MODULE 3: Financial Statement Analysis

Module Objectives:

The purpose of this module is to provide a guide in analyzing financial statements by

computing and interpreting financial ratios.
This module will show the use of trend analysis and common size statements as way of
analyzing financial statements.

Intended Learning Outcomes:

On successful completion of this module, the learner will be able to;

 Perform vertical and horizontal analysis of financial statements of a sole proprietorship
 Describe the measurement levels – liquidity, solvency, and profitability
 Compute, analyze, and interpret financial ratios

Module Content:

Lesson 1 –Importance of Financial Statement Analysis

Lesson 2 – Horizontal and Vertical Analysis

Lesson 3 – Financial Ratios

Lesson 3.1 – Liquidity Ratios

Lesson 3.2 – Solvency Ratios

Lesson 3.3 – Profitability Ratios

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Lesson 1 Financial Statement Analysis
In the previous module, the different types of financial statements were discussed. In this
module, the figures in the balance sheet and income statement will be broken down for analysis
and interpretation.

The figures will tell the story of how the business has performed over time. Analysis will
allow stakeholders and decision makers to have a clear view of the financial performance of the
business.

The financial statement analysis is important for different reasons. The importance of
financial statement analysis can be presented as follows:

1. Holding of Share

Shareholders are the owners of the company. Time and again, they may have to take decisions
whether they have to continue with the holdings of the company's share or sell them out. The
financial statement analysis is important as it provides meaningful information to the
shareholders in taking such decisions.

2. Decisions and Plans

The management of the company is responsible for taking decisions and formulating plans and
policies for the future. They, therefore, always need to evaluate its performance and effectiveness
of their action to realize the company's goal in the past. For that purpose, financial statement
analysis is important to the company's management.

3. Extension of Credit

The creditors are the providers of loan capital to the company. Therefore they may have to take
decisions as to whether they have to extend their loans to the company and demand for higher
interest rates. The financial statement analysis provides important information to them for their
purpose.

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4. Investment Decision

The prospective investors are those who have surplus capital to invest in some profitable
opportunities. Therefore, they often have to decide whether to invest their capital in the
company's share. The financial statement analysis is important to them because they can obtain
useful information for their investment decision making purpose.

Objectives of Financial Statement Analysis are as follows;

1. Assessment of Past Performance

Past performance is a good indicator of future performance. Investors or creditors are

interested in the trend of past sales, cost of goods sold, operating expenses, net income, cash
flows and return on investment. These trends offer a means for judging management's past
performance and are possible indicators of future performance.

2. Assessment of current position

Financial statement analysis shows the current position of the firm in terms of the types of
assets owned by a business firm and the different liabilities due against the enterprise.

3. Prediction of profitability and growth prospects

Financial statement analysis helps in assessing and predicting the earning prospects and growth
rates in earning which are used by investors while comparing investment alternatives and other
users in judging earning potential of business enterprise.

4. Prediction of bankruptcy and failure

Financial statement analysis is an important tool in assessing and predicting bankruptcy and
probability of business failure.

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5. Assessment of the operational efficiency

Financial statement analysis helps to assess the operational efficiency of the management of a
company. The actual performance of the firm which are revealed in the financial statements can
be compared with some standards set earlier and the deviation of any between standards and
actual performance can be used as the indicator of efficiency of the management.

Methods or Techniques of Financial Statement Analysis

Financial statement analysis can be performed by employing a number of methods or

techniques. The following are the important methods or techniques of financial statement
analysis.

1. Ratio Analysis

Ratio analysis is the analysis of the interrelationship between two financial figures.

2. Cash Flow Analysis

Cash flow analysis is the analysis of the change in the cash position during a period.

3. Comparative Financial Statements

Comparative financial statement is a analysis of financial statements of the company for

two years or of the two companies of similar types.

4. Trend Analysis

Trend analysis is the analysis of the trend of the financial ratios of the company over the
years.

https://accountlearning.blogspot.com/2010/02/methods-or-techniques-of-financial.html

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 The methods to be selected for the analysis depend upon the circumstances and the
users' need. The user or the analyst should use appropriate methods to derive required
information to fulfill their needs.

Lesson 2 Vertical and Horizontal Analysis

Horizontal and vertical analyses are two tools commonly used to assess
organizational performance.

A good way to do some ratio and trend analysis work is to prepare both
horizontal and vertical analyses of the income statement. Both analyses involve
comparing income statement accounts to each other in amount and in percentages.

Horizontal Analysis

Horizontal analysis (also known as trend analysis) is a financial statement analysis

technique that shows changes in the amounts of corresponding financial statement items over a
period of time. It is a useful tool to evaluate the trend situations.
Horizontal analysis is the comparison of financial information over a series of reporting
periods. The earliest period is usually used as the base period and the items on the statements
for all later periods are compared with items on the statements of the base period. The changes
are generally shown both in amount and percentage.
Horizontal analysis may be conducted for balance sheet, income statement, schedules of
current and fixed assets and statement of retained earnings.

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 Examples:
An example of the horizontal analysis of balance sheet, schedule of current assets , and
income statement is given below:

Comparative balance sheet with horizontal analysis:

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Comparative income statement with horizontal analysis:

https://www.accountingformanagement.org/wp-content/uploads/2012/11/horizontal-analysis-ca.png

Horizontal analysis helps you spot trends

While financial statements are essential for managing your business, an income
statement or balance sheet for a single period of time will not tell the complete story. Horizontal
analysis answers a lot of questions, including:

 How much has my revenue increased in the last quarter/year?

 Is my cost of goods sold going up or down?
 What areas of my business have seen the most changes?
 Is my net income increasing or decreasing?

There’s a reason horizontal analysis is often referred to as trend analysis. Looking at and
comparing the financial performance of your business from period to period can help you spot
positive trends, such as an increase in sales, as well as red flags that need to be addressed.

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 Activity 3.1
Horizontal Analysis
ABM Company
Comparative Statement of Financial Position
Increase (decrease)
2019 2018 Amount %
ASSETS
Current Assets
Cash 45,325 27,000
Accounts receivable 20,000 25,000
Inventories 18,500 21,000
Office supplies 5,000 3,000
Total Current Assets 88,825 76,000
Non-Current Assets
Building 60,000 60,000
Equipment 27,000 20,000
Machines 8,000 5,000
Accumulated depreciation (3,000)
Total Non-Current Assets 92,000 85,000
Total Assets 180,825 161,000
LIABILITIES
Current Liabilities
Accounts payable 10,800 10,000
Salaries payable 8,000 8,000
Notes payable 6,700 5,150
Total Current Liabilities 25,500 23,150
Non-Current Liabilities
Long-term debts 60,000 50,000
Owner's Equity
Owner's Capital 95,325 87,850
Total Liabilities and Equity 180,825 161,000

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Vertical Analysis

Vertical analysis, also called common-size analysis, focuses on the relative size of
different line items so that you can easily compare the income statements and balance sheets of
different sized companies.

To conduct a vertical analysis of balance sheet, the total of assets and the total of liabilities and
stockholders’ equity are generally used as base figures. All individual assets (or groups of assets if
condensed form balance sheet is used) are shown as a percentage of total assets. The current liabilities,
long term debts and equities are shown as a percentage of the total liabilities and stockholders’ equity.

Comparative Balance Sheet with Vertical Analysis:

Current assets:

2018: (550,000 / 1,139,500) × 100 = 48.3%

2017: (530,000 / 1,230,500) × 100 = 43.3%

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 To conduct a vertical analysis of income statement, sales figure is generally used as the
base and all other components of income statement like cost of sales, gross profit, operating
expenses, income tax, and net income etc. are shown as a percentage of sales.

Comparative income statement with vertical analysis:

*Cost of goods sold:

2018: (1,043,000/1,498,000) × 100 = 69.6%

2017: (820,000/1200,000) × 100 = 68.3%

https://www.accountingformanagement.org/vertical-analysis-of-financial-statements/

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Advantages of Vertical Analysis

 The percentages can be used by a company’s management to set goals and threshold
limits.
 It is a relatively more potent tool than horizontal analysis, which shows the
corresponding changes in the finances of a particular unit/ account/department over a
certain period of time.
 It is also useful in comparing a company’s financial statement to the average trends in the
industry.
 It is also highly effective while comparing two or more companies operating in the same
industry but with different sizes.

Activity 3.2
Vertical Analysis
ABM Company
Comparative Statement of Financial Position

2019 2018 2019 2018

ASSETS
Current Assets
Cash 45,325 27,000
Accounts receivable 20,000 25,000
Inventories 18,500 21,000
Office supplies 5,000 3,000
Total Current Assets 88,825 76,000
Non-Current Assets
Building 60,000 60,000
Equipment 27,000 20,000
Machines 8,000 5,000
Accumulated depreciation (3,000)
Total Non-Current Assets 92,000 85,000
Total Assets 180,825 161,000
LIABILITIES
Current Liabilities
Accounts payable 10,800 10,000
Salaries payable 8,000 8,000
Notes payable 6,700 5,150
Total Current Liabilities 25,500 23,150
Non-Current Liabilities
Long-term debts 60,000 50,000
Owner's Equity
Owner's Capital 95,325 87,850
Total Liabilities and Equity 180,825 161,000

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Lesson 3 Financial Ratios

Financial ratios are grouped into the following categories:

 Liquidity ratios
 Leverage ratios
 Efficiency ratios
 Profitability ratios

Analysis of financial ratios serves two main purposes:

1. Track company performance

Determining individual financial ratios per period and tracking the change in their values
over time is done to spot trends that may be developing in a company. For example, an
increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may
eventually be facing default risk.

2. Make comparative judgments regarding company performance

Comparing financial ratios with that of major competitors is done to identify whether a
company is performing better or worse than the industry average. For example, comparing the
return on assets between companies helps an analyst or investor to determine which company is
making the most efficient use of its assets.

Liquidity Ratios

Liquidity ratios are financial ratios that measure a company’s ability to repay both short-
and long-term obligations. Common liquidity ratios include the following:

1. Current Ratio measures a company’s ability to pay off short-term liabilities with current
assets
Current ratio = Current assets / Current liabilities

2. Acid-Test Ratio measures a company’s ability to pay off short-term liabilities with
quick assets

Acid-test ratio = Current assets – Inventories / Current liabilities

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 3. Cash Ratio measures a company’s ability to pay off short-term liabilities with cash and
cash equivalents

Cash ratio = Cash and Cash equivalents / Current Liabilities

Leverage Financial Ratios/ Solvency Ratios

Leverage ratios measure the amount of capital that comes from debt. In other words,
leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios
include the following:

4. Debt Ratio measures the relative amount of a company’s assets that are provided from
debt
Debt ratio = Total liabilities / Total assets

5. Debt To Equity Ratio calculates the weight of total debt and financial liabilities against
shareholders’ equity

Debt to equity ratio = Total liabilities / Shareholder’s equity

6. Interest Coverage Ratio shows how easily a company can pay its interest expenses

Interest coverage ratio = Operating income / Interest expenses

Efficiency Ratios

Efficiency ratios, also known as activity financial ratios, are used to measure how well a
company is utilizing its assets and resources. Common efficiency ratios include:

7. Asset Turnover Ratio measures a company’s ability to generate sales from assets

Asset turnover ratio = Net sales / Total assets

8. Inventory Turnover Ratio measures how many times a company’s inventory is sold and
replaced over a given period

Inventory turnover ratio = Cost of goods sold / Average inventory

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 9. Accounts Receivable Turnover Ratio measures how many times a company can turn
receivables into cash over a given period

Receivables turnover ratio = Net credit sales / Average accounts receivable

10. Days Sales In Inventory Ratio measures the average number of days that a company
holds on to inventory before selling it to customers

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Profitability Ratios

Profitability ratios measure a company’s ability to generate income relative to revenue,

balance sheet assets, operating costs, and equity. Common profitability financial ratios include
the following:

11. Gross Margin Ratio compares the gross profit of a company to its net sales to show how
much profit a company makes after paying its cost of goods sold

Gross margin ratio = Gross profit / Net sales

12. Operating Margin Ratio compares the operating income of a company to its net sales to
determine operating efficiency

Operating margin ratio = Operating income / Net sales

13. Return On Assets Ratio measures how efficiently a company is using its assets to
generate profit

Return on assets ratio = Net income / Total assets

14. Return On Equity Ratio measures how efficiently a company is using its equity to
generate profit

Return on equity ratio = Net income / Shareholder’s equity

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 Activity 3.3
Financial Ratios

Compute for the following ratios

and interpret the result.

A. LIQUIDITY RATIOS
1. Current ratio
2. Acid-test ratio
3. Cash ratio

B. LEVERAGE RATIOS
1. Debt Ratio
2. Debt To Equity Ratio
3. Interest Coverage Ratio

C. PROFITABILITY RATIOS
1. Gross Margin Ratio
2. Operating Margin Ratio
3. Return On Assets Ratio
4. Return On Equity Ratio

D. EFICIENCY RATIOS
1. Asset Turnover Ratio
2. Inventory Turnover Ratio
3. Accounts Receivable
Turnover Ratio
4. Days Sales in Inventory
Ratio

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