Analysis of financial

statements
Objectives in analysis of financial statements
 Financial statements are analyzed
to determine the profitability
of the business, its liquidity to
meet its obligations, safety of
investment in the business, and
effectiveness of its management.
Tools and techniques

1. Horizontal Analysis
2. Vertical Analysis
HORIZONTAL ANALYSIS
 The changes or behavior patterns of the
different items in the financial
statements of two or more years are
shown and it involves the use of :


 A) Comparative Statements
 B) Trend ratios and
 percentages
 ET Trading Corp.
Comparative Statement of Income
For the years ended December 31,200A and 200B

(Decrease)
200B 200A %
Sales 240,000 200,000 Increase
40 ,000 20%
Less: Cost of Sales 182,000 140,000 42,000 30%
Gross Profit 58,000 60,000
Amount
(2,000) (3.33%)
Less: Operating
Expenses:
Selling Expenses 17,000 18,000 (1,000) (6%)
Administrative 11,800 14,000 (2,200) (16%)
Operating Income 29,200 28,000 1,200 4.3%

Income tax (9,344) (8,960) 384 4.28%

Profit 19,856 19,040 816 4.29%

Column 3 / column 2
VERTICAL ANALYSIS
The relationship between the different items in
the financial statement for the same year are
pointed out with the use of Financial Ratios
PROFITABILITY RATIOS

- ratios that indicate the

profitability of a business,
involve net income and other
statement of income items.
Rate of Return on Sales

Formula: Significance :


 Net Income
 Indicates the
amount of net
 Net Sales income per peso of
sales or the
profitability
based on sales
Rate of Return on Total Assets
Formula Significance
 
 Net Income Indicates the
Average Total profitability in
the use of the
 Assets total assets or
total capital,
Total assets , beg . + both borrowed
total assets , end / 2 and invested
 Asset Turnover
Formula: Significance:
 
 Net Sales Indicates the rate at


which total capital

 Average Total is being used or the
 Assets efficiency in the use
 of total resources
Total assets beg + total
assets end / 2
 Ex. Co. X operates a supermarket while Co. Y operates a
department store. The following data are given:
Co. X Co. Y
Co. X Co. Y
Rate of
Net Sales 5M 5M Return on
Sales
250T/5M 5%
Net Income 250T 500T 500T/5M 10%
Total Assets: Asset
Turnover
5M/1M* 5 times
End 1.2M 2.3M 2.5 times
5M/2M**

Beg. 800T 1.7M Rate of Return

on Total
250T/1M 25%
Assets:
500T/2M 25%
*1.2 + 800T/2
**2.3 + 1.7 / 2
 Company X operates at a low margin and
therefore has low rate of return on sales
(5%). However, it is able to earn the same
rate of return on its total assets as Co. Y
does by having greater volume of sales in
relation to its total resources or by having
a higher asset turnover.
Gross Profit Ratio

  Indicates the gross

margin per peso of
 sales. Used in
determining the
 Gross Profit adequacy of gross
 Net Sales margin to cover
operating expenses
and provide desired
profit
 Operating Ratio


 Indicates what
portion of sales
Cost of Sales +

is absorbed by
Operating operating costs


Expenses
 Net
Sales
Rate of Return on Current Assets

 

  Indicates the
profitability in
 Net Income the use of
Average Current current assets.
Assets
Rate of Return on Working Capital*

 

  Indicates the
 Net Income profitability in
 Average Working the use of working
 Capital capital.


*Working Capital =
Current Assets –

Current Liabilities
Rate of Return on Owner’s Equity

 

  Indicates
profitability in
 Net Income the use of
 Average Owner’s invested capital
Equity or the amount of
return per peso
of owner’s equity
Earnings Per Share

 

 Net Income less  Indicates the

Preference Share amount of return
Dividend on each share of
 Requirement ordinary share
 No. of Ordinary
Shares Outstanding
Market Price to Book Value Per Share

 

 Market Price  Indicates whether

per Share the share is
 Book Value undervalued or
 per Share not
 LIQUIDITY RATIOS

provide information about a firm’s ability to

meet its short-term financial obligations

the more liquid are the assets of a company, the
greater is its ability to meet its current
obligations
 CURRENT RATIO
(Banker’s Ratio)
 

  Indicates the
 Current Assets ability to pay
 Current Liabilities current
obligations
 Analysis

Current ratio is positive when current assets exceed

current liabilities.

When current liabilities exceed current assets, the
ratio is negative, meaning, the company will not be
able to meet its maturing obligations.
 ILLUSTRATION

Current Ratio is 1 : 1
Total Current Assets 20,000
Total Current Liabilities 20,000
Current Ratio 1:1 or 100%
Current Ratio is Positive 2 : 1
Total Current Assets 20,000
Total Current Liabilities 40,000
2:1 or 200%
Current Ratio is Negative 1 : 2
Total Current Assets 10,000
Total Current Liabilities 20,000
Current Ratio 1:2 or 50%
 ACID TEST RATIO OR QUICK RATIO

 Indicates the ability to
Quick Assets* pay current
 Current Liabilities obligations from the

more liquid current
assets
*Cash, Marketable Securities,


Receivables
 Inventories are excluded
because of the
uncertainty as to
their saleability
Some analyst consider an acid test ratio of 100%
satisfactory



one acid-test ratio cannot be considered satisfactory for

all businesses


ratio for one company is preferably compared what is

typical for the specific trade or industry

Most of the inventory items may be considered more liquid
than some of the receivables because of the greater
volume of cash sales
 Current Assets to Total Assets

 
 
 Current Assets indicates the liquidity of
 Total Assets total assets


Some types of
businesses will have
higher investment in
PPE
 Ratio of Each Current Asset Item to Total
Current Assets

 

 

 Each Current Asset Item  Indicates the liquidity

 Total Current Assets of the total current
assets and the
distribution thereof
 ILLUSTRATION

X Co. Co. Ratio Industry

Ratio
Cash 12,000 10% 15%

Trading Securities 36,000 30% 10%

Receivables, net 12,000 10% 10%

Inventories 54,000 45% 60%

Prepaid Expenses 6,000 5% 5%

TOTAL 120,000
 Receivable Turnover
  Indicates the number of
times average amount

of receivables is
 Net Credit Sales collected during the
Average Receivables
period and the
efficiency in
collection


 A high turnover rate

indicates that
receivables are
collectible within a
shorted period
 Number of Day’s Sales in Average Receivables or Average Collection Period

 
 

 360
 Indicates the average
age of receivables or
 --------- the number of days to
 Receivable Turnover collect average
receivables
 Illustration:
Net Credit Sales 200,000  Receivable Turnover:
 Net Credit Sales
Accounts 35,000  Average Receivables
Receivable, Jan 1 

Accounts Receivable, 45,000  200,000

Dec 31
 40,000 5 times

Average Receivables = 35,000 + No. of days’ sales in

45,000/2 receivables

= 40,000 360/ 5 times = 72days

 The analyst should compare the
receivable turnover rate with the
turnover rate of accounts payable to
determine the gap between the
collection period and the length of
time before payables are paid so that
proceeds from sales can be used in the
payment of the latter.
Merchandise Inventory or Finished Goods
Turnover
 • Indicates the number of
times average inventory
 was sold during the
period and the over or
 Cost of Goods Sold (under) investment in
 Average Inventory inventory
Interpretation:
• A high turnover rate may
indicate that inventory levels
are too low
• On the other hand, low
turnover rates may
indicate that inventory
levels are too high so
that capital is
unnecessarily tied up in
inventories and the
company incurs more
storage costs
Work in Process Turnover
 •
 •
 • Indicates the number of
times average inventory
 Cost of Goods Manufactured was manufactured during
Average Work in Process the period and the length
Inventory of the manufacturing
process
Raw materials turnover
 •
 •
Raw Materials Used
  Indicates the number of
times average inventory was
 Average Raw Materials used and the sufficiency of
Inventory raw materials in stock
Number of Days’ Supply in Inventory

•
 360 • Indicates the
---------------------
number of days
 Inventory Turnover required to sell
or consume average
inventory
 Accounts Payable Turnover
• Payables Turnover: • Indicates the number of
times the amount of
• average payables is paid
 Net Credit Purchases during the period.
 Average Accounts Payable


 No , of Days ’ Purchases in
Average Payables


 360
 --------------------
 Payables Turnover
Illustration:
 Payables Turnover:
Purchases on 350,000  = 350,000 / 35,000
account 10 x
Accounts, net of 30,000 =


returns
Payable , and
Jan 1 40,000 
Accounts
allowancesPayable,  No. of Days’ Purchases in
Dec 31 Average Payables
 = 360 / 10x = 36 days


 * If suppliers grant
credit for 14 days , the
payables , on the average ,
are overdue by 22 days (
36 - 14 ).
Financial Leverage Ratio
 - provides an indication of the long-term
solvency of the firm

 Measures the extent to which the firm is using
long term-debt

 Measures stability or long-term solvency


Debt to Equity Ratio
 

 


 Measures the
proportion of
 Total Liabilities borrowed capital to
 Owner’s Equity invested capital
ILLUSTRATION


 Debt/Equity Ratio:


Total Liabilities 200,000

 Owner’s Equity 300,000


 = 66 2/3 %
Equity To Debt Ratio
 

 
 Owner’s Equity  Indicates the margin of
 Total Liabilities safety to creditors
PROPRIETARY OR Equity Ratio
 

  Indicates what
 Owner’s Equity portion of total
 Total Assets assets is provided
by owners or
shareholders
ILLUSTRATION

 Equity Ratio:

 Owner’s Equity 300,000
 Total Assets 500,000


 = 60%
A high equity ratio gives a business
entity the flexibility it needs in
times of poor economic condition.

 A rise in the equity ratio indicates an
improvement in the long-term financial
position of the company because of the
greater protection for creditors and the
reduced debt amortization and financing
charges.
A relatively low proprietary (or equity)
ratio may indicate that the company
has greater financial burden in the
form of the periodic amortization and
interest charges.
Debt Ratio or Total Liabilities to
Total Assets
 
  Indicates what portion
of total assets is
 Total Liabilities provided by
 Total Assets creditors or the
extent of trading in
equity
To what extent may trading on equity be
resorted to with safety?


 There is no definite limit to trading on equity
for it depends on a variety of factors such
as characteristics of the industry,
availability of working capital, liquidity of
assets, earning capacity of the company.
Plant , property and Equipment To Total
Owner ’ s equity
 

  Indicates the portion

of owner’s equity
 Total PPE invested in Plant,
Total Owner’s Equity
Property and
Equipment
PPE to Owner’s Equity


 PPE 350,000
------------- ----------- =1.16 2/3
Owner’s Equity 300,000 or 117 %


The owners financed 300,000 of the PPE with the 50,000



difference financed by creditors.

PPE to Long Term Liabilities
 
  Indicates the
 PPE* cover provided by
 ------------------ book value of PPE
to long-term debt.
 Total Long Term
Liabilities


 *based on book
values
Illustration

 PPE 350,000loan
-------------- ------------- = 3.5or
Long-Term Debt 100,000 350%


- There is a lien of 100,000 on the PPE of 350,000



and the difference of 250,000 may be considered

as a possible source of funds through long-term
borrowings when the need for the same arises.
PPE Turnover
 Indicates the efficiency
 in the use of property


 A low turnover rate may
 Net Sales indicate an over
Average PPE(net) investment in PPE or
management’s


ineffectiveness in the
use thereof.

 Rate should be compared
with the industry

COST – VOLUME - PROFIT ANALYSIS
 refers to the determination of the effects
of changes in volume on revenue, costs,
and profit

 It provides management with a desired tool
in the performance of its planning
function for estimates of revenue, cost
and profit.
 DEFINITION OF TERMS
 Breakeven Point

 Point at which sales is just enough to cover
total cost

 Point at which there is no profit nor loss

 Total sales are just enough to avoid a loss
Contribution Margin
 Refers to the contribution of a unit of product
to the absorption of fixed costs and to profit

 Contribution Margin = Selling Price –
 Variable Cost
Variable Costs
- vary in direct proportion to changes in
production or sales volume


Examples:
Direct Labor
Direct Materials
Salesmen’s Commission
Depreciation based on units of production
FIXED COSTS
Refers to cost items not affected by changes
in volume of production


Examples:
 Rent of space
 Depreciation under the straight line method
 Fixed salaries of employees

Mixed or Semi-Variable

Costs vary in amount but not in direct
proportion to changes in volume of
production

Example: Light and Power Expense

Direct Materials Cost

Refers to cost of materials that form an
integral part of the finished product and
can easily be included in calculating the
cost of the finished product.

Example: lumber in making
furniture
DIRECT LABOR COST

Refers to cost of labor expended directly on
goods being processed and can easily be
included in calculating the cost of the
finished product.

Example: Wages of sewers in garments
manufacturing.
MANUFACTURING OVERHEAD
COST

Refers to all manufacturing costs incurred in
production and not classified as either
direct labor or direct materials.

Example: Fuel and Oil
 Repairs and Maintenance
 ILLUSTRATION
 Co. X produces a single


BEP Sales Volume:
product and provides the Fixed Cost / Contribution


ff. data: Margin

 

 Unit Selling Price 30  = 60,000 / 12 = 5,000units



 Unit Variable Costs 18 


 BEP Sales :
 Total Fixed Costs= 60,000  Fixed Cost / Contribution

Margin %
 Contribution Margin / Unit : 

Selling Price – Variable Cost

 = 60 , 000 / 40 % = P150 , 000
 30 - 18 = 12  12 / 30



SALES WITH DESIRED PROFIT

 Fixed Cost + Desired
Profit
Peso Sales = -------------------------------
 Contribution Margin
%


 Fixed Cost + Desired Profit

Sales Volume= ------------------------------

 Contribution Margin per Unit

 ILLUSTRATION
 Co. X produces a single Peso Sales :


product and provides the  60,000 + 24,000

ff. data:  40%
= P210,000



 Unit Selling Price 30



Unit Variable Costs 18
Sales Volume :




Total Fixed Costs= P60,000

60,000 + 24,000




Desired Profit = P24,000

 12
Contribution Margin / Unit : 7,000 units



 =
Selling Price – Variable Cost

 30 - 18 = 12