CPAR:MS 9107A_FINANCIAL STATEMENTS ANALYSIS BATCH MAY 2022

MS9107A – FINANCIAL STATEMENTS ANALYSIS

TOPIC OUTLINE
Definition

Basic
Objectives
Concepts

Problems and
FINANCIAL Limitations
STATEMENTS
ANALYSIS Horizontal Liquidity
Analysis Ratios

Techniques in Vertical Activity

FS Analysis Analysis Ratios

Financial Solvency
Ratios Ratios

Profitability
Ratios

Market-test
Ratios

LECTURE NOTES
BASIC CONCEPTS
Definition
FS Analysis involves careful selection of data from financial statements in order to assess and
evaluate the firm’s past performance, its present condition and future business potentials.
Objectives of FS Analysis
The primary objective of FS Analysis is to determine the extent of firm’s success in attaining its
financial goals in the following areas:
(1) Maximizing profitability
(2) Ability of the firm to pay its obligations
(3) Safety of the investment in the business
(4) Effectiveness and efficiency of management in utilizing the resources entrusted to them
(5) Attain stability in operations.
Problems and Limitations of FS Analysis
(1) The nature of the information
(a) The use of estimates in allocating costs to each period.
(b) Financial data is not adjusted for price changes or inflation/deflation because of cost principle.
(c) Companies have a choice of accounting methods. These differences impact ratios and make it
difficult to compare companies using different methods.
(d) Companies may have different fiscal year ends making comparison difficult if the industry is
cyclical.
(2) The need to look beyond ratios
Ratios or any information generated by FS analysis are not the ultimate goal. The company must
interpret and look beyond this results for a more proper evaluation.
TECHNIQUES IN FS ANALYSIS
(1) HORIZONTAL ANALYSIS
It is the process of analyzing the firms’ financial data across two or more consecutive periods. This is
done through either:
(a) Comparative FS (b) Trend Analysis
TREND PERCENTAGES – are index numbers showing relative changes in financial data resulting to
passage of time.

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In horizontal analysis, the amount of change and percentage of change should be shown.
PERCENTAGE CHANGE (%) = AMOUNT OF CHANGE / BASE
CAUTION ABOUT THE BASE:
(1) The base may be last year’s or earlier period data, average industry data or even chief
competitors’ data.
(2) The percentage change is NOT computed if the base is ZERO or NEGATIVE.
(2) VERTICAL ANALYSIS
Vertical analysis is a method of financial statement analysis in which each line item is listed as a
percentage of a base figure within the statement. Vertical analysis is the process of comparing figures
in the FS of a single period only.
Proper application of vertical will generate a COMMON-SIZE FINANCIAL STATEMENTS. Common size
financial statements are financial statements that translate peso amounts to percentages in relation
to a chosen base.
NOTE: In vertical analysis, only percentages are shown.
What base to use?
Financial Statement Proper Base
Income Statement Net Sales
Balance Sheet Total Assets
Statement of Cash Flows Total Cash Available
(3) FINANCIAL RATIOS
It is a comparison in fraction, decimal or proportion of two significant figures taken from the financial
statements.
REMINDER IN USING FINANCIAL RATIOS: In comparing balance sheet items with income statement
items in a single ratio, the balance sheet items are being averaged if the beginning and ending
balances are available.
Cautions in using ratios:
(1) Ratios have great disparities from one industry to another.
(2) Conservatism has a bias towards diminishing value of the firm.
(3) Historical cost principle may significantly contribute to a distorted FS Analysis.
Summary of Effect of Transactions in Ratios
Numerator + 0 - 0 + -
Denominator 0 + 0 - - +
Effect on Ratio + - - + + -

Based from the above table, we can say that movements on the numerator have a direct effect on the
ratio while movements on the denominator have an inverse effect on the ratio.
EXCEPTION:
Numerator + - + -
Denominator + - + -
Effect on Ratio + - - +
IF PROPER FRACTION IF IMPROPER FRACTION
LIST OF PROPER FRACTION AND IMPROPER FRACTION RATIOS
PROPER FRACTION IMPROPER FRACTION
Debt Ratio Current Ratio
Equity Ratio Quick Asset Ratio
Profit Margin AR Turnover Ratio
Gross Profit Margin Inventory Turnover Ratio
Return on Sales Asset Turnover Ratio
Return on Assets AP Turnover Ratio
Return on Equity Earnings per Share
Dividend Pay-out Ratio Book Value per Share
Dividend Yield Ratio Times Interest Earned
SUMMARY OF COMMONLY USED FINANCIAL RATIOS
(a) Liquidity ratios: are ratios used in measuring the ability of the firm to meet its currently
maturing obligations.
RATIO FORMULA
Total Current Assets
Current Ratio
Total Current Liabilities
Total Quick Assets*
Quick Ratio
Total Current Liabilities
*Cash + Marketable Securities + AR

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Total Current Assets - Total Current

Working Capital
Liabilities
(b) Activity ratios: are ratios that measure the liquidity of specific assets and efficiency in managing
assets.
RATIO FORMULA
Net Credit Sales*
AR Turnover
Average AR
* Net Sales if not available
360 days / 365 days
Days AR / Ave. Collection Period
AR Turnover
Cost of Goods Sold**
Inventory Turnover (For Merchandising)
Average Inventory
** Sales or Net Sales if not available
Cost of Goods Sold**
FG Inventory Turnover
Average FG Inventory
** Sales or Net Sales if not available
Cost of Goods Manufactured
WIP Inventory Turnover
Average WIP Inventory
Raw Materials Used
RM Inventory Turnover
Average RM Inventory
360 days / 365 days
Days Inventory / Ave. Conversion Period
Inventory Turnover
Net Credit Purchases***
AP Turnover
Ave. Accounts Payable
*** Net Purchases if not available
360 days / 365 days
Days AP / Ave. Payment Period
AP Turnover
Net Sales
Total Assets Turnover
Average Total Assets
Net Sales
Fixed Assets Turnover
Average Fixed Assets

(c) Solvency ratios: are ratios that measure the ability of the firm to pay its long-term financing
and the extent of a firm’s financing.
RATIO FORMULA
Total Liabilities
Debt Ratio
Total Assets
Total Equity
Equity Ratio
Total Assets
Total Liabilities
Debt to Equity Ratio
Total Equity
Total Assets
Total Equity
Leverage Ratio / Equity Multiplier or
1
Equity Ratio
Earnings Before Interest and Taxes (EBIT)
Times Interest Earned (TIE)
Annual Interest
Earnings Before Interest and Taxes (EBIT)
Basic Earnings Power
Total Assets

(d) Profitability ratios: are ratios that measure the overall performance of the firm.
RATIO FORMULA
Gross Profit
Gross Profit Ratio
Net Sales
Net Income
Return on Sales / Profit Margin Ratio
Net Sales
Operating Income after Tax*
Average Total Assets
Return on Assets *Net income if cannot be determined
or
Profit Margin x Asset Turnover
Return on Equity Net Income
Average Total Equity

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CPAR:MS 9107A_FINANCIAL STATEMENTS ANALYSIS BATCH MAY 2022

or
Profit Margin x Asset Turnover x Leverage Ratio
Net Income - Preferred Dividends
Earnings per Share
Ave. Ordinary Shares Outstanding
Annual Dividends
Dividends per Share
Ave. Ordinary Shares Outstanding
Dividends per Share
Dividend Pay-out Ratio
Earnings per Share
Retention Ratio / Plowback Ratio 1 - Dividend Pay-out Ratio
Total Shareholders' Equity
Book Value per Share
Ave. Ordinary Shares Outstanding
NOTE: Operating income is synonymous to EBIT

(e) Market-test ratios: these ratios are concerned with the return on investment for shareholders, and
with the relationship between return and the value of an investment in company's shares.
RATIO FORMULA
Market Price
Price - Earnings Ratio
Earnings per Share
Dividends per Share
Dividend Yield Ratio
Market Price
Earnings per Share
Earnings Yield Ratio
Market Price

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CPAR:MS 9107A_FINANCIAL STATEMENTS ANALYSIS BATCH MAY 2022

DISCUSSION EXERCISES
STRAIGHT PROBLEMS:
HORIZONTAL ANALYSIS, VERTICAL ANALYSIS & RATIO ANALYSIS
1. Comparative data for LUZON CORP. for the two-year period 2019 and 2018 are as follows:
INCOME STATEMENT
2018 2019
Sales P1,500,000 P2,000,000
Cost of goods sold 900,000 1,200,000
Gross profit 600,000 800,000
Selling, general, and other expenses 100,000 150,000
Income tax expense 150,000 195,000
Net income 350,000 455,000
BALANCE SHEET
2018 2019
ASSETS
Cash P100,000 P150,000
Accounts Receivable 400,000 450,000
Inventory 300,000 400,000
Prepaid expenses - 50,000
Plant and Equipment, net 1,200,000 1,150,000
TOTAL ASSETS P2,000,000 P2,200,000
LIABILITIES & EQUITY
Accounts Payable 150,000 200,000
Short-term Notes Payable 350,000 400,000
Bonds Payable (10%) 500,000 500,000
Common Stock (P10 par) 400,000 400,000
Retained Earnings 600,000 700,000
TOTAL LIABILITIES & EQUITY 2,000,000 2,200,000
Additional information:
 For the year 2018 and 2019, LUZON declared dividends amounting to P300,000 and P450,000,
respectively.
 The market price of the share for the years 2018 and 2019 are P15 and P18.
REQUIREMENTS:
(a) Prepare a vertical and horizontal analysis for the year 2019.
(b) Prepare a ratio analysis for 2019 by computing the following ratios:
1. Current ratio. 16. Gross profit ratio
2. Acid-test ratio. 17. ROS
3. Accounts receivable turnover. 18. ROA
4. Inventory turnover. 19. ROE
5. Accounts payable turnover. 20. EPS
6. Days AR 21. DPS
7. Days Inventory 22. Dividend pay-out ratio
8. Days AP 23. Price-earnings ratio
9. Total asset turnover 24. Dividend yield ratio
10. Fixed asset turnover 25. Earnings yield ratio
11. Debt ratio
12. Equity ratio
13. Debt to equity ratio
14. Times interest earned
15. Basic earning power
EFFECTS OF TRANSACTIONS
2. Indicate the effects of each of the following transactions on the following ratios. There are three
possible answers: increase (+), decrease (-), and no effect (0). Before each transaction takes place,
the current ratio is greater than 1 to 1 and the acid-test ratio is less than 1 to 1.
Current Acid-test Debt ROS ROA EPS
Ratio Ratio Ratio
(a) Sell merchandise for cash
(b) Buy inventory for cash
(c) Pay an account payable
(d) Borrow cash on a short-term loan
(e) Purchase plant assets for cash
(f) Issue long-term bonds payable
(g) Collect an account receivable
(h) Record accrued expenses payable
(i) Sell a plant asset for cash at a profit

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CPAR:MS 9107A_FINANCIAL STATEMENTS ANALYSIS BATCH MAY 2022

(j) Sell a plant asset for cash at a loss

(k) Buy marketable securities for cash
(l) Declare and issue a stock dividend
(m) Purchase treasury stock for cash
(n) Acquire land by issuing common stock
(o) Write off an uncollectible account receivable
WORKING BACK AND COMPREHENSIVE PROBLEMS
3. Answer the questions for each of the following independent situations
(a) The current ratio is 2.5 to 1; the acid-test ratio is 0.9 to 1; cash and receivables are P270,000.
The only current assets are cash, receivables, and inventory. What are current liabilities? What
is inventory?
(b) A company had current assets of P600,000. It then paid a current liability of P90,000. After
the payment, the current ratio was 2 to 1. What were current liabilities before the payment was
made?
(c) A company has a debt ratio of 0.50, a total assets turnover of 0.25, and a profit margin of 10%.
The president is unhappy with the current return on equity, and he thinks it could be doubled.
This could be accomplished (1) by increasing the profit margin to 14% and (2) increasing debt
utilization. Total assets turnover will not change. What new debt ratio, along with the 14%
profit margin, is required to double the return on equity?
(d) The company has P1.6 million of accounts receivable on its balance sheet. The company’s DSO
is 40 (based on a 360-day year), its current assets are P2.5 million, and its current ratio is 1.5.
The company plans to reduce its DSO from 40 to the industry average of 30 without causing a
decline in sales. The resulting decrease in accounts receivable will free up cash that will be used
to reduce current liabilities. If the company succeeds in its plan, what will it’s new current ratio
be?
CONSTRUCTING FINANCIAL STATEMENTS FROM RATIOS
4. The following data are available for VISAYAS CORP. as of December 31, 2019 and for the year ended.
Current ratio 2.5 to 1
Days’ sales in account receivable 55 days
Inventory turnover 4 times
Debt ratio 40%
Current liabilities P450,000
Stockholders’ equity P1,500,000
Return on sales 10%
Return on common equity 20%
Gross profit ratio 40%
VISAYAS has no preferred stock, no marketable securities, and no prepaid expenses. Beginning-of-
year balance sheet figures are the same as end-of-year figures. The only noncurrent assets are plant
and equipment.
REQUIREMENT: Prepare a balance sheet as of December 31, 2019 and an income statement for 2019
in as much details as you can with the available information.

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CPAR:MS 9107A_FINANCIAL STATEMENTS ANALYSIS BATCH MAY 2022

MULTIPLE CHOICE (THEORIES)

1. Which one of the following is not a characteristic generally evaluated in analyzing financial
statements?
A. Liquidity C. Marketability
B. Profitability D. Solvency
2. In common size analysis,
A. a base amount is required.
B. a base amount is optional.
C. the same base is used across all financial statements analyzed.
D. the results of the horizontal analysis are necessary inputs for performing the analysis.
3. Which of the below statements is (are) incorrect?
A. In horizontal analysis both the amount of and percentage change is shown.
B. The base in horizontal analysis is the last year’s or earlier period data which can be used even if
it has a negative balance.
C. In comparing balance sheet items and income statement items using ratio analysis, ONLY
balance sheet items should be averaged.
D. Return on asset is computed as operating income after tax divided by average asset.
4. KGA Inc. has a current ratio of 0.50:1 before accounting for the following transactions
I. Payment of accounts payable worth P20,000
II. Retirement of bonds through issuance of equity securities P150,000.
III. Write-off of accounts receivable worth P15,000
Which of the following transactions above will increase the entity’s current ratio?
A. I and II D. III only
B. II and III E. None from I, II and III
C. I and III
5. A company has a current ratio of 2 to 1. The ratio will decrease if the company
A. Borrow cash on a six-month note.
B. Pays a large account payable which had been a current liability.
C. Receives a 5% stock dividend on one of its marketable securities.
D. Sells merchandise for more than cost and records the sale using the perpetual inventory
method.
6. Mabuhay Corp. has current assets of P180,000 and current liabilities of P360,000. Which of the
following transactions would improve Mabuhay’s current ratio?
A. Paying P40,000 of short-term accounts payable.
B. Collecting P20,000 of short-term accounts receivable.
C. Refinancing a P60,000 long-term mortgage with a short-term note.
D. Purchasing P100,000 of merchandise inventory with a short-term accounts payable.
7. Which of these ratios are measures of a company’s profitability?
1. Earnings per share 5. Return on assets
2. Current ratio 6. Inventory turnover
3. Return on sales 7. Receivables turnover
4. Debt-equity ratio 8. Price-earnings ratio
A. 1, 3, and 5 only C. 1, 3, 5, 6, 7, and 8 only.
B. 1, 3, 5, and 8 only. D. All eight ratios.
8. The ratio that measures a firm's ability to generate earnings from its resources is
A. Asset turnover. C. Days' sales in receivables.
B. Days' sales in inventory. D. Sales to working capital.

9. If a company is profitable and is effectively using leverage, which one of the following ratios is likely
to be the largest?
A. Return on total assets. C. Return on common stockholders' equity.
B. Return on total liabilities. D. Cannot be determined.
10. 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.
D. calculated by subtracting current liabilities from current assets.
- END OF HANDOUTS -

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