Fundamentals of

Accounting, Business
and Management 2
Quarter 1 – Module 5:
Part I: Analysis and
Interpretation of Financial
Statements
 What I Need to Know

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Feeling accomplished about learning the preparation of financial statements?

How about learning how to interpret them? What tools do we use to interpret the
figures in the financial statement? You will learn all of these in this module.

There are 3 lessons in this module, to wit:

Lesson 1: Introduction to Financial Statement Analysis

Lesson 2: Horizontal Analysis

Lesson 3: Vertical Analysis

At the end of the lessons, you should be able to:

1. Define the measurement levels, namely, liquidity, solvency, stability, and

profitability.
(ABM_FABM12-Ig-h-12)

2. Perform vertical and horizontal analyses of financial statements of a single

proprietorship.
(ABM_FABM12-Ig-h-13)

What I Know

A company’s financial statement achieves its real purpose when its interpreted
and used as a basis for decision making. Interpreting, as the last part of the 4 phases
of accounting, will cover your learnings on how to interpret data in a financial
statement using different techniques. Still don’t have an idea? These few questions
will give you a sneak peek.

True or False. Answer on a separate answer sheet,

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 1. There are two phases of financial statement analysis, computation, and
interpretation phase.
2. The computation is the most important in financial analysis.
3. Horizontal analysis compares the same account in the financial statement of
two periods.
4. The vertical analysis shows the relationship of each part from the whole
financial statement.
5. The company had a net income of P23,000 (2018) and P15,000 (2019). This
indicates good performance of the company.
6. Maintaining a great amount of cash is sometimes not good for the company.
7. Miss Beautiful Salon’s asset is P1,000,000, liabilities of P 800,000, and equity
of P200,000. Ms. Beauty interprets that most of her assets are funded through
liabilities.
8. The 2018 cash balance is P200,000, while the 2019 cash balance is P300,000.
There is an increase of 50% from the base year.
9. Deduct base year from the current year to get the difference in amount in
computing horizontal analysis.
10. Liquidity is the ability of the company to settle its obligations as they fall due.

Lesson
Introduction to Financial
1 Statement Analysis

Financial statements are sources of important financial information for a

business. This information, however, is not yet to achieve its purpose until it is
interpreted and used in the decision making of the stakeholders. Financial
statements give clear figures in which managers analyze rather than mere guesses
on crucial financial decisions or plans.

There are two phases in the analysis of financial statements, namely: the
computation phase and the interpretation phase.

*Computation involves looking for differences, percentages, or ratios. While

the interpretation phase is a crucial part of the analysis as it provides meaningful
and relevant decisions based on the results of the computation. To do the
interpretation, there are certain financial tools or methods used to give financial
figures for analysis.

Horizontal Analysis compares the same account in the financial statement of two
periods (current and past year), determining the amount of changes, and computing
its percentage change using a base year as a comparison (Ong and Gomendoza

5
2017). Horizontal analysis, however, is useful only to businesses that have 2 or more
years of operation.

Is there an increase in the balance sheet accounts of 2019 vs 2018?

SFP 2018
SFP 2019

Assets P 2000 Assets P 1000

Liabilities 1500 Liabilities 500
Owner’s Equity 500 Owner’s Equity 500

*Horizontal comparison 2018 Assets to 2019 Assets; 2018 Liabilities to 2019

Liabilities; and 2018 Owner’s Equity to 2019 Owner’s Equity.

Vertical Analysis shows a relationship among the elements of a financial statement

where each item is represented in a percentage.

How much percentage does operating expenses take from its total sales?

SCI 2019
Sales
P 1000 100%
Cost of Sales
50 5%
Gross Profit
P 950 P 95%
Operating
500 50%
Expenses
P 450 P 45%
Net Income

*Vertical comparison on financial statements, Sales represents the whole and other
accounts as its parts.

Financial Ratios can be used to compare a company’s current financial position and
performance to be able to identify their strengths and weakness. Ratios can be used
to compare your status, not only within your operations but also with other
companies. Financial ratios have four categories, namely, liquidity, solvency,
profitability, and valuation.

Financial ratios will be discussed comprehensively in Part II of this module.

Lesson

2 Horizontal Analysis

Horizontal analysis (also called comparative analysis) helps management

analyze the statement of financial position and statement of comprehensive income’s

6
increase and decrease in accounts. As the name implies, accounts are compared
horizontally between two periods.

Computation Phase

The illustration below shows the steps in performing horizontal analysis:

1. Prepare financial statements of 2 consecutive periods.

2. Get the amount of increase/decrease in the third column.
a. Select a base year. It is usually the initial or the previous year.
b. Deduct the current year from the base year.
3. Compute for the percentage of increase or decrease by using the formula
below:

current year - base year

% of change = x 100
base year

% of change = 167.8 – 195.3 x 100

195.3

% of change = -14%

ABM Appliance Center

Statement of Financial Position
As of December 31
(in millions)

ASSETS 2019 2018 Increase/Decrease

Amount Percent
Current Asset
Cash ₱ 167.8 ₱ 195.3 (27.5) -14%
Accounts Receivable 212.3 199.1 13.2 7%
Inventory 56.1 34.7 21.4 62%
Prepaid Expenses 20.0 18.1 1.9 10%
Total Current Assets ₱ 456.2 ₱ 447.2 9.0 2%
Property, Plant and Equipment (net) 1,265.0 764.3 500.7 66%
Total Assets ₱ 1,721.2 ₱ 1,211.5 509.7 42%

LIABILITIES AND OW NER'S EQUITY

Current Liabilities ₱ 324.5 ₱ 293.1 31.4 11%

Non-current Liabilities 987.4 659.2 328.2 50%
Total Liabilities ₱ 1,311.9 ₱ 952.3 359.6 38%
Owner's Equity 409.3 259.2 150.1 58%
Total Liabilities and Owner's Equity ₱ 1,721.2 ₱ 1,211.5 509.7 42%

7
 ABM Appliance Center
Statement of Comprehensive Income
For the year ended December 31
(in millions)

2019 2018 Increase/Decrease

Amount Percent

Net Sales ₱ 324.3 ₱ 254.8 69.5 27%

Cost of Goods Sold 169.1 159.3 9.8 6%
Gross Profit ₱ 155.2 ₱ 95.5 59.7 63%
Selling and Administrative Expense 21.1 9.4 11.7 124%
Operating Income ₱ 134.1 ₱ 86.1 48.0 56%
Interest Expense 6.9 7.5 (0.6) -8%
Income Before Taxes ₱ 127.2 ₱ 78.6 48.6 62%
Income Tax Expense 38.1 21.3 16.8 79%
Net Income ₱ 89.1 ₱ 57.3 31.8 55%

Interpretation Phase

In this phase, the users of financial information may have a different perspective on
the figures. By interpreting, they will be able to decide objectively based on the results
of the computation.

The interpretations vary, for every user of financial information, on which way would
the horizontal analysis be of use to them. There are a lot more to see on the
computations and below are some examples:

Statement of Financial Position

1. Total assets increased by 42% due to the purchase of PPE which reflects a
66% increase. However, current assets have only 2% growth compared to non-
current assets which may indicate that liquidity is very small.
2. Total liabilities increased by 38% due to a 50% increase in non-current
liabilities. It reflects that PPE could have been financed by a loan. The owner’s
equity, on the other hand, increased 58% from the previous year. This may be
due to additional investments made by the owner to the business.

Statement of Comprehensive Income

1. Almost all accounts in the SCI increased. It could be because of increased PPE
from the SFP that could have boost the selling process. It s understood that
with greater sales, COGS are parallel, as well as operating expenses and taxes.
It is noticeable that interest decreased by 8% which could mean that loans
acquired by the business may have longer period payments.

8
 Lesson

3 Vertical Analysis

SFP Vertical Analysis (also called common-size analysis) helps the

management analyze the components of the total assets, total liabilities, and owner’s
equity. It analyzes the financial statements in a vertical manner, as its name implies.

Here are some questions to help you understand how SFP vertical analysis goes.

a. Of the total assets, how much percentage is classified as current? Non-

current?
b. Of the total assets, how big/small is merchandise inventory? Accounts
receivable? Or other accounts?
c. Of the total liabilities, how much percentage is classified as current? Non-
current?
d. Of the total liabilities and owner’s equity, how much percentage are liabilities?
Owner’s equity?

Answering these questions will lead to disclosing the percentages of the

components that occupy the total assets, liabilities, and owner’s equity. It may lay
some problems that needed to be addressed and you can recommend solutions.

Example: The current assets which consist mostly of account receivable may indicate
that most sales are collectible until the end of the accounting period. The problem
found is that the company has below average collection policy and may need
improvement on it. The management may suggest better sales discount terms to
make customers settle their accounts earlier than possible.

SCI Vertical Analysis, on the other hand, helps the management analyze the
components to the overall sales.

Here are some questions to help you understand how SCI vertical analysis goes.

a. Of the net sales, how much percentage does the cost of sales occupy? Gross
profit? Operating expenses?
b. Of the operating expenses, how big/small is the percentage of administrative
expenses? Selling expenses?
c. Compare the percentages of net income to net sales.

9
Computation Phase

The illustration below shows the steps in performing vertical analysis.

1. Prepare the financial statements of two consecutive periods.

2. Add a column on each year of comparison.
3. Express each component account as a percentage of the total assets, liabilities
and owners (for SFP) or to the Net sales (for SCI). Use the formula below in
getting the percentage:

167.8
% of cash = x 100
1,721.2

% of cash = 10%

ABM Appliance Center

Statement of Financial Position
As of December 31
(in millions)

ASSETS 2019 Percent 2018 Percent

Current Asset
Cash ₱ 167.8 10% ₱ 195.3 16%
Accounts Receivable 212.3 12% 199.1 16%
Inventory 56.1 3% 34.7 3%
Prepaid Expenses 20.0 1% 18.1 1%
Total Current Assets ₱ 456.2 27% ₱ 447.2 37%
Property, Plant and Equipment (net) 1,265.0 73% 764.3 63%
Total Assets ₱ 1,721.2 100% ₱ 1,211.5 100%

LIABILITIES AND OW NER'S EQUITY

Current Liabilities ₱ 324.5 19% ₱ 293.1 24%

Non-current Liabilities 987.4 57% 659.2 54%
Total Liabilities ₱ 1,311.9 76% ₱ 952.3 79%
Owner's Equity 409.3 24% 259.2 21%
Total Liabilities and Owner's Equity ₱ 1,721.2 100% ₱ 1,211.5 100%

169.1
% of cost of goods sold = x 100
324.3

% of cost of goods sold = 52%

10
 ABM Appliance Center
Statement of Comprehensive Income
For the year ended December 31
(in millions)

2019 Percent 2018 Percent

Net Sales ₱ 324.3 100% ₱ 254.8 100%

Cost of Goods Sold 169.1 52% 159.3 63%
Gross Profit ₱ 155.2 48% ₱ 95.5 37%
Selling and Administrative Expense 21.1 7% 9.4 4%
Operating Income ₱ 134.1 41% ₱ 86.1 34%
Interest Expense 6.9 2% 7.5 3%
Income Before Taxes ₱ 127.2 39% ₱ 78.6 31%
Income Tax Expense 38.1 12% 21.3 8%
Net Income ₱ 89.1 27% ₱ 57.3 22%

Interpretation Phase

In comparing vertically and horizontally, this phase can be done to fully

analyze the position of the company and its results of operation. Doing both analyses
entails a holistic approach in addressing the possible problems and planning the
necessary actions. As always, interpretations may vary depending on the purpose of
the user financial information.

Statement of Financial Position

1. The current asset of 2019 is 27% of the total assets. However, comparing from
2018, current assets are more liquid at 37%.
2. Of the total liabilities and OE, 76% is the total liabilities and 24% is the
owner’s equity. This could be the result of investing through loans than the
owners making the additional investment.

Statement of Comprehensive Income

1. Net income is 27% from net sales. Of all the expenses deducted after gross
profit, income tax comprises the biggest percentage at 12%. The company
should spread the impact of incurring expenses by getting better sales
performance.

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 What’s In

Let’s sum-up the lesson with these few takeaways. This may help you take down
important notes.

Fill in the blanks with the correct answer.

1. FS analysis has two phases; they are ______________ and ______________.

2. There are 3 tools which can be used to analyze financial statements; these are
__________, __________ and __________.

3. ______________ is a tool used to compare FS accounts between two periods.

4. ______________ is a tool used to analyze the components of a financial

statement.

5. ______________ can be used to compare a company’s current financial position

and performance with past years and identify its strengths and weaknesses.

Notes to the Teacher

Financial ratios and analysis help management identify the
strengths and weaknesses of the business. Good or favorable ratios
indicate sustainability and growth while poor or unfavorable ratios
mean that the business needs improvement in their actions.

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 What’s New

The following are the financial statement of Limay Store. Perform a horizontal
analysis and vertical analysis.

Special instruction: Use 1 decimal place for percentage result on vertical analysis.

Limay Store
Statement of Financial Position
As of December 31
(in millions)

ASSETS 2019 2018

Current Asset
Cash ₱ 461.0 ₱ 389.0
Accounts Receivable 178.0 226.0
Short-term Investment 4.5 2.4
Inventory 60.9 55.1
Prepaid Expenses 12.5 10.9
Total Current Assets ₱ 716.9 ₱ 683.4
Property, Plant and Equipment (net) 2,114.0 1,589.0
Total Assets ₱ 2,830.9 ₱ 2,272.4

LIABILITIES AND OW NER'S EQUITY

Current Liabilities ₱ 452.1 ₱ 338.4

Non-current Liabilities 967.4 1,090.0
Total Liabilities ₱ 1,419.5 ₱ 1,428.4
Owner's Equity 1,411.4 844.0
Total Liabilities and Owner's Equity ₱ 2,830.9 ₱ 2,272.4

Limay Store
Statement of Comprehensive Income
For the year ended December 31
(in millions)

2019 2018

Net Sales ₱ 3,112.0 ₱ 2,365.0

Cost of Goods Sold 1,200.0 978.9
Gross Profit ₱ 1,912.0 ₱ 1,386.1
Selling and Administrative Expense 211.1 311.0
Operating Income ₱ 1,700.9 ₱ 1,075.1
Interest Expense 2.4 3.1
Income Before Taxes ₱ 1,698.5 ₱ 1,072.0
Income Tax Expense 16.8 17.9
Net Income ₱ 1,681.7 ₱ 1,054.1

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 What is It

Good job! Computation seems easy. Let’s try to analyze the details of the
computation. Refer to your table of Limay Store and answer the following questions.

Horizontal Analysis

1. Compare the total assets of 2018 and 2019. Is there an increase or decrease?
Explain the result of the increase or decrease in amount.
___________________________________________________________________________
___________________________________________________________________________
2. Compare the total liabilities of 2018 and 2019. Is there an increase or
decrease? Explain the result of the increase or decrease in amount.
___________________________________________________________________________
___________________________________________________________________________
3. Compare net income of 2018 and 2019. Is there an increase or decrease?
Explain the result of the increase or decrease in amount.
___________________________________________________________________________
___________________________________________________________________________

Vertical Analysis

1. Of the 2019 total assets, how much percentage is classified as current? Non-
current? Explain your analysis.
___________________________________________________________________________
___________________________________________________________________________
2. Of the 2019 total liabilities and owner’s equity, how much percentage are
liabilities? Owner’s equity? Explain your analysis.
___________________________________________________________________________
___________________________________________________________________________
3. Of the 2019 net sales, how much percentage is taken up by the cost of goods
sold? Explain your analysis.
___________________________________________________________________________
___________________________________________________________________________

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 What’s More

Computation of vertical analysis is further understood when presented using a pie

chart. Here is an example for ABM Appliance Center:

ABM Appliance Center ABM Appliance Center

SFP Asset Section (2019) SFP Liabilities and Owner's Equity
Section (2019)
cash

10% current
accounts liabilities
12% receivable 19%
24%
3% inventory non-current
liabilities
1%
prepaid expense
74% owner's equity
57%
ppe

ABM Appliancce Center

SCI 2019

Net Income
27%

COGS
Income Tax 52%
Expense
12%

Interest Expense
2%
S & A Expense
7%

Required: You have performed vertical analysis for Limay Store in What’s New on
page 15. Present 2019 Vertical Analysis of SFP Asset section, Liabilities and Owner’s
Equity section and SCI using a pie chart.

15
 What I Have Learned

Learning is a give-and-take relationship. It’s your turn to discuss something

about the lesson. Give your simple explanations on the concepts below. Each
question corresponds to 10 points.

1. What is a horizontal analysis? Explain.

___________________________________________________________________________
___________________________________________________________________________

2. What is a vertical analysis? Explain.

___________________________________________________________________________
___________________________________________________________________________

3. What are the importance of vertical and horizontal analysis? Explain.

___________________________________________________________________________
___________________________________________________________________________

Scoring Rubrics:

9-10 pts – the concept is well defined and discussed comprehensively through
giving an example or illustration.

6-8 pts – the concept is well defined and discussed but without example or
illustration.

3-5 pts – the concept is defined ambiguously.

0-2 pts – the concept is not accurately defined, and the explanation is far from
the concept or main idea.

16
 What I Can Do

Practice makes perfect! Let’s do more! You have accomplished the pie chart from
What’s More on page 17.

Interpretation matters. Describe the operations of Limay Store by interpreting the

results of the pie chart by answering these questions.

Limay Store – SFP Asset section

1. Which of the current asset takes the biggest part?
2. How could this affect the operation of the business?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Limay Store – SFP Liabilities and Owner’s Equity section

1. Which of the components takes the biggest part?
2. How could this affect the operation of the business?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Limay Store – SCI

1. Which of the components takes the biggest part?
2. How could this affect the operation of the business?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

17
 Assessment

Assessment 1: Below is the financial information of the XYZ Company. Perform a

horizontal and vertical analysis.

Special instruction: Use 1 decimal place for percentage result on vertical analysis.

XYZ Company
Statement of Comprehensive Income
For the year ended December 31
(in millions)

2019 2018

Net Sales ₱ 3,412.0 ₱ 1,998.0

Cost of Goods Sold 1,200.0 978.9
Gross Profit ₱ 2,212.0 ₱ 1,019.1
Selling and Administrative Expense 200.0 176.0
Operating Income ₱ 2,012.0 ₱ 843.1
Interest Expense 2.5 2.0
Income Before Taxes ₱ 2,009.5 ₱ 841.1
Income Tax Expense 10.3 8.9
Net Income ₱ 1,999.2 ₱ 832.2

Assessment 2: Interpret the results of the horizontal and vertical analyses by

answering these questions:

Horizontal analysis

1. How much is the increase or decrease in cost of good sold from 2018 to 2019?
How could this affect the operations of the business?
2. How much is the increase or decrease in net income? How could this affect
the operations of the business?

18
Vertical analysis

1. Which of the components take the biggest part from net sales? Is this good for
the business? Why?
2. How much percentage is cost of good sold from net sales? How could this
affect the operations of the business?

Additional Activities

You have performed vertical analysis for XYZ Company in Assessment on page 20.

Required:

1. Present 2018 Vertical Analysis of SCI using a pie chart.

2. Present 2019 Vertical Analysis of SCI using a pie chart.

19
 20
What’s New: Vertical analysis
What I Know:
What’s In: 1. True
2. False
A. 3. True
1. Computation and interpretation phase 4. True
2. Horizontal analysis, vertical analysis 5. False
and financial ratios 6. True
3. Horizontal analysis
7. True
4. Vertical analysis
8. True
5. Financial ratios
9. True
10. True
Answer Key
 21
What’s More: Pie Chart
Data needed: SFP Asset section
What I Have Learned:
1. Cash 16.3%
**Student answers may vary. 2. AR 6.3%
3. Short term investment 0.2%
4. Inventory 2.2%
5. Prepaid expenses 0.4%
6. PPE 74.7%
Data needed: SFP Liabilities and OE
section.
What I Can Do: 1. Current liab 16%
Asset section 2. Non-current liab 34.2%
1. cash 16.3% 3. OE 49.9%
2. **Student answers may vary. Data needed: SCI
L & OE section
1. COGS 38.6%
1. OE 49.9% 2. Selling and admin exp 6.8%
2. **Student answers may vary. 3. Interest exp 0.1%
SCI 4. Income tax exp 0.5%
5. Net income 54%
1. Net income 54%
2. **Student answers may vary
What is it: (Student will expound What’s New: Horizontal analysis
their answers)
Horizontal analysis
1. Increase/ due to PPE
2. Decrease/ PPE is
contributed by owners
3. Increase/increase in net
sales
Vertical analysis
1. Current assets 25.3%, non
current 74.7%/ high
percentage of NCA means
difficulty in liquidation.
2. Current liabilities 16%
non current liabilities
34.2%/ almost twice of
the current liab is long
term debt.
3. COGS is 38.6% of net
sales indicating a stable
cost management
compared to 41.4% of
2018
 22
Assessment A:
Horizontal Analysis
Vertical Analysis
Assessment B:
Horizontal analysis (students should elaborate their answers)
1. P221.1M increase/ increase in sales means increase in cost of sales.
2. P1167M increase/ the company has become profitable compared to last year.
Vertical analysis
1. Net income with 58.6%. The company’s profitability is at favorable and good condition.
2. Cogs is takes 35.2% of net sales. It is the expense incurred by purchases made, however comparing to last
year’s 49%, the company seems to regulate the cogs effectively.
 23
Additional Activities: