02 Financial Statements Analysis

2
Learning Objectives
1. Understand the objectives of financial statement analysis, and its limitations.

2. Use the analytical techniques in financial statements analysis:
a. Horizontal analysis
b. Trend analysis
c. Vertical analysis
d. Ratio analysis
3. Prepare and interpret common- size financial statements.
4. Compute the various financial ratios, turnover and their interpretations and how to use them for
profit planning.
Introduction
Financial statements provide the basic source of information by managers and other interested
parties outside the organization regarding its financial conditions and results of operations. Financial
statements communicate the firm's financial strengths and weaknesses as well as its performance for
the current period. Though financial statements are primarily prepared for external users
(stockholders, investors, government agencies, etc.), managers find it equally useful for their making
decisions such as performance evaluation, developing operating plans and any other matters related to
their operating activities.
Although financial statements are based on historical accounting information, which reflects
transactions and other events that affected the firm, it would help the users in predicting future, as
indicated by the trend analysis. A potential lender or investor could assess the company's overall
financial strength, income and growth potential as well as the financial effects on some matters that
required future decisions. The company's ability to repay obligations and distribution of returns on
investments are the primary concerns of the potential lenders and investors.
Overview of Financial Statements
The four key financial statements are:
1. Balance Sheet – the purpose of the balance sheet is to present a summary of the assets owned by
a firm, its liabilities, and its net financial position at a given point in time. The assets are often
referred to as investments and the liabilities and owner’s equity as financing.
2. Income Statement - provides a financial summary of a company’s operating results during a
specified period.
3. Cash Flow Statement - provides a summary of the firm’s operating, investment, and financing
cash flows and reconciles them with changes in its cash and marketable securities during the
period. It also ties together the income statement and previous and current balance sheets.
4. Statement of Retained Earnings - reconciles the net income earned during a given year, and any
cash dividends paid, with the change in retained earnings between the start and the end of that
year.
Chapter 2 Financial Statements Analysis 12
The basic structure of each of these statements and their relationships:
FINANCIAL STATEMENT RELATIONSHIPS
Balance Sheet Balance Sheet

Beginning (12-31-x1) Ending (12-31-x2)
Liabilities Liabilities
ASSETS = + ASSETS = +
Capital Capital
Transactions during the period

From 12-31-x1 to 12-31-x2
Income Statement
For the year ended Dec. 31, 20x2
Revenues earned/Gains
- Expenses/Losses
= Net Income/Loss
Cash Flow Statement

For the year ended Dec. 31, 20x2
Cash balance beginning

+ Cash inflows in 20x2
- Cash outflows in 20x2
= Cash balance ending
Cash balance 12-31-x2

- Cash balance 12-31-x1
= Change in cash in 20x2
In this chapter, analysis will be focused on these two statements, balance sheet and income
statements. The most widely used techniques in financial statement analysis are:
1. Comparative analysis
a. horizontal analysis
b. trend analysis
c. vertical analysis
2. Ratio or Component analysis including turnovers.
Cautions About Financial Statements Analysis
Managers should look beyond the ratios. They should consider the technological changes,
industry trends, consumer tastes and various economic factors.
Here are some cautions about using financial ratios:

1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem.
2. A single ratio does not generally provide enough information from which to judge the overall
performance of the firm.
3. The ratios being compared should be calculated using financial statements dated at the same
point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in the same way.
6. Results can be distorted by inflation.
Comparative Analysis
An item on a financial statement has little meaning by itself. The meaning of the numbers can
be enhanced by drawing comparisons. Percentage changes and relative ratios are widely used in
comparative and trend analyses. Horizontal analysis is comparing two periods and becomes trend
analysis if extended to three or more periods having the earliest year as the base period. Vertical
analysis, also known as common-size statements is analysis of the component parts of a single
statement in a given period.
The analyst must have in mind that these percentage changes and ratios are only indicators of
the performance or financial condition of the company. No single measure could tell us more. To give
a more meaningful interpretation, these financial measures must be compared between periods and
between other companies within the same industry but, most preferably, a comparison between
companies of the same size and capacities. Using the industry norm or standards could also add sense
to the interpretation.
Horizontal Analysis
Horizontal analysis is a technique for evaluating a series of data over a period time to determine
the increase or decrease that has taken place, expressed as either an amount or a percentage. The peso
changes (increase or decrease) are normally presented in each item as well as their percentage changes.
Quantifying peso changes over time serves to highlight the changes that are the most important
economically. Quantifying percentage changes over time serves to highlight the changes that are the
most unusual.
The following simple rules should be observed:
1. To compute for the peso changes, current year less prior year.
2. To compute for the percentage changes, peso change divided by the prior year (serve as the
base figure). If there is no amount in prior year, no percentage change will be shown, as a
matter of rule in mathematics.
3. To compute for the ratio presentation, current year divided by the prior year. Again, if the base
year is zero or no amount in prior year, no ratio will be shown in the analysis, thus, peso
amount presentation is important.
JAMES CORPORATION
COMPARATIVE BALANCE SHEET
DECEMBER 31, Year 2 and Year 1
Changes
Increase (Decrease)
Peso
Year 2 Year 1 Amount % Ratio
ASSETS
Current Assets:
Cash 2,400 2,100 300 14.3% 1.14
Marketable Securities 1,350 900 450 50.0% 1.50
Accounts Receivable, net 36,000 33,000 3,000 9.1% 1.09
Inventory 60,000 51,000 9,000 17.6% 1.18
Prepaid Expenses 750 900 (150) -16.7% 0.83
Total Current Assets 100,500 87,900 12,600 14.3% 1.14
Long-Term Investments 1,500 1,650 (150) -9.1% 0.91

Property and Equipment
Land 18,000 18,000 - 0.0% 1.00
Building, net 165,000 156,000 9,000 5.8% 1.06
Equipment, net 75,000 69,000 6,000 8.7% 1.09
Total Property and 258,000 243,000 15,000 6.2% 1.06
Equipment
TOTAL ASSETS 360,000 332,550 27,450 8.3% 1.08
LIABILITIES & STOCKHOLDERS’ EQUITY

Current Liabilities:
Accounts Payable 22,500 21,150 1,350 6.4% 1.06
Accrued Expense 6,600 6,300 300 4.8% 1.05
Notes Payable 10,900 8,700 2,200 25.3% 1.25
Total Current Liabilities 40,000 36,150 3,850 10.7% 1.11
Long Term Liabilities 110,000 108,000 2,000 1.9% 1.02

Total Liabilities 150,000 144,150 5,850 4.1% 1.04
Stockholders’ Equity
Preferred Stock, P100 par, 8% 18,000 18,000 - 0.0% 1.00
Common Stock, P10 par value 75,000 72,000 3,000 4.2% 1.04
Additional paid in Capital 12,000 11,400 600 5.3% 1.05
Retained Earnings 105,000 87,000 18,000 20.7% 1.21
Total Stockholders’ Equity 210,000 188,800 21,600 11.5% 1.11
TOTAL LIABILITIES &
STOCKHOLDERS’ EQUITY 360,000 332,550 27,450 8.3% 1.08
JAMES CORPORATION
COMPARATIVE INCOME AND RETAINED EARNINGS STATEMENT
FOR THE YEARS ENDED DECEMBER 31, Year 2 and Year 1
Changes
Increase (Decrease)
Peso
Year 2 Year 1 Amount % Ratio
Net Sales 261,000 246,000 15,000 6.1% 1.06

Cost of Sales 182,790 169,050 13,740 8.1% 1.08
Gross Profit 78,210 76,950 1,260 1.6% 1.02
Operating Expenses 21,000 20,100 900 4.5% 1.04
Net Operating Income 57,210 56,850 360 0.6% 1.01
Interest Expenses 12,090 11,670 420 3.6% 1.04
Net Income Before Tax 45,120 45,180 (60) -0.1% 1.00
Tax Expense 11,280 11,400 (120) -1.1% 0.99
Net Income 33,840 33,780 60 0.2% 1.00
Add Retained Earnings, beg. 87,000 68,460 18,540 27.1% 1.27
Total 120,840 102,240 18,600 18.2% 1.18
Dividends 15,840 15,240 600 3.9% 1.04
Retained Earnings, ending 105,000 87,000 18,000 20.7% 1.21
Net Operating Income 33,840 33,780 60 0.2% 1.00

Dividends to Preferred 1,440 1,440 - 0.0% 1.00
Stock
Net Income Available to 32,400 32,340 60 0.2% 1.00
Common
Dividends to Common 14,400 13,800 600 4.3% 1.04
Stock
Net Income 18,000 18,540 (540) -2.9% 0.97
JAMES CORPORATION
COMPARATIVE INCOME AND RETAINED EARNINGS STATEMENT
FOR THE YEARS ENDED DECEMBER 31, Year2 and Year 1
COMMON SIZE PRESENTATION
Year 1 Year 2 Year 2 Year 1

Net Sales 261,000 246,000 100.0% 100.0%
Less Cost of Sales 182,790 169,050 70.0% 68.7%
Gross Profit 78,210 76,950 30.0% 31.3%
Less, Operating Expenses 21,000 20,100 8.0% 8.2%
Net Operating Income 57,210 56,850 21.9% 23.1%
Less, Interest Expenses 12,090 11,670 4.6% 4.7%
Net Income 45,120 45,180 17.3% 18.4%
Less, Tax Expense 11,280 11,400 4.3% 4.6%
Net Income 33,840 33,780 13.0% 13.7%
JAMES CORPORATION
COMPARATIVE COMMON-SIZE BALANCE SHEET
DECEMBER 31, Year 2 and Year 1
Year 2 Year 1 Year 2 Year 1

ASSETS
Current Assets:
Cash 2,400 2,100 0.7% 0.6%
Current Securities 1,350 900 0.4% 0.3%
Accounts Receivable, net 36,000 33,000 10.0% 9.9%
Inventory 60,000 51,000 16.7% 15.3%
Prepaid Expenses 750 900 0.2% 0.3%
Total Current Assets 100,500 87,900 27.9% 26.4%
Long Term Investments 1,500 1,650 0.4% 0.5%
Property and Equipment
Land 18,000 18,000 5.0% 5.4%
Building, net 165,000 156,000 45.8% 46.9%
Equipment, net 75,000 69,000 20.8% 20.7%
Total Property & 258,000 243,000 71.7% 73.1%
Equipment
TOTAL ASSETS 360,000 332,550 100.0% 100.0%
LIABILITIES AND STOCKHOLDERS’ EQUITY

Current Liabilities:
Accounts Payable 22,500 21,150 6.4% 6.4%
Accrued Expense 6,600 6,300 1.9% 1.9%
Notes Payable 10,900 8,700 2.6% 2.6%
Total Current Liabilities 40,000 36,150 10.9% 10.9%
Long Term Liabilities 110,000 108,000 32.5% 32.4%

TOTAL LIABILITIES 150,000 144,150 43.3% 43.3%
Stockholders’ Equity
Preferred Stock, P100 par 18,000 18,000 5.4% 5.4%

value at 8%
Common Stock, P10 par value 75,000 72,000 21.7% 21.6%
Additional paid in Capital 12,000 11,400 3.4% 3.4%
Retained Earnings 105,000 87,000 26.2% 26.3%
Total Stockholders’ Equity 210,000 188,400 56.7% 56.7%
TOTAL LIABILITIES AND

STOCKHOLDERS’ EQUITY 360,000 332,550 100.0% 100.0%
Trend Analysis
An extended horizontal analysis could be developed as the so-called "Trend Analysis". Trend
percentages state several years’ financial data in terms of a base year, which equals 100 percent.
Assume in the given financial statements by James Corporation, the following Sales and Net
income items for the past six years are as follows:
2018 2017 2016 2015 2014 2013

Sales 261,000 246,000 234,000 224,400 219,000 216,000
Net 33,840 33,780 33,000 31,500 30,600 29,700
Income
The trend (in percent) could be developed as follows:
2018 2017 2016 2015 2014 2013

Sales 121* 114** ***108 104 101 100
Net 114 114 111 106 103 100
Income
* P261,000 / P216,000 = 1.208 or 121

** P246,000 / P216,000 = 1.138 or 114
*** P234,000 / P216,000 = 1.083 or 108
This trend would serve as what we call "attention-directing" where the analyst would focus his
attention on such trends in comparison with the industry standards. For instance, the analyst knows
that the industry grew tremendously and yet the company was unable to have a significant sales
growth. Using James Corporation’s trend analysis, it could be interpreted that the company was
unable to convert its sales growth into net income as we compare the trend in 2008 and 2009.
A smart financial analyst would try to deeply relate these financial measures and be able to find
explanations on the issues. For instance, sales increased by 6% [(P261,000–P246,000)/P246,000] but net
income increased by less than 1% [(P33,840–P33,780)/P33,780].
Vertical analysis
Vertical analysis is a technique that expresses each item within a financial statement as a
percentage of a relevant total or a base amount. It focuses on the relationship between various financial
items in a given financial statements in a single period. The financial statements then will be presented
in percentages commonly called "common-size statements". Certain rules are also observed:
➢ For the balance sheet, Total Assets and Total Liabilities & Capital are both considered 100% and
each item in the particular section are presented as a certain percent of the total. In James
Corporation, Cash is 7.8% of total assets while Accounts Payable represents 6.3% of total
liabilities and stockholders’ equity.
➢ For the Income Statement, Net Sales is considered as the 100%. Each item in the income
statement represents a certain percent of sales. In James Corporation, Cost of Sales is 70% of
sales.
Ratio Analysis
Many related items in the balance sheet help the analyst develop his interpretation as to the
company's financial strengths and operation’s performance. Financial statements report both the firm’s
position as of a certain period and on its operations for a certain period. As mentioned earlier, the real
value of financial statements is in the fact that they can be used to help predict the firm’s future
earnings and dividends, thus, an analysis of the firm’s ratios is generally the first step in a financial
analysis. The ratios are designed to show relationships between financial statement accounts. For
instance, Company X might have a debt of P5 million and interest charges of P400 thousand, while
Company Y might have debt of P50 million and interest charges of P4 million. Which company is
stronger? The true burden of these debts, and the companies’ ability to repay them can be ascertained
(1) by comparing each firm’s debt to its assets and (2) by comparing the interest it must pay to the
income it has available for payment of interest. Such comparisons are what we called ratio analysis.
The three major areas that concern the users of financial statements are:
1. Stability
2. Solvency or liquidity, and
3. Profitability.
Analyzing ratios as a whole could be more meaningful, even though they are computed
individually; the totality of it could give the final interpretation about the company's financial and
operating conditions. The following are the most common ratios used by financial analysts:
Analyzing the Balance Sheet
A. Liquidity Ratios
These are ratios that show the relationship of the company’s cash and other current
assets to its current liabilities. Liquidity is the number one concern of most financial analysts.
This will indicate whether the firm can meet its maturing obligations. The most common
liquidity ratios and their procedural computations are:
1. Working Capital = Current assets minus current liabilities
This is the excess of current assets over current liabilities. To some, working capital is
used to designate current assets only as the amount intended for day to day operations of the
business. Thus, the use of the term net working capital is more appropriate. The bigger the net
working capital the better as it would mean more current assets are available for operations.
2. Current Asset Ratio = Current assets divided by current liabilities
This is the basic test of liquidity of the firm. This will determine the adequacy of
working capital or the ability to meet current obligations. The higher the current asset ratio, the
better, as this would mean there are more current assets available for paying its current
obligations.
3. Quick (Acid) Test Ratio = Quick assets divided by current liabilities
Quick or acid test ratio is a more stringent test of ability to pay current obligations as
they come due. Quick assets are: Cash and cash equivalents, marketable securities, short-term
notes and accounts receivables. In this regard, inventory and prepaid expenses are not included
in the computation of quick asset ratio as inventories are typically least liquid among the
current assets, while, prepaid expenses are not convertible to cash. Though the analyst must do
a careful analysis since accounts receivable could be converted into cash later than inventory. It
is in the case of aged accounts receivable which are normally considered as bad debts. The
opposite could be observed wherein inventory can be converted to cash earlier than accounts
receivable, in the case of cash sales. The higher the quick asset ratio, the better liquidity position
of the firm.
B. Asset Management Ratios
These are set of ratios, which measures how effectively a firm is managing its assets.
These ratios are also called asset utilization ratio, which pertains to how effectively the firm
utilized its assets to earn profits.
These ratios are designed to answer questions like:
• Does the total amount of each type of asset as reported on the balance sheet seem
maintained at a reasonable level?
• Will too high or too low current assets in relation to the projected or actual operating
levels affect profitability?
Normally companies borrow or obtain capital from other sources to acquire assets. If a
company has too many assets acquired through borrowings, the interest expenses will be too
high and, hence the profits will be lower. On the other hand, if assets are too low, profitable
sales may be lost. Therefore, managing these assets, particularly current assets will help the
firm avoid borrowing funds to finance operations. The most common asset management ratios
are:
1. Accounts Receivable Turnover = Net sales on account divided by average A/R*
*Average A/R = (Beg + End) divided by 2
This will measure the efficiency of collections. How fast collections are being made.
Whenever possible, monthly balances of accounts receivable is used in determining average
accounts receivable. The net sales used as numerator are assumed to be all credit sales only.
The higher the turnover, the better, this would mean a greater number of times receivable is
reinvested for more profit.
2. No. of days in A/R or Average collection period

= 365 days( in a year) divided by AR Turnover
or
= Average AR divided by the Average Daily Sales
This is to measure the number of days the firm invests in accounts receivable. The
shorter the collection period, the better for the company as it could present reinvestment
opportunities, which mean additional income.
3. Inventory Turnover = Cost of Sales divided by Average Inventory
*Average Inventory = (Beg + End) divided by 2
Similar with accounts receivable, inventory turnovers are used to determine how fast
inventory were converted into sales. Whenever possible, monthly average inventory is a better
measure. The higher the inventory turnover, the better, as this would mean more number of
times inventory is reinvested and more profit will be realized.
4. No. of days in Inventory or Average Selling period

= 365 days( in a year) divided by Inventory Turnover
This determines the number of days’ in inventory is held as stock before it will be sold.
The shorter the number of days it is held on stock, the better it will be as it means more number
times it is reinvested by the firm.
For a manufacturing firm, the number of days and turnover will be determined for each
item in the inventory, such as the finished goods, the work in process and raw materials
inventory.
• Finished goods turnover is computed by dividing the cost of sales by the average
finished goods inventory
• Work in process turnover is computed by dividing the cost of goods
manufactured by the average work in process.
• Raw materials turnover is computed by dividing the raw materials used by the
average raw materials inventory.
5. Fixed Assets Turnover or Fixed Assets Utilization Ratio

= Sales divided by Net Fixed Assets
6. Total Assets Turnover = Sales divided by Total Assets

These two measures determine the number of times investments in assets are reinvested
in sales. The more the number of times it turnover, means the higher profit the company
utilized its assets.
C. Debt Management Ratios or Financial Leverage
These ratios will measure the extent to which firm uses its debt financing or the so-called
financial leverage. Some important implications could be raised in managing financial leverage,
these are:
• By raising funds through debt, the owners can maintain control of the firm with limited
investment.
• Creditors look to the equity, or owner-supplied funds, to provide a margin of safety,
that is, if the owners have provided only a small proportion of the total financing, the
risks of the enterprise are borne mainly by its creditors.
Financial leverage raises the expected rate of return to stockholders for two reasons:
• Since interest is deductible, the use of debt financing lowers the tax and leaves more of
the firm’s operating income available to its investors.
• If the rate of return on assets (income before tax divided by the total assets) exceeds the
interest rate on debt, as it generally does, then a company can use debt to finance assets,
pay the interest on the debt, and have something left over for its stockholders.
Normally, firms with relatively high debt ratios are exposed to more risk of losses when
the economy is in a recession, but they also have higher expected returns when the economy
booms. Conversely, firms with low debt ratios are less risky, but they also forego the
opportunity to leverage up their return on equity. The prospects of high returns are desirable,
but investors are reluctant to risk. Therefore, decisions about the use of debt require firms to
balance higher expected returns against increased risk. Determining the optimal amount of
debt for a given firm is a complicated process. That is why this chapter will simply look at the
procedures on how to:
• examine the firm’s debt ratio as to the extent to which borrowed funds have been used
to finance assets, and
• review income statement ratios to determine the number of times fixed charges are
covered by operating profits.
These two ratios are complementary and must be analyzed at the same time.
1. Debt to Total Asset Ratio = Total Debt divided by Total Assets
This is the ratio of total liabilities to total assets. As discussed earlier, it measures to
what extent that portion of the total assets provided by the creditors.
2. Debt to Equity Ratio

= Total Liabilities divided by Total Stockholder's Equity
It measures the resources provided by the owners in the business. It provides

information on the equivalent amount provided by creditors for every P1 provided by the
owners.
3. Times-Interest-Earned Ratio = EBIT* divided by the Interest Charges
*EBIT - Earnings Before Interest and Taxes

This measures the ability of the firm to meet its annual interest payments. It will also
measure the extent to which operating income can decline before the firm is unable to meet its
annual interest costs. Failure to meet this obligation can bring legal action by the firm’s
creditors, possibly resulting in bankruptcy.
Note that earnings before interest and taxes, rather than net income is used in the
numerator. This is because interest is a deductible cost, and the ability to pay current interest is
not affected by taxes.
4. Fixed Charge Coverage = (EBIT + Fixed Charges ) divided by

(Interest Charges + Fixed Charges)
This ratio is like the “times interest earned ratio”, but it is more inclusive in that it
recognizes that many firms incur many fixed charges. As many firms lease assets, retirement
fund contributions, sinking funds contribution, and incur long-term obligations under lease
contracts. Leasing has become widespread in certain industries making this ratio a must to
many financial analysts. Fixed charges are defined as interest plus annual fixed charges.
5. Cash Flow Coverage Ratio
= (EBIT + Fixed Charges + Depreciation) divided by

[Interest Charges + Fixed Charges + (Preferred Stock Dividends/(1–tax rate) + (Debt
Repayment/1–tax rate)]
This ratio shows the margin by which the firm’s operating cash flows cover its financial
requirements. Normally, firms with preferred stocks require paying preferred dividends as
well as its annual repayments of principal on loans. Depreciation is added back to EBIT, since it
was deducted from income to arrive at EBIT without cash outflow. Dividing an after-tax
number by (1-tax rate) is often called “grossing up” the net after-tax number. Because preferred
dividends and loan payments must be made from income remaining after payment of income
taxes, dividing by (1-tax rate) “grossed up” the payments and shows the before-tax amounts
necessary to produce a given after-tax amount.
For instance, to pay P10,000 of preferred dividends and the tax rate is 40%, we need
P16,667 computed as follows: [P10,000 /(1-.40)]. To prove, P16,667 earnings before income tax
(EBIT) less the tax of P6,667 (P16,667 x 40%) will give us P10,000.
6. Book Value of Securities = Value of each security* divided by

each number of shares outstanding
*Securities are bonds, preferred stocks and common stocks
7. Capitalization Ratios
= the proportion of the face value of a particular type of security to the company's total
equity (creditors' and owners' equities). This is normally applicable only to long term debts.
Analyzing the Income Statement
D. Profitability Ratios
These ratios would show the net result of the policies and decisions the management did in the
current period. The combined effects of liquidity, asset management, and debt management on
operating results will be analyzed using these ratios.
1. Profit Margin = Net Income available to Common Stock

divided by Sales
2. Return on Sales = Net income divided by Net Sales
3. Return on Total Assets (ROA)

= Net Income available to Common Stock divided by Average Total Assets
or
= (Net Income plus Interest Expenses net of its tax effect)
divided by Average Total Assets
Average Total Assets = (TA beg + TA, end) divided by 2
4. Return on Common Equity (ROE)

= Net Income available to Common Stock divided by
the Average Common Stock Equity
5. Basic Earning Power = EBIT divided by Average Total Assets
This ratio indicates the ability of the firm’s assets to generate operating income. This
ratio shows the raw earning power of the firm’s assets, before the influence of taxes and
leverage, and it is useful for comparing firms with different tax situations and different degrees
of financial leverage.
6. Earnings Per Share (EPS) or Basic EPS

= (Net Income Available to Common Stockholders before Extraordinary Items net of its
tax effect) divided by
Weighted Average Number of Shares Outstanding
7. Dividend Per Share = Dividends Paid to Common Stock divided by

Common Shares Outstanding
8. Dividend Pay- Out Ratio = Dividends Per Share of Common Stock divided by
Earnings Per Share
This measures the amount of dividend paid for every P1 earnings or the percentage of
distributed earnings in relation to EPS.
Analyzing the Retained Earnings
E. Market Value Ratios
This is a set of ratios that relate the firm’s stock price to its earnings and book value per share.
These ratios give the management an indication of what investors think of the company’s past
performance and prospects. If the firm’s liquidity, asset management, debt management and
profitability ratios are all good, then, its market value ratios will be high, and its stock price is expected
to be as high it can be.
1. Price-Earnings Ratio = Market Price Per Share of Common Stock divided by EPS
This ratio shows the peso amount investors will pay for every P1 of current earnings.
2. Market-Book Ratio = Market Price Per Share divided by

Book Value Per Share
This ratio of a stock’s market price to its book value gives another indication of how investors
regard the company. Companies with relatively high rates of return on equity generally sell at higher
multiples of book value than those with low returns.
3. Dividend Yield Ratio = Dividends Per Share of Common Stock

divided by Market Price Per Share
This ratio measures the rate of return on actual dividend distribution to common stockholders.
Note: All of these turnover and ratios could be more meaningful if they are compared to the industry
standards so that the analyst could assess the performance of the company in relation to its competitors.
Illustrative Problem
Financial Statements Analysis of James Corporation
Year 2 Year 1
1. Working Capital
Current Assets P100,500 P87,900
Less, Current Liabilities 40,000 36,150
Working Capital P 60,500 P51,750
2. Current Asset Ratio

Current Assets P100,500 P87,900
Current Liabilities 40,000 36,150
CAR 2.6 : 1 2.43 : 1
3. Quick Asset Ratio

Quick Assets P39,750 P36,000
Current Liabilities 40,000 36,150
QAR .99 : 1 .99 : 1
4. Accounts Receivable Turnover
Net sales / Ave. A/R = P261,000 / [(36,000 + 33,000)/2 = 7.56 times
5. No. of Days in A/R

365 days / 7.56 = 48.28 days or
Ave. A/R / average daily sales
P34,500 / (P261,000 / 365 days)= 48.25 days
6. Inventory Turnover
= Cost of Sales / Ave. Inventory
= P187,790 / [(P60,000 + 51,000)/2]
= 3.38 times
7. No. of Days in Inventory

= 365 days / 3.38 = 108 days or
Ave. Inventory / average daily cost of sales
P187,790 / (P187,790 / 365 days)= 108 days
8. Debt Equity Ratio

Total Liabilities P150,000 P144,150
Total Stockholders' Equity 210,000 188,800
Debt Equity ratio .71 : 1 .76 : 1
9. Book Value of Securities

Preferred Stock = P18,000/(P18,000/ P100)
= P18,000/180 shares = P100 per share
Common Stock = P192,000 / (P75,000 / P10)

= P192,000 / 7,500 shares
= P25.60 per share
But if book value is computed to serve as a backing of Long-Term liabilities, Preferred stocks in
case of liquidation, computational procedure would be as follows:
Total Assets P360,000

Less, Current Liabilities 40,000
Net Assets backing the claims of bondholders P320,000
Book Value per Bond/Notes = Net Assets available divided by of Bond Outstanding
= P320,000 / 110
= P2,909 per share of P1,000 bond outstanding
Net Assets Backing Bonds P320,000

Less, Bonds Payable/Notes 110,000
Net Assets Backing Preferred Stock P210,000
Book Value Per Share of P/S = Net Assets available divided by

No. of P/S Outstanding
= P210,000 / 180 shares
= P1,667 per share of P100 par
value Preferred Stock
Net Assets Backing Preferred Stock P210,000

Less, Preferred Stock 18,000
Net Assets Backing Common Stockholders P192,000
Book Value Per Share of C/S = Net Assets Available divided by

No. of Common Shares Outstanding
= P192,000 / 7,500 shares
= P25.60 per share of P10 par common stock
Notice that the book value per share in No. 9 is the same at P25.60.
10. Capitalization Ratios, Proportion of the Face Value of a particular security:
Amount Percentage
Long Term Notes P110,000 34%
Preferred Stock 18,000 6%
Common Stock 192,000 60%
Totals P320,000 100%
11. Return on Sales = Net Income / Net Sales

= P33,840 / P261,000 = 12.96%
12. Return on Assets = Net Income Before Interest, net of tax / Ave. T.A
= (33.840 + P8,463) / [(P360,000 + P332,550) /2]
= (P33,840+ 8,463) / P346,250 = 12.21%
Interest net of tax:

Interest Expense P12,090
Assume tax rate of30% 3,627
Interest net of tax effects P 8,463
13. Return on Equity = Net income available to CS / Average total SE

= (P33,840 - P1,440)/[(P192,000 + P170,800)/2]
= (P33,840 - P1,440)/P181,400 = 17.86%
14. Interest Coverage = [Operating Income or EBIT]/Interest Expense

= P57,210/P12,090 = 4.73 times
15. Preferred Stock Coverage = (Net Income after Interest and After Tax)
Divide by Stated Preferred Stock Dividends
= P33,840/P1,440 = 23.50 times
16. Earnings Per Share = Net Income/No. of C/S Outstanding (simple)

= (P33,840 - P,440) / 7,500 shares = P4.32 per share
17. Price Earnings Ratio = Market Value Per Share/EPS

= P195 / P4.32 = 45.13
18. Dividend Pay Out = Dividend Per Share of CS/EPS

(P14,400 /7,500)/P4.32 = 44.44%
19. Dividend Yield = Dividend Per Share/Market Price Per Share

= P1.92/P195 = 10%
Notes to Financial Statements
Published financial statements are accompanied by notes. These narratives provide greater
detail of information that is included very concisely in the financial statements. Many people find
some notes to be complicated. Nevertheless, they can be extremely important, and should be viewed
as an integral part of the financial statements. Information typically disclosed in the notes includes:
➢ Details of the inventory costing and depreciation methods used.

➢ Contingent liabilities and pending lawsuits
➢ Long term leases, if any.
➢ Terms of executive employment contracts, profit sharing programs, pension plans, and stock
options granted to employees.
Note that if you really want to analyze a set of financial statements thoroughly don't pass over
the "Notes to Financial Statements".
Limitations of Financial Statement Analysis
Financial statements and the financial ratios derived from them are but a single source of
information about a company. Like any management accounting information, financial ratios serve
only as an attention-directing device. The ratios raise questions more often than they answer them. An
analyst must follow up the financial statement analysis with in-depth research on a company's
management styles, its history and trends, the industry, and the national and international economies
in which the firm operates.
Further, as financial statements are historical costs, inflation could badly distort balance sheets
particularly depreciation charges and inventory costs which affect profit. Thus, a ratio analysis for one
firm for several periods or different companies of different ages must be interpreted with extra care
and judgement.
Several factors make financial analysis difficult. One of them is variations in accounting methods
among firms. As in the case of different methods of inventory valuations and depreciation can lead to
differences in reported profits for identical firms, and a good financial analyst must be able to adjust for
these differences so that he or she can make valid comparisons among companies. Again, analysis will
be more meaningful if we make comparisons.
Another is timing. An action is taken at one point in time, but its full effects cannot be
accurately measured until some later period. As the cash account is the steering wheel of every firm,
the effects of the cash flow cycle could be accurately measured at a different time. Cash could be
depleted as a result of acquisition of fixed assets to boost production and sales activities and net income
was recognized at the same period though collection of cash again could be done at a later period.
As such, at that same period, current asset ratio may seem not good, but profit seems better. It is
also difficult to generalize whether a particular ratio is “good” or “bad”. For instance, a high current
ratio may indicate strong liquidity position which in fact illiquid since most of its current asset is in the
form of non-moving inventory or in the form of aged accounts receivable. Even excessive cash is not
good as cash itself is a non-earning asset.
Therefore, financial statement analysis must be interpreted as a whole, co-relating its

weaknesses and strengths rather individual ratios.
I. TRUE-FALSE STATEMENTS Write “True” if the statement is true and write “False” if the statement is
false.
1. Attention directing is one of the many basic objectives of financial statement analysis.
2. Since financial statements are summary of historical data, it cannot be used to predict the future
for management decision making purposes.
3. The ratio that shows the margin by which the firm’s operating cash flows cover its financial
requirements is the cash flow coverage ratio.
4. Companies with relatively high rates of return on equity generally sell at higher multiples of
book value than those with low returns.
5. If the firm’s liquidity, asset management, debt management and profitability ratios are all good,
then, its market value ratios will be high, and its stock price is expected to be as high it can be.
6. A high current asset ratio is always an indication of strong liquidity position.
7. In trend analysis, percentage figures are usually computed by using the most recent year as a
base.
8. Common-size statements are statements of companies of similar size and operations.
9. An extremely high current ratio may be an indication that receivables and inventories are
excessive.
10. Trend percentages in financial statements would be an example of vertical analysis.
11. A common-size statement is one that shows the separate items appearing on it in percentage
form, with each item stated as a percentage of some total of which that item is a part.
12. If earnings remain unchanged and the price/earnings ratio goes up, then, one would expect the
market price of a stock to go down.
13. Investors seeking capital gains would like the dividend pay-out ratio to be high.
14. Dividing the market price of share of stock by the dividends per share gives the price/earnings
ratio.
15. Book value per share is not a good predictor of either earnings potential or debt paying ability.
16. In computing the dividend yield ratio, the investor should use the current market price for the
stock, rather than the price that he or she paid for it.
17. If the return on total assets is greater than the after-tax cost of long-term debt, then, leverage is
positive, and the common stockholders will benefit.
18. The inventory turnover is computed by dividing sales by average inventory.
19. Companies that experience high earning on some occasions and suffer losses on other occasions
should rely heavily on the use of financial leverage.
20. If a company’s return on total assets is substantially higher than its cost of borrowing, then, the
common stockholders would normally want the company to have a high debt/equity ratio.
21. Comparisons within a company are often useful to detect changes in financial relationships and
significant trends.
22. Comparisons with other companies provide insight into a company’s competitive position.
23. Comparisons with industry averages provide information about a company’s relative position
within the industry.
24. Horizontal analysis is a technique for evaluating financial statement data that expresses each
item in a financial statement as a percent of a base amount.
25. Comparisons of company data with industry averages provide information about a company's
relative position within the industry.
26. Horizontal, vertical, and ratio analyses are the basic tools of financial statement analysis.
27. Horizontal analysis is a technique for evaluating a financial statement item in the current year
with other items in the current year.

28. If a company has sales of P110 in 2008 and P154 in 2007, the percentage increase in sales from
2007 to 2008 is 140%.
29. In horizontal analysis, if an item has a negative amount in the base year, and a positive amount
in the following year, no percentage change for that item can be computed.
30. A primary purpose of vertical analysis is to observe trends over a three-year period.
31. Vertical analysis is a technique for evaluating a series of financial statement data over a period
to determine the increase (decrease) that has taken place.
32. Using vertical analysis of the income statement, a company's net income as a percentage of net
sales is 10%; therefore, the cost of goods sold as a percentage of sales must be 90%.
33. Liquidity ratios measure the ability of the enterprise to survive over a long period of time.
34. A solvency ratio measures the income or operating success of an enterprise for a given period.
35. Receivable turnover is useful in assessing the profitability of receivables.
36. The inventory turnover ratio measures the number of times on average the inventory was sold
during the period.
37. Inventory turnover is a measure of liquidity that focuses on efficient use of inventory.
38. Profitability ratios are frequently used as a basis for evaluating management's operating
effectiveness.
39. The return on assets ratio will be greater than the rate of return on common stockholders'
equity if the company has been successful in trading on the equity at a gain.
40. From a creditor's point of view, the higher the total debt to total assets ratio, the lower the risk
that the company may be unable to pay its obligations.
II. MULTIPLE CHOICE QUESTIONS Encircle the letter that corresponds to the best answer.
1. The percentage change in total assets between two balance sheet dates is an example of:
a. vertical analysis.
b. horizontal analysis.
c. capital analysis.
d. profitability analysis.
2. The tools and techniques used to analyze financial statements are divided into broad categories
including all the following except:
a. capital analysis.
b. vertical analysis.
c. horizontal analysis.
d. ratio analysis.
3. The percentage change in any individual item shown on comparative financial statements is
calculated by dividing the peso amount of the change from the base-period to the current
period by:
a. the amount shown for the current period.
b. the sum of the current period amount and the base-period amount.
c. the average of the amounts shown for the base period and the current period.
d. the base-period amount.
4. The fact that sales increased by P20,000 from 2017 to 2018 would most likely be revealed by:
a. horizontal analysis.
b. vertical analysis.
c. ratio analysis.
d. liquidity analysis.
5. Horizontal analysis involves the study of:

a. percentage changes in the balances shown in comparative financial statements.
b. the percentage amount of various financial statement amounts compared to a total amount
on the financial statement.
c. the change in key financial statement ratios over a certain time frame or horizon.
d. the interrelationship between the income statement and balance sheet.
6. When preparing a horizontal analysis of financial statements, subtract the:

a. later year amount from the earlier year amount and divide by the later
year amount.
b. earlier year amount from the later year amount and divide by the later year amount.
c. earlier year amount from the later year amount and divide by the earlier year amount.
d. later year amount from the earlier year amount and multiply by the earlier year amount.
7. When calculating trend percentages, all percentages shown are relative to:
a. an average index calculated for all the years shown.
b. the current year.
c. the base year.
d. the immediately preceding year.
8. Under which of the following cases may a percentage change be computed?

a. The trend of the amounts is decreasing but all amounts are positive.
b. There is no amount in the base year.
c. There is a negative amount in the base year and a negative amount in the subsequent year.
d. There is a negative amount in the base year and a positive amount in the subsequent year.
9. Horizontal analysis is a technique for evaluating a series of financial statement data over a
period.
a. that has been arranged from the highest number to the lowest number.
b. that has been arranged from the lowest number to the highest number.
c. to determine which items are in error.
d. to determine the amount and/or percentage increase or decrease that has taken place.
10. Horizontal analysis of comparative financial statements includes the

a. development of common size statements.
b. calculation of liquidity ratios.
c. calculation of peso amount changes and percentage changes from the previous to the
current year.
d. evaluation of financial statement data that expresses each item in a financial statement as a
percentage of a base amount.
11. Ratios are most useful in identifying

a. trends.
b. differences.
c. causes.
d. relationships.
12. Short-term creditors are usually most interested in assessing

a. solvency.
b. liquidity.
c. marketability.
d. profitability.
13. A common measure of liquidity is

a. return on assets.
b. receivable turnover.
c. profit margin.
d. debt to equity.
14. A common measure of profitability is

a. the acid test or quick ratio.
b. current cash debt coverage ratio.
c. return on common stockholders’ equity ratio.
d. debt to total assets.
15. A common measure of long-term solvency is
a. cash debt coverage ratio.
b. current ratio.
c. asset turnover ratio.
d. inventory turnover.
16. Return on assets ratio is most closely related to
a. profit margin and debt to total assets ratio.
b. profit margin and asset turnover ratio.
c. times interest earned and debt to stockholders’ equity ratios.
d. profit margin and free cash flow.
17. Return on common stockholders’ equity ratio is most closely related to
a. gross profit rate and operating expenses to sales ratio.
b. profit margin and free cash flow.
c. times interest earned and debt to stockholders’ equity ratios.
d. return on asset ratio and leverage (debt to total asset ratio).
18. Long-term creditors are usually most interested in evaluating
a. liquidity.
b. marketability.
c. profitability.
d. solvency.
19. Which one of the following would be considered a long-term solvency ratio?
a. Receivable turnover
b. Return on total assets

c. Current cash debt coverage ratio
d. Debt to total asset ratio
20. Stockholders are most interested in evaluating
a. liquidity.
b. solvency.
c. profitability.
d. marketability.
21. The current ratio is
a. calculated by dividing current liabilities by current assets.
b. used to evaluate a company's liquidity and short-term debt paying ability.
c. used to evaluate a company's solvency and long-term debt paying ability.
a. calculated by subtracting current liabilities from current assets.
22. A company with P60,000 in current assets and P40,000 in current liabilities pays a P1,000 current
liability. As a result of this transaction, the current ratio and working capital will
a. both decrease.
b. both increase.
c. increase and remain the same, respectively.
d. remain the same and decrease, respectively.
23. The receivable turnover and inventory turnover ratios are used to analyze
a. long-term solvency.
b. profitability.
c. liquidity.
d. leverage.
24. A high receivables turnover ratio indicates

a. customers are making payments quickly.
b. a large portion of the company’s sales are on credit.
c. many customers are not paying their receivables.
d. the company’s sales have increased.
25. The assets turnover ratio measures

a. how often a company replaces its assets.
b. how efficiently a company uses its assets to generate sales.
c. the portion of the assets that have been financed by creditors.
d. the overall rate of return on assets.
26. The profit margin ratio is calculated by dividing

a. sales by cost of goods sold.
b. gross profit by net sales.
c. net income by stockholders' equity.
d. net income by net sales.
27. The debt to total assets ratio measures

a. the company's profitability.
b. whether interest can be paid on debt in the current year.
c. the proportion of interest paid relative to dividends paid.
d. the percentage of the total assets provided by creditors.
28. Trading on the equity (leverage) refers to the

a. amount of working capital.
b. amount of capital provided by owners.
c. use of borrowed money to increase the return to owners.
d. number of times interest is earned.
29. A company that is leveraged is one that

a. has a high earnings per share.
b. contains debt financing.
c. contains equity financing.
d. has a high current ratio.
30. A weakness of the current ratio is

a. the difficulty of the calculation.
b. it doesn't take into account the composition of the current assets.
c. it is rarely used by sophisticated analysts.
d. it can be expressed as a percentage, as a rate, or as a proportion.
31. A supplier to a company would be most interested in the
a. asset turnover ratio.
b. profit margin ratio.
c. current ratio.
d. earnings per share.
32. Which one of the following ratios would not likely be used by a short-term creditor in evaluating
whether to sell on credit to a company?
a. Current ratio
b. Inventory turnover ratio
c. Asset turnover ratio
d. Receivables turnover ratio
33. Ratios are used as tools in financial analysis

a. instead of horizontal and vertical analyses.
b. because they can provide information that may not be apparent from inspection of the
individual components of the financial statements.
c. because even single ratios by themselves are quite meaningful.
d. because they are prescribed by GAAP.
34. The ratios that are used to determine a company's short-term debt paying ability are
a. asset turnover, times-interest-earned, current ratio, and receivables turnover
b. times-interest-earned, inventory turnover, current ratio, and receivables turnover
c. times-interest-earned, acid-test ratio, current ratio, and inventory turnover
d. current ratio, acid-test ratio, receivables turnover, and inventory turnover
35. Sweet Company had P250,000 of current assets and P90,000 of current liabilities before
borrowing P60,000 from the bank with a 3-month note payable. What effect did the borrowing
transaction have on Sweet Company's current ratio?
a. The ratio remained unchanged.
b. The change in the current ratio cannot be determined.
c. The ratio decreased.
d. The ratio increased.
36. A liquidity ratio measures the

a. income or operating success of an enterprise over a period of time.
b. ability of the enterprise to survive over a long period of time.
c. short-term ability of the enterprise to pay its maturing obligations and to meet unexpected
needs for cash.
d. number of times interest is earned.
37. If equal amounts are added to the numerator and the denominator of the current ratio and the
ratio is over one, the ratio will always
a. increase.
b. decrease.
c. stay the same.
d. equal zero.
38. If a company has a current ratio of 1.2:1, what respective effects will the
borrowing of cash by short-term debt and collection of accounts receivable have
on the ratio?
Short-term Borrowing Collection of Receivable
a. Increase No effect
b. Increase Increase
c. Decrease No effect
d. Decrease Decrease
39. A general rule to use in assessing the average collection period is

a. that it should not exceed 30 days.
b. it can be any length as long as the customer continues to buy merchandise.
c. that it should not greatly exceed the discount period.
d. that it should not greatly exceed the credit term period.
40. The inventory turnover is calculated by dividing

a. cost of goods sold by the ending inventory.
b. cost of goods sold by the beginning inventory.
c. cost of goods sold by the average inventory.
d. average inventory by cost of goods sold.
III. MULTIPLE CHOICE PROBLEMS Encircle the letter that corresponds to the best answer.
1. A company reported P18,000 of net income for 2016, P24,000 for 2017, and P26,000 for 2018. The
percentage change in net income from 2017 to 2018 was:
a. 20.00%.
b. 30.00%.
c. 10.00%.
d. 8.33%.
2. Assuming the inventory balance at the end of 2016 is P20,000 and it has increased by 15% since
the end of 2015, the balance at the end of 2015 (rounded to the nearest whole peso) was:
a. P17,000.
b. P18,000.
c. P16,364.
d. P17,391.
3. If year one equals P700, year two equals P742, and year three equals P770, the percentage to be
assigned for year three in a trend analysis, assuming that year one is the base year, is
a. 110%.
b. 106%.
c. 91%.
d. 100%.
4. Assume the following sales data for a company:

2018 P1,000,000
2017 900,000
2016 750,000
2015 600,000
If 2015 is the base year, what is the percentage increase in sales from 2015 to 2016?
a. 125%
b. 167%
c. 25%
d. 20%
5. A company had a balance in the Accounts Receivable account of P780,000 at the beginning of
the year and a balance of P820,000 at the end of the year. Net credit sales during the year
amounted to P5,840,000. The average collection period of the receivables in terms of days was
a. 30 days.
b. 365 days.
c. 100 days.
d. 50 days.
6. A company had a balance in the Accounts Receivable account of P780,000 at the beginning of
the year and a balance of P820,000 at the end of the year. Net credit sales during the year
amounted to P5,840,000. The receivable turnover ratio was
a. 7.1 times.
b. 7.3 times.
c. 7.5 times.
d. 7 times.
Use the following information for questions 7-8.

Banner Corporation had net income of P250,000 and paid dividends to common
stockholders of P50,000 in 2016. The weighted average number of shares outstanding in 2016 was
50,000 shares. Banner Corporation's common stock is selling for P50 per share on the Makati Stock
Exchange.
7. The company’s price-earnings ratio is

a. 2 times.
b. 8 times.
c. 10 times.
d. 5 times.
8. The company's payout ratio for 2016 is

a. P5 per share.
b. 25%.
c. 20%.
d. 12.5%.
9. Cliff Company reported the following on its income statement:

Income before income taxes P420,000
Income tax expense 120,000
Net income P 300,000
An analysis of the income statement revealed that interest expense was P80,000. The company’s
times-interest-earned ratio was
a. 8 times.
b. 5.25 times.
c. 6.25 times.
d. 5 times.
10. A company has a receivables turnover ratio of 10. The average net receivables during the
period are P400,000. What is the amount of net credit sales for the period?
a. P40,000
b. P4,000,000
c. P480,000
d. P520,000
11. A company has an average inventory on hand of P60,000 and its average days in inventory is
29.2 days. What is the cost of goods sold?
a. P750,000
b. P1,752,000
c. P1,680,000
d. P876,000
12. Net sales are P1,500,000, beginning total assets are P700,000, and the asset turnover is 3.0. What
is the ending total asset balance?
a. P500,000
b. P300,000
c. P700,000
d. P400,000
Use the following information to answer questions 13-20.

The following information pertains to Greenwich Company. Assume that all balance sheet
amounts represent both average and ending balance figures. Assume that all sales were on credit.
Assets
Cash and short-term investments P 40,000
Accounts receivable, net 25,000
Inventory 20,000
Property, plant and equipment 210,000
Total Assets P295,000
Liabilities and Stockholders’ Equity

Current liabilities P 60,000
Long-term liabilities 85,000
Stockholders’ equity-common 150,000
Total Liabilities and
Stockholders’ Equity P295,000
Income Statement
Sales P 85,000
Cost of goods sold 45,000
Gross margin 40,000
Operating expenses 20,000
Net income P 20,000
Number of shares of common stock 6,000

Market price of common stock P20
Dividends per share .90
Cash provided by operations P30,000
13. What is the current ratio for this company?

a. 1.42
b. 0.80
c. 1.16
d. 0.60
14. What is the receivable turnover for this company?

a. 2.8 times
b. 2 times
c. 3.4 times
d. 3 times
15. What is the inventory turnover for this company?

a. 2 times
b. 2.25 times
c. 1 time
d. 0.44 time
16. What is the return on assets for this company?

a. 6.8%
b. 10.5%
c. 11.7%
d. 26.7%
17. What is the profit margin for this company?

a. 42.86%
b. 18.75%
c. 23.5%
d. 15.0%
18. What is the return on common stockholders’ equity for this company?
a. 13.3%
b. 5%
c. 23.3%
d. 53.3%
19. What is the price earnings ratio for this company?

a. 6 times
b. 2.5 times
c. 8 times
d. 4 times
20. What is the current cash debt coverage ratio for this company?
a. 0.5 times
b. 3 times
c. 0.33 times
d. 0.14 times
21. A company has the following balance sheet information in ‘000:
Current Assets P4,000

Current Liabilities 1,000
Long term Assets 8,000
Long term Liabilities 2,000

Common Stock 4,000
Retained Earnings 5,000
There was no interest expense and no dividends were declared. What is the debt/equity ratio
at year-end?
a. 400%
b. 75%
c. 300%
d. 33%
22. A company’s net accounts receivable were P250,000 at December 31, 2016 and P300,000 at
December 31, 2017. Net cash sales for 2017 were P100,000 and the accounts receivable turnover
ratio for 2017 was 5. What were the company’s total net sales for 2017?
a. P135,000
b. P147,500
c. P137,500
d. P150,000
23. Financial records of a company reveal the following:
Net sales P180,000

Cost of goods sold 120,000
Ending inventory 25,000
Beginning inventory 35,000
Assuming a 360 day year, what was the average days to sell inventory?
a. 60 days
b. 75 days
c. 70 days
d. 90 days
24. Assuming that the company has an average inventory of P80,000, sales of P560,000 and a cost of
sales of P480,000, What is the inventory turnover ratio?
a. 13
b. 6
c. 7
d. 1
25. A company reported net income of P10,000 and paid cash dividend on common stock of P2 per
share on each of 2,000 shares outstanding. What is the EPS?
a. P5.00
b. P3.00
c. P4.00
d. P2.00
26. A company’s income statement showed no extraordinary items but showed a net income of
P50,000. There are 100,000 common shares outstanding during the period. Dividends totaled
P20,000 was declared and paid. What is the EPS of the company?
a. P5.00
b. P0.50
c. P3.00
d. P0.30
27. Assume liabilities total P25,000; average common stockholders’ equity totals P80,000; expenses
total P43,000 and return on common stockholders’ equity is 12%. Total revenues earned for the
period is:
a. P9,600
b. P52,600
c. P33,400
d. P77,600
28. A company has a total assets of P80,000 and stockholders’ equity of P60,000. Total current
liabilities is P10,000. The debt to equity ratio is:
a. 0.75 to 1
b. 0.17 to 1
c. 0.33 to 1
d. 13 to 1
From the following information answer the next questions 29-31:

The stockholders’ equity section had the following balances both beginning and ending:
Preferred Stock, P100 par, 8% P100,000

Common Stock, 20 par 60,000
Additional Paid in Capital , common 150,000
Retained Earnings 30,000
During the year, Joy reported interest expense of P4,000, earned net income of P36,800 after taxes
at the rate of 30% and had an average total assets of P400,000.
29. The return on total assets during the year is:

a. 10.2%
b. 9.5%
c. 9.9%
d. 9.2%
30. The return on common stockholders equity is:

a. 61%
b. 15.3%
c. 48%
d. 12%
31. The earnings per share is:

a. P12.27
b. P9.60
c. P10.4
d. P7.20
32. The company uses the allowance method for bad debts. During the year, the company charged
P30,000 to bad debts expense, and wrote-off P25,000 of uncollectible accounts receivable. These
transactions resulted in a decrease in working capital of
a. P0
b. P25,200
c. P4,800
d. P30,000
33. The company's net accounts receivable were P500,000 at December 31, 2016 and P600,000 at
December 31, 2017. Net cash sales for 2017 were P200,000. The accounts receivable turnover for
2017 was 5.0. What was the company’s net sales for 2017?
a. P2,950,000
b. P3,200,000
c. P3,000,000
d. P5,500,000
34. During the year, a company purchased P2,000,000 of inventory. The cost of goods sold for 2017
was P2,200,000 and the ending inventory at December 31, 2017 was P400,000. What was the
inventory turnover for the year?
a. 4.0 times
b. 5.5 times
c. 4.4 times
d. 11.0 times
Use the following information for question 35-38:

The management of a company is preparing its plans for the year 2017. The average assets to be
employed for the year are estimated at P2,600,000 with 20% of this amount borrowed at no interest
cost. Materials and labor cost for the year is budgeted at P4,000,000 while operating cost is
estimated at P1,500,000. All sales are to be billed at 162.5% of materials and labor cost. Income tax
rate is at an average of 35% of income before income tax.
35. The estimated rate of return on sales for 2017 is

a. 10.0%
b. 14.29%
c. 12.5%
d. 27.86%
36. The estimated rate of return on average total assets for 2017 is
a. 20.0%
b. 31.25%
c. 25.0%
d. 40.50%
37. The expected asset turnover for 2017 is:

a. 1.50 times
b. 3.36 times
c. 2.50 times
d. 3.75 times
38. The rate of return on stockholders' equity for 2017 is:

a. 20.0%
b. 31.25%
c. 25.0%
d. 40.50%
Use the following information for questions 39-40: The building of Emerald, Inc. was flashed by
flood thereby destroying its inventories and its financial and accounting records. The recent prior
year, however, the company maintained the following relationships among the data on its
financial statements:
Gross margin on net sales 40%
Net income on net sales 10%
Accounts receivable turnover (sales / ending A/R) 8 per year
Inventory turnover (Cost of sales/Ending inventory) 6 per year
Current Asset ratio 3 to 1
Acid test ratio 2 to 1
Quick asset composition:
Cash 8%
Marketable securities 32%
Accounts receivable 60%
Asset turnover (sales/year-end Total Assets) 2 per year
Ratio of total assets to Intangible assets 20 to 1
Ratio of accumulated depreciation to cost of fixed assets 1 to 3
The company had a net income of P120,000 for the year. Accounts were reconstructed
based on the above given information.
39. What is the balance of the cash account?

a. P25,000
b. P35,000
c. P20,000
d. P30,000
40. What is the accounts receivable, net balance?

a. P100,000
b. P150,000
c. P125,000
d. P200,000
PROBLEMS
2.1
The following table shows selected data for Romulo Corporation for the past four years ended
December 31:
2019 2018 2017 2016

Net credit sales P20,300 P18,400 P17,200 P15,500
Cost of goods sold 9,500 10,300 9,500 8,900
Inventory 13,000 12,200 8,700 9,500
Net accounts 7,500 6,800 7,200 7,000
receivable
Instructions:
a. What was the accounts receivable turnover for 2019?
b. What was the inventory turnover for 2018?
2.2
From the given data, calculate the following ratios for the Salvacion Corporation for 2017.
a. current ratio
b. quick ratio
c. debt to total assets ratio
d. profit margin ratio
Accounts payable P74,000

Accounts receivable 75,000
Cash 125,000
Inventory 90,000
Short-term investments 60,000
Short-term notes payable 40,000
Notes payable (due in 2019) 50,000
Total assets 469,000
Total liabilities 185,000
Net sales 240,000
Net income 31,500
2.3
Comparative information taken from the 7RS Company financial statements
is shown below:
2018 2017
(a) Accounts receivable 175,000 140,000
(b) Retained earnings 30,000 (40,000)
(c) Sales 855,000 750,000
(d) Operating expenses 170,000 200,000
(e) Income taxes payable 22,000 20,000
Instructions:
1. Calculate the peso changes for each item and indicate whether the change is increase of
decrease
2. Calculate the percentage change from 2017 to 2018 with 2017 as the base year.
2.4
The following items were taken from the financial statements of Kam’s Korner, Inc., over a
three-year period:
Item 2019 2018 2017

Net Sales P226,000 P212,000 P200,000
Cost of Goods Sold 150,000 140,000 136,000
Gross Profit P 76,000 P 72,000 P 64,000
Instructions:
Using horizontal analysis and 2017 as the base year, compute the trend percentages for net
sales, cost of goods sold, and gross profit. Explain whether the trends are favorable or unfavorable for
each item.
2.5
Selected information from the comparative financial statements of UrTurn Company for the
year ended December 31 appears below:
2018 2017
Accounts receivable (net) P 175,000 P200,000
Inventory 130,000 150,000
Total assets 1,100,000 800,000
Current liabilities 140,000 110,000
Long-term debt 410,000 300,000
Net credit sales 800,000 700,000
Cost of goods sold 600,000 530,000
Interest expense 40,000 25,000
Income tax expense 60,000 29,000
Net income 150,000 85,000
Net cash provided by operating activities 220,000 135,000
Instructions: Answer the following questions relating to the year ended December 31, 2018. Show
computations.
1. The inventory turnover ratio for 2018 is __________.

2. The number of times interest earned ratio in 2018 is __________.
3. The receivables turnover ratio for 2018 is __________.
4. The return on assets ratio for 2018 is __________.
5. The current cash debt coverage ratio for 2018 is __________.
2.6
UrProf Corporation had the following comparative current assets and current liabilities:
12-31-2018 12-31-2017
Current assets
Cash P 25,000 P 30,000
Marketable securities 40,000 10,000
Accounts receivable 60,000 95,000
Inventory 110,000 90,000
Prepaid expenses 35,000 20,000
Total current assets P 270,000 P245,000
Current liabilities
Accounts payable P120,000 P110,000
Salaries payable 40,000 30,000
Income tax payable 10,000 15,000
Total current liabilities P170,000 P155,000
During 2018, net credit sales and cost of goods sold were P475,000 and P250,000, respectively.
Net cash provided by operating activities for 2018 was P120,000.
Instructions: Compute the following liquidity measures for 2018:

a. Current ratio
b. Current cash debt coverage ratio
c. Receivables turnover
d. Inventory turnover
2.7
The balance sheet for Violeta Corporation at the end of the current year includes the following:
Bonds payable, 6% ..................................................... P5,000,000

6% Preferred stock, P100 par .................................... 1,000,000
Common stock, P10 par ............................................ 2,000,000
Income before income taxes was P950,000 and income tax expense for the current year
amounted to P285,000. Cash dividends paid on common stock were P200,000, and the common stock
was selling for P40 per share at the end of the year. There were no ownership changes during the year.
Instructions: Determine each of the following:

a. Number of times that bond interest was earned.
b. Earnings per share for common stock.
c. Price-earnings ratio.
2.8
GGEM Corporation had net income of P4,000,000 in 2017. Using 2017 as the base year, net
income decreased by 40% in 2018 and increased by 110% in 2019.
Instructions: Compute the net income reported by GGEM Corporation for 2018 and 2019.
2.9
The following ratios have been computed for the RMO Company for 2018.
Profit margin ratio 20%
Times interest earned 12 times
Receivable turnover ratio 5 times
Acid-test ratio 1.4:1
Current ratio 2.5:1
Debt to total assets ratio 24%
The 2018 financial statements of the company with missing information was presented on the
next page:
Use the above ratios and information from RMO Company financial statements to fill in the
missing information on the financial statements. Follow the sequence indicated. Show computations
that support your answers.
Comparative Balance Sheet
December 31
Assets
2018 2017
Cash P 25,000 P 35,000
Marketable securities 15,000 15,000
Accounts receivable (net) ? (6) 50,000
Inventory ? (8) 50,000
Property, plant, and equipment (net) 200,000 160,000
Total Assets P ? (9) P310,000
Liabilities and stockholders' equity

Accounts payable P ? (7) P 25,000
Short-term notes payable 35,000 30,000
Bonds payable ? (10) 20,000
Common stock 200,000 200,000
Retained earnings 47,000 35,000
Total Liabilities and Stockholders' Equity P ? (11) P310,000

Income Statement
For the Year Ended December 31, 2018
Net sales ............................................................................................ P200,000
Cost of goods sold ............................................................................ 100,000
Gross profit ........................................................................................ P100,000
Expenses:
Depreciation expense ................................................................ P ? (5)
Interest expense ......................................................................... 5,000
Selling expenses ......................................................................... 10,000
Administrative expenses .......................................................... 15,000
Total expenses ............................................................................. ? (4)
Income before income taxes ……….............................................. ? (2)
Tax expense ....................................................................................... ? (3)
Net income ........................................................................................ P ? (1)
2.10
RED Corporation has issued common stock only. The company has been successful and has a
gross profit rate of 20%. The information shown below was taken from the company's financial
statements.
Beginning inventory P 482,000
Purchases 4,146,000
Ending inventory ?
Average accounts receivable 700,000
Average common stockholders' equity 3,500,000
Sales (all on credit) 5,200,000
Net income 420,000
Instructions: Compute the following:

a. Receivables turnover
b. Average number of days required to collect the accounts receivable.
c. The inventory turnover
d. Average days in inventory.
e. Return on common stockholders' equity.
2.11
Indicate the effects of the transactions listed in the following table on total current assets, current
ratio, and net profit. Indicate it by a ( + ) sign to mean increase, (- ) to indicate a decrease, and (NE)
for no effect or an indeterminate effect. Assume an initial current ratio of more than 1.0.
Item Total Current Current Effect on

Transactions
s Assets Ratio Net Income
1 Issuance of additional common stock in cash
2 Merchandise is sold for cash
3 A fixed asset is sold less than its book value
4 Income tax due for the previous year is paid
5 A fixed asset is sold for less than book value
6 A fixed asset is sold for more than book value
7 Merchandise is sold on credit

8 Payment is made to trade accounts payable
9 A cash dividend is declared and paid
10 Cash is obtained through short-term loans
11 Short-term notes receivable is sold at a
discount
12 Marketable securities are sold below cost
13 Advances are made to employees
14 Current operating expenses are paid
2.12
PhilArms, Inc. had earnings per share of P4 last year and it paid a P2 dividend. Book value per
share at year-end was P40, while total retained earnings increased by P12 million during the year. The
company has no preferred stock, and no new common stock was issued during the year. If the
company’s year-end debt (which equals its total liabilities) was P120 million, what was the company’s
year-end debt assets ratio?
2.13
Given the following data, reconstruct the balance sheet and the income statement of Libby
Company for the year 2018:
1. Acid test ratio was 1.3 to 1

2. Gross profit was 35% of net sales
3. The age of receivables was 36 days
4. Inventory turnover was 4 times. Beginning inventory, P250,000
5. Total debt to stockholder’s equity was .8 to 1
6. Operating expenses were 15% of sales
7. Times interest earned was 6 times
8. Beginning accounts receivable was P160,000
9. Annual Business day is 360 days
BALANCE SHEET
ASSETS LIABILITIES & EQUITY
Cash ? Current Liabilities ?
Marketable Securities 50,000 Bonds Payable,12.5% long ?
term
Accounts Receivable, ? Common Stock 500,000
net
Inventories ? Retained Earnings 300,000
Plant Assets ?
TOTAL ASSETS ? TOTAL LIABILITES & ?
EQUITY
INCOME STATEMENT
Net Sales ?
Less, Cost of goods sold ?
Gross profit on sales 525,000
Less, Operating expenses ?
Operating Income ?
Less, Other Expense – Interest Expense ?
Net Income before taxes ?
Less, Tax Expense ( 35% rate) ?
Net Income after tax ?
2.14 MATCHING
For each of the ratios listed below, indicate by the appropriate code letter, whether it is a
liquidity ratio, a profitability ratio, or a solvency ratio.
Code: L = Liquidity ratio; P = Profitability ratio; S = Solvency ratio

____ 1. Price-earnings ratio
____ 2. Return on assets ratio
____ 3. Receivables turnover ratio
____ 4. Earnings per share ratio
____ 5. Payout ratio
____ 6. Current cash debt coverage ratio
____ 7. Current ratio
____ 8. Debt to total assets ratio
____ 9. Free cash flow
____ 10. Inventory turnover ratio
2.15
For this coming General Stockholders meeting of Mydear Corporation, the Chief Finance Officer,
Mr. Santos, is tasked to discuss the financial statement analysis. The Chief Accountant prepared the
following financial statements for the years 2018 and 2017 for management purposes:
Instructions:
1. Based on the financial statements presented prepare following:

a. Common size financial statements for both years
b. Horizontal comparison using peso changes and percentage changes.
2. Using the format provided, make a financial statement analysis and make interpretations based on
the given industry standards.
Mydear Corporation
Income Statements for years ending December 31
(In thousands of pesos, except for per share data)
2018 2017
Net sales 3,000 2,850
Cost and expenses
Labor and materials 2,544 2,413
Depreciation 100 90
Selling 22 20
General and Administrative expenses 40 35
Lease payments on buildings 28 28
Total operating costs 2,734 2,586
Net Earnings before interest and taxes (EBIT) 266 264
Less, Interest Expense
Interest on notes payable 8 2
Interest on firs mortgage bonds 40 42
Interest on debenture bonds 18 3
Total interest 66 47
Net earnings before taxes 200 217
Tax expense (average rate of 40%) 80 87
Net income before preferred dividends 120 130
Dividends to preferred stockholders 8 8
Net income available to common stockholders 112 122
Disposition of net income
Dividends to common stockholders 92 82
Addition to retained earnings 20 40
Per share of common stock
Stock price (year end) 26.50 27.00
Earnings per share (EPS)* 2.24 2.44
Dividends per share (DPS)* 1.84 1.64
*There are 50,000 shares of common stock outstanding. EPS is based on earnings after preferred
dividends. EPS and DPS for Y2018 :
EPS = Net income after tax / Common shares outstanding

= P112,000 / 50,000 shares = P2.24
DPS = Dividends paid to common stockholders / common shares outstanding

= P92,000 / 50,000 shares = P1.84
Mydear Corporation
December 31 Balance Sheets
(In thousands of Pesos)
2018 2017
ASSETS
Cash 50 55
Marketable Securities 0 25
Accounts Receivable 350 315
Inventories 300 215
Total current assets 700 610
Plant and Equipment 1,800 1,470
Less, Accumulated Depreciation 500 400
Net book value 1,300 1,070
TOTAL ASSETS 2,000 1,680
LIABILITIES AND EQUITY

Accounts payable 60 30
Notes payable 100 60
Salaries and Wages Payable 10 10
Taxes Payable 130 120
Total Current Liabilities 300 220
First mortgage bonds Payable 500 520
Debenture bonds Payable 300 60
Total Long-term Debt 800 580
Equity
Preferred Stock (20,000 shares, P1 par value) 20 20
Common Stock (50,000 shares, P1 par value) 50 50
Additional paid in capital 80 80
Retained Earnings 750 730
Total Equity 900 880
TOTAL LIABILITIES AND EQUITY 2,000 1,680
Note: The first mortgage bonds have a sinking fund of P20,000 as a requirement for repayment. The current
portion of long-term debt is included in notes payable.
Statement of Retained Earnings

(In thousands of Pesos)
Retained Earnings, December 31, 2017 P730

Add, Net income for 2018 112
Less, Dividends to stockholders 92
Retained Earnings, December 31, 2018 P750
Mydear Corporation
Summary of Financial Ratios
For the year 2018
(in thousand of pesos)
INDUSTRY
RATIO
RATIOS FORMULA COMPUTATION AVERAGE COMMENTS
RESULT
STANDARD
Liquidity
Current asset
2.5x
ratio
Acid test
1x
ratio
Asset management
Inventory
9x
TO
Day sales in
36 days
inventory
A/R Turn
5x
over
Day sales in
36 days
A/R
Fixed assets
3x
TO
Total Assets
1.8x
TO
Debt Management
Debt to Total
40%
assets
Times
interest 6x
earned
Fixed charge
5.5x
coverage
Cash flow
3.2x
coverage
Profitability
Profit margin 5%
Basic earning
17.2%
power
Return on
total assets 9%
(ROA)
Return on
common 15%
equity(ROE)
Market
value
Price-
earnings 12.5x
ratio
Market-book
1.8x
ratio

02 Financial Statements Analysis

Uploaded by

Copyright:

Available Formats

02 Financial Statements Analysis

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

02 Financial Statements Analysis

Uploaded by

Copyright:

Available Formats

2

1. Understand the objectives of financial statement analysis, and its limitations.

Overview of Financial Statements

The four key financial statements are:

The basic structure of each of these statements and their relationships:

FINANCIAL STATEMENT RELATIONSHIPS

Balance Sheet Balance Sheet

Transactions during the period

Cash Flow Statement

Cash balance beginning

Cash balance 12-31-x2

Cautions About Financial Statements Analysis

Here are some cautions about using financial ratios:

The following simple rules should be observed:

Long-Term Investments 1,500 1,650 (150) -9.1% 0.91

TOTAL ASSETS 360,000 332,550 27,450 8.3% 1.08

LIABILITIES & STOCKHOLDERS’ EQUITY

Long Term Liabilities 110,000 108,000 2,000 1.9% 1.02

Net Sales 261,000 246,000 15,000 6.1% 1.06

Net Operating Income 33,840 33,780 60 0.2% 1.00

Year 1 Year 2 Year 2 Year 1

Year 2 Year 1 Year 2 Year 1

TOTAL ASSETS 360,000 332,550 100.0% 100.0%

LIABILITIES AND STOCKHOLDERS’ EQUITY

Long Term Liabilities 110,000 108,000 32.5% 32.4%

Preferred Stock, P100 par 18,000 18,000 5.4% 5.4%

TOTAL LIABILITIES AND

2018 2017 2016 2015 2014 2013

The trend (in percent) could be developed as follows:

2018 2017 2016 2015 2014 2013

* P261,000 / P216,000 = 1.208 or 121

Analyzing the Balance Sheet

1. Working Capital = Current assets minus current liabilities

2. Current Asset Ratio = Current assets divided by current liabilities

3. Quick (Acid) Test Ratio = Quick assets divided by current liabilities

B. Asset Management Ratios

1. Accounts Receivable Turnover = Net sales on account divided by average A/R*

*Average A/R = (Beg + End) divided by 2

2. No. of days in A/R or Average collection period

3. Inventory Turnover = Cost of Sales divided by Average Inventory

*Average Inventory = (Beg + End) divided by 2

4. No. of days in Inventory or Average Selling period

5. Fixed Assets Turnover or Fixed Assets Utilization Ratio

6. Total Assets Turnover = Sales divided by Total Assets

C. Debt Management Ratios or Financial Leverage

1. Debt to Total Asset Ratio = Total Debt divided by Total Assets

2. Debt to Equity Ratio

It measures the resources provided by the owners in the business. It provides

3. Times-Interest-Earned Ratio = EBIT* divided by the Interest Charges

*EBIT - Earnings Before Interest and Taxes

4. Fixed Charge Coverage = (EBIT + Fixed Charges ) divided by

5. Cash Flow Coverage Ratio

= (EBIT + Fixed Charges + Depreciation) divided by

6. Book Value of Securities = Value of each security* divided by

*Securities are bonds, preferred stocks and common stocks

Analyzing the Income Statement

1. Profit Margin = Net Income available to Common Stock

2. Return on Sales = Net income divided by Net Sales