K to 12 BASIC EDUCATION CURRICULUM SENIOR HIGH SCHOOL

ACCOUNTANCY, BUSINESS AND MANAGEMENT (ABM)

SPECIALIZED SUBJECT
 Financial Statement Analysis

Financial Statement Analysis – is the

process of evaluating risks,
performance, financial health and
future prospects of a business using
computational and analytical
techniques with the objective of
making economic decisions.
 Reasons to Analyze and Interpret Financial Statements

The preparation of financial

statements is not the end of
accounting. The next step is financial
analysis and interpretation. The
purpose of financial analysis is to
transform data in the statements into
information which is interpreted and
used as a basis for better economic
decisions and actions.
 Reasons to Analyze and Interpret Financial Statements

Users Reasons
Investors To determine whether to buy, hold or sell their
investments in equity ownership in the business;
to assess the ability of the investee to pay
dividends or to pay return to investors
Employees To determine stability and profitability of
employers; to determine the ability of the
employer to pay salaries and fringe benefits
Lenders To determine the ability of the borrowers to pay
the loans granted to them on time
Suppliers To determine the ability of the customers to pay
debts as they fall due; to determine the ability of
the customer to remain as a continuing buyer
 Reasons to Analyze and Interpret Financial Statements

Users Reasons
Management to determine the activities of the enterprise for
planning, organizing, leading and controlling
Customer To determine the ability of the enterprise to be a
continuing source of supply; determine the ability
of the company to exist over a long period of time
Public To determine the activities of the enterprise; to
determine the contribution to the economy in the
form of (1) number of employees, (2) ownership
of asset, (3) prices of their products, (4) patronage
of local suppliers, and (5) patronage by customers
Government To determine the capacity of the enterprise to pay
Agencies taxes and its tax compliance; to provide the basis
for monitoring and regulating the activities of
enterprise and individuals
 Financial Statement Analysis

The statement of financial position

presents the assets, liabilities, and owner’s
equity of the entity as of a specific date.
The statement of income presents the
sales, cost of sales, selling expenses,
administrative expenses and net income
for a period of time. Every item in these
financial reports is of varying importance
to the users of financial statements.
 Financial Statement Analysis

The value of the individual information is

enhanced through comparative analysis.
Comparison may be:

(1) Intracompany – comparison within the entity

(2) Intercompany – involves comparison of data
of one entity with those of another entity
(3) Industry averages – shows the standing of an
entity in the industry where it belongs
Financial Statement Analysis

Horizontal Analysis

Vertical Analysis
 Horizontal Analysis

- Is a technique for evaluating a series of financial

statement data over a period of time.
- Increases or decreases from period to period are
computed in peso and percentage.
- The annual reports of corporations include
comparative statements per requirement of the
SEC and BIR.
- Involves sideways comparison, it shows changes
from year to year. When two years are being
compared, the earlier year is used as a base year
- Also known as “trend analysis”
 Horizontal Analysis

The formula for percentage change is as follows:

% of change = (amount of change / base

year amount) x 100%

20X4 20X5
Sales
1,200,000 1,500,000
Horizontal Analysis
Horizontal Analysis
Horizontal Analysis
 Horizontal Analysis

1. The increase in net assets is about P88,000. The increase in current liabilities is P149,000. We infer
that some of the acquisitions of long-term assets are financed by current liabilities.
2. The 9.4% increase in sales revenue is consistent with the 9.6% increase in cost of goods sold. The
increase in sales maybe a result of increase in the number of goods sold and not an increase in
selling price.
 Vertical Analysis

Vertical analysis is the preparation of

common size financial statements. It
is a technique that expresses each
financial statement line item as a
percentage of base amount. For the
SFP the base amount used is the total
assets. On the other hand, sales or net
sales is used as a base amount for the
SCI.
 Vertical Analysis

A common size SFP shows each line

account as a percentage of total
assets. From the asset side we can
infer the composition of assets. On
the other side we can determine the
company’s financing mix – the
percentage of assets financed by
liability and equity.
 Vertical Analysis

A common size SCI expresses each line

as a percentage of sales. This way, we
can see how sales is “used up” by
various expense. Effectively net
income is the portion of sales not
eaten up by expenses.
Vertical Analysis
Vertical Analysis
Financial Statement Analysis

Financial Ratios
 Financial Ratios

A financial ratio is composed of a

numerator and a denominator. It
expresses the relationship between
specific financial statement data. The
resulting ratio may be interpreted as a
percentage, a rate or a proportion.
 Financial Ratios

Take for example a company with sales of

P1,000,000 and net income of P100,000. If we
take the ratio of net income divided by sales, the
result is 10%. We can understand this as “net
income is 10% of sales”. We can also look at it
as a rate or proportion. For every P1.00 of sales
that the company generate, it earns P0.10 of net
income.
 Profitability Ratios

Profitability ratios measure the ability of the

company to generate income from the use of its
assets and invested capital. The company’s
ability to control its cost is also inferred from
profitability ratios.
 Profitability Ratios

Name of Ratio Formula

Gross Profit Margin Gross Profit
Net Sales
Gross Profit Rate Net Sales – Cost of Goods Sold
Net Sales
Operating Income Margin Operating Income
Net Sales
Net Profit Margin Net Income
Net Sales
Return on Assets Net Income
Average Assets
Return on Equity Net Income
Average Total Equity
 Profitability Ratios

Name of Ratio Description

Gross Profit Margin Gross profit margin expresses gross profit as a percentage of
sales. It can be interpreted as the peso value of gross profit
earned for every peso of sales

Operating Income/Profit Operating profit margin expresses operating income as a

Margin percentage of sales. Operating income is computed as gross
profit less operating expenses. Therefore, between two
companies with the same gross profit margin, the company
with the better operating income margin has leaner
operations. In business, leaner operations imply lower
operating expenses as a percentage of sales

Net Profit Margin A company with a higher net profit margin is considered more
profitable
 Profitability Ratios

Name of Ratio Formula

Return on Assets Also known as ROA, return on asset is computed as net income
(in higher accounting, earnings before interest and taxes is
used of numerator instead of net income) divided by average
total asset
Average Assets = (Assets Beginning + Asset Ending) / 2
ROA can also be computed using the ending balance of total
assets. It also measures the company’s efficiency to generate
income by employing its assets. The company with higher ROA
is more profitable.

Return on Equity ROE or return on equity is computed as net income divided by

average total equity.
Average Equity = (Capital Beginning + Capital Ending) / 2
ROE can also be computed using the ending balance of equity.
It measures the return (net income) generated by the capital
invested by the owner in the business. Higher ROE means the
company is more profitable.
 Profitability Ratios
Examples will be using the Financial Statements from Analysis Trading Company.
Profitability Ratios
 Profitability Ratios

Name of Ratio Formula Solution

Gross Profit Gross Profit 4,011.07 ÷ 5,385.86 = 74.47%
Margin Net Sales
Gross Profit Rate
Operating Income Operating Income
604.61 ÷ 5,385.86 = 11.23%
Margin Net Sales
Net Income
Net Profit Margin 592.79 ÷ 5,385.86 = 11.00%
Net Sales
Net Income
Return on Assets 592.79 ÷ 8,532.92 = 7.10%
Average Assets
Net Income
Return on Equity 572.79 ÷ 6,594.99 = 8.69%
Average Total Equity
 Operational Efficiency

Operational efficiency measures the

ability of the company to utilize its assets.
Assets are generally acquired for the
purpose of generating sales. Operational
efficiency is measured based on the
company’s ability to generate sales from
the utilization of its assets, as a whole or
individually. The turnover ratios are
primarily used to measure operational
efficiency.
 Operational Efficiency
Ratio Formula
Asset turnover Net sales
Average Assets
Fixed asset Net Sales
turnover Average Fixed Assets
Inventory turnover Cost of goods sold
Average Inventory
Days in inventory 365
Inventory turnover
Accounts receivable Net Sales
turnover Average Accounts Receivable
Days in account 365
receivable Average Accounts receivable turnover
collection period
 Operational Efficiency
Ratio Formula
Asset turnover Is an indicator of the efficiency with which the company is
utilizing all of its assets. It measures the peso value of sales
generated for every peso of company’s assets. Higher the
turnover rate, the more efficient the company is in using its
assets.
Fixed asset turnover This ratio is similar to asset turnover, except that it is focused
on fixed asset only. It is an indicator of the efficiency of fixed
assets in generating sales.
Inventory turnover Is measured based on cost of goods sold and not sales. This is
because inventory, upon sale, is transferred to cost of goods
sold. It makes both the numerator and denominator
measured at cost. This ratio is an indicator of how fast the
company can sell its inventory.
Assume that the company will restock merchandise only when all
inventory in the warehouse is sold. This means inventory is zeroed
out before purchasing a new batch. Inventory turnover measures the
number of times the company restock the inventory. Company A
with and inventory turnover of 3x(read 3 times) means that it made 3
purchases for the year.
 Operational Efficiency
Ratio Formula
Days in inventory For some, inventory turnover might be harder to visualize. It
is much easier to appreciate the concept of number of days in
inventory. This ratio computes the average number of days
that inventories are held until days sold. Days in inventory
can easily be derived from inventory turnover by multiplying
365 by 1/inventory turnover.

Average Inventory ÷ Average Daily Cost of Goods Sold

Where:

Average Inventory = (Inventory Beg + Inventory End) ÷ 2

Average Daily Cos of goods sold = Cost of goods sold ÷ 365
 Operational Efficiency
Ratio Formula
Accounts receivable Measures the number of times the company can convert
turnover accounts receivables to cash during the year. Basically, the
ratio asks how many times the company was able to collect
on its average accounts receivable during the year.

AR turnover = Net Sales ÷ Average Accounts Receivable

Where

Average AR = (AR Beg + AR End) ÷ 2

Days in account receivable Can be computed from turnover ratio or computed on its
Average collection period own. Days in receivable is a more visual indicator as
compared to accounts receivable turnover. It computes for
the
 Operational Efficiency
Ratio Formula
Days in account receivable Can be computed from turnover ratio or computed on its
Average collection period own. Days in receivable is a more visual indicator as
compared to accounts receivable turnover. It computes for
the average number of days from date of sale to collection.

Days in Accounts Receivable = 365 ÷ AR Turnover

Days in Accounts Receivable = Average AR ÷ Average Daily

Sale

Where:

Average Accounts Receivable = (AR Beg + AR End) ÷ 2

Average Daily Sale = Sales ÷ 365

 Operational Efficiency
Ratio Formula Solution
Net sales
Asset turnover 5,385.86 ÷ 8,352.92 = 0.65X
Average Assets
Fixed asset Net Sales
5,385.86 ÷ 5,706.10 = 0.94X
turnover Average Fixed Assets
Inventory Cost of goods sold
1,374.79 ÷ 604.27 = 2.28X
turnover Average Inventory
365
Days in inventory 365 ÷ 2.28 = 160.43X
Inventory turnover
Accounts
Net Sales
receivable 5,385.86 ÷ 612.64 = 8.79X
Average Accounts Receivable
turnover
Days in account
receivable 365
365 ÷ 8.79 = 41.52X
Average Accounts receivable turnover
collection period
 Financial Health

To evaluate the financial health of a business,

we will look into the company’s solvency and
liquidity ratios. Solvency refers to the
company’s capacity to pay their long term
liabilities. On the other hand, liquidity ratio
intends to measure the company’s ability to pay
debts that are coming due (current liabilities).
Liquidity is a more urgent issue as compare to
solvency. Creditors look at both solvency and
liquidity ratios to evaluate the company’s ability
to pay back their debts as well as pay interests.
 Financial Health

Ratio Formula
Solvency Measures
Debt to equity ratio Total Debt
Equity
Debt ratio Total Debt
Total Assets
Interest coverage ratio Operating Income
Interest Expense
Liquidity
Current ratio Current Assets
Current Liabilities
Quick ratio Quick Assets
Current Liabilities
 Financial Health

Ratio Formula

Debt to equity ratio Debt to equity ratios indicates the company’s reliance to debt
or liability as a source of financing relative to equity. A high
ratio suggests a high level of debt that may result in high
interest expense. A debt to equity ratio of greater than 1
implies that the company’s debt exceeds its capital.
Debt ratio This ratio is similar to debt to equity ratio. It indicates the
percentage of the company’s assets that are financed by
debt. A high debt to asset ratio implies a high level of debt.
Interest coverage ratio This ratio measures the company’s ability to cover the
interest expense on its liability with its operating income. A
ratio greater than 1 means the company’s operating income
can meet its interest expense. But 1 is a very low ratio.
Creditors prefer a high coverage ratio to give them protection
that interest can be repaid from income.
 Financial Health

Ratio Formula
Current ratio This ratio is used to evaluate the company’s liquidity.
Basically we want to know whether there are sufficient
current assets to pay for current liabilities. A ratio of 1
means current assets can fully cover current liabilities.
However, creditors want a margin of safety. Some creditors
require a current ratio of 2.
An alternative measure of liquidity is the net working
capital. This refers to current assets less current liabilities.
A positive net working capital means that not only is current
liabilities fully covered by current assets, there are excess
current assets that the company can use for other purposes.
On the other hand, a negative net working capital means
that current assets are not sufficient to pay liabilities that
are coming due.
 Financial Health

Ratio Formula
Quick ratio This ratio is stricter than current ratio. It suggests that not
all current assets can be easily liquidated to pay for short
term liabilities. Current assets such as inventory will take a
longer time to liquidate. There are also items like prepaid
expenses that are not convertible to cash. By definition,
quick assets include only current assets that can be quickly
turned to cash such as cash and cash equivalents, accounts
receivable and marketable security.
Like current ratio, we want to know whether there are
sufficient quick assets to pay for current liabilities. A quick
ratio of 1 is acceptable.
 Financial Health

Ratio Formula
Solvency Measures
Total Debt
Debt to equity ratio 1,850.63 ÷ 6,762.32 = 27.37%
Equity
Total Debt
Debt ratio 1,850.63 ÷ 8,612.95 = 21.49%
Total Assets
Operating Income
Interest coverage ratio 604.61 ÷ 11.82 = 51.15
Interest Expense
 Financial Health

Ratio Formula
Liquidity
Current Assets
Current ratio 1,957.22 ÷ 1,273.05 = 1.54
Current Liabilities
Quick Assets
Quick ratio 1,130.42 ÷ 1,273.05 = 0.89
Current Liabilities
 Uses and Limitations of Financial Analysis

The following are some of the uses of Financial

Analysis:

1. Benchmarking refers to comparing the company’s

growth performance, common-sized financial
statement and financial ratios against industry
average, another company, its historical
performance and established forecasts or targets.
2. Results of financial statement analysis can also be
used for preparing forecasted financial statements.
 Uses and Limitations of Financial Analysis

The following are some of limitations of Financial

Analysis:

1. Historical performance may provide indication but

will not ensure future performance.
2. A good financial analysis is worthless if the financial
statement is erroneous or fraudulent.
3. Financial statements of companies may not be
directly comparable if there are differences in
accounting treatment of transactions.