ANALYSIS OF FINANCIAL

STATEMENTS
HORIZONTAL ANALYSIS, VERTICAL ANALYSIS AND RATIO
ANALYSIS
Learning Objectives:

At the end of this topic, you should be able to:

► Analyze financial statements horizontally
► Analyze financial statements vertically
► Analyze financial statements through ratio analysis
 Financial Statement Analysis

► The objective of accounting is to provide information that will be helpful in

decision making. Truly enough, financial statements are able to provide
information about the entity’s financial position, financial performance, and cash
flows.
► It is important for the owners and managers of the entity to be able to evaluate the
results of all their business activities. This analysis can help them:
✔ Confirm past expectations
✔ Evaluate present financial results
✔ Predict future outcomes
THREE WAYS OF FS ANALYSIS

1. Horizontal Analysis
2. Vertical Analysis
3. Analysis through ratio interpretation
HORIZONTAL ANALYSIS

► Horizontal Analysis is the method of comparing

and analyzing financial results of different
accounting periods in each financial statement
account and element
ILLUSTRATION:
VERTICAL ANALYSIS

► Vertical Analysis is the method of analyzing financial results

expressing each financial statement account and element as a
component of a base
► Also known as Common-size Analysis
ILLUSTRATION:
RATIO ANALYSIS

► It is a quantitative analysis technique applied by an entity to be able

to assess the company’s liquidity, solvency, profitability, and
operational efficiency through scrutiny of account balances reported
in the balance sheet and income statement.
LIQUIDITY RATIOS

► Liquidity ratios determine whether an entity can be able to pay for current liabilities as they become due
with the use of current assets
 Current Ratios

► The current ratio is a liquidity ratio that measures a company's ability to pay short-term
obligations or those due within one year. It tells investors and analysts how a company can
maximize the current assets on its balance sheet to satisfy its current debt and other payables.
Illustration:
 Current Ratios
Answer the question:
Can the company pay for their current liabilities with current assets?

FORMULA

Calculation

For both years, the entity’s current assets are larger than current liabilities. The entity can pay
Interpretation for their current liabilities using their current assets since the ratio is greater than 1.

REMEMBER ▪ CR>1, entity can pay CL using CA

▪ CR=1, CA=CL
▪ CR<1, entity cannot pay CL using CA
Acid Test Ratio/Quick Ratio

► The quick ratio is an indicator of a company’s short-term liquidity position and

measures a company’s ability to meet its short-term obligations with its most
liquid assets.
► Since it indicates the company’s ability to instantly use its near-cash assets
(assets that can be converted quickly to cash) to pay down its current liabilities,
it is also called the acid test ratio. An "acid test" is a slang term for a quick test
designed to produce instant results.
Illustration:
 Acid Test Ratio/Quick Ratio
Answer the question:
Can the company pay for their current liabilities with quick assets?

FORMULA

Calculation

For both years, the entity’s quick assets are larger than current liabilities. The entity can pay
Interpretation for their current liabilities using their quick assets since the ratio is greater than 1.

▪ ATR>1, entity can pay CL using QA

REMEMBE
▪ ATR=1, QA=CL
R
▪ ATR<1, entity cannot pay CL using QA
 Cash Ratios
Answer the question:
Can the company’s cash pay for their current liabilities?

FORMULA

Calculation

For both years, the entity’s current liabilities are larger than cash. The entity cannot pay for
Interpretation their current liabilities using their total cash since the ratio is less than 1.

▪ Cash ratio >1, entity can pay CL using total cash

REMEMBE ▪ Cash ratio=1, Cash=CL
R ▪ Cash ratio<1, entity cannot pay CL using total cash
Working Capital

► Net working capital, or sometimes just "working capital", refers to short-term assets left after deducting
short-term liabilities. In other words, it shows how much current assets the company would have left if it
had to use them to settle all of its current liabilities.

► Working capital is a measure of a company's liquidity, operational efficiency, and short-term financial
health
Net working capital = Current assets – Current liabilities
Illustration
DEBT MANAGEMNT RATIO/SOLVENCY
RATIOS

❑ Debt management ratio/Solvency ratio is a computation that is used to measure a

companies ability to pay it’s long term debt obligation.
❑ Debt management ratio/Solvency ratio determine whether an entity has more ownership
rather than debts.
❑ It is also called leverage ratios.
❑ These ratios involve comparisons of debt, assets, equity, and interest.

► Debt to asset ratio/Debt ratio

► Debt to equity ratio
► Times interest earned
Debt Ratio/Debt to Asset Ratio

❑ It measures the portion of asset finance by debts.

 Debt Ratios
Answer the question:
How much of the assets are financed by debt?

FORMULA

Calculation

For 2023, 53.79% of assets are financed by debt. For 2022, 65.03% of assets are financed by
Interpretation debt. In both years, debt is greater than equity since debt ratios are both higher than 50%

REMEMBE ▪ When debt ratio is less than 50%, assets are financed more by equity
R ▪ When debt ratio is greater than 50%, assets are financed more by debt
▪ When both debt and equity is 50%, assets are financed equally by debt and equity
Question:

1. How will “I will Graduate Company” express the accounting equation using
assets, debt, and equity percentages for 2023?
a. 100%=18%+82%
b. 100%=82%+18%
c. 100%=54%+46%
d. 100%=46%+54%
ANSWER: C
Question:

1. How will “Grumphy Cat Company” express the accounting equation using
assets, debt, and equity percentages for 2022?
a. 100%=46%+54%
b. 100%=54%+46%
c. 100%=65%+35%
d. 100%=35%+65%
ANSWER: C
QUESTION

What is your conclusion?

a. The company is always using debt financing
b. The company is always using equity financing
c. The company is always using debt financing but the company is slowly
shifting from debt financing to equity financing
d. The company is always using equity financing but the company is slowly
shifting from equity financing to debt financing
ANSWER: C
Debt to equity ratio

It measures the portion of equity finance by debts.

Debt to equity ratio=

 Debt to Equity Ratio
Answer the question:
Which has more weight? Debt or Equity?

FORMULA

Calculation

For both years, debt has more weight than equity since both ratios are greater than 1
Interpretation

REMEMBE ▪ When debt to equity ratio is less than 1, equity has more weight than debt
R ▪ When debt to equity ratio is greater than 1, debt has more weight than equity
▪ When debt to equity ratio is equal to 1, debt is equal to equity
Times Interest Earned Ratio

► It measures how well the company can pay the interest related to debts.

Time Interest Earned Ratio=

 Times Interest Earned Ratio
Answer the question:
How many times can entity pay for interest expenses with their operating income?

FORMULA

Calculation

The company’s operating income can cover interest payments for 150 times.
Interpretation

REMEMBE ▪ The higher the TIE ratio the better. It shows how the company is able to meet its interest
R obligation with the income it earns.
 ASSET MANAGEMENT/EFFICIENCY RATIOS

► Asset management ratios indicate how successfully a company is utilizing its

assets to generate revenues. Analysis of asset management ratios tells how
efficiently and effectively a company is using its assets in the generation of
revenues. They indicate the ability of a company to translate its assets into the
sales. Asset management ratios are also known as asset turnover ratios and
asset efficiency ratios.
► measure how well doe an entity utilizes their assets and resources to generate
income
 ASSET MANAGEMENT/EFFICIENCY RATIOS

I. Asset Turnover
II. Inventory Turnover
III. Average Sale Period/Days Sales in Inventory
IV. Accounts Receivable (AR) Turnover
V. Average Collection Period/Days in Receivable
VI. operating Cycle
VII. Accounts Payable Turnover
VIII. Payable Turnover in Days
IX. Cash Conversion Cycle
Asset Turnover Ratio

► The asset turnover ratio measures the value of a company's sales or

revenues relative to the value of its assets. The asset turnover ratio can be
used as an indicator of the efficiency with which a company is using its
assets to generate revenue.
Inventory Turnover Ratio

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed
by comparing cost of goods sold with average inventory for a period. This measures how many
times average inventory is “turned” or sold during a period.
 Inventory Turnover Ratio
Answer the question:
How many times can entity sell their inventories and have it replaced within a period?

FORMULA

Calculation

Interpretation The company’s inventory turnover is low

REMEMBE ▪ A low turnover might mean weak sales and excess inventory
R ▪ A high turnover might mean strong sales and insufficient inventory
 Days Sales in Inventory
Answer the question:
How many days does an entity holds on to their inventory before a sales transaction?

FORMULA

Calculation

Interpretation The company has a weak sales/ holding inventory for a long period of time
Accounts Receivable Turnover Ratio

► The receivables turnover ratio is an accounting measure used to quantify a company's

effectiveness in collecting its accounts receivable, or the money owed by customers or
clients. This ratio measures how well a company uses and manages the credit it extends to
customers and how quickly that short-term debt is collected or is paid. A firm that is
efficient at collecting on its payments due will have a higher accounts receivable turnover
ratio.
 Receivable Turnover Ratio
Answer the question:
How many times can the entity collect their accounts receivable?

FORMULA

Calculation

Interpretation In a period, the company turns receivables into cash 5.20 times over the whole period

REMEMBE ▪ A low turnover signals weak collection effort

R ▪ A high turnover signals strong collection efforts
 Days in Receivables
Answer the question:
How many days does an entity wait for a receivable to become cash?

FORMULA

Calculation

Interpretation The company has a weak collection efforts

Operating Cycle (OC)

► An Operating Cycle (OC) refers to the days required for a business to receive inventory,
sell the inventory, and collect cash from the sale of the inventory. This cycle plays a major
role in determining the efficiency of a business.
Accounts payable turnover ratio

► The accounts payable turnover ratio is a short-term liquidity measure used to quantify the
rate at which a company pays off its suppliers. Accounts payable turnover shows how
many times a company pays off its accounts payable during a period.
Accounts Payable Turnover in Days

► The accounts payable turnover in days shows the average number of days that a payable
remains unpaid. To calculate the accounts payable turnover in days, simply divide 365
days by the payable turnover ratio.
Cash Conversion Cycle

► the cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it
takes for a company to convert its investments in inventory and other resources into cash
flows from sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC
attempts to measure how long each net input dollar is tied up in the production and sales
process before it gets converted into cash received.
PROFITABILITY RATIOS

► Measure how well does an entity generate income that relates to their revenues, operating
costs, assets and capital
 Gross Profit Ratio
Answer the question:
How much gross profit does the company makes after considering cost of goods that were sold?

FORMULA

Calculation

Interpretation 59.23% of sales is the entity’s gross profit

REMEMBE ▪ Gross profit ratio represents the amount of gross profit for every P1.00 sale
R
 RETURN ON ASSETS
Answer the question:
How much was “returned” in the usage of assets to generate profit?

FORMULA

Calculation

Interpretation The entity enjoyed 10.63% returns in the usage of its assets to generate profit

REMEMBE ▪ The higher the returns the better

R
 RETURN ON EQUITY
Answer the question:
How much income was “returned” in the usage of equity to generate profit?

FORMULA

Calculation

Interpretation The entity enjoyed 23% returns to the shareholder’s investments.

REMEMBE ▪ The higher the returns the better

R