FINANCIAL STATEMENT ANALYSIS: BUSINESS FINANCE

Financial Analysis
 It is used for investment and credit decisions.
 It is definitely used by management for monitoring performance and for identifying
strategies to further improve the company’s operations.
 It gives unbiased view of financial health of the company
Accounting Principle
 Accounting is divided into three important parts which is identifying, recording and
communicating.
Two Types of Users in Accounting:
1. Internal Users 2. External Users
 Managers  Equity Investors
 Employees  Potential Investors
 Labor Union  Shareholders
 Creditors
 Potential Creditors
 Regulators
 The Public
Income Statement (Revenues & Expenses): Statement of Comprehensive Income
1. Gross Profit= Net Sales- Cost of Sales
2. Operating Income=Gross Profit – Operating Expenses
3. Income before taxes=Operating income- taxes
4. Net Income= Taxes – Income before taxes

Balance Sheet (Assets, Liabilities, Equity): Statement of Financial Position

 Accounting Equation: Assets= Liabilities + Equity

 Current Assets, Non-current Assets

 Current Liabilities, Non-current Liabilities

TOOL OF ANALYSIS
1. Horizontal Analysis
 also called trend analysis evaluates a series of financial statement data over a period
of time.
  2 consecutive period
 behavior of the account, decrease and increase during the period
Peso Value/ Change since base period= Current year amount – Base year amount
Base year amount
If the base year amount is 0 and negative, we can compute the peso change and can’t compute in
percentage change.
Percentage Change= Sales of current year – Sales of base year x 100%
Sales of base year
These changes for the different accounts are important to identify trends. This horizontal analysis can
be done for the different accounts from the statement of financial position, statement of profit/loss,
statement of cash flows.
2. Vertical Analysis
 Also called common-size analysis, evaluates financial statement data by expressing
each item in a financial statement as a percentage of a base amount.
 All accounts in the statement of financial position are presented of total assets.
 All accounts in the statement of profit/ or loss are presented as percentage of sales or
revenues.
%= Each item on Balance Sheet
Total Assets
%= Each item in Income Statement
Net Sales
 For the SFP (balance sheet), the base amount is Total Assets. balance of account/ total assets
 For the SCI (income statement), the base amount is Net sales

3. Financial Ratios (the company need to be consistent is using financial ratios)

 PROFITABILITY RATIOS
 refers to the company’s ability to generate earnings
 it is one of the most important goals of businesses
1. Return on Assets- measures overall profitability of assets. The higher the better.
Return on Assets= Operating Income x 100%
Total Assets
Return on Assets (If the problem is silent) = Net Income
Average Total Assets
Excluded in computing Operating Income: Interest expense, income tax expense.
If the ratio or the formula requires data from 2 report which is the income statement and
balance sheet. In the balance sheet component or balance sheet account it should be
always in the average.
Return on Assets= 4, 048, 696 (Operating Income) x100%
22, 298, 020 (Total Assets)
= 18.96%
The 18.16% means that in 2018, ABM Company generated 18.16c for every P1.00 of assets
in the company.
2. Return on Equity- measures profitability if owner’s investment. The higher the
better
Return on Equity= Net Income x 100%
Shareholder’s Equity
Return on Equity (If the problem is silent) = Net Income
Average Shareholder’s Equity
Return on Equity= 2, 659, 087 (Net Income) x100%
12, 478, 559 (Total Shareholder’s Equity)
= 21.31%
The 21.31& means that for every P1.00 of stockholder’s equity, c21.31 was earned in 2018
3. Gross Profit Margin- measures gross profit generated by each peso of sales. It provides
information regarding the ability of a company to cover its manufacturing cost from its
sales. Remember that gross profit is just sales less cost of goods or cost of services
Gross Profit Margin= Gross Profit
Net Sales
4. Operating Profit Margin- shows how many pesos of operating profit is earned for every
peso of sale. It measures the amount of income generated from the core business of a
company.
Operating Profit Margin= Operating Profit
Net Sales
5. Profit Margin- measures how much net profit a company generates for every peso of
sales or revenues that it generates.
Net Profit Margin= Net Income
Net Sales
Net Profit Ratio= Net sales- COGS- operating expenses- interest expense-
income tax expense
Net Profit Margin= 2, 659, 087 (Net Income) x100%
52, 501, 085 (Net Sales)
= 5.06%
In 2018, ABM Company earned c5.06 for evert P1.00 of revenues generated.

 EFFICIENCY OR TURN OVER RATIOS

 Speed of the company on converting its assets into cash, receivables into
collection, inventories into inventory sold, and how many days we should wait
before we collect the receivable, how many days we can wait before we can
sell the inventory.
1. Asset Turnover- measures how efficiently assets are used to generate sales.

Asset Turnover= Net Sales

Total Assets
Asset Turnover (If the problem is silent) = Net Sales
Average Assets
Asset Turnover=52, 501, 085 (Net Sales)
22, 298, 020 (Total Assets)
= 2.35
The asset turnover ratio of 2.35 means that every P.100 of asset ABM Company has in 2018,
it is able to generate sales of P2.35
2. Fixed Asset Turnover-measures effectiveness in generating sales from investments
in fixed assets.
Fixed Asset Turnover= Net Sales
PPE
Fixed Asset Turnover (If the problem is silent) =Net Sales
Average Fixed Assets
Fixed Asset Turnover= 52, 501, 085 (Net Sales)
 12, 200, 000 (PPE)
= 4.30
In 2018, ABM Company was able to generate P4.30, for every P1.00 of PPE that it has.
3. Receivables Turnover- measures liquidity of receivables. The Higher the better
Receivables Turnover= Net Credit Sales (Net Sales)
Accounts Receivables
Receivables Turnover (If the problem is silent) = Net Credit Sales (Net Sales)
Average Accounts Receivables
Receivables Turnover= 52, 501, 085 (Net Sales)
2, 300, 000 (Trade Receivables)
= 22.82
The accounts receivables turnover ratio become more meaningful when converted to days’
receivable or average collection period.

Average Collection Period= Accounting Period (days)

AR Turnover Ratio
Average Collection Period= 360
22.82
Average Collection Period= 17.78 or 16 days
In 2018, ABM Co. had an average of 16 days collecting its accounts receivables. This means that
from the day the sale was made, it took the company 16 days on the average, to collect its accounts
receivables.
4. Inventory Turnover- measures liquidity of inventory. The higher the better.
Inventory Turnover=Cost of Goods Sold (Net Sales)
Inventory
Inventory Turnover= 41, 954, 730 (Cost of Sales)
4, 849, 304 (Inventories)
= 8.65
The inventory ratio become more meaningful when converted to days receivable or average
collection period.
Days’ Inventories (Average age of inventory) = Accounting Period (days)
The lower the better Inventory Turnover Ratio
Days’ Inventories= 360
8.65
Days Inventories= 41.62 or 42 days
This 42days inventories means that in 2018. ABM company took 42 days on the average, to sell its
inventories from the time they were brought
5. Accounts Payable Turnover- provides info regarding rate by which payables are paid.
It depends on the company if they want the accounts payables turnover is high or low.
Payables Turnover= Net Credit Purchases > Net Purchases > Cost of Sales > Net Sales
Accounts Payables
Payables Turnover= Net Credit Purchases > Net Purchases > Cost of Sales > Net Sales
Accounts Average Payables

Cost of sales= Beginning Inventory + Purchases – Ending Inventory

Payables Turnover= 41, 954, 730 (Cost of Sales)
5, 050, 810 (Trade Payables)
= 8.31
Days’ Payable= Accounting Period (days)
AP Turnover Ratio
Days’ Payable= 360
 8.31
Days’ Payable= 43.42 or 43 days
This number suggests that in 2018, the average payment period of the company for its accounts
payable was 43 days.

Other Ratios:
1. Operating Cycle - days’ inventories + days’ receivable
2. Cash conversion cycle - operating cycle - days payable
Days inventories= 42 days
Days’ receivable= 16 days
Days’ payable=15 days
Operating cycle= 58 days
Cash conversion cycle= 15 days

 LIQUIDITY RATIOS
1. Current Ratio- measures the short-term debt. Paying ability of the entity
Current Ratio= Current Assets
Current Liabilities
Current Ratio= 9, 262, 331 (Current Assets)
7, 819, 461 (Current Liabilities)
Current Ratio= 1.18
The current ratio of 1.18 means that for every P1.00 of current liabilities that the company it has
P1.18 current assets as of December 31, 2018.
2. Acid Test Ratio- also called quick ratio; measures the immediate short-term liquidity of the
entity.
Quick Ratio= Cash + Short=term investments + Net receivables
Current Liabilities
Quick Asset- assets that can be easily be converted to cash; cash accounts, short-term investments,
receivables
Alternative Formula for Quick Ratio= Current Asset – Inventory – Prepaid Expense
Current Liabilities
Quick Asset Ratio= Cash + Net Receivables + Short-term inventories
Current Liabilities
Quick Ratio=1, 062, 527 (Cash) + 2, 300, 500 (Trade Receivables)
7, 819, 461 (Current Liabilities)
Quick Ratio= 0.43
This ratio means that for every P1.00 current liability, it has c0.43

 SOLVENCY RATIOS
 Also called leverage ratios; measure the ability of a company to survive over a
long period of time. Also shows the capital structure of a company.
1. Debt to total assets ratio- measures the percentage of total assets provided by creditors.
Debt Ratio= Total Liabilities
Total Assets
Debt Ratio=9, 819, 461 (Total Liabilities)
22, 298, 020 (Total Assets)
= 0.44 (means the equity is higher)
The debt ratio of less than 0.50 means that the company has less liabilities as compared to its
stockholders’ equity. If the debt ratio is 0.50 this means that the amount of total liabilities is exactly
equal to stockholders’ equity
 2. Debt to equity ratio- debt to equity ratio of more than 1 means that a company has more
liabilities as compared to stockholder’s equity.
If the debt-to-equity ratio is more than 1, this means the liability is higher than equity.
Debt to equity Ratio= Total Liabilities
Total Stockholder’s Equity
Debt to Equity Ratio=9, 819, 461(Total Liabilities)
12, 478, 559 (Total Stockholder’s Equity)
= 0.79
Since the company’s debt ratio is less than 1, it is expected that the debt-to-equity ratio is less than 1.

Equity Ratio= Total Equity

Total Assets
3. Time interest earned- also called interest coverage ratio; measures ability to meet interest
payments as they come due.
Time interest Earned= Earnings before income taxes and interest expense (other term for operating
income)
Interest Expense
Time Interest Earned= 4, 048, 696 (Operating Income)
250, 000 (Interest Expense)
= 16.19
The 16.19 means that company has more than enough operating income or earnings before interest
and taxes to cover its interest expense.

Factors that Influence Capital Structure:

 Nature of Business
 Stage of business development
 Macroeconomic conditions
 Prospects of industry and expected growth rates
 Bond and stock market conditions
 Financial Flexibility
 Regulatory environment
 Taxes
 Management style
Limitations of Financial Statement Analysis:
 Financial analysis deals only with quantitative data.
 Management can take short-run actions to influence ratios.
 Different companies may use different accounting principles though they come from same
industry
 Different formulas can be used in computing financial ratios.
 Amounts found in the FS are already part of historical data
 Financial ratio standing alone is useless.