CHAPTER 5

FINANCIAL ANALYSIS

Financial Analysis refers to an assessment of the viability, stability, and profitability of a business, sub-business or
project. It is performed by professionals who prepare reports using ratios and other techniques, that make use of
information taken from financial statements and other reports.

Analysis of Financial Information

This is the final step in understanding business finance. The pre-requisite to this analysis is knowing and understanding
available information and drawing logical conclusions.

Steps to consider:
1. Information must be understood by the user
Financial information must be treated with total transparency and honesty – understanding its context, and an
understanding of everything that is presented. In business finance, it is essential to know and appreciate even the
simplest terms and their contextual definition to avoid confusion.

2. Information must be organized

The presentation of changes in investments and their funding set out in the cash flow statement is vital for organizing
the data to obtain greater meaning.

3. Information measurement
Measurement can be done using applied common sense and analysis by means of financial ratios.

4. Finally, the data can be interpreted

Managerial and financial accounting

Accounting is the process of collecting, reporting, and analyzing the cost associated with operating a business. There are
internal and external users of the accounting information.

EXTERNAL USERS:
1. The Bureau of Internal Revenue, for tax liability purposes
2. The Securities and Exchange Commission for annual reporting for shareholders records
3. Banks for evaluation of financial standing for loan applications
4. Private individuals for investment interests

This system is called Financial Accounting

Internal users may require different types of data and reports generated by the accounting staff or the firm’s
accountant. These data may guide the organization, particularly the finance executive, to decide on projects to
undertake, financial planning, and funding, as well as expenditures.

This type is called Managerial Accounting

The information provided in the accounting reports will be a major financial management tool to use in order to make
future decisions.

The finance manager is responsible for maintaining the steady supply of cash needed to sustain operations while
minimizing the cost of keeping those funds.
Accounting data are critical to financial decision-making.
The accounting system communicates information about the company’s operations.

4 MAIN ACCOUNTING STATEMENT

The basic financial statements
THE BALANCE SHEET
The balance sheet accounts concepts: (Koth)
The balance sheet accounts concepts: (Koth)
The balance sheet accounts concepts: (Koth)
THE INCOME STATEMENT
The INCOME STATEMENT accounts concepts: (Koth)
The INCOME STATEMENT accounts concepts: (Koth)
SALES
Capital INVESTED BY STOCKHOLDERS
DEBt FUNDS RAISED FROM CREDITORs
VERTICAL AND HORIZONTAL ANALYSES OF FINANCIAL
STATEMENTS
VERTICAL ANALYSIS
VERTICAL ANALYSIS
Horizontal analysis
Horizontal analysis
FINANCIAL RATIOS
What is
FINANCIAL RATIO?
A financial ratio or "accounting ratio" in other word is a relative magnitude of two selected numerical values taken from
an enterprises financial statements. Often used in accounting, there are many standard rations used to try to evaLuate
the overall financial condition of a corporation or other organization.
“These are indices used in expressing data on such a way that it can be compared and trends identified and thus
questions for analysis can be raised.”
—Jones Ernest
6 KIND OF FINANCIAL RATIOS
Primary Ratio
It considers the profit or the return level of the business entity, for the year, in relation to the capital employed or
invested, or net' assets during the same period.
This is the primary measurement for all investment anywhere and in business, where the money has gone to.
Secondary Ratio
Are further investigations of primary ratio. They are concerned with profitability-profit in relation to sales: and related
activities-sales in relation to capital employed or net assets.
Profitability ratio might be studied from the point of view of gross profit or contribution to sales as a percentage . This
can then be expanded by relating direct materials or merchandise, labor and expenses to sales while viewing the fixed
overhead categories as amounts. At the same time, extend the examination by comparing sales with fixed assets and
working capital. This will reveal how many times we are turning over the investment in this two areas in relation to the
sales for the period. It analyzes whether the business is increasing in value through increase turnover or sales, for money
invested.
Tertiary Ratio
Tertiary ratio evaluate profitability of the business and analysis of activity. Profitability ratio can be assessed from the
point view of the gross profit or the contribution to sales as a percentage. Activity or use of assets ration is an
examination of activity by comparing sales separately with fixed assets and working capital. This will reveal how many
times we are turning over our investment in these two areas in relation to the salesfor the period, or for the year.
Financial Status Ratios
are those that help analyze a business financial standing in terms of its ability and settle obligations. Liquidity Ratios is
the relationship of current assets to current liabilities. Also, acid test or quick test ratio can be used to measure liquidity.
In here, we account only for the most liquid currents assets such as receivables and cash before dividing them by the
current liabilities. Inventories or stock are excluded, as they may take some time before becoming cash. Stock Turnover,
collection and payment ratios include stock turnover, collection period and payment period, in conjunction with the
liquidity ratios to evaluate whether stocks are being controlled and credit policies enforced.
Solvency Ratios
Investment Ratio
Are intended to give investors financial position of the business and the invested capital. Return on equity confines its
view to the profits belonging to the shareholders-the profit after tax and interest, and its relationship to the
shareholders' funds. Earnings per share is the central measurement of profitability from an investor's point of view.
This is the ratio of profit after tax and interest against numbers of issued shares. Price/earnings ratio expresses the
number of times the price of the share exceeds the earnings per share. Dividend yield reveals rewards to investor-the
dividends paid to them, with the market price of their shares. Dividend cover uncovers generosity of the business, in
terms of determining the proportion of the profits distributed to investors. The higher the dividend cover, the greater
the retention: the lower, the greater the distribution.
Commonly Calculated
LIQUIDITY RATIOS
- Liquidity is the ability of assets to be converted quickly into cash.
- Ideally, the company has to be liquid to meet current debts.
Ratios
USE TO MEASURE
LIQUIDITY
· Current Ratio
· Quick Ratio/Acid test Ratio
Current Ratio
- Is the ratio of current assets to current liabilities.
-
Current Ratio = Current asset
Current liabilities
Quick Ratio
- Is the ratio of current assets, excluding inventory, divided by current liabilities.
NOTE:
If the quick ratio is less than 1.0, the firm must plan on selling inventory in order to cover current liabilities.
The Industry’s standard
current ratio is 2:0.
If the quick ratio is larger than 1.0, the firm must be do something to improve its sales.
2. Activity Ratios
INVENTORY TURNOVER
Average collection period called
“ Days of sales outstanding”
Inventory Conversion cycle
- Combines the day of sales in inventory and days of sales in accounts receivable.
- It gives the company an idea as to how long it takes t convert inventory to accounts receivables, and subsequently
into cash.
Asset turnover
- Is concerned with efficient use of assets.
- The goal is not to sell through the fixed assets but to maximize the efficiency of those assets.
- For service firms, fixed asset turnover ratios are a better indicator of success.
Fixed asset turnover
- Looks at sales in comparison to the long-term assets of the firm, such as lands, equipment, plant.
Fixed asset turnover = Sales
Fixed assets
Total asset turnover
- Combines the effect of current asset management, the conversion of inventory and accounts receivable into cash;
and fixed asset management.
- It allows the firm to compare how well it is managing each type of asset.
Total asset turnover = Sales
Total assets
3. Leverage Ratios
- Explains the impact of debt or determines the level of debt that is appropriate for a firm.
- If the firm can earn more than the cost of its loan’s interest, it may be worth securing an additional loan or
leveraging the firm.
Debt to equity ratio
Note:
Where:
The higher the debt of a firm in relationship to its equity, the more leverages it has, and more risk it has assumed.
Shows the relationship between debt and equity
Debt to equity ratio= Debt
Equity
Another way is to compare the debt burden to the value of the total assets.
Where:
Debt ratio= Debt
Total assets
Times-interest-earned ratio
4. Profitability RATIOS
Gross profit margin profitability
The broadest measure of the firm’s profit level.
Gross profit margin = Revenues – Cost of goods sold
Sales
Note:
Gross margin measures profit before operating expenses, interest, and taxes are subtracted.
From the data:
while research and development costs amount to 94,200,000 resulting in a loss from operations.
The yearly revenue is Php 2,000,000
Operating profit margin
- Examines the income of the company before taking into account the interest and taxes.
Net profit margin
- Demonstrate a better assessment of a firm’s profitability, particularly for a company who has interest and tax
obligations.
5. Market Values
- A firm’s value is relative to what an investor will pay for its stock.
- If demand for the stuck increases, then its price will increase. Likewise, its increase in share price can be tied to
the expectation of increase in future earnings.
Tools that
Determine share prices are:
· Book Value
· Earnings per share
Book Value
- The basis for fairly determining the worth of the assets in relation to a holders’ share, upon liquidation of the firm.
Earnings per share
- Aims to identify the valid earnings per share value, by looking at trends over time or the earnings of other
companies in the same industry.
-END
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