Analysis of

Financial
Statements-
Comparative
Approach
Financial Statement Analysis process of selecting
related data from financial statements for evaluating an
entitys past financial position and operating performance
in order to predict the possible outcome of future
operations.

Procedures in Analyzing Financial Statements

1. Establish the objective of the financial statement
analysis.
2. Gather complete information about the firm and study
the industry in which the firm operates.
3. Perform mathematical analysis using applicable tools.

4. Make conclusions relative to the established objectives.

Establish the Objective of the Analysis
The objectives of the analysis must be clear and specific in the
mind of the analyst since different users have different objectives
and priorities.
Investors are more interested in the future earnings and the
capacity of the entity to pay dividends, while from the
managements perspective, financial statement analysis serves as
the starting point for planning and evaluation of past performance.

The different objectives of the analysis are usually directed toward

the following concerns:
1. Liquidity refers to the ability of the business to pay current
maturing financial obligations.
2. Solvency or stability ability of the entity to settle long-term
debts when they mature and still remain stable.
3. Profitability ability of an entity to earn income equal or
above the industry, also reflects the efficiency of the
management in utilizing the resources entrusted to them.
 Different users have different priorities. From the
standpoint of short-term creditors, liquidity is what financial
statement analysis is all about, while from long-term
creditors standpoint, financial analysis is valuable to
determine the solvency of an entity. The result, therefore of
the analysis becomes more meaningful and valuable if the
objectives have been clearly spelled out before the actual
evaluation.
Gather Information About the Firm and the Industry
Analysis of the financial statements is not a mere
mathematical computation and comparison of financial data.
It also involves the gathering of qualitative information
relative to the study conducted.
The following information must be available and studied by
the analyst:
1. Corporate vision and mission

2. Articles of corporation and by-laws

3. Corporate board resolutions particularly on acquisition of
property, plant and equipment, dividends payment, plant
expansion, introduction of new product lines and
discontinuance of operation
4. Strategic plans, performance budget of the entity
5. Government regulations affecting the industry (SEC
issuances, BIR regulations, Central Bank regulations and
issuances from other regulatory bodies)
6. Industry standards and economic indexes provided by the
Central Bank, Philippine Stock Exchange, Securities and
Exchange Commission and other government agencies
7. National government economic agenda affecting the
industry, which is usually provided by the National
Economic Development Authority
8. Industry players and competitors
Perform Mathematical Analysis
The following quantitative techniques are used to evaluate and
interpret financial statements:
1. Horizontal or comparative analysis

2. Vertical or common-size analysis

3. Trend analysis

4. Financial mix ratio analysis

Summary of Findings and Conclusions

The following guidelines may be considered in the presentation of
the report
5. The analyst should communicate or report all significant
matters related to his evaluation or analysis
6. The analyst should disclose the major assumptions adopted
when making a forecast, including his sources of information
7. The language of the report should be simple and adapted to
the ordinary users range of understanding
Horizontal or Comparative Analysis analytical tool
that evaluates the present performance of an entity
compared to that of last year. The analysis reflects the
differences in absolute amount and in percentage between
two periods only, the present and the immediate past.
The following simple guidelines may be observed in the
horizontal analysis:
1. Present the current years and last years financial
statements in comparative format.
2. Compute the absolute amount of change or difference.
The difference could either be increase or decrease.
2009 2008 Increase
(Decrease)
Cash and cash equivalents 150, 000 180, 000 (30, 000)
3. Express the difference in percentage by dividing the amount of
change by the base.
Percentage of change = (P30, 000)/180, 000
=16.67%
The tabular presentation may appear as follows:
2009 2008 Increase(Decrease) Percentage
Cash and cash
equivalents 150, 000 180, 000 (30, 000) (16.67%)
4. The computation of percentage of change will not apply if the base
amount is negative or zero.
2009 2008 Increase(Decrease) Percentage
Investment
in bonds 1,000,000 - 1,000,000 -
5. Interpret the change of an item by relating it with the change or
movement of other items. For example, the change in current assets
would be related with the change in current liabilities or the change in
trade accounts and notes receivable will be interpreted by considering
the change in sales.
Vertical or Common-Size Analysis determines the size
or proportion of an item in the financial statements in
relation to the total. This approach becomes more valuable
if the common-size financial statements of an entity are
compared with the statements of other entities in the
industry.
The following guidelines may be observed:
1. Convert the absolute peso amount of the items in the
statement of financial position and statement of
comprehensive income into percentage by dividing each
item by base. The base shall be equal to 100%.
2. For the financial position, the base is the total assets;
for the statement of comprehensive income, the base is
the net sales.
Trend Analysis tool used to analyze the financial
statements that extend beyond two years through the use of
index numbers or percentage.
The operating performance of an entity can be evaluated
better if the analysis is not limited within the last two
years, since there are temporary items that may not be
significant to the long-term operations of the company. A
trend analysis of business operations covering more than
five years presents a better perspective of the entitys
operating performance than a two-year horizontal analysis.
The following guidelines may be followed in handling trend
analysis:
1. Present the financial statements covering several years
in tabular format.
2. Select a base year which is purely judgmental. The
base year should serve as the normal operating activity
of an entity. Normally, the base year is the earliest year
used in the analysis and has an index of 100 or 100%.
3. Divide each absolute amount by the base year in order
to determine the relationship of each item with the
base year.
 Sunny Company
Statement of Financial Position
December 31, 2005 to 2009
(Amounts in Thousand Pesos)
2005 2006 2007 2008 2009
Current Assets
Cash & cash equivalents 84 176 177 222 249
Trading securities 315 119 119 118 135
Trade & other Receivables 783 610 691 810 876
Inventory 592 659 726 805 760
Prepaid Expenses 182 152 155 156 106
Total 1,956 1,716 1,868 2,111 2,126
Non-current Assets
Property, plant & equipment 1,281 2,047 2,071 2,143 2,160
Long-term investment 13 332 487 487 524
Total 1,294 2,379 2,558 2,630 2,684
Total Assets 3,250 4,095 4,426 4,741 4,180
Important Considerations in Financial Statement
Analysis
1. The results of financial statement analysis are only
indicators of the liquidity, solvency, profitability and
management efficiency of a business entity. The results
are not absolute measures of the financial strengths and
weakness of an entity.

2. Both the results of quantitative measurements and

qualitative should be considered in defining the probable
tendencies of a business firm. The threats and
opportunities of external environment usually have great
influence on the expected financial condition of an entity.

3. The analyst should never vouch for the attainment of

forecast based on the result of analysis.
 ANALYSIS of
FINANCIAL
STATEMENTS
FINANCIAL
MIX RATIOS
Concept and Nature
Financial statement analysis involves the process of:
1. Selecting related financial data

2. Making relevant mathematical computations

3. Comparing the performance of the business firm with

other firms within the industry
4. Evaluating trends in the operating performance of the
business firm.

Financial Mix Ratio Analysis analytical tool employing

the ratio or proportion of a certain item in the financial
statement in relation to other items in the same statement
or other statements to judge comparative performance.
Four Basic Classifications of Financial Ratio
1. Liquidity Ratios

2. Solvency or Stability Ratios

3. Profitability Ratios

4. Growth Ratios

Liquidity Ratios group of ratios that measures the ability

of the business firm to pay-off short-term obligations as they
mature. These ratios show the relationship of the firms
current assets to its current liabilities.
Liabilities are classified as short-term or current obligations
when they are expected to be settled within 12 months after
the date of the statement of financial position.
The following ratios are commonly used to evaluate the liquidity
status of a business firm:
1. Current Ratio 4. Average Collection Period
2. Quick or Acid Test Ratio 5. Inventory Turnover
3. Receivable Turnover 6. Average Sales Period
Current Ratio indicates the extent to which current liabilities are
covered by current assets. It is the most commonly used measure of
short-term solvency, because it serves as a single indicator of the
extent to which the claims of short-term creditors are covered by
current assets.
Current Ratio = Current Assets/Current Liabilities
A declining trend in current ratio is an unfavorable indicator of
the entitys liquidity. It may indicate that the business does not
have the capacity to pay currently maturing obligations. Similarly,
an increasing current ratio does not necessarily indicate a favorable
trend. The analyst should evaluate carefully the individual items
comprising the current assets. It may happen that the big slice of
the current assets is invested in receivables or inventory.
Quick or Acid Test Ratio more stringent measure of the
liquidity of a business firm.
Quick Assets includes cash, trading securities and trade
receivables. Trading securities and trade receivables are
convertible easily to cash without reducing much the value of
the assets.
Inventories excluded in the computation of quick ratio since
they are the least liquid of a firms current assets and of which
losses are most likely to be incurred at the time of liquidation.
Prepaid Expenses also excluded since they represent future
obligation and the possibility of converting the items to cash is
very slim.

Quick Assets = Cash + Trading Securities + Trade

Receivables
Quick Ratio = Quick Assets/Current Liabilities
Receivable Turnover measures the velocity of conversion of
trade receivables into cash during the year. It answers the
typical question: How many times during the year has a
receivable been converted into cash?
-considered as an asset management ratio since it measure
the effectiveness of management in handling its resources. It
also measures the efficiency of the collection effort and credit
policy of the company.
Generally, it is favorable for the company to have a high
receivable turnover. However, a very high or a very low
receivable turnover may not be a favorable indicator of the
liquidity status.

Receivable Turnover = Net Credit Sales/Average Trade

Receivables
Average Trade Receivables = (Receivable Beg +
Receivable End)/2
Average Collection Period also called the days sales
outstanding
-measures the speed of collecting trade receivables.
-represents the average length of time that the business must
wait to receive cash after making a sale.
Average Collection Period = 360 days/Receivable Turnover
Average Collection Period = Average Receivables/Average Daily Sales
Average Daily Sales = Annual Sales/360

Inventory Turnover ratio measures the number of times

inventories are acquired and sold during the year.
Normally, profits are realized from sale of inventories.
Inventory Turnover = Cost of Goods Sold/Average Inventory
Average Inventory = (Inventory Beg + Inventory End)/2
Higher inventory turnover is favorable and preferable over low
inventory turnover since it will indicate management efficiency in
handling its inventory.
Average Sales Period called conversion period
-measures the length of time involved to sell the
inventory to customers
Low sales period is favorable to the company since it will
indicate that only few days are needed to sell the inventory.
Average Sales Period = 360 days/Inventory Turnover

Solvency or Stability Ratios

-group of financial ratios that measure the ability of the
business firm to settle its financial obligations when they
mature and still remain stable.
The different ratios under this category also reflect the
extent to which a firm utilizes debt financing; hence they
are called financial leverage ratio.
(1) Operating Leverage affects the short-term
investment and non-current assets of an entity or the left-
hand side of the statement of the financial position. It is
also concerned with how fixed costs influences the
operations of the company.
(2) Financial Leverage affects the right-hand side of the
statement of financial position or the short-term debt and
shareholders equity. It reflects the amounts of debts
utilized in the capital structure of the business firm.

Commonly Used Financial Leverage Ratios

1. Debt Ratio

2. Equity Ratio

3. Debt to Equity Ratio

4. Times Interest Earned

Debt Ratio measures the proportion of funds provided by
creditors. It reflects the percentage of total assets that are
financed with debts.
-answer the question Of the total resources, how much
is provided by creditors?
Debt Ratio = Total Liabilities/Total Assets

Equity Ratio determines the proportion of resources by

owners of the business firm. It presents the financial
strengths of the business because it provides the margin of
safety that company affords to creditors.
Equity Ratio = Total Equity/Total Assets
Equity Ratio = 1-Debt Ratio
Debt to Equity Ratio measures the proportion of debt and
equity in the capital structure of the company. It also indicates
whether the company favor risk in its capital structure.
Debt to Equity Ratio = Total Liabilities/Total Equity

Times Interest Earned measures the debt paying ability of

the company. It reflects the degree of protection provided by
an entity to its long-term creditors. It is favorable to investors
if the business firm has a higher ratio of times interest earned.
Times Interest Earned = Income before Interest and Taxes/Interest
Expense

Profitability Ratios group of ratios that reflect the

combined effects of liquidity and management efficiency in
handling the assets and liabilities on the operating results of
the business. The ratios show the effectiveness of business
operations.
Common Measures of Profitability
1. Gross Profit Rate

2. Operating Profit Margin

3. Net Profit Margin

4. Return on Investments

5. Return on Equity

Gross Profit Rate measures the percentage of gross

profit to sales. It indicates the percentage of margin
available to cover operating expenses. It also reveals the
percentage of cost of sales to sales.
Gross Profit Rate = Gross Profit/Net Sales
Operating Profit Margin measures the percentage of
profit available after deducting cost of sales and operating
expenses from sales. It reflects the overall efficiency of the
management in handling the production, selling and
administrative costs.
Operating Profit Margin = Operating Profit/Net
Sales

Net Profit Margin also called return on sales, it

measures the overall operating results of an entity. It
considers all income recognized and all expenses incurred
during the period.
Net Profit Margin = Net Income/Net Sales
Return on Investment also called return on assets, it
measures the amount of net income per peso of investment in
a business. It reflects the profitability of every peso invested.
Return on Investment = Net Income/Average Total
Assets

If the business entity has interest-bearing liabilities:

ROI = (Net Income + (Interest (1-Tax Rate)))/Average
Total Assets

Return on Equity measures the rate of return on ordinary

shareholders investment. It is only applicable to ordinary
shares since preference shares normally have a fixed rate of
return.
Return on Equity = Net Income Applicable to
Ordinary Shares/Average Shareholders Equity
Growth Ratios also called market value ratios, group
of ratios that reflect the value of the shares to its earnings,
book value per share and cash flow.
Generally, if the liquidity, solvency and profitability ratios
are favorable or the trends indicate improvement, then
growth ratios will look good to investors.

Growth ratios that are commonly used:

1. Earnings per share

2. Price-earnings ratio

3. Dividend-yield ratio

4. Dividend-payout ratio

5. Book Value per share

Earnings per Share measure the value of ordinary
shares relative to earnings of the business firm. Only the
net income attributable to ordinary shares shall be included
in the computation; hence, dividends applicable to
preference shares shall be deducted from net income.
When the preference shares are non-cumulative, only the
dividends declared in respect to the period shall be
deducted. However, if the preference shares are cumulative,
all required dividends applicable, whether declared or not,
shall be deducted in the net income.
2 Kinds of Earnings per Share:
1. Basic

2. Diluted higher accounting

Return Earnings per Share = Net Income Applicable

to Ordinary Shares/Average numbers of Shares
Outstanding
Price Earning Ratio measures price per share in relation
to the earnings of the company. This also reflects the amount
an investor is willing to pay for every 1 peso of current
earnings.
Price Earning Ratio = Market Price per
Share/Earnings per Share

Dividend Yield Ratio measures the amount of dividends

in relation to the market.
Dividend Yield Ratio = Dividend per Share/Market
Price per Share

Dividend Payout Ratio = measures the percentage of

dividend payments in relation to earnings.
Dividend Payout Ratio = Dividend per Share/Earnings
per Share
Book Value per Share measures the amount payable to
each share based on the realizable amount of assets in the
event of liquidation. It applies to ordinary and preference
shares.
Book Value per Share = Stockholders Equity/Average # of
Shares Outstanding

Qualitative Factors in Financial Statement Analysis

1. The presence of one major customer.

2. The presence of one major product.

3. The competitors in the market.

4. Reliance on a single supplier.

5. The goals of the company.