Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)

BSBA 3A

Material no. 2
FINANCIAL STATEMENT ANALYSIS

CONCEPT MAP

Definition

Basic
Objectives
Concepts

Problems and
FINANCIAL Limitations
STATEMENTS
ANALYSIS Horizontal Liquidity
Analysis Ratios

Techniques in Vertical Activity

FS Analysis Analysis Ratios

Financial Solvency
Ratios Ratios

Profitability
Ratios

Market-test
Ratios

LECTURE NOTES
BASIC CONCEPTS
Definition
FS Analysis involves careful selection of data from financial statements in order to assess and evaluate the
firm’s past performance, its present condition and future business potentials.

Objectives of FS Analysis
The primary objective of FS Analysis is to determine the extent of firm’s success in attaining its financial
goals in the following areas: (1) Maximizing profitability
(2) Ability of the firm to pay its obligations
(3) Safety of the investment in the business
(4) Effectiveness and efficiency of management in utilizing the resources entrusted to them
(5) Attain stability in operations.

Problems and Limitations of FS Analysis

(1) The nature of the information
(a) The use of estimates in allocating costs to each period.
(b) Financial data is not adjusted for price changes or inflation/deflation because of cost principle.
(c) Companies have a choice of accounting methods. These differences impact ratios and make it
difficult to compare companies using different methods.
(d) Companies may have different fiscal year ends making comparison difficult if the industry is cyclical.

(2) The need to look beyond ratios

Ratios or any information generated by FS analysis are not the ultimate goal. The company must interpret and
look beyond this results for a more proper evaluation.

TECHNIQUES IN FS ANALYSIS
(1) HORIZONTAL ANALYSIS
It is the process of analyzing the firms’ financial data across two or more consecutive periods. This is done
through either:
(a) Comparative FS (b) Trend Analysis
TREND PERCENTAGES – are index numbers showing relative changes in financial data resulting to passage
of time.
In horizontal analysis, the amount of change and percentage of change should be shown.

PERCENTAGE CHANGE (%) = AMOUNT OF CHANGE / BASE

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA Page 1 of 5

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material no. 2
FINANCIAL STATEMENT ANALYSIS
CAUTION ABOUT THE BASE:
(1) The base may be last year’s or earlier period data, average industry data or even chief competitors’
data.
(2) The percentage change is NOT computed if the base is ZERO or NEGATIVE.
(2) VERTICAL ANALYSIS
Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of a
base figure within the statement. Vertical analysis is the process of comparing figures in the FS of a single
period only.

Proper application of vertical will generate a COMMON-SIZE FINANCIAL STATEMENTS. Common size financial
statements are financial statements that translate peso amounts to percentages in relation to a chosen base.
NOTE: In vertical analysis, only percentages are shown.

What base to use?

Financial Statement Proper Base Income Statement Net Sales Balance
Sheet Total Assets
Statement of Cash Flows Total Cash Available

(3) FINANCIAL RATIOS

It is a comparison in fraction, decimal or proportion of two significant figures taken from the financial
statements.
REMINDER IN USING FINANCIAL RATIOS: In comparing balance sheet items with income statement items in a
single ratio, the balance sheet items are being averaged if the beginning and ending balances are available.

Cautions in using ratios:

(1) Ratios have great disparities from one industry to another.
(2) Conservatism has a bias towards diminishing value of the firm.
(3) Historical cost principle may significantly contribute to a distorted FS Analysis.

Summary of Effect of Transactions in Ratios

Numerator + 0 - 0 + - Denominator 0 + 0 -
- +
Effect on Ratio + - - + + -

Based from the above table, we can say that movements on the numerator have a direct effect on the ratio
while movements on the denominator have an inverse effect on the ratio.

EXCEPTION:
Numerator + - + - Denominator + - + -
Effect on Ratio + - - +
IF PROPER FRACTION IF IMPROPER FRACTION

LIST OF PROPER FRACTION AND IMPROPER FRACTION RATIOS

PROPER FRACTION IMPROPER FRACTION
Debt Ratio Current Ratio
Equity Ratio Quick Asset Ratio
Profit Margin AR Turnover Ratio
Gross Profit Margin Inventory Turnover Ratio Return on Sales Asset
Turnover Ratio Return on Assets AP Turnover Ratio
Return on Equity Earnings per Share
Dividend Pay-out Ratio Book Value per Share
Dividend Yield Ratio Times Interest Earned

SUMMARY OF COMMONLY USED FINANCIAL RATIOS

(a) Liquidity ratios: are ratios used in measuring the ability of the firm to meet its currently maturing
obligations.
RATIO FORMULA
Total Current Assets
Current Ratio
Total Current Liabilities

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA Page 2 of 5

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material no. 2
FINANCIAL STATEMENT ANALYSIS
Total Quick Assets*
Quick Ratio
Total Current Liabilities
*Cash + Marketable Securities + AR
Total Current Assets - Total Current
Working Capital
Liabilities
(b) Activity ratios: are ratios that measure the liquidity of specific assets and efficiency in managing assets.
RATIO FORMULA
Net Credit Sales*
AR Turnover
Average AR
* Net Sales if not available
360 days / 365 days
Days AR / Ave. Collection Period
AR Turnover
Cost of Goods Sold**
Inventory Turnover (For
Average Inventory
Merchandising)
** Sales or Net Sales if not
available
Cost of Goods Sold**
Average FG Inventory
FG Inventory Turnover
** Sales or Net Sales if not
available
Cost of Goods Manufactured
WIP Inventory Turnover
Average WIP Inventory
Raw Materials Used
RM Inventory Turnover
Average RM Inventory
Days Inventory / Ave. Conversion 360 days / 365 days
Period Inventory Turnover
Net Credit Purchases***
Ave. Accounts Payable
AP Turnover
*** Net Purchases if not
available
360 days / 365
Days AP / Ave. Payment
days AP
Period
Turnover
Net Sales
Total Assets Turnover Average Total
Assets
Net Sales
Fixed Assets Turnover Average Fixed
Assets
(c) Solvency ratios: are ratios that measure the ability of the firm to pay its long-term financing and the
extent of a firm’s financing.
RATIO FORMULA
Total Liabilities
Debt Ratio
Total Assets
Total Equity
Equity Ratio
Total Assets
Total Liabilities
Debt to Equity Ratio
Total Equity
Total Assets
Total Equity
Leverage Ratio / Equity Multiplier or
1
Equity Ratio
Earnings Before Interest and Taxes (EBIT)
Times Interest Earned (TIE)
Annual Interest
Earnings Before Interest and Taxes (EBIT)
Basic Earnings Power
Total Assets
(d) Profitability ratios: are ratios that measure the overall performance of the firm.

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA Page 3 of 5

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material no. 2
FINANCIAL STATEMENT ANALYSIS
RATIO FORMULA
Gross Profit
Gross Profit Ratio Net Sales

Net Income
Return on Sales / Profit Margin Ratio Net Sales
Operating Income after Tax*
Average Total Assets
Return on Assets *Net income if cannot be determined
or
Profit Margin x Asset Turnover
Net Income

Return on Equity Average Total Equity or

Profit Margin x Asset Turnover x Leverage Ratio

Earnings per Share Ave. Ordinary Shares Outstanding Net Income - Preferred
Dividends
Dividends per Share Ave. Ordinary Shares Outstanding Annual Dividends

Dividends per Share

Dividend Pay-out Ratio Earnings per Share
Retention Ratio / Plowback Ratio 1 - Dividend Pay-out Ratio
Book Value per Share Ave. Ordinary Shares Outstanding Total Shareholders'
Equity
NOTE: Operating income is synonymous to EBIT

(e) Market-test ratios: these ratios are concerned with the return on investment for shareholders, and with
the relationship between return and the value of an investment in company's shares.
RATIO FORMULA
Market Price Earnings
Price - Earnings Ratio
per Share
Dividends per Share
Dividend Yield Ratio
Market Price
Earnings per Share
Earnings Yield Ratio
Market Price

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA Page 4 of 5