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CHAPTER 2
FINANCIAL STATEMENTS
(Components, Analysis & Interpretations)
Learning Objectives
At the end of this chapter, the students would be able to:

• Identify the three basic components of financial statements.

• Understand the objectives of financial statement analysis.
• Identify the basic analytical techniques in financial analysis, such as:
a) Horizontal Analysis
b) Trend Analysis
c) Vertical Analysis
d) Ratio Analysis
• Interpret common-size financial statements and its uses.
• Compute the various financial ratios, turnover and the interpretations and how to use them for
profit planning.
• Understand the limitations of financial statement analysis

Objectives of financial statement analysis

Financial statements provide the basic source of information by managers and other interested
parties outside the organization regarding its financial conditions and results of operations. Financial
statements communicate the firm’s financial strengths and weaknesses as well as its performance for
the current period. Though financial statements are primarily prepared for external users (stockholders,
investors, government agencies, etc.) managers find it equally useful for their making decisions such as
performance evaluation, developing operating plans for the future and any other matters related to
their operating activities.

Although financial statements are based on historical accounting information, which reflects
transactions and other events that affected the firm, it would help the users in predicting the future, as
indicated by the trend analysis. A potential lender or investor could assess the company’s overall
financial strength, income and growth potential as well as the financial effects on some matters that
require future decisions. For instance, the company’s ability to repay obligations and distribution of
returns on investments are the primary concerns of the potential lender and investors.
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Components of financial statements:

The primary financial statements are:

1. Balance sheet – presents the financial condition of the company at a given date. This statement
shows the total assets, total liabilities and total owners' equity accumulated to date.
2. Income statement – reports the income and expenses in a given period. This statement shows
the total revenues or sales earned, the cost of sales or service and operating expenses incurred
in such a given period.
3. Cash flow statement – shows how cash obtained during the period and how it was used in a
given period. This statement shows the sources and uses of cash categorized as from paying
activities, investing activities and financing activities also in such given period.

In this chapter analysis will be focused only on the balance sheet and income statements:

Note: As per financial accounting rules and principles, titles to the above statements may vary,
nonetheless, to the internal user's headings on these three statements will not change in meanings and
definitions.

Analytical techniques used in financial statement analysis

The most widely used techniques in financial statement analysis are:

1. Comparative analysis
a) Horizontal analysis
b) Trend analysis
c) Vertical analysis
2. Ratio or Component analysis including turnovers.

The analysis must have in mind that these percentage changes and ratios are only indicators of the
performance or financial condition of the company.

No single measure could tell us more. To give more meaningful interpretations, these financial measures
must be compared between periods and between other companies within the same industry but, most
preferably, a comparison between companies of the same size and capacities. Using the industry norm
or standards could also add sense to the interpretation.

Procedural Computations of comparative analyses

a. Horizontal analysis
A horizontal analysis is a technique for evaluating a series of data over a period of time
to determine the increase or decrease that has taken place, expressed as either an
amount or a percentage. The peso changes are normally presented with each item as
well as their percentage changes.
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The following simple rules should be observed:

Step1 – Compute for the peso changes, current year less prior year.

Step2 – Compute for the percentage changes, peso change derived from step1 divided by the prior year.

If there is no amount in the prior year or the prior year is negative, no percentage change will be shown,
as a matter of rule in mathematics.

If the analyst wants to show for the ratio presentation current year, divided by the prior year. Again, if
the base year is zero or negative, no ratio will be shown in the analysis, thus, peso amount presentation
is important. Ratio presentation is not mandatory in horizontal analysis but percentage presentation is a
must.

b. Trend analysis

An extended horizontal analysis could be developed as the so called “Trend analysis”.

Assume in the given financial statements by James Corporation, the following Sales and
Net income items for the past six years are as follows:

Y6 Y5 Y4 Y3 Y2 Y1
Sales 261,000 246,000 234,000 224,0000 219,000 216,000
Net income 33,840 33,780 33,000 31,500 30,600 29,700

The trend could be developed as follows:

Y6 Y5 Y4 Y3 Y2 Y1
Sales 121* 114** 108*** 104 101 100
Net income 114 114 111 106 103 100

*P261,000 / P216,000 = 1.208 or 121

**P246,000 / P216,000 = 1.138 or 114

***P234,000 / P216,000 = 1.083 or 108

This trend would serve as what we call “attention-directing” where the analyst would focus his
attention on such trends in comparison with the industry standards. For instance, the analyst knows that
the industry grew tremendously and yet the company was unable to convert its sales growth into net
income as we compare the trend in Year 5 and 6.

A smart financial analyst would try to deeply relate these financial measures and be able to find
explanations on the issues. For instance, sales increased by 6% but net income decreased by less than
1% only.
 27

A comprehensive illustration for horizontal analysis in the comparative financial statements of

James Corporation is shown on the next pages:

JAMES CORPORATION
COMPARATIVE INCOME AND RETAINED EARNINGS STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, YEAR 6 AND YEAR 5
Changes
Increase (Decrease)
Year 6 Year 5 Peso Amount % Ratio

Net sales 261,000 246,000 15,000 6.1% 1.06

Less, Cost of sales 182,790 169,050 131,740 8.1% 1.08
Gross profit 78,210 76,950 1,260 1.6% 1.02
Less, Operating Expenses 21,000 20,100 900 4.5% 1.04
Net Operating Income 57,210 56,850 360 0.6% 1.01
Less, Interest Expenses 12,090 11,670 420 3.6% 1.04
Net Income before Tax 45,120 45,180 (60) -0.1% 1.00
Less, Tax Expense 11,280 11,400 (120) -1.1% 0.99
Net Income 33,840 33,780 60 0.2% 1.00
Add. Retained Earnings, beg. 87,000 68,460 18,540 27.1% 1.27
Total 120,840 102,240 18,600 18.2% 1.18
Less, Dividends Declared 15,840 15,240 600 3.9% 1.04
Retained Earnings, ending 105,000 87,000 18,000 20.7% 1.21

Net Income 33, 840 33,780 60 0.2% 1.00

Less, Dividends to preferred stock 1,440 1,440 - 0.0% 1.00
Net income available to common 32,400 32,340 60 0.2% 1.00
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JAMES CORPORATION
COMPARATIVE BALANCE SHEET
DECEMBER 31, YEAR 6 AND YEAR 5
Changes
Increase (Decrease)
Year 6 Year 5 Peso Amount % Ratio
ASSETS

Current Assets:

Cash 2,400 2,100 300 14.3% 1.14

Marketable Securities 1,350 900 450 50.0% 1.50
Accounts Receivable, net 36,000 33,000 3000 9.1% 1.09
Inventory 60,000 51,000 9,000 17.6% 1.18
Prepaid Expenses 750 900 (150) -6.7% 0.83
TOTAL CURRENT ASSETS 100,500 87,900 12,600 14.3% 1.14

Long-term Investments 1,500 1,650 (150) -9.1% 0.91

Property and Equipment
Land 18,000 18,000 - 0.0% 1.00
Building, net 165,000 156,000 9,000 5.8% 1.06
Equipment, net 75,000 69,000 6,000 8.7% 1.06
TOTAL PROPERTY AND EQUIP. 258,000 243,000 15,000 6.2% 1.06
TOTAL ASSETS 360,000 332,550 27,450 8.3% 1.08

LIABILITIES & STOCKHOLDER’S EQUITY

Changes
Increase (Decrease)
Year 6 Year 5 Peso Amount % Ratio
Current Liabilities
Accounts payable 22,500 21,150 1,350 6.4% 1.06
 29

Accrued expense 6,600 6,300 300 4.8% 1.05

Notes Payable 10,900 8,700 2,200 25.3% 1.25
TOTAL CURRENT LIABILITIES 40,000 36,150 3,850 10.7% 1.11
Long term liabilities 110,000 108,000 2,000 1.9% 1.02
Total liabilities 150,000 144,150 5,850 4.1% 1.04
Stockholder’s Equity
Preferred Stock, P100 par, 8% 18,000 18,000 - 0.0% 1.0
Common Stock, P10 par value 75,000 72,000 3,000 4.2% 1.04
Additional Paid in capital 12,000 11,400 600 5.3% 1.05
Retained Earnings 105,000 87,000 18,000 20.7% 1.21
TOTAL STOCKHOLDER’S EQUITY 210,000 188,800 21,600 11.14% 1.11
TOTAL LIABILITIES & S 360,000 332,550 27,450 8.3% 1.08
TOCKHOLDER’S EQUITY

C. Vertical Analysis

Vertical analysis is a technique that expresses each item within a financial statement as a
percentage of a relevant total or a base amount. It focuses on the relationship between various financial
items in a given financial statements in a single period. The financial statements then will be presented
in percentages commonly called “common-size statements”. Certain rules are also observed:

➢ For the balance sheet, Total assets and total liabilities & capital are both considered 100% and
each item in the particular section are presented as a certain percent of such total. In James
Corporation, Cash is 7.0% of total assets while accounts payable represents 6.4% of total
liabilities and stockholder’s equity in year 6.
➢ For the income statement, Net Sales is considered as the 100%. Each item in the income
statement represents a certain percent of sales. In James Corporation, Cost of sales is 70% of
sales in year 6.

A comprehensive illustration of vertical analysis in the comparative financial statements of James

Corporation is shown below and on the next pages:

JAMES CORPORATION
COMPARATIVE INCOME STATEMENT
FOR THE YEARS ENDED DECEMBER 31, YEAR 6 AND 5
COMMON SIZED PRESENTATION
Year 6 Year 5 Year 6 Year 5

Net Sales 261,000 246,000 100.0% 100.0%

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Less, Cost of Sales 182,790 169,050 70.0% 68.7%

Gross Profit 78,210 76,950 30.0% 31.3%

Less, Operating Expenses 21,000 20,100 8.0% 8.2%

Net Operating Income 57,210 56,850 21.9% 23.1%

Less, Interest Expenses 12,090 11,670 4.6% 4.7%

Net Income 45,120 45,180 17.3% 18.4%

Less, Tax Expense 11,280 11,400 4.3% 4.6%

Net Income 33,840 33,780 13.0% 13.7%

JAMES CORPORATION
COMPARATIVE COMMON SIZE BALANCE SHEET
DECEMBER 31, YEAR 6 AND YEAR 5
Year 6 Year 5 Year 6 Year 5

ASSETS

Current Assets:
Cash 2,400 2,100 0.7% 0.6%
Current Securities 1,350 900 0.4% 0.3%
Accounts Receivable, net 36,000 33,000 10.0% 9.9%
Inventory 60,000 51,000 16.7% 15.3%
Prepaid Expenses 750 900 0.2% 0.3%
TOTAL CURRENT ASSETS 100,500 900 27.9% 26.4%
Long term investments 1,500 1,650 0.4% 0.5%
Property and Equipment
Land 18,000 18,000 5.0% 5.4%
Building, net 165,000 156,000 45.8% 46.9%
Equipment, net 75,000 69,000 20.8% 20.7%
TOTAL PROPERTY & EQUIP. 258,000 243,000 71.7% 73.1%
TOTAL ASSETS 360,000 332,550 100.0% 100.0%

LIABILITIES AND STOCKHOLDER’S EQUITY

Year 6 Year 5 Year 6 Year 5

Current liabilities:
Accounts payable 22,500 21,150 6.4% 6.4%
Accrued expense 6,600 6,300 1.9% 1.9%
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Notes Payable 10,900 8,700 2.6% 2.6%

TOTAL CURRENT LIABILITIES 40,000 36,150 10.9% 10.9%
Long term liabilities 110,000 108,000 32.5% 32.4%
TOTAL LIABILITIES 150,000 144,150 43.3% 43.3%
Stockholder’s Equity
Preferred stock, P100 par value at 8% 18,000 18,000 5.4% 5.4%
Common stock, P10 par value 75,000 72,000 21.7% 21.6%
Additional Paid in capital 12,000 11,400 3.4% 3.4%
Retained Earnings 105,000 87,000 26.2% 26.3%
TOTAL STOCKHOLDER’S EQUITY 210,000 188,400 56.7% 56.7%
TOTAL LIABILITIES & 360,000 332, 550 100.0% 100.0%
STOCKHOLDER’S EQUITY

Ratio Analysis

Many related items in the balance sheet and income statement help the analyst develop his
interpretation as to the company’s financial strengths and operation’s performance. Financial
statements report both the firm’s position as of a certain period and on its operations for a certain
period. As mentioned earlier, the real value of financial statements is in the fact that they can be used to
help predict the firm’s future earnings and dividends, thus, an analysis of the firm’s ratios is generally
the most important technique in a financial statement analysis.

The ratios are designed to show relationships between financial statement’s accounts. For
instance, Company X might have debt of P5 million and interest charges of P400 thousand, while
Company Y might have debt of P50 million and interest charges of P4 million. Which company is
stronger? The true burden of these debts and the companies’ ability to repay them can be ascertained
by 1. Comparing each firm’s debt to its assets and 2. Comparing the interest it must pay to the income it
has available for payment of interest. Such comparisons are what we call ratio analysis.

The three major areas that concern the users of financial statements are:

1. Stability
2. Solvency or liquidity
3. Profitability

Analyzing ratios as a whole could be more meaningful, even though they are computed
individually; the totality of it could give the final interpretation of the company’s financial and
operating conditions. The following are the most common ratios used by financial analysts,
managers and business owners:

I. Analyzing the Balance Sheet

➢ Liquidity Ratios
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These are ratios that show the relationship of the company’s cash and other current assets to its
current liabilities. Liquidity is the number one concern of most financial analysts. This will indicate
whether the firm can meet its maturing obligations. The most common liquidity ratios and their
procedural computations are:

1. Working Capital = Current assets minus current liabilities.

This would mean the difference between current assets and current liabilities.

To some, working capital is used to designate current assets only as the amount
intended for the day-to-day operations of the business. Thus, the use of the term net
working capital is more appropriate. The bigger the net working capital the better as it
would mean more current assets are available for operations.

2. Current asset ratio = Current assets divided by current liabilities.

This is the basic test of liquidity of the firm. This will determine the adequacy of working
capital or the ability to meet current obligations. The higher the current asset ratio, the
better, as this would mean there are more current assets available for paying its current
obligations.

3. Quick test ratio = Quick assets divided by current liabilities.

Quick or acid test ratio is a more stringent test of ability to pay current obligations as
they come due. The higher the quick asset ratio, the better liquidity position of the firm.
Quick assets are Cash and cash equivalents, marketable securities, short-term notes and
accounts receivables. In this regard, inventory and prepaid expenses are not included in
the computation of quick asset ratio as inventories are typically least liquid among the
current assets, while prepaid expenses are not convertible to cash. However, the analyst
must do a careful review since amounts receivable could be converted into cash later
than inventory. It is in the case of aged accounts receivable which are normally
considered as bad debts. The opposite could be observed wherein inventory can be
converted to cash earlier than accounts receivable, in the case of cash sales.

➢ Assets Management Ratios

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These are a set of ratios, which measures how effective a firm is managing its assets.
These ratios are also called asset utilization ration which pertains to how effectively the
firm utilized its assets to earn profits.

These ratios are designed to answer a question like:

• Does the total amount of each type of assets as reported on the balance sheet seem maintained
at a reasonable level?
• Will too high or too low current assets in relation to the projected or actual operating levels
affect probability?

Normally companies borrow or obtain capital from other sources to acquire assets. If a company has too
many assets acquired through borrowings, the interest expenses will be too high and, hence the profits
will be lower. Therefore, managing these assets, particularly current assets, will help the firm avoid
borrowing funds to finance operations. The most common asset management ratios are:

1. Accounts Receivable = Net credit sales divided by average AR turnover

This will measure the efficiency of collections or how fast collections are being made. Whenever
possible, monthly balances of accounts receivable is used in determining average accounts receivable.
Net sales used as numerators are assumed to be all credit sales only. The higher the turnover the better,
this would mean a greater number of times receivable is reinvested for more profit.

2. Number of days in AR = 365 days divided by AR turnover

This is to measure the number of days the firm invests in accounts receivable. The shorter the
collection period the better for the company as it could present reinvestment opportunities
which mean additional income.

3. Inventory turnover = Cost sales divided by Average inventory

Similar with accounts receivable, inventory turnovers are used to determine how fast inventory
were converted into sales. Whenever possible, monthly average inventory is a better measure.
The higher the inventory turnover the better, as this would mean more number of times
inventory is reinvested and more profit will be realized.

4. Number of days in inventory = 365 days divided by Inventory turnover

This determines the number of days in inventory is held as a stock before it will be sold. The
shorter the number of days it is held on the stock the better it will be as it means more number
times it is reinvested by the firm.
For a manufacturing firm, the number of days and turnovers will be determined for each item in
the inventory such as finished goods, the work in process and raw materials inventory.
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• Finished goods turnover is computed by dividing the cost of sales by the average
finished goods inventory.
• Work in process turnover is computed by dividing the cost of goods manufactured by
the average work in process.
• Raw materials turnover is computed by dividing the raw materials used by the average
raw materials inventory.

5. Total assets turnover = Sales divided by total assets

This determines the number of times investments in assets are reinvested in sales. The more the
number of times in turnover means the higher the profit the company utilized its assets.

➢ Debt Management Ratios or Financial Leverage

These ratio will measure the extent to which firm uses its debt financing or the so-called
financial leverage. Financial leverage Is use of borrow funds or preferred stock capital to increase the
earnings per common share before interest and taxes. Financial leverage is also called fixed-cost
financing.

By raising funds through debt, the owners can maintain control of the firm with limited
investments however creditors look to the equity, or owner supplied funds. Thus creditors provide a
margin of safety in extending credits that is if the owners have provided only a small proportion of total
financing, the risks of the enterprise are borne mainly by its creditors. In such case, the creditors will be
very cautious in granting credits or public investors might be having second thoughts in buying any debt
securities to be issued by such firm.

On the other hand firms resulted to favor in financial leverage in their objective of maximizing
short term profits. Used of borrowed funds will increase the rate of return of stockholders for two
reasons:

1. Since interest is deductible for income tax purposes, the use of debt financing lowers the
income taxes and leaves more of the firms operating income available to its investors.
2. If the rate of return assets exceeds the interest rate of debt as it generally does then a
company can use debt to finance assets pay the interest on the debt and have something to
left over for its stockholders.

That is why present and prospective shareholders and lenders pay close attention to the firm’s
degree of indebtedness and ability to repay debt. Shareholders are concerned since the claim of
creditors must be satisfied prior to the distribution of earnings of them. Lenders are concerned since the
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more indebted the firm the higher the probability that the firm will be unable to satisfy the claims and
all its creditors.

Normally firms with relatively high debt ratios are exposed to more risk of losses when the
economy is in a recession, but they also have higher returns when the economy booms. Conversely,
firms with low debt ratios are less risky, but they also forego the opportunity to leverage up their return
on equity. The prospects of high returns are desirable, but investors are reluctant to take risks.
Therefore, the decisions about the use of debt require firms to balance higher expected returns against
increased risk. As the say “Higher risk, higher return” while “Low risk, low returns”.

The risk return analysis is discussed in higher financial management courses.

Determining the optional amount of the debt for a given firm is a complicated process. That is
why this chapter will simply look at the procedures on how to:

• Examine the firm's debt ratio as to the extent to which borrowed funds have been used to
finance assets, and
• Review the income statement ratios to determine the number of times fixed interest charges
are covered by operating profits.

The following are the ratios that must be analyzed at the same time as they are complementary ratios.

1. Debt to total asset ratio = total debt divided by total assets

This is the ratio of total liabilities to total assets. As discussed earlier, it measures to
what extent to that portion of the total assets provided by the creditors.
2. Debt + Equity ratio = total liabilities divided by the total stockholder’s equity
It measures the sources provided by the owners in the business. It provides information
on the equivalent amount provided by the creditors for every peso provided by the
owner. Total liabilities means both current and long-term liabilities.
3. Times-Interest-Earned ratio = earnings before interest and taxes divided by interest charges
This measures the ability of the firm to meet its annual interest payments. It will also
measure the extent to which operating income may decline before the firm is unable to
meet its annual interest cost.

Failure to meet this obligation can bring legal action by the firms' creditors possible resulting to
bankruptcy. Note that the item “Earnings before interest and taxes” rather than the net income is used
as numerator because interest is deductible cost, and the liability to pay current interest in not affected
by taxes. The higher the number of times interest is earned, the better for the firm as it was able to
utilize more the cost of its borrowed funds.
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II. Analyzing the income statement

➢ Profitability Ratio
These ratios would show the net result of the policies and decisions the management
did in the current period. The combined effects of liquidity, asset management, and
debt management on operating results will be analyzed using these ratios. Net income
refers to net income after income taxes.

1. Net profit margin = net income available to common stock divided by sales

Net income available to common stock is net income less dividends to preferred stocks,
if any.

2. Total asset turnover = Sales divided by total assets

3. Return on total assets = Net income available to common stock divided by total assets
4. Return on sales = Net income divided by net sales
5. Return on common equity = Net income available to common stock divided by the average
common stock equity
6. Earnings per share = Net income available to common stockholders divided by weighted average
number of shares outstanding
7. Divided per share = Dividends paid to common stock divided by common shares outstanding
8. Dividend pay-out ratio = Dividends per share of common stock divided by EPS

Pay-out ratio measures the amount of dividend paid for every peso earnings or the percentage of
distributed earning in relation to EPS.

DuPoint is the most popular in analyzing profitability of the company. DuPoint system of analysis
combines profitability, asset efficiency, and leverage. The division of ROE among these three ratios
allows the analyst to segregate factors that are contributing to the ROE into profitability, asset
efficiency, and use of debt.
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The DuPoint formula allows the firm to break down its return into net profit margin which measures
the firm profitability on sales and its total asset turnover which indicates how efficiently the firm has
used its assets to generate sales. DuPoint formula multiplies the firm net profit margin by its total asset
turnover to calculate the firms return on total assets (ROA). Its basic ratios are:

a. Net profit margin ratio

b. Total asset turnover
c. Equity multiplier or the debt ratio

It is presented as follows:

ROA = NET PROFIT MARGIN x TOTAL ASSET TURNOVER

Note that all of these turnovers and ratios could be more meaningful If they are compared to
the industry standards so that the analyst could assess the performance of the company in the relation
to its competitors.

Using the previous illustrative problem, James Corporation, ration analysis on its financial
statements are shown on the next pages:

Year 6 Year 5

1. Working Capital
Current assets P100,500 P87,900
Less, Current liabilities 40,000 36,150
Working capital P60,500 P51,750

2. Current asset ratio

Current assets P100,500 P87,900
+Current liabilities 40,000 36,150
CAR 2.51 : 1 2.43 : 1

3. Quick asset ratio

Quick assets P39,750 P36,000
+Current liabilities 40,000 36,150
QAR 0.99 : 1 0.99 : 1

4. Accounts receivable turnover

ARTO = NET SALES DIVIDED BY AVERAGE AR
=P261,000 + [(36,000 + 33,000) % 2]
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=7.56 times

5. Number of days in AR = 365 days / 7.56 = 48.28 days

Or
Average AR divided by average daily sales =
P34,500 + (P261,000 + 365days) = 48.25 days

6. Inventory turnover = Cost of sales divided by average inventory

=P182,790 / [(P60,000 + 51,000) % 2]
=3.29 times

7. Number of days in inventory = 365 days / 3.29 days = 111 days

Or
Average inventory divided by average daily cost of sales=
=[(P60,000 + P51,000) % 2] / (P182,790 / 365days)
=P55,500 + P500.79 = 110.82 days or 111 days

8. Debt equity ratio = total liabilities divided by total stockholder’s equity

Total liabilities P150,000 P144,150
%Total stockholder’s equity 210,000 188,800
Debt equity ratio .71 : 1 .76 : 1

9. Net profit margin = net income available to common stocks divided by sales
=(P33,840 – P1,440) % P261,000 = 12.41%

10. Total asset turnover = sales divided by total assets

=P261,000 / P360,000 = 7.21 times

11. Return on total assets = net income available to common stock divided by total assets
=(P33,840 – P1,440) % P360,000 = .09 OR 9%

Using Dupont in computing ROA,

ROA = Net profit margin x Total asset turnover

ROA = 12.41% x 7.25 = 9%

12. Return on Sales = Net income divided by net sales

=P33,840 / P261,000 = 12.96%
 39

13. Return on equity = Net income available to common stock divided by average total common
equity
=(P33,840 – P,1440) / [(P192,000 + P170,400) / 2]
=(P32,400) / P181,200 = 17.88%

14. Interest coverage or the number of times interest is earned ratio

=Operating income or EBIT divided by interest expense
=P57,210 / P12,090 = 4.73 times

15. Earnings per share = net income divided by number of shares of common stock outstanding
=P32,400 / 7,500 shares = P4.32 per share

16. Dividend per share = dividends paid to common stock divided by common shares outstanding
Total dividend declared P15,840
Less, dividend to preferred stock 1,440
Dividend to common stock P14,400

Number of common shares outstanding

Total common shares P75,000
% Par value per share P10.00
Total number of share outstanding is 7,500

Divided per share = P14,400 / 7,500 shares = P1.92 per share

17. Dividend pay-out ratio = dividends per share of common stock divided by EPS
=P1.92 per share / P4.32 per share
=44%

Notes to financial statements

Published financial statements are accompanied by notes. These narratives provide greater
detail of information that is included very concisely in the financial statements. Many people find some
notes to be complicated. Nevertheless, they can be extremely important and should be viewed as an
integral part of the financial statements. Information typically disclosed in the notes included:

➢ Details of the inventory costing and depreciation methods used

➢ Contingent liabilities and pending lawsuits
➢ Long term leases, if any
➢ Terms of executive employment contract, profit sharing programs, pension plans, and stock
options granted to employees.
 40

Remember that if you really want to analyze a set of financial statements thoroughly don’t
pass over the “Notes to financial statements”.

Limitations of financial statement analysis

Financial statements and the financial ratios derived from them are but a single source of
information, financial ratios serve only as an attention-directing device. The ratios raise questions more
often than they answer them. An analyst must follow up the financial statement analysis with in-depth
research on a company’s management styles, its history and trends, the industry and the national and
international economies in which the firms operates

Further, as financial statements are costs, inflation could badly distort balance sheets
particularly depreciation charges and inventory cost which affect profit. Thus, a ratio analysis for one
firm for several periods or different companies of different ages must be interpreted with extra care and
judgment.

Several factors that make financial analysis difficult

One of them is variations in accounting methods among firms. As in the case of different
methods of inventory valuations and depreciation can lead to differences in reported profits for
identical firms, and a good financial analyst must be able to adjust for these differences so that he or she
can make valid comparisons among companies. Again, analysis will be more meaningful if we make
comparisons.

Another is timing. An action is taken at one point in time, but its full effects cannot be accurately
measured until a later period. As the cash account is the steering wheel of every firm, the effects of the
cash flow cycle could be accurately measured at different time. Cash could be depleted as a result of
acquisition of fixed assets to boost production and sales activities and net income was recognized at the
same time period though collection of cash again could be done at a later period.

As such, at the same period, current asset ratio may seem not good but profit seems better. It is
also difficult to generalize whether a particular ratio is “good” or “bad”. For instance, a high current ratio
may indicate strong liquidity position which in fact is the company is illiquid since most of its current
assets are in the form of non-moving inventory or in the form of aged accounts receivable. Even
excessive cash itself is a non-earning asset.

Therefore, financial statement analysis must be interpreted as a whole co-relating its

weaknesses and strengths rather individual ratios.
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In summary, the following statements must be remembered in analyzing financial statements:

• Liquidity ratios measure how well the firm can meet is current obligations when they come due.
• The current ratio proves to be better liquidity measure when all of the firms current assets are
reasonably liquid.
• The quick ratio would prove to be the better or superior measure if the inventory of the firm is
considered to lack the ability to be easily converted into cash.
• Activity ratios are used to measure the frequency or speed with which various accounts are
converted into cash or sales.
• The average collection period of receivable should be compared to a firms own credit terms.
• The average payment period should be compared to the creditor’s credit terms.
• Debt ratios measure how much of the firm is financed with other people’s money and the firm’s
ability to meet fixed charges. The liquidity and debt ratios are most important to present and
prospective creditors.
• Profitability ratios measure a firm’s return in relation to sales, assets or equity.
• Financial leverage is the term used to describe the importance of risk and return introduced
through the use of fixed-cost financing, such as debt and preferred stock.
• The debt ratio and the debt-equity ratio may be used to measure the firm’s degree of
indebtedness.
• The times-interest-earned and the fixed-payment coverage ratios can be used to assets the
firm’s ability to meet fixed payments associated with debt.
• There are three ratios of profitability found on a common-size income statement are: 1. The
gross profit margin, 2. The operating profit margin, and 3. Net profit margin.
• Return in equity indicated rate of return the owners earn on their investment in the firm. ROE is
calculated by taking earnings available to common shareholder and dividing by stockholder’s
equity.
• The price-earnings ratio is the market price per share of common stock divided by the earning
per share. It indicates the amount the investor is willing to pay for each peso of earnings. It is
used by owners to assess the value of the firm’s earnings. It indicates the degree of confidence
that investors have in the firm’s future.
• The analyst should devote primary attention to any significant deviations from the normal or the
standard that has been set by the firm, whether above or below. Favorable or positive
deviations from the norm are not necessarily a better performance. Likewise an unfavorable or
below may mean a bad performance. Further examination into the deviation would be required
especially significant difference on the normal.
• The DuPont system of analysis combines profitability, asset efficiency and leverage debt ratio.

Discussion Questions

1. What is a financial statement report?

2. What are the primary financial statement reports? Discuss each kind of report.
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3. Discuss the objectives of financial statement analysis.

4. What are the two basic financial statement analysis techniques? Discuss each kind.
5. Define horizontal analysis of analyzing financial statements.
6. Define vertical analysis of analyzing financial statements.
7. What is a trend analysis?
8. What is a ratio analysis?
9. What is the so-called “notes to financial statement analysis?” Discuss its importance to
financial statement analysis.
10. Why do you think the use of borrowed funds is usually practiced by businessmen?
11. Enumerate the two reasons why financial leverage improves the rate of returns to
stockholders or owners.
12. Discuss some limitations in financial statement analysis.
13. What is a working capital?
14. What is a financial leverage?
15. Outline the formula of the following ratios and discuss each terms:
a. Current asset and current asset ratio
b. Quick assets and quick asset ratio
c. Accounts receivable turnover
d. Inventory turnover
e. Debt to total assets ratio
f. Debt to equity ratio
g. Profit margin ratio
h. Total asset turnover
i. Return on total asset
j. Return on sales
k. Return on equity
l. Earnings per share
m. Dividend per share
n. Dividend payout ratio
o. Dupont formula in determining Return on Assets (ROA)