FSs Analysis and Interpretation 5

INDUSTRY-BASED LEARNING 1
Financial Statements Analysis and Interpretation
At the end of the lesson, you should be able to learn:
1. General objective of financial statements analysis

2. Analyze versus Interpret
3. Cardinal rules to be followed
4. Limitations of the financial statements
5. Kinds of Financial Ratios and use of ratio analysis
6. Techniques in analyzing financial statements
IN THE LAST LESSON, WE LEARNED….
Financial Statements
Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Financial Position
Statement of Cash Flows
FINANCIAL STATEMENTS ANALYSIS
General Objective
To evaluate the PAST performance of the business as a
whole for a given period of time as a basis for making
PRESENT and FUTURE plans or decisions.
It is important for the owners and managers of the
entity to be able to evaluate the results of all their
business activities. The analysis can help them:
Confirm past expectations
Evaluate present financial results
Predict future outcomes
Analyze versus Interpret

To ANALYZE means to develop significant financial ratios,
while to INTERPRET means to explain the significance of
the financial ratios developed.
Cardinal Rules to be followed (before interpreting the financial
ratios):
1. Develop a group of related financial ratios – a single ratio is
meaningless because it is an isolated ratio. It only becomes meaningful
after relating to other allied ratios.
2. Make comparison – In the analysis and interpretation of financial
statements, comparison is a must. Without comparison, no
interpretation can be made.
3. Be aware of the assumptions and limitations of financial statements –
The results of the analysis will depend on how reliable is the
information contained in the financial statements.
Limitations of the financial statements
1. The financial statements are not exact.
2. The financial statements are not yet final. They are merely
interim statements.
3. The statements are quantitative rather than qualitative.
4. Inflation is ignored.
5. Non-comparability of companies although they are engaged
in the same line or they belong to the same industry.
Kinds of Financial Ratios

Statement of Comprehensive Income Ratio – the ratio of one
item in the Statement of Comprehensive Income in the same
Statement of Comprehensive Income.
Example: Gross Profit rate – the ratio of the gross profit
to sales. (both items are found in the Statement of
Comprehensive Income)

Statement of Financial Position Ratio – the ratio of one item
in the Statement of Financial Position in the same Statement
of Financial Position.
Example: Current Ratio – the ratio of current assets to
the current liabilities. (both items are found in the
Statement of Financial Position)
 Inter-Statement Ratio – the ratio of one item in the
Statement of Comprehensive Income to another item in the
Statement of Financial Position.
Example: Accounts Receivable Turnover – the ratio of
net credit sales to the average accounts receivable. (The
sales revenue is shown in the Statement of
Comprehensive Income, while the accounts receivable
item is shown in the Statement of Financial Position)

 Trend Ratio – the ratio of one item in the same item.
Example: the ratio of sales this year compared to the
sales last year.
Use of Ratio Analysis:
1. It provides an indication of the firm’s financial strengths
and weaknesses and should generally be used in
conjunction with other evaluation techniques.
2. Ratios are useful tools in the analysis of financial
statements because they summarize data in a form easy to
understand, interpret, and compare.
SPECIFIC OBJECTIVES:
 The results of the analysis should be able to determine the following:
 LIQUIDITY – the ability of the company to convert non-cash current
assets into cash.
 SOLVENCY – the ability of the company to pay liabilities on time. A
company which cannot pay on time is said to be “technically
insolvent”. Solvency is of two types:
 Short-term Solvency – which is the ability to pay current
liabilities.
 Long-term Solvency – which is the ability to pay principal on
SPECIFIC OBJECTIVES:
STABILITY – the ability to withstand financial reverses.
PROFITABILITY – the ability to generate adequate
profits to sustain the operations of the business and earn
satisfactory return to the owners.
EFFICIENCY – the ability to manage the business
effectively and meet the goals and objectives.
TECHNIQUES IN ANALYZING FSs:

1. Comparative Statements – The presentation of comparative
financial statements for the current and prior periods, allows
the user or reader to compare the changes in the individual
items.
2. Horizontal Analysis – Under this technique, each item in the
financial statements of the current period is compared with the
previous period. The increase or decrease in peso amount will
be expressed in percentage or as a ratio to be more meaningful.
3. Vertical Analysis – Under this technique, the ratio of each
item in the financial statements to a certain base item is
obtained and is expressed in percentage. In the Statement of
Comprehensive Income the base item is the net sales. In the
Statement of Financial Position, the base item is the total
assets.
Statements, which show only the COMPONENT
PERCENTAGES of each item without the corresponding
amount is called “COMMON SIZE STATEMENTS”

4. Dynamic Ratio Analysis or Analysis through ratio
interpretation
THE FOLLOWING ARE DYNAMIC FINANCIAL
RATIOS:
(see print-out copies)

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INDUSTRY-BASED LEARNING 1

Financial Statements Analysis and Interpretation

At the end of the lesson, you should be able to learn:

1. General objective of financial statements analysis

Analyze versus Interpret

Kinds of Financial Ratios

Kinds of Financial Ratios

Kinds of Financial Ratios

TECHNIQUES IN ANALYZING FSs:

TECHNIQUES IN ANALYZING FSs:

(see print-out copies)

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