Corner Leon Kilat and P.

del Rosario Streets, Cebu City, 6000, Cebu, Philippines

Telephone: 238-2380, 238-2381, 238-2384 Fax: 255-1773
Website: www.act.edu.ph E-mail Address: asian_college@yahoo.com

SENIOR HIGH SCHOOL DEPARTMENT

SLA No. 5: Financial Statement Analysis
Subject Code/Number: ABM05
Subject Title: Fundamentals of Accountancy, Business, and Management 2
Teachers: Maricel N. Oroc, Aries Venlym Tanola, LPT

I. Introduction

Hey, have you ever tried deciding on something without anyone helping you in the process? How does it feel? What
were the things you consider to arrive at a sound decision? In life, decision-making process is indeed a very crucial thing
to consider and even also in businesses, the same things apply. Now that you already have the knowledge about how to
prepare and read financial statements, the next logical step is now to analyze these statements to arrive at a sound
judgment. Ergo, it is really a must for you to read this SLA-5 and answer the activities after.

(These learning competencies are extracted from the DepEd curriculum guide)

A. Learning Competencies

1. Define the measurement levels, namely liquidity, solvency, stability and profitability
2. Perform horizontal and vertical analysis of financial statements of a sole proprietorship
3. Compute and interpret financial ratios, working capital, gross profit ratio, net profit ratio, receivable
turnover, inventory turnover, debt-to-equity ratio and the likes

B. Learning Outcome

1. Solve exercises and problems that require computation and interpretation using horizontal analysis, vertical
analysis and financial ratios
2. Using the downloaded sample financial statements, perform the horizontal and vertical analysis; compute
the various financial ratios and interpret it thereafter

II. Learning Content

LECTURE NOTES ON FINANCIAL STATEMENT ANALYSIS

Financial statement (FS) analysis is the process of evaluating risks, performance, financial health, and future prospects
of a business by subjecting financial statement data to computational and analytical techniques with the objective of
making economic decisions (White et.al 1998).

There are three kinds of FS analysis techniques:

- Horizontal analysis
- Vertical analysis
- Financial ratios
 HORIZONTAL ANALYSIS
It is also called trend analysis, is a technique for evaluating a series of financial statement data over a period of
time with the purpose of determining the increase or decrease that has taken place (Weygandtet.al 2013).
This will reveal the behavior of the account over time. Is it increasing, decreasing or not moving? What is the
magnitude of the change? Also, what is the relative change in the balances of the account over time?
- Horizontal analysis uses financial statements of two or more periods.
- All line items on the FS may be subjected to horizontal analysis.
- Only the simple year-on-year (Y-o-Y ) grow this covered in this lesson.
- Changes can be expressed in monetary value (peso) and percentages computed by using the following formulas:
• Peso change=Balance of Current Year-Balance of Prior Year
• Percentage change= (Balance of Current Year-Balance of Prior Year)/(Balance of Prior Year)

NOTA BENE: In a simpler statement, we can derive a formula for horizontal analysis as follows:
CURRENT YEAR AMOUNT-PREVIOUS YEAR AMOUNT
PREVIOUS YEAR AMOUNT

ILLUSTRATIVE EXAMPLE

The following information was taken from the comparative income statement of Lino Gaw Company for the year
2016 and 2017. Analyze the following using Horizontal Analysis.

2014 2015
SALES P175,000 P250,000
Cost of Sales (100,000) (125,000)
Gross Profit P75,000 P125,000

% change of SALES= CURRENT YEAR AMOUNT-PREVIOUS YEAR AMOUNT

PREVIOUS YEAR AMOUNT

= P250,000-175,000
175,000

% change of SALES= 42.86%

Interpretation: The sales in 2015 increased by P75,000 or 42.86% from the sales of the previous year

% change of COST of SALES= CURRENT YEAR AMOUNT-PREVIOUS YEAR AMOUNT

PREVIOUS YEAR AMOUNT

= P125,000-100,000
100,000

% change of COST OF SALES= 25%

Interpretation: The cost of sales in 2015 increased by P25,000 or 25% from the cost of sales of the previous year
% change of GROSS PROFIT= CURRENT YEAR AMOUNT-PREVIOUS YEAR AMOUNT
PREVIOUS YEAR AMOUNT

= P125,000-75,000
75,000

% change of GROSS PROFIT= 66.67%

Interpretation: The cost of sales in 2015 increased by P50,000 or 66.67% from the gross profit of the previous year

VERTICAL ANALYSIS
This is also called as the common-size analysis and it expresses each financial statement item as a percentage of a base
amount (Weygandt et. al., 2013)

For the Statement of Financial Position, the base amount is the TOTAL ASSETS. From the common-size financial
statement, the person looking at the FS can infer the composition of assets and the company’s financing mix

ILLUSTRATIVE EXAMPLE
 For the Income Statement, the base amount is *NET SALES
Balance of Account/ Net sales
This will reveal on how “NET SALES” is used up by various expenses
Net Income as a percentage of Sales is also known as net profit margin
*NET SALES is the residual amount after deducting SALES DISCOUNTS and SALES RETURNS & ALLOWANCES from the
amount of GROSS SALE

ILLUSTRATIVE EXAMPLE

WORKING CAPITAL
Working Capital is the difference between current assets and current liabilities. Let us say for example, if Mina
Thay’s current assets revealed an amount of P450,000 and its current liabilities amounted to P150,000 thus the
working capital is P300,000 (P450,000-P150,000). For obvious reasons, one should hope to find a positive amount of
working capital. If not, it may be an indication of financial stress.

RATIO ANALYSIS

DEFINITION OF TERMS
 Ratio is a mathematical expression of the relationship of one item to another. It provides an information of
how well the company and its business units are performing
 Turnover refers to the number of times an item is used or disposed of
ILLUSTRATIVE PROBLEM TO BE USED

The following are the condensed balance sheet and income statement taken from the records of Dina Eng’s Company
for the year ended December 31, 20xx

Dina Eng’s Company

Balance Sheet
As of the year ended December 31, 20xx

Cash P200,000 Accounts Payable P300,000

Accounts Receivable 400,000 Notes Payable 400,000
Inventory 250,000 Dina Eng, Capital 700,000
Equipment 550,000
TOTAL ASSETS P,1,400,000 TOTAL LIABILITIES AND EQUITY P1,400,000

Dina Eng’s Company

Income Statement
For the year ended December 31, 20xx

Sales P900,0000
Cost of Goods Sold (400,000)
Gross Profit P500,000
Operating Expenses (200,000)
Operating Income P300,000
Interest expense (80,000)
NET INCOME P280,000

1. PROFITABILITY RATIOS
These ratios measure the ability of the company to generate income from the use of its assets and invested
capital as well as control its cost. The following are the commonly used profitability ratios:

 GROSS PROFIT RATIO that reports the peso value of the gross profit earned for every peso sale. We
can infer the average pricing policy from the gross profit margin. This usually expressed as GROSS
PROFIT over NET SALES or Gross Profit per unit over Selling Price per Unit

 OPERATING INCOME RATIO that expresses operating income as a percentage of sales. It measures the
percentage of profit earned from each peso of sales in the company’s core business operations
(Horngren et. Al., 2013). A company with a high operating income ratio may imply a lean operation
and have low operating expenses. Maximizing operating income depends on keeping operating costs
as low as possible. This is usually expressed as OPERATING INCOME over NET SALES.

 NET PROFIT RATIO relates the peso value of the Net Income earned for every peso of sales. This
shows how much profit will go to the owner for every peso of sales made.

 RETURN ON ASSET (ROA) measures the peso value of income generated by employing the company’s
assets. It is viewed as an interest rate or as a form of yield on asset investment. The numerator of
ROA is NET INCOME. However, net income is allocated for the shareholders. On the other hand, asset
is allocated to both creditors and shareholders. There are two acceptable denominators for ROA, one
 is the ending balance of the total assets and the other is the amount of average assets during the year.
Average asset is computed as beginning balance plus ending balance divided by 2.
NOTA BENE: If both the income statement account and a balance sheet account is used in the same formula, always
express the balance sheet account as an average total- that is beginning balance sheet account balance plus ending
balance sheet account balance divided by 2. However, if there is only one balance sheet figure shown in the
problem, it is safe to assume that the ending balance is also the average balance.

 RETURN ON EQUITY (ROE) measures the return (net income) generated by the owner’s capital
investments in the business. Similar to ROA, the denominator or ROE could also be total or average
equity.
 2. OPERATIONAL EFFICIENCY RATIOS
These ratios measure the ability of the company to utilize its assets. Operational efficiency is measured based
on the company’s ability to generate sales from the utilization of its assets, as a whole or individually. The
turnover ratios are primarily used to measure operational efficiency

 ASSET TURNOVER measures the peso value of the sales generated for every peso of the company’s
assets. The higher the turnover rate, the more efficient the company in using its assets.

 FIXED ASSET TURNOVER is indicator of the efficiency of fixed assets (PPE) in generating sales

 INVENTORY TURNOVER is measured based on cost of goods sold and not on sales (but there are these
rare circumstances that the numerator used is the amount of net sales). As such both the numerator
and the denominator of this ratio is measured at cost. It is an indicator of how fast a company can sell
inventory. An alternative to inventory turnover is the “days in inventory” that measures the number of
days from acquisition to sale.

 ACCOUNTS RECEIVABLE TURNOVER measures the number of times the company was able to collect
on its average accounts receivable during the year. An alternative to accounts receivable turnover is
“days in accounts receivable” that measures the company’s collection period which is the number of
days from sale to collection.
NOTA BENE: If both the income statement account and a balance sheet account is used in the same formula, always
express the balance sheet account as an average total- that is beginning balance sheet account balance plus ending
balance sheet account balance divided by 2. However, if there is only one balance sheet figure shown in the
problem, it is safe to assume that the ending balance is also the average balance.
3. FINANCIAL HEALTH RATIOS
These ratios look into the company’ solvency and liquidity. Solvency refers to the company’s capacity to pay
their long-term liabilities while liquidity refers to measure the company’s ability to meet its short-term
obligations.

 DEBT RATIO indicates the percentage of the company’s assets that are financed by debts. A high debt
to asset ratio implies that most asset of the company are acquired through debts

 EQUITY RATIO indicates the percentage of the company’s assets that are financed by capital. A high
equity to asset implies a high level of capital.

 DEBT TO EQUITY RATIO indicates a company’s reliance to debt or liability as a source of financing
relative to equity. A high ratio suggests a high level of debt that may result in high interest expense

 INTEREST COVERAGE RATIO measures the company’s ability to cover the interest expense on their
liability with its operating income. Creditors prefer a high coverage ratio to give them a protection that
interest due to them can be paid.

 CURRENT RATIO is used to evaluate the company’s liquidity. It seeks to measure whether there are
sufficient current assets to pay for current liabilities. Creditors normally prefer a high current ratio.

 QUICK RATIO OR ACID TEST RATIO is a stricter measure of liquidity. It does not consider all the current
assets, only those that are easier to liquidate such as cash and accounts receivable that are required to
as quick assets.
 III. Looking Back (Evaluation)

A. ESSAY
Instruction. Answer the following questions as briefly and concise as possible. For those who have internet
connection at home, send your answers in a word document format in our Group Chat or thru my e-mail.
For those who do not have internet connection at home, write your answer in a short bond paper and
pass it to me once we meet. Criteria: Content-15 pts; Coherence-10 pts; Correctness of grammar- 5 pts

1. Cite the role played by Horizontal Analysis, Vertical Analysis and Financial Ratios in the decision-
making process of a company.
2. Cite all the ratios used in FS Analysis and briefly describe the use of each ratio

B. PROBLEM
Instruction. Provide what is asked in the problem below. For those who have internet connection at
home, send your answers in a word document format in our Group Chat or thru my e-mail. For those who
do not have internet connection at home, write your answer in a short bond paper and pass it to me once
we meet.

PROBLEM 1- Financial Statement Analysis

The following information is available concerning the PAPASA-KA Company’s expected results in 2019 (in thousand
pesos). Turn-overs are based on year end values
REQUIRED: Find all the values of the unknown variables

1. Return on sales 6%
2. Gross profit percentage 40%
3. Receivables turnover 5 times
4. Inventory turnover 4 times
5. Current ratio 3
6. Ratio of total debts to assets 40%

CONDENSED INCOME STATEMENT CONDENSED BALANCE SHEET

Sales P900 Cash P30 Current Liabilities ________
Cost of Sales ______ Receivables ______ Long term debts ________
Gross profit ______ Inventory ______ Equity ________
OpEx _____ PPE 670
Net income _____ Total ______ Total _________
PROBLEM II Financial Ratios (Adapted from MAS Reviewer by Aljohn Lee)

Lyn merchandising has 1,000,000 common shares with each share priced at P8. In 2017, the company declared
dividends of P0.10 per share. The balance sheet at the end of 2017 showed approximately the same amounts as that at
the end of 2016. The financial statements of Lyn Merchandising are as follows:

Lyn Merchandising, Income Statement for 2017 (In thousands)

Sales P4,700
Cost of Goods Sold (2,300)
Gross Profit P2,400
Operating Expenses:
Depreciation P320
Others 1,230 (1,550)
EBIT P850
Interest Expense (150)
Earnings before tax P700
Income Tax (280)
NET INCOME P420

Lyn Merchandising, Balance Sheet at December 31, 2017 (In Thousands)

ASSETS LIABILITIES and SHE
Cash P220 Accounts Payable P190
Accounts Rec. 440 Accrued expenses 180
Inventory 410 Total Current Liab. P370
Total Current Ass. P1,070 Long-term debt 1,960
PPE 5,600 Common stocks 1,810
Accum. Dep. (2,100) Retained earnings 430
Total Assets P4,570 Total Liab and SHE P4,570

REQUIRED: (Round answers to two decimal places)

1. Current Ratio 11. Earnings Per Share
2. Acid-test Ratio 12. P/E ratio
3. Accounts Receivable Turnover 13. Dividends Yield
4. Inventory Turnover 14. Payout Ratio
5. Gross Profit Margin 15. Debt Ratio
6. Operating Profit Margin 16. Debt-Equity ratio
7. Return on Sales 17. Times interest earned
8. RoA-Operational 18. Defensive Interval ratio
9. RoA-Total Management performance 19. Cash flow to total debt
10. Return on Equity 20. Cash flow margin

PROBLEM III

Ray Co.’s net accounts receivable were $500,000 at December 31, 2016 and $600,000 at December 31, 2017.
Net cash sales for 2017 were $200,000. The accounts receivable turnover for 2017 was 5.0. What were Ray
total net sales for 2017?

PROBLEM IV

Last year, Quayle Energy had sales of $200 million and its inventory turnover ratio was 5.0. The company’s current assets
totaled $100 million and its current ratio was 1.2. What was the company’s quick ratio?
PROBLEM V
Oliver Incorporated has a current ratio equal to 1.6 and a quick ratio equal to 1.2. The company has $2 million in sales
and its current liabilities are $1 million. What is the company’s inventory turnover ratio?

PROBLEM VI

An enterprise has total asset turnover of 3.5 times and a total debt to total assets ratio of 70%. If the enterprise has total
debt of $1,000,000, it has a sales level of _____________________.

IV. Extension of Learning

A. For learners with internet connection
1. Download the latest comparative financial statements of MerryMart through www.merrymart.com
and St. Peter Funeral homes through www.stpeter.com.ph.
2. Study and analyze carefully their financial statements and perform financial statement analysis.
3. Write your answers in a short bond paper and send it to me through our group chat or via e-mail.

B. For learners without internet connection

1. Print the latest comparative financial statements of MerryMart through www.merrymart.com and St.
Peter Funeral homes through www.stpeter.com.ph.
2. Study and analyze carefully their financial statements and perform financial statement analysis.
3. Write your answers in a short bond paper and pass it to me as soon as we meet.

V. References

Ocampo, 2019. Financial Accounting and Reporting Reviewer

Uberita, 2017. Financial Accounting and Reporting Reviewer
Lee, 2017. Management Advisory Services Reviewer
Bobadilla, 2017. Management Advisory Services Reviewer
Piper, 2010. Accounting Made Simple
Walther and Skousen, 2009. The Accounting Cycle
Salazar, 2016. Fundamentals of Accountancy, Business and Management 2 1 st Edition
Orale, 2018. DLSU Easy Handouts in Basic Accounting.