PRINCIPLES OF FINANCE

LECTURE 4
FINANCIAL ANALYSIS
GERONIMO ANDREW A. RIVERA, CPA, CIA
 FINANCIAL ANALYSIS
The use of the company’s financial statements
to measure the entity’s financial position and
performance

It provides information on the following

areas:
Liquidity
Solvency
Stability
Profitability
 LIQUIDITY

Pertains to the company’s ability to meet

its currently maturing obligations

It is the capability to pay for short –term

debts
 SOLVENCY

Pertains to the company’s ability to meet

its long-term obligations.

It provides measures on whether the

company’s assets are sufficient to cover
for their liabilities
 STABILITY

Pertains to the company’s dependence on

creditors or own equity

It provides insights on whether a company

is geared towards finances coming from
their equity or those provided by
creditors
 PROFITABILITY

Indicates measures on how well a

company performed on their operations

It provides information as to the

performance of the company regarding
their income and expenses
 METHODS OF ANALYZING FINANCIAL STATEMENTS

Horizontal Analysis – Compares financial data

from two consecutive periods (Increase-Decrease
Method)

Vertical Analysis – Analyzes financial statements

though finding out the relationship between
accounts within a particular period

Financial Ratios – Makes use of the relationship of

accounts through ratios and percentages
 STEPS IN PERFORMING HORIZONTAL ANALYSIS

1. Select two consecutive years of financial statements.

The earlier period will be called the base year

2. Compute for the difference between the base year and

the current year. The formula would be current year
minus the base year. A positive difference would
indicate an increase in the current year while a negative
difference would indicate a decrease in the current year

3. Divide the difference with the base year figures

 HORIZONTAL ANALYSIS ILLUSTRATION

Star Company
Statement of Financial Position
December 31, 2019 and 2020

ASSETS
Current Assets 2019 2020 Difference Percentage
Cash 150,000 190,000 40,000 27%
Accounts Receivable, net 75,000 102,000 27,000 36%
Inventory 50,000 55,000 5,000 10%
Short-Term Investments 20,000 20,000 - -
Prepaid Expenses 10,000 8,000 (2,000) (20%)
Total Current Assets 305,000 375,000 70,000 23%
 HORIZONTAL ANALYSIS ILLUSTRATION

Star Company
Statement of Financial Position
December 31, 2019 and 2020

ASSETS
Non-Current Assets 2019 2020 Difference Percentage
Land 800,000 800,000 - -
Building, net 490,000 480,000 (10,000) (2%)
Machinery, net 295,000 290,000 ( 5,000) (1.7%)
Furniture and Fixtures, net 98,000 96,000 ( 2,000) (2%)
Long Term Investments 100,000 80,000 (20,000) (20%)
Total Non-Current Assets 1,783,000 1,746,000 (37,000) (2%)

Total Assets 2,088,000 2,121,000 33,000 1.6%

 HORIZONTAL ANALYSIS ILLUSTRATION

Star Company
Statement of Financial Position
December 31, 2019 and 2020

LIABILITIES AND EQUITY

Current Liabilities 2019 2020 Difference Percentage
Accounts Payable 50,000 55,000 5,000 10%
Short Term Liabilities 45,000 50,000 5,000 11%
Total Current Liabilities 95,000 105,000 10,000 11%
Non-Current Liabilities
Long-Term Debts 120,000 100,000 -20,000 17%
Bonds Payable 90,000 90,000 - ___-
Total Non-Current Liabilities 210,000 190,000 -20,000 9.5%
Total Liabilities 305,000 295,000 -10,000 7.6%
Total Capital 1,783,000 1,826,000 43,000 2.4%
Total Liabilities & Capital 2,088,000 2,121,000 33,000 1.6%
 HORIZONTAL ANALYSIS ILLUSTRATION

Star Company
Income Statement
For the year ended December 31, 2019 and 2020

2019 2020 Difference Percentage

Net Sales 90,000 120,000 30,000 33.33%
Cost of Goods Sold 50,000 60,000 10,000 20.00%
Gross Profit 40,000 60,000 20,000 50.00%
Administrative Expenses 10,000 10,000 - -
Selling Expenses 5,000 6,000 1,000 20.00%
Net Income 25,000 44,000 19,000 76.00%
 VERTICAL ANALYSIS

Analyzes financial statements through finding out the

relationship between accounts within a particular period.
Unlike horizontal analysis that compares the position and
performance of the company for two separate periods,
vertical analysis computes the percentage of each account
with a base amount for each accounting period.

An example of vertical analysis is the Common Size

Financial Statement. This determines the percentage of an
account balance in comparison to the total base amount.
 VERTICAL ANALYSIS

For the statement of financial position, each item

is converted to percent by dividing it by total
assets

For the income statement, each item is restated

as a percentage of net sales
 VERTICAL ANALYSIS ILLUSTRATION

Star Company
Statement of Financial Position
December 31, 2019 and 2020

ASSETS
Current Assets 2019 Percent 2020Percent
Cash 150,000 7.18% 190,000 8.96%
Accounts Receivable, net 75,000 3.59% 102,000 4.81%
Inventory 50,000 2.39% 55,000 2.59%
Short-Term Investments 20,000 0.96% 20,000 0.94%
Prepaid Expenses 10,000 0.48% 8,000 0.38%
Total Current Assets 305,000 14.61% 375,000 17.68%
financial ratios
 VERTICAL ANALYSIS ILLUSTRATION

Star Company
Statement of Financial Position
December 31, 2019 and 2020

ASSETS
Non-Current Assets 2019 Percent 2020 Percent
Land 800,000 38.31% 800,000 37.72%
Building, net 490,000 23.47% 480,000 22.63%
Machinery, net 295,000 14.13% 290,000 13.67%
Furniture and Fixtures, net 98,000 4.69% 96,000 4.53%
Long Term Investments 100,000 4.79% 80,000 3.77%
Total Non-Current Assets 1,783,000 85.39% 1,746,000 82.32%

Total Assets 2,088,000 100% 2,121,000 100%

 VERTICAL ANALYSIS ILLUSTRATION

Star Company
Statement of Financial Position
December 31, 2019 and 2020

LIABILITIES AND EQUITY

Current Liabilities 2019 Percent 2020 Percent
Accounts Payable 50,000 2.39% 55,000 2.59%
Short Term Liabilities 45,000 2.16% 50,000 2.36%
Total Current Liabilities 95,000 4.55% 105,000 4.85%
Non-Current Liabilities
Long-Term Debts 120,000 5.75% 100,000 4.71%
Bonds Payable 90,000 4.31% 90,000 4.24%
Total Non-Current Liabilities 210,000 10.06% 190,000 8.96%
Total Liabilities 305,000 14.61% 295,000 13.91%
Total Capital 1,783,000 85.39% 1,826,000 86.09%
Total Liabilities & Capital 2,088,000 100% 2,121,0001 100%
financial ratios
 VERTICAL ANALYSIS ILLUSTRATION

Star Company
Income Statement
For the year ended December 31, 2019 and 2020

2019 Percent 2020 Percent

Net Sales 90,000 100.00% 120,000 100.00%
Cost of Goods Sold 50,000 55.56% 60,000 50.00%
Gross Profit 40,000 44.44% 60,000 50.00%
Administrative Expenses 10,000 11.11% 10,000 8.33%
Selling Expenses 5,000 5.56% 6,000 5.00%
Net Income 25,000 27.78% 44,000 36.67%
 FINANCIAL RATIOS

Makes use of the relationship of accounts

through ratios and percentages

To illustrate the most commonly used financial

ratios, the financial statements of Star Company
for the year 2020 is used
 FINANCIAL RATIOS

Liquidity
Current Ratios – test the ability of the company to pay for
its current obligations
Formula:
Total Current Assets / Total Current Liabilities
Computation: P375,000 / P105,000 VERTICal
analysis illustration VERTICal analysis illustration
Current Ratio: 3.57 : 1
Interpretation: This means that for every 1-peso current
liability of the company, they have approximately 3.57
current assets to pay for it
 FINANCIAL RATIOS

Liquidity
Acid test ratio or quick ratio – a more strict test of the company’s
ability to pay current obligations. Inventory and Prepaid Assets
are removed from the equation.
Formula:
Total Quick Assets / Total Current Liabilities
Computation: P312,000 / P105,000
Current Ratio: 2.97 : 1
Interpretation: This means that even if the inventory and prepaid
assets are removed, the Company is still able to meet their
current obligations. For every 1-peso current liability, they
have an estimated amount of 2.97 current assets to pay for it
 FINANCIAL RATIOS

Liquidity
Working Capital – Excess of current assets after covering
the current liabilities. Shows the remaining amount of
current assets that can be used in the operations.
Formula:
Current Assets – Current Liabilities
Computation: P375,000 - P105,000
Working Capital: P270,000
Interpretation: This means that the company has 270,000
pesos free current assets that they can use for the
operations of the business
 FINANCIAL RATIOS

Management Efficiency
Receivable Turnover – Tests the efficiency of
management’s collection of receivables.
Formula:
Net Credit Sales/Average Accounts Rcvble (net)
Computation: P120,000 / P102,000
Receivable Turnover: 1.18 times
Interpretation: The low receivable turnover indicates
the inefficiency of the company in collecting their
receivables
 FINANCIAL RATIOS

Management Efficiency
Inventory Turnover – Determines the efficiency of the
company in managing inventory levels
Formula:
Cost of Goods Sold/Average Merchandise Invty
Computation: P60,000 / P55,000
Inventory Turnover: 1.09 times
Interpretation: The low inventory turnover indicates the
inefficiency of the management in managing inventory.
This could indicate that the company is storing too much
inventory about its ability to sell
 FINANCIAL RATIOS

Stability
Debt Ratio – Shows proportion of all assets that are
financed with liabilities
Formula:
Total Liabilities / Total Assets
Computation: P295,000 / P2,121,000
Debt Ratio: 13.9%
Interpretation: This means that 13.9% of the
company’s assets are being financed by the creditors
 FINANCIAL RATIOS

Stability
Equity Ratio – Shows proportion of assets from
owners
Formula:
Total Equity / Total Assets
Computation: P1,826,000 / P2,121,000
Equity Ratio: 86.1%
Interpretation: This means that 86.1% of the
company’s assets are being financed by the
company’s own capital
 FINANCIAL RATIOS

Stability
Debt to Equity Ratio – Measures debt over equity
Formula:
Total Liabilities / Total Equity
Computation: P295,000 / P1,826,000
Debt to Equity Ratio: 16.16%
Interpretation: This means that compared to the
total equity, the liabilities represent only around
16.16% of the company’s capital
 FINANCIAL RATIOS

Profitability
Gross Profit Margin – Determines the percentage of
profit generated after deducting cost of goods sold
Formula:
Gross Profit / Net Sales
Computation: P60,000 / P120,000
Gross Profit Margin: 50%
Interpretation: This means that after deducting cost
of goods sold, 50% of the net sales is left and is
available for other expenses
 FINANCIAL RATIOS

Profitability
Net Profit Margin – Determines the percentage of profit
after adding all income and deducting all expenses
Formula:
Net Profit / Net Sales
Computation: P44,000 / P120,000
Net Profit Margin: 36.67%
Interpretation: This means that after all the income and
expenses have been considered, 36.67% of the net sales
is left for the company
 FINANCIAL RATIOS

Profitability
Rate of Return on Equity – Measures rate of return on
resources provided by owners
Formula:
Net Income / Average Equity
Computation: P44,000 / P1,826,000
ROE: 2.4%
Interpretation: This means that the owner was able to get
returns equivalent to 2.4% of his investment in the
company based on the performance of the company this
year
 END
QUESTION AND ANSWER