Learning Module No. 10

PHILIPPINE STATE COLLEGE OF AERONAUTICS
INSTITUTE OF LIBERAL ARTS AND SCIENCES

AVIATION TOURISM DEPARTMENT
Learning Module 10: Financial Statement Analysis
LEARNING
MODULE 10:
Financial Statement
Analysis
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TABLE OF CONTENTS
Modul
Title Page
e No.
Financial Statement Analysis 10 1
Learning Outcomes 10 21
Financial Statement Analysis is a method of reviewing and analyzing a

company’s accounting reports (financial statements) in order to gauge its past,
present or projected future performance. This process of reviewing the financial
statements allows for better economic decision making.
Globally, publicly listed companies are required by law to file their financial
statements wit the relevant authorities. For examples, publicly listed firms in America
are required to submit their financial statements to the Securities and Exchange
Commission (SEC). Firms are also obligated to provide their financial statements in
the annual report that they share with their stakeholders. As financial statements are
prepared in order to meet requirements, the second step in the process is to analyze
them effectively so that future profitability and cash flows can be forecasted.
Therefore, the main purpose of financial statement analysis is to utilize

information about the past performance of the company in order to predict how it will
fare in the future. Another important purpose of the analysis of financial statements is
to identify potential problem areas and troubleshoot those.
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USERS OF FINANCIAL STATEMENT ANALYSIS
There are different users of financial statement analysis. These can be

classified into internal and external users. Internal users refer to the management of
the company who analyzes financial statements in order to make decisions related to
the operations of the company. On the other hand, external users do not necessarily
belong to the company but still hold some sort of financial interest. These include
owners, investors, creditors, government, employees, customers, and the general
public. These users are elaborated on below:
1.Management
The managers of the company use their financial statement analysis to make
intelligent decisions about their performance. For instance, they may gauge cost per
distribution channel, or how much cash they have left, from their accounting reports
and make decisions from these analysis results.
2.Owners
Small business owners need financial information from their operations to
determine whether the business id profitable. It helps in making decisions like
whether to continue operating the business, whether to improve business strategies
or whether to give upon the business altogether.
3.Investors
People who have purchased stock or shares in a company need financial
information to analyze the way the company is performing. They use financial
statement analysis to determine what to do with their investments in the company.
So, depending on how the company is doing, they will either hold onto their stock,
sell it or buy more.
4.Creditors
Creditors are interested in knowing if a company will be able to honor its
payments as they become due. They use cash flow analysis of the company’s
accounting records to measure the company’s liquidity, or its ability to make short-
term payments.
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5.Government
Governing and regulating bodies of the state look at financial statement
analysis to determine how the economy is performing in general so they can plan
their financial and industrial policies. Tax authorities also analyze a company’s
statements to calculate the tax burden that the company has to pay.
6.Employees
Employees need to know if their employment is secure and if there is a
possibility of a pay raise. They want to be abreast of their company’s profitability and
stability. Employees may also be interested in knowing the company’s financial
position to see whether there may be plans for expansion and hence, career
prospects for them.
7.Customers
Customers need to know about the ability of the company to service its
clients into the future. The need to know about the company’s stability of operations
is heightened of the customer (i.e. distributor or procurer of specialized products) or
dependent wholly on the company for its supplies.
8.General Public
Anyone in the general public, like students, analysts and researchers, may
be interested in using a company’s financial statement analysis. They may wish to
evaluate the effects of the firm on the environment, or the economy or even the local
community. For instance, if the company is running corporate social responsibility
programs for improving the community, the public may want to be aware of the future
operations of the company.
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There are basically two sources of capital for your

business:
 Internal Source
 Ex. SAVINGS
 External Source
 Ex. Financial support from FRIENDS and RELATIVES
Here’s a look at four options:
1. BOOTSTRAPPING - It means using whatever resources you have on hand to

help you get your business to the next level.
Where do entrepreneurs find the money?
While a large part comes from personal savings and home-equity loans,
they also tend to use plastic heavily. In fact, perhaps half of all startups are funded by
the owners’ credit card.
2. FRIENDS AND FAMILY – At the very early stages of any startup, entrepreneurs
also tend to raise money from relatives, colleagues and other people they know well.
3. BANKS – For most startups, getting a traditional bank loan is a long shot. That’s
because banks typically will only consider companies that have been in business for
two years. What’s more, they need to see a tangible asset that can be used as
collateral. The exception is a manufacturing company building or using heavy
equipment.
4. CUSTOMERS AND SUPPLIERS – Some customers may be willing to help fund

your product development if you customize it for them. As for suppliers, you may be
able to convince one to hold inventory for you, as long as you guarantee them, you’ll
pay for the material by a certain date. Remember: when you’re raising money for
your business, it pays to be creative.
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LEARNING FINANCIAL BASICS
It’s a good start by first putting a sound financial system in place to ensure that
your business will be managed properly. Having a foolproof recording system is a
step towards the right direction.
The mark of a good financial record is one where it shows clearly where the
company’s money is being spent-expenses-and where is it coming from, in the form
of revenues or earning.
Financial statements are also needed when you are applying for credit with
banks and financial institutions. There are two ways to set up your own financial
system manual and automated.
A manual record system works for small cm software maybe expensive and
impractical. To set up a formal financial system, you need to hire a certified public
accountant or a bookkeeper to make a chart of accounts, prepare a book such as
journals or ledgers which will be registered with the BIR. Aside from these he will be
in charge of periodically generating your financial statements, such as income
statements and the balance sheet, and to do the audited financial statements that
you have to submit with your income tax return at the end of the year.
METHODS OF FINANCIAL STATEMENT ANALYSIS
There are two main methods of analyzing financial statements: horizontal or

trend analysis, and vertical analysis. These are explained below along with the
advantages and disadvantages of each method.
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Horizontal Analysis
Horizontal analysis is the comparison of financial information of a company

with historical financial information of the same company over a number of reporting
periods. It could also be based on the ratios derived from the financial information
over the same time span. The main purpose is to see if the numbers are high or low
in comparison to past records, which may be used to investigate any causes for
concern. For example, certain expenditures that are high currently, but were well
under budget in previous years may cause the management to investigate the cause
for the rise in costs; it may be due to switching suppliers or using better quality raw
material.
This method analysis is simply grouping together all information, sorting them
by time period: weeks, months or years. The numbers in each period can also be
shown as a percentage of the numbers expressed in the baseline (earliest/starting)
year. The amount given to the baseline year is usually 100%. This analysis is also
called dynamic analysis or trend analysis.
Advantages and Disadvantages of Horizontal Analysis
When the analysis is conducted for all financial statements at the same time,
the complete impact of operational activities can be seen on the company’s financial
condition during the period under review. This is a clear advantage of using
horizontal analysis as the company can review its performance in comparison to the
previous periods and gauge how it's doing based on past results.
A disadvantage of horizontal analysis is that the aggregated information expressed in

the financial statements may have changed over time and therefore will cause
variances to creep up when account balances are compared across periods.
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Horizontal analysis can also be used to misrepresent results. It can be manipulated

to show comparisons across periods which would make the results appear stellar for
the company. For instance, if the profits for this month are only compared with those
of last month, they may appear outstanding but that may not be the case if compared
with the same month the previous year. Using consistent comparison periods can
address this problem.
Vertical Analysis
Vertical analysis is conducted on financial statements for a single time period

only. Each item in the statement is shown as a base figure of another item in the
statement, for a given time period, usually for year. Typically, this analysis means
that every item on an income and loss statement is expressed as a percentage of
gross sales, while every item on a balance sheet is expressed as a percentage of
total assets held by the firm.
Vertical analysis is also called static analysis because it is carried out for a
single time period.
Advantages and Disadvantages of Vertical Analysis
Vertical analysis only requires financial statements for a single reporting

period. It is useful for inter-firm or inter-departmental comparisons of performance as
one can see relative proportions of account balances, no matter the size of the
business or department.
Because basic vertical analysis is constricted by using a single time period, it

has the disadvantages of losing out on comparison across different time periods to
gauge performance. This can be addressed by using it in conjunction with timeline
analysis, which shows what changes have occurred in the financial accounts over
time, such as a comparative analysis over a three-year period. For instance, if the
cost of sales comes out to be only 30 percent of sales each year I the past, but this
year the percentage comes out to be 45 percent, it would be a cause for concern.
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KEY FINANCIAL STATEMENTS & HOW THEY

AREANALYZED
The main types of financial statements are the balance sheet, the income
statement and the statement of cash flows. These accounting reports are
analyzed in order to aid economic decision-making of a firm and also to predict
profitability and cash flows.
I. The Balance Sheet
The balance sheet shows the current financial position of the firm, at a given
single point in time. It is also called the statement of financial position. The structure
of the balance sheet is laid out such that on one side assets of the firm are listed,
while on the other side liabilities and shareholders’ equity is shown. The two sides of
the balance sheet must balance as follows:
Assets = Liabilities + Shareholders’ Equity
The main items on the balance sheet are explained below:
Current Assets
Current assets held by the firm refer to cash and cash equivalents. These
cash equivalents are assets that can be easily converted into cash within one year.
Current assets include marketable securities, inventory and accounts receivable.
Long-term Assets
Long-term assets are also called non-current assets and include fixed assets like
plant, equipment and machinery, and property, etc. A firm records depreciation of its
fixed, long-term assets every year. It is not an actual expense of cash paid, but is
only a reduction in the book value of the asset. The book value is calculated by
subtracting the accumulated depreciation of prior years from the price of the assets.
Total Assets = Current Assets + Book Value of Long-Term Assets
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Current Liabilities
Current liabilities of the firm are financial payments or obligations due after
one year. These include loans that the firm has to repay in more than a year, and
also capital leases which the firm has to pay for in exchange for using a fixed asset.
Shareholders’ Equity
Shareholders’ equity is also known as the book value of equity or net worth of
the firm. It is the difference between total assets owned by a form and total liabilities
outstanding. It is different from the market value of equity (stock market
capitalization) which is calculated as follows: number of shares outstanding multiplied
by the current share price.
XYZ HOTEL AND RESTAURANT

Balance Sheet
As of December 31, 2019
ASSETS LIABILITIES & SHAREHOLDER’S EQUITY

Current Assets: Liabilities:
Current Liabilities:
Cash 250,000 Notes Payable 15,000
Accounts Receivables 15,000 Accounts Payable 250,000
Office Supplies 6,000 Bonds Payable 6,000
Hotel Supplies 560,000 Salaries & Wages Payable 560,000
___________ Taxes Payable 258,000
___________
TOTAL CURRENT ASSETS 831,000
TOTAL CURRENT LIABILITIES 1,089,000
Non-Current Assets (Fixed Assets)
SHAREHOLDER’S EQUITY
Building 3,000,000 Common Shares 4,256,000
Property, Plant and Equipment 650,000 Preferred Shares 991,000
Long-term Investment 505,000 Retained Earnings 150,000
____________ _____________
TOTAL NON-CURRENT ASSETS 5,655,000 TOTAL SHAREHOLDER’S EQUITY 5,397,000
TOTAL ASSETS: 6,486,000 TOTAL LIABILITIES &

SHAREHOLDER’S EQUITY 6,486,000
Figure 10.1 Example of Balance Sheet
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Balance Sheet Analysis
The balance sheet is analyzed to obtain some key ratios that help explain the
health of the firm at a given point in time. These metrics are as follows:
Debt-Equity Ratio = Total Debt / Total Equity
The debt-equity ratio is also called a leverage ratio. It is calculated to assess

the leverage, or gearing, of a firm to show how much it relies on debt to finance its
activities. This ratio has pertinent implications for the financial health of the firm and
the risk and return of its shares.
Market-to-Book Ratio = Market Value of Equity / Book Value of Equity
The market-to-book ratio is used to reflect any changes in a firm’s

characteristics. The variations in this ratio also show any value added by the
management and its growth prospects.
Enterprise Value = Market Value of Equity = Debt – Cash
The enterprise value of a firm shows the underlying value of the business. It
reflects the true value of the firm’s assets, not including any cash or cash
equivalents, while unencumbered by the debt the firm carries.
II. The Income Statement
This indicates your earnings, expenses, and any gains or losses. It is also
known as the Profit and Loss Statement. Shows how much a business earned in a
given period. Expenses are deducted from the income (either from sales or from
other sources) to arrive at a net profit or net loss.
The purpose of an income statement is to report the revenues and

expenditures of a firm over a specific period of time. It was previously also called a
profit and loss account. The general structure of the income statement with major
components id as follows:
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Sales revenue
- Cost of goods sold (COGS)
= Gross Profit
- Selling, general and administrative costs (SG&A)
- Research and development (R&D)
= Earnings before interest, taxes, depreciation and amortization (EBITDA)
- Depreciation and amortization
= Earnings before interest and taxes (EBIT)
- Interest expense
= Earnings before taxes
- Taxes
= Net income
The net income on the income statement, if positive, shows that the company
has made a profit. If the net income is negative, it means the company incurred a
loss.
Earnings per share can e derived from knowing the total number of shares
outstanding of the company:
Earnings per Share = Net Income / Shares Outstanding
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Components of an Income Statement

Sales – gross revenue less returns and allowances
Cost of goods sold – direct cost of producing the items
Gross profit – profit from manufacturing the product
Operating expenses – Expenses incurred when running the business
Other income and expenses – Profit earned outside the business normal
operations
Net Profit – Gross profit less the expense. The net profit is the basis for computing
your income tax.
XYZ HOTEL AND RESTAURANT

Income Statement
For the year ended December 31, 2019
Sales revenue 25,000,000
Cost of goods sold (19,568,000)
Gross Profit 5,432,000
Selling, general and administrative cost (SG&A) (1,256,800)
Research and development (R&D) (112,300)
Earnings before interest, taxes, depreciation, and 4,062,900
amortization (EBITDA)
Depreciation and Amortization (1,980,560)
Earnings before interest and taxes (EBIT) 2,082,340
Interest expense (359,660)
Earnings before taxes (EBT) 1,722,680
Taxes (516,804)
Net Income 1,205,876
Figure 10.2 Example of Income Statement
Earnings per share can be derived from knowing the total number of shares
outstanding of the company:
Earnings per Share = Net Income / Shares Outstanding
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Income Statement Analysis
Some useful metrics based on the information provided in the income

statement and the balance sheets are as follows:
Profitability Ratios:
1. Net profit margin: This ratio calculates the amount of profit that the company has
earned after taxes and all expenses have been deducted from net sales.
Net profit Margin = Net Income / Net Sales
2. Return on Assets (ROA). This ratio shows the percentage of profit a company
earns in relation to its overall resources.
Return on Assets = Net Income / Average Total Assets
3. Return on Equity: This ratio is used to calculate company profit as a percentage of

total equity.
Return on Equity = Net Income / Book Value of Equity
Valuation Ratios:
Price to earnings ratios (P/E ratio)
The P/E ratio is used to evaluate whether the value of a stock is proportional
to the level of earnings it can generate for its stockholders. It assesses whether the
stock is overvalued or undervalued.
(P/E) Ratio = Market Capitalization / Net Income = Share Price /

Earnings per Share
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III. The Statement of Cash Flows
The statement of cash flows shows explicitly the sources of the firm’s cash
and where the cash is utilized. It is essentially a statement whereby the net income is
adjusted for non-cash expenses and any changes to the net working capital. It also
reflects changes in cash coming from, or being used by, investing and financing
activities of the firm. The structure and main components of the cash flow statement
are as follows:
Cash from operating activities = Net income + Depreciation ±

Changes in net working capital
Cash from financing activities = New debt + New shares – Dividends

– Shares repurchased
Cash from investment activities = Capital expenditure – Proceeds

from sales of long-term assets
All three of the above determine the bottom line: changes in cash flows.
Cash Flows Statement Analysis
To measure how much cash is available to the company for investments

without outside financing or money diverting from operations, it is useful to conduct a
simple cash flow statement analysis. The free cash flow, as the name suggests,
allows a company to be able to pay dividends, repay its debts, buy back its stock and
also make new investments to facilitate future growth. The excess cash produced by
the company, free cash flow, is calculated as follows:
Net Income
+ Amortization/Depreciation
- Changes in Working Capital
- Capital Expenditures
= Free Cash Flow
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Some analysts also study the cash flow from operating activities to see if the
company is earning “quality” income. In order for the company to be doing extremely
well, the cash from operating activities must be consistently greater than the net
income earned by the company.
OTHER FINANCIAL STATEMENT INFORMATION
Apart from the key financial statements, complete financial reporting

statements also include the following:
Business and Operating Review
The business and operating review is also called “management discussion

and analysis”. It serves as a preface to all the complete reporting statements in which
the management talks about recent events, discloses essential information regarding
expansion and future plans, and discusses significant developments in the business
industry.
The business and operating review is a good place for the company to share
any good news with the general public. They have room to elaborate on plans that
would help enhance the company’s image and address any unpleasant events that
may have occurred, to show the customers that they truly care about talking openly
to their customers.
Statement of Change in Shareholders’ Equity
The statement of change in shareholders’ equity is also known as equity

analysis. It provides information about all the changes in the company’s equity value
over a certain period. It reconciles the opening balances of the equity accounts with
the closing balances. There are two types of changes expressed in the statement of
change in shareholders’ equity:
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1. Changes arising from any transactions conducted with shareholders of the

company. For example, issuing new shares, paying dividends, purchasing
treasury stock, and issuing bonus shares, etc.
2. Changes that are a result of alterations in the comprehensive income of

the company. These changes might include revaluation of fixed assets,
net income for the period and fair value of for-sale investments, etc.
Notes to the Financial Statements
Notes to the financial statements are basically additional information provided

in a company’s financial statements. These notes provide details and information that
are left out of the main reporting documents. They are important for the sake of
clarity on many points as they outline the accounting methodology used for recording
certain transactions. The notes to the financial statements are essentially footnotes
because if included in the main statements, they would obscure the important
information, as they are generally quite elaborate and detailed.
The following notes are usually used to impart important disclosures for
explaining the numbers on the financial statements:
1. Notes that show the basis for presentation

2. Notes that advise on significant accounting policies
3. Notes about valuing inventory
4. Notes about depreciating assets
5. Notes about intangible assets
6. Notes that disclose subsequent events
7. Notes about employee benefits
8. Notes that reveal contingency plans
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PROBLEMS WITH FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is a brilliant tool to gauge the past performance

of a company and predict future performance, but there are several issues that one
should be aware of before using the financial statement analysis results blindly, as
these issues can interfere with how the results are interpreted. Some of the issues
are:
Comparability between Companies

This is a big issue for analysts because they can seemingly compare financial
statement analyses between different companies on the basis of ratios used, but in
reality, it may not paint an accurate picture. The financial ratios of two different
companies may be compared to see how they match up against each other, but each
company may aggregate all their information different from each other in order to
draw up their accounting statements. This may lead to incorrect conclusions drawn
about a company in relation to other companies in the industry.
Comparability between Periods

The change in accounts where financial information is stored may skew the
results of the financial statement analysis, from one period to the next. For example,
of a company records an expense in one period as cost of goods sold, while in
another period, it is recorded as a selling and distribution expense, the analysis
between those two periods would not be comparable.
Operational Information
Analysts do not take into account operational information of a company, as
only financial information is analyzed and reviewed. There may be several indicators
in operational information of the company which may be predictors of future
performance, for example. The number of backlogged orders, any changes in
licenses or warranty claims submitted to the company or even changes in the culture
and work environment. Therefore, analysis of financial information may only relay
half the story.
LEARNING OUTCOMES
At the end of the discussion, the student must be able to:
 Define financial statement analysis;
 Identify the different users of financial statement;
 Generate and analyze financial reports in the business;
 Recognize the different financial statement and analysis methods.
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PHILIPPINE STATE COLLEGE OF AERONAUTICS

INSTITUTE OF LIBERAL ARTS AND SCIENCES

Financial Statement Analysis 10 1

Financial Statement Analysis is a method of reviewing and analyzing a

Therefore, the main purpose of financial statement analysis is to utilize

USERS OF FINANCIAL STATEMENT ANALYSIS

There are different users of financial statement analysis. These can be

There are basically two sources of capital for your

Here’s a look at four options:

1. BOOTSTRAPPING - It means using whatever resources you have on hand to

Where do entrepreneurs find the money?

4. CUSTOMERS AND SUPPLIERS – Some customers may be willing to help fund

LEARNING FINANCIAL BASICS

METHODS OF FINANCIAL STATEMENT ANALYSIS

There are two main methods of analyzing financial statements: horizontal or

Horizontal analysis is the comparison of financial information of a company

Advantages and Disadvantages of Horizontal Analysis

A disadvantage of horizontal analysis is that the aggregated information expressed in

Horizontal analysis can also be used to misrepresent results. It can be manipulated

Vertical analysis is conducted on financial statements for a single time period

Advantages and Disadvantages of Vertical Analysis

Vertical analysis only requires financial statements for a single reporting

Because basic vertical analysis is constricted by using a single time period, it

KEY FINANCIAL STATEMENTS & HOW THEY

I. The Balance Sheet

Assets = Liabilities + Shareholders’ Equity

The main items on the balance sheet are explained below:

Total Assets = Current Assets + Book Value of Long-Term Assets

XYZ HOTEL AND RESTAURANT

ASSETS LIABILITIES & SHAREHOLDER’S EQUITY

TOTAL NON-CURRENT ASSETS 5,655,000 TOTAL SHAREHOLDER’S EQUITY 5,397,000

TOTAL ASSETS: 6,486,000 TOTAL LIABILITIES &

Figure 10.1 Example of Balance Sheet

Balance Sheet Analysis

Debt-Equity Ratio = Total Debt / Total Equity

The debt-equity ratio is also called a leverage ratio. It is calculated to assess

Market-to-Book Ratio = Market Value of Equity / Book Value of Equity

The market-to-book ratio is used to reflect any changes in a firm’s

Enterprise Value = Market Value of Equity = Debt – Cash

II. The Income Statement

The purpose of an income statement is to report the revenues and

- Cost of goods sold (COGS)

- Selling, general and administrative costs (SG&A)

- Research and development (R&D)

= Earnings before interest, taxes, depreciation and amortization (EBITDA)

- Depreciation and amortization

= Earnings before interest and taxes (EBIT)

= Earnings before taxes

Earnings per Share = Net Income / Shares Outstanding

Components of an Income Statement

XYZ HOTEL AND RESTAURANT

Figure 10.2 Example of Income Statement

Earnings per Share = Net Income / Shares Outstanding

Income Statement Analysis

Some useful metrics based on the information provided in the income

Net profit Margin = Net Income / Net Sales

Return on Assets = Net Income / Average Total Assets

3. Return on Equity: This ratio is used to calculate company profit as a percentage of

Return on Equity = Net Income / Book Value of Equity

Price to earnings ratios (P/E ratio)