FINANCIAL STATEMENTS ANALYSIS

FS ANALYSIS – involves the evaluation of the firm’s past performance,

present condition, and business potentials by way of careful analysis of its
financial statements.

FINANCIAL STATEMENTS (FS) ANALYSIS TOOLS AND TECHNIQUES

1. Horizontal analysis
2. Vertical analysis
3. Financial Ratios
4. Gross profit variation analysis
5. Cash flow analysis

HORIZONTAL ANALYSIS
Horizontal analysis (trend or index analysis) involves comparison of
figures shown in the FS of two or more consecutive periods. The difference
of the amount between two periods is calculated, and the percentage change
from one period to the next is computed using the earlier period as the base
period.

Percentage Change (∆%) = Most Recent Value – Base Period Value

Base Period Value

LIMITATION: If a negative or a zero amount appears in the base year,

percentage change cannot be computed.

VERTICAL ANALYSIS
Vertical analysis is the process of comparing figures in the FS of a
single period. It involves conversion of amounts in the FS to a common base.
This is accomplished by expressing all figures in the FS as percentages of an
important item such as total assets (in the balance sheet) or net sales (in the
income statement). These converted statements are called common-size
statements or percentage composition statements.

FINANCIAL RATIOS
Financial ratios involve development of mathematical relationships
among accounts found in the FS. Financial ratios provide users and analysts
with relevant information about the firm’s liquidity, solvency, stability,
profitability and other aspects of an entity’s situation and potential.

• TESTS OF LIQUIDITY (Liquidity refers to the company’s ability to pay

its current liabilities as they fall due)
Current Ratio Current Assets It is a measure of
(Banker’s Ratio) Current Liabilities adequacy of working
(Working Capital Ratio) capital. It is the primary
test of liquidity to meet
current obligations from
current assets.
Quick Ratio Quick Assets It measures the number
(Acid Test Ratio) Current Liabilities of times that the current
liabilities could be paid
with the available cash
and near-cash assets
(i.e., cash equivalents,
accounts receivable anx
marketable securities).
Working Capital Activity Ratios ( Efficiency Ratios)
Turnover Income Statement Average age No. of days in a
Account year
Average Balance Turnover
Sheet Account
Receivable Turnover Net Credit Sales It measures the number
Average Receivables of times receivables are
recorded and collected
during the period.
Average Age of 360 days It indicates the average
Receivables Receivables Turnover number of days during
(Average Collection which the company
Period) must wait before
(Days’ Sales in receivables are
Receivables) collected.
Inventory Turnover Cost of Goods Sold It measures the number
Ave. Merchandise of times that the
Inventory inventory is replaced
during the period.
Average Age of 360 days It indicates the average
Inventory* Inventory Turnover number of days during
(Inventory Conversion which the company
Period) must wait before the
(Days’ Sales in inventories are sold.
Inventory)
Raw Materials Turnover Cost of Materials Used
Average Raw Materials Inventory
Work in Process Turnover Cost of Goods Manufactured
Average Work in Process Inventory
Finished Goods Turnover Cost of Goods Sold
Average Finished Goods Inventory
 Normal Operating Cycle Average Age of Inventory +
Average Age of Receivables
Trade Payables Turnover Net Credit Purchases
Average Trade Payables
Average Age of Trade 360 days It indicates the length of
Payables Payables Turnover time during which
(Payable Deferral payables remain
Period) unpaid.
(Days’ Purchases in
Payables)
Current Assets Cost of Sales + It measures the
Turnover Operating Expenses ** movement qnd
Average Current Assets utilization of current
assets to meet
operating
requirements.
* In some accounting and finance texts, average inventory age is also called
as the average sales period.
** Operating Expenses exclude depreciation, amortization and other
expenses related to long-term assets.

• TESTS OF SOLVENCY (Solvency refers to the ability of company to pay

its debts)
These ratios involve leverage ratios. ‘Leverage’ refers to how much of
company’s resources are financed by debt and/or preferred equity, both
of which require fixed payment of interests and dividends.
Times Interest Earned EBIT It determines the extent
Interest Expense to which operations
cover interest expense.
Debt-Equity Ratio Total Liabilities Proportion of assets
Total Equity provided by creditors
compared to that
provided by owners.
Debt Ratio Total Liabilities Proportion of total
Total Assets assets provided by
creditors.
Equity Ratio Total Equity Proportion of total
Total Assets assets provided by
owners.

• TESTS OF PROFITABILITY
Return on Sales Income Determines the portion
Net Sales of sales that went into
company’s earnings.
 Return on Assets Income Efficiency with which
Average Assets assets are used to
operate the business.

What INCOME figure should be used?

▪ If the intention is to measure operational performance, income is
expressed as before interest and tax; alternatively, income before ‘after-
tax’ interest may be used to exclude the effect of capital structure.
▪ If the intention is to evaluate total managerial effort, income is
expressed after interest and tax.

Return on Equity Income Measures the amount

Average Equityearned on the owners’
or stockholders’
investment.
Earnings Per Share Net Income – Preferred Measures the amount of
Dividends net income earned by
WACSO each common share.
WACSO – Weighted Average Common Shares Outstanding

• MARKET TESTS
Price-Earnings (PE) Price Per Share It indicates the number
Ratio Earnings Per Share of pesos required to buy
P1 of earnings.
Dividend Yield Dividend Per Share Measures the rate of
Price Per Share return in the investor’s
common stock
investments.
Dividend Pay-Out Dividend Per Share It indicates the
Earnings Per Share proportion of earnings
distributed as dividends.

OTHER MEANINGFUL RATIOS

• RATIOS USED TO EVALUATE LONG-TERM FINANCIAL POSITION OR

STABILITY
Fixed Assets to Fixed Assets Measures the
Total Equity Total Equity proportion of owners’
equity to fixed assets.
Indicative of over or
under investment by
owners and weakness
in trading on the
equity*
 Fixed Assets to Fixed Assets (Net) Indicates possible over-
Total Assets Total Assets expansion of plant and
equipment.
Sales to Fixed Net Sales Tests roughly the
Assets Fixed Assets (Net) efficiency of
(Plant Turnover) management in keeping
plant properties
employed.
Book Value Per Common Shareholders’ Equity Measures recoverable
Share – Common Common Shares Outstanding amount by common
Stock stockholders in the
event of liquidation if
assets are realized at
their book values.
Times Preferred Net Income After Taxes It indicates ability to
Dividend Earned Preferred Dividends provide dividends to
preferred stockholders.
Capital Intensity Total Assets Measures efficiency of
Ratio Net Sales the firm to generate
sales through
employment of its
resources.
Times Fixed Net Income before taxes & Measures ability to
Charges Earned fixed charges meet fixed charges.
(Fixed Charges + sinking fund
payment)**
* ‘Trading on the equity’ is another name for leverage.
** Fixed charges shall include rent, interests and other relevant fixed
expenses; sinking fund payment must be expressed before tax.

• TESTS OF OVER-ALL SHORT-TERM SOLVENCY OR SHORT-TERM

FINANCIAL POSITION
Working Capital Net Sales Indicates adequacy of
Turnover Average Working working capital to
Capital support operation
(sales)
Defensive Interval Current Liabilities Measures coverage of
Ratio Cash & Cash current liabilities.
Equivalents
Payable Turnover Net Purchases Measures efficiency of
Average Accounts the company in meeting
Payable the accounts payable.
Fixed Assets to Long- Fixed Assets Reflects extent of the
Term Liabilities Long-Term Liabilities utilization of resources
 from long-term debt.
Indicative of sources of
additional funds.

• RATIOS INDICATIVE OF INCOME POSITION

Rate of Return on Income Measures the
Average Current Asset Average Current Assets profitabIlity of current
assets invested.
Operating Profit Margin Operating Profit Measures profit
Net Sales generated after
consideration of
operating costs.
Cash Flow Margin Operating Cash Flow Measures the ability of
Net Sales the firm to translate
sales to cash.