Financial Statements Analysis

References:
Abeleda, N. (2012) Simplified Accounting for Sole Proprietorship, Vol. 1
Valix, C. (2017) Theory of Accounts

Financial Financial statements are prepared to be useful in the decision-

Statements making process of the users, primarily the management.
Analysis
As such, FS undergo analysis and interpretation for users to fully
understand the performance and situation of the business.

Objective of FS analysis – to assess the overall performance of

the business for a given period of time and be the basis of the
management in making present and future decisions, to be
incorporated in existing and future plans.

Analysis usually shows the strengths and weaknesses of the

business. It also determines the liquidity, solvency, stability,
profitability and efficiency of the business.

Analysis vs Analysis – the process of determining and computing financial

Interpretation ratios

Interpretation – the process of explaining the significance of the

financial ratios computed.

Cardinal rules in Cardinal rules to be followed:

FS analysis and • Develop a group of related financial ratios – a single ratio is
interpretation meaningless when isolated. It becomes meaningful when
related to other allied ratios.

• Make comparison – comparison allows the management to

see whether there are improvements or whether things
became worse. Financial ratios can be compared with the
past (time-series analysis) or with a similar company
engaged in the same line of business (cross sectional
analysis).

Limitations of financial statements to be considered:

• The FS are not exact in the sense that there are estimated
figures presented (depreciation, impairment, allowances)
• The FS are not yet final. The amounts can change from
period to period.
 • The effect of inflation is mostly ignored.
• The FS are historical in nature. Amounts presented are
results of past activities and it may not be the same as the
future.
• The FS are quantitative rather than qualitative.

Financial ratios Financial ratio – the ratio of one item in the FS to another item
in the same FS

Kinds of FS ratios

Income statement ratio – ratio of one item in the Income

statement to another item in the same Income statement, usually
the Net Sales.

Balance sheet ratio – ratio of one item in the Balance sheet to

another item in the same Balance sheet, usually the Total Assets.

Inter-statement ratio – ratio of one item in the Income

statement to another item in the Balance sheet. Example: Accounts
Receivable turnover, Inventory turnover, etc.

Trend ratio – ratio of one item to the same item of different

periods. Example: Sales this year to Sales last year.

Uses of the Ratio Analysis

• Shows the business’ financial strengths and weaknesses,
which can be used with other techniques in analyzing FS
• Can be used for making future plans
• Can be used for performance evaluation

Significance of Liquidity – ability to convert non-cash current assets into cash.

liquidity,
solvency, Solvency – ability to pay liabilities on time.
stability,
profitability, and • Short-term solvency – ability to pay current liabilities on
efficiency ratios time
• Long-term solvency – ability to pay the amortization of the
long-term liabilities plus interest

Stability – ability to withstand financial reverses; survivability in

the event of financial crisis.
 Profitability – ability to generate adequate profits to sustain the
operations of the business and earn satisfactory return to the
owner(s).

Efficiency – ability of the business to operate utilizing the least

resources to generate the most profit; or improving the process
continuously to achieve such.

Horizontal vs Horizontal analysis – each item in the FS of the current period is

Vertical analysis compared with the prior period. Changes in peso amount and in
percentage are shown.

Oldest year is the base year.

2017 2018 Peso change % change
Sales P50,000 P55,000 5,000 10.00%
Cost of sales P35,000 P37,500 2,500 7.14%
Gross Profit P15,000 P17,500 2,500 16.67%
Expenses P8,000 P9,500 1,500 18.75%
Net Profit P7,000 P8,000 1,000 14.29%

Vertical analysis – ratio of each item in the FS to a certain base

item is obtained and expressed in percentage. In Income
Statement, the base item is the Net Sales, while in the Balance
Sheet the base item is Total Assets.

Income Statement
Sales P55,000 100.00%
Cost of sales P37,500 68.18%
Gross Profit P17,500 31.82%
Expenses P9,500 17.27%
Net Profit P8,000 14.55%

Balance Sheet
Current Assets:
Cash 20,000 11.23%
Accounts Receivable 45,000 25.28%
Inventory 60,000 33.71%
Total 125,000 70.22%
Non-current Assets:
Office Eqpt. 35,000 19.67%
Furniture/Fixture 18,000 10.11%
Total 53,000 29.78%
Total Assets 178,000 100%
 Current Liabilities:
Accounts Payable 18,000 10.11%
Notes Payable 25,000 14.05%
Total 43,000 24.16%
Non-current liabilities:
Loan Payable 60,000 33.71%
Total Liabilities 103,000 57.87%

Owner’s Equity
Tutor, Capital 75,000 42.13%
Total Liabilities and Equity 178,000 100.00%

Common-size Common-size Statement – shows only the component

Statements percentage of each item without the corresponding amount

2017 2018
Sales 100.00% 100.00%
Cost of sales 70.00% 68.18%
Gross Profit 30.00% 31.82%
Expenses 16.00% 17.27%
Net Profit 14.00% 14.55%

Financial Ratios Short-term solvency ratios

and
Measurements Ratio Formula Significance
Net Working Current Assets – Measure of short-
Capital Current Liabilities term solvency
Net Quick Assets Quick Assets – Measure of
Current Liabilities immediate short-
term solvency
Current ratio Current Assets / Measures the
Current Liabilities degree of short-
term solvency
Quick ratio Quick Assets / Measures the
Current Liabilities degree of
immediate short-
term solvency

Quick assets – cash or directly convertible to cash (Cash and

Accounts Receivable)
Liquidity ratios

Ratio Formula Significance

Inventory Cost of Sales / Measures the
Turnover Average Inventory efficiency of the
selling process.
Age of inventory No. of Business Average number of
or Days sales in days / Inventory days to sell the
Inventory Turnover inventory
Accounts Net Credit Sales / Measures the
Receivable Average Accounts efficiency of the
Turnover Receivable collection process.
Age of No. of Business Average number of
receivables or days / Accounts days to collect
Average Receivable Turnover receivables
collection period
Operating Cycle Age of Inventory + Average number of
Age of Receivables days to convert
inventory into cash
Note: Above ratios are also called activity ratios or efficiency ratios.

Ratio Formula Significance

Current Assets to Current Assets / Measures the over-
Total Assets Total Assets all liquidity of the
total assets

Stability ratios

Ratio Formula Significance

Debt utilization Total liabilities / Measures
ratio Total assets proportion of the
total liabilities to the
total assets
Equity ratio Owner’s equity / Measures the
Total assets proportion of the
owner’s equity to
the total assets
Debt-equity ratio Total liabilities / Measures the extent
Owner’s equity of borrowing in
relation to the
capital
 Equity-Debt ratio Owner’s Equity / Measures the extent
Total Liabilities of capital provided
in relation to the
total liabilities
Times interest Net profit before Ability to pay the
earned ratio interest / Interest interest requirement
expense
Debt-service Net profit before Ability to pay the
coverage ratio interest / (Principal principal and
+ Interest) interest

Profitability ratios

Ratio Formula Significance

Gross Profit Rate Gross Profit / Sales Measures the
on Sales markup based on
selling price
Gross Profit Rate Gross Profit / Cost Measures the
on Cost of Sales markup based on
cost
Operating ratio Cost of Sales + Measures total cash
Expenses (exc. operating costs
Depreciation) / Net expressed in
Sales percentage
Return on Sales Net Profit / Net Measures
Sales profitability rate
based on sales
Return on Assets Net Profit / Average Measures rate of
Total Assets profit based on the
assets utilized
Return on Equity Net Profit / Average Measures rate of
Owner’s Equity return on the capital
of the owner