Management Accounting 2 1

Financial Statement Analysis

Week 001: Financial Statement Analysis

At the end of this module, you will be able to:

1. Explain business analysis and its relation to financial statement analysis
2. Identify and discuss different types of business analysis
3. Describe the component analyses that constitute business analysis
4. Explain business activities and their relation to financial statements
5. Describe the purpose of each financial statement and linkages between
them

A three-pronged approach is commonly followed in coming up with the analysis of a firm’s

financial information. First, trends within a company’s own financial information are
analyzed, such as sales and earnings from one year to the next. This is done using two
methods—trend analysis and common-size analysis. Next, financial measures are
compared among competitors. Finally, financial ratios are compared to industry averages.
Vertical analysis comes from every income statement amount expressed as a percentage of
sales. For example, the Php 500,000 would be expressed as 50 (500,000 divided by
500,000). The cost of goods sold is for example Php 360,000 would be presented as 36
(Php 360,000 divided by sales of Php 500,000). The interest expense of Php 25,000 would
be expressed as 2.50 ( Php 25,000 divided by Php 500,000). The restated amounts are
referred to as a common-size income statement. A firm's income statement can be
compared to the income statement of another firm with the use of common-size income
statement.
Meanwhile, horizontal analysis focuses on the amounts on the financial statements in the
previous years. This analysis shows how each entry has changed in relationship to the
changes in other items. Horizontal analysis is also known as trend analysis.

Trend Analysis
An organization’s fiscal information over a period of time is computed with trend analysis.
Periods may be stated in months, quarters, or years, depending on the conditions and
organizational needs. The focus is to evaluate and analyze the amount of change and
percent of change from one period to the next.

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 These can be computed using the following:
Amount of change = Present year amount – Base year amount
Percentage of change = (Present year amount – Base year amount) ÷ Base year amount

Let’s look at this example below:

Kiel Corporation reported the following income statement and balance sheet amounts and
additional information for the end of the current year.

End of current End of prior

year year
Net sales revenue (all credit) Php 611,000
Cost of goods sold Php 362,500
Gross profit Php 247,500
Selling/general expenses Php 140,000
Interest expense Php 21,000
Net Income Php 86,500

Current assets Php 56,500 Php 41,000

Long-term assets Php 256,000 Php 220,000
Total assets Php 312,500 Php 261,000
Current liabilities Php 28,500 Php 26,000
Long-term liabilities Php 137,500 Php 122,500
Common stockholders' equity Php 146,500 Php 112,500
Total liabilities and stockholders' equity Php 312,500 Php 261,000

Inventory and prepaid expenses account for Php 15,000 of the current year's current assets.
Average inventory for the current year is Php 18, 125.
Average net accounts receivable for the current year is Php 22,500.
There are 35,000 shares of common stock outstanding.
Total dividends paid during the current year were Php 8,500.
The market price per share of common stock is Php 10.

Answer: 37.49 %
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Financial Statement Analysis

Common-size Analysis
Each line of financial statement data is transformed to an easily comparable,
or common-size, amount measured as a percent is called common-size
analysis or vertical analysis. Income statement items are presented as a
percent of net sales and balance sheet items as a percent of total assets (or
total liabilities and shareholders’ equity) in this method.
Common-size analysis works with these two advantages:
(1) to evaluate information from one year to another; and
(2) to evaluate a firm relative to its competitors
Common-size analysis provides answers to questions such as: “How do our
current assets as a percent of total assets compared with last year?” and
“How does our net income as a percent of net sales compared with that of our
competitors?”

Common-size analysis is obviously critical to comparative analysis. In fact,

some sources of industry data present the information exclusively in a
common-size format, and most of the accounting software available today
has been engineered to support this type of analysis.

Financial Ratios
The following ratios underline income statement or profitability:
1. Gross profit ratio=Gross profit /Net sales
a ratio that tells us how much Gross Profit is made for every one peso of revenue

2. Return on sales=Net income/Net sales

a comparison of net income and net sales; it measures how well a company's
management team is doing its job.

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3. Return on assets=Net income/Average total assets
reveals how much income management has been able to squeeze from each peso's worth
of a company's assets.

4. Return on ordinary shareholders’ equity=Net income –(Preferred dividends

Average ordinary
shareholders’equity)
measures how much earnings the shareholders are getting out of their invested money.

5. Earnings per share=Net income –(Preferred dividends

Weighted average ordinary shares outstanding)
the portion of a company's profit allocated to each outstanding ordinary share

6. Current ratio=Current assets / Current liabilities

a liquidity test that will show how a company's current assets can meet its short-term
liabilities

7. Quick ratio=Cash + Trading securities + Short-term receivables

Current liabilities
measures a company's ability to meet its short-term obligations with its most liquid
assets

8. Accounts Receivables turnover ratio=Net Credit sales/ Average accounts receivable

evaluate the ability of a company to efficiently issue credit to its customers and collect
funds from them in a timely manner

9. Average collection period=365 days/ Receivables turnover ratio

evaluate the ability of a company to efficiently issue credit to its customers and collect
funds from them in a timely manner

10. Inventory turnover ratio=Cost of goods sold /Average inventory

an efficiency calculation used to control and manage turns by comparing cost of goods
sold and average inventory in an equation

11. Average age of inventory=365 days/ Inventory turnover ratio

the average amount of time it takes for a company to sell its inventory
 Management Accounting 2 5
Financial Statement Analysis

12. Debt ratio=Total liabilities/Total assets

measures debt level of a business as a percentage of its total assets

13. Debt to equity=Total liabilities/Total shareholders’ equity

indicates the soundness of long-term financial policies of a company

14. Times interest earned= Operating income / Interest expense

indicates how well a company can cover its interest payments on a pretax basis

15. Price-earnings ratio=Market price per share/Earnings per share

compare different investments or the same investment over different periods of time

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Glossary
Trend Analysis: The focus is to evaluate and analyze the amount of change and percent
of change from one period to the next.
Common-size Analysis: an easily comparable, or common-size, presentation of financial
statement data in amount measured as a percent
Gross profit ratio: a ratio that tells us how much Gross Profit is made for every one peso
of revenue
Return on sales: a comparison of net income and net sales; it measures how well a
company's management team is doing its job
Return on assets: reveals how much income management has been able to squeeze from
each peso's worth of a company's assets
Return on ordinary shareholders’ equity: measures how much earnings the
shareholders are getting out of their invested money.
Earnings per share: the portion of a company's profit allocated to each outstanding
ordinary share
Current ratio: a liquidity test that will show how a company's current assets can meet its
short-term liabilities
Quick ratio: measures a company's ability to meet its short-term obligations with its
most liquid assets
Accounts Receivables turnover ratio: evaluate the ability of a company to efficiently
issue credit to its customers and collect funds from them in a timely manner
Average collection period: evaluate the ability of a company to efficiently issue credit to
its customers and collect funds from them in a timely manner
Inventory turnover ratio: an efficiency calculation used to control and manage turns by
comparing cost of goods sold and average inventory in an equation
Average age of inventory: the average amount of time it takes for a company to sell its
inventory
Debt ratio: measures debt level of a business as a percentage of its total assets
Debt to equity: indicates the soundness of long-term financial policies of a company
Times interest earned: indicates how well a company can cover its interest payments on
a pretax basis
Price-earnings ratio: compare different investments or the same investment over
different periods of time
 Management Accounting 2 7
Financial Statement Analysis

References and Supplementary Materials

Books and Journals
Garrison, R (2011). Managerial Accounting for Managers. USA. McGraw-Hill, 2nd Edition.
Weygandt, Kieso, and Kimmel (2008). Managerial Accounting. USA. Wiley International
Edition.
Hansen and Mowen (2011). Managerial Accounting. USA. Cengage Philippine Edition.
Drury, Colin (2014). Management and Cost Accounting. USA. Cengage Philippine Edition.
Schneider & Sollenberger (2009). Managerial Accounting. USA. Cengage Philippine
Edition.

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