Analysis and Interpretation of

Financial Statements
Prepared and Presented:

NIÑ A GLORIA Z. PENDANG

 LEARNING OBJECTIVES
1. Define the measurement levels namely:
liquidity, solvency, stability and profitability;
2. Perform vertical and horizontal analyses of
financial statements of a single proprietorship;
3. Compute and interpret financial ratios such as
current ratio, working capital ratio, gross
profit, net profit ratio, receivable turn-over,
debt to equity ratio and the like.
 Financial Statements
• As a tools in decision making process.
• The works of an accountant do not end only
in the preparation of financial statements.
They displays analytical abilities, skills and
expertise in the field of accounting by
analyzing and interpreting the data found in
the financial statements.
 Objectives of the Analysis

The main purpose of the statement analysis is to evaluate

the progress made by the business in the past as a guide to
future operations.
1. Liquidity- is the ability of the enterprise to meet
currently maturing obligations
2. Solvency- is the availability of cash to meet the longer-
term maturing obligations.
3. Stability- measures the ability of the company to
continue operations for a relatively longer period of time.
4. Profitability- the ability of the business to generate more
profit.
 Methods Used in Statement Analysis
• The most common method of statement analysis
employed by accountants as financial analyst are as
follows:
1. Presentation of Statement showing the
component percentages;
2. By using trends by means of percentages;
3. Using ratio to establish the relationship between
certain items in the Statement of Financial
Position and Statement of Comprehensive Income
 Component Percentages
• The ratio of the peso amount of each item as
related to the total of which it is a part is
called “Component Percentages”.
• A statement showing the component
percentages is called “ Common-size”
statements because in the financial
statements are being condensed. Condensed
means compressed.
• The analytical technique used in this
method is the “vertical or static analysis’.
Vertical Analysis converts amounts of
components of financial statements within a
given date or period or the relative
importance of an item in relation to the
other or to a total. This can be done in both
the Statement of Financial Position and
Statement of Comprehensive Income.
 Whitesugar Enterprise
Statement of Comprehensive Income
For the year 31 December 20A
Percent
Sales 125,000 104%
Less: Sales Returns and 1,300
Allowances
Sales 4,000 5,300 4%
Discounts
Net Sales 119,700 100%
Less: Cost of Sales 72,000 60%
Gross Profit 47,700 40%
Less: Operating Expenses 30,000 25%
Profit 17,700 15%
 Whitesugar Enterprise
Statement of Comprehensive Income
For the year 31 December 20A

Percent
Sales 104%
Less: Sales Returns and
Allowances
Sales 4%
Discounts
Net Sales 100%
Less: Cost of Sales 60%
Gross Profit 40%
Less: Operating Expenses 25%
Profit 15%
 Trends by Means of Percentages
• The financial statements become more
meaningful to the users when the financial
condition and the results of operations of
one period is compared with the other,
showing the changes in peso amount and
the relative changes in percentages. The
analytical technique that is being used is the
“ Horizontal or Dynamic Analysis”.
• The tool used in the analysis is the
“Comparative Statements.”
 Whitesugar Enterprise
Statement of Comprehensive Income
For the year 31 December 20A
20B 20A Amount of % of
Increase increase
(Decrease) (decrease)
Sales P150,000 P125,000 P25,000 20%
Less: Sales Returns and P 2,015 P 1,300 P 715 55%
Allow
Sales Discounts 2,000 4,000 (2,000) (50%)
Total P4,015 P 5,300 P(1,285) (24%)
Net Sales P 145,985 P 119,700 P 26,285 22%
Less: Cost of Sales 64,800 72,000 (7,200) (10%)
Gross Profit P 81,185 P 47,700 P 33,485 70%
Less : Operating Expenses 41,335 30,000 11,335 38%
Total P39,850 P17,700 P22,150 125%
 Analysis
1. Sales has increased by 20%
2. Sales Returns and Allowances has increased
by 55%. Management should take a look
into It because the increase in the return of
merchandise sold might be caused by
carelessness or efficiency of the clerk in
shipping merchandise which do not
conform with the orders and much more
when goods delivered are defective.
3. The decrease in Sales Discounts must be
checked. This could mean that customers could
not pay their accounts within the discount
period. The discount period might be too short
or the discount rate might be too low losing the
initiative of the customers to pay within the
discount period. This is a good indication if the
credit sales are too low which means that the
customers are going into cash basis.
4. The increase in operating expenses is
higher than the increase in sales. The details
of the must be analyzed.
5. The results of 20B’s operation is quite
satisfactory. The profit of 20A is more than
doubled in 20B.
 Ratio Analysis
Ratio analysis is a method of financial
evaluation whereby the relationship between
the items found in the Statement of Financial
Position, Statement of Comprehensive Income
or both are being established.
 LIQUIDITY RATIO
a. Current Ratio or Banker’s Ratio
Significance: This measures the ability of the
business to pay its current obligations arising
from operations.
Formula:
Current Ratio or Banker’s Ratio= Current Assets
Current Liabilities
Example:
Current Assets = P 150,000 = 3:1
Current Liabilities 50,000
Acid- Test or Quick Ratio
Significance
This is very strict test or measurement of the
liability of the business to convert its non-cash
current assets into cash payment of its
obligations. The inventories are excluded because
it takes time to convert these to cash. Likewise,
prepaid expenses are excluded because it is not
intended for conservation to cash.
Formula
Acid Test or Quick Ratio= Quick Assets
Current Liabilities
125,000 = 2.5:1
50,000
The current ratio 2.5: 1 indicates that P2.5 is
used to pay the obligation of P1.00
 Inventory Ratio
a. Rate of Inventory Turnover
Significance:
A high rate on turnover indicates a great demand of
the commodities and a low rate indicates a poor
demand. With this , the business should be able to
determine what commodities are sold fast and
which are sold slow to avoid loss due to
obsolescence. The number of times merchandise
replaced is represented by the rate of the inventory
turnover.
 Formula
• Rate of Inventory Turnover= Cost of Sales
Average Inventory
Merchandise Inventory, Beginning P 30,000
Add: Purchases 140,000
Cost of Goods Available for Sale 170,000
Less: Merchandise Inventory, End 20,000
Cost of Sales 150,000
 Application of the Formula
Merchandise Inventory, Beginning P30,000
Add: Merchandise Inventory, End 20,000
Total 50,000
Divided by 2
Average Inventory P 25,000
Cost of Sales = P 150,000 = 6 times
Average Inventory P25,000
 Number of Days Sales in Inventory

Significance
The number of days sale in inventory
indicates the length of time it takes to acquire,
sell and replace the merchandise inventory. In
this, the analyst must consider the nature of
commodities sold by the business. Basic
commodities are sold in shorter length of time
compared to machineries for obvious reasons.
 Formula
Number of Days Sales in = Number of Days in a year
Inventory Rate of Inventory Turnover

Number of Days in a Year = 365 days = 60days

Rate of Inventory Turnover 6 times

60 days is 2 mos to buy, sell and replace the

merchandise
 Accounts Receivable Turnover
• Significance
The accounts receivable turnover indicates the
number of times the accounts receivable were
collected during the period. A high rate indicates
efficiency in collecting the customer’s accounts.
Formula
Accounts Receivable Turnover= Credit Sales
Average Receivable
 To illustrate, let us assume the following
data:
• Accounts Receivable, Jan.1 P30,000
• Accounts Receivable, Dec. 31 10,000
• Cash Sales 50,000
• Credit Sales 160,000
Application of the Formula
Accounts Receivable, Jan 1 P30,000
Add: Accounts Receivable, Dec. 31 10,000
Total 40,000
Divided by 2
Average Accounts Receivable P 20,000
Credit Sales = P 160,000 = 8 times
Average Receivable 20,000
 Average Collection Period
• Significance
• The average collection period indicates the
number of days it takes to collect the
customer’s accounts
• Formula
• Average Collection Period= Number of Days in a year
Accounts Receivable Turnover
 Application of the Formula
• Using the same given illustrative data, the
average collection period is computed as
follows:
Number of Days in a Year = 365 days = 45 days
Accounts Receivable Turnover 8 times

It takes 45 days to collect receivable

 Profitability Ratio
a. Rate of Return on Total Assets
Significance:
It is a measurement of enterprise’s efficiency
in using its assets to earn profits.
Formula
Rate of Return on Total Assets= Profit + Interest Expense
Average Total Assets
 Illustration
The following data were taken from Orange Company
Profit for the year= P 55,000
Interest Expense= 5,000
Average in Total Assets:
Total Assets- Jan 1 180,000
Total Assets- Dec. 31 220,000
Total 400,000
Divided by 2
Total 200,000
 Application of the Formula

Profit + Interest Expense = P60,000 =30 %

Average Total Assets 200,000

Orange Company earned an average of 30% or

P30,000 for every peso or asset invested
b. Rate of Return on Sales
Significance:
It indicated the enterprise’s ability to
effectively utilize its advantage in shaping the
pricing policy.
Formula
Rate of Return on Sales = Profit
Net Sales
 Illustration
• The following data were taken from Durian
Company
Net Sales P 120,000
Profit 15,000
Application of the formula
Profit = P15,000 = 12.5%
Net Sales P120,000
Durian Company earns P12.5 profit for every P1 of
sales
c. Gross Profit Ratio
Significance:
It is a measurement of the profitability of a
company’s product
Formula
Gross Profit Rate= Gross Profit
Net Sales
• Illustration
With the given data, determine the gross
profit are
Net Sales P1,000,000
Cost of Sales 600,000
Gross Profit P 400,000
• Application of the Formula
Gross Profit = P400,000 40%
Net Sales 1,000,000
• Rate of Return of Investment (ROI)
• Significance
• It measures the percentage of profit
generated by investment.
• Formula
• Rate of Return on Investment= Profit
Average Investment
(Owner’s Equity)
The following data were taken from Pomelo
Co.
Profits P150,000
Owner’s Equity, beg 780,000
Owner’s Equity, End 800,000
Application of the Formula
Profit = 150,000 18.9%
Average Investment 790,000
4. Solvency or Stability Ratio
Solvency Ratio is a measurement that will
answer how long can enterprise survive. Both
the owner’s and long- term creditors want to
be assured of their investments and the ability
of it to pay their long-term obligations
a. Debt to Total Assets Ratio
Significance
It indicates the claims of various creditors
from the assets of the enterprise.
Formula
Debt to Total Assets Ratio= Total Liabilities
Total Assets
b. Owner’s Equity to Total Assets Ratio
Significance
It indicates the claim of owner’s from the total
assets of the enterprise
Formula
Owner’s Equity to Total Assets= Total Owner’s Equity
Ratio Total Assets
Combined Illustration
The following data were taken from Highland Company
Total Liabilities P 30,000
Total Assets 150,000
Total Equity 120,000
Application of the Formula
Total Assets 150,000 100%
Total Liabilities 30,000 20%
Total Equity 120,000 80%
Total Liabilities = P 30,00 = 20%
Total Assets 150,000

Total Owner’s Equity= P120,000 = 80%

Total Assets 150,000
 PROFITABILITY RATIOS
RATIO FORMULA DESCRIPTION
Return on Sales Profit Also called as net profit
Net Sales rate; net profit margin;
measures profit
percentage per peso sales
Gross Profit Rate Gross Profit Measures gross profit
Sales percentage on sales to
recover operating
expenses.
Return on Total Assets Profit/ Interest Expense, Measures overall asset
net of tax profitability; indicates
Average Total Assets how well assets have been
employed by
management
Return on Shareholders’ Profit Measures percentage of
Equity Average Shareholders’ income derived for every
Equity peso of owner’s equity
 Profitability Ratios Cont.
RATIO FORMULA DESCRIPTION
Return on ordinary Earnings available to Earning available to common
stockholders equals net income
shareholders’ equity ordinary shareholders less preferred dividends; this
Average ordinary ratio measures the percentage of
shareholders’ equity profit derived for every peso of
common equity money used;
when compared to the return on
total assets, it measures the
extent to which financial leverage
is working for against common
stockholders.
Operating Leverage Contribution Margin Measures the number of
EBIT times profit will increase
or decrease in relation to
change in net sales
Times preferred dividend Profit Measures the adequacy of
earned Preferred dividend current earnings to meet
requirements preferred dividend
payments
 LIQUIDITY RATIOS
RATIO FORMULA DESCRIPTION
Operating Turnover Collection Period + Measures the speed of the
Inventory Days business cycle; the
number of days cash was
invested in the normal
business operations until
it was recovered back
Inventory Turnover Cost of Goods Sold Indicates the number of
Average Inventory times inventories were
acquired and sold during
the period.
Inventory days 365 days Indicates the length of
Inventory Turnover time spent before the
average inventory is sold
to customers the number
of days is 365 in a year,
360 days is used for ease
in computation
 LIQUIDITY RATIOS
RATIO FORMULA DESCRIPTION
Receivable Turnover Net Credit Sales Indicates the efficiency in
Average Trade Receivables credit and collection
policies; trade receivables
include open account and
on notes
Collection Period 365 days Measures quickness in
Receivable Turnover collecting trade receivables
Payable Turnover Net Credit Purchases Measures effectiveness in
Average Trade Payables using trade credit facility
from suppliers
Payable Days 365 days Indicates the number of
Payable Turnover days spent before paying
liabilities to merchandise
suppliers
Materials Turnover Materials Used Indicates the number of
Average Materials times materials were used
Inventory on the average during the
period
 LIQUIDITY RATIOS
RATIO FORMULA DESCRIPTION
Work-in Process Turnover Cost of Goods Indicates the number of
Manufactured times average work- in
Average work- in process process inventories is
inventory converted to finished
goods
Finished goods inventory Cost of Goods Sold Indicates the number of
Average finished goods times average finished
inventory goods is sold during the
period.
Cash Turnover Cash operating Expenses Measures the ability of the
Average Cash Balance business to meet operating
expenses payments given a
particular cash balance
Days to Pay Operating 365 days Indicates the number of
Expenses Cash Turnover days spent before meeting
operating expenses
payments
 LIQUIDITY RATIOS
RATIO FORMULA DESCRIPTION
Working Capital Turnover Net Sales Measures the adequacy
Average Working Capital and effective use of
working capital; indicates
reasonableness of the
amount of current assets
Assets Turnover Net Sales Measures Effectiveness of
Average Total Assets asset utilization
Current Assets Turnover Net Sales excluding Indicates the
depreciation and reasonableness of the
amortization amount of current assets
Average Current Assets

Net Working Capital Current Assets- Current Indicates the amount

Liabilities invested by the business
to operate its normal
business activities
 LIQUIDITY RATIOS
RATIO FORMULA DESCRIPTION
Current Ratio Current Assets A rough estimate on the
Current Liabilities ability of the business to
meet its currently maturing
obligations; this ratio varies
in great disparity from one
industry to another
Quick Assets Ratio Quick Assets A more sever test of
Current Liabilities immediate liquidity to meet
currently maturing
obligations, quick assets
include cash, marketable
securities and receivables;
this ratio is also referred to
as acid –test ratio.
Defensive- Interval Ratio Defensive Assets Measures the number of
Average Daily days defensive assets are
Expenditures available to meet daily cash
expenses. Defensive assets
include cash, marketable
securities, and trade
receivables
 LIQUIDITY RATIOS
RATIO FORMULA DESCRIPTION

Earnings per share Net Income – Preferred Perhaps the most

Dividends) frequently quoted ratio
Average Common Shares of earnings and growth
outstanding performance; measures
the value of common
stock by attributing to it
a portion of the
company’s earning
 GROWTH RATIOS
RATIO FORMULA DESCRIPTION
Price- Earnings Ratio Market Price per Share Measures the number of period
Earning Per Share investment in stock will be recovered;
measures the profitability of the firm
in relation to the market value of the
stock; measures investors’ beliefs on
the growth potential of the stock
Dividend yield ratio Dividend per share Measures rate of cash return to
Market price per share investment in stock.

Dividend payout ratio Dividend per share Represents the percentage of net
Earnings per share income distributed as dividends; a low
ratio may indicate the reinvestment of
profits by a growth-oriented firm
Book value per share Stockholders` equity Indicates the value of the stock on cost
Average shares perspective; the relevance of this ratio
outstanding diminishes when the balance sheet
valuation does not approach fair
market values; may be computed for
both common and preferred stocks.
 LEVERAGE RATIOS
(SOLVENCY RATIOS OR STABILITY RATIOS)
RATIOS FORMULA DESCRIPTION
Debt-to-equity ratio Total debt Measures the use of debt to
Net stockholders` finance operations; provides
equity a measure of the relative
amount of resources
contributed by the creditors
and owners.

Debt-to-assets ratio Total debt Measure the relative share

Total assets of creditors over the total
resources of the firm.

Equity-to-assets ratio Net shareholders` Measures the amount of

(equity ratio) equity resources provided by the
Total assets owners in the firm

Equity multiplier Total assets Indicates the number of

Net shareholder`s times owners` equity is
equity multiplied
 LEVERAGE RATIOS
(SOLVENCY RATIOS OR STABILITY RATIOS)
RATIO FORMULA DESCRIPTION
Times interest EBIT Measures the long term debt paying
earned Interest expense ability of the firm ; a high number of
times interest earned ratio indicates
that the business is under-leveraged
and its return on common equity
could still be improved; EBIT=
earning before interest and tax
Financial EBIT Measures the risk associated in using
leverage (EBIT – Interest expense – debt to finance investments
Preference dividend before tax)
Total leverage (Degree of operating leverage) Measures the overall leverage of the
(Degree of financial leverage) business, indicates the variability of
the stockholders` equity with
respect to changes in contribution
margin, EBIT, interest expense, and
preferred dividends before tax
 LEVERAGE RATIOS
(SOLVENCY RATIOS OR STABILITY RATIOS)
RATIOS FORMULA DESCRIPTION
Fixed charges rate Cash flows before fixed charges Measures the ability to
Total fixed charges meet fixed charges by cash;
examples of fixed charges
are rent, insurance, taxes
and depreciation.
Total assets-to-total Total assets A rough estimate of the
liabilities ratio Total liabilities firm's ability to meet
interest payments to
creditors
Non-current assets- Non – current assets Shows the capability to
to-long-term Long term liabilities meet non-current liabilities
liabilities ratio using non-current
resources.
 CASH FLOW RATIOS FORMULA
Cash flow adequacy Cash from operations / (long term debt paid +
Purchases of assets)
Long-term debt payment Long term debt payments / Cash from operations
Dividend payout on cash from operations Dividends / Cash from operations
Reinvestment Purchase of assets / Cash from operations
Total debt coverage Total liabilities / Cash from operations

Depreciation – amortization impact Depreciation + Amortization / Cash from

operations
Cash flow to sales
Cash from operations / Sales
Cash flow to net income
Cash from operations / Income from ordinary
operations
Cash flow return on sale
Cash from operations / Total assets
Current cash debt coverage
Cash flows from operations / Total debt
Cash flows from operations to current
liabilities Cash flows from operations / Current liabilities