FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis is defined as the process of identifying financial strengths

and weaknesses of the firm by properly establishing relationship between the items of the
balance sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial statements,
such as comparative statements, schedule of changes in working capital, common size
percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for
decision making purposes. They play a dominant role in setting the framework of
managerial decisions. But the information provided in the financial statements is not an
end in itself as no meaningful conclusions can be drawn from these statements alone.
However, the information provided in the financial statements is of immense use in
making decisions through analysis and interpretation of financial statements.

Tools and Techniques of Financial Statement Analysis

1. Horizontal and Vertical Analysis

Horizontal Analysis or Trend Analysis

Comparison of two or more year’s financial data is known as horizontal analysis, or
trend analysis. Horizontal analysis is facilitated by showing changes between years in
both peso and percentage form.

Trend Percentage
Horizontal analysis of financial statements can also be carried out by computing trend
percentages. Trend percentage states several years’ financial data in terms of a base
year. The base year equals 100%, with all other years stated in some percentage of
this base.

Vertical Analysis
Vertical analysis is the procedure of preparing and presenting common size
statements. Common size statement is one that shows the items appearing on it in
percentage form as well as in peso form. Each item is stated as a percentage of some
total of which that item is a part. Key financial changes and trends can be highlighted
by the use of common size statements.

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 2. Ratios Analysis
The ratios analysis is the most powerful tool of financial statement analysis. Ratios
simply means one number expressed in terms of another. A ratio is a statistical
yardstick by means of which relationship between two or various figures can be
compared or measured. Ratios can be found out by dividing one number by another
number. Ratios show how one number is related to another.

Profitability Ratios
Profitability ratios measure the results of business operations or overall performance
and effectiveness of the firm. Some of the most popular profitability ratios are as under:

• Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed
as a percentage. It expresses the relationship between gross profit and sales.

Formula: Gross Profit Ratio = (Gross profit / Net sales) × 100

Analysis:
Gross profit ratio may be indicated to what extent the selling prices of goods per unit
may be reduced without incurring losses on operations. It reflects efficiency with which
a firm produces its products. As the gross profit is found by deducting cost of goods
sold from net sales, higher the gross profit better it is. There is no standard GP ratio
for evaluation. It may vary from business to business. However, the gross
profit earned should be sufficient to recover all operating expenses and to build up
reserves after paying all fixed interest charges and dividends.

• Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as
percentage.

Formula: Net Profit Ratio = (Net profit / Net sales) × 100

Analysis:
NP ratio is used to measure the overall profitability and hence it is very useful to
proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall
not be able to achieve a satisfactory return on its investment. This ratio also indicates
the firm’s capacity to face adverse economic conditions such as price competition, low
demand, etc. Obviously, higher the ratio the better is the profitability. But while
interpreting the ratio it should be kept in mind that the performance of profits also be
seen in relation to investments or capital of the firm and not only in relation to sales.

• Operating ratio is the ratio of cost of goods sold plus operating expenses to net
sales. It is generally expressed in percentage.

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 Formula: Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] ×
100

Analysis:
Operating ratio shows the operational efficiency of the business. Lower operating ratio
shows higher operating profit and vice versa. An operating ratio ranging between 75%
and 80% is generally considered as standard for manufacturing concerns. This ratio is
considered to be a yardstick of operating efficiency but it should be used cautiously
because it may be affected by a number of uncontrollable factors beyond the control of
the firm. Moreover, in some firms, non-operating expenses from a substantial part of the
total expenses and in such cases operating ratio may give misleading results.

• Expense ratios indicate the relationship of various expenses to net sales. The
operating ratio reveals the average total variations in expenses. But some of the
expenses may be increasing while some may be falling. Hence, expense ratios are
calculated by dividing each item of expenses or group of expense with the net sales to
analyze the cause of variation of the operating ratio. The ratio can be calculated for
individual items of expense or a group of items of a particular type of expense like cost of
sales ratio, administrative expense ratio, selling expense ratio, materials consumed ratio,
etc. The lower the operating ratio, the larger is the profitability and higher the operating
ratio, lower is the profitability. While interpreting expense ratio, it must be remembered
that for a fixed expense like rent, the ratio will fall if the sales increase and for a variable
expense, the ratio in proportion to sales shall remain nearly the same.

Formula: Particular Expense = (Particular expense / Net sales) × 100

• Return on assets is the ratio of annual net income to average total assets of a business
during a financial year. It measures efficiency of the business in using its assets to
generate net income. It is a profitability ratio.

Formula:
Annual Net Income
ROA =
Average Total Assets

Analysis:
Return on assets indicates the number of cents earned on each peso of assets. Thus
higher values of return on assets show that business is more profitable. This ratio should
be only used to compare companies in the same industry. The reason for this is that
companies in some industries are most asset-insensitive i.e. they need expensive plant

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 and equipment to generate income compared to others. Their ROA will naturally be lower
than the ROA of companies which are low asset insensitive. An increasing trend of ROA
indicates that the profitability of the company is improving. Conversely, a decreasing trend
means that profitability is deteriorating.

• Return on equity or return on capital is the ratio of net income of a business during
a year to its stockholders' equity during that year. It is a measure of profitability of
stockholders' investments. It shows net income as percentage of shareholder equity.

Formula:
Annual Net Income
ROE =
Average Stockholders' Equity

Analysis:
Return on equity is an important measure of the profitability of a company. Higher values
are generally favorable meaning that the company is efficient in generating income on
new investment. Investors should compare the ROE of different companies and also
check the trend in ROE over time. However, relying solely on ROE for investment
decisions is not safe. It can be artificially influenced by the management, for example,
when debt financing is used to reduce share capital there will be an increase in ROE even
if income remains constant.

• Dividend yield ratio is the relationship between dividends per share and the market
value of the shares. Shareholders are real owners of a company and they are interested
in real sense in the earnings distributed and paid to them as dividend. Therefore, dividend
yield ratio is calculated to evaluate the relationship between dividends per share paid and
the market value of the shares.

Formula: Dividend Yield Ratio = Dividend Per Share / Market Value Per Share

Analysis:
This ratio helps as intending investor knows the effective return he is going to get on the
proposed investment.

• Dividend payout ratio is calculated to find the extent to which earnings per share have
been used for paying dividend and to know what portion of earnings has been retained in
the business.

Formula: Dividend Payout Ratio = Dividend per Equity Share / Earnings per Share

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 Analysis:
The payout ratio and the retained earnings ratio are the indicators of the amount of
earnings that have been ploughed back in the business. The lower the payout ratio, the
higher will be the amount of earnings ploughed back in the business and vice versa. A
lower payout ratio or higher retained earnings ratio means a stronger financial position of
the company.

• Earnings per share ratio (EPS Ratio) is a small variation of return on equity capital
ratio and is calculated by dividing the net profit after taxes and preference dividend by the
total number of equity shares.

Formula: Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) /
No. of equity shares (common shares)

Analysis:
The earnings per share is a good measure of profitability and when compared with EPS
of similar companies, it gives a view of the comparative earnings or earnings power of the
firm. EPS ratio calculated for a number of years indicates whether or not the earning
power of the company has increased.

• Price earnings ratio (P/E ratio) is the ratio between market price per equity share and
earnings per share. The ratio is calculated to make an estimate of appreciation in the
value of a share of a company and is widely used by investors to decide whether or not
to buy shares in a particular company.

Formula: Price Earnings Ratio = Market price per equity share / Earnings per share

Analysis:
Price earnings ratio helps the investor in deciding whether to buy or not to buy the shares
of a particular company at a particular market price. Generally, higher the price earnings
ratio the better it is. If the P/E ratio falls, the management should look into the causes that
have resulted into the fall of this ratio.

Liquidity Ratios:
Liquidity ratios measure the short-term solvency of financial position of a firm. These
ratios are calculated to comment upon the short-term paying capacity of a concern or the
firm’s ability to meet its current obligations. Following are the most important liquidity
ratios.

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 • Current ratio may be defined as the relationship between current assets and current
liabilities. This ratio is also known as “working capital ratio“. It is a measure of general
liquidity and is most widely used to make the analysis for short term financial position or
liquidity of a firm. It is calculated by dividing the total of the current assets by total of the
current liabilities.

Formula: Current Ratio = Current Assets / Current Liabilities Or

Current Assets:Current Liabilities

Analysis:
Current ratio matches current assets with current liabilities and tells us whether the
current assets are enough to settle current liabilities. Current ratio below 1 shows critical
liquidity problems because it means that total current liabilities exceed total current
assets. General rule is that higher the current ratio better it is but there is a limit to this.
Abnormally high value of current ratio may indicate existence of idle or underutilized
resources in the company.

• Liquid ratio is also termed as “Liquidity Ratio “, “Acid Test Ratio” or “Quick Ratio“.
It is the ratio of liquid assets to current liabilities. The true liquidity refers to the ability of a
firm to pay its short-term obligations as and when they become due.

Formula: Liquid Ratio = Liquid Assets / Current Liabilities

Analysis:
The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm. It
measures the firm’s capacity to pay off current obligations immediately and is more
rigorous test of liquidity than the current ratio. It is used as a complementary ratio to
the current ratio. Liquid ratio is more rigorous test of liquidity than the current ratio
because it eliminates inventories and prepaid expenses as a part of current assets.
Usually a high liquid ratio is an indication that the firm is liquid and has the ability to meet
its current or liquid liabilities in time and on the other hand a low liquidity ratio represents
that the firm’s liquidity position is not good. As a convention, generally, a quick ratio of
“one to one” (1:1) is considered to be satisfactory.

Absolute liquidity is represented by cash and near cash items. It is a ratio of absolute
liquid assets to current liabilities. In the computation of this ratio only the absolute liquid
assets are compared with the liquid liabilities. The absolute liquid assets are cash, bank
and marketable securities. It is to be observed that receivables (debtors/accounts

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 receivables and bills receivables) are eliminated from the list of liquid assets in order to
obtain absolute4 liquid assets since there may be some doubt in their liquidity.

Formula: Absolute Liquid Ratio = Absolute Liquid Assets / Current Assets

This ratio gains much significance only when it is used in conjunction with the current and
liquid ratios. A standard of 0.5: 1 absolute liquidity ratio is considered an acceptable norm.
That is, from the point of view of absolute liquidity, fifty cents worth of absolute liquid
assets are considered sufficient for one-peso worth of liquid liabilities. However, this ratio
is not in much use.

• Working capital is a measure of liquidity of a business. It equals current assets minus

current liabilities.

Formula:
Working Capital = Current Assets − Current Liabilities

Analysis:
If current assets of a business at the point in time are more than its current liabilities the
working capital is positive, and this tells that the company is not expected to suffer from
liquidity crunch in near future. However, if current assets are less than current liabilities
the working capital is negative, and this communicates that the business may not be able
to pay off its current liabilities when due.

Activity Ratios:
Activity ratios are calculated to measure the efficiency with which the resources of a firm
have been employed. These ratios are also called turnover ratios because they indicate
the speed with which assets are being turned over into sales. Following are the most
important activity ratios:

• Inventory turnover is the ratio of cost of goods sold by a business to its average
inventory during a given accounting period. It is an activity ratio measuring the number of
times per period; a business sells and replaces its entire batch of inventory again.

Formula:
Cost of Goods Sold
Inventory Turnover =
Average Inventory

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 Analysis:
Inventory turnover ratio is used to measure the inventory management efficiency of a
business. In general, a higher value of inventory turnover indicates better performance
and lower value means inefficiency in controlling inventory levels. A lower inventory
turnover ratio may be an indication of over-stocking which may pose risk of obsolescence
and increased inventory holding costs. However, a very high value of this ratio may be
accompanied by loss of sales due to inventory shortage. Inventory turnover is different
for different industries. Businesses which trade perishable goods have very higher
turnover compared to those dealing in durables. Hence a comparison would only be fair
if made between businesses of same industry.

• Days' inventory on hand (also called days' sales in inventory or simply days of
inventory) is an accounting ratio which measures the number of days a company takes
to sell its average balance of inventory. It is also an estimate of the number of days for
which the average balance of inventory will be sufficient. Days' sales in inventory ratio are
very similar to inventory turnover ratio and both measure the efficiency of a business in
managing its inventory.

Formula:
Number of Days in the Period
Days of Inventory =
Inventory Turnover for the Period

If we substitute inventory turnover as "cost of goods sold ÷ average inventory" in the

above formula and simplify the equation, we get:
Average Inventory
Days of Inventory = × Number of Days in the Period
Cost of Goods Sold

Analysis:
Since inventory carrying costs take significant investment, a business must try to reduce
the level of inventory. Lower level of inventory will result in lower days' inventory on hand
ratio. Therefore, lower values of this ratio are generally favorable and higher values are
unfavorable. However, inventory must be kept at safe level so that no sales are lost due
to stock-outs. Thus, low value of days of inventory ratio of a company which finds it difficult
to satisfy demand is not favorable. Days' sales in inventory vary significantly between
different industries. For example, business which sells perishable goods such as fruits
and vegetables have very low values of days' sales in inventory whereas companies
selling non-perishable goods such as cars have high values of days of inventory.

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 • Accounts receivable turnover is the ratio of net credit sales of a business to its
average accounts receivable during a given period, usually a year. It is an activity ratio
which estimates the number of times a business collects its average accounts receivable
balance during a period.

Formula:
Receivables Net Credit Sales
=
Turnover Average Accounts Receivable

Analysis:
Accounts receivable turnover measures the efficiency of a business in collecting its credit
sales. Generally, a high value of accounts receivable turnover is favorable and lower
figure may indicate inefficiency in collecting outstanding sales. Increase in accounts
receivable turnover overtime generally indicates improvement in the process of cash
collection on credit sales. However, a normal level of receivables turnover is different for
different industries. Also, very high values of this ratio may not be favorable, if achieved
by extremely strict credit terms since such policies may repel potential buyers.

• Days' sales outstanding ratio (also called average collection period or days' sales in
receivables) is used to measure the average number of days a business takes to collect
its trade receivables after they have been created. It is an activity ratio and gives
information about the efficiency of sales collection activities.

Formula:
Accounts Receivable
DSO = × Number of Days
Credit Sales

Another formula which uses the accounts receivable turnover is:

Number of Days in the Period
DSO =
Accounts Receivable Turnover

Analysis:
Since it is profitable to convert sales into cash quickly, this means that a lower value of
Days Sales Outstanding is favorable whereas a higher value is unfavorable. However, it
is more meaningful to create monthly or weekly trend of DSO. Any significant increase in
the trend is unfavorable and indicates inefficiency in credit sales collection.

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 • Working capital turnover ratio is an activity ratio that measures pesos of revenue
generated per peso of investment in working capital. Working capital is defined as the
amount by which current assets exceed current liabilities.

Formula:
Revenue
Working Capital Turnover Ratio =
Average Working Capital

Analysis:
A higher working capital turnover ratio is better. It means that the company is utilizing its
working capital more efficiently i.e. generating more revenue using less investment.

Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios convey a firm’s ability to meet the interest costs
and payment schedules of its long-term obligations. Following are some of the most
important long-term solvency or leverage ratios.

• Debt-to-Equity ratio Debt-to-Equity ratio is the ratio of total liabilities of a business to

its shareholders' equity. It is a leverage ratio and it measures the degree to which the
assets of the business are financed by the debts and the shareholders' equity of a
business.

Formula:
Total Liabilities
Debt-to-Equity Ratio =
Shareholders' Equity

Analysis:
Lower values of debt-to-equity ratio are favorable indicating less risk. Higher debt-to-
equity ratio is unfavorable because it means that the business relies more on external
lenders thus it is at higher risk, especially at higher interest rates. A debt-to-equity ratio of
1.00 means that half of the assets of a business are financed by debts and half by
shareholders' equity. A value higher than 1.00 means that more assets are financed by
debt that those financed by money of shareholders' and vice versa. An increasing trend
in of debt-to-equity ratio is also alarming because it means that the percentage of assets
of a business which are financed by the debts is increasing.

• Times interest earned (also called interest coverage ratio) is the ratio of earnings
before interest and tax (EBIT) of a business to its interest expense during a given period.
It is a solvency ratio measuring the ability of a business to pay off its debts.

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 Formula:
Earnings before Interest and Tax
Times Interest Earned =
Interest Expense

Analysis:
Higher value of times interest earned ratio is favorable meaning greater ability of a
business to repay its interest and debt. Lower values are unfavorable. A ratio of 1.00
means that income before interest and tax of the business is just enough to pay off its
interest expense. That is why times interest earned ratio is of special importance to
creditors. They can compare the debt repayment ability of similar companies using this
ratio. Other things equal, a creditor should lend to a company with highest times interest
earned ratio. It is also beneficial to create a trend of times interest earned ratio.

Advantages and Limitations

Financial ratio analysis is a useful tool for users of financial statement. It has following
advantages:

Advantages
1. It simplifies the financial statements.
2. It helps in comparing companies of different size with each other.
3. It helps in trend analysis which involves comparing a single company over
a period.
4. It highlights important information in simple form quickly. A user can judge
a company by just looking at few numbers instead of reading the whole financial
statements.

Limitations
Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits
of financial ratio analysis are:
1. Different companies operate in different industries each having different
environmental conditions such as regulation, market structure, etc. Such factors are
so significant that a comparison of two companies from different industries might
be misleading.
2. Financial accounting information is affected by estimates and assumptions.
Accounting standards allow different accounting policies, which impairs
comparability and hence ratio analysis is less useful in such situations.
3. Ratio analysis explains relationships between past information while users are
more concerned about current and future information.

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 PROBLEMS

1. The comparative balance sheet of Glider Company appears below:

GLIDER COMPANY
Comparative Balance Sheet
December 31,
Assets 2020 2019
Current assets ................................................... P 360 P300
Plant assets ....................................................... 640 500
Total assets .................................................. P1,000 P800

Liabilities and Stockholders' Equity

Current liabilities ................................................ P 150 P120
Long-term debt .................................................. 240 160
Common stock ................................................... 350 280
Retained earnings .............................................. 260 240
Total liabilities and stockholders' equity ........ P1,000 P800

a. Using horizontal analysis, show the percentage change for each balance sheet item
using 2019 as a base year.

b. Using vertical analysis, prepare a common size comparative balance sheet.

2. Shelter Corporation's most recent balance sheet and income statement appear
below:
Shelter Corporation
Statement of Financial Position
As of December 31,

2020 2019
Current Assets
Cash P 180,000 P 150,000
Accounts receivable 200,000 190,000
Inventory 140,000 140,000
Prepaid expenses 100,000 90,000
Total current assets 620,000 570,000
Plant and equipment, net 780,000 800,000
Total Assets P 1,400,000 P 1,370,000

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 Current Liabilities:
Accounts payable P 110,000 P 130,000
Accrued liabilities 80,000 70,000
Notes payable, short term 60,000 60,000
Total current liabilities 250,000 260,000
Bonds payable 220,000 240,000
Total Liabilities 470,000 500,000
Stockholders’ Equity:
Preferred stock, P100 par value, 5% 200,000 200,000
Common stock, P20 par value 400,000 400,000
Additional paid-in-capital – common 100,000 100,000
Retained earnings 230,000 170,000
Total Stockholders’ Equity 930,000 870,000
Total Liabilities & Stockholders’ Equity P 1,400,000 P1,370,000

Shelter Corporation
Income Statement
For the Year Ended December 31, 2020

Sales (all on account) P 1,130,000

Cost of goods sold (700,000)
Gross Margin 430,000
Selling and administrative expense (244,000)
Net operating income 186,000
Interest expense (29,000)
Net income before taxes 157,000
Income taxes (47,000)
Net income P 110,000

Dividends on common stock during 2020 totaled P40,000. Dividends on preferred stock
totaled P10,000. The market price of common stock at the end of 2020 was P98.00 per
share.

Required:
Compute the following for 2020:
a. Gross margin percentage.

b. Earnings per share (of common stock).

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 c. Price-earnings ratio.

d. Dividend payout ratio.

e. Dividend yield ratio.

f. Return on total assets.

g. Return on common stockholders' equity.

h. Book value per share.

i. Working capital.

j. Current ratio.

k. Acid-test ratio.

l. Accounts receivable turnover.

m. Average collection period.

n. Inventory turnover.

o. Average sale period.

p. Times interest earned.

q. Debt-to-equity ratio.

3. Condensed financial statements of Mill Company at the beginning and at the end of
the current year are given below:
Mill Company
Balance Sheet

End of CY Beg. of CY
Cash P 10,000 P 8,000
Marketable securities 20,000 22,000
Accounts receivable 90,000 110,000
Inventories 150,000 100,000

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 Plant and equipment, net 280,000 260,000
Total Assets P 550,000 P 500,000

Accounts payable P 80,000 P 60,000

Accrued short-term liabilities 20,000 25,000
Bonds payable 75,000 75,000
Preferred stock, 10%, P10 par 50,000 50,000
Common stock, P10 par 100,000 100,000
Additional paid-in-capital – common 50,000 50,000
Retained earnings 175,000 140,000
Total Liabilities & Stockholders’ Equity P 550,000 P 500,000
Mill Company
Income Statement
For the Current Year

Sales (all on account) P 650,000

Cost of goods sold (350,000)
Gross Margin 300,000
Selling and administrative expense (200,000)
Net operating income 100,000
Interest expense (10,000)
Net income before taxes 90,000
Income taxes (40,000)
Net income P 50,000

The company paid total dividends of P15,000 during the year, of which P5,000 were to
preferred stockholders. The market price of a share of common stock at the end of the
year was P30.

Required:

On the basis of the information given above, fill in the blanks with the appropriate figures.

Example: The current ratio at the end of the current year would be computed by dividing
P270,000 by P100,000

a. The acid-test ratio at the end of the current year would be computed by dividing

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 _______________ by _________________.

b. The inventory turnover for the year would be computed by dividing _______________
by _________________.

c. The debt-to-equity ratio at the end of the current year would be computed by dividing
_______________ by _________________.

d. The earnings per share of common stock would be computed by dividing

_______________ by _________________.

e. The accounts receivable turnover for the year would be computed by dividing
_______________ by _________________.

f. The times interest earned for the year would be computed by dividing
_______________ by _________________.

g. The return on common stockholders' equity for the year would be computed by dividing
_______________ by _________________.

h. The dividend yield would be computed by dividing _______________ by

_________________.

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