FINANCIAL STATEMENT (FS) ANALYSIS

➢ 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

DEFINITION OF MEASUREMENT LEVELS

The following are the standards by which financial health and performance are
measured:
1. Liquidity - ability to pay current liabilities from current assets. This is
particularly useful to someone who may be thinking of extending a short-term
loan to the business, or to suppliers who may be assessing the extent to which
they may sell goods or services on account to the business entity.
2. Solvency - long-term liquidity or the ability of a company to meet its long-term
debts and financial obligations. While a business is primarily financed by the
capital of the owner, the owner may desire to go into long-term borrowing to
finance a promising but initially very expensive business venture. If the business
entity is solvent, banks and other financiers may extend loans to it.
3. Stability - ability to make enough money from your operations to pay for your
regular business expenses and feeling that the long-term financial success of your
business is secure. Having financial stability is important since it ensures you can
continue to pay your business expenses and handle potential downturns in the
market as well as take advantage of opportunities to expand.
4. Profitability - a satisfactory return of the business on the owner's capital.
Profitability brings about a decision to continue or expand operations of the
existing line of business, or not continue and shift to a more profitable business
venture.

THE NEED FOR FINANCIAL STATEMENT ANALYSIS

FS Analysis allows owners and managers to:
1. confirm past expectations - e.g. Were sales goals met? Did we stick to the budget?
2. evaluate present financial results - e.g. How can we improve collections? Why
did ending inventory increase?
 3. predict future outcomes - e.g. Will net income continue to increase by 4%? Will
we be able to pay off long term debts in 5 years?

KINDS OF FS ANALYSIS TECHNIQUES

Horizontal Analysis
➢ 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
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 called trend analysis
➢ uses financial statements of two or more periods
Changes over time can be expressed in monetary value (peso) and/or percentages
computed by using the following formulas:

Pesos Change (Balance of Current Year) - (Balance of Prior Year)

(Balance of Current Year) - (Balance of Prior Year)

(Balance of Prior Year)
Percentage Change Or
Peso Change
Balance of Prior Year

If we look at the illustration below showing the line items in a Statement for Financial
Position, all line items on the FS can be subjected to horizontal analysis. Try computing
for peso change and percentage change using the formulas given and check if you will
arrive at the same amounts.
Vertical Analysis
➢ a technique that expresses each financial statement item as a percentage of a base
amount
➢ also called common-size analysis
The formula to be used in analysis is:

common size = balance of account / base

When doing vertical analysis on the Statement of Financial Position, the base amount is
Total Assets. In the Statement of Comprehensive Income, the base amount is Sales.
The illustration below shows the line items in a Statement for Financial Position and
their corresponding common size for the current and prior years. If we take the account
'Trade and Other Receivables' to compute for common size, we divide the balance of the
account which is P240,000 by the base which is total assets amounting to P1,793,000.
We have 240,000 ÷ 1,793,000 = 0.13 or 13%. Try dividing other account balances to the
base and see if you arrive at the common size stated below.

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. Common-size statements
used in analysis are statements where available figures are not peso amounts but
percentages only.
Ratio analysis is a quantitative analysis technique applied by an entity to be able to
assess the company’s liquidity, solvency, operational efficiency (stability) and
profitability through scrutiny of account balances reported in the Statement of Financial
Position and Statement of Comprehensive Income. A financial ratio is composed of a
numerator and a denominator but it can be expressed in terms of a percentage, a rate, or
a simple proportion.
The financial ratios used in business are generally grouped into these categories:
1. Liquidity ratios
2. Solvency Ratios
3. Operational Efficiency Ratios
4. Profitability Ratios
In the sample computations that will follow, we will use the data from Financial
Statements below.
Liquidity Ratios determine whether an entity has the ability to use current assets to
pay for current liabilities as they become due.
1. 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. If the
current ratio is greater than 1, it means that the business can pay its current
liabilities using its current assets. Creditors normally prefer a current ratio of 2.
2. Acid Test/ 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, marketable securities and accounts receivable are referred to
as quick assets. If the quick ratio is greater than 1, it means that the business'
quick assets can cover for its current liabilities.
3. Cash Ratio is the strictest measure of liquidity. If the cash ratio is greater than
1, it means that the business' total cash can pay for all current liabilities.
The table below shows the formula for these ratios and the sample computation for
each:

Solvency Ratios determine whether an entity has more ownership than debts. It is
also called leverage ratios and these ratios involve comparisons of debt, asset, equity and
interest.
1. 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. If Debt Ratio is
greater than 50%, this means that assets are financed more by debt.
2. 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.
 3. Times Interest Earned Ratio 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.
The table below shows the formula for these ratios and the sample computation for
each:

Operational Efficiency Ratios or Stability Ratios measure how well an entity

utilizes their assets and resources to generate income.
1. Asset Turnover Ratio 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.
2. Inventory Turnover Ratio 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.
3. Accounts Receivable Turnover Ratio 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.
The table below shows the formula for these ratios and the sample computation for
each:
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.
1. 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.
2. Return on Assets 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, assets are allocated to both creditors and
shareholders. Some analysts prefer 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 are
computed as beginning balance + ending balance divided by 2.
3. Return on Equity 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.
The table below shows the formula for these ratios and the sample computation for
each:

All the ratios in this lesson are summarized in the table below.

LIQUIDITY SOLVENCY OPERATIONAL PROFITABILITY

RATIOS RATIOS EFFICIENCY RATIOS RATIOS

Current Ratio Debt Ratio Asset Turnover Gross Profit Ratio

Debt to Equity
Acid Test Ratio Inventory Turnover Return on Assets
Ratio

Times Interest Accounts Receivable

Cash Ratio Turnover
Return on Equity
Earned Ratio