PILAR COLLEGE OF ZAMBOANGA CITY, INC.

R.T. LIM BOULEVARD, ZAMBOANGA CITY

BASIC EDUCATION DEPARTMENT

PAASCU Accredited Level III
A.Y. 2020-2021

SENIOR HIGH SCHOOL

GRADE 11

LEARNING
MODULE in
FUNDAMENTALS OF ACCOUNTANCY,
BUSINESS & MANAGEMENT (ABM) 2

Unit Topic: Analysis and Interpretation of Financial Statements

Lesson 4: The Nature of Analysis and Interpretation of
Financial Statements

Jade A. Salvador
NAME: ______________________________________________
11 - Our Lady of Mt. Carmel
SECTION: ___________________________________________

MRS. ROWENA L. ESTERO

TEACHER
 Subject Area: Fundamentals of Accountancy, Business & Management 2 Quarter: FIRST
Unit Topic: Analysis & Interpretation of Statement Statements Time Allotment: 180 minutes

Lesson 4: ANALYSIS AND INTERPRETATION OF

FINANCIAL STATEMENTS

INTRODUCTION

Analysis and interpretation of financial statements are an attempt to determine the significance and
meaning of the financial statement data so that a forecast may be made of the prospects for future earnings,
ability to pay interest, debt maturities, both current as well as long term, and profitability of sound dividend
policy.

The main function of financial analysis is the pinpointing of the strength and weaknesses of a business
undertaking by regrouping and analysis of figures contained in financial statements by making
comparisons of various components and by examining their content. The analysis and interpretation of
financial statements represent the last of the four major steps of accounting.

In this lesson, the main focus for discussion is the levels of measurement of financial statements, vertical
and horizontal analyses and the techniques in the analysis and interpretation of financial statements

OBJECTIVES:

Students will be able to:

a. define the measurement levels namely: liquidity, solvency, stability and profitability;;
b. perform vertical and horizontal analyses of financial statements of a single proprietorship;
c. prepare and interpret financial ratios such as current ratio, working capital, gross profit ratio, net
profit ratio, receivable turnover, inventory turnover. Debt-to-equity ratio, and the like; and
d. demonstrate accuracy, open-mindedness, diligence and patience in performing the discussion,
activities and the preparation of the statement of changes in equity and cash flow statement of a
single proprietorship.

Motivation

Direction: Analyze and Interpret

Transactions Accounts Affected
When an owner invests cash in a business, owner's
1. Owner invests cash equity decreases.
_________________________________
Liabilities, in terms of accounts payable, increase, and current
2. Purchases supplies on credit _________________________________
assets increase as well.

3. Buys land paying cash
4. Rendered services for cash
Assets, liabilities and equity have net effect of zero
_________________________________
Increase assets, service revenue generates income, and increases
_________________________________
capital

5. Paid utilities expense for the month Utilities expense

_________________________________

Analysis & Interpretation of Financial Statements Page 1 of 17 11

 DISCUSSION

What is the Nature of the Analysis and Interpretation of Financial Statements ?

The first three steps involving the work of the accountant in the accumulation and summarization of
financial and operating data as well as in the construction of financial statements are:
(i) Analysis of each transaction to determine the accounts to be debited and credited and the
measurement and variation of each transaction to determine the amounts involved.

(ii) Recording of the information in the journals, summarization in ledgers and preparation of
a worksheet.
(iii) Preparation of financial statements.

The fourth step of accounting, the analysis and interpretation of financial statements, results in the
presentation of information that aids the business managers, investors and creditors.
Interpretation of financial statements involves many processes like arrangement, analysis, establishing
relationship between available facts and drawing conclusions on that basis .

Types of Financial Analysis:

The process of analysis may partake the varying types. Normally, it is classified into different categories
on the basis of information used and on the basis of modus operandi.
(a) On the basis of Information Used:
(i) External analysis - External analysis is an analysis based on information easily
available to outsiders (externals) for the business. Outsiders include creditors,
suppliers, investors, and government agencies regulating the business in a normal
way.
These parties do not have access to the internal records (information) of the
concern and generally obtain data for analysis from the published financial
statements. Thus an analysis done by outsiders is known as external analysis.
(ii) Internal analysis - Internal analysis is an analysis done on the basis of information
obtained from the internal and unpublished records and books. While conducting
this analysis, the analyst is a part of the enterprise he is analyzing. Analysis for
managerial purposes is the internal type of analysis and is conducted by executives
and employees of the enterprise as well as governmental and court agencies which
may have major regulatory and other jurisdiction over the business.
(b) On the basis of Modus Operandi:
(i) Horizontal analysis - Horizontal analysis is also known as ‘dynamic analysis’ or
‘trend analysis’. This analysis is done by analysing the statements over a period of
time. Under this analysis, we try to examine as to what has been the periodical
trend of various items shown in the statement. The horizontal analysis consists of a
study of the behaviour of each of the entities in the statement.
(ii) Vertical analysis - Vertical analysis is also known as ‘static analysis’ or ‘structural
analysis’. It is made by analysing a single set of financial statement prepared at a
particular date. Under such a type of analysis, quantitative relationship is
established between the different items shown in a particular statement. Common
size statements are the form of vertical analysis. Thus vertical analysis is the study
of quantitative relationship existing among the items of a particular data.

Analysis & Interpretation of Financial Statements Page 2 of 17

11
 DISCUSSION

Preliminaries Required for Analysis and Interpretation of Financial Statements:

The following procedures are required to be completed for making an analysis and interpretation of
financial statements:
(i) Data should be presented in some logical way.
(ii) Data should be analyzed for preparing comparative statements.
(iii) All data shown in financial statements should be studied just to understand their
significance.
(iv) The objective and extent of analysis and interpretation should be determined.
(v) Facts disclosed by the analysis should be interpreted taking into account economic facts.
(vi) Interpreted data and information should be in a report form.

Objectives of Analysis and Interpretation of Financial Statements:

The following are the some of the common objects of interpretation:
(i) To investigate the future potential of the concern.
(ii) To determine the profitability and future prospects of the concern.
(iii) To make comparative study of operational efficiency of similar concerns.
(iv) To examine the earning capacity and efficiency of various business activities with the help
of income statements.
(v) To estimate about the performance efficiency and managerial ability.
(vi) To determine short term and long term solvency of the business concerns.
(vii) To enquire about the financial position and ability to pay of the concerns.

Importance of Analysis and Interpretation of Financial Statements:

The following factors have increased the importance of the analysis and interpretation of financial
statements:
(i) Decision taken on the basis of intuition may be wrong and defective on the other hand.
Analysis and interpretation are based on some logical and scientific methods and hence
decisions taken on that basis seldom prove to be misleading and wrong.
(ii) The user as individual has a very limited personal experience. He can only understand the
complexities of business and mutual relationship by observation and external experience.
Thus it becomes necessary that financial statements in an implicit form should be analyzed
in an intelligible way.
(iii) Decision or conclusions based on scientific analysis and interpretation are relative and easily
to be read and understood by other people.
(iv) Even to verify and examine the correctness and accuracy of the decisions already taken on
the basis of intuition, analysis and interpretation are essential.

Techniques of Analysis and Interpretation:

The most important techniques of analysis and interpretation are:
1. Ratio Analysis 2. Fund Flow Analysis 3. Cash Flow Analysis.
1. Ratio Analysis = Two individual items on the statements can be compared with one another and the
relationship is expressed as a ratio. Ratios are computed for items on the same financial statement or on
different statements. These ratios are compared with those of prior years and with those of other companies
to make them more meaningful.
A ratio is a simple mathematical expression. Ratio may be expressed by a number of ways. It is a number
expressed in terms of another number. It i s a statistical yard stick that provides a measure of relationship
between two figures.

11
Analysis & Interpretation of Financial Statements Page 3 of 17
 DISCUSSION

2. Fund Flow Analysis - Funds Flow Analysis has been the salient feature of the evolution of accounting
theory and practice. The financial statement of a business provides only some information about financial
activities of a business in a limited manner. The income statement deals solely with operations and the
balance sheet shows the changes in the assets and liabilities.
In fact, these statements are substantially an analysis of static aspects of financial statements. Under this
context, it is imperative to study and to analyse the fund movements in the business concern. Such a study
or analysis may be undertaken by using another tool of financial analysis, which is called ‘Statement of
Sources, and Uses of Funds’ or simply ‘Fund Statement’ or Fund Flow Analysis.
This statement is also called by other several names and they are:
(a) Application of Funds Statement (e) Where Got and Where Gone Statement
(b) Statement of Sources and Applications of Funds (f) Fund Movement Statement
(c) Statement of Funds Supplied and Applied (g) Inflow-Outflow of Fund Statement
(d) Statement of Resources Provided and Applied.
Fund statement is a new contribution of science of accounting but has become the doyen of tools of
Financial Analysis.

3. Cash Flow Analysis -Fund Flow Statement fails to convey the quantum of inflow of cash and outflow of
cash. When we say cash, we refer to the cash as well as the bank balances of the company at the end of the
accounting period as reflected in the Balance Sheet of the company. Cash is a current asset like inventory
and Accounts Receivables. Cash reflects its liquidity position.
The term cash can be viewed in two senses. In a narrow sense, it includes actual cash in the form of notes
and coins and bank drafts held by a firm and the deposits withdrawable on demand the company has held in
commercial banks. But in a broader sense, it also includes what are called ‘marketable securities’ which are
those securities which can be immediately sold or converted into cash if required.
Cash flow statement is a statement of cash flow and cash flow signifies the movements of cash in and out
of a business concern. Inflow of cash is known as sources of cash and outflow of cash is called uses of
cash. This statement also depicts factors for such inflow and outflow of cash.
Thus cash flow statement is a statement designed to highlight upon the causes which bring changes in cash
position between two Balance Sheets dates. It virtually takes the nature and character of cash receipts and
cash payments though the basic information used in the preparation of this statement differs from that
which is used in recording cash receipts and cash payments.
This is particularly useful to the management, credit grantors, investors and others. As regards the
management, it is helpful in budgeting cash requirements.

What are the measurement levels of financial statements?

1. Liquidity is the availability of cash (funds) to finance the

current operations of the business.
2. Solvency is the firm’s ability to pay its current obligations.
Definition 3. Stability is the firm’s ability to pay its long term liabilities.
4. Profitability is the ability of the business enterprise to increase
of Terms capital as a result of business operation.
5. Capital Structure is the ability of the business to borrow
capital and invest owner’s capital in the business.
6. Financial Flexibility is the availability of excess cash for
investment opportunities and other uncertainties.

11
Analysis & Interpretation of Financial Statements Page 4 of 17
 DISCUSSION

What are Financial Ratios?

Financial ratios are used to express one financial quantity in relation to another and can assist with
company and security valuations, as well as with stock selections, and forecasting.

A variety of categories may be used to classify financial ratios. Although the names of these categories and
the ratios that are included in each category can vary significantly, common categories that are used
include: activity, liquidity, solvency, profitability, and valuation ratios. Each category measures a different
aspect of a company’s business; however, all are useful for evaluating a company’s overall ability to
generate cash flows from operating its business.

What are the Categories of Financial Ratios?

1. ACTIVITY RATIOS
Activity ratios, also known as asset utilization ratios or operating efficiency ratios, measure how
efficiently a company performs its daily tasks such as managing its various assets. They generally
combine income statement information in the numerator and balance sheet information in the
denominator.
The list below provides a description of the most commonly used activity ratios:

 Inventory turnover
Computation: Cost of goods sold / Average inventory
Interpretation: The ratio can be used to measure the effectiveness of inventory management. A
higher inventory turnover ratio implies that inventory is held for a shorter time period.

 Days of inventory on hand (DOH)

Computation: Number of days in period / Inventory turnover
Interpretation: The ratio can also be used to measure the effectiveness of inventory management. A
lower DOH implies that inventory is held for a shorter time period.

 Receivables turnover
Computation: Revenue / Average receivables
Interpretation: This measures the efficiency of a company’s credit and collection processes. A
relatively high receivables turnover ratio may indicate that a company has highly efficient credit and
collections, or it could imply that a company’s credit or collection policies are too stringent.

 Working capital turnover

Computation: Revenue / Average working capital
Interpretation: This indicates how efficiently a company generates revenue with its working capital.
A high working capital turnover ratio indicates greater efficiency.

 Fixed asset turnover

Computation: Revenue / Average net fixed assets
Interpretation: This measures how efficiently a company generates revenues from its investments in
fixed assets. A higher fixed asset turnover ratio indicates a more efficient use of fixed assets in
generating revenue.

11
Analysis & Interpretation of Financial Statements Page 5 of 17
 DISCUSSION

 Total asset turnover

Computation: Revenue / Average total assets
Interpretation: This measures a company’s overall ability to generate revenues with a given level of
assets. A low asset turnover ratio can be indicative of inefficiency or of the relative capital

 Days of sales outstanding (DSO)

Computation: Number of days in period / Receivables turnover
Interpretation: This measures the elapsed time between a sale and cash collection, and reflects how
fast a company collects cash from customers to whom it offers credit. A low DSO indicates that a
company is efficient in its credit and collection processes.

 Payables turnover
Computation: Purchases / Average trade payables
Interpretation: This measures how many times per year a company theoretically pays off all its
creditors.

 Number of days of payables

Computation: Number of days in period / Payables turnover
Interpretation: This reflects the average number of days that a company takes to pay its suppliers.
intensity of the company.

2. LIQUIDITY RATIOS
Liquidity ratios measure a company’s ability to satisfy its short term obligations. The list below provides a
description of the most commonly used liquidity ratios. These ratios reflect a company’s position at a point in
time and, therefore, usually uses ending balance sheet data rather than averages.

 Current ratio
Computation: Current assets / Current liabilities
Interpretation: A higher current ratio indicates a higher level of liquidity or ability to meet short-
term obligations.
 Quick ratio
Computation: (Cash + Short-term marketable investments + Receivables) / Current liabilities
Interpretation: A higher quick ratio indicates a higher level of liquidity or ability to meet short-
term obligations. It is a better indicator of liquidity than the current ratio in instances where
inventory is illiquid.
 Cash ratio
Computation: (Cash + Short-term marketable investments) / Current liabilities
Interpretation: The ratio is a reliable measure of liquidity in a crisis situation.

 Defensive interval ratio

Computation: (Cash + Short-term marketable investments + Receivables) / Daily cash expenditures
Interpretation: This measures how long a company can pay its daily expenditures using only its
existing liquid assets, without any additional cash inflow.

 Other ratios
In addition to the above ratios, the cash conversion cycle is an additional liquidity measure that can be used.
Computed as DOH + DSO – Number of days of payables, it measures the length of time that is required for a
company to go from cash paid (used in operations) to cash received (as a result of operations).

Analysis & Interpretation of Financial Statements Page 6 of 17

11
 DISCUSSION

3. Solvency Ratios
Solvency ratios measure a company’s ability to satisfy its long-term obligations. They provide
information relating to the relative amount of debt in a company’s capital structure and the adequacy of
earnings and cash flow to cover interest expenses and other fixed charges as they fall due.
There are two types of solvency ratios: (i) debt ratios, which focus on the balance sheet and measure the
amount of debt capital relative to equity capital, and (ii) coverage ratios, which focus on the income
statement and measure the ability of a company to cover its debt payments. Both sets of ratios are useful
in assessing a company’s solvency and evaluating the quality of its bonds and other debt obligations.
The list below provides a list and description of the most commonly used solvency ratios:

 Debt-to-assets ratio
Computation: Total debt / Total assets
Interpretation: This measures the percentage of a company’s total assets that are financed with
debt. A higher ratio implies higher financial risk and weaker solvency.

 Debt-to-capital ratio
Computation: Total debt / (Total debt + Total shareholders’ equity)
Interpretation: This measures the percentage of a company’s capital (debt + equity) that is
represented by debt. A higher ratio implies higher financial risk and weaker solvency.

 Debt-to-equity ratio
Computation: Total debt / Total shareholders’ equity
Interpretation: This measures the amount of debt capital relative to equity capital. A higher ratio
implies higher financial risk and weaker solvency.

 Financial leverage ratio

Computation: Average total assets/Average total equity
Interpretation: This measures the amount of total assets that is supported for each one money unit
of equity. The higher the ratio, the more leveraged the company in its use of debt and other liabilities
to finance assets.

 Interest coverage ratio

Computation: EBIT / Interest payments
Interpretation: This measures the number of times that a company’s EBIT could cover its interest
payments. A higher ratio indicates stronger solvency.

 Fixed charge coverage ratio

Computation: (EBIT + Lease payments) / (Interest payments + Lease payments)
Interpretation: This measures the number of times a company’s earnings (before interest, taxes,
and lease payments) can cover its interest and lease payments. A higher ratio indicates stronger
solvency.

Analysis & Interpretation of Financial Statements Page 7 of 17

11
 DISCUSSION
4. Profitability Ratios

Profitability ratios measure a company’s ability to generate profits from its resources (assets). There are
two types of profitability ratios: (i) Return-on-sales profitability ratios, which express various subtotals on
the income statement as a percentage of revenue, and(ii) Return-on-investment profitability ratios, which
measure income relative to the assets, equity, or total capital employed by a company.
The list below provides a description of the most commonly used solvency ratios:

 Gross profit margin

Computation: Gross profit / Revenue
Interpretation: This indicates the percentage of revenue that is available to cover operating and other
expenses and to generate profit. A higher gross profit margin indicates a combination of higher
product pricing and lower product costs.

 Operating profit margin

Computation: Operating income / Revenue
Interpretation: An operating profit margin that increases faster than the gross profit margin can
indicate improvements in controlling operating costs, such as administrative overheads.

 Pretax margin
Computation: EBT (earnings before tax but after interest) / Revenue
Interpretation: This reflects the effect on profitability of leverage and other non-operating income
and expenses.
 Net profit margin
Computation: Net income / Revenue
Interpretation: This measures how much of each dollar collected as revenue translates into profit.

 Operating ROA
Computation: Operating income / Average total assets
Interpretation: This measures the return (prior to deducting interest on debt capital) that is earned by
a company on its assets.
 Return on Assets (ROA)
Computation: Net income / Average total assets
Interpretation: This measures the return earned by a company on its assets.
 Return on total capital
Computation: EBIT / Short- and long-term debt and equity
Interpretation: This measures the profits that a company earns on all of the capital that it employs.

 Return on Equity (ROE)

Computation: Net income / Average total equity

Interpretation: This measures the return earned by a company on its equity capital, including
minority equity, preferred equity, and common equity.

 Return on common equity

Computation: (Net income – Preferred dividends)/Average common equity
Interpretation: This measures the return earned by a company only on its common equity.

Analysis & Interpretation of Financial Statements Page 8 of 17

11
 DISCUSSION
5. Valuation Ratios

Valuation ratios measure the quantity of an asset or flow that is associated with the ownership of a
specified claim.
The list below provides a list and description of the most commonly used valuation ratios:
 Price to earnings or P/E ratio
Computation: Price per share / Earnings per share
Interpretation: This tells how much an investor in common stock pays per dollar of earnings.
 Price to cash flow or P/CF ratio
Computation: Price per share/Cash flow per share
Interpretation: This measures a company’s market value relative to its cash flow.

 Price to sales or P/S ratio

Computation: Price per share / Sales per share
Interpretation: This compares a company’s stock price to its revenue and is sometimes used as a
comparative price metric when a company does not have positive net income.

 Price to book value or P/BV ratio

Computation: Price per share / Book value per share
Interpretation: This compares a stock’s market value to its book value and is often used as an
indicator of market judgment about the relationship between a company’s required rate of return
and its actual rate of return. A higher ratio implies that investors expect management to create
more value from a given set of assets, all else equal.

HORIZONTAL AND VERTICAL ANALYSES

Comparison Chart
BASIS FOR HORIZONTAL ANALYSIS VERTICAL ANALYSIS
COMPARISON
Meaning Horizontal analysis is the comparative Vertical analysis is proportional evaluation of
evaluation of the financial statement the financial statement wherein each item on
for two or more period, to calculate the the statement is expressed as a percentage of
absolute and relative variances for the total, in the respective section.
every line of item.
Use It represents the growth or decline of It helps in forecasting and determining the
an item. relative proportion of an item to the common
item in the financial statement.
Aims at Ascertaining the trend and changes in It aims at ascertaining the proportion of items
an item over time. to the common item of the single accounting
year
Expresses Item from past financial statement are Each item of financial statement is denoted as
restated to a percentage of amount a percentage of another item.
from base year.
Comparison Helpful in intra-firm comparison Helpful in both intra-firm comparison and
inter-firm comparison

11
Analysis & Interpretation of Financial Statements Page 9 of 17
 DISCUSSION

Example

Horizontal Analysis Key Differences Between

Horizontal and Vertical Analysis

The difference between horizontal

and vertical analysis can be drawn
clearly on the following grounds:
1. Horizontal Analysis refers to
the process of comparing the
line of items over the period, in
the comparative financial
statement, to track the overall
trend and performance. On the
other hand, vertical analysis
refers to the tool used to study
Formula Used:
financial statement by making
a comparison of each line of
the item as a proportion of the
base figure within the
statement, i.e. assets, liabilities,
sales or equity.
2. Horizontal Analysis is
Vertical Analysis undertaken to ascertain how
the company performed over
the years or what is its
financial status, as compared to
the prior period. As against,
vertical analysis is used to
report the stakeholder about
the portion of line items to the
total, in the current financial
year.
3. The primary aim of horizontal
analysis is to keep a track on
the behaviour of the individual
items of the financial statement
over the years. Conversely, the
Formula Used: vertical analysis aims at
showing an insight into the
relative importance or
proportion of various items on
a particular year’s financial
statement.

4. In horizontal analysis, the items of the present financial year are compared with the base year’s amount,
in both absolute and percentage terms. On the contrary, in vertical analysis, each item of the financial
statement is compared with another item of that financial statement.
5. The horizontal analysis is helpful in comparing the results of one financial year with that of another. As
opposed, the vertical analysis is used to compare the results of one company’s financial statement with
that of another, of the same industry. Further, vertical analysis can also be used for the purpose of
benchmarking.

Analysis & Interpretation of Financial Statements Page 10 of 17

11
 PILAR COLLEGE OF ZAMBOANGA CITY, INC.
R.T. LIM BOULEVARD, ZAMBOANGA CITY

BASIC EDUCATION DEPARTMENT

PAASCU Accredited Level III
A.Y. 2020-2021

SENIOR HIGH SCHOOL

GRADE 11

RETURN THIS
MODULE 4
FUNDAMENTALS OF ACCOUNTANCY,
BUSINESS & MANAGEMENT (ABM) 2
Unit Topic: Analysis and Interpretation of Financial Statements
Lesson 4: The Nature of Analysis and Interpretation of
Financial Statements

Lesson’s knowledge Check (Activity 1)

Activities 2 to 5
Assessment Page

Name: Jade A. Salvador Date Returned:

Section: 11 - Our Lady of Mt. Carmel

MRS. ROWENA L. ESTERO

TEACHER
 Kindly answer the lesson’s knowledge check, activities 1 to 5 and the assessment part with all
honesty and sincerity. You may write your answers in the indicated spaces of the activity.
.

KNOWLEDGE CHECK

ACTIVITY 1: SURVEY SAYS!

Read the following questions and write your answer on the space provided for.
1. What do I understand about the Analysis and Interpretation of Financial Statements? What function of
Accounting will I be able to relate the analysis and interpretation of financial statements with? How?

It is about the process of determining financial strengths and weaknesses of the firm by establishing strategic
relationship between the items of the balance sheet, profit and loss account and other operative data. Analysis
and interpretation of financial statements are an attempt to determine the significance and meaning of the
financial statement data so that a forecast may be made of the prospects for future earnings,
ability to pay interest, debt maturities, both current as well as long term, and profitability of sound dividend policy.

2. Integration No. 2 (Social Integration) How will I be able to use my knowledge on analysis and
interpretation to help myself and the other members of my community?
Financial analysis and reporting help to answer a host of vital questions on all aspects of your
company's financial activities, giving both internal and external stakeholders an accurate,
I
comprehensive snapshot of the strategic as well as operational metrics they need to make
decisions and take informed action. In relation to community, by this topic it will provide accuracy
that relationship among others will buid foundation.
3. Integration No. 1: (ICV) What values am I expected to learn and develop in the process of studying
the analysis and interpretation of financial statements? Why?

This will produce a great affect to students as it helps to be creative and ready in mind about
dealing with competitors, with the help of what you have. This will develop in creating thoughts of
knowing the strengths and weaknesses of every aspects.

4. The financial statements prepared by the accountant will be of no value if the owner/entrepreneur
will not interpret their relevance to the business. How will each financial statement affects the other
financial statements prepared by the company?
Financial statements provide a snapshot of a corporation's financial health, giving insight into its performance,
operations, and cash flow. Financial statements are essential since they provide information about a company's
revenue, expenses, profitability, and debt and is the company's responsible in pinpointing of the strength and
weaknesses of a business undertaking by regrouping and analysis of figures contained in financial statements by
making comparisons of various components and by examining their content.
5. Integration No. 3 (Lesson Across Discipline - Economics) Why is the analysis and interpretation of
financial statements important to the users of financial information?
Financial statements provide a snapshot of a corporation's financial health at a particular point in
time, giving insight into its performance, operations, cash flow, and overall conditions. Financial
ratio analysis involves the evaluation of line items in financial statements to compare the results
to previous periods and competitors.

Short Essay Rubric:

Standard Excellent Very Good Good Fair

 Explains the topic with correct description and
provides related examples. 5 4 3 2
 Content shows connection of the concept and explains
sensible decision about the topic that can help achieve
the goal.

Analysis & Interpretation of Financial Statements Page 11 of 17

11
 ACTIVITIES

ACTIVITY 2: Interpret the Financial Statements!

Direction: Below is a list of data taken from Roxanne Batutay Business’ Financial Statements.
Compute for the financial ratio and interpret the results thereof. Write your answers
on the space provided below.

Income Statement Accounts Balance Sheet Accounts

Sales P 6,054,000 Current Assets P 532,200
Gross Profit 2,098,000 Current Liabilities 0
Net Income before & after tax 657,200 Total Assets 1,057,200
Owner’s Equity 857,200 Total Liabilities 200,000

Compute for the following:

1. Gross Profit Ratio 4. Return on Assets Ratio
2. Return on Sales Ratio 5. Current Ratio
3. Return on Equity Ratio 6. Debt to Equity Ratio

1. Gross Profit Ratio

Computation: __________________________________________
Interpretation: _________________________________________________________
_________________________________________________________
2. Return on Sales Ratio
Computation: __________________________________________
Interpretation: _________________________________________________________
_________________________________________________________

3. Return on Equity Ratio

Computation: __________________________________________
Interpretation: _________________________________________________________
_________________________________________________________
4. Return on Assets Ratio
Computation: __________________________________________
Interpretation: _________________________________________________________
_________________________________________________________
5. Current Ratio
Computation: __________________________________________
Interpretation: _________________________________________________________
_________________________________________________________
6. Debt to Equity Ratio
Computation: __________________________________________
Interpretation: _________________________________________________________
_________________________________________________________

11
Analysis & Interpretation of Financial Statements Page 12 of 17
 ACTIVITIES

ACTIVITY 3: Multiple Choice!

Direction: Choose the best answer. Write the CAPITAL LETTER of your choice on the space provided
before each number. (STRICTLY NO ERASURES)
D
________ 1. Which ratio or ratios measure the overall efficiency of the firm in managing its investment
in assets and in generating return to shareholders?
a) Return on investment
b). Gross profit margin and net profit margin
c) Return on investment and return on equity.
d) Total asset turnover and operating profit margin.
B
________ 2. An inflow of cash would result from which of the following?
a) The increase in an asset account other than cash c). The decrease in an equity account
b) The decrease in an asset account other than cash d) The decrease in a liability account
A
________ 3. What is the first step in an analysis of financial statements?
a) Check references containing financial information c). Do a common size analysis
b) Specify the objectives of the analysis d). Check the auditor’s report
A
________ 4. Why is the quick ratio a more rigorous test of short-term solvency than the current ratio?
a) The quick ratio considers only cash and marketable securities as current assets.
b) The quick ratio eliminates prepaid expenses for the numerator.
c) The quick ratio eliminates prepaid expenses for the denominator.
d) The quick ratio eliminates inventories from the numerator.
D
________ 5. What is a serious limitation of financial ratios?
a) Ratios can be used only by themselves c). Ratios are screening devices.
b) Ratios indicate weaknesses only d). Ratios are not predictive.
B
________ 6. What is the most widely used liquidity ratio?
a) Quick ratio. b) Current ratio. c) Inventory turnover. d) Debt ratio.
D
________ 7. What is a creditor’s objective in performing an analysis of financial statements?
a) To determine the firm’s capital structure
b) To determine the company’s future earnings stream
c) To decide whether or not the firm has operated profitably in the past
d) To decide whether or not the borrower has the ability to repay interest and principal on
borrowed funds.
D
________ 8. What is an investor’s objective in financial statement analysis?
a) To determine if the firm is risky.
b) To determine the stability of earnings.
c) To determine changes necessary to improve future performance.
d) To determine whether or not an investment is warranted by estimating a company’s
future earnings stream.
A
_________9. Which profit margin measures the overall operating efficiency of the firm?
a) Gross profit margin c) Operating profit margin
b) Net profit margin d) Return on equity
A
________ 10. Which of the following is not required to be discussed in Management’s Discussion and
Analysis of the Financial Condition and Results of Operations?
a) Liquidity. b) Capital resources. c) Operations. d) Earnings projections.

Analysis & Interpretation of Financial Statements Page 13 of 17

11
 ACTIVITIES

ACTIVITY 4: Calculate the Financial Ratios !

OG Corporation’s balance sheet and income statement is listed

below. Direction:
Balance Sheet This Year Last Year Based on the financial statements
Cash P 50,000 P40,000 prepared, calculate the efficiency
Accounts receivable 80,000 60,000 ratios, liquidity ratios, leverage
Inventories 180,000 110,000 ratios, and profitability ratios for OG
Plant & equipment 300,000 260,000 Corporation for this year. Where
Less accumulated depreciation 40,000 20,000 data is available, also calculate ratios
Total assets 570,000 450,000 for last year. Use a 360-day year.
All sales are on credit to business
Accounts payable 100,000 150,000 customers. Assume an income tax
Accrued liabilities 70,000 50,000 rate of 30 percent.
-- Mortgage payable 80,000
Common stock 130,000 90,000
Retained earnings 190,000 160,000
Total liabilities and equity 570,000 450,000

Income Statement This Year Last Year

Net Sales P 680,000 P 600,000
Cost of goods sold 410,000 330,000
Gross profit 270,000 270,000
Operating expenses 190,000 192,000
Operating income 80,000 78,000
Interest expense 7,000 2,000
Profit before taxes 73,000 76,000
Taxes 22,000 22,800
Net income 51,000 53,200

OG Corporation
Computation of Efficiency Ratios, Liquidity Ratios, Leverage Ratios, and Profitability Ratios
For the year ended December 31, __________

11
Analysis & Interpretation of Financial Statements Page 14 of 17
 ACTIVITIES

ACTIVITY 5: THINK ABOUT IT!

Direction: Answer the questions in two or three complete sentences. Write your answers inside the
box provided below
1. How do you differentiate horizontal analysis from vertical analysis? Which of the two (2) analyses
do you think is best to use in interpreting the financial statements?

In horizontal analysis, we try to examine as to what has been the periodical trend of
various items shown in the statement while vertical analysis is made by analysing a
single set of financial statement prepared at a particular date. The best analysis is
the vertical analysis for it makesmuch easier to compare the financial statements of
one company with another, and across industries. This is because one can see the
relative proportions of account balances
2. Integration No. 4 (Faith/ Biblical Reflection: Philippians 4:13). How will you relate the bible verse
with the lesson on the Analysis and interpretation: “I can do all things through him who strengthens
me”?

This verse means that no matter what circumstances I face, I can

respond with the strength of Christ. Your strength is good in doing
an effective analyzation to reports and transaction in order to be
resulted as success.

3. Which of the three (3) elements of financial statements (Statement of Comprehensive Income, Statement of
Financial Position and Statement of Cash Flow) is the easiest to interpret? Why?

The Statement of Cash Flow is the easiest to interpret. This financial

statement is about what money came in and out in a company, also helps to
verify the liquidity position, the same is applicable for profitability. Cash Flow
Statement helps to verify the capital cash balance of businesses.

Short Essay Rubric:

Standard Excellent Very Good Good Fair
Content shows connection of the concept and explains sensible 5 4 3 2
decision about the topic that can help achieve the goal.

SUMMARY

In this lesson, you learned the meaning of the different measurement levels namely: liquidity, solvency,
stability and profitability. You also learned to perform vertical and horizontal analyses of financial
statements of a single proprietorship. Lastly, you are expected to prepare and interpret financial ratios
such as current ratio, working capital, gross profit ratio, net profit ratio, receivable turnover, inventory
turnover. Debt-to-equity ratio, and the like;

Analysis & Interpretation of Financial Statements Page 15 of 17 11

 ASSESSMENT

Direction: Solve the following questions:

A. Using the following information below on company ABC, what is company ABC’s net profit
margin?
December 31, 2016 (audited)
Revenue: 5,276,987
Gross profit: 3,534,099
Net income: 2,956,123
Answer:
Net Profit Margin:
0.56
___________________________________________________

B. Which of the following categories of ratios could be used to evaluate a company’s ability to pay
back a bank loan? Why?
A. Liquidity ratios
B. Solvency ratios
C. Profitability ratios
Answer: Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. The
_________________________________________________________________________
information you need to calculate these ratios can be found on your balance sheet,
which shows your assets, liabilities, and shareholder's equity.
_________________________________________________________________________

C. From the Balance Sheet and Income Statement information (page 14), prepare a common size
vertical analysis of OG’s income statement and reconcile the retained earnings account. Round
percentages to one decimal place.

Analysis & Interpretation of Financial Statements Page 16 of 17 11

 EXIT INSTRUCTIONS

You have just completed the unit topics for the first semester. I am so excited to start sharing with you the
topics for the next semester.

However, please answer activities with all honesty and sincerity. Check your answer on the lesson’s knowledge
check, activities 1 to 5 and the assessment part to ensure that all blanks have been answered. Make sure that you
do not leave any blank space unanswered. Please do not forget to write your name and the date of submission
of your answer sheets.

The entire module should be submitted back to the teacher before getting the next module.

Congratulations!

SUPPORTING REFERENCES

www.economics.net “Analysis and Interpretation of Financial Statements”

www.economicsdiscussion.net
www.analystprep.com “Activity, Liquidity, solvency, profitability, and valuation ratios”
www.keydifferences.com
Valencia, Edwin G., Basic Accounting, 2002, page 60
Ong, Flocer Lao., Fundamentals of Accounting, Textbook for Beginners, Second Edition, 2008, pages
7-31

FEEDBACK

Write your comments and suggestions, if any, inside this box.

Analysis & Interpretation of Financial Statements Page 17 of 17

11