
techniques
3. Discover the different types of ratio analysis

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2.1 Classification of Financial Statement Analysis

Financial statements are records that outline the financial activities of a

business, an individual or any other entity. These are meant to present
the financial information of the entity in question as clearly and
concisely as possible for both the entity and for readers (Investopedia).

The objective of financial statements is to provide information about

the financial position and the financial performance and cash flows of
an entity that is useful to a wide range of users in making economic
decisions (Valix, 2015).

The elements of financial statement include the financial position and

financial performance. Financial position is the status of the assets,
liabilities, and owners' equity while the financial performance is a
subjective measure of how well a firm can use assets from its primary
mode of business and generate revenues.

A complete set of financial statements comprises of the following:

 Statement of Financial Position
 Income Statement
 Statement of Comprehensive Income
 Statement of Changes in Equity
 Statement of Cash Flows
 Notes

Financial analysis can be classified on the basis of materials used and

on the basis of the methods of application.

Financial Statement Analysis based on Material Used

Based on the material used, financial statement analysis may be

classified into two types: external analysis and internal analysis.

External Analysis

This type of analysis is usually done by other people or entities that are
outside a certain business entity. They are just relying upon the data
that are published by the entity that they are analysing. External
analysis is usually done by investors, creditors, government
organizations and other credit agencies.

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Internal Analysis

This type of analysis is made by people inside the business entity.

This analysis is usually used to understand operational performance of
the entity to help in making their business decisions.

Financial Statement Analysis based on Methods of Operation

This type of analysis may be classified into two types which includes
horizontal analysis and vertical analysis:

Horizontal Analysis

From the word itself, we can say that the figures subject to
mathematical analysis is on a horizontal basis. For instance, we
compare figures from several years, so we are comparing the amounts
in each account from the past up to the present.

Vertical Analysis

Under this type of analysis, the financial statements are measured

based on the relationship of each item in the financial statement with
respect to the amount of a certain account. This facilitates analysis
that is on a vertical basis.

2.2 Basic Financial Statement Analysis Techniques

There are many methods or techniques that are used to analyze the
financial statements. In this part we will just discuss the basic
methods that are the following:

Index Analysis

This is an analysis of percentage financial statements where all balance

sheet or income statement figures are expressed for a base year equal
100 percent and subsequent financial statement items are expressed as
percentages of the values in the base year.

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Common Size Analysis

In this method, figures reported are converted into percentage to some

common base. It is usually considered as the vertical analysis. In the
balance sheet, the total assets figure is assumed to be 100% and all
other figures are expressed as percentages with respect to the amount
of the total assets.

2.3 Ratio Analysis

Ratio is a mathematical relationship between one number to another
number. This is used as an index for evaluating the financial
performance of the business concern. We can classify ratio in various
types. This includes liquidity ratio, activity ratio, leverage ratio and
profitability ratio.

Liquidity Ratio

These ratios are financial metrics used to determine a

company's ability to pay off its short-term debts obligations. The
following are some of the liquidity ratios:

Current Ratio =

Quick Ratio =

Activity Ratio

This is also known as efficiency or turnover ratio for this measures

how effectively the firm is using its assets. This focuses primarily on
how effectively the firm is managing two specific asset groups, the
receivables and the inventories, and its total assets in general. The
following are the activity ratios:

Receivables Turnover =

Average Collection Period =

Payable Turnover =

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Average Payment Period =

Inventory Turnover =

Asset Turnover Ratio =

Profitability Ratios

These are ratios that relate profits to sales and investment. From the
word itself, this ratio deals with profitability. The following are some
of the profitability ratios:

Gross Profit Margin =

Net Profit Margin =

Return on Assets =

Return on Equity =

Leverage Ratios

This measures the long-term obligation of the business. This ratio

helps to understand how the long-term funds are used in the business
concern. Some of the solvency ratios are given below:

Debt to Equity Ratio =

Debt to Total Assets Ratio =

Total Capitalization Ratio =

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Glossary
Financial statements - records that outline the financial activities of an
entity

Liquidity - the ability of an entity to meet its short-term financial

obligations.

Profitability - the ability of a business to have more income than

expenses

Solvency - the ability of an entity to meet its long-term financial

obligations.

References
C. Paramasivan and T. Subramanian. (2005). “Financial
Management”, New Age International Ltd., Publishers.
Investopedia.com

C. Valix and C.A. Valix. (2015). “Theory of Accounts”, GIC

Enterprise & Co. Inc.

J. Van Horne and J. Wachowics (2008). “Fundamentals of Financial

Management”, Pearson Education Limited.