Unit 2:

Financial Statement Analysis and

Forecasting
(6 hours)

Introduction

At first glance, financial statements can be overwhelming – but if we know

what we are looking for, we can quickly learn a great deal about a company
after a quick review of its financial statements. Looking at the balance sheet
we can see how a company is, the types of assets it holds, and how it finances
those assets. Looking at the income statement, we can see if the company’s
sales increased or declined and whether the company made a profit. Glancing
at the statement of cash flows, we can see if the company made any new
investments, if it raised funds through financing, repurchased debts or equity,
or paid dividends
In this unit, we will explore financial accounting, particularly on the financial
statements on a totally different perspective using the lens of financial
managers. We will create forecast on the direction of a certain company and
create decisions that surely leads to the accomplishment of financial
management goal: to maximized stockholders wealth.

Learning Outcomes

At the end of this unit, you should be able to:

 List each of the key financial statements and identify the kinds of
information they provide to corporate managers and investors;
 Explain and apply what ratio analysis is.
 Discuss each ratio’s relationship to the balance sheet and income
statement.

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Topic 3: FINANCIAL STATEMENT ANALYSIS AND FORECASTING

Things to Ponder
Success isn’t about how much money you make, it’s about the difference you
make in people’s lives.

Learning Objectives
At the end of this topic, students will be able to:

 Explain the basic objectives of analyzing financial statements;

 Describe the general approach to financial statement analysis;
 Enumerate the steps in financial statements analysis;
- Horizontal Analysis of Comparative Statements (Increase-Decrease
Method)
- Trend Analysis
- Vertical Analysis or Common Size Financial Statements
- Financial Ratios Analysis
 Explain the limitations of financial statement analysis

Activating Prior Learning

In Topic 1: Introduction to financial management, we discussed that in an

enterprise system, the primary goal of financial management is to maximize
shareholder value or wealth. Further, we discussed the concept of valuation
and explain how it depends on future cash flows and risk.

Going deeper, in this new topic, we will show you how accounting data can be
analysed and used to measure how well a company has operated in the past
and how well it is likely to perform in the future. We will also let you
understand that the financial management’s goal which is to maximize
stockholder’s wealth was based on the firm’s cash flows. So financial
managers should focused on decisions on which actions are most likely to
increase those flows.

Questions to Ponder:
1. How is it important to know how to interpret financial statements in
creating critical financial decisions like investment?

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 Presentation of Contents

Financial Statement Analysis

-involves careful selection of data from financial statements for the primary
purpose of forecasting the financial health of the company.

Sample specific questions to be resolved in arriving at the BEST DECISION

after careful analysis of the financial statements may include the following:
1. Will the e-commerce industry like Amazon, Lazada or Shoppee continue
to make good results after this COVID 19 pandemic? How about the oil
industry, can they still recover from massive losses after this COVID 19
pandemic? What could be the effects of the unending US-China trade war
to emerging economies like the Philippines? (This is a macro environment
scanning where a company may be greatly impacted by the current
economic developments in the world or in the Philippines)
2. Can BPI extend more credit to potential short-term creditors despite the
increase in credit defaults due to government-imposed regulation during
this pandemic?
3. Do online sellers have sufficient stock of goods to meet promptly orders
despite problems in logistics brought about by this pandemic?
4. Can ABS-CBN pay its huge long-term obligation amid denial of franchise
renewal?
5. Can GMA7 maintain its position as one of the publicly listed companies
in the Philippines which gives high and consistent dividend payments to
the shareholders amid this pandemic?
6. Can DITO Telecommunity, having a huge debt over equity, translate
borrowings into earnings in 3 to 5 years?
7. Despite Ramon Ang’s philanthropic activities (CSR) which entails
substantial cost, could this greatly affect San Miguel Corporation’s
profitability? How about its effect on the company’s stock price?

In summary of the foregoing questions, we can have the following as general

approach when analyzing financial statements:
 Background study and evaluation of firm industry, economy and outlook.
 Analysis of the short-term solvency (working capital analysis)
 Analysis of the capital structure and long-term solvency (Equity and long
term assets and liabilities analysis)
 Analysis of operating efficiency and profitability (revenues and expenses
analysis)

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 Other considerations:
a) Quality of earnings –A good quality of earnings are those that are result
of recurring revenues (operating income).
b) Quality of assets and relative amount of debt
c) Transparent financial reporting – The more reliable the economic
information provided by a company through the financial statements,
the more confidence potential investors can place in that information.

Steps in Financial Statement Analysis

 Establish objectives of the analysis
- Do you have any plan to lend capital to ABS CBN or DITO?
- Will you invest with GMA7 or Meralco because they are consistent in
paying high dividends?
- Would you like to invest with Jollibee despite huge downside of its
stock price?
- Or you’re just bored and you want to impress someone by showing
your knowledge in current events, financial statement analysis and
financial ratios?
 Study the industry in which firm operates and relate industry climate to
current and projected economic development
- Maybe it is good to invest with PUREGOLD or FRUITAS in this time
of pandemic. There is a high consumption of basic goods today.
- It might be a good decision to invest with Netflix today. In this
situation, people can do nothing but to stay at home and movies and
series.
- PLDT and Globe might be a good choice, having an internet
connection is the new trend most especially for online learners.
 Develop knowledge of the firm and the quality of management
 Who is DITO? Who is the owner of the 3rd Telco player? Who is
Dennies Uy? What is its connection with China Telecom? What are
their management goals and objectives?
 Evaluate financial statements using any of the techniques below:
a. Horizontal analysis of Comparative Statements (Increase-Decrease
Method) - presents a comparative financial statements for the current
and previous years. For every line item, the difference between the
two years are computed and divided by the amount of the base year
or previous year to determine the percentage of change.
b. Trend Analysis - a modification of the vertical and horizontal
analysis. The percentage changes are determined for several
successive periods instead of the typical two-year period horizontal
analysis. In here, items not seen in two-period analysis may surface in
a longer based study such as trend analysis. In computing the trend,
the oldest year becomes the base year. The percentage relationship of

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 each account in the statements is then computed by dividing each
amount by the base year figure. A trend is then determined by
comparing percentage relationships. Based on the trends,
interpretations, conclusions and implications are derived.
c. Vertical Analysis or Common Size Financial Statements - uses
percentages/ratios that present the relationship of the different
accounts/items in the financial statement relative to a base figure or
amount. It presents the relative size of an account/item in proportion
to the whole or the base amount. For the Statement of Financial
Position, the total asset is the base amount while the Statement of
Income uses the net sales/revenue as the base amount. The outcome
of the percentages is presented in the common-sized statement which
management looks into to have a better understanding if the changes
to total assets (SFP) or net sales/revenue (SI) that have transpired
from one period to another. This also aids management to assess
their financial position and performance by comparing their
statements with other companies belonging to the same company.
d. Financial Ratios Analysis - A comparison in fraction, proportion,
decimal or percentage form of two significant figures taken from
financial statements. It expresses the direct relationship between two
or more quantities in the statement of financial position and income
statement of a business firm. Through ratio analysis, the financial
statement user comes into possession of measures which provide
insight into the profitability of operations, the soundness of the firm’s
short-term and long-term financial condition and the efficiency with
which management has utilized the resources entrusted to it.

Financial ratios can be divided into five basic types: liquidity,

leverage (debt), coverage, activity, and profitability. No one ratio is
itself sufficient for realistic assessment of the financial condition and
performance of a firm. With a group of ratios, however, reasonable
judgments can be made. The number of key ratios needed for this
purpose is not particularly large – about a dozen or so.

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 Summarize findings based on analysis and reach conclusions about firm
relevant to the established objectives.
At the end of the day, you will go back to your objectives. Based on the
figures which you obtained after applying the various techniques, we must
make a decision.
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Before we proceed to our illustrative cases, let’s have first a quick review of
financial statements which you have learned in your FAR, CFAS and IA series
especially in IA 3.

The Financial Statements

 Statement of Financial Position – it shows the financial condition or
financial position of a company on a particular date. It is a summary of
what the firm owns (assets) and what the firm owes to outsiders
(liabilities) and to internal owners (stockholders equity)

ASSETS
Current Assets
Cash and cash equivalents
Marketable securities
Accounts receivable
Inventories
Prepaid expenses
Non-current Assets
Property, plant and equipment (Land, Buildings and Leasehold
Improvements, and Equipment)
Other non-current assets (Long-term investments, Intangible assets,
Goodwill, Deferred tax assets)

LIABILITIES
Current Liabilities
Accounts payable
Short-term Notes payable
Current Maturities of Long-term debt
Accrued liabilities
Non-current Liabilities
Long-term debt
Deferred tax liabilities

EQUITY
Share capital
Additional paid-in capital/Share Premium
Retained earnings
Other Equity accounts

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 Statement of Income – the performance of the firm for a period of time.

Net sales
Cost of goods sold
Gross profit or gross margin
Operating expenses
Selling and administrative
Marketing/Advertising Costs
Lease payments
Depreciation and amortization
Repairs and Maintenance
Operating income
Other income/expense (dividend income, interest income, interest
expense, gains (losses) from investments, and gains (losses) from sale
of fixed assets)
Income from continuing operations before income tax
Provision for income taxes on continuing operations
Income from continuing operations
Gains (losses) on discontinued operations
Net income

WARNING: There are income statement terms that are used in Financial
Statement Analysis which cannot be seen from a pro-forma or standard income
statement (for external use).

Earnings Before Interest and Taxes (EBIT) is a term you will see frequently
in financial statement analysis. EBIT is not the same as operating income,
though in some cases they may be the same.

A line titled “EBIT” does not appear on a standard income statement because
EBIT is a calculated amount used in financial statement analysis and other
types of analysis. Earnings Before Interest and Taxes is equivalent to net
income adjusted to add back any deduction for interest expense and any
deductions for taxes. EBIT can be calculated in more than one way. Beginning
with operating income, it would be calculated as follows:

Operating income
+ Interest and dividend income
+/− Non-operating gains/(losses)
+/− Gains/(losses) from discontinued operations (gross, not net of applicable taxes)
= Earnings Before Interest and Taxes (EBIT)

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In other words, in contrast to operating income, EBIT includes non-operating
gains and losses such as gains and/or losses on acquisitions or investments,
interest and dividend income, pretax additions or deductions for discontinued
operations.

EBIT does not include any deductions for interest expense or for taxes.
Therefore, if the company has gains and/or losses on acquisitions or
investments, interest or dividend income, and income/losses from discontinued
operations, its Earnings Before Interest and Taxes will not be the same as its
operating income. All of those items constitute the difference between
operating income and EBIT. If the company has none of those items, its
operating income will be the same as its EBIT, but that will be true only
because the items that would create the difference are zero.

Earnings Before Taxes (EBT) is another term used in financial statement

analysis that you will not see on a standard income statement. Earnings Before
Taxes is Earnings Before Interest and Taxes minus
Interest Expense.

 Statement of Cash Flow – the sources and uses of funds during an

accounting period
 Operating – generation of the principal revenue of the firm or ability
to generate sufficient cash to meet maturing obligations, sustain the
firms operating capability and pay dividends without recourse to
external source of financing
 Financing – borrowings to support firm’s operation
 Investing – cash flow from sale or purchase transaction wherein non-
operating assets are involved.

After reviewing the basic financial statements, I will now present to you the
illustrative cases for each of the five techniques.

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Illustrative Case No. 1 - Horizontal analysis of Comparative Statements
(Increase-Decrease Method)

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REQUIRED:
Evaluate the company's financial position and results of operations using the
Comparative Statements Analysis.

SOLUTION:
Financial Statements Analysis of Golden Garments, Inc.

1. Short-term Solvency Analysis - As shown on the statement of financial

position, the percentage of increase in total current assets (10.1%) was
lower than the percentage of increase in total current liabilities (15%). It
can be observed that accounts payable and bank loans increased
significantly. Accounts receivable and inventory increased at a much
higher percentage than the percentage of increase in Sales revenue (11%).
This indicates slower conversion of inventory and receivables to cash.
The changes mentioned resulted to the deterioration in the short-term
solvency position of the company as of the end of year 2014 compared
with year 2013.
2. Long-term Financial Position Analysis - The book value of property,
plant and equipment declined because of the depreciation provision for
the year. Total liabilities increased by only 1%, whereas shareholders'
equity increased by 11.8%. Thus, the company's capital structure shifted
slightly away from borrowing and toward capital provided by profitable
operations. These changes can be viewed favorably because they indicate
strengthening of the long-term financial position by end of year 2014.
3. Operating Efficiency and Profitability Analysis - Sales revenues increased
by 11% while cost of goods sold increased by 12.4%. This is unfavorable
because this could indicate that the company was unable to adjust the
selling price of the goods commensurate to the increase in cost of goods
purchased or manufactured or it was unable to control the price factor of
its cost of sales. These changes resulted to the reduction in the gross profit
rate which is unfavorable. The 11% increase in sales was accompanied by
a 7.8% and 2.8% increase in selling and administrative expenses,
respectively. This is favorable because this could indicate management's
efficiency in keeping expenses within control.

On an overall basis, operating performance could be considered satisfactory or

favorable because of the lower increase in operating costs of 10.5% as
compared with the increase in revenue of which resulted to an 18.4% increase
in operating income. Repayment of notes payable reduced interest expense by
4.7%. Reduced interest expense together with higher operating income
increased income before taxes by 25.9%.

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Illustrative Case No. 2 - Trend Analysis

REQUIRED:
1. Compute the trend percentages for the Statement of Financial
Position and Income Statements from 2010 to 2014.
2. Evaluate the company’s short-term solvency, long-term financial
position and profitability using the trend percentages obtained in No. 1.

SOLUTION:

Requirement 1 – Computation of trend percentages

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Requirement: Analysis and Evaluation
1. Short-term Solvency - Current assets increased by 9% while current
liabilities decreased by 27% by 2014. The current financial position of the
Gilbert Company improved as reflected by the upward trend in total
current assets accompanied by the downward trend in current liabilities.
The improvement in the current financial position is also indicated by the
fact that the current assets were 2.05 times the current liabilities as of
December 31, 2010 and 3.05 times at the most recent date.

- The trend data reveal that cash, receivables and inventory showed upward
tendencies over the years. The increase in receivables and inventory is
favorable because net sales increased at a faster rate. The favorable
tendency indicates that more effective credit, collection and
merchandising policies, could have been established and made effective.
The relatively smaller amount of trade receivable reflects more rapid
turnover of customer accounts and possibly a large increase in cash sales.

- The decline in marketable securities and other current assets over the
years also indicates lesser investment in not-so-productive assets. All
these trends in different directions reflect an increasing efficiency of
working capital management.

2. Long-term financial position - A comparison of the trends in total

liabilities and equity reveals that the former declined and the latter
increased. As a result of these variations, the creditors' margin of safety
increased significantly.

- The expansion in property, plant and equipment which substantially

increased was financed by shareholders' capital through the issuance of
share capital at a premium, long-term liabilities and working capital
derived from operations.

- A greater reliance on equity funds rather than on creditor funds increased

the margin of safety of the creditors and therefore strengthened the
financial position of the company.

3. Profitability - It will be observed that both sales and cost of sales showed
upward trends with sales increasing at a faster rate. These data reflect a
favorable situation from the point of view of managerial ability to control
costs relative to change on sales volume. This more desirable percentage
may have been the result of one or more factors such as favorable price-
level changes, more effective markup policies or greater efficiency in
purchasing.

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- An unfavorable tendency is reflected by the fact that trend percentages for
selling, general and administrative expenses increased at a faster rate than
the net sales. The company could have earned more profit if better and
more effective control over operating expenses were instituted.

Illustrative Case No. 3 - Vertical Analysis or Common Size Financial

Statements

The percentages here are computed based on the Illustrative Case No.2

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 Evaluation of the Financial Position
I. The Gilbert Company's statements of financial position showed that there
had been substantial changes in the proportions of current and fixed assets
and current and long-term liabilities during the period from December 31,
2010 to December 31, 2014. The percentages showed a declining liquidity
in the company's assets accompanied by a consistent reduction in
liabilities over the five-year period.
II. It can be observed that Cash balance and accounts receivable as a
percentage of total assets had been increasing while investment in
inventory in relation to total assets had been decreasing. Considering that
the volume of sales was increasing, these changes can be viewed as
beneficial to the company.
III. The increase in investment in fixed assets had been financed largely from
owners' investment as indicated in the increasing percentage of equity to
total assets.
IV. The decreasing percentage of total liabilities to total assets further
indicates lesser reliance of the company from creditors in raising
additional capital. This, of course, is favorable as far as the long-term
financial position of the company is concerned because a wider margin of
safety is provided among the creditors.

Evaluation of Profitability
1. Favorable changes could be observed in the gross margin percentage in
relation to net sales. The increase in percentage over the years could be
due to improvement in the company's mark-up policy or better
procurement policy.
2. Selling expenses in relation to sales however, show increasing
percentages from 2010 to 2014, while administrative expenses had more
or less remained constant. Better control over the selling expenses should
be instituted to further improve the profitability of the company.
3. Decrease in percentage of other expenses to net sales is traceable to the
decreasing amount of notes payable and long-term debts.

It can be concluded that the figures presented will have no meaning without
interpreting it. Financial statement analysis does not end on computation. A
good financial manager must be able to articulate in his financial statement
analysis report the relevance and meaning of the figures computed. Hence, in
order to maximize the objectives of this topic, we will not focus only on
computations. The essay part could be challenging for you, but that is the
essence of the topic - to summarize findings based on your analysis and reach
conclusions about firm relevant to your established objectives.

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 Outline of the Topic
I. Definition of Financial Statement Analysis
II. General Approach in the conducting FS analysis
III. Steps in FS Analysis
IV. Review of Basic Financial Statements
V. Discussion of the four techniques of FS analysis:
 Horizontal analysis of Comparative Statements (Increase-Decrease
Method)
 Trend Analysis
 Vertical Analysis or Common Size Financial Statements
 Financial Ratios Analysis
VI. Illustrative Cases for:
 Horizontal analysis of Comparative Statements (Increase-Decrease
Method)
 Trend Analysis
 Vertical Analysis or Common Size Financial Statements

Application

Divide the class into 6 groups with 5 members each.

1. Think for a company you are familiar with.

2. Identify what type of industry does it belong.
3. Search for the background of that Company (“About us?”).
4. Write down some of their latest updates (management plans, company
status and issues).
5. Search and download a copy of their latest annual financial reports.
6. Evaluate their financial statements using financial ratio analysis. Then
make a report on the following aspects of the company: 1) liquidity; 2)
activity or efficiency in managing resources; 3) debt management
(leverage); and 3) profitability.
7. Create a financial forecast of their financial statements. Discuss your
basis and assumptions.

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 Feedback

Complete the table below by enumerating the different types of financial

ratios, formula and their strength and weaknesses.

Financial Ratios Formula Strength and Weaknesses

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