Senior High School Fundamentals of Accounting, Business and Management 2 Quarter 1 - Module 5: Part I: Analysis and Interpretation of Financial Statements DepEDWhat I Need to Know ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS Feeling accomplished about learning the preparation of financial statements? How about learning how to interpret them? What tools do we use to interpret the figures in the financial statement? You will learn all of these in this module, ‘There are 3 lessons in this module, to wit: Lesson 1: Introduction to Financial Statement Analysis Lesson 2: Horizontal Analysis Lesson 3: Vertical Analysis At the end of the lessons, you should be able to: 1. Define the measurement levels, namely, liquidity, solvency, stability, and profitability (ABM_FABM12-Ig-h-12) wb Perform vertical and horizontal analyses of financial statements of a single proprietorship. (ABM_FABM12-Ig-h-13) What I Know A company’s financial statement achieves its real purpose when its interpreted and used as a basis for decision making. Interpreting, as the last part of the 4 phases of accounting, will cover your learnings on how to interpret data in a financial statement using different techniques. Still don’t have an idea? These few questions will give you a sneak peek. ‘True or False. Answer on a separate answer sheet,1. There are two phases of financial statement analysis, computation, and interpretation phase. 2. The computation is the most important in financial analysis. 3. Horizontal analysis compares the same account in the financial statement of two periods. 4. The vertical analysis shows the relationship of each part from the whole financial statement ‘The company had a net income of P23,000 (2018) and P15,000 (2019). This indicates good performance of the company. Maintaining a great amount of cash is sometimes not good for the company. Miss Beautiful Salon’s asset is P1,000,000, liabilities of P 800,000, and equity of P200,000. Ms. Beauty interprets that most of her assets are funded through liabilities. 8. The 2018 cash balance is P200,000, while the 2019 cash balance is P300,000. ‘There is an increase of 50% from the base year, 9, Deduct base year from the current year to get the difference in amount in computing horizontal analysis. 10. Liquidity is the ability of the company to settle its obligati 6. x ns as they fall due. Introduction to Financial 1 Statement Analysis Financial statements are sources of important financial information for a business. This information, however, is not yet to achieve its purpose until it is interpreted and used in the decision making of the stakeholders. Financial statements give clear figures in which managers analyze rather than mere guesses on crucial financial decisions or plans. There are two phases in the analysis of financial statements, namely: the computation phase and the interpretation phase. *Computation involves looking for differences, percentages, or ratios. While the interpretation phase is a crucial part of the analysis as it provides meaningful and relevant decisions based on the results of the computation. To do the interpretation, there are certain financial tools or methods used to give financial figures for analysis. Horizontal Analysis compares the same account in the financial statement of two periods (current and past year), determining the amount of changes, and computing, its percentage change using a base year as a comparison (Ong and Gomendoza2017). Horizontal analysis, however, is useful only to businesses that have 2 or more years of operation. Is there an increase in the balance sheet accounts of 2019 vs 2018? SFP 2019 = SFP 2018 Assets P_ 2000 | Assets P 1000 Liabilities 1500 | Liabilities 500 Owner's Equity 500 | Owner's Equity 500 “Horizontal comparison 2018 Assets to 2019 Assets; 2018 Liabilities to 2019 Liabilities; and 2018 Owner's Equity to 2019 Owner's Equity. Vertical Analysis shows a relationship among the elements of a financial statement where each item is represented in a percentage. How much percentage does operating expenses take from its total sales? SCI 2019 Sales Cost of Sales P _ Gross Profit Pp 980 Operating 500 Expenses so P_450 Net Income “Vertical comparison on financial statements, Sales represents the whole and other accounts as its parts. Financial Ratios can be used to compare a company’s current financial position and performance to be able to identify their strengths and weakness. Ratios can be used to compare your status, not only within your operations but also with other companies. Financial ratios have four categories, namely, liquidity, solvency, profitability, and valuation, Financial ratios will be discussed comprehensively in Part II of this module. y) Horizontal Analysis Horizontal analysis (also called comparative analysis) helps management analyze the statement of financial position and statement of comprehensive income'sincrease and decrease in accounts. As the name implies, accounts are compared horizontally between two periods, Computation Phase The illustration below shows the steps in performing horizontal analysis: 1. Prepare financial statements of 2 consecutive periods. 2. Get the amount of increase/ decrease in the third column. a, Select a base year. It is usually the initial or the previous year. b. Deduct the current year from the base year, 3. Compute for the percentage of increase or decrease by using the formula below: % of change % of change 195.3 % of change -14% 195.3 ABM Appliance Center Statement of Financial Position ‘As of December 31 current year - base year base year x 100 x 100 (in millions) ASSETS 2019 2018 Increase/Decrease ‘Amount Percent current Asset cash, Pr oler8 2 195.3 (275) Accounts Receivakle 212.3 199.1 13.2 Inventory. 56.1 S47, 214 Prepaid Expenses 20.0 18.1 19 JTotal Current Assets P 456.2 P 447.2 9.0) Property, Plant and Equipment (net) __1.265.0 O43 300.7 Total Assets PoLai2 = 12s ‘500.7 LIABILITIES AND OWNER'S EQUITY Current Liabilities Po 324.5 P2981 314 1194] Non-current Liabilities 987.4 659.2 328.2 509% |Total Liabilities P isin9 P9523 350.6 38%6 owner's Equity 409.3 259.2 150.1 5896 |Total Liabilities and Owner's Equity P72 > 12115 309.7 4226‘ABM Appliance Center Statement of Comprehensive Income For the year ended December 31 (in millions) 2019 2018 Increase/Decrease ‘Amount — Percent Net Sales P P 254.8 69.5 [Cost of Goods Sold 159.3, 98 |Gross Profit P55 50.7 Selling and Administrative Expense 9.4 17 (Operating Income P P 86.1 48.0 interest Expense 75 (0.6) Income Before Taxes P P7860 48.6 Income Tax Expense 16.8 Net Income P 318 Interpretation Phase In this phase, the users of financial information may have a different perspective on the figures. By interpreting, they will be able to decide objectively based on the results of the computation. ‘The interpretations vary, for every user of financial information, on which way would the horizontal analysis be of use to them. There are a lot more to see on the computations and below are some examples: Statement of Financial Position 1. Total assets increased by 42% due to the purchase of PPE which reflects a 66% increase. However, current assets have only 2% growth compared to non- current assets which may indicate that liquidity is very small. 2. Total liabilities increased by 38% due to a 50% increase in non-current liabilities. It reflects that PPE could have been financed by a loan. The owner's equity, on the other hand, increased 58% from the previous year. This may be due to additional investments made by the owner to the business. Statement of Comprehensive Income 1. Almost all accounts in the SCI increased. It could be because of increased PPE from the SFP that could have boost the selling process. It s understood that with greater sales, COGS are parallel, as well as operating expenses and taxes. It is noticeable that interest decreased by 8% which could mean that loans acquired by the business may have longer period payments.3 Vertical Analysis SFP Vertical Analysis (also called commor is) helps the management analyze the components of the total assets, total liabilities, and owner's equity. It analyzes the financial statements in a vertical manner, as its name implies. Here are some questions to help you understand how SFP vertical analysis goes a. Of the total assets, how much percentage is classified as current? Non- current? b. Of the total assets, how big/small is merchandise inventory? Accounts receivable? Or other accounts? c. Of the total liabilities, how much percentage is classified as current? Non- current? d. Of the total liabilities and owner’s equity, how much percentage are liabilities? Owner's equity? Answering these questions will lead to disclosing the percentages of the components that occupy the total assets, liabilities, and owner's equity. It may lay some problems that needed to be addressed and you can recommend solutions. Example: The current assets which consist mostly of account receivable may indicate that most sales are collectible until the end of the accounting period. The problem found is that the company has below average collection policy and may need improvement on it. The management may suggest better sales discount terms to make customers settle their accounts earlier than possible. SCI Vertical Anals components to the overall sales. s, on the other hand, helps the management analyze the Here are some questions to help you understand how SCI vertical analysis goes. a. Of the net sales, how much percentage does the cost of sales occupy? Gross profit? Operating expenses? b. Of the operating expenses, how big/small is the percentage of administrative expenses? Selling expenses? c. Compare the percentages of net income to net sales.Computation Phase ‘The illustration below shows the steps in performing vertical analysis. 1, Prepare the financial statements of two consecutive periods. 2. Add a column on each year of comparison 3. Express each component account as a percentage of the total assets, liabilities and owners (for SFP) or to the Net sales (for SCI). Use the formula below in getting the percentage: 167.8 % of cash = x 100 1,721.2 % of cash = 10% ABM Appliance Center Statement of Financial Position As of December 31 (Ga millions) ‘ASSETS 2019 Percent 2018 Percent Current Asset Cash P1678 10% «=P «195.3—16% Accounts Receivable 2123 128% 199.1 16% Inventory 56.1 3% B47 3% Prepaid Expenses 20.01% 18.11% oes a] ‘Total Current Assets P 45627 27% P72 37% Property, Plant and Equipment (net) 1,265.0 73% 7643 63% Total Assets P1211 100% LIABILITIES AND OWNER'S EQUITY Current Listilities P2245 oP 93.1 24%, Non-current Liabilities 987.4 57% 659.2 34% Total Liabilities PISlL9” 76% P9523 79% Owner's Equity 409.3 249% 259.2 21% ‘Total Liabilities and Owner's Equity Po 100% P 1211.5 100% % of cost of goods sold = x 100 % of cost of goods sold = 52% 10ABM Appliance Contor ‘Statement of Comprehensive Income For the year ended December 31 (in millions) 2019 Percent 2018 Percent Net Sales P3243 P2588 [Cost of Goods Sold 169.1 159.3 Gross Profit 155.2 [Selling and Administrative Expense 21 lOperating Income Fist e861 Interest Expense 6.9 75 income Before Taxes P1272 ? 186 income Tax Expense 38.1 213 Net Income eo.L 32.3 Interpretation Phase In comparing vertically and horizontally, this phase can be done to fully analyze the position of the company and its results of operation. Doing both analyses entails a holistic approach in addressing the possible problems and planning the necessary actions. As always, interpretations may vary depending on the purpose of the user financial information. ‘Statement of Financial Position 1. The current asset of 2019 is 27% of the total assets. However, comparing from, 2018, current assets are more liquid at 37%. 2. Of the total liabilities and OB, 76% is the total liabilities and 24% is the owner's equity. This could be the result of investing through loans than the owners making the additional investment Statement of Comprehensive Income 1. Net income is 27% from net sales. Of all the expenses deducted after gross profit, income tax comprises the biggest percentage at 12%. The company should spread the impact of incurring expenses by getting better sales performance. 1What’s In Let’s sum-up the lesson with these few takeaways. This may help you take down important notes. Fill in the blanks with the correct answer. 1. FS analysis has two phases; they are and 2. There are 3 tools which can be used to analyze financial statements; these are and 3 is a tool used to compare FS accounts between two periods. 4 is a tool used to analyze the components of a financial statement. 5 can be used to compare a company’s current financial position and performance with past years and identify its strengths and weaknesses. Notes to the Teacher Financial ratios and analysis help management identify the strengths and weaknesses of the business. Good or favorable ratios indicate sustainability and growth while poor or unfavorable ratios mean that the business needs improvement in their actions. 12What’s New The following are the financial statement of Limay Store. Perform a horizontal analysis and vertical analy: Special instruction: Use 1 decimal place for percentage result on vertical analysis. Limay Store Statement of Financial Position ‘As of December 31 (in millions) ASSETS 2019) 2018 Current Asset Cash P 461.0 P 289.0 Accounts Receivable 178.0 26.0 Short-term Investment 48 24 Inventory 60.9 55.1 Prepaid Expenses 12.5, 10.9 Total Current Assets P7169 P6834 Property, Plant and Equipment (net) __2.114.0 1,589.0 [Total Assets. 2,890.9 P 2,272.4 LIABILITIES AND OWNER'S EQUITY Current Liabilities > 4521 P3984 Non-current Liabilities 967.4 1,090.0 [Total Liakilities P 1419.5 P 14284 owner's Bquity 44 544.0 ITotal Liakilities and Owner's Equi P 2,890.9 P 2,972.4 Limay Store Statement of Comprehensive Income For the year ended December 31 (in millions) 2019) 2018 Net Sales P 31120 P 2,365.0 Cost of Goods Sold 1,200.0 978.9 Gross Profit ? 1,912.0 P 1,386.1 [Selling and Administrative Expense Qu. 311.0 Operating Income P 1,700.9 P 1,075.1 interest Expense 24 aa income Before Taxes 1,608.5 P 1,072.0 income Tax Expense 16.8 17.9 Net Income P i687 P i054.1 13What is It Good job! Computation seems easy. Let's try to analyze the details of the computation. Refer to your table of Limay Store and answer the following questions. Horizontal Analysis 1. Compare the total assets of 2018 and 2019. Is there an increase or decrease? Explain the result of the increase or decrease in amount. 2. Compare the total liabilities of 2018 and 2019. Is there an increase or decrease? Explain the result of the increase or decrease in amount. 3. Compare net income of 2018 and 2019. Is there an increase or decrease? Explain the result of the increase or decrease in amount. Vertical Analysis 1, Of the 2019 total assets, how much percentage is classified as current? Non- current? Explain your analysis. 2. Of the 2019 total liabilities and owner’s equity, how much percentage are liabilities? Owner's equity? Explain your analysis. 3. Of the 2019 net sales, how much percentage is taken up by the cost of goods sold? Explain your analysis. 14What’s More Computation of vertical analysis is further understood when presented using a pie chart. Here is an example for ABM Appliance Center: ABM Appliance Center ABM Appliance Center SFP Assot Section (2019) SFP Liabilities and Owner's Equity Section (2019) meash accounts ibiiies receivable 3% Mlnventory sm non-current ibiiies 1% pin 7386 moreoaid expense mowner's equity pre ABM Appliancce Center SCI 2019 Net Income 21% S& ABxpense 1% Required: You have performed vertical analysis for Limay Store in What's New on page 15, Present 2019 Vertical Analysis of SFP Asset section, Liabilities and Owner's Equity section and SCI using a pie chart. 15Reo What I Have Learned Learning is a give-and-take relationship. It’s your turn to discuss something about the lesson. Give your simple explanations on the concepts below. Each question corresponds to 10 points 1. What is a horizontal analysis? Explain. 2. What is a vertical analysis? Explain. 3. What are the importance of vertical and horizontal analysis? Explain. Scoring Rubrics: 9-10 pts ~ the concept is well defined and discussed comprehensively through giving an example or illustration. 6-8 pts - the concept is well defined and discussed but without example or illustration. 3-5 pts — the concept is defined ambiguously. 0-2 pts ~ the concept is not accurately defined, and the explanation is far from the concept or main idea. 16What I Can Do Practice makes perfect! Let's do more! You have accomplished the pie chart from What's More on page 17. Interpretation matters. Describe the operations of Limay Store by interpreting the results of the pie chart by answering these questions. Limay Store ~ SFP Asset section 1, Which of the current asset takes the biggest part? 2. How could this affect the operation of the business? Limay Store ~ SFP Liabilities and Owner's Equity section 1. Which of the components takes the biggest part? 2. How could this affect the operation of the business? Limay Store - SCI 1. Which of the components takes the biggest part? 2. How could this affect the operation of the business? 7Assessment Special instruction: Use 1 decimal place for percentage result on vertical analysis. XYZ Company Statement of Comprehensive Income For the year ended December 31 (in millions) 2019 2018 Net Sales P 3,412.0 P Cost of Goods Sold 200. Gross Profit P 2,212.0 P Selling and Administrative Expense 200.0 Operating Income P 2,012.0 P Interest Expense 2.5 Income Before Taxes P 2,009.5 P Income Tax Expense 10.3 Net Income P_ 1,999.2 _P. Horizontal analysis 1. How much is the increase or decrease in cost of good sold from 2018 to 2019? How could this affect the operations of the business? 2. How much is the increase or decrease in net income? How could this affect the operations of the business? 18Vertical analysis 1. Which of the components take the biggest part from net sales? Is this good for the business? Why? © How much percentage is cost of good sold from net sales? How could this affect the operations of the business? Additional Activities You have performed vertical analysis for XYZ Company in Assessment on page 20. Required: 1. Present 2018 Vertical Analysis of SCI using a pie chart 2. 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