Review of Financial

Statement
Preparation, Analysis
and Interpretation
CHAPTER 2
Basic Financial Statement
• Statement of Financial Position / Balance Sheet
• Statement of Profit or Loss / Income Statement
• Statement of Cash Flows
• Statement of Changes in Stockholders’ Equity
• Notes to Financial Statements
Statement of Financial Income / Balance Sheet
A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity
at a specific point in time, and provides a basis for computing rates of return and evaluating its capital
structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as
the amount invested by shareholders.

The balance sheet is a snapshot representing the state of a company's finances at a moment in time. By
itself, it cannot give a sense of the trends that are playing out over a longer period. For this reason, the
balance sheet should be compared with those of previous periods. It should also be compared with those
of other businesses in the same industry since different industries have unique approaches to financing.
Statement of
Financial Income
Example
an example of Amazon’s 2017 balance
sheet taken from CFI’s Amazon Case
Study Course. As you will see, it starts
with current assets, then non-current
assets and total assets. Below that is
liabilities and stockholders’ equity
which includes current liabilities, non-
current liabilities, and finally
shareholders’ equity.
Statement of Profit and Loss / Income Statement
Also known as the profit and loss statement or the statement of revenue and expense, the income statement
primarily focuses on the company’s revenues and expenses during a particular period.

The income statement focuses on the four key items - revenue, expenses, gains, and losses. It does not
cover receipts (money received by the business) or the cash payments/disbursements (money paid by the
business). It starts with the details of sales, and then works down to compute the net income and eventually
the earnings per share (EPS). Essentially, it gives an account of how the net revenue realized by the company
gets transformed into net earnings (profit or loss).
Revenues, Gains, Expenses and Losses
• Operating Revenue - Revenue realized through primary activities

• Non-Operating Revenue - Revenues realized through secondary, non-core business activities are often
referred to as non-operating recurring revenues.

• Gains - Also called other income, gains indicate the net money made from other activities, like the sale
of long-term assets.

• Primary Activity Expenses - All expenses incurred for earning the normal operating revenue linked to
the primary activity of the business.

• Secondary Activity Expenses - All expenses linked to non-core business activities, like interest paid on
loan money.

• Losses as Expenses - All expenses that go towards a loss-making sale of long-term assets, one-time
or any other unusual costs, or expenses towards lawsuits.
Income Statement
Structure
Mathematically, the Net Income is
calculated based on the following:

Net Income = (Revenue + Gains) –

(Expenses + Losses)

To understand the above details with some

real numbers, let’s assume that a fictitious
sports merchandise business, which
additionally provides training, is reporting
its income statement for the most recent
quarter.
Statement of Cash Flows
The statement of cash flows, or the cash flow statement, is a financial statement that summarizes
the amount of cash and cash equivalents entering and leaving a company.

The cash flow statement (CFS) measures how well a company manages its cash position, meaning
how well the company generates cash to pay its debt obligations and fund its operating
expenses. The cash flow statement complements the balance sheet and income statement and is a
mandatory part of a company's financial reports since 1987.

The CFS allows investors to understand how a company's operations are running, where its money
is coming from, and how money is being spent. The CFS is important since it
helps investors determine whether a company is on a solid financial footing.

Creditors, on the other hand, can use the CFS to determine how much cash is available (referred to
as liquidity) for the company to fund its operating expenses and pay its debts
The Structure of the CFS
• Cash from operating activities

• Cash from investing activities

• Cash from financing activities

• Disclosure of noncash activities is sometimes included when prepared under the generally accepted
accounting principles, or GAAP

Note: It's important to note that the CFS is distinct from the income statement and balance sheet because it
does not include the amount of future incoming and outgoing cash that has been recorded
on credit. Therefore, cash is not the same as net income, which on the income statement and balance sheet,
includes cash sales and sales made on credit.
Operating Activities
The operating activities on the CFS include any sources and uses of cash from business activities. In other words, it reflects how
much cash is generated from a company's products or service

Important: Generally, changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are reflected in
cash from operations.

These operating activities might include:

• Receipts from sales of goods and services

• Interest payments

• Income tax payments

• Payments made to suppliers of goods and services used in production

• Salary and wage payments to employees

• Rent payments

• Any other type of operating expenses

Investing Activities and Cash Flow
Investing activities include any sources and uses of cash from a company's investments. A purchase or sale of an
asset, loans made to vendors or received from customers or any payments related to a merger or acquisition is
included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.

Usually, cash changes from investing are a "cash out" item, because cash is used to buy new equipment,
buildings, or short-term assets such as marketable securities. However, when a company divests an asset, the
transaction is considered "cash in" for calculating cash from investing.
Cash From Financing Activities
Cash from financing activities include the sources of cash from investors or banks, as well as the
uses of cash paid to shareholders. Payment of dividends, payments for stock repurchases and the
repayment of debt principal (loans) are included in this category.

Changes in cash from financing are "cash in" when capital is raised, and they're "cash out" when
dividends are paid. Thus, if a company issues a bond to the public, the company receives
cash financing; however, when interest is paid to bondholders, the company is reducing its cash.
How Cash Flow is Calculated
Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses, and
credit transactions (appearing on the balance sheet and income statement) resulting from transactions that occur from one period to the
next. These adjustments are made because non-cash items are calculated into net income (income statement) and
total assets and liabilities (balance sheet). So, because not all transactions involve actual cash items, many items have to be re-evaluated
when calculating cash flow from operations.

As a result, there are two methods of calculating cash flow, the direct method, and the indirect method.

Direct Cash Flow Method

The direct method adds up all the various types of cash payments and receipts, including cash paid to suppliers, cash receipts from
customers and cash paid out in salaries. These figures are calculated by using the beginning and ending balances of a variety of business
accounts and examining the net decrease or increase in the accounts.

Indirect Cash Flow Method

With the indirect method, cash flow from operating activities is calculated by first taking the net income off of a company's income
statement. Because a company’s income statement is prepared on an accrual basis, revenue is only recognized when it is earned and not
when it is received. Net income is not an accurate representation of net cash flow from operating activities, so it becomes necessary to
adjust earnings before interest and taxes (EBIT) for items that affect net income, even though no actual cash has yet been received or
paid against them. The indirect method also makes adjustments to add back non-operating activities that do not affect a company's
operating cash flow.

For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of an asset that has previously
been accounted for. That is why it is added back into net sales for calculating cash flow.
Example of Cash
Flow
Statement of Changes in Stockholders’ Equity
A statement of changes in shareholders equity is a financial statement that presents a
summary of the changes in shareholders’ equity accounts over the reporting period. It
reconciles the opening balances of equity accounts with their closing balances.
There are two types of changes in shareholders’ equity: (a) changes that originate from
transactions with shareholders such as issue of new shares, payment of dividends, etc.
and (b) changes that result from changes in total comprehensive income, such as net
income for the period, revaluation of fixed assets, changes in fair value of available for
sale investments, etc.
Components
• Common stock - represents the legal capital of the company and it equals the product of shares issued
and the stated value of each share.
• Additional paid-up capital (also called share premium) - is the excess of paid-up capital over the legal
capital. Additional paid-up capital = (issue price – stated price) * total number of shares issued.
• Treasury stock - represents the value of shares repurchased by the company. It is a contra-account to
the paid-up capital.
• Capital reserve(s).
• Retained earnings: accumulated earnings since the start of the company net of dividends paid or any
restatement adjustments.
• Gains and losses on cash flow hedge: unrealized portion of change in fair value.
• Gains and losses on available for sale securities: i.e. the unrealized portion of change in fair value.
• Revaluation surplus: represents the effect of revaluation of fixed assets.
Components
• Issue of new share capital: it increases the common stock and additional paid-up capital component.

• Net income (loss) for the period: it increases (decreases) retained earnings.

• Payment of cash dividends: it decreases retained earnings.

• Purchase of treasury stock: it increases treasury stock component and eventually decreases total net shareholders equity.

• Sale of treasury stock: it decreases treasury stock component and affects retained earnings and additional paid-up capital
and ultimately increases total shareholders equity.

• Issue of bonus shares: affects common stock, additional paid-up capital and retained earnings.

• Revaluation of fixed assets: increases revaluation surplus.

• Reversal of revaluation of fixed assets: may decrease revaluation surplus.

• Effect of foreign-exchange translation: increase/decrease in foreign-exchange reserve.

• Effect of changes in value of available-for-sale securities: increase/decrease in available-for-sale securities reserve.

• Restatement of financial statements, for e.g. due to change in accounting principle: changes in retained earnings.
Format: Example
Alumina, Inc. is a company engaged in extraction of Aluminum. The company’s CFO has asked you to prepare a statement of
changes in equity for the company for the year ended 30 June 2014.

Following information is available:

The composition of the company’s shareholders equity as at 1 July 2013 was as follows:

USD in million
Common stock, 20 M authorized shares, 5 M
50
issued and outstanding
Additional paid-in capital 120
Capital reserves 30
Retained earnings 90
Revaluation surplus 15
305
Format: Example
• On 30 August 2014, the company declared and issued 10% bonus shares. Price per share at
the date was $40.

• On 1 September 2014, the company issued 1 million new shares for total consideration of
$45 million. The stated price of a common share is $10.

• Profit for the financial year ended 30 June 2014 amounted to $50 million and the company
paid dividends totaling $16 million.

• The company is required under law to set a side 10% of net income for the period and
credit it to capital reserve.

• 500,000 shares were bought back on 30 December 2014 at $40 per share.

• The company reversed upward revaluation of an asset by $5 million. The revaluation

surplus already includes $7 million of such initial upward revaluation.
Alumina, Inc.
Addition
Statement of Shareholders Revaluat
Common al Capital Treasury Retained
Equity ion
A Note
for the year ended 30 June 2014
stock paid-in
capital
reserve stock earnings
surplus
[Note] [USD in million]
• Balance as at 1-Jul-13 50 120 30 - 90 15 305
• Issue of bonus shares A 5 15 - - (20) - -
• Issue of new shares B 10 35 - - - - 45
• Net income C - - - - 50 - 50
• Transfer to capital reserveD - - 5 - (5) - -
• Dividends E - - - - (16) - -16
• Share buyback F - - - (2) - - (2)
• Reversal of revaluation G - - - - - (5) (5)
• Balance as at 30-Jun-14 65 170 35 (2) 99 10 377
Notes to Financial Statement
• Brief description of the company
• Summary of significant accounting policies
• Breakdown of amouts found in the financial statements
Review of the Financial Statement Preparation
• Analyzing business transaction
• Recording in the journals
• Posting to ledger accounts
• Preparing the unadjusted trial balance
• Making the adjusting entries
• Preparing the adjusted trial balance
• Preparing financial statements
• Making the closing entries
• Post-closing trial balance
Financial Statement Analysis
• Each financial statement provides multiple years of data. Used together, analysts track
performance measures across financial statements using several different methods for financial
statement analysis, including vertical, horizontal, and ratio analyses. An example of vertical
analysis is when each line item on the financial statement is listed as a percentage of another.
Horizontal analysis compares line items in each financial statement against previous time
periods. In ratio analysis, line items from one financial statement are compared with line items
from another. For example, many analysts like to know how many times a company can pay off
debt with current earnings. Analysts do this by dividing debt, which comes from the balance
sheet, by net income, which comes from the income statement. Likewise, return on assets
(ROA) and the return on equity (ROE) compare company net income found on the income
statement with assets and stockholders' equity found on the balance sheet.
Profatibility ratios
• Profitability ratios are a class of financial metrics that are used to assess a business's ability to
generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders'
equity over time, using data from a specific point in time.

• For this chapter, the following financial ratio will be discussed

• Return on equity (ROE)

• Return on assests (ROA)

• Gross profit margin

• Operating profit margin

• Net profit margin

Return on Equity (ROE)
Return on equity (ROE) is a measure of financial performance calculated by dividing net
income by shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt,
ROE could be thought of as the return on net assets.

ROE is considered a measure of how effectively management is using a company’s assets to create profits. ROE
is expressed as a percentage and can be calculated for any company if net income and equity are both positive
numbers. Net income is calculated before dividends paid to common shareholders and after dividends to
preferred shareholders and interest to lenders.

The Formula for ROE is:

ROE = (Net Income ÷ Stockholders’ Equity) x 100%

How to Use ROE
For example, imagine a company with an annual income of $1,800,000 and average shareholders'
equity of $12,000,000. This company’s ROE would be as follows:

ROE = ($12,000,000 ÷ $1,800,000​) x 100

ROE = 15%

Consider Apple (NASDAQ: AAPL) – for the fiscal year ending Sept. 29, 2018, the company generated
$59.5 billion in net come. At the end of the fiscal year, it’s shareholders’ equity was $107.1 billion
versus $134 billion at the beginning. Apple’s return on equity, therefore, is 49.4%, or $59.5 billion /
(($107.1 billion + $134 billion) / 2).

Compared to its peers, Apple has a very strong ROE. Amazon (NASDAQ: AMZN) has a return on
equity of 27%, Microsoft (NASDAQ: MSFT) 23%, and Google (NASDAQ: GOOGL) 12%.
Return on Assets (ROA)
• Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is
at using its assets to generate earnings. Return on assets is displayed as a percentage.

The Formula for ROA is:

ROA = (Net Income ÷ Total Assests) x 100%

Gross Profit Margin
• Gross profit margin is a metric used to assess a company's financial health and business model
by revealing the amount of money left over from sales after deducting the cost of goods sold. The
gross profit margin is often expressed as a percentage of sales and may be called the gross
margin ratio.

The Formula for Gross Profit Margin is:

Gross Profit Margin = (Gross Profit / Sales) x 100%

Operating Profit Margin
• The operating margin measures how much profit a company makes on a dollar of sales, after
paying for variable costs of production, such as wages and raw materials, but before paying
interest or tax. It is calculated by dividing a company’s operating profit by its net sales.

The Formula for Operating Profit Margin is:

Operating Profit Margin = (Operating Income / Sales) x 100%

Net Profit Margin
• The net profit margin is equal to how much net income or profit is generated as a percentage of
revenue. Net profit margin is the ratio of net profits to revenues for a company or business
segment. Net profit margin is typically expressed as a percentage but can also be represented in
decimal form. The net profit margin illustrates how much of each dollar in revenue collected by a
company translates into profit.

Formula for Net Profit Margin:

Net Profit Margin = (Net Income / Sales) x 100%

Efficiency Ratio
The efficiency ratio is typically used to analyze how well a company uses its assets and liabilities
internally. An efficiency ratio can calculate the turnover of receivables, the repayment of liabilities, the
quantity and usage of equity, and the general use of inventory and machinery. This ratio can also be used
to track and analyze the performance of commercial and investment bank

What Does an Efficiency Ratio Tell You?

Efficiency ratios, also known as activity ratios, are used by analysts to measure the performance of a
company's short-term or current performance. All these ratios use numbers in a company's current
assets or current liabilities, quantifying the operations of the business.

An efficiency ratio measures a company's ability to use its assets to generate income. For example, an
efficiency ratio often looks at various aspects of the company, such as the time it takes to collect cash
from customers or the amount of time it takes to convert inventory to cash. This makes efficiency ratios
important, because an improvement in the efficiency ratios usually translates to improved profitability.

These ratios can be compared with peers in the same industry and can identify businesses that are better
managed relative to the others. Some common efficiency ratios are accounts receivable turnover, fixed
asset turnover, sales to inventory, sales to net working capital, accounts payable to sales and stock
turnover ratio.
Liquidity Ratios
Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to
pay off current debt obligations without raising external capital. Liquidity ratios measure a
company's ability to pay debt obligations and its margin of safety through the calculation of
metrics including the current ratio, quick ratio, and operating cash flow ratio.

Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term
debts in an emergency.
Current Ratio
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.

Formula and Calculation for Current Ratio

To calculate the ratio, analysts compare a company's current assets to its current liabilities. Current
assets listed on a company's balance sheet include cash, accounts receivable, inventory and other
assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities
include accounts payable, wages, taxes payable, and the current portion of long-term debt.

Current Ratio = Current Assets / Current Liabilities

Acid-Test Ratio / Quick Asset Ratio
The acid-test ratio uses a firm's balance sheet data as an indicator of whether it has sufficient
short-term assets to cover its short-term liabilities. This metric is more useful in certain situations
than the current ratio, also known as the working capital ratio, since it ignores assets such as
inventory, which may be difficult to quickly liquidate. The acid-test ratio is also commonly known
as the quick ratio.

Formula for Quick Asset Ratio

Quick Asset Ratio = (Cash + Current Accounts Receivable + Market Securities) / Current Liabilities

Quick Asset Ratio = (Current Assets – Inventories) / Current Liabilities

Note that the first formula is a stricter measure of quick asset ratio.
Example of Quick Asset Ratio:
A company's acid-test ratio can be calculated using its balance sheet. Below is an abbreviated version of Apple Inc.'s balance sheet
as of September 29, 2018, showing the components of the company's current assets and current liabilities (all figures in millions
of dollars):
APPLE, INC. BALANCE SHEET AS OF SEPTEMBER 29, 2018
Cash and cash equivalents $25,913
Short-term marketable securities 40,388
Accounts receivable 23,190
Inventories 3,956
Vendor non-trade receivables 25,809
Other current assets 12,087
Total current assets $131,399

Accounts payable $55,888

Long-term debt 93,735
Total current liabilities $115,92
To obtain the company's liquid current assets, add cash and cash equivalents, short-term marketable securities, accounts
receivable and vendor non-trade receivables. Then divide current liquid current assets by total current liabilities to calculate
the acid-test ratio. The calculation would look like the following:
$25,913+40,388+23,190+25,809​
Apple’s acid-test ratio= =0.99​
$115,929
Leverage Ratio
A leverage ratio is any one of several financial measurements that look at how much capital comes in the form
of debt (loans) or assesses the ability of a company to meet its financial obligations. The leverage ratio category is
important because companies rely on a mixture of equity and debt to finance their operations, and knowing the
amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due. Several
common leverage ratios will be discussed below.

What Does a Leverage Ratio Tell You?

Too much debt can be dangerous for a company and its investors. However, if a company's operations can generate a
higher rate of return than the interest rate on its loans, then the debt is helping to fuel growth in profits. Nonetheless,
uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too few debts can also raise
questions. A reluctance or inability to borrow may be a sign that operating margins are simply too tight.

There are several different specific ratios that may be categorized as a leverage ratio, but the main factors considered
are debt, equity, assets, and interest expenses.

A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in
output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the
company and the industry, the mix will differ.

Finally, the consumer leverage ratio refers to the level of consumer debt as compared to disposable income and is used
in economic analysis and by policymakers.
Leverage Ratio
A question may be raised as to what an appropriate capital structure is, that is, a combination of debt and
equity, for a company. The capital structure of company is influenced by the following factors:

• Nature of business

• Stage of business development

• Macroeconomics conditions

• Prospect of the industry and expected growth rates

• Bond and stock market conditions

• Financial Flexibility

• Regulatory environment

• Taxes

• Management Style
Debt Ratio
(Leverage Ratio)

The debt ratio is a financial ratio that measures the extent of a company’s leverage. The debt ratio
is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be
interpreted as the proportion of a company’s assets that are financed by debt.

A ratio greater than 1 shows that a considerable portion of debt is funded by assets. In other
words, the company has more liabilities than assets. A high ratio also indicates that a company may
be putting itself at a risk of default on its loans if interest rates were to rise suddenly. A ratio below
1 translates to the fact that a greater portion of a company's assets is funded by equity.

The debt ratio is also referred to as the debt-to-assets ratio.

Debt Ratio Formula:

Debt Ratio = Total Liabilities / Total Assets

Debt to Equity Ratio
(Leverage Ratio)

The debt-to-equity (D/E) ratio is calculated by dividing a company’s total liabilities by its
shareholder equity. These numbers are available on the balance sheet of a company’s financial
statements.

The ratio is used to evaluate a company's financial leverage. The D/E ratio is an important metric
used in corporate finance. It is a measure of the degree to which a company is financing its
operations through debt versus wholly-owned funds. More specifically, it reflects the ability of
shareholder equity to cover all outstanding debts in the event of a business downturn.

Debt to Equity Ratio Formula:

Debt to Equity Ratio = Total Liabilities / Total Stockholders’ Equity

Interest Coverage Ratio
(Leverage Ratio)

The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a
company can pay interest on its outstanding debt. The interest coverage ratio may be calculated by
dividing a company's earnings before interest and taxes (EBIT) during a given period by the
company's interest payments due within the same period.

The Interest coverage ratio is also called “times interest earned.” Lenders, investors, and creditors
often use this formula to determine a company's riskiness relative to its current debt or for future
borrowing.

Interest Coverage Ratio Formula:

Interest Coverage Ratio = EBIT / Interest Expense

EBIT = Earning Before Interest and Taxes
Efficiency Ratios or Turnover Ratios
Efficiency ratios measure a company's ability to use its assets and manage its liabilities effectively in the
current period or in the short-term. Although there are several efficiency ratios, they are similar in that
they measure the time it takes to generate cash or income from a client or by liquidating inventory.

Efficiency ratios include the inventory turnover ratio, asset turnover ratio, and receivables turnover ratio.
These ratios measure how efficiently a company uses its assets to generate revenues and its ability to
manage those assets. With any financial ratio, it's best to compare a company's ratio to its competitors in
the same industry.
The following Efficiency Ratio will be discussed in this chapter:

• Total asset turnover ratio

• Fixed asset turnover ratio

• Accounts receivable turnover ratio

• Inventory turnover ratio

• Accounts payable turnover ratio

Total asset turnover ratio
The asset turnover ratio is an efficiency ratio that measures a company’s ability to generate sales
from its assets by comparing net sales with average total assets. In other words, this ratio shows
how efficiently a company can use its assets to generate sales.

The total asset turnover ratio calculates net sales as a percentage of assets to show how many sales
are generated from each dollar of company assets. For instance, a ratio of .5 means that each dollar
of assets generates 50 cents of sale

Total asset turnover ratio formula:

Total asset turnover ratio = Sales / Total Assets

Fixed Asset Turnover Ratio
The fixed asset turnover ratio (FAT) is, in general, used by analysts to measure operating
performance. This efficiency ratio compares net sales (income statement) to fixed assets (balance
sheet) and measures a company's ability to generate net sales from its fixed-asset investments,
namely property, plant, and equipment (PP&E).

The fixed asset balance is used as a net of accumulated depreciation. In general, a higher fixed asset
turnover ratio indicates that a company has more effectively utilized investment in fixed assets to
generate revenue.

Fixed asset turnover ratio formula:

Fixed asset turnover ratio = Sales / PPE

Accounts receivable turnover ratio
Accounts receivable turnover is an efficiency ratio or activity ratio that measures how many times
a business can turn its accounts receivable into cash during a period. In other words, the accounts
receivable turnover ratio measures how many times a business can collect its average accounts
receivable during the year.

Accounts receivable turnover ratio formula:

Accounts receivable turnover ratio = Sales / Accounts Receivable

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. In other words, it measures how many
times a company sold its total average inventory dollar amount during the year.

This ratio is important because total turnover depends on two main components of performance.
The first component is stock purchasing. If larger amounts of inventory are purchased during the
year, the company will have to sell greater amounts of inventory to improve its turnover. If the
company can’t sell these greater amounts of inventory, it will incur storage costs and other holding
costs.

The second component is sales. Sales have to match inventory purchases otherwise the inventory
will not turn effectively. That’s why the purchasing and sales departments must be in tune with
each other.

Inventory Turnover Ratio formula:

Inventory Turnover Ratio = Cost of Sales / Inventories

Accounts payable turnover ratio
Accounts payable turnover is a ratio that measures the speed with which a company pays its
suppliers. If the turnover ratio declines from one period to the next, this indicates that the
company is paying its suppliers more slowly, and may be an indicator of worsening financial
condition. A change in the turnover ratio can also indicate altered payment terms with suppliers,
though this rarely has more than a slight impact on the ratio. If a company is paying its suppliers
very quickly, it may mean that the suppliers are demanding fast payment terms, or that the
company is taking advantage of early payment discounts.

Accounts payable turnover ratio formula:

Accounts payable turnover ratio = Cost of Sales / Trade Accounts Payable

Operating Cycle and Cash Conversion Cycle
The length of time between a firm's purchase of inventory and the receipt of cash from
accounts receivable. It is the time required for a business to turn purchases into cash receipts
from customers. CCC represents the number of days a firm's cash remains tied up within the
operations of the business. A cash flow analysis using CCC also reveals in, an overall manner,
how efficiently the company is managing its working capital.
The cash conversion cycle is also referred to as the cash cycle, asset conversion cycle or net
operating cycle.
Calculation (formula)
The cycle is composed of three main working capital components: Days Inventory
Outstanding (DIO), Days sales outstanding (DSO) and Days Payable Outstanding (DPO). The
Cash Conversion Cycle (CCC) is equal to the time is takes to sell inventory and collect
receivables less the time it takes to pay the company's payables:
Cash Conversion Cycle (CCC) = DIO + DSO – DPO
Vertical Analysis
Vertical analysis is the proportional analysis of a financial statement, where each line item on a
financial statement is listed as a percentage of another item. This means that every line item on an
income statement is stated as a percentage of gross sales, while every line item on a balance sheet
is stated as a percentage of total assets.

The most common use of vertical analysis is within a financial statement for a single reporting
period, so that one can see the relative proportions of account balances. Vertical analysis is also
useful for trend analysis, to see relative changes in accounts over time, such as on a comparative
basis over a five-year period.
Vertical Analysis of the Income Statement
The most common use of vertical analysis in an income statement is to show the various expense
line items as a percentage of sales, though it can also be used to show the percentage of different
revenue line items that make up total sales. An example of vertical analysis for an income
statement is shown in the far right column of the following condensed income statement:
$ Totals Percent
Sales $1,000,000 100%
Cost of goods sold 400,000 40%
Gross margin 600,000 60%

Salaries and wages 250,000 25%

Office rent 50,000 5%
Supplies 10,000 1%
Utilities 20,000 2%
Other expenses 90,000 9%
The information provided by this income statement format is useful not only for
Total expenses 420,000 42% spotting spikes in expenses, but also for determining which expenses are so small
Net profit 180,000 18% that they may not be worthy of much management attention.
 Vertical Analysis of the Balance Sheet
The central issue when creating a vertical analysis of a balance sheet is what to use as the denominator in the percentage
calculation. The usual denominator is the asset total, but one can also use the total of all liabilities when calculating all liability
line item percentages, and the total of all equity accounts when calculating all equity line item percentages. An example of
vertical analysis for a balance sheet is shown in the far right column of the following condensed balance sheet:
$ Totals Percent
Cash $100,000 10%
Accounts receivable 350,000 35%
Inventory 150,000 15%
Total current assets 600,000 60%

Fixed assets 400,000 40%

Total assets $1,000,000 100%

Accounts payable $180,000 18%

Accrued liabilities 70,000 7%
Total current liabilities 250,000 25%

Notes payable 300,000 30%

Total liabilities 550,000 55%

Capital stock 200,000 20%

Retained earnings 250,000 25%
Total equity 450,000 45%
Total liabilities and equity $1,000,000 100%
Horizontal analysis
Horizontal analysis (also known as trend analysis) is a financial statement analysis technique that
shows changes in the amounts of corresponding financial statement items over a period of time. It
is a useful tool to evaluate the trend situations.

The statements for two or more periods are used in horizontal analysis. The earliest period is
usually used as the base period and the items on the statements for all later periods are compared
with items on the statements of the base period. The changes are generally shown both in dollars
and percentage.

Dollar and percentage changes are computed by using the following formulas:
Quality of Earnings
• Is the income coming from the business?
• How much of net income translates into cash flows?
• Is the income stable?
Limitations of Financial Statement Analysis
• Financial analysis deals only with quantitative data
• Management can take short-run actions and influence ratios
• Different companies may use different accounting principles
• Different formulas can be used in computing financial ratios
• The amounts found in the financial statements are already part of
historical data
• A financial ration standing alone is useless
Business Finance (Chapter 2) Reporters:

Lualhati Cabrera Michael John Ben Bataliran

Rizza Gotoman
Citings:
• https://www.investopedia.com/terms/b/balancesheet.asp

• https://www.investopedia.com/investing/what-is-a-cash-flow-statement/

• https://xplaind.com/969555/changes-in-shareholders-equity

• https://www.investopedia.com/terms/f/financial-statement-analysis.asp

• https://www.investopedia.com/terms/g/gross_profit_margin.asp

• https://www.investopedia.com/terms/e/efficiencyratio.asp

• https://www.investopedia.com/terms/l/liquidityratios.asp

• https://www.investopedia.com/terms/a/acidtest.asp

• https://www.investopedia.com/terms/d/debtratio.asp

• https://www.investopedia.com/terms/d/debtequityratio.asp

• https://www.myaccountingcourse.com/financial-ratios/asset-turnover-ratio

• https://www.fundera.com/blog/accounts-receivable-turnover-ratio

• https://www.readyratios.com/reference/asset/cash_conversion_cycle.html