MS-12: FINANCIAL STATEMENT ANALYSIS

F/S ANALYSIS – involves the assessment and evaluation of the firm’s past performance,
its present condition and future business potentials. The analysis
serves to provide information about the following:
 Probability of the business firm
 Ability to meet its obligation
 Safety of investment in the business
 Effectiveness of management in running the firm

F/S ANALYSIS TOOLS AND TECHNIQUES

1. Vertical analysis (common-size statement or percentage composition statements)
2. Horizontal analysis (trend percentages or index analysis)
3. Financial ratios (ratio analysis)
4. Gross profit variation analysis
5. Cash flow statement

HORIZONTAL ANALYSIS
Horizontal or index analysis involves comparison of figures shown in the
financial statements of two or more consecutive periods. The difference between the
figures of the two periods is calculated, and the percentage change from one period to
the next is computed using the earlier period as the base.
Formula:

Percentage Change = (Most Recent Value – Base Period Value)

Base Period Value

Comparison may be:

1. Actual vs. Budget (base)
2. Present period vs. Previous period (base)

VERTICAL ANALYSIS
The process of comparing figures in the financial statements of a single period.
It involves conversion of figures in the statements to a common base. This is
accomplished by expressing all figures in the statements as percentages of an important
item such as total assets (in the balance sheet) or total or net sales (in the income
statement). These converted statements are called common-size statements or percentage
composition statements.

Percentage composition statements are used for comparing:

1. Multiple years of data from the same firm
2. Companies that are different in size
3. Company to industry averages

SAMPLE PROBLEM 1: VERTICAL AND HORIZONTAL ANALYSIS

Following are the financial statements of JAGUAR Company:

JAGUAR COMPANY
Condensed Statement of Financial Position
December 31,2018 (In thousands)

ASSETS LIABILITIES AND

STOCKHOLDER’S EQUITY
Cash P 75 Current P 50
Liabilities
Non-cash Current 125 Long-term Debts 150
Fixed Assets 300 Capital Stock 200
Retained Earnings 100
TOTAL ASSETS P 500 TOTAL LIAB. & SHE P 500

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 JAGUAR COMPANY
Condensed Statement of Financial Position
December 31,2017 (In thousands)

ASSETS LIABILITIES AND

STOCKHOLDER’S EQUITY
Cash P 60 Current P 24
Liabilities
Non-cash Current 120 Long-term Debts 120
Fixed Assets 300 Capital Stock 200
Retained Earnings 136
TOTAL ASSETS P 480 TOTAL LIAB. & SHE P 480

For 2018, net sales totaled P 2,000; CGS, P 1,300; Operating Expenses, P 300;
Interest and tax charges, P 220.
For 2017, net sales totaled P 1,600; CGS, P 1,000; Operating Expenses, P 300;
Interest and tax charges, P 200.

REQUIRED:
1. Prepare a comparative statement of financial position showing peso and percentage
changes for 2018 as compared to 2017. (common-size financial statements).
2. Perform index analysis or compute trend percentages for (net) sales, EBIT, and
net income.

SOLUTION GUIDE Change (+,-)

ASSETS 2018 2017 Pesos %
Cash
Non-cash Current
Fixed Assets
TOTAL ASSETS

LIABILITIES
Current
Long-term Debts
TOTAL LIABILITIES

STOCKHOLDER’S EQUITY
Capital Stock
Retained Earnings

SOLUTION GUIDE

RATIO ANALYSIS
Ratio analysis involves development of mathematical relationships between
accounts in the financial statements. Ratios calculated from these statements provide
users and analysis with relevant information about the business firm’s liquidity,
solvency, profitability and Market Test.

CALCULATION RULES AND LIMITATIONS

1. When calculating a ratio using balance sheet number only, the numerator and
denominator should be from the SAME balance sheet date, not different time
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 periods. The same is true with ratios using only income statement numbers.
EXCEPTION: calculation of growth ratios.
2. When an income statement number and a balance sheet number are both used, the
balance sheet number should be an average (simple) for the time period
represented by the income statement number. If the beginning balance of a
balance sheet account is not available, the ending balance is normally used to
represent the average balance of the account.
3. Generally, the number of days in a month or year are not critical to the
analysis; a year may have 360 days. 52, weeks, and 12 months; alternatively, a
year may be comprised of 365 calendar days or 300 working days.
4. Limitation for percentage change calculations: if a negative or a zero amount
appears in the base year, percentage change cannot be computed.
FINANCIAL RATIOS
 TESTS OF LIQUIDITY (Liquidity refers to the company’s ability to pay its current
liabilities as they fall due.)
Current Ratio It is a measure of
(Banker’s Ratio) Current Assets adequacy of working
(Working Capital Current Liabilities capital.
Ratio) It is the primary test
of solvency to meet
current obligations from
current assets.
Quick Ratio Quick Assets It measures the number
(Acid Test Ratio) Current Liabilities of times that the
current liabilities
could be paid with the
available cash and near-
cash assets (i.e., cash,
accounts receivable and
marketable securities.
Working Capital Activity Ratios (TURNOVERS)
It is the time required
to complete one
Receivables Turnover Net Credit Sales collection cycle from
Average Receivables the time receivables are
recorded, then
collected, to the time
new receivables are
recorded again.
Average Age of It indicates the average
Receivables 360 days number of days during
(Average Collection Receivable Turnover which the company must
Period) wait before receivables
(Days’ Sales in are collected.
Receivables)
Cost of Goods Sold It measures the number
Inventory Turnover Ave. Merchandise Inventory of times that the
inventory is replaced
during the period.
Average Age of 360 days It indicates the average
Inventory Inventory Turnover number of days during
which the company must
wait before the
inventories are sold.
Raw Materials Turnover Cost of Materials Used
Average Raw Materials Inventory

Goods in Process Cost of Goods Manufactured

Turnover Average Work in Process Inventory

Finished goods Cost of Goods Sold

Turnover Average Finished Goods Inventory

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 (Days in) Operating Sum of average ages of receivables, raw materials, goods in
Cycle process, and finished goods inventories (for manufacturing
firms)
Trade Payable Turnover Net Credit Purchases
Ave. Trade Payables

360 days It indicates the length

Average Age of Trade of time during which
Payable Payables Turnover payables remain unpaid.

Current Asset Turnover

Cost of Sales + Operating Expenses It measures the movement
(excluding depreciation and amortization) and utilization of
Ave. Current Assets current assets to meet
operating requirements.
 TESTS OF SOVENCY (Solvency refers to the ability to pay its debts, current or non-
current)
Time Interest Earned ____EBIT___ It determines the extent
Interest Expense to which operations
cover interest expense.
Debt-Equity Ratio Total Liabilities Proportion of assets
Total SHE provided by creditors
compared to that
provided by owners.
Debt Ratio Total Liabilities Proportion of total
Total Assets assets provided by
creditors
Equity Ratio Total SHE Proportion of total
Total Assets assets provided by
owners.
 TESTS OF PROFITABILITY
Return on Sales Income Determines the amount of
(Net Profit Margin) Net Sales income by owners
Return on Total Assets Income Efficiency with which
Ave. Total Assets assets are used to
operate the business

What income figure should be used?

1. Net income from continuing operations, excluding extraordinary items, disposals of
segments of business, and cumulative effects changes in accounting principles.
2. Include dividends and interest earned on investments in net income, if the said
investments are included in asset base.
3. Use income before interest and tax if the intention is to measure operational
performance.
4. Use net income (after interest and tax) if the intention is to evaluate total
managerial effort.

Return on Owner’s Net Income Measures the amount

Equity Ave. Owner’s Equity earned on the owners’ or
stockholders’
investments.
Net Income – preferred Dividends
_____(if any)_____
Earnings per Share Weighted Ave. Common Shares Measures the amount of
Outstanding net income earned by
each common share.

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  MARKET TESTS
Price-Earnings Ratio Price Per Share It indicates the number
(P/E) Earning Per Share of pesos required to buy
P1 of earnings.
Dividends Yield Dividends per Share Measures the rate of
Price per Share return in the investor’s
common stock
investments.
Dividends Pay-Out Common Dividends per Share____ It indicates the
Earnings per Share proportion of earnings
distributed as
dividends.
OTHER MEANINGFUL RATIOS
 RATIOS USED TO EVALUATE LONG-TERM FINANCIAL POSITION OR STABILITY
Measures the proportion
of owners’ equity to
Fixed Assets to Total Fixed Assets fixed assets. Indicative
Equity Total Equity of over or under
investment by owners and
weakness in trading on
the equity.
Fixed Assets to Total Fixed Assets (Net) Indicates possible over-
Assets Total Assets expansion of plant and
equipment
Sales to Fixed Assets Net Sales Tests roughly the
(Plant Turnover) Fixed Assets (net) efficiency of management
in keeping plant
properties employed
Book Value per Share – Common Stockholders’ Equity Measures recoverable
Common Stock Common share outstanding amount by common
stockholders in the event
of liquidation if assets
are realized at their
book values.
Time Preferred Net Income After
Dividends Requirements ____Taxes_____ It indicates ability
Preferred Dividends provide dividends to
Requirements preferred stockholders.
Capital Intensity Total Assets Measures efficiency of
Ratio Net Sales the firm to generate
sales through employment
of its resources
Times Fixed Changes Net Income before Taxes and
Earned Fixed _____Charges_____
Fixed Charges (Rent + Measures ability to meet
Interest) + Sinking Fund fixed charges
payment (before taxes)
 TESTS OF OVER-ALL SHORT-TERM SOLVENCY OR SHORT-TERM FINANCIAL POSITION
Working Capital Net Sales It indicates adequacy and
Turnover Ave. Working Capital activity of working
capital
Defensive Interval Current Liabilities Measures coverage of
Ratio Cash & Cash Equivalents current liabilities
Payable Turnover Net Purchases Measures efficiency of
Ave. Accounts Payable the company in meeting
the accounts payable
Fixed Assets to Long- Fixed Assets Reflects extent of the
term Liabilities Long-term Liabilities utilization of resources
from long-term debt.
Indicative of sources of
additional funds.

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 RATIOS INDICATIVE OF INCOME POSITION
Rate of Return on Ave. Net Income Measures the
Current Assets Ave. Current Assets profitability of current
assets invested
Operating Profit Operating Profit Measures profit generated
Margin Net Sales after consideration of
operating assets
Cash Flow Margin Operating Activities Cash Flow Measures the ability of
Net Sales the firm to translate
sales to cash

STRAIGHT PROBLEM 2: LIQUIDITY ANALYSIS

Indicate the effects of each of the following transactions on the company’s (A)
current ratio and (B) acid-test ratio. There are three possible answers: (+)
increase, (-) decrease, and (0) no effect. Before each transaction takes place, both
ratios are greater than 1 to 1.

_______________Effects
on__________________
Transactions: (A) Current Ratio (B) Acid-test
Ratio
Example: Sell merchandise for + +
cash
1. Buy inventory for cash __________________ __________________
2. Pay an accounts payable __________________ __________________
3. Borrow cash on a short-term __________________ __________________
loan
4. Purchase plant assets for __________________ __________________
cash
5. Issue long-term bonds __________________ __________________
payable
6. Collect an accounts __________________ __________________
receivable
7. Record accrued expenses __________________ __________________
payable
8. Sell a plant assets for __________________ __________________
cash at a profit
9. Sell a plant assets for __________________ __________________
cash at a loss
10. Buy marketable __________________ __________________
securities, for cash

STRAIGHT PROBLEM 3: FINANCIAL RATIOS

ISOY has 1,000,000 common shares outstanding. The price of the stock is P 8. Isoy
declared dividends per share of P 0.10. The balance sheet at the end of 2001 showed
approximately the same amounts as that at the end 2002. The financial statements for
Isoy Merchandising are as follows:

Isoy Company, Income Statement for 2002 (in

thousands)
Sales P 4,700
Cost of Goods Sold __2,300
Gross Profit P
2,400
Operating Expenses:
Depreciation P 320
Other 1,230 1,550
Income before interest and taxes P 850
Interest expense 150
Income before taxes P 700
Income taxes 280
Net income P 420

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 Isoy Company, Balance Sheet at 2002 (in thousands)

Assets Liabilities and SHE

Cash P 220 Accounts payable P 190
Accounts Receivable 440 Accrued expenses 180
Inventory 410 Total current P 370
liabilities
Total current Assets P 1,070 Long-term Debt 1,960
Plant and Equipment 5,600 Common stock 1,810
Accumulated (2,100) Retained Earnings 430
Depreciation
Total Assets P 4,570 Total Liabilities & P 4,570
SHE

REQUIRED: (round-off answers to one decimal place)

1. Current ratio 11. EPS
2. Acid-test ratio 12. P/E Ratio
3. Accounts Receivable turnover 13. Dividend Yield
4. Inventory turnover 14. Payout ratio
5. Gross Profit margin 15. Debt ratio
6. Operating profit margin 16. Debt-Equity ratio
7. Net profit margin or RoS 17. Times interest earned
8. RoA – operational performance 18. Defensive interval ratio
9. RoA – total management effort 19. Cash flow to total debt
10. RoE 20. Cash flow Margin

STRAIGHT PROBLEM 4: CONSTRUCTION OF FINANCIAL STATEMENTS

The following information is available concerning Timang Company’s expected
results in 2003 (in thousands of pesos). Turnovers are based on year-end values.

REQUIRED: Fill in the blanks

Return on sales 6%
Gross profit percentage 40%
Inventory turnover 4 times
Receivable turnover 5 times
Current ratio 3 to 1
Ratio of total debt to total assets 40%

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 Condensed Income Statement
Sales P 900
Cost of Sales _________
Gross profit _________
Operating expenses _________
Net income P _________

Condensed Balance Sheet

Cash P 30 Current liabilities _________
Receivables _________ Long-term debt _________
Inventory _________ Stockholders’ equity _________
Plant and Equipment 670
TOTAL _________ TOTAL _________

4. RELATIONSHIPS Answer the questions for each of the following independent

situations: (use 360-day year)
A.)The current ratio is 2.5 to 1; the acid-test ratio is 0.9 to 1; cash and
receivables are P 270,000. The only current assets are cash, receivables, and
inventory. (1) What are current liabilities? (2) What is inventory?
B.)A company had current assets of P 600,000. It then paid a current liability of
P 90,000. After the payment, the current ratio was 2 to 1. What were current
liabilities before the payment was made?
C.)Accounts Receivable turnover is 5 times; inventory turnover is 4 times. The
company recently bought inventory. (1) On the average, how long will it take
before the new inventory is sold? (2) On the average, how long after the
inventory is sold will the cash be collected?
D.)Accounts receivable equal 45 days’ credit sales. Annual sales of P 900,000 are
spread evenly throughout the year. What should accounts receivable be at the
end of the year?
E.)ROA is 2%. ROE is 10%. There is no preferred stock. Net income is P 4 million.
What is the debt-equity ratio?
F.)Net sales is P 100,000. Net profit margin is 12%. Interest charges are earned
6 times. How much is the operating income before interests and taxes (assume a
tax rate of 40%)?
G.)Assume the data in letter F, the average age in inventory is 30 days and the
average amount of inventory for the year is P 5,000, how much is the operating
expenses?

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MULTIPLE CHOICE QUESTION

Question Nos. 1 through 3 are based on the data taken from the balance sheet of Nomad
Company at the end of the current year:
Accounts payable P145,000
Accounts receivable 110,000
Accrued liabilities 4,000
Cash 80,000
Income tax payable 10,000
Inventory 140,000
Marketable securities 250,000
Notes payable, short-term 85,000
Prepaid expenses 15,000

1. The amount of working capital for the company is:

a. P351,000 b. P361,000 c. P211,000 d. P336,000

2. The company’s current ratio as of the balance sheet date is:

a. P2.67:1 b. P2.44:1 c. P2.02:1 d. P1.95:1

3. The company’s acid-test ratio as of the balance sheet date is:

a. P1.80:1 b. P2.40:1 c. P2.02:1 d. P1.76:1

4. Milward Corporation’s books disclosed the following information for the year ended
December 31, 2007:
Net credit sales P1,500,000
Net cash sales 240,000
Accounts receivable at beginning of year 200,000
Accounts receivable at end of year 400,000
Milward’s accounts receivable turnover is
a. 3.75 times b. 4.35 times c. 5.00 times d. 5.80 times

5. The Missouri Corporation sells on credit with terms of net 30 days. If the company's credit policy and collection activity
is efficient, what is the corporation's accounts receivable turnover?
a. 6 times b. 8 times c. 10 times d. 12 times

6. Real Estates Corporation has stockholders’ equity equal to 60% of total liabilities
and stockholders’ equity of P120 million. If the return on total assets invested
registers at 9% what is the return on stockholders’ equity
a. 10% b. 6% c. 15% d. 12%

8. A fire has destroyed many of the financial records of R. Son & Company. You are
assigned to put together a financial report. You have found the return on equity to
be 12% and the debt ratio was 0.40. What was the return on assets?
a. 5.35% b. 8.4% c. 6.60% d. 7.20%

9. Recto Co. has a price earnings ratio of 7, earnings per share of P2.20, and a pay out ratio of 80%. The dividend
yield is
a. 80% b. 39.3% c. 11.4% d. 31.4%

10. The Delta Company projects the following for the upcoming year:
Earnings before interest and taxes P40 million
Interest expense P 5 million
Preferred stock dividends P 4 million
Common stock dividend payout ratio 20%
Average number of common shares outstanding 2 million
Effective corporate income tax rate 40%
The expected dividend per share of common stock is
a. P1.70 b. P1.86 c. P2.10 d. P1.00

11. The following were reflected from the records of War Freak Company:
Earnings before interest and taxes P1,250,000
Interest expense 250,000
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 Preferred dividends 200,000
Payout ratio 40 percent
Shares outstanding throughout 2003
Preferred 20,000
Common 25,000
Income tax rate 40 percent
Price earnings ratio 5 times
The dividend yield ratio is
a. 0.50 b. 0.40 c. 0.12 d. 0.08

12. Calumpang Company has a total assets turnover of 0.30 and a profit margin of 10 percent. The president is
unhappy with the current return on assets, and he thinks it could be doubled. This could be accomplished (1) by
increasing the profit margin to 12 percent, and (2) by increasing the total assets turnover. What new asset
turnover ratio, along with the 12 percent profit margin, is required to double the return on assets?
a. 25% b. 36% c. 50% d. 60%

13. JayR has debt ratio of 0.50, a total asset 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) by increasing debt utilization. Total asset turnover will not change.
What new debt ratio, along, with 14% profit margin is required to double the return on equity?
a. 0.75 b. 0.70 c. 0.65 d. 0.55

14. Glo expects sales for 2002 to be P2,000,000, resulting in a return on sales of 10%. The dividend payout rate is
60%. Beginning stockholders’ equity was P850,000 and current liabilities are projected to be P300,000 at the end
of 2002. What are the total equities available if the ratio of long-term debt to stockholders’ equity is 60%?
a. P1,788,000 b. P1,980,000 c. P2,046,000 d. P858,000

15. Assume you are given the following relationships for the Marhya Company:
Sales/total assets 1.5X
Return on assets (ROA) 3%
Return on equity (ROE) 5%
The Marhya Company’s debt ratio is
a. 40% b. 60% c. 35% d. 65%

16. Salami Company has a total assets turnover of 0.30 and a profit margin of 10 percent. The president is
unhappy with the current return on assets, and he thinks it could be doubled. This could be accomplished (1) by
increasing the profit margin to 15 percent, and (2) by increasing the total assets turnover. What new asset
turnover ratio, along with the 15 percent profit margin, is required to double the return on assets?
a. 35% b. 45% c. 40% d. 50%

17. Delo Co. 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?
a. 0.75 b. 0.70 c. 0.65 d. 0.55

18. The percentage analysis of increases and decreases in individual items in comparative financial statements is called:
A. vertical analysis C. profitability analysis
B. solvency analysis D. horizontal analysis

19. Horizontal analysis is also known as

A. linear analysis. C. trend analysis.
B. vertical analysis D. common size analysis.

20. In 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.
21. Horizontal analysis is a technique for evaluating a series of financial statement
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 data over a period of time
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.

22. Trend analysis allows a firm to compare its performance to:

A. other firms in the industry C. other industries
B. other time periods within the firm D. none of the above

23. Which of the following generally is the most useful in analyzing companies of
different sizes?
A. comparative statements C. price-level accounting
B. common-sized financial statements D. profitability index

24. Statements in which all items are expressed only in relative terms (percentages
of a base) are termed:
A. Vertical statements C. Funds Statements
B. Horizontal Statements D. Common-Size Statements

25. The percent of property, plant and equipment to total assets is an example of:
A. vertical analysis C. profitability analysis
B. solvency analysis D. horizontal analysis

26. Vertical analysis is a technique that expresses each item in a financial

statement
A. in pesos and centavos.
B. as a percent of the item in the previous year.
C. as a percent of a base amount.
D. starting with the highest value down to the lowest value.

27. In performing a vertical analysis, the base for prepaid expenses is

A. total current assets. C. total liabilities.
B. total assets. D. prepaid expenses in a previous year.

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