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Module 12 Financial Statement Analysis

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21 views

Module 12 Financial Statement Analysis

Uploaded by

glenn.apon24
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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MODULE 12

FINANCIAL STATEMENTS ANALYSIS


Just looking at the financial statements will not give you a complete picture
of the company’s financial position and operating performance. You need to
convert the absolute amounts into ratios, turnovers and percentages after which
these are compared against the figures of the previous year ( intra-comparability)
or against the figures of a competitor (inter- comparability or bench marking).
Although it is important to study the new figures in the financial statements, it
also becomes more meaningful when the figures are “standardized” or reduced
into a common size by using ratios and percentages, especially when comparing
two companies which have different scale of operation.

An analysis of the previous year financial statements is a stepping stone in


forecasting the company’s future financial position and performance. The
financial data contained in the financial statements should be evaluated primarily
for two reasons:

1) Evaluate operating performance of the business based on profitability


2) Assess strength in financial position based on liquidity and solvency.

It is because of these reasons that financial statement analysis has been


recognized as a powerful tool assisting all users in obtaining meaningful
knowledge and in making informed judgment and decision.

Profitability

Profitability is the ability of the entity to obtain adequate profit for the
investors.

The relevant data are:

1. The revenues earned


2. The net income obtained
3. The assets used in the operation
4. The investment made by the owner.

The owners or investors will be interested in the following ratios:

Profit Margin : Net Income / Revenues

This shows the adequacy of the revenue to earn profit, the higher the
ratio the more profitable the business is.

Return on Total Assets: Net Income/ Average Total Assets

If the total assets of the previous period is given, get average total
assets: the sum of the total assets at the start of the year and at the end of
the year and divide by 2. You can consider the initial investment of the
owner as the beginning balance if this is the first year of the firm.

The rate of return shows the income earned by the business based
on assets invested. A high rate means the assets are being used profitably
by the business.

Rate of Return on Equity : Net Income/Average Owner’s Equity

This show the rate the owner earned from his investment.

LIQUIDITY

Liquidity is the ability of the business to pay for its short term obligations.
Short term creditors such as suppliers and lenders (banks) are interested in this
information. For liquidity, the relevant data are:

1. Current assets and


2. Current liabilities

Working Capital: Current Assets – Current Liabilities

Current Ratio: Current Assets/ Current Liabilities

The rule of thumb is a ratio of 2:1. This shows that the business is
liquid.
Quick Ratio or Acid Test Ratio: Quick Assets/ Current Liabilities

This is a stricter measurement of liquidity since only the quick assets


(cash, accounts receivable, and marketable securities) are in reality used to
pay for the firm’s obligations. There are two ways of assessing this ratio
which shows the business is highly liquid considering the rule of thumb is
only a ratio of 1:1.

1. If the company is going to use this for growth and expansion, then
it is wise to build up current assets or working capital.
2. If there is no plan for expansion, then it seems that the firm is
keeping idle funds. These funds must be moved and used
profitably else return on equity will be adversely affected.

SOLVENCY

Solvency is long term liquidity and is measured based on ability of the


business to pay for long term obligations when they fall due. This is determined
by computing for the debt ratio and the equity ratio. The debt ratio shows the
proportion of the assets provided by the creditors whereas the equity ratio shows
the proportion of the assets invested by the owner. A balanced financial structure
shows the creditors and investors contributed an equal proportion of assets to
the business.

Debt Ratio : Total Liabilities/ Total Assets

Equity Ratio: Total Owner’s Equity/ Total Assets

Take note that to facilitate interpretation of the financial statements one


must consider the following:

1) Use ratios, trends and percentages to standardize data.


2) Compare two or more periods
3) Compare your company against a competitor
4) Compare data in income statement (sales) against data in statement of
financial position.

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