Common-size financial statements translate peso amount to percentages, which indicates the

relative size of an item in proportion tho the whole. Common-size statements of financial position
show asset, liabilities, and owners’ equity as percentage of total assets while common-size income
statements express revenue and expenses as a percentage of sales revenues. The preparation of
common-size statements is know as vertical analysis.

Purposes

Common-size statements also known as “Component percentage” or”100 percent” statements

enable to analyst to:

1. Comprehend or visualized the changes in individual items that have taken place from year
to year in relation in the total assets, total liabilities ans owners’ equity or net sales.

2. Compare statements of two or more companies or statement of one company with the
statements of an entire industry and evaluate their current financial position and
operating results.

3.

Guidelines in the Interpretation of Common-size Statements

Statement of Financial Position

1. A common-size statement if financial position shows the percent of total assets

that has been invested in each type or kind of asset. These percentage may
be compared with those of a competitor or the industry to determine whether or
not firm has over or under-invested in one or more of its assets. This should
however, be supplemented by turn over or other statistics before final
conclusion can be drawn.

2. The common-size statement will also show the distribution will also show the
distribution of liabilities and equity, I.e., the sources of the capital invested in
the assets. This will indicate whether or not the company is highly levered or too
large a percentage of the total assets have been obtained from creditors. Debt
pressure for he company and a low margin of safety for creditors may also be
revealed.

3. The percentage of current assets may also be related to the percentage of

current liabilities to determine debt-paying capacity of the company.

Income Statement

1. The common-size income statement shows the amount or percentage of the

sales that has been absorbed by each individual cost or expense item and the
percentage that remains as net income.
 2. A comparison of year-to-year income statement common-size ratios will show
whether a larger or smaller relative amount of net sales was used to meet particular
costs or expenses. These percentages may also be compared with a competitor’s
statements to determine in order effect a higher profit margin.

Financial Ratio Analysis

A financial ratio is a comparison in friction, proportion, decimal or percentage form of two

significant figure taken from financial statements. It expresses the direct relationship between
two or more quantities in the statement of financial position and income statement of a
business firm.

Purpose

Through ratio analysis, the financial statements user comes into possession of measures which
provide insight into the profitability of operations, the soundness of the firm’s short-term and
long-term financial condition and the efficiency with which management has utilized resources
entrusted to do it.

Limitations of Financial Ratios

1. Ratios must be used only as financial tools, that is, as indicators of weakness or strength or
not to be regarded as good or bad per se.

2. Financial ratios are generally computed directly from the company financial statements,
without adjustment. Conventional financial statements prepared in accordance with PFRS
have a number of weaknesses that managers must consider if the ratio as are to be
meaningful.

3. Ratios are a composite of many different figures - some covering a time period, others an
instant time and still others representing averages.

4. Ratios to be meaningful should be evaluated with the use of certain yardsticks. The most
common of these are:

a. Company’s own experience (prior years)

b. Other companies in the same industry (industry average)

c. A standard set by management (a budget)

d. Rules of thumb

Financial Ratio Analysis

Liquidity ratios are ratios that measures the firm’s ability to meet cash needs as they arise.

Activity ratios are ratios that measure the liquidity of specific assets and efficiency in managing
assets such ad accounts receivable, inventory and fixed assets.
Leverage ratios are ratios that measures the extent of a firm’s financing, with debt relative to equity
and its ability to cover interest and other fixed charges such as rent and sinking fund payments.

Profitability ratios are ratios that measures the overall performance of the firm and its efficiency
managing assets, liabilities and equity.

I. Analysis of Liquidity or Short-term Solvency

Current Ratio

Formula: Current Assets

Current Liabilities

Current ratio is widely regarded as measure of short-term debt-paying ability. Current liabilities are
used the denominator because they are considered to represent the most urgent debts requiring
retirement within one year or one operating cycle. A declining ration could indicate a deteriorating
financial condition or it might be the result of paring of obsolete inventories or other stagnant
current assets. An increasing ratio might be the result of an unwise stock piling of inventory or it
might indicate an improving financial situation. The current ratio is useful but tricky to interpret and
therefore, the analyst must look closely and the individual assets and liabilities involved.

Quick or Acid Ratio

Formula: Quick Assets

(Cash+Marketable securities+ Accounts Receivable,net)

Current Liabilities

The acid-test (quick) ratio is much more rigorous test of a company’s ability to meet its short-term
debts. Inventories are prepared expenses are excluded from total current assets leaving only the
more liquid assets to be divided by current liabilities. This is designed measure how well a company
can meets its obligations without having to liquidate or depend too heavily on its inventory. Since
inventory is not an immediate source of cash and may nit even be saleable in times of economic
stress, it is generally felt that to be properly protected, each peso of liabilities should be backes by at
least P1 of quick assets.

Cash-Flow Liquidity Ratio

 Formula: Cash+Marketable Securities+

Cash Flow from Operating Activities

Current Liabilities

The cash flow liquidity ratio considers cash floe from operating activities )from the statement of cash
flows) in addition to the truly liquid assets, cash and marketable securities.

II. Analysis of Assets Liquidity and Asset Management Efficiency

Accounts Receivable Turnover

Formula: Net Sales*

Average Account Receivable balance

The accounts receivable turnover roughly measures how many times a company’s accounts
receivable have been turned into cash during the year.

Average Collection Period

Formula: 365

Accounts Receivable Turnover

Or

Average Accounts Receivable

Average daily sales

The average collection period helps evaluate the liquidity of accounts receivable and the firm’s cedit
policies. The long collection period may be a result of the presence of many old accounts of doubtful
collectibility, or it may be result of poor day-today credit management such as inadequate checks on
customers or perhaps no follow-ups are being made on show accounts. There could be other
explanations such as temporary problem caused by a depressed economy.

Inventory Turnover
 Formula: Cost of good sold

Average Inventory balance

Theaverage turnover measures the efficiency of the firm in managing and selling inventory. It is
computed dividing the cost of good sold by the average level of inventory on hand. The ratio is
sometimes calculated with net sales as the numerator and the average level of the inventory as the
denominator.

Average Sale Period

Formula: 365 days

Inventory turnover

The number of days being taken to sell the entire inventory one time(called the average sale or
conversion period) is computes by dividing 365 days by the inventory turnover period. Generally, the
faster inventory sells, the fewer the finds are tied up in inventory and more profits are generated.

Fixed Asset Turnover

Formula: Net Sales

Average net property, plant and equipment

The fixed asset turnover is another approach to assessing management’s effectiveness on generating
sales form investments in fixed assets particularly for a capital-intensive firm.

Total Asset Turnover

Formula: Net sales

Average Total Assets

The total asset turnover is a measure of the efficiency of management to generate sales and thus
earn more profit for the firm. When the asset turnover ratios are low relative to the industry of the
firm’s historical record. It could mean that either be investment in assets is too heavy or sales are
sluggish. They may however be justification for the low turnover.
III. Analysis of Leverage : Debt Financing and Coverage

Debt ratio

Formula: Total Liabilities

Total Assets

The debt ratio measures the proportion of all assets that are financed with debt. Generally, the
higher the proportion of debt, the greater the risk because creditors must be satisfied before owners
in the event of bankruptcy.

The use debt involves risk because debt carries a fixed obligation in the form of interest charges and
principal repayment. Failure to satisfy the fixed charges associated with debt will ultimately result in
bankruptcy.

Debt Equity Ratio

Formula: Total Liabilities

Total Equity

The debt equity ratio measures the riskiness of the firm’s capital structure in terms of relationship
between the funds supplied by creditors (debt) and investors (equity).

Times Interest Earned

Formula: Operating profit

Interest Expense

Times interest earned ratio is the most common measure of the ability of a firm’s operations to
provide protection to long-term creditors. The more times a company can cover its annual interest
expense from operating earnings, the better off will be the firm’s investors.

Fixed Charge coverage

 Formula: Operating Profit + Lease payments

Interest Expense + lease payments

The fixed charge coverage the firm’s coverage ability to cover not only interest payments but also the
fixed payment associated with leasing which must be met manually. This ratio is particularly
important for firms that operate extensively with leasing arrangements, whether operating leases or
capital leases.

IV. Operating Efficiency and Profitability

Gross Profit Margin

Formula: Gross Profit

Net Sales

Gross profit margin which shows relationship between sales and the cot of product sold, measures
the ability of a company both to control costs and inventories or manufacturing of products and to
pass along price increases through sales to customers.

Operating Profit Margin

Formula: Operating profit

Net sales

The operating profit margin is a measure of overall operating efficiency and incorporated all of the
expenses associated with ordinary or normal business activities.

Net Profit Margin

Formula: Net Income

Net sales

Net profit measures profitability after considering all revenue and expenses, including interest, taxes
and non-operating items such as extaordianry items, cumulative effect accounting chaged, etc.
Cash flow Margin

Formula: Cash flow from operating activities

Net Sales

Cash flow margin in another important measure or perspective on opersting performance. This
measures the ability of the firm to translate sales to cash to enable it ti service debt, pay dividends or
invest in new capital sales.

Return on Investment on Assets (ROA)

Formula: Net Income

Average Total Asset

If the firm has interest-bearing debt, ROA is computed using the following formula:

Net Income

Average total asset

Return on Equity (ROE)

Formula: Net Income

Average stockholer equity

Or

Return on Assets x Financial Leverage or Equity Multiplier*

*Equity Multiplier = 1

Equity ratio

Return on Assets and Return on equity are two ratios that measures the overall efficiency of the firm
in mangaing its tiatal investment in assets and in generating return to shareholders. These ratios
indicate the amount of profit earned relative to the level of investment of common shareholders.

Financial leverage is computed as follows Return on equity

 Return on Assets

Other Ratios used to measure Returns to Investors

A. Earnings per share (EPS)

Formula:

Basic EPS = Net income

Weighted average number of

ordinary shares outstanding

Diluted EPS = Net income (as adjusted)

Weighted Average number

Of ordinary shares outstanding

and potential diluter

B. Price Earning Ratio (P/E)

Formula: Market Price Ordinary shares

Earnings per share

C. Dividend payout Ratio

Formula: Dividends per share

Earnings per share

D. Dividend Yield

Formula: Dividends per share

Market value per share