FINANCIAL STATEMENTS: TOOLS FOR

DECISION MAKING
THE ANALYTICAL PROCESS:
FINANCIAL ANALYSIS – deals with the understanding of the
relationship between financial concepts and daily decision-making.
 Selecting the appropriate tool to use in financial analysis is of
utmost importance in the analytical process.
 Helfert (1994) stated, “Financial analysis is both an analytical and a
judgemental process which help answer questions that have been
carefully posed in a managerial context.”
 An analytical process should always focus on structuring the issue
in its context and manipulating the proper data.
 The end purpose of financial analysis is to help people make sound
decisions and judgments.
 The result is always dependent upon the reliability of the information
gathered and the points of view of people who need the analysis and
not necessarily the one making the analysis.
 Effective financial analysis is more than mere manipulation of
financial data. The analytical process and its results clearly achieve
the desired objectives – financial, economic, or otherwise.
 No matter how complex our business world is, all businesses have a
common goal – profit maximization to increase owners’ wealth and
company value.
 Basic Decisions Areas:
Helfert (1994) identified three basic decision areas that managers
face. These are:
1. Operation;
2. Investment; and
3. Finance.
OPERATION DECISION – deals with the day-to-day
operations/activities
of the firm.
 This includes decisions that are relevant to pricing, selecting markets,
choosing appropriate production processes and technology, outsourcing
payroll, outsourcing maintenance, and janitiorial services, among others.
 It also includes decisions relative to a firm’s operating leverage.
 Operating leverage involves the determination of the profitable
level and the proportion of fixed cost of operation versus the
amount and nature of variable costs (changes with volume)
incurred in manufacturing, trading, and service operations.

 Break-even analysis is used to determine the volume of business a

company needs to reach where the income equals expenses. This
analysis enable the manager to set target sales figures that will
guide the sales personnel in their sales efforts to earn the desired
profit.
INVESTMENT DECISION – refers to deciding what assets to
acquire, be they current assets as marketable securities or non-
current assets as property, plant, or equipment and long-term
investments in stocks and bonds.
 It includes decisions relative to projects to undertake or business to
enter to.
 Current available resources and new funding obtained can be
utilized to fund:
Working Capital – current assets minus current liabilities. Current
assets include cash, receivables, short-term investments, and prepaid
expenses. Current liabilities include interest and salaries palyable,
accounts payable, short-term notes payable, and unearned revenues.
Operating expenses involve expenses for current operations like
salaries, advertising, delivery, rent, maintenance, communications,
among others.
 FINANCING DECISION – refers to decision that involves
funding investments and operations over the long run.
 It includes decisions that relate to the company’s capital structure,
debt-equity mix, funding sources, dividend policies, cost of capital,
among others.
STEPS IN ANALYZING THE FINANCIAL STATEMENTS:
1. Understanding the information provided in the financial
statements:
Any reader of the financial statements, especially the
manager, who is to make decisions to benefit the enterprise,
needs to have a basic knowledge of finance in its contextual
meaning to avoid confusion and misleading or wrong decisions,
which are sometimes, fatal to the business.
2. Drawing logical conclusion based on the data presented:
Generally, comparative financial statements, i.e., financial
statements for two or more periods are necessary before one
can make a decision on how the business is performing or how the
condition of the company is changing.
3. Making the appropriate decision on the course of action to take:
After drawing logical conclusion, the manager or user of
the financial statements is now able to determine yhe course of
action to take to correct what needs correction and the steps
necessary to redirect company efforts toward the goals that the
company has set to achieve.
HORIZONTAL ANALYSIS – refers to comparative analysis of the
financial statements. Financial statements of the current period are
compared with the past period or periods. It reveals trends; hence, it is
also called trend analysis.
Comparative statements show the direction and velocity of
change being taken by a company. Further analysis, however, is
essential to arrive at logical conclusion and, ultimately, at
appropriate and wise decision.
Data for series of years, rather than just the past and current
years, are more useful for arriving at a more logical conclusion and
better judgment.
COMPARATIVE INCOME STATEMENT – shows the changes that
occur in the different elements of the income statement in absolute
money value and percentage of increas/ (decrease) to see if the
performance of the company is improving or not.
COMPARATIVE BALANCE SHEET
VERTICAL ANALYSIS – refers to the type of analysis where one
number is compared to another to identify significant relationships.
There two types of vertical analysis:
1. Common-size statement or percentage analysis – is a type of
ratio analysis that shows the relationship between items in a
single statement, either in the balance sheet or
in the income statement.
- it shows the percentage relationship of an element of the
financial statement to a significant total
amount in the financial statement.
- it refers to the traditional financial statements expressed
in percent.
COMMON SIZE INCOME STATEMENT
COMMON SIZE BALANCE SHEET
FINANCIAL RATIOS
Liquidity Ratios
Liquidity is the ability of assets to be converted quickly into cash.
Ideally, a company wants to be liquid to meet current debts. Balance
sheet has current liabilities for short-term debts, payable for a period of
less than a year; and long term debts, payable for more than a year. It
is assumed that the firm’s inventory will be converted to cash during
the course of a year so that the receipts from the inventory can be used
to service the current debt. Commonly used ratios to measure liquidity
are: current ratio and quick or acid test ratio.
a. Current ratio
The current ratio measures the number of times that the current
liabilities could be paid with the avaialble current asset.
Current asset
Current ratio = Current liabilitieS
b. Acid test ratio
It is similar to the current ratio, except that the inventories
and prepayments are excluded from the numerator
Quick assets
Acid test ratio = Current liabilities
Test of Profitability
Profitability can be measured in absolute peso terms, like net income,
or in terms of ratios. When we express profit as a ratio, we relate
profit to the amount of investment acquired or used in generating
such return.
Income
Return on investment = Investment
Return on sales, or profit margin, measures the amount of income
provided by the average peso sales. The formula is
Income
Return on sales = Net sales
Payback Period
Accumulated
Year Cash inflow Cash Inflow Payback Period
1 13000 13000 1
2 25000 38000 1
3 56000 94000 1
4 10000 104000 0.06
5 2000 106000
6 3000 109000
7 40000 149000
8 11000 160000
9 32000 192000
10 8000 200000
Total 200000 3.06