Chapter 2
FINANCIAL STATEMENT ANALYSIS
OBJECTIVES OF
FINANCIAL STATEMENT ANALYSIS
The objective of financial statements analysis is to
determine the extent of a firm’s success in attaining in
financial goals, namely:
a) To earn maximum profit
b) To maintain solvency
c) To attain stability
MAJOR FINANCIAL STATEMENT USERS
 Creditors – lend money to a company on either
a short-term or a long-term basis. Short-term
creditors include trade creditors and lending
institutions. Long-term creditors include lending
institutions and corporate bondholders.
 Equity investors – those who purchase an
ownership interest in a company. They are after
the dividends.
 Management – analyzes the company’s
financial statements with a view toward
favorably impressing external parties.
 General economic environment
Business periodicals are good sources for
information about anticipated changes in economic
conditions.
PROFITABILITY, LIQUIDITY & SOLVENCY
 Political event
-an action that has already taken place, while
the political climate is a situation that can lead t an
action. Example: Actions taken by the Congress or the
President on government regulation, income taxes,
health care, etc.
 Industry outlook
-defines both the opportunities the company
may seize and the challenges it must face. Government
regulation and deregulation and technological changes
are examples of items that can directly impact an
industry.
 Profitability is the ease with which a company
generates income.
 Liquidity is the ease with which an item, such as
an asset, can be converted to cash. It is the
ability to generate sufficient cash to meet its
short-term obligations.
 Solvency is a company’s ability to meet the
obligations created by its long-term debt.
Liquidity Ratios -Give us an idea of the firm’s ability to
pay off debts that are maturing within a year or within
the next operating cycle.
Current ratio is the primary test of solvency to meet
current obligations from current assets.
Acid-test (quick) ratio is a more severe test of
immediate solvency; test of ability to meet demands
from current assets.
Cash flow liquidity ratio measures short-term liquidity
by considering as cash resources (numerator) cash plus
cash equivalents plus cash flow from operating
activities.
Asset Management Ratios –Give us the idea of how
efficiently the firm is using its assets.
Good asset management ratios are necessary for the
firm to keep its costs low and thus, its net income high.
Accounts receivable turnover measures the velocity of
collection of trade accounts; tests the efficiency of
collection
Average collection period evaluates the liquidity of
accounts receivable and the firm’s credit policies.
Inventory turnover measures the efficiency of the firm
in managing and selling inventory.
Average sale period measures average number of days
to sell or consume the average inventory.
Fixed asset turnover measures the effectiveness in
generating sales from investments in fixed assets
particularly for a capital-intensive firm.
Total asset turnover measures the efficiency of
management to generate sales and thus earn more
profit for the firm.
Debt Management Ratios - Tell us how the firm has
financed its assets as well as the firm’s ability to repay
its long-term.
Debt ratio measures the proportion of all assets that are
financed with debt.
Times interest earned ratio measures the ability of a
firm’s operations to provide protection to long-term
creditors.
Fixed charge coverage measures the firm’s coverage
capability to cover not only interest payments but also
the fixed payment associated with leasing which must
be met annually.
Profitability - Give us an idea of how profitability the
firm is operating and utilizing its assets.
Gross profit margin shows the relationship between
sales and the cost of products sold, measures the ability
of a company both to control costs and inventories or
manufacturing of products and to pass along price
increases through sales to customers.
Operating profit margin is a measure of overall
operating efficiency and incorporates all of the
expenses associated with ordinary or normal business
activities.
Net profit margin measures profitability after
considering all revenues and expenses, including
interest, taxes and non-operating items such as
extraordinary items, cumulative effect of accounting
changes, etc.
Cash flow margin measures the ability of the firm to
translate sales to cash to enable it to service debt, pay
dividends or invest in new capital assets.
Return on Investment on Assets measures overall
efficiency of the firm in managing assets and generating
profits.
Return on equity measures the rate of return on
resources provided by owners.
Financial Leverage Index (FLI) - If the FLI is greater than
1 indicating the return on equity exceeds return on
assets, the firm is using debt effectively. If FLI is less
than 1, the financial leverage is negative which means
that the firm is not using debt successfully.
Earnings per share is the peso return on each ordinary
shares. It shows the ability to pay dividends.
P/E ratio relates earnings per ordinary share to the
market price at which the stock trades, expressing the
“multiple” which the stock market places on a firm’s
earnings.
Dividend payout ratio shows percentage of earnings
paid to shareholders.
Dividend yield shows the rate earned by shareholders
from dividends relative to current price of stock.
Financial Statement Analysis – Involves the evaluation
of the firm’s past performance, present condition, and
business potentials. The analysis provides information
about the following, among others:
 Profitability of the business firm
 Ability to meet company obligations
 Safety of investment in the business
 Effectiveness of management in running the
firm
Financial Statement (FS) Analysis Tools and Techniques
1. Horizontal Analysis (Trend Analysis) – involves
comparison of figures shown in the financial
statements of two or more consecutive periods.
Percentage Change (%) = (Most Recent Value –
Base Period Value) / Base Period Value
Comparisons can be made between an actual
amount compared against a budgeted amount,
with the ‘budget’ serving as the base or pattern
of performance.
Limitation: If a negative or zero amount appears
in the base year, percentage change cannot be
computed.
2. Vertical Analysis (Common-Size Analysis) –
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 net sales (in the
income statement).
 3. Ratio Analysis – involves development of Current Liabilities
mathematical relationships among accounts in
the financial statements.  Working Capital Activity Ratios or Efficiency
Ratios
Basic Rules on Ratio Calculations
Income
 When calculating a ratio using balance
Statement
sheet numbers only, the numerator and No. of
Account
denominator should be from the same Average days in a
Turnover Ave.
balance sheet date. The same is true for Age year
Balance
ratios using only income statement Turnover
Sheet
numbers. Exception: Calculation of Account
Growth Ratios
 If an income statement account and a Receivable Net (Credit) Sales
balance sheet account are both used to Turnover Average Receivables
calculate ratio, the balance sheet Average Age of
account should be expressed as an Receivables
average for the time period (Average 360 days
represented by the income statement Collection Period) Receivable Turnover
(Days’ Sales in
account.
Receivables)
 If the beginning balance of a balance
Cost of Goods Sold
sheet account is not available, the Inventory
Ave. Merchandise
ending balance is normally used to Turnover
Inventory
represent the average balance of the Average Age of
account. Inventory*
 If sales and/or purchases are given (Inventory
360 days
without making distinction as to Conversion
Inventory Turnover
whether made in cash or on credit, Period)
assumptions are made depending on (Days’ Sales in
the ratio being calculated: Inventory)
o Turnover Ratios: Sales and Normal Operating Average Age of Inventory +
Purchases are made on credit. Cycle Average Age of Receivables
*In some accounting and finance texts, average
o Cash Flow Ratios: Sales and
inventory age is also called as the average sales
Purchases are made in cash.
period.
 Generally, the number of days in a
month or year is not critical to the
analysis: a year may have 360 days, 52  Test of Solvency
weeks, and 12 months; alternatively, a Times Interest EBIT
Earned Interest Expense
year may be comprised of 365 calendar
Debt-Equity Total Liabilities
days, 300 working days or any
Ratio Total Shareholders’ Equity
appropriate number of days.
Total Liabilities
Debt Ratio
Total Assets
Total Shareholders’ Equity
Equity Ratio
Total Assets
Financial Ratios:
 Test of Liquidity  Test of Profitability
Current Assets Income
Current Ratio Return on Sales
Current Liabilities Net Sales
Quick Ratio Quick Assets (Cash & Cash Return on Income + Interest after-tax
(Acid-Test Equivalents, Receivables & Assets Average Assets
Ratio) Marketable Securities)
 What income figure should be used? Common
o If the intention is to measure Book Value Shareholders’ Equity
operational performance, income is Per Share Common Shares
expressed as before interest and tax; Outstanding
alternatively, before ‘after-tax’ interest Times
Net Income After
may be used to exclude the effect of Preferred
Taxed
capital structure. Dividend
Preferred Dividends
Earned
o If the intention is to evaluate total
Capital Total Assets
managerial effort, income is expressed
Intensity Ratio Net Sales
after interest and tax.
Net Income before
o The practice of expressing income after Time Fixed taxes & fixed charges
interest but before tax is now being Charges (Fixed charges +
discouraged. Earned Sinking Fund
o Income should include dividends and payment)*
interest earned if the said investments *Fixed charges shall include rent,
are included in asset base. interests, and other relevant fixed
o If used in the Dupont techniques, expenses; sinking fund payment must
income must be after interests, taxes be expressed before tax.
and preferred stock dividends.
o Tests on overall Short-term Solvency or
Return on Equity = Return on Sales x Short-term Financial Position
Assets Turnover x Equity Multiplier Working Net Sales
Capital Average Working
Turnover Capital
Return on Income
Current Liabilities
Equity Average Equity Defensive
Cash & Cash
Net Income – Preferred Interval Ratio
Equivalent
Earnings Per Dividends
Net Purchases
Share Weighted Average Common Payable
Average Accounts
Shares Outstanding Turnover
Payable
Fixed Assets to
Fixed Assets
Long-Term
 Market Tests Long-term Liabilities
Liabilities
Price-Earnings Price Per Share
(P/E) Ratio Earnings Per Share o Ratios indicative of Income Position
Dividend Per Share Rate of Return Income
Dividend Yield
Price Per Share on Average Average Current
Dividend Per Share Current Asset Assets
Dividend Pay-Out
Earnings Per Share Operating Operating Profit
Profit Margin Net Sales
 Other Meaningful Ratios Cash Flow Operating Cash Flow
Margin Net Sales
o Ratios used to evaluate Long-term
Financial Position or Stability
Fixed Assets Fixed Assets (Net)
to Total Equity Total Equity
Fixed Assets Fixed Assets (Net)
to Total Assets Total Assets
Sales to Fixed
Assets Net Sales
(Plant Fixed Assets (Net)
Turnover)