UNIVERSITY OF SAN CARLOS

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTANCY

Financial Statement Analysis G.R. CURSO

FINANCIAL STATEMENT ANALYSIS

- is a judgmental process which aims to estimate current and past financial positions and the
results of the operation of an enterprise, with primary objective of determining the best
possible estimates and predictions about the future conditions. It essentially involves
regrouping and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a business
enterprise, which can be useful in decision-making involving comparison with other firms (cross
sectional analysis) and with firms’ own performance, over a time period (time series analysis).
- the process of analyzing a company's financial statements for decision-making purposes and to
understand the overall health of an organization
- designed to reveal relationships among items on the financial statements and trends of
individual items over time
- helps readers analyze and interpret the data in a logical and systematic manner

Procedures in Analyzing the Financial Statements

1. Establish the objective of the financial statement analysis
2. Gather complete information about the firm and study the industry which the firm operates
3. Perform mathematical analysis using applicable tools
4. Make conclusions relative to the established objectives

Objectives of Financial Statement Analysis

The objectives of the analysis are to apprehend the information contained in financial statements
with a view to know the weaknesses and strengths of the firm and to make a forecast about the
future prospects of the firm thereby, enabling the analysts to take decisions regarding the
operation of, and further investment in the firm. Specifically,
1. to assess the current profitability and operational efficiency of the firm as a whole as well as
its different departments so as to judge the financial health of the firm.
2. to ascertain the relative importance of different components of the financial position of the
firm.
3. to identify the reasons for change in the profitability/financial position of the firm.
4. to judge the ability of the firm to repay its debt and assessing the short-term as well as the
long-term liquidity position of the firm.

Limitations of Financial Statement Analysis

1. The results are not absolute status of entity’s financial performance.
2. There are different thresholds among companies and among industries.
3. Financial data do not reflect changes in the purchasing power.

Changing Price Level

A financial analyst must consider the effect of price level. Price level refers to the average current
prices of goods and services produced in the economy.

Three types of indexes used in the computation:

1. Consumer Price Index- measure of the average change over time in the prices of a market
basket of consumer goods and services paid by urban consumer
2. Gross Domestic Product Price Index – measure of the level of prices of all goods
domestically produced in an economy
3. Producer Price Index – measures the average changes in prices of goods by domestic
producers for their output.

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Major Techniques for Financial Analysis
1. Vertical Analysis (Common-size financial statements)
2. Horizontal Analysis (trend percentages and index analysis)
3. Financial Ratio Analysis
a. Liquidity ratios
b. Leverage ratios
c. Profitability ratios
d. Growth ratios
4. Gross profit variance analysis (price, cost and volume factors)
5. Cash Flow Analysis
6. Financial forecasting using additional funds needed

VERTICAL ANALYSIS
- also called static measure or structural ratio
- concerned with relationship among items within a particular period
- expresses the line item as a percentage of some other line item for the same period
- analyst sets the total figure at 100 percent and computes each component’s percentage of that
total
- useful in comparing the importance of specific components in the operation of a business and in
identifying important changes in the components from one year to the next
- often used to make comparisons between companies. They allow managers and analysts to
compare the operating and financing characteristics of two companies of different size in the
same industry.

HORIZONTAL ANALYSIS
- expresses a line item showing the changes from the previous year to the current year are
computed in both dollar amounts and percentages
- percentage change is computed as: 100 x (Amount of change / Base year amount)
- The base year is always the first year to be considered in any set of data. For example, when
comparing data for 2017 and 2018, 2017 is the base year.

TREND ANALYSIS
- Trend analysis is a variation of horizontal analysis. With this tool, the managers and analysts
calculate percentage changes for several successive years instead of for just two years. Because
of its long-term view, trend analysis can highlight basic changes in the nature of a business.
- It determines the direction upwards or downwards and involves the computation of the
percentage relationship that each item bears to the same item in the base year.

FINANCIAL RATIO ANALYSIS

- analytical tool employing ratio or proportion of certain item in the financial statement in
relation to other related item in the same financial statement or other statements to judge
comparative performance.

LIQUIDITY
- also known as Working Capital Position or Short-Term Financial Position

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- measure the ability of a company to meet its current obligations

TN: most of the ratios under the liquidity ratios are also considered activity ratios that measure how
effectively a firm is managing its assets and measures the speed with which accounts are converted
into cash.

LIQUIDITY RATIOS FORMULA DESCRIPTION/ INTERPRETATION

Net Working Current assets – Current liabilities - the amount invested by the business to
Capital operate its normal business activities
- the equity participation of the enterprise
in managing and completing its normal
operating activities
- Represents current assets financed from
long-term capital sources that don’t
require near-term repayment

Working Capital Net sales/ Average working capital - measures the adequacy and effectiveness
Turnover in using working capital
- indicates reasonableness of the amount
of current assets and net working capital

Working Capital to Working Capital/ Total Assets - indicates relative liquidity of total assets
Total Asset ratio and distribution of resources employed

Current Ratio Current assets/ Current liabilities - measures a company’s ability to pay
current liabilities with its current assets
- a high current ratio indicates that the
business has sufficient current assets to
maintain normal business operations.

Acid-Test Ratio or Quick assets/ Current liabilities - tells us whether the entity could pay all its
Quick Ratio current liabilities if they came due
immediately
- measures the instant debt paying ability
of the firm

Operating turnover Collection period + Days in inventory - measures the speed of the business cycle
- the number of days from which cash was
invested in the normal business
operations until the day of its recovery

Inventory Turnover Cost of goods sold/ Average - ratio measures the number of times a
inventory company sells its average level of
inventory during a year
- a high rate of turnover indicates ease in
selling inventory; a low rate indicates
difficulty; or
- a high inventory turnover indicates more
sales and at high levels, frequent stock-
outs occur and sales may be lost; a low IT
implies that inventory is poorly used;
perhaps too much inventory
Days in Inventory 365 days/ Inventory turnover - measures the average number of days
inventory is held by the company
- the length of time before the average

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 inventory is sold to customers

Receivable Net credit sales/ Average trade - measures efficiency in credit and
Turnover receivables collection policies
- measures the velocity of collection of
trade accounts and notes
- measures how many times AR is turned
into cash during the year

Collection Period 365 days/ Receivable turnover - measures how fast trade receivables are
collected

Payable Turnover Net credit purchases/ Average trade - measures effectiveness in using trade
receivables credit facility from suppliers

Materials Turnover Materials used/ Average materials - indicates the number of times materials
inventory were used on the average during the
period

Work-in-process Cost of goods manufactured/ - indicates the number of times average

Turnover Average work-in-process inventory work-in-process inventories is converted
to finished goods

Finished Goods Cost of goods sold/ Average finished - indicates the number of times average
Turnover goods inventory finished goods is sold during the period

Cash turnover Cash operating expense/ Average - measures the ability of the business to
cash balance meet operating expenses payments
given a particular cash balance

Days to pay 365 days/ Cash turnover - indicates the number of days spent
operating expenses before meeting operating expense
payments

Assets Turnover Net sales/ Average total sales - measures effectiveness of asset utilization

Current Assets Net sales/ Average current assets - indicates the reasonableness of the
Turnover amount of current assets

Cash Debt Cash flow from operations / Average - this will overcome the deficiency of debt
Coverage total liabilities to equity ratio which do not consider the
availability of cash to cover various level
of debt

Cash Flow Cash flow from operations / - measures the ability to generate sufficient
Adequacy (Purchase of long-term assets + cash to satisfy predictable cash
repayments of long-term debt + cash requirements
dividend payment)

LEVERAGE
- measure the ability of a company to meet its long- and short-term obligations.
- provide measure of the degree of protection provided to a company’s creditors

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- increase in leverage result in increased return and risk, whereas decreases in leverage result in
decreased return and risk. The amount of leverage in the firm's capital structure - the mix of
long-term debt and equity maintained by the firm can affect return and risk.

BASIC TYPES OF LEVERAGE

1. Operating Leverage- defined as the potential use of fixed operating costs to magnify the effects
of changes in sales on the firm's EBIT.
2. Financial Leverage- involves the financing of assets in a company with funds that have been
acquired from creditors or from preferred stockholders at a fixed rate of return. It is the
potential use of fixed financial costs to magnify the effects of changes in EBIT on the firm's EPS.
3. Total Leverage- the potential use of fixed cost both operating and financial to magnify the effect
the changes in Sales on the firm's EPS. It is viewed as the total impact of the fixed costs in the
firm's operating and financial structure.

LEVERAGE RATIOS FORMULA DESCRIPTION/ INTERPRETATION

Debt-to-equity Total debt/ Shareholders’ equity -measures the use of debt to finance
operations;
-provides a measure of the relative amount
of resources contributed by the creditors
and owners
-the higher the debt ratio, the more
financially leveraged the company is

Debt-to-assets Total debt/ Total assets -measures the relative share of creditors
over the total resources of the firm

Equity-to-assets Net shareholders’ equity/ Total -measures the amount of resources

assets provided by the owners in the firm

Equity Multiplier or Total assets (or equity) / Net -indicates the number of times owners’
Financial Leverage shareholders’ equity equity is multiplied
Multiplier -indicates how much total investment can
1 + Debt-to-equity ratio be financed from owner-provided equity
-As the capital multiplier decreases, more
1 / Equity ratio equity money is used to finance assets;
and more safety is assumed. A higher
1 / (1-Debt ratio) capital multiplier indicates an ability to
lever our equity into more assets, using
other people's money to finance the firm.

Times Interest Profit before interest and tax / -measures the long-term paying ability of
Earned Interest expense the firm
-a high number of TIE indicates that the
business is under-leveraged

Degree of Contribution margin / Earnings -the numerical measure of the firm's

Operating Leverage before interest and taxes operating leverage
-as the DOL is greater than 1 there is
operating leverage
Percentage change in EBIT / -the higher is the firm's fixed operating
Percentage change in sales costs relative to variable operating costs,
the greater is the DOL.
-measures the sensitivity of Operating
Profit to changes in the level of output

Financial Leverage Profit before interest and tax / -measures the risk associated in using debt

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 (PBIT-Preference dividend before to finance investments
tax) -higher interest expense leads to greater
financial risk and greater EPS sensitivity
Percentage change in EPS / to changes in EBIT
percentage change in EBIT

Fixed Charges Rate Cash flows before fixed charges / -measures the ability to meet fixed charges
Total fixed charges by cash

Total Assets to Total Assets / Total Liabilities -firm’s ability to meet interest payments to
Total Liabilities creditors

Non-current Assets Non-current Assets / Long-term -capability to meet non-current liabilities

to Long-term Liabilities using non-current resources
Liabilities
Total Leverage DOL x DFL -the numerical measure of the firm's total
leverage
Percentage change in EPS /
Percentage change in sales

PROFITABILITY
- measure the earning ability of a company, its operating effectiveness and its ability to recover
long-term investment from money generated by its normal operating activities
- allow investors, creditors, and managers to evaluate the extent to which invested funds are
being used efficiently.

PROFITABILITY RATIOS FORMULA DESCRIPTION/ INTERPRETATION

Return on Sales or Profit/ Net sales - measures profit percentage per peso
Profit Margin sales

Gross Profit Rate Gross profit/ Net sales - measures gross profit percentage on
sales to recover operating expenses

Return on Investment (Profit + Interest expense, net of - measures overall asset profitability
tax)/ Average total assets - indicates how effective assets have
been employed by management
Return on Sales x Asset Turnover

(Profit/Net Sales) x (Net Sales/

Average total assets)

Return on shareholders’ Return on Sales x Asset Turnover x - measures percentage of income

equity Equity Multiplier derived for every peso of owners’
equity
(Profit/Net Sales) x (Net Sales/
Investments) x (Investments/
Shareholders’ equity)

Profit/ Average shareholders’ equity

Return on Assets / Equity Ratio

Return on ordinary Profit available to ordinary - measures the percentage of profit
shareholders’ equity shareholders/ Average ordinary derived for every peso of ordinary

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 shareholders’ equity equity money used
- measures the effective extent in
using financial leverage for or
against the ordinary shareholders’
equity
Operating Leverage Contribution margin/ Profit before - measures the number of times profit
interest and tax will increase or decrease in relation
to change in net sales

Times Preference Profit/ Preference dividend - measures the adequacy of current

Dividend Earned requirements earnings to meet preference
dividends payments

Basic Earnings per share (Profit - Preference dividends) / - measures the rate of earnings per
Average ordinary shares outstanding share of ordinary share
- measures the value of ordinary share
by attributing to it a portion of the
company’s earnings

GROWTH
- reflect the potential strength of the enterprise in the marketplace
- measured by the expansion and growth into new markets, the rate of growth in existing
markets, the rate of growth in EPS and the amount of expenditures for R & D

GROWTH RATIOS FORMULA DESCRIPTION/ INTERPRETATION

Price-earnings or Market price per share / Earnings per - measures the number of years
earnings multiplier share investment in share will be
recovered
- measures the profitability of the firm
in relation to the market value of
the share
- measures investors’ beliefs on the
growth potential of the share
Dividend-yield Dividend per share / Market price - measures the rate of cash return on
per share investment in share

Dividend-payout ratio Dividend per share / Earnings per - represents the percentage of profit
share distributed as dividends
- a low payout ratio may indicate a
high investment of profits by
growth-oriented firm
Book value per share Shareholders’ equity / Average - indicates the value of the share on
shares outstanding cost perspective

DU PONT RATIO ANALYSIS

 DuPont model was created in the early 1900s to assess the profitability of a business.
 Modified twice after its initial conception, the original DuPont method of financial ratio analysis
was developed in 1918 by F. Donaldson Brown, an engineer at DuPont in charge of
understanding the finances of a company that DuPont was acquiring, who recognized a

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 mathematical relationship between profitability and return on equity (ROE) that was
determined by return on assets (ROA).
 The DuPont system of financial analysis is based on return on equity, with the components of
this ratio being the net profit margin, the total asset turnover and the equity multiplier.
 There are three major financial metrics that drive return on equity (ROE): operating efficiency,
asset use efficiency and financial leverage. Operating efficiency is represented by net profit
margin or net income divided by total sales or revenue. Asset use efficiency is measured by
the asset turnover ratio. Financial leverage is equal to average assets divided by average equity.

OTHER FORMULAS:
AFN:

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(Spont assets/sales)increase in sales - (spont liab/ sales) increase in sales - net prof margin(1-
payout)

BONDS:

PV = PMT x (1-(1 + r)^-t + par/(1+r)^t

/r)

YTM = (EXPECTED CY) + (EXPECTED CGY)

CURRENT YIELD = ANNUAL COUPON PAYMENT/CURRENT PRICE

CURRENT GAINS YIELD = CHANGE IN PRICE/BEGINNING PRICE

YTC = PMT X (PV) + CALL PRICE/ (1+R)^T

Preferred stock:

PV = D/rp or rp= d/price(1-fc)

Common stock:

CAPM = rrf + (rm-rrf)b () is also mrp

Dcf = d0(1+g)/P0 + g

OBYRP = rd + RP

Cost of equity is also cost of common stock

WACC = wdrd(1-T) + wprp + wcrs

Retained Earnings Breakpoint REBP = addition to RE for the year/ equity weight

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