Module 3 ANALYSIS OF FINANCIAL STATEMENT

TOOLS AND TECHNIQUES

Lesson Objective

 Be familiar with the different tools in analysing financial statements

A company's financial statements provide important information about a business

enterprise. 1he analysis helps the user make an informed decision or judgment rather than rely on
guesses and intuition in the process of decision making by effectively and systematically using the
financial data. It lessens the uncertainty of outcomes with every decision made because of the use of
analytical tools to financial statements and the related data.
In order to evaluate a company, one-year data or a one year's financial statement is not
sufficient. One needs at least two periods to make an evaluation or even three to five years if one is to
make a trend analysis. Financial statements are analyzed to evaluate a company's present financial
position and operating performance in relation to its past. Using these figures, the company can
predict or forecast future operations.

FINANCIAL STATEMENT ANALYSIS

Different methods and techniques are used in analyzing financial statements. There are two
phases involved, namely, the computation phase and the interpretation phase. In the first phase, we
compute for differences, percentages, or ratios. In the second stage, we interpret the results of the
figures we get from the first phase. The second phase, although more difficult than the first phase,
makes the analysis of financial statements more meaningful because it communicates to the users the
significance of the results.
Using the statement of financial position and the income statement, financial statements can
be analyzed using the following techniques. These are considered the tools in analyzing the financial
data provided by the financial statements.

Horizontal Analysis compares the same account in the financial statements of two periods
(current and past year) determining the amount of changes and computing its percentage change
using a base year as comparison. It should be noted that for accounts in the base year with zero or
negative balances, the computation of percentage of change will not apply.

Vertical Analysis shows the relationship of each part to the whole ina single financial
statement. In the statement of financial position or balance sheet, each item is expressed as a
percentage of total assets or total liabilities and owner's equity. In the income statement, each item is
presented as a percentage of net sales.
Trend Analysis compares not only two years but covers three, four, or five years' financial
statements. This is to determine the trends in the industry.

Financial Ratio Analysis describes the significant relationship between the numbers
presented in the financial statements. Ratios can be expressed either as a rate, percentage, or a
proportion.
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TEST YOUR UNDERSTANDING

1. What are the two phases involved in the analysis of financial statements?
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2. Enumerate and describe the tools used in analysing financial statements.
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Module 3 ANALYSIS OF FINANCIAL STATEMENT

HORIZONTAL ANALYSIS

LESSON OBJECTIVE
 Use horizontal analysis to evaluate financial statements

HORIZONTAL ANALYSIS IN FINANCIAL STATEMENTS

Horizontal analysis, otherwise known as comparative analvsis, helps management

analyze increases and decreases in balance sheet and income statement accounts. For
example, in the balance sheet, a significant increase in property, plant, and eguipment will
indicate purchases of land, equipment, machinery or other plant assets necessary for use in
the business. On the other hand, a significant decrease will reveal disposal of such assets as
management may have deemed necessary. Comparing two consecutive years and noting
magnanimous increases or decreases other balance sheet items may also be used by
management for decision making purposes.

For income statement accounts, horizontal analysis also helps management analyze
significant increases or decreases in sales, cost of sales and expenses. For example, an
alarming decrease n net income may call management's attention as the generation of net
income is the company s main goal in doing business. This may lead management to
evaluate other income statement items such as sales, cost of sales, and expenses which are
crucial components in arriving at a company's net income.

In conclusion, getting the amount of increases and decreases and their percentages, is
just the first step of the analysis. The difficult part is the interpretation of the results. In the
real world, this is subjective as there are no strict and fast rules to follow. Experience and
industry trends are considered in the picture.
Module 3 ANALYSIS OF FINANCIAL STATEMENT

The following are the steps in performing a horizontal analysis

1. Prepare comparative financial statements of two consecutive years.

Fidas Merchandising
Statement of Financial Position
As of December 31
(In Millions)

Assets 2017 2016

Current Assets
Cash ₱222.9 ₱ 330.2
Accounts Receivable (Net) 282.5 172.1
Inventory 146.3 92.8
Prepaid expenses 74.1 70.3
Total Current Assets ₱725.8 ₱665.4
Property, Plant, and Equipment (net) 1,866.4 556.2
Total Assets ₱2,592.2 ₱1,221.6

Liabilities and Owner’s Equity

Current Liabilities ₱ 551.9 ₱620.6

Non-Current Liabilities 1,822.4 376.6
Total Liabilities ₱2,374.3 ₱997.21
Owner’s Equity 217.9 224.4
Total Liabilities and Owner’s Equity ₱2,592.2 ₱1,221.6

2. Add a third column for the increase or decrease in amount and a fourth column for the
percentage of the increase or decrease.
3. Get the per cent of increase or decrease for each account.
a. Choose a base year which is usually the initial year of analysis.
b. Deduct the amount of the current year from the base year.
c. Divide the difference above by the amount of the base year.
d. Multiply the quotient by 100 to get the percentage of change.

This is represented by the following formula:

%change = Current year amount-Base year amount x 100%

Base year amount
%change in current assets = ₱665.4 - ₱725.8 x 100%
₱665.4
= 9.1%
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Note: For accounts with the zero balance in the earlier or initial year, the formula for the percentage of
change will not apply.
Fidas Merchandising
Statement of Financial
As of December 31
(In Millions)
Module 3 ANALYSIS OF FINANCIAL STATEMENT

INTERPRETATION OF DATA

In interpreting the data, it is important to note that the materiality of increases or

decreases depends on the size of the company. A material amount in one company may not be
material to another. For example, a hundred-thousand increase in the receivable of a small
grocery may be considered material to the small grocery but not to SM's Hyper Mart
considering their size, capitalization, and volume of transactions. Hence, there is no strict rule
to follow in determining the materiality of an amount.

In analyzing the significance of a percent change in value, the analysis should not only
center on internal factors controllable by management. An example is the drop in sales of
plastic bags. A 25% drop in the sales of a plastic bag company may be significant to the
company but because of the plastic ban issued by the Philippine government in some areas in
Metro Manila, other company's plastic bag sales may have dropped by 30% to 50% considering
the trend in the industry. This is an outside factor over which management has no control.
Hence, internal factors are not the only factors considered in data analysis and interpretation
but external factors as well. Management should be well informed on the latest trends affecting
their industry.

Analysis
1. Current assets increased by 9.1%. This increase is a result of a 64.1% increase in
accounts receivable and a 57.7% increase in inventory. This increase in accounts
receivable entails management to check their credit and collection policy for prompt
collection o accounts especially that increase in net sales was only 27.3% and cash
decreased by 32.5%. Likewise, the increase in merchandise inventory necessitates
management to check their inventory stocks for obsolescence or slow moving items
comparing their increase in sales and the increase in inventory.

2. Property, Plant, and Equipment showed a 235.6%. Increase. This may be due to
purchases made by the company to invest in plant assets. It is possible for the owner to
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invest property and equipment in the business. However, in the case of Fidas
Merchandising, owner's equity showed a decrease of 2.9%. This might not be possible
unless the owner invested non-current assets then afterwards made large amounts of
withdrawals during the year.

3. Current liabilities and owner's equity decreased despite increase in total liabilities and
owner's equity. This can be explained by the 383.9% increase in the company's non-
current liabilities which means that the company made heavy borrowings during the
year. Sources of business funds are generated either from the investment of the owner
or loans from banks or financial institutions. In the case of Fidas Merchandising, the
company obtained additional funds through loan. With the significant increase in non-
current assets, it can be inferred that the loan obtained by the company was used to
finance the acquisitions of the property, plant, and equipment.

4. Net sales increased by 27.3% during the year. However, despite the increase in sales, ne
income decreased by 7.3%. Looking at the other components of the income statement
cost of goods sold increased by 24.1%. Even with this increase in cost of goods sold,
gross margin registered a 30.2% increase. Selling and administrative expenses showed
a 34.8% increase. Despite this, income from operations recorded an 18% increase. The
company's increase in interest expense of 198% resulted in a decrease in income before
taxes despite the increase in net sales. Analyzing the components of the income
statement, we were able to explain the decrease in net income despite increase in net
sales. Hence, management can now understand that the magnanimous increase in
interest expense caused the decrease in overall net income.
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TEST YOUR UNDERSTANDING

1. What is horizontal analysis
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DRILL 1
Presented below are the comparative statements of financial position and
comparative income statement of On The Dot Trading. Perform a horizontal analysis
showing the increase or decrease for the year 2017 in comparison to the year 2016.

On the Dot Trading

Statement of Financial Position
As of December 31
Module 3 ANALYSIS OF FINANCIAL STATEMENT