CHAPTER 3:

Analyzing Financial
Statements

INTRODUCTION
This chapter covers how to analyze a business enterprises financial statements, comprised of the statement of financial position and income statement.

LOUIS VINCENT MORTA

Financial statement analysis shall answer the following questions:

1. How well is the business doing? 2. What are its strengths? 3. What are its weaknesses? 4. How does it fare in the industry? 5. Is the business improving or deteriorating?

The analysis of financial statements is important to creditors, current and prospective investors, and the business enterprises own management. This chapter has presented various financial statement analysis tools that are useful in evaluating the business enterprises current and future financial condition.

These techniques include horizontal, vertical and ratio analysis, which provide relative measures of the performance and financial health of the business enterprise.
Two methods, trend analysis and industry comparison, for analyzing were financial ratios were demonstrated.

WHAT IS FINANCIAL STATEMENT ANALYSIS?

The analysis of financial statements means different things to different people, depending on their individual interests. Creditors, current and prospective investors, and the corporations own management look at different parts of the analysis to find solutions to the questions that are of greatest concern to them.

Investors are very interested in the current and future level of return and risk. Investors evaluate a share capital based on an examination of the business enterprises financial statements.
This evaluation considers overall financial health, economic and political conditions, industry factors, and future outlook of the business enterprise.

Management is concerned with all the questions raised by the creditors and investors, since both must be satisfied if the business enterprise is to obtain the capital it needs.

Major component of stockholders equity

RENZ RICHARD ORTIZ

Capital Stock
refers to the shares of the company sold to the investor. Each share represents ownership and provides benefits to the shareholder. This includes the right to receive dividends when the company pays them, the right to receive remaining assets at liquidation and voting rights.

Par value - This is a value of preferred and common stock that is arbitral (artificial); it is set by management on a per share basis. This artificial value has no relation or impact on the market value of the shares. Legal capital of the corporation - This is par value per share multiplied by the total number of shares issued. Additional paid-in capital (paid-in capital) - This is the difference between the actual value the company sold the shares for and their par value.

Treasury Shares
Treasury stock represents shares of stock the company purchased of itself. Companies purchase its own stock through the stock exchange in order to reduce the number of outstanding shares, to manipulate the stock price or to award shares to employees. The company reports treasury stock as a deduction from stockholders equity for the total amount it pays

Retained Earnings
Retained earnings form the stockholders equity not invested by stockholders. The company generates retained earnings through its income production.

Net income increases the retained earnings, while net loss decreases it. Dividends paid also decrease it.

HORIZONTAL AND VERTICAL ANALYSIS

GILLINA R. MISOLA

Horizontal Analysis
is the comparison of two or more years financial data.

concentrates on trend in the accounts in peso value and the percentage terms.
typically presented in comparative financial statements.
helps you pinpoint areas of wide divergence that require investigation.

VERTICAL ANALYSIS
Key changes and trends can also be highlighted by the use of common-size statements.
A common-sized statement is one that reveals each item in percentage terms.

Preparation of common-size statements is known as vertical analysis, in which a material financial statement item is used as a base value and all other accounts on the financial statements are compared to it.

Ratio Analysis
is the comparison of the results to generally accepted norms

Ana Jilenie Pangilinan

Results of Ratio Analysis

1. Appraise the position of the business 2. Identify trouble spots that need attention 3. Make projections and forecast about the cause of future operations

Industry Comparison
It is the comparison of the business enterprises ratios to those of competing companies in the industry

Industry norms can be obtain from financial services such as the following:
International a. Risk Management Association b. Dun and Breadstreet c. Value Line Investment Service d. Others e.Trend Analysis Philippines a. Securities and Exchange Commission b. BAP Credit Bureau and the Credit Management Association of the Philippines c. Credit Information Corporation

Financial Ratios
a. Liquidity Ratios
a. Net Working Capital Formula : b. Current Ratio Formula : c. Acid-test Ratio Formula :

b.

Asset Utilization Ratio a. Accounts Receivable Ratio consists of AR turnover and the average collection period Accounts Receivable Turnover number of times AR is collected in the year

Average Collection Period length of time it takes to collect receivables; it represents the no. of days receivable are held

b.

Inventory Ratio

Operating Cycle number of days it takes to convert inventories and receivables to cash

c. Solvency Ratio

Solvency the ability to satisfy long-term debt as it becomes due. It also depends on earning power Financial Leverage size of the debt in the business capital structure Capital Structure mix of long-term sources of funds used by the business enterprise Leverage Capital Structure fixed interest charges

Profitability Ratios
Gross Profit Margin Profit Margin Return on Investment Market Value Ratios

LARA ELYNNE NACARIO

Profitability Ratios
I. GROSS PROFIT MARGIN -the percentage of each peso remaining once the business has paid for goods acquired
Gross Profit Margin =

Gross Profit Net Sales

Profitability Ratios
II. PROFIT MARGIN -shows the earnings generated from revenue and is a key indicator of operating performance -provides an idea of the firms pricing, cost, structure, and efficiency. Profit Margin =

Net Income Net Sales

Profitability Ratios
III. RETURN ON INVESTMENT -allows you to evaluate the profit you will earn if you invest in the business. 2 Key Ratios: 1. Return on total assets 2. Return on equity

Profitability Ratios
III. RETURN ON INVESTMENT 1. Return on total assets -shows whether management is efficient in using available resources to get profit =

Net Income Average Total Assets

Profitability Ratios
III. RETURN ON INVESTMENT 2. Return on equity -reflects the rate of return earned on the shareholders investment. = Net Income available to shareholders
Average shareholders equity

Profitability Ratios
IV. MARKET VALUE RATIOS 1. Earnings per Share (EPS) 2. Price/Earnings Ratio (P/E) 3. Boo Value per Share 4. Price/Book Value per Share 5. Dividend Ratios

Profitability Ratios
IV. MARKET VALUE RATIOS 1. Earnings per share -shows the net income per ordinary share owned. =Net Income - Preference Share Dividends
Ordinary Shares Outstanding

Profitability Ratios
IV. MARKET VALUE RATIOS 2. Price/Earnings ratio -reflects the business enterprises relationship to its shareholders -represents the amount investors are willing to pay for each peso of the business enterprise earnings. = Market Price per Share
Earnings per Share

Profitability Ratios
IV. MARKET VALUE RATIOS 3. Book Value per Share

Total Shareholders Equity = Ordinary Shares Outstanding

Profitability Ratios
IV. MAKET VALUE RATIOS 4. Price/Book Value Ratios -shows the market value of the business enterprise with old asset may have a high ratio, whereas one with new one may have a low ratio

= Market Price per Share

Book Value per Share

Profitability Ratios
IV. MARKET VALUE RATIOS 5. Dividend Ratios -help you determine the current income from an investment. Dividends per Share A. Dividend Yield = Book Value per Share

B. Dividend Payout =

Dividends per Share Earnings per Share

LIMITATIONS OF RATIO ANALYSIS

Accounting policies vary among companies and can inhibit useful comparisons. Management may manipulate the figures in order to make them look more impressive. A ratio is statistics and does not reveal future flows. A ratio does not indicate the quality of its components.

LIMITATIONS OF RATIO ANALYSIS

Reported liabilities, such as lawsuit in which the business enterprise may be found liable, may be undervalued. The business enterprise may have multiple lines of business, making it difficult to identify the industry group of which it is a part. Industry averages cited by financial advisory services are only approximations.