CHAPTER 6

FINANCIAL STATEMENT: TOOLS FOR DECISION MAKING

INTRODUCTION

The information contained in the financial statements is used by managers and other external users,
like investors and creditors, in making sound financial decisions. Most of these decisions have financial
implications that are of utmost importance to these decision makers. For managers, the decision to acquire
an asset, build a bigger plant, expand operations, acquire computers to update the company's information
system, liquidate liabilities, obtain a loan, and grant salary and benefit increases to employees have financial
implications. For suppliers and creditors, the decision to grant additional credit, collect receivables, or
continue to supply a company with all its needs for products they sell have financial implications. For
current and future stockholders, decisions to buy more shares of the company or to sell their current holdings
have financial implications.

Financial statements are indispensable tools in making financial decisions. They shed light on the
performance of the company (income statements) and the financial condition of the company (balance
sheet). The cash flow statement shows where the cash came from and where it was spent. The statement of
changes in owners' equity shows investments by owners (additional sale or issuance of stock), withdrawals
by owners (dividends declared by the board of directors), and any profit earned or logs incurred by the
company. As such, financial statements help not only managers and internal users of the statements but also
the external users of the financial statements including the government (relevant to taxes to be collected
and adherence to government laws, rules, and regulations) as well.

Financial statements analysis highlights the connection, relation, and importance of accounting to
financial management in particular and to finance in general. It is, however, important to bear in mind that
financial analysis is not an end in itself but rather an effort to understand and judge the characteristics and
performance of a highly interrelated system of financial relationships. In this chapter, we will discuss the
different kinds of analysis done by financial analysts and decision makers.

This chapter will show illustrative examples of comparative income statements and balance sheets
using the horizontal analysis and the vertical analysis for a theoretical corporation. These same analyses
can be done for sole proprietorship and partnership by just substituting owner's equity for the former and
partners' equity for the latter for "stockholders' equity

INTENDED LEARNING OUTCOMES

At the end of the chapter the students should be able to:

1. Appreciate the importance of financial analysis as an analytical process.
2. Discuss the three basic decision areas dealt with by managers and the items involved in these decisions.
3. Explain the steps in analyzing financial statements.
4. Differentiate horizontal analysis from vertical analysis and appreciate their importance in business
decision making.
5. Demonstrate how to prepare a common-size balance sheet and income statement and analyze the changes
therein.
6. Explain the different profitability ratios and their importance in decision making and solve problems
using them.
7. Discuss the limitations of financial statements and financial statement analysis.
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DISCUSSION

THE ANALYTICAL PROCESS

• Financial analysis deals with the understanding of the relationship between financial concepts and
daily decision making; generally done for financial statements.

BASIC DECISION AREAS

1. Operating Decision - deals with the day-to-day operations of the firm; includes decisions that are
relevant to pricing, selecting markets, choosing appropriate production processes and technology,
outsourcing payroll, outsourcing maintenance, and janitorial services, etc.

2. Investment Decision - deals with what assets to acquire, projects to undertake, or business
endeavors to enter into; includes investments in working capital (current assets/current liabilities),
property, plant, and equipment, and major spending programs.

3. Financing Decision — deals with decisions that relate to the company's capital structure, debt-
equity mix, funding sources, dividend policies, cost of capital, etc.

STEPS IN ANALYZING FINANCIAL STATEMENTS

1. Understanding the information provided in the financial statements.
2. Drawing logical conclusion based on the data presented.
3. Making the appropriate decision on the course of action to take.
4. Management needs a basic understanding of finance and accounting to appreciate and benefit from
financial analysis.

FINANCIAL STATEMENT ANALYSIS

1. Horizontal Analysis — also known as trend analysis; makes use of comparative financial
statements to establish trends. It involves analysis of significant changes in absolute amounts and
in percentages and an analysis of significant changes in ratios used in ratio analysis.

2. Vertical Analysis - involves comparing one number with another to identify significant
relationships.

There are two types of vertical analysis:

2.1 Common Size Statements - the financial statements are translated into percentages with total
assets and sales taken as 100% to which the other elements are compared.
2.2 Ratio Analysis - shows relationships:
2.2.1 within a period
2.2.2 between periods

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RATIO ANALYSIS
1. Profitability Ratios
1.1 Return on Owners' Investment (ROI) - generally means return on owners' equity; hence, it is
sometimes referred to as ROE.
ROI = Income or Profit
After Income Tax

1.2 Profit Margin/Return on Sales (ROS)

ROS= Income
Net Sales

1.3 Return on Assets (ROA)

ROA= Operating Income
Average total assets

2. Liquidity/Short-term Solvency Ratios

2.1 Current Ratio (Working Capital Ratio) = Current Assets
Current Liabilities

2.2 Quick Ratio (Acid-Test Ratio) = Quick Assets

Current Liabilities
3.Long-term Debt Ratios
3.1 Debt Ratio = Total Liabilities
Total Assets

3.2 Stockholders' Ratio = Total Stockholders' Equity

Total Assets

3.3 Debt-Equity Ratio = Total Liabilities

Total Stockholders' Equity
3.4 Interest Coverage Ratio = Operating Income
Interest Expense

LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS

1. Data are reported at historical costs.
2. (Historical costs = acquisition costs of assets)
3. Data are all in monetary terms.
4. Financial statements use estimates.
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5. Financial statements use judgments.
6. Financial statements are interim in nature.
7. Financial statements assume stable monetary unit

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