SUBJECT: FINANCIAL ANALYSIS AND THEORY TOPIC NO.

: 1
PROFESSOR: APRIL JOY F. BORERES, CB, RCA, CAT

Introduction to Financial Analysis

At the end of the class, the students should be able to:

1. Appreciate the importance of financial analysis as an analytical process

2. Discuss the three basic decision areas dealt with by managers and the items involved in
these decisions.
3. Identify the Objectives of financial statement analysis
4. Enumerate the general approach to financial statement analysis
5. Problems and limitations in financial statement analysis
6. Explain the steps in analyzing financial statements
7. Types of Analysis

What is financial analysis?

According to R. Medina(Business Finance,2007), financial analysis may be defined

as the process of interpreting the past, present and the future financial condition of
the company.
According to R. Roque(Management Advisory Services,2011), financial analysis
involves careful selection of data from financial statements in order to assess and
evaluate the firms past performance, its present condition and future business
potentials
According to N. Mariano(Elements of Finance,2014), financial analysis highlights the
connection, relation and importance of accounting to financial management in
particular and to finance in general. Hence, it deals with the understanding of the
relationship between financial concepts and daily-decision making.
Stated by Helfert(1994), financial analysis is both analytical and a judgmental
process which help answer questions that have been carefully posed in managerial
context.
DRAW a GRAPH

FINANCIAL ANALYSIS AS ANALYTICAL PROCESS

Financial analysis as an analytical process should always focus on structuring the

issue in its context and manipulating the proper data.
The end purpose of financial analysis is to help people make sound decisions and
judgment.
The result is always dependent upon the reliability of the information or data
gathered and points of view of depend of people who need the analysis and not
necessarily the one making the analysis.

NOTE:

Financial analysis is aimed at finding answers to relevant and significant questions.

Both quantitative and qualitative are important in making important financial decisions.

5 Key Elements of a Financial Analysis

1. Revenues

Revenues are probably your business's main source of cash. The quantity, quality and timing of
revenues can determine long-term success.

Revenue growth (revenue this period - revenue last period) revenue last period.
When calculating revenue growth, don't include one-time revenues, which can distort the
analysis.

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SUBJECT: FINANCIAL ANALYSIS AND THEORY TOPIC NO.: 1
PROFESSOR: APRIL JOY F. BORERES, CB, RCA, CAT

Revenue concentration (revenue from client total revenue). If a single customer

generates a high percentage of your revenues, you could face financial difficulty if that
customer stops buying. No client should represent more than 10 percent of your total
revenues.
Revenue per employee (revenue average number of employees). This ratio measures
your business's productivity. The higher the ratio, the better. Many highly successful
companies achieve over $1 million in annual revenue per employee.

2. Profits

If you can't produce quality profits consistently, your business may not survive in the long run.

Gross profit margin (revenues cost of goods sold) revenues. A healthy gross profit
margin allows you to absorb shocks to revenues or cost of goods sold without losing the
ability to pay for ongoing expenses.
Operating profit margin (revenues cost of goods sold operating expenses)
revenues. Operating expenses don't include interest or taxes. This determines
your companys ability to make a profit regardless of how you finance operations (debt or
equity). The higher, the better.
Net profit margin (revenues cost of goods sold operating expenses all other
expenses) revenues. This is what remains for reinvestment into your business and for
distribution to owners in the form of dividends.

3. Operational Efficiency

Operational efficiency measures how well you're using the companys resources. A lack of
operational efficiency leads to smaller profits and weaker growth.

Accounts receivables turnover (net credit sales average accounts receivable). This
measures how efficiently you manage the credit you extend to customers. A higher number
means your company is managing credit well; a lower number is a warning sign you
should improve how you collect from customers.
Inventory turnover (cost of goods sold average inventory). This measures how
efficiently you manage inventory. A higher number is a good sign; a lower number means
you either aren't selling well or are producing too much for your current level of sales.

4. Capital Efficiency and Solvency

Capital efficiency and solvency are of interest to lenders and investors.

Return on equity (net income shareholders equity). This represents the return
investors are generating from your business.
Debt to equity (debt equity). The definitions of debt and equity can vary, but generally
this indicates how much leverage you're using to operate. Leverage should not exceed
what's reasonable for your business.

5. Liquidity

Liquidity analysis addresses your ability to generate sufficient cash to cover cash expenses. No
amount of revenue growth or profits can compensate for poor liquidity.

Current ratio (current assets current liabilities). This measures your ability to pay off
short-term obligations from cash and other current assets. A value less than 1 means
your company doesn't have sufficient liquid resources to do this. A ratio above 2 is best.
Interest coverage (earnings before interest and taxes interest expense). This
measures your ability to pay interest expense from the cash you generate. A value less than
1.5 is cause for concern to lenders.

NOTE: Basis for Comparison

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SUBJECT: FINANCIAL ANALYSIS AND THEORY TOPIC NO.: 1
PROFESSOR: APRIL JOY F. BORERES, CB, RCA, CAT

The final part of the financial analysis is to establish a proper basis for comparison, so you can
determine if performance is aligned with appropriate benchmarks. This works for each data point
individually as well as for your overall financial condition.

The first basis is your companys past, to determine if your financial condition is improving or
worsening. Typically, the past three years of performance is sufficient, but if access to older data is
available, you should use that as well. Looking at your past and present financial condition also
helps you spot trends. If, for example, liquidity has decreased consistently, you can make changes.

The second basis is your direct competitors. This can provide an important reality check. Having
revenue growth of 10 percent annually may sound good, but if competitors are growing at 25
percent, it highlights underperformance.

The final basis consists of contractual covenants. Lenders, investors and key customers usually
require certain financial performance benchmarks. Maintaining key financial ratios and data points
within predetermined limits can help these third parties protect their interests.

BASIC DECISION AREAS

1. Operation
2. Investment
3. Finance

Operation Decision deals with the day-to day operations/activities of the firm. This includes
decision that relevant to pricing, selecting, markets choosing the appropriate production processes
and technology, outsourcing payroll, outsourcing maintenance, and janitorial services, among
others. It also includes decisions relative to a firms operating leverage.

Operating leverage involves determination of the profitable level and the proportion of the fixed
cost of operation versus the amount and nature of variable costs (changes with volume incurred in
manufacturing, trading and service operations.

NOTE:

Financial analyst uses operating ratio as well as determines variances between budget and actual
performance. Break-even analysis used to determine the volume of business a company needs to
reach where the income equal expenses. It means the company get over this point to earn a profit.
This analysis enables the manager to set target sales figures that will guide the sales personnel in
their sales effort to earn the desired profit.

Investment Decision refers to deciding what assets to acquire, be they current assets as
marketable securities or non-current assets as property, plant or equipment and long-term
investments in stocks and bonds. It includes decision relative to projects to undertake or business
to enter into. Current Available resources and new funding obtained can be utilized to fund:

1. Working Capital
Working Capital ( Capital =Current Assets- Current Liabilities )

2. Property Plant and Equipment

Property, Plant and Equipment are the non-current assets of the firm. Involves the
term capital budgeting.

3. Major Spending Program

Major spending programs are programs such as research and development, product
or service development, the promotional and advertising programs, or long-term
investment alternatives for excess funds so that can be converted into an earning

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SUBJECT: FINANCIAL ANALYSIS AND THEORY TOPIC NO.: 1
PROFESSOR: APRIL JOY F. BORERES, CB, RCA, CAT

assets. Funds available for the short term are invested in marketable securities or
short-term investments, while funds available over the long term invested in either
stocks or bond.

Financing Decision refers to decision that involves funding investment and operations over the
long run. It includes decisions that relate to the companys capital structure, debt-equity mix.
Funding sources, dividend policies, cost of capital, among others.

Management has to decide whether borrowing directly from bank, issuing bonds or issuing stock is
the best and most fitted means of financing a certain need.

Objectives of Financial Statement Analysis

The primary purpose of Financial Statement Analysis is to evaluate and forecast the companys
financial health. Interested parties, such as the managers, investors, and creditors, can identify the
companys financial strengths and weaknesses and know about the:

1. Profitability of the Business Firm

2. Firms Ability to meet its obligation
3. Safety to investment in the business; and
4. Effectiveness of management in running the firm.

General Approach to Financial Statement Analysis

1. Evaluation of the environment (industry and economy as a whole) where the company
conducts business
2. Analysis of the firms short-term solvency
3. Analysis of the companys capital structure and long-term solvency
4. Evaluation of the managements efficiency in running the business
5. Analysis of the firms profitability

Problems and Limitations in Financial Statements Analysis

1. Comparison of financial data

a. Differences between companies a ratio that is acceptable to one company may not
be acceptable to another when other factors are considered.
b. Differences in accounting methods and estimates
c. Valuation problem financial statements are based on historical costs and
therefore, do not reflect the current market value of the firms assets. Moreso, the
effects of price level changes must be considered.
d. The timing of transactions and use of average in applying the various techniques in
Financial Statement Analysis affect the result obtained.
2. The need to look beyond ratios
Ratios are not sufficient in themselves as basis for judgments about the future. Other factors
must be considered, such as:

a. Industry trends
b. Changes in technology
c. Changes in consumer tastes
d. Changes in the economy as a whole
e. Changes that are taking place within the company itself

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SUBJECT: FINANCIAL ANALYSIS AND THEORY TOPIC NO.: 1
PROFESSOR: APRIL JOY F. BORERES, CB, RCA, CAT

Steps in Financial Analysis

1. Establish the objectives of the analysis conducted.

2. Study the industry where the firm belongs.
3. Study the firms background and quality if its management.
4. Evaluate the firms financial statement using the evaluation techniques
available.
5. Summarize the results of the studies and evaluation conducted
6. Develop conclusions relevant to the established objectives.

Types of Analysis

According to R. Medina(2007), in the analysis of the financial standing of the firm, procedures may
be categorized as follows:

1. Single-period analysis; and

2. Comparative or trend analysis

Single-Period Analysis refers to comparison and measurements based upon the financial data of a
single period. It reveals financial position and relationship as of given point or period time.

Ratios, percentages, and other analytical techniques disclose the financial positions and results of
operations of the firm at the end of the current period. Examples of the single-period analysis are
the current and equity ratio.

The comparative or trend analysis compares and measures items on the financial statement of two
or more fiscal periods. The improvements or lack of improvement in financial position and in the
results of operation is determined.

REFERENCES:

REVIEWER IN MANAGEMENT ADVISORY SERVICESBY R. ROQUE (2011 EDITION)

ELEMENTS IF FINANCE BY N. MARIANO (2014)

BUSINESS FINANCE BY R. MEDINA (2007)

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