CHAPTER 4

Analysis and Interpretation of Financial Statements

Reasons to Analyze and Interpret Financial Statement

The preparation of financial Statement is not the end of accounting. The next step is financial
analysis and interpretation. The purpose of financial statement analysis is to transform the data in the
statements into information which is interpreted and used as basis for better economic decisions and
actions. Bankers and creditors analyze statements to determine if it is profitable to lend money to a
particular business. Organized employees look for the stability of their employer and decide whether it
is reasonable to demand increases in wages and other fringe benefits. Various government agencies
analyze the statements to see if the companies are conforming with government regulations.
Management analyzes statements of their own companies to determine past performance, as a means
of control and as a guide of future action.

The users of financial statements have the following reasons to analyze and interpret financial
statements:
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 returns 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 customer to pay debts as they fall due; to determine the ability of the
customer to remain as a continuing buyer
Management
– to determine the activities of the enterprise for planning, organizing, leading, controlling.
Customer
- to determine the ability of the enterprise to be a continuing source of supply; to determine the ability
of the company to exist over a long period of time
Public
– to determine the activities of the enterprise; to determine contribution to the economy in the form of
(1) number of employees, (2) ownership of assets, (3) prices of their products, (4) patronage of local
suppliers, (5) patronage by customers
Government Agencies – to determine the capacity of the enterprise to pay taxes and its tax compliance;
to provide the basis for monitoring and regulating the activities of enterprises and individuals.
The statement of financial position( balance sheet) 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. The value of the individual
information is enhanced through comparative analysis. Comparison may be (1) intracompany, (2)
intercompany, (3) with industry averages. Intracompany involves comparison within the entity, while
intercompany involves comparison of data of one entity with those of another entity. Comparison with
the industry’s averages shows the standing of the entity in the industry where it belongs.
Horizontal Analysis
Is a technique for evaluating a series of financial statement data over a period of time. Increases or
decreases from 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 requirements of
the Securities and Exchange Commission and the Bureau of Internal Revenue. Comparative statements
show figures for the current period and the preceding period or periods. These statements may be
analysed horizontally, vertically, or with the use of other analytical tool.
Involves sidewise comparison. It shows changes from year to year. When two years are being compared,
the earlier year is used as the base year. The increase or decrease from the base year to the succeeding
years is computed for each item. The amount of change, in terms of increase or decrease, is divided by
the amount in the base year. The quotient is stated as the percentage. It should be noted that if a
certain item has value in the base year and none in the next year, the percentage of decrease is 100%.
The formula for the percentage of change is as follows:

Percentage of change= amount of change x 100%

Base year

Trend Percentages
When several years are involved in a horizontal analysis, the base year is the earliest year. The
base year is 100%. The amount of the items for succeeding years are divided by the base year amount.
The series of quotients show the trend in the item.
To illustrate, consider the following trend in the net income of Paso Company:
Year Net Income Computation Trend Percentage
20x2 P 2,100,000 P 2,100,000 ÷ P 2,100,000 = 100 %
20x3 2,205,000 P 2,205,000 ÷ P2, 100, 000 = 105%
20x4 2,310,000 P 2, 310, 000 ÷ P 2,100,000 = 110%
The base year is 20x2, which is 100%. The 20x3 net income of P 2,205,000 is divided by 20x2 or the
base year’s net income of P 2,100,000 to produce 105%. The 20x4 net income of P 2,310,000 is divided
by 20x2 net income of 2,100,000 to arrive at 110%. The computations indicate upward trend in net
income. An upward trend in net income may be an indication of a progressive business. A downward
trend is an indication of an ailment that management should investigate as basis for corrective
measures. Trend percentages may be computed for both income statement and balance sheet items.
Excellent Company
Comparative Balance Sheet
(in Philippines Peso)
December 31,20x1- 20x4

20x1 20x2 20x3 20x4

Assets
Current assets
Cash 140,000 120,000 110,000 210,000
Accounts Receivable(net) 670,000 620,000 930,000 1,000,000
Merchandise inventory 1,090,000 1,360,000 1,350,000 1,190,000
Total Current Assets 1,900,000 2,100,000 2,390,000 2,400,000
Noncurrent Assets
Furniture and Equipment (net) 1,720,000 1,660,000 1,720,000 1,750,000
Total assets 3,620,000 3,760,000 4,110,000 4,150,000
Liabilities and Owner’s Equity
Current Liabilities
Accounts payable 870,000 760,000 880,000 690,000
Accrued expense 60,000 50,000 80,000 90,000
Total current liabilities 930,000 810,000 960,000 780,000
Long-term Liability
Mortgage payable 500,000 500,000 800,000 800,000
Total Liabilities 1,430,000 1,310,000 1,760,000 1,580,000
Owner’s Equity 2,190,000 2,450,000 2,350,000 2,570,000
Total Liabilites and
Owner’s equity 3,620,000 3,760,000 4,110,000 4,150,000

Vertical Analysis
-is a technique for evaluating financial statement data that expresses each item in a financial statement
as a percentage of base amounts.
Composition of Assets and Equities
Working capital may appear to be adequate and the business sufficiently liquid, based on the preceding
computations, but it may still lack the proper balance among components. One way of judging whether
or not the balance is proper is to determine the percentage of each asset to total assets. This is known
as vertical analysis, common size statement, or statement of component percentages. This measure of
asset composition is then compared with those of the same company at earlier dates and with those of
similar companies at the same date.
Formula:
Cash = P 100,000 = 4.9%
Total assets P 2,040,000

Composition of Income and Expenses

Income is the result of two kinds of flows which have opposite effects: revenue, which tends to
increase income; and expense, which tends to reduce it. To enable management to pinpoint trouble
spots or determine which specific revenue or expense item needs attention. This is done by dividing the
income and expense items by the net sales. This is known as vertical analysis, component percentages,
or common size statement.

Ratio Analysis
The following are concepts on ratio analysis for basic financial statement:
Liquidity ratio – measure the ability of an entity to pay currently maturing obligations and meet
unexpected cash needs.
Profitability ratio – measure the ability of an entity to earn income over a period of time.
Solvency ratio – measure the ability of an entity to survive over a long period of time.
Ratios may be computed through intracompany comparisons ( within one entity) or intercompany
comparisons ( between entities).

Liquidity ratios
Current ratio
Is the relationship of available current assets to meet payments of current liabilities. It is also called
working capital ratio or banker’s ratio. This is computed as follows:

Current ratio = Current assets

Current liabilities
Acid-Test Ratio or = cash + temporary investment + short-term receivables (net)
Quick Ratio Total Current Liabilities

The quick asset consist of cash, temporary investment, and receivables. Inventories are not included as
it takes a long period of time to be realized inventories in cash. Generally, inventories are sold on
account. The receivables from such credit sales are collected before payments are made to creditors.
Prepaid expenses as well as other receivables which will not become cash in the near future are not
considered quick assets. The quick ratios of both companies are as follows:

Cable Co. Field Co.

Cash P 100 000 P 360 000
Temporary investment 70 000 40 000
Accounts receivable 110 000 200 000
Total quick assets P 280 000 P 600 000
Total current liabilities P 300 000 P 400 000
Quick ratio .93:1 1.5:1

The computation means that Cable Co. has available P .93 of quick assets to pay for every P 1.00mof
current liabilities, whereas, Field Co. has P 1.50 of quick assets for every P 1.00 of current liabilities. In
other words , Field Co. is in a better financial position to pay its debts on the due date. There is no
standard acceptable ratio. The acceptable ratio is determined by the creditor or management or
whoever is using the quick ratio as a too; for analysis.

Profitability Ratios
Refers to the ability of a business to earn profits from its operations. There ar several ratios used to test
the profitability of a company among them are the following:

Ratio of Gross Profit to Net Sales

– is the relationship between gross profit and net sales. The gross profit must be sufficient to cover all
expenses and yield income to the owners of the business. This ratio is computed by dividing gross profit
by net sales.
Gross Profit Ratio = Gross Profit
Net Sales

Ratio of Net Income to Net Sales – is a measure of the profitability for each peso sale.
Net Profit Ratio = Net Income
Net Sales

Operating Ratio – is the relationship of cost of sales and operating expenses to net sales. The ratio is
useful in ascertaining operating efficiency of the business.
Operating Ratio = Cost of Sales + Operating Expenses
Net Sales

Ratio of Net Income to Owner’s Equity

– is the relationship of net income to owner’s equity. The ratio is a measure of the profitability of the
business. It shows the rate of return on the investment of the owners. A big ratio indicates the owner is
getting return on his investment.
Ratio of Net Income to Owner’s Equity = Net Income for the Period
Average Owner’s Equity
Ratio of Net Income to Total Assets
– is used to determine efficiency with which management utilizes the assets of the business. The
percentage of net income against the total assets.
Ratio of Net Income to Total Assets = Net income
Total Assets
Ratio of Net Sales to Total Assets
– shows the relationship between the peso sales volume and the total assets of the business. It
measures efficiency in the use of the company’s resources.
Ratio of Net Sales to Total Assets = Net Sales
Total Assets

Solvency Ratios
Debt to Equity Ratio = Total liabilities
Total owner’s equity
May adversely affect the entity’s ability to meet maturing obligations. When the owners have a
large share in the entity’s asset, there is enough cushion or buffer for uncertainties. This situation means
that the entity has the ability to withstand losses. Generally, a low debt in total assets is desirable for the
creditors.
Debt to Total assets = total liabilities
Total assets
Proprietor or Equity Ratio – is the ratio of the total owner’s equity to the total assets.
Proprietor Ratio = Total owner’s equity
Total Assets

Basic Accounting equation:

Assets = Liabilities + Equity
Liabilities – are the creditor’s claim on the total assets, and equity is the owner’s claim on total assets.
Graduated Income Tax Rates for Individual
On the taxable income of;
Not over P 10 000
Over P 10 000 but not over P 30 000
Over P 30 000 but not over P 70 000
Over P 70 000 but not over P 140 000
Over P 140 000 but not over P 250 000
Over P 250 000 but not over P 500 000
Over P 500 000
Tax is;
5%
P 500 + 10 % of excess over P 10 000
P 2 500 + 15 % of excess over P 30 000
P 8 500 + 20 % of excess over P 70 000
P22 500 + 25 % of excess over P 140 000
P 50,000 + 30 % of excess over P 250 000
P 125 000 + 32 % of excess over P 500 000

General professional partnership – are partnership formed by persons for the sole purpose of exercising
their common profession. No part of the income is derived from engaging in any trade or business. As
such shall not be subjected to income tax. Deemed as corporation is taxed like a corporation. Taxable
income. The National Internal Revenue Code – provides the following:
Section 31 Taxable Income Defined.
The term taxable income – refers to the pertinent items of gross income specified in this code,
less the deduction and or personal and additional exemptions, if any , authorized for such type of
income by this Code or other special Laws.

Section 32 Gross Income.

Except when otherwise provide in this title.
Gross income – refers to all income derived from whatever source, including ( but not limited to) the
following items:

•Compensation for Services in whatever form paid, including, but not limited to fees, salaries, wages,
commissions, and similar items.
•Gross income derived from the conduct of trade, business, or the exercise of a professions
•Gains derived from dealings and property
•Interest
•Rents
•Royalties
•Dividends
•Annuities
•Prizes and winnings
•Pensions
•Partner’s distributive share from the net income of the general professional partnership.

Allowance of Personal exemption for Individual Taxpayer

Based on the National Internal Revenue Code of 1997, as updated until 2011 by Republic Acts
and as relevant ruling of the Bureau of Internal Revenue(BIR) there shall be allowed a basic personal
exemption amounting to 50 000 for each individual taxpayer.

In the case of married individuals where only one of the spouses is deriving income, there is
additional exemption of 25000 for each dependent not exceeding 4 . The additional exemptions for
dependents shall be claimed by only one of the spouses in the case of married individuals.

In the case of legally separated spouses, additional exemption may be claimed only by the spouse
who has custody of the child or children. Provided that the total amount of the additional exemption
that may be claimed by both shall exceed the maximum additional exemptions of 25 000 for each
dependent not exceeding 4. A dependent means legitimate, illegitimate or legally- adopted child chiefly
dependent upon, and living with taxpayer if such dependent is not more than 21 years of age,
unmarried and not gainfully employed, or if such dependent, regardless of age, is incapable of self-
support because of mental or physical defect.

Optional Standard Deduction

In lieu of the deduction allowed, an individual subject to income tax may elect a standard
deduction in an amount not exceeding 40% of his gross sales or gross receipts, as the case may be. In
case of a corporation subject to income tax, it may elect an optional standard deduction (OSD) in an
amount not exceeding 40% of its gross income. Unless the taxpayer signifies in his first quarter return
his intention to elect the optional standard deductions, he shall be considered as having availed himself
of the itemized in deductions. Such election when made in the return shall be irrevocable for the taxable
year for which the return is made. It is important for a taxpayer to consult practicing CPA’s on matters
of income taxation to minimize future assessment by the Bureau of Internal Revenue (BIR). Assessments
are computed not only for the basic income tax but also include penalties, interest and surcharges. In –
house accountants of businesses have the expertise to the tax work and review. However, it is common
for the in-house accountants to consult their tax consultants.

Rates of Income Tax on Corporation

In general, the corporate income tax rate on domestic corporation is 35%. However, effective
January 1, 2009, the rate of income tax on domestic corporation shall be 30%
Proprietary educational institutions and hospital which are non- profit shall pay a tax of 10% on their
taxable income subject to certain exemptions.

Value Added Tax or Percentage Tax

Another national tax is the value – added tax (VAT). The VAT is also called expanded value-added
tax (E- VAT). It is a tax which is a percentage of selling price. VAT is a tax on consumptions levied on the
sale, barter, exchange or lease of goods, properties and services in the Philippines, and on importation
of goods into the Philippines. If a person engaged in sale of real estate property, the basis computing the
VAT is selling price or fair market value, whichever is higher. The seller himself is statutorily liable for the
payments of the tax, but the amount of the tax may be shifted or passed on to the buyer, transferee, or
lessee of the goods, properties or services.

The term input tax means the value-added tax due from or paid by a VAT-registered person in
the course of his trade or business on importation of goods or local purchase of goods or properties or
services by a VAT-registered entity.

Excess Output Tax or Excess Input Tax – if at the end of any taxable quarter the output tax
exceeds the input tax, the excess shall be paid by the VAT-registered person. If the input tax exceeds
the output tax, the taxpayer has three options:
1. Carry over the excess to the succeeding period
2. Obtain a refund
3. Apply for a tax credit certificate (assuming all input taxes are creditable to the output tax).

Value –Added Tax (VAT) Worksheet

One of the major accounting task in the accounting for business taxes is the accumulation of VAT
on sales ( output tax) and the VAT on purchases ( input tax). The VAT columnar book accumulates the
input tax on purchases of goods or services from VAT registered sellers. The goods and services may
include the following:

Office Supplies Rent Gasoline

Insurance Meralco
Restaurant Bills Water bills
Cable Bills Cell phone bills
 Whenever, a bill is received and paid, make sure the pertinent information is recorded, so that
at the end of month, all VAT (billed and/or paid for), is added together. The total VAT less input VAT is
the VAT payable.

Percentage taxes are taxes measured in percentage of gross-selling price or gross value in
money of goods sold, bartered, exchanged in the sale of service. Percentage taxes are privileged taxes.
Percentage taxes and value-added tax are imposed on the privilege to sell commodities or services.
Certain non-vatable sales or receipts are subject to the 3 % percentage tax. Assume that the gross sales
receipts of Dr. Manuel Santos is P 100 000. The percentage tax at 3% is P 3 000.

Electronic Filing and Payment System (EFPS) is a system of enrolment where a taxpayer files
electronically and the bank pays for the tax by simply debiting the cash deposits of the depositor. Non-
EFPS are manual filers.

BIR Registrations and Permits

1. Tax Identification Number (TIN) is a registration requirement.

2. Evidences of income of businesses and professionals are to be registered with the BIR. These
are the official receipts and sales invoices. If the taxpayer is engaged in the sale of goods,
he/she is to issue sales invoice. If he/she is engaged in sale of service, he/she issues of official
receipt.
3. Books of accounts: journals and ledger are to be stamped by BIR prior to use and kept for a
period of time as required by BIR.

Date Accounts Titles/ Explanation Debit Credit

Jun2 Merchandise Inventory 10,600
Accounts Payable 10,600
To record merchandised inventory on account.
Note: If paid;
Accounts payable 10,600
Cash 10,388
Merchandise Inventory 212
To record payment of merchandised inventory.