Analysis and

Interpretation of
Financial Statements
MSEM 506- Applied Accounting and Finance for Engineering Management

Suzette M. Mercado, PIE, ASEAN Engg

 Financial management is the arrangement of funds with an aim to
Financial Analysis and achieve desired objective of the organization in an effective and
Interpretation efficient manner. The main purpose of preparing this report is to
determine the financial position of the company by calculating
various ratios.
In addition to this, impact of legal, political, economic and tax
changes on the financial statements of the company is also
evaluated. Along with this, the other purpose of preparing this
report is to find out the stock market performance of the company.
If management wants to maximize a firm’s value, it must take
advantage of the firm’s strengths and correct its weaknesses.
Financial analysis involves (1) comparing the firm’s performance to
that of other firms in the same industry and (2) evaluating trends in
the firm’s financial position over time. These studies help managers
identify deficiencies and then take corrective actions.
Ratio analysis refers to the analysis and interpretation of the figures
appearing in the financial statements (i.e., Profit and Loss Account,
Balance Sheet and Fund Flow statement etc.).
 It is a process of comparison of one figure against another. It enables the
users like shareholders, investors, creditors, Government, and analysts
etc. to get better understanding of financial statements.
 Ratio analysis is a very powerful analytical tool useful for measuring
performance of an organization. The financial analyst analyze the
accounting ratios to diagnose the financial health of an enterprise.
 Ratio analysis is a technique which involves regrouping of data by
application of arithmetical relationships, though its interpretation is a
complex matter. It requires a fine understanding of the way and the rules
used for preparing financial statements.
 By calculating a small number of ratios it is often possible to build up a
revealing picture of the position and performance of a business. It is not
surprising, therefore, that ratios are widely used by those who have an
interest in businesses and business performance.
Although ratios are not difficult to calculate, they can be difficult to
interpret. It is important to appreciate that they are really only the starting
point for further analysis.
 A ratio is a mathematical number calculated as a reference to
relationship of two or more numbers and can be expressed as a
fraction, proportion, percentage and a number of times.
 When the number is calculated by referring to two accounting
numbers derived from the financial statements, it is termed as
accounting ratio.
 Ratio analysis provides a lot of information which helps the analyst:
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with
the effort in the desired direction;
Objectives of 3. To provide a deeper analysis of the profitability, liquidity,
Ratio Analysis solvency and efficiency levels in the business;
4. To provide information for making cross-sectional analysis by
comparing the performance with the best industry standards;
and
5. To provide information derived from financial statements useful
for making projections and estimates for the future
 Generally, ratio analysis involves four steps:
(i) Collection of relevant accounting data from financial
Procedure for statements.
(ii) Constructing ratios of related accounting figures.
computation (iii) Comparing the ratios thus constructed with the standard ratios
of ratios which may be the corresponding past ratios of the firm or
industry average ratios of the firm or ratios of competitors.
(iv) Interpretation of ratios to arrive at valid conclusions.
  There is no generally accepted list of ratios that can be applied to
Types of the financial statements, nor is there a standard method of
calculating many ratios. However, it is important to be consistent
Financial in the way in which ratios are calculated for comparison purposes.
Ratios  Ratios can be grouped into categories, with each category relating
to a particular aspect of financial performance or position. The
following five broad categories provide a useful basis for
explaining the nature of the financial ratios to be dealt with.

 Profitability Ratio.
 Liquidity Ratio.
 Activity or Efficiency or Asset Management Ratio.
 Financial gearing or Solvency or Debt Management Ratio.
 Investment or Market Value Ratio.
Profit is the primary objective of all businesses. All businesses need a
consistent improvement in profit to survive and prosper. A business
that continually suffers losses cannot survive for a long period.
 Profitability ratios measure the efficiency of management in the
employment of business resources to earn profits.
 These ratios indicate the success or failure of a business enterprise
for a particular period of time.
 Profitability ratios gives an idea of how profitably the firm is
operating and utilizing its assets.
 Profitability ratios are used by almost all the parties connected with
the business.
 A strong profitability position ensures common stockholders a higher
dividend income and appreciation in the value of the common stock
in future. Creditors, financial institutions and preferred stockholders
expect a prompt payment of interest and fixed dividend income if the
business has good profitability position.
 Liquidity ratios measure the adequacy of current and liquid assets and
help evaluate the ability of the business to pay its short-term debts.
 The ability of a business to pay its short-term debts is frequently referred
to as short-term solvency position or liquidity position of the business.
 Generally a business with sufficient current and liquid assets to pay its
current liabilities as and when they become due is considered to have a
strong liquidity position and a businesses with insufficient current and
liquid assets is considered to have weak liquidity position.
 Short-term creditors like suppliers of goods and commercial banks use
liquidity ratios to know whether the business has adequate current and
liquid assets to meet its current obligations.
 Financial institutions hesitate to offer short-term loans to businesses
with weak short-term solvency position.
 Activity ratios (also known as turnover ratios) measure the
efficiency of a firm or company in generating revenues by
converting its production into cash or sales.
 Generally a fast conversion increases revenues and profits.
 Asset management ratios gives an idea of how efficiently the firm
is using its assets.
 Activity ratios show how frequently the assets are converted into
cash or sales and, therefore, are frequently used in conjunction
with liquidity ratios for a deep analysis of liquidity.
 Solvency ratios (also known as long-term solvency ratios) measure
the ability of a business to survive for a long period of time.
 These ratios are very important for stockholders and creditors.
 Gearing ratios tend to highlight the extent to which the business
uses borrowings.
 Solvency ratios are normally used to:
 Analyze the capital structure of the company
 Evaluate the ability of the company to pay interest on long term
borrowings
 Evaluate the ability of the company to repay principal amount of the
long term loans (debentures, bonds, medium and long term loans
etc.).
 Evaluate whether the internal equities (stockholders’ funds) and
external equities (creditors’ funds) are in right proportion
  Certain ratios are concerned with assessing the returns and
performance of shares in a particular business from the
perspective of shareholders who are not involved with the
management of the business.
Investment or Market Value
Ratio.  Market value ratios, which bring in the stock price and gives an
idea of what investors think about the firm and its future
prospects.
 The market value ratios are important for investors, management,
etc as these ratios are used to decide whether the valuation of the
shares are overvalued, undervalued or at par with the market.
These ratios are used for making investment decisions in stocks of
companies.
 The following are the principal advantages of ratio analysis:
(i) Forecasting and Planning
(ii) Budgeting
Advantages of (iii) Measurement of Operating Efficiency

Ratio Analysis (iv) Communication

(v) Control of Performance and Cost
(vi) Inter-firm Comparison
(vii) Aid to Decision-making
 When performing ratio analyses, it is advisable to follow this set of
generally recommended guidelines:
1.Focus on a limited number of significant ratios.
Generally 2.Collect data over a number of past periods to identify the
prevalent trends.
recommended 3.Present results in graphic or tabular form according to standards
guidelines: (e.g. industrial averages).
4.Concentrate on all major variations from the standards.
5.Investigate the causes of these variations by cross-checking with
other ratios and raw financial data.
  Trend analysis involves the collection of information from multiple
time periods and plotting the information on a horizontal line for
further review. The intent of this analysis is to spot actionable
patterns in the presented information.
 Revenue and cost information from a company's income
statements can be arranged on a trend line for multiple reporting
Trend Ratio/ periods and examined for trends and inconsistencies.
 For example, a sudden spike in expense in one period followed by a
Trend Analysis sharp decline in the next period can indicate that an expense was
booked twice in the first month.

 Thus, trend analysis is quite useful for examining preliminary

financial statements for inaccuracies, to see if adjustments should
be made before the statements are released for general use.
 When used internally (the revenue and cost analysis function), trend
analysis is one of the most useful management tools available.
The following are examples of this type of usage:
1. Examine revenue patterns to see if sales are declining for
certain products, customers, or sales regions.
Uses of Trend 2. Examine expense report claims for evidence of fraudulent
Analysis claims.
3. Examine expense line items to see if there are any unusual
expenditure in a reporting period that require additional
investigation.
4. Extend revenue and expense line items into the future for
budgeting purposes, to estimate future results
  One year is taken as a base year. Generally, the first or the last is
taken as base year.
Procedure for  The figures of base year are taken as 100.
Calculating  Trend percentages are calculated in relation to base year. If a
figure in other year is less than the figure in base year the trend
Trends percentage will be less than 100 and it will be more than 100 if
figure is more than base year figure. Each year’s figure is divided
by the base year’s figure.
  Attempts have been made in the past to modify these ratios as
corporate measurement metrics.
 Kaplan and Norton24 suggest a new set of corporate
measurement metrics, the balanced scorecard, to cover four
areas:
Balanced (a) financial—shareholder value;

Scorecard (b) customers—time, quality, performance and service, and

cost;
(c) internal business processes—core competencies and
responsiveness to customer needs; and
(d) innovation and corporate learning—value added to the
customer, new products, and continuous refinement.
 The balanced scorecard (BSC) is a strategic planning and
management system. Organizations use BSCs to:

Balanced  Communicate what they are trying to accomplish

 Align the day-to-day work that everyone is doing with strategy
Scorecard
 Prioritize projects, products, and services
 Measure and monitor progress towards strategic targets
 The BSC suggests that we examine an organization from four
Balanced different perspectives to help develop objectives, measures (KPIs),
Scorecard targets, and initiatives relative to those views.

1. Financial (or Stewardship): views an organization’s financial

performance and the use of financial resources
2. Customer/Stakeholder: views organizational performance from
the perspective of the customer or key stakeholders the
organization is designed to serve
3. Internal Process: views the quality and efficiency of an
organization’s performance related to the product, services, or
other key business processes
4. Organizational Capacity (or Learning & Growth): views human
capital, infrastructure, technology, culture, and other capacities
that are key to breakthrough performance
 Ratios are a powerful tool in the interpretation of the accounts and can
discover issues and problems not immediately evident from the accounts
and financial information provided in the annual report.
They can provide the basis for inter-firm comparisons allowing managers to
benchmark the performance and efficiency of the firm against its
competitors.
Trends can then be examined and analyzed.
To Sum up… Stakeholders may use ratios to support their decision making. Employees,
for example may use profit ratios to support pay claims and creditors can
use liquidity ratios to evaluate whether debts will be repaid.
Both trend analysis and ratio analysis are done to assess the profitability
and performance of businesses. Irrespective of the size and scale of
businesses, these analyses can help organizations have an insight into their
business performance over a specified period of time. The ratio analysis is
often used to calculate the trends and that is why trend and ratio analyses
are connected to each other.
  Choose one (1) type of Ratio Analysis
 Discuss the different ratio involve (Show computations)
 Provide a sample of financial report to be used for the analysis and
interpretation of each ratio.
Activity: Report on:
Report on 

Profitability – joseph, juan carlos, topher
Liquidity – Ibanez. pascua
Ratio Analysis  Asset management – Ronald, john paul
 Solvency –celso, rimar
 Market value –zeus, shairra
 Trend ratio analysis –arbel, trend
 Balanced Scorecard- ian, aeron paul