FINANCIAL STATEMENT

ANALYSIS

Lecture 1.1

Jay Stephen Siy, CPA, MM

 FINANCIAL STATEMENT ANALYSIS

the process of establishing or determining

relationships, changes and trends in the different
elements of the financial statements to be able to
come up with certain generalizations/conclusions
as to:
- what might have caused these changes
- effects of these changes on the
organizations’ financial position and results
of operations
FINANCIAL STATEMENTS ANALYSIS

- involves comparison of a firm’s performance:

a) In one period against another period
b) In one period against a predetermined
performance
c) In one period against another company
within the same industry

- this helps management identify deficiencies and

then take actions to improve performance.
FINANCIAL STATEMENT ANALYSIS

METHODS AND TECHNIQUES OF FS ANALYSIS:

A. HORIZONTAL OR COMPARATIVE

B. VERTICAL OR COMMON-SIZE

C. FINANCIAL RATIO ANALYSIS

FINANCIAL STATEMENT ANALYSIS

HORIZONTAL OR COMPARATIVE
- horizontal analysis presents differences in
absolute amounts and in percentages
between accounts in two periods (e.g. years,
quarters, etc.), two companies, actual and
budgeted

- a percentage is computed through:

% of change =Amount of change /
Base
FINANCIAL STATEMENT ANALYSIS

HORIZONTAL OR COMPARATIVE

Note: A base may be last year’s data, budgeted

data, average industry data, or competitor’s data.
The percentage of change is not computed if the
denominator or base is Zero or Negative. If base is
zero, the percentage change cannot be computed.
If the base is negative, the percentage of change
does not reflect the true nature of the change,
hence the percentage change is not computed.
HORIZONTAL OR COMPARATIVE
ANALYSIS

ILLUSTRATION: Consider the comparative balance sheets of ABC Inc.

for the years 2018 and 2019
ABC Inc.
Comparative Analysis - Balance Sheets
December 31, 2018 and 2019 (PhP in Thousands)
Increase (Decrease)
2005 2006 Amount Percentage
ASSETS
Cash P400 P600 P200 50%
Accounts receivable 2,600 2,900 300 12
Inventories 1,200 1,000 (200) (17)
Long-term investments 2,000 2,200 200 10
Property and equipment 4,000 4,400 400 10
Other assets 0 400 400 --
TOTAL P10,200 P11,500 P1,300 13%
HORIZONTAL OR COMPARATIVE
ANALYSIS

ILLUSTRATION: Consider the comparative balance sheets of ABC Inc.

for the years 2018 and 2019

Increase (Decrease)
2018 2019 Amount Percentage
LIAB. & SHE
Accounts payable P3,000 P3,500 P500 17%
Bonds payable 500 400 (100) (20)
Common stock 3,100 3,200 100 3
Additional paid-in capital 2,000 2,200 200 10
Retained earnings 1,600 2,200 600 37
TOTAL P10,200 P11,500 P1,300 13 %
HORIZONTAL OR COMPARATIVE
ANALYSIS

Account Change Analysis*

Cash 50% Unfavorable. Generally, cash

increase increase on top of the optimum
cash balance would be an excess
cash, an idle resource, and would
not give a good business return
for the company.
HORIZONTAL OR COMPARATIVE
ANALYSIS

Accounts Change Opinion*

Accounts 12% Unfavorable. Increase in accounts

receivable increase receivable would generally mean
more investment extended to
customers through a credit line, lost
opportunity from the additional
money tied up on the hands of the
customers, higher costs of credit and
collection, and increase in the
occurrence of uncollectible accounts.
HORIZONTAL OR COMPARATIVE
ANALYSIS

Account Change Opinion*

Inventories 17% Favorable. A decrease in inventories
generally indicates an amount
decrease
released form inventory investment
which could now be used to generate
earnings; a reduction in inventory
balance would also mean lesser costs
of carrying inventories such as rent,
insurance, warehouse salaries,
interest, taxes, depreciation, and
clerical costs.
HORIZONTAL OR COMPARATIVE
ANALYSIS

Account Change Opinion*

Long- 10% An increase in long-term

term increase investment would indicate an
investme addition in revenue from an
nts auxiliary source of income (non-
operating revenue)
HORIZONTAL OR COMPARATIVE
ANALYSIS

Account Change Opinion*

PPE 10% An increase in property and

increase equipment reflects a favorable
preparation of the organization
for its long-term existence and
business activities as it manifests
opportunity for expansion.
HORIZONTAL OR COMPARATIVE
ANALYSIS

Account Change Opinion*

Accounts 17% Favorable. An increase in

payable increase accounts payable generally means
more resources entrusted by
suppliers to the business in
running its normal business
operations and lesser cash inflows
for current assets to sustain
working capital requirements.
HORIZONTAL OR COMPARATIVE
ANALYSIS

Account Change Opinion*

Retained 37% An increase in retained earnings

earnings increase could be read as healthy ability of
the organization to generate
internal financial for its long-term
growth and commitments.
FINANCIAL STATEMENT ANALYSIS

TREND ANALYSIS
- variation of horizontal analysis
- trend analysis extends analysis beyond
two years (generally five years)
- track down what happened in the past and
provide a pattern on what may happen in
the coming years (thus the term trending)
 FINANCIAL STATEMENT ANALYSIS

TREND ANALYSIS
ILLUSTRATION:

2010 2011 2012 2013 2014 2015

Net sales (in thou) P22,980 P23,601 P28,999 P22,767 P29,766 P34,675

2010 2011 2012 2013 2014 2015

Net sales indexes 100 103 126 99 130 151
Net sales ratio 1.00 1.03 1.26 0.99 1.30 1.68
FINANCIAL STATEMENT ANALYSIS

VERTICAL ANALYSIS
- The vertical or common-size analysis gets
the proportional components of each of the
variables in the financial statement in
relation to a chosen base (i.e. 100%). As in
horizontal analysis that financial statements
are treated individually and each is analyzed
independent of the others.
Common-Size Income Statement
-Income statement that presents items as
a percentage of revenues

Common-Size Balance Sheet

- Balance sheet that presents items as
a percentage of total assets
VERTICAL ANALYSIS

ILLUSTRATION:

Comparative Income Statement

For the Year Then Ended, December 31, 2005
(in thousands)
ABC Inc XYZ Corp
Gross sales P203,600 P3,400
Less: Sales return and allowances 3,600 400
Net sales 200,000 3,000
Less: Cost of goods sold 160,000 1,000
Gross Profit 40,000 2,000
Less: Operating expenses 10,000 500
Operating income 30,000 1,500
Less: Interest expense 3,000 200
Income before income tax 27,000 1,300
Less: Income tax 10,800 520
Net income P 16,200 P 780
VERTICAL ANALYSIS

ILLUSTRATION:
Comparative Income Statement
For the Year Then Ended, December 31, 2005
(in thousands)
ABC Inc XYZ Corp
Gross sales 101.8% 113.3%
Less: Sales return and allowances (1.8) (13.3)
Net sales 100.0 100.0
Less: Cost of goods sold (80.0) (33.3)
Gross Profit 20.0 66.7
Less: Operating expenses (5.0) (16.7)
Operating income 15.0 50.0
Less: Interest expense (1.5) (6.7)
Income before income tax 13.5 43.3
Less: Income tax (5.4) (17.3)
Net income 8.1% 26.0%
VERTICAL ANALYSIS

Money/Resource from (to) ABC Inc. XYZ Corp.

Customer (Sales) 100.0% 100.0%

Suppliers, labor, overhead
(Cost of sales) 80.0 33.3
Employees, lessors, utilities, etc.
(Operating expenses) 5.0 16.7
Creditors (Interest) 1.5 6.7
Government (Taxes) 5.4 17.3
Owners (Net income) 8.1 26.0
FINANCIAL STATEMENT ANALYSIS

RATIO ANALYSIS
- horizontal, trend, and vertical analyses are
stand-alone analyses for each financial
statement components
– Financial Ratios are used as a relative
measure that facilitates the evaluation of
efficiency or condition of a particular aspect
of a firm's operations and status
FINANCIAL STATEMENT ANALYSIS

RATIO ANALYSIS

– Ratio Analysis involves methods of

calculating and interpreting financial ratios
in order to assess a firm's performance and
status
- four financial ratio categories include:
PROFITABILITY RATIOS, LIQUIDITY RATIOS,
SOLVENCY RATIOS, ACTIVITY RATIOS
FINANCIAL STATEMENT ANALYSIS

RATIO ANALYSIS
Words of caution in using ratio analysis
•A single ratio rarely tells enough to make a sound
judgment
•Financial statements used in ratio analysis must
be from similar points in time

•Audited financial statements are more reliable

than unaudited statements
FINANCIAL STATEMENT ANALYSIS

RATIO ANALYSIS

Words of caution in using ratio analysis

•The financial data used to compute ratios must

be developed in the same manner

•Inflation can distort comparisons

•Income statement data is totaled while the

balance sheet data is averaged
Ratios: Other Issues

• Proportionality (Whittington; McDonald & Morris, 1984)

• Distribution of F/S numbers (Horrigan, 1965)
• Normality of Data (Deakin, 1976; Durry & Bongen, 1980)
• Computational Issues
• Correlation and Co-movements between F/S
numbers (Horrigan, 1965; Chen & Shimador, 1981)
• Stationarity
Key Questions on Ratios

• Are alternative firms’ accounting treatment

comparable?
• How homogeneous is the firm?
• Are the implied results consistent?
• Is the ratio within a reasonable range within the
industry?
Uses of Ratios
 Industry Benchmarks
 Inputs to formal decision-making
 Aids in investment decisions by
investors
 Aids in analysis of business transactions
(inefficient markets)
 Helps in performance prediction and risk
evaluation in efficient markets
 Contractual limits, Incentives system
RATIO ANALYSIS

TYPES OF FINANCIAL RATIOS

PROFITABILITY – measures management’s

effectiveness in turning a profit on their investment
in assets and on shareholders’ investments in the
company
LIQUIDITY RATIOS – measure’s organization’s
ability to meet current obligations
RATIO ANALYSIS

TYPES OF FINANCIAL RATIOS

SOLVENCY RATIOS – measures organization’s

ability to service its long-term obligations as
they fall due

ACTIVITY RATIOS – measures management’s

effectiveness in managing available resources
LIQUIDITY RATIOS

Ratio Formula

Net working capital Current assets – current

liabilities
  Current assets/ Current
Current ratio liabilities
Quick-assets ratio* Quick assets/Current liabilities
 Ratio Formula

Net working capital Net working capital/Total

to Total assets ratio assets

  Cash + Marketable Securities/

Cash ratio Current liabilities

Interval Ratio Cash + MS +

Receivables/Average daily
expenditures from operations
ILLUSTRATION- Interval Ratio

Cash P 311,000
Marketable Securities 83,000
Receivables 2,453,000
Cost of Sales 9,330,000
Operating Expenses 8,912,000
Other Expenses 291,000

exp / 365 days

LIQUIDITY CONSIDERATIONS

• Unused credit lines

• Long-term assets could be converted to cash

quickly
• Notes discounted on which other party may have
full recourse against the firm
• Major contingent liabilities that have not been
recorded
• Guaranteed bank notes for other organization
ACTIVITY RATIOS*

Ratio Formula

 Inventory turnover * Cost of Sales*/ Average inventories

Number of days to sell 360 days/ Inventory turnover

inventories
 Receivable Turnover** Net credit sales*/ Average trade
receivables*
Collection period 360 days/ Receivable turnover

 Payable Turnover*  Net credit purchases/ Average trade

payables*
* involve spontaneous assets and liabilities i.e., AR, Invty, AP; Acc.
expenses
 Ratio Formula

 Total assets turnover * Sales/ Average total assets

Fixed assets turnover* Sales/ Average fixed assets**

Net working capital Sales/

turnover Average Net working capital
Current assets turnover* Sales/Ave. NWC or Cash-MS,
(not computed; expressed in terms of) Receivable and Inventory Turnovers
 

**or Net noncurrent assets since Intangibles are normally excluded in Ratio analysis
 To illustrate the principles of the activity ratios, consider
the following selected information from AAA and BBB
corporation:

  AAA BBB

Net credit sales P60M P120M

Cost of goods sold 20M 45M
Net credit purchases 20M 43M
Ave. trade receivables 4M 4M
Ave. inventories 2M 2M
Ave. trade payables 3.5M 3.5M
Sales credit terms 2/10,n/30 2/10,n/30
Purchases credit terms 3/30,n/60 3/30,n/60
SUMMARY

AAA BBB Industry

Days to sell inventory 36 days 16 days 18 days

Collection period 24 12 18
OPERATING CYCLE 60 days 28 days 36 days
Less: Payment period 64 30 60 days
Days’ cash short (over) (4)days (2) days (24) days
Cash Cycle
- length of time that cash is tied up in the system

Statement of Cash Flows-related Ratio

Operating Cash Flows*/ Current Liabilities +

Current Notes Payables
LEVERAGE RATIOS

Ratio Formula

   
Debt ratio* Total debt/ Total equity (or total
assets)
Long term debt ratio Long term debt/Long term debt +
stockholders’ equity
Debt-to-equity ratio* Total debt or Long term debt/ Total
stockholders’ equity*
Times interest earned Earnings before interest and
taxes**/ Interest expense*
 Ratio Formula

   
Cash coverage ratio* EBIT + Depreciation/ Interest
charges
EBITDA coverage EBITDA+ Lease payment/Interest
ratio + Loan repayment + Lease payment
Debt Management involves:
•Special items that influence a firm’s long-term debt
paying ability
• Long-term assets vs. long-term debt
• Long-term leasing*
• Pension plans
• Post retirement benefits other than pension
• Joint ventures*
• Contingencies
• Disclosure about FV of securities
• Extension *sources of OBS debt
PROFITABILITY RATIOS
Ratio Formula
Gross Profit Margin Gross Profit / Sales
(GPM)*
Operating Profit Margin  Operating profit (EBIT) / Sales
(OPM)*
 Net Profit Margin or  Net income avail to CS/ Sales
Return on Sales (ROS)*
   Net income avail to CS / Average Assets
Return on Assets (ROA)*
  Net income avail to CS / Average
Return on Equity (ROE)* common equity
  (Net income – Preferred Dividend
Earnings per share (EPS)** Requirement) / Ave. CS outstanding
   
Dividends per share (DPS) Dividends paid/ Average CS outstanding
*discuss different profitability bases (6 incl. NOPAT) ; Du Pont
Analysis ** versus Diluted earnings per share
Profitability and Market Ratios
• Basic Earnings Power= EBIT / Total Assets
• ROI (Return on Investments):
ROA, ROE, ROIC**

Market Ratios (aside from EPS and DPS):

• Dividend Payout = DPS / EPS or Total dividends / NI

• Retention or Plowback Ratio= 1- Div. Payout
• Dividend Yield= DPS / Market price per share
• Price / Earning (P/E) Ratio= MPS / EPS
** NI avail to CS/ LTD + Equity
Profitability Considerations

• Overextension of the meaning of “revenues”

• Non-recording of costs properly

- “Accounting Minefields” (2013)

a Harvard Business Review article
Profitability Considerations

* Gains or Losses that bypass the Income Statement:

– Gains or losses from prior period adjustments

– Unrealized declines in market values of
investments (Balance Sheet)
– Foreign currency translation adjustments (B/S)
– Change in accounting policy (B/S)

* highlight the need to review Retained Earnings and other

accounts in the Stockholders’ Equity (Statement of changes
in Stockholders’ Equity)
Quality of Financial Statements

Balance Sheet
• High Quality
-conservative use of debt or leverage
-assets with market values greater than
book values

• Low Quality
-Non-performing assets (NPAs)
-Off Balance Sheet Liabilities
Quality of Financial Statements

Income Statement

• High Quality
-Repeatable earnings
-Conservative accounting principles
-Earnings “closer” to cash
End