\

MODULE 2

ANALYSIS OF FINANCIAL STATEMENTS

Learning Objectives:

At the end of this module, you will be able to:

1. Understand the importance of Financial Statement analysis for management
decision making.
2. Have a good understanding of Horizontal, Vertical and Ratio analysis
3. Use financial ratios to analyze the business liquidity, profitability, asset
management, debt management and market value
4. Use a summary of financial ratios and Dupont system of analysis to perform the
complete ratio analysis\
5. Know the importance of comparing the performance of the company using the
financial ratios against its years of operation (time series analysis) and against
other companies in the same industry (Cross sectional analysis).

INTRODUCTION

Looking into the financial statements will give readers a glimpse of how business
performed, what its resources and obligations are and how much claim does an
owner have on these resources. The figures we see in the financial statements are
more than just the peso value amounts. There are stories beyond these numbers.
In any case, these stories are more interesting as they give us insights meaningful
enough to strategize the next business move. They paint the picture of fhe of the
character of the management. It could reveal what went wrong, enabling decision
makers to take actions to avoid the same in the future. The value of the financial
statement for management lies heavily on one’s ability to interpret them.
This module will allow learners to appreciate and understand the different
technique in analyzing financial statements, in the hope that they will apply these
techniques to interpret financial reports for management decision making.

Explain: Analysis of Financial Statement

In this part of the module, we will be going deep into the line items of the
financial statements. We will now focus on what the ratios really mean and how will
they be used to analyze the performance of the company (the interpretation part).
Before going through this part of the module, make sure to read the assigned
readings from pages 110-139 (Essentials of Financial Management 4th Edition by
Brigham, et al. (2019)
\
\

FINANCIAL STATEMENT ANALYSIS:

Is the process of extracting information from financial statements to better
understand a company’s current and future performance and financial conditions. An
in-depth study of the different figures found in the financial statements.

TYPES OF ANALYSIS OF FINANCIAL STATEMENT:

1. Horizontal (Time Series) Analysis
2. Vertical (Common Size) Analysis
3. Financial Ratio Analysis

Horizontal (Time Series) Analysis

(Text adopted
from: https://www.accountingformanagement.org/horizontal-analysis-of-financial-stat
ements/)
Horizontal analysis (also known as trend analysis) is a financial statement analysis
technique that shows changes in the amounts of corresponding financial statement
items over a period of time. It is a useful tool to evaluate the trend situations.
The statements for two or more periods are used in horizontal analysis. The earliest
period is usually used as the base period and the items on the statements for all later
periods are compared with items on the statements of the base period. The changes
are generally shown both in dollars and percentage.
Dollar and percentage changes are computed by using the following formulas:

Horizontal analysis may be conducted for balance sheet, income statement,

schedules of current and fixed assets and statement of retained earnings.

An example of the horizontal analysis of balance sheet is given below:

\
\

Comparative balance sheet with horizontal

analysis:

Vertical (Common Size) Analysis

(texts adopted
from: https://www.accountingformanagement.org/vertical-analysis-of-financial-state
ments/ (Links to an external site.))

Vertical analysis (also known as common-size analysis) is a popular method of

financial statement analysis that shows each item on a statement as a percentage of
a base figure within the statement.
To conduct a vertical analysis of balance sheet, the total of assets and the total of
liabilities and stockholders’ equity are generally used as base figures. All individual
assets (or groups of assets if condensed form balance sheet is used) are shown as a
percentage of total assets. The current liabilities, long term debts and equities are
shown as a percentage of the total liabilities and stockholders’ equity.
\
\

To conduct a vertical analysis of income statement, sales figure is generally used as

the base and all other components of income statement like cost of sales, gross profit,
operating expenses, income tax, and net income etc. are shown as a percentage of
sales.
In a vertical analysis the percentage is computed by using the following formula:
Percentage of base = (Amount of individual item/Amount of base item) × 100
A basic vertical analysis needs an individual statement for a reporting period but
comparative statements may be prepared to increase the usefulness of the analysis.
An example of the vertical analysis of income statement is given below:
Comparative income statement with vertical analysis:

*Cost of goods sold:

2018: (1,043,000/1,498,000) × 100 = 69.6%
2017: (820,000/1200,000) × 100 = 68.3%
Vertical analysis states financial statements in a comparable common-size format
(percentage form). One of the advantages of common-size analysis is that it can be
used for inter-company comparison of enterprises with different sizes because all
items are expressed as a percentage of some common number.
\
\

FINANCIAL RATIO ANALYSIS

Also known as Ratio Analysis is the most applied ways of analyzing the financial
statements. This involves methods of calculating and interpreting figures in the
financial statements based on the use ratios or relative values. It expresses the direct
relationship between two or more quantities in the balance sheet and income
statement.

Why are Financial Ratios Useful?

 Ratios standardize numbers and facilitate comparisons.

 Ratios are used to highlight weaknesses and strengths.
 Ratio comparisons should be made through time and with competitors.
 Industry analysis:

 Benchmark (peer) analysis

 Trend analysis

Types of Ratio Comparison

Ratio analysis is not merely the calculation of given ratio. More important is the
interpretation of the ratio value. A meaningful basis for comparison is needed to
answer such questions as “Is it too high or too low?” and “Is it good or bad?”Two
types of ratio comparison can be made:
Cross-Sectional Analysis - involves the comparison of the different firms’
financial ratios at the same point in time. This will show how a company has
performed in relation to other firms in the same industry. Frequently, a firm will
compare its ratio values to those key competitors or group of competitors that it
wishes to emulate. This type of cross-sectional is called Benchmarking.
Time-Series Analysis - evaluates performance overtime. Comparison of current
to past performance, using ratios, enables analysts to assess the firm’s progress.
Developing trends can be seen by using multi-year comparison. Time=series
analysis is also called Trend Analysis

Five Major Categories of Ratios and the Questions They Answer

 Liquidity: Can we make required payments?

 Asset management: Right amount of assets vs. sales?
 Debt management: Right mix of debt and equity?
 Profitability: Do sales prices exceed unit costs, and are sales high enough
as reflected in PM, ROE, and ROA?
 Market value: Do investors like what they see as reflected in P/E and M/B
ratios?
\
\

Summary of the Formula

Market Value Ratios

Type Formula Purpose
Earnings per share = Net Income/ No. of common shares relate the firm’s market
outstanding value, as measured by its
current share price to
certain accounting values.
Gives insight as to how well
investors in the
marketplace the firm is
doing in terms of risk and
return
Price- Earnings Ratio = Market Price per share/Earnings per
share
Market-Book value = Market Price per share/Book value per
ratio share
\
\
\
\

Analyzing and Interpreting Ratios

Meaning of Analysis
Analysis means the process of splitting or broken up of the contents of financial
statements into
many parts for getting meaningful information at the maximum.

Meaning of Interpretation
Interpretation means explaining the meaning and significance of the rearranged
and/or modified data of the financial statements.
\
\

Procedure for Analysis and Interpretation

To make an effective analysis and interpretation of financial statements, the following
groundwork are required to be completed.

1. The objectives of financial statement analysis is the basis for the selection of
techniques of analysis. Hence, the organization should decide the purpose of
financial statement analysis.
2. The extent of interpretation is also decided to select right type of techniques of
financial statement analysis.
3. The financial statements are prepared on certain assumptions, principles and
practices which are ascertained to understand their significance.
4. Additional information required for the work of interpretation should be collected
properly.
5. The collected data should be presented in a logical sequence by rearrangement of
data.
6. Data should be analyzed for preparing comparative statement, common size
statement, trend percentage, calculation of ratios and the like.
7. General market conditions and economic conditions are taken into consideration
for analyzing and interpreting the collected facts.
8. Interpreted data and information should be presented in a suitable report form.

Objectives of Analysis and Interpretation

Many interested parties of financial statements are analyzed and interpreted
according to their varied objectives. In spite of the variations in the objectives of
analysis and interpretation by various classes of people, there are some common
objectives of interpretation which are presented below.

1. To examine the earning capacity and efficiency of various business activities with
the help of income statements.
2. To measure the managerial efficiency under various business situations.
3. To estimate the performance evaluation of different departments over a period of
time.
4. To measure short term and long term solvency position of the business
organization with the help of Balance Sheet.
5. To examine the source of finance and way of utilizing the available finance.
6. To determine earning capacity and future prospects of the business concern.
7. To identify the way of utilizing fixed assets and the role of fixed assets on
maintaining the earning capacity of the business concern.
8. To investigate the future potential of the business concern.
9. To compare operational efficiency of similar concerns engaged in the same
industry.
10. To identify the growth trend of the business organization.
\
\

THE DUPONT EQUATION (FORMULA)

The DuPont system first brings together the net profit margin, which measures
the firm profitability on sales, with its total assets turnover, which indicates how
efficiently the firm has used its to generate sales. In DuPont formula, the product of
these two ratios result in the return of total assets (ROA}. Multiplying ROA to
Equity multiplier (Total assets/Total equity) will result to return in Equity (ROE)

ROA = Net profit margin xTotal assets turnover

Net Income/Sales x Sales/Total Assets

ROE = Net profit margin x Total asset turnover x Equity multiplier

Net income/Sales x Sales/Total assets x Total assets/Equity

LEARNING TASK I
Instructions:

1. Answer the tasks below.

2. This is a graded output.
3. Submission due Date: October 13
4. Submit using an electronic format (MS Word, Excel or PDF) or write on a yellow paper and take a
photo.

Part 1. Answer the following problems found in chapter 4 of your textbook:

1. Problem 4 – 1, page 142

2. Problem 4 – 4, page 143
3. Problem 4 – 9, page 143
4. Problem 4 – 15, page 144
5. Problem 4 – 16, page 144
6. Problem 4 – 20, page 145
7. Problem 4 – 21, page 145
8. Problem 4 – 22, page 145
\
\

Part 2. Using the given financial statement for Midwest Tours, prepare the following:

1. Common Size Income Statement for 2009 (Vertical Analysis); and

2. Horizontal / Trend Analysis for 2009 Balance Sheet, using 2008 as base figures.
\
\

ELABORATE; LEARNING TASK 2

The previous discussions have already given us a concrete background on performing financial statement
analysis. At this point, you are tasked to answer a case study as a group. The reporting group should be
able to present the work in class. Other groups also need to prepare the case and must be able to
participate in the synchronous discussion.

Instructions:

1. Answer the case that follow. Process it using MS Office and submit a soft file. This is due on Oct.
15 at 5pm
2. This is an graded activity. (can be done individually, by pair or maximum of three persons)
3. Answer the guide questions given in the case with supporting computations if required.
4. The case will be discussed on the Synchronous meeting on Oct. 15 by the reporting groups

Case Study #1: Bigger Isn’t Always Better!

Andre Pires opened his automobile parts store, Quickfix Auto Parts, five years ago, in a
mid-sized city located in the mid-western region of the United States. Having worked for an automobile
dealership, first as a technician, and later as the parts department manager, for over 15 years, Andre
had learned the many nuances of the fiercely competitive automobile servicing business. He had
developed many contacts with dealers and service technicians, which came in really handy when
establishing his own retail store. Business had picked up significantly well over the years, and as a
result, Andre had more than doubled his store size by the third year of operations. The industry and
local forecasts for the next few years were very good and Andre was confident that his sales would
keep growing at or above recent levels.
However, Andre had used up most of his available funds in expanding the business and was well
aware that future growth would have to be funded with external sources of funds. What was worrying
Andre was the fact that over the past two years, the store’s net income figures had been negative, and
his cash flow situation had gotten pretty weak (See Tables 1 and 2). He figured that he had better take
a good look at his firm’s financial situation and improve it, if possible, before his suppliers found out.
He knew fully well that being shut out by suppliers would be disastrous!
Andre’s knowledge of finance and accounting, not unlike many businessmen’s, was very limited.
He had often entertained the thought of taking some financial management courses, but could never
find the time. One day, at his weekly bridge session, he happened to mention his problem to Tom
Andrews, his long-time friend and bridge partner. Tom had often given him good advice in the past
and Andre was desperate for a solution. “I’m no finance expert, Andre”, said Tom, “but you might want
to contact the finance department at our local university’s business school and see if you can hire and
MBA student as an intern. These students can often be very insightful, you know.”
That’s exactly what Andre did. Within a week he was able to recruit Juan Plexo, a second
semester MBA student, who had an undergraduate degree in Accountancy and was interested in
concentrating in Finance. When Juan started his internship, Andre explained exactly what his
concerns were. “I’m going to have to raise funds for future growth, and given my recent profit situation,
the prospects look pretty bleak. I can’t seem to put my finger on the exact cause. The bank’s
commercial loan is going to want some pretty convincing arguments as to why they should grant me
the loan. I need to put some concrete remedial measures in place, and was hoping that you can help
sort things out, Juan,” said Andre. “I think I may have bitten off more than I can currently chew.”
\
\

Table 1

Quickfix Autoparts
Balance Sheets

ASSETS 2000 2001 2002 2003 2004

Cash and Marketable Securities $155,000 $309,099 $75,948 $28,826 $18,425

Accounts Receivable 10,000 12,000 20,000 77,653 90,078
Inventory 250,000 270,000 500,000 520,000 560,000

Current Assets $415,000 $591,099 $595,948 $626,479 $668,503

Land, Buildings, Plant, and Equipment $250,000 $250,000 $500,000 $500,000 $500,000
Accumulated Depreciation (25,000) (50,000) (100,000) (150,000) (200,000)
Net Fixed Assets $225,000 $200,000 $400,000 $350,000 $300,000

Total Assets $640,000 $791,099 $995,948 $976,479 $968,503

LIABILITIES AND EQUITIES
Short-term Bank Loans $50,000 $145,000 $140,000 $148,000 $148,000
Accounts Payable 10,000 10,506 19,998 15,995 16,795
Accruals 5,000 5,100 7,331 9,301 11,626

Current Liabilities $65,000 $160,606 $167,329 $173,296 $176,421

Long-term Bank Loans $63,366 $98,000 $196,000 $190,000 $183,000

Mortgage 175,000 173,000 271,000 268,000 264,000
Long-term debt $238,366 $271,000 $467,000 $458,000 $447,000

Total Liabilities $303,366 $431,606 $634,329 $631,296 $623,421

Common Stock (100,000 shares) $320,000 $320,000 $320,000 $320,000 $320,000

Retained Earnings 16,634 39,493 41,619 25,184 25,082

Total Equity $336,634 $359,493 $361,619 $345,184 $345,082

Total Liabilities and Equity $640,000 $791,099 $995,948 $976,480 $968,503

\
\

Table 2

Quickfix Autoparts
Income Statements

2000 2001 2002 2003 2004

Net Sales $600,000 $655,000 $780,000 $873,600 $1,013,376
Cost of Goods Sold 480,000 537,100 655,200 742,560 861,370
Gross Profit $120,000 $117,900 $124,800 $131,040 $152,006

Admin and Selling Exp $30,000 $15,345 $16,881 $43,680 $40,535

Depreciation 25,000 25,000 50,000 50,000 50,000
Miscellanous Expenses 2,027 3,557 5,725 17,472 15,201
Total Operating Expenses $57,027 $43,902 $72,606 $111,152 $105,736
EBIT $62,973 $73,998 $52,194 $19,888 $46,270
Interest on ST Loans 15,000 15,950 14,000 13,320 13,320
Interest on LT Loans 8,000 7,840 15,680 15,200 14,640
Interest on Mortgage 12,250 12,110 18,970 18,760 18,480
Total Interest $35,250 $35,900 $48,650 $47,280 $46,440
Before-tax earnings $27,723 $38,098 $3,544 ($27,392) ($169)
Taxes 11,089 15,239 1,418 (10,957) (68)
Net Income $16,634 $22,859 $2,126 ($16,435) ($102)
Dividends on Stock 0 0 0 0 0
Addition to Retained Earnings $16,634 $22,859 $2,126 $16,435 $102
EPS (100,000 shares) $0.17 $0.23 $0.02 ($0.16) ($0.00)

Questions:
1. How does Quickfix’s average compound growth rate in sales compare with its earnings growth rate
over the past five years?
2. Which statements should Juan refer to and which ones should he construct so as to develop a fair
assessment of the firm’s financial condition? Explain why?
3. What calculations should Juan do in order to get a good grasp of what is going on with Quickfix’s
performance?
4. Juan knows that he should compare Quickfix’s condition with an appropriate benchmark. How
should he go about obtaining the necessary comparison data?
5. Besides comparison with the benchmark what other types of analyses could Juan perform to
comprehensively analyze the firm’s condition? Perform the suggested analyses and comment on your
findings.
6. Comment on Quickfix’s liquidity, asset utilization, long-term solvency, and profitability ratios. What
arguments would have to be made to convince the bank that they should grant Quickfix the loan?
7. If you were the commercial loan officer and were approached by Andre for a short-term loan of
$25,000, what would your decision be? Why?
8. What recommendations should Juan make for improvement, if any?
9. What kinds of problems do you think Juan would have to cope with when conducting a
comprehensive financial statement analysis of Quickfix Auto Parts? What are the limitations of
financial statement analysis in general?
\
\