2018

Analysis of Financial Statements

Limitations of financial Statements:

 Do not contain all significant facts about a business
 Do not reflect changes in the purchasing power of the monetary unit
 Interim in nature although they give an impression of being accurate
 Contents of financial statements may vary with the variation in the application of
generally accepted accounting principles

Tools and techniques

 Horizontal analysis – changes in behavior of different items in financial statements
of two or more years
o Gross profit variation analysis
o Analysis of variation in net income
o Comparative statements
o Trend ratio
 Vertical analysis
o Common size statements
o Financial ratios
o Cash flow analysis

Gross profit variation analysis

Increase Decrease
Increase in volume X
Decrease in volume X
Increase in unit selling price X
Decrease in unit selling price X
Increase in unit cost X
Increase in unit cost X

Volume factor:
Change in volume x Gross profit per unit last year

Price factor:
Change in unit selling price x current year’s sales volume

Cost factor:
Change in unit cost x current year’s sales volume

19B 19A
Sales volume (units) 5,000 4,000
Unit selling price P12 P16
Unit cost 9 8
Operating expenses:
Selling expenses 6,000 10,000
General and admin expenses 8,000 7,000
 A Trading Co.
Income Statement
For the years 19B and 19A
19B 19A
Sales 60,000 64,000
Less: Cost of sales 45,000 32,000
Gross profit 15,000 32,000
Less: operating expenses
Selling 6,000 10,000
General and Administrative 8,000 7,000
14,000 17,000
Net Income 1,000 15,000

Decrease in gross profit: 32,000 – 15,000 = 17,000

Decrease in net income: 15,000 – 1,000 = 14,000

Volume factor
Increase in sales volume 1,000
Gross profit 16 - 8 8 8,000 favorable
Price factor
Decrease in unit selling price 4
Sales volume 5,000 20,000 unfavorable
Cost factor
Increase in unit cost 1
Sales volume 5,000 5,000 unfavorable
Decrease in gross profit 17,000
Analysis of variation in net income
Decrease in gross profit
Increase in volume 8,000 favorable
Decrease in unit selling price 20,000 unfavorable
Increase in unit cost 5,000 unfavorable
Decrease in gross profit 17,000
Decrease in selling expenses 4,000 favorable
Increase in general and admin expenses 1,000 unfavorable
Decrease in net income 14,000

Comparative Statements
19B 19A Increase/Decrease %
Sales 60,000 64,000 (4,000) (6.25%)
Less: Cost of sales 45,000 32,000 13,000 40.63%
Gross profit 15,000 32,000 (17,000) (53.13%)
Less: operating expenses
Selling 6,000 10,000 (4,000) (40%)
General and Admin 8,000 7,000 1,000 14.30%
14,000 17,000 (3,000) (17.65%)
Net Income 1,000 15,000 (14,000) (93.33%)
Common size statement
19A 19B
Sales 100% 100%
Less: Cost of sales 75 50
Gross profit 25 50
Less: operating expenses
Selling 10 16
General and Admin 13 11
23 27
Net Income 2 23

Trend analysis
19A 19B 19C 19D 19E
Sales P80,000 P96,000 P60,000 P50,000 P84,000
Cost of sales 40,000 50,000 36,000 24,000 44,000
Selling exp 10,000 12,000 9,000 8,000 15,000
Gen and adm exp 6,000 9,000 8,000 6,000 7,500
Net income 24,000 25,000 7,000 12,000 17,500

Sales 1.00 1.20 .75 .62 1.05

Cost of sales 1.00 1.25 .90 .60 1.10
Selling exp 1.00 1.20 .90 .80 1.50
Gen and adm exp 1.00 1.50 1.33 1.00 1.25
Net income 1.00 1.04 .29 .50 .73

Financial ratios

Profitability
1. Rate of return on sales Net income Net income per peso of
Net Sales sales

2. Rate of return on assets Net income Profitability in the use of

ave total assets assets or total capital

3. Asset Turnover Net sales Indicates efficiency in the

Ave. Total Assets use of total resources

4. Gross profit ratio Gross Profit Gross margin per peso of

Net sales sales; adequacy of gross
margin to cover operating
expenses and provide
desired profit

5. Operating ratio Cost of sales + Op. Exp. What portion of sales is

Net Sales absorbed by operating
costs

6. Rate of return of Net Income Profitability in the use of

current assets Average Current Assets current assets

7. Current Asset Turnover Cos of sales + Op. Rate at which current

Exp(exclude charges not assets are being used
req. current assets)
Ave. Current Assets

8. Rate of return on Rate of return on current Percentage of profit every

working capital assets time current assets are
Current asset turnover used
9. Rate of return on Net income Profitability in the use of
working capital Ave. working capital working capital

10. Working capital COS + OE exc. Charges not Rate at which working
turnover requiring working capital capital is being used
Ave. Working capital

11. Rate of return per Rate of return on working Percentage of profit

working capital turnover capital earned every time
Working capital turnover working capital is used

12. Invested Capital Net sales Rate at which owner’s

Turnover Ave. owner’s equity capital is being used or the
rate at which assets
provided by owners are
being used

13. Rate of return on Net Income Profitability in the use of

Owner’s Equity Ave. Owner’s equity invested capital or the
amount of return per peso
of owner’s equity

14. Earnings per share Net income less preferred Amount of returns on each
stock dividend share of common stock
Ave. No. of common and ability to pay
shares outstanding dividends

15. Price-earnings ratio Market price per share Measures relationship

Earnings per share between market price and
earnings on each share

16. Capitalization rate or Earnings per share Rate at which the stock
earnings/price ratio Market price per share market is apparently
capitalizing the value of
current earnings

17. Dividends per share Dividends paid or Amount of distributed

declared earnings per share
Common shares
outstanding

18. Yield on common Dividends per share Percentage of distributed

stock Common shares earnings based on market
outstanding value

19. Payout ratio Dividends per share Percentage of distributed

Earnings per share earnings based on
earnings made per share

20. Retained earnings to Retained earnings Probability of dividend

capital stock Capital stock declaration

21. Market price to Book Market price per share Whether stock is
value per share Book value per share undervalued or not
Liquidity or short-term solvency
1. Current ratio Current Assets Indicates ability to pay
Current Liabilities current obligations

2. Acid test ratio Quick assets Ability to pay current

Current Liabilities obligations from the more
liquid current assets

3. Current assets to total Current assets Liquidity of the total

assets Total assets assets

4. Ratio of each current Each current asset item Liquidity of the total
asset item to total current Total current assets current assets and the
assets distribution thereof

5. a. Receivable Turnover Net Credit sales Number of times average

Ave. Receivables amount of receivables is
collected during the
period and the efficiency
in collection

5. b. Number of days’ sales 360 Average age of receivables

in average receivables or Receivables Turnover or the number of days to
ave. collection period collect average
receivables

6. a. Merchandise Cost of goods sold Number of times average

inventory (or finished Ave. inventory inventory was sold during
goods) turnover the period and
over(under) investment in
inventory

6.b. Work in process Cost of goods Number of times average

turnover manufactured inventory was
Ave. work in process manufactured during the
inventory period and over(under)
investment in work in
process inventory

6.c. Raw materials Raw materials used Number of times average

turnover Ave. raw materials inventory was used and
inventory the sufficiency of raw
materials in stock

6.d. Number of days’ 360 Number if days required

supply in inventory Inventory turnover to sell or consume average
inventory

7. Working Capital Cost of goods sold + Rate at which working

Turnover operating expenses capital is being used and
(excluding charges not the adequacy of working
requiring working capital capital
Ave. working capital
8. Current Asset Turnover Cost of goods sold + Rate at which current
operating assets are being used and
expenses(exclude charges adequacy of current assets
not req. current assets
Ave. current assets

9. Payable Turnover Net credit purchases Number of times amount

Ave. Payables of average payables is
being paid

10.a. Cash and Marketable Cost of goods sold + Number of times amount
securities turnover Operating of cash and its equivalent
expenses(exclude charges is used during the period
not requiring cash)
Ave. cash and marketable
securities

10.b. Number of days’ 360 days Number of days

operations covered by Cash and marketable operations covered by
cash and marketable securities turnover cash and its equivalent
securities

Stability and Long-term Solvency

1. Debt/Equity ratio Total Liabilities Measures the proportion
Owner’s Equity of borrowed capital to
invested capital

2. Equity/Debt ratio Owner’s Equity Indicates the margin of

Total Liabilities safety to creditors

3. Proprietary (Equity) Owner’s Equity Indicates what portion of

ratio or owners’ equity to Total Assets total assets is provided by
total assets owners or stockholders

4. Debt ratio or total Total Liabilities Indicates what portion of

liabilities to total assets Total Assets total assets is provided by
creditors

5. Fixed asset to total Fixed assets Indicates portion of

owner’s equity Total owner’s equity owner’s equity invested in
fixed assets

6. Fixed assets to total Fixed assets Underinvestment or

equity (total assets) Total liabilities and overinvestment in plant,
owner’s equity property and equipment

7. Fixed assets to total Fixed assets Portion of long-term debt

long-term liabilities Total long-term liabilities secured by fixed assets

8. Plant turnover Net sales Efficiency in the use of

Ave. fixed assets property

9. Book value per share Common stock equity Book value of net assets
Number of common for every outstanding
shares outstanding share of common stock
10. Number of times Income before interest Company’s ability to pay
interest is earned and taxes fixed interest charges
Annual interest charges

11. No. of times preferred Net income after tax Ability to meet annual
dividend requirement is Preferred stock dividend preferred stock dividend
earned requirement requirement

12. No. of times fixed Income before taxes and Ability to meet annual
charges are earned fixed charges fixed charges
Fixed charges (rent
expense + interest

Number of days in operating cycle

Trading Manufacturing
No. of days’ sales in inventory Xx
No. of days’ usage in raw materials inventory Xx
No. of days to process Xx
No. of days sales in finished goods inventory Xx
Average collection period(number of days dales in Xx
receivables)
No. of days in operating cycle xx
xx xx