CHAPTER 2

Review of Financial
Statement Preparation,
Analysis, and
Interpretation
Objectives:
1. Know the information found in the different
financial statements.
2. Be familiar with the preparation of financial
statements.
3. Determine the quality of earnings of a
company.
4. Know how to compute different financial ratios
such as liquidity, leverage, efficiency or turnover,
and profitability ratios.
5. Know how to use horizontal and vertical
analysis in analyzing a company.
6. Apply the different financial statement analysis
tools in assessing the financial position and
operating performance of a company.
Basic Financial Statements
1. Statement of Financial Position
or Balance Sheet
The statement of financial position is the new name
that the International Accounting Standards Board (IASB)2
suggested for the “balance sheet” since 2009 to better reflect
the kind of information found in the financial report. This
financial report provides information regarding the liquidity
position and capital structure of a company as of a given date.
It must be noted that the information found in this report are
only true as of a given date.
Liquidity refers to the ability of a company to pay
maturing obligations. The current assets of a company are
compared with its current liabilities to determine its paying
capacity. Generally, assets which are expected to be
converted to cash within one year such as accounts receivable
and inventories are classified as current assets. Liabilities
which are expected to be settled or paid within one year are
classified as current liabilities.
Capital structure provides information regarding the
2. Statement of Profit or Loss or Income
Statement
The statement of profit or loss or otherwise known as
income statement provides information regarding the
revenues or sales, expenses, and net income of a company
over a given accounting period. This accounting period may
be for a month, a quarter, or a year. The income reported by
a company is not that useful if the accounting period is not
stated. In analyzing earnings performance, a comparison
with the previous periods and with other companies,
especially those coming from the same industry, is a must.
Such comparison will not be made possible without knowing
the accounting periods covered in the statement of profit or
loss. In analyzing statement of profit or loss, it is important
to identify how much of the income comes from core
business and how much comes from the non-core business.
Core business refers to the main business of a company.
3. Statement of Cash Flows
The statement of cash flows provides an explanation
regarding the change in cash balance from one accounting
period to another. The cash flows are also classified into
three main categories: operating, investing, and financing
The statement of cash flows is a very important
financial statement because it provides information
regarding the quality of earnings of a company as shown in
the cash flows from operating activities. In this section, the
income reported from the statement of profit or loss which is
based on accrual principle is converted to cash. This is a
very important piece of information found in this financial
report because a company may have so much reported
income, but if such income is not translated into cash, then
that income is useless. One cannot use net income to pay
debt or to pay salaries of employees. Cash is needed.
 The cash flows from investing activities provide information
regarding the future direction of the company. This section shows
how much investment the company is making over a given
accounting period. Expansion allows companies to grow. Note,
however, that expansions or investments are not always good
especially when management has undertaken them too
aggressively and are also financed aggressively.
To find out if a company, which is undergoing expansion,
will potentially encounter liquidity problems in the future, an
examination of the third section of the statement of cash flows
has to be made. The cash flows from financing activities provide
information whether there is a proper matching of investing and
financing activities. An expansion which will take a longer period
of time to realize the benefits warrant a more patient source of
financing such as equity. If loan is to be incurred to partially
finance this kind of expansion, the tenor of the loan has to be
studied properly and a reasonable amount of equity must also be
provided to minimize the probability of liquidity problems in the
future.
4. Statement of Changes in
Stockholder’s Equity
This financial statement provides information
that explains the changes in the stockholder’s
equity account from one accounting period to
another. The changes may be due to the following:
1. Profit or loss for the accounting period
2. Cash dividend declaration
3. Issuance of new shares of stocks
4. Other transactions that affect the
stockholder’s equity such as other comprehensive
income, treasury stocks, and revaluation of assets.3
Notes to Financial Statements
The notes to financial statements are integral part of the financial
statements. Among the additional information that the notes to financial
statements provide are the following:
1. Brief description of the company. Information may include the
nature of business of the company and the owners behind the company.
2. Summary of significant accounting policies. This is very important
because the existing generally accepted accounting principles provide
alternative accounting policies to companies. It is therefore important to
find out what specific accounting policies are used by the company.
3. Breakdown of amounts found in the financial statements. The
company’s property, plant, and equipment (PPE) account may have too
many components. Putting all the details on the face of the balance sheet
may make the balance sheet too long. An alternative presentation is to
provide a single amount on the face of the balance sheet for PPE but the
breakdown of PPE can be presented in the notes to financial statements.
This breakdown may be provided for other financial statements
accounts such as account receivable, inventories, loans, operating
expenses, among others.
Review of the Financial
Statement Preparation
1. Analyzing business transactions
In this step, a transaction is analyzed to find out if it affects
the company and if it needs to be recorded. Personal transactions
of the owners and managers that do not affect the company should
not be recorded. In this step, a decision may have to be made to
identify if a transaction needs to be recorded in special journals
such as sales journals or purchases journals.
2. Recording in the journals
Once a transaction is identified and analyzed, the next step is
the preparation of the journal entry. For repetitive transactions,
special journals are made. These special journals include sales
journal, purchases journal, cash receipts journal, and cash
disbursements journal. Transactions which do not fall under any of
these four may be recorded in general journal.
The source documents which will serve as the basis for
recording must be examined. Official receipts may be needed to
support a recording in the cash receipts journal.
3. Posting to ledger accounts
After transactions have been recorded in the
journals, the next step is posting the transactions
to the ledgers. Ledgers provide chronological
details as to how transactions affect individual
accounts. There are two types of ledgers: the
general ledger and the subsidiary ledger. The
general ledger is a summary of the different
subsidiary ledgers and can serve as a control
account.
Posting in the subsidiary ledgers can be done
anytime and the balances are summarized at the
end of an accounting period. Posting in the general
ledger is done at the end of an accounting period.
4. Preparing the unadjusted
trial balance
At the end of each accounting period,
unadjusted trial balance is prepared from the
financial statement account balances found in
the general ledgers. Accounts with debit
balances and credit balances are then added.
The sum for the debit balances must exactly
equal that of the credit balances. If there are
discrepancies, steps have to be taken to identify
the sources of discrepancies. Possible sources of
discrepancies can erroneous posting and
additions or improper recording of a transaction.
5. Making the adjusting
entries
Once the unadjusted trial balance is prepared, adjusting
entries are then prepared to account for the following, among
others:
a. Accruals. These include unpaid salaries for the accounting
period, unpaid interest expense, or unpaid utility expense.
b. Prepayments. If a company has prepaid expenses such as
prepaid rent or prepaid insurance, then the correct balances for
these accounts have to be established at the end of each accounting
period to reflect their correct balances.
c. Depreciation and amortization expenses. Depreciation
expenses are recognized at the end of each accounting period
through adjusting entries. If there are intangible assets such as
franchise, the allocation of their costs which is called amortization
expense, is also recognized at the end of each accounting period
through adjusting entries.
d. Allowance for uncollectible accounts. Bad debt expense from
account receivable is also recognized through adjusting entries.
6. Preparing the adjusted trial balance
An adjusted trial balance is prepared after
taking into consideration the effects of the
adjusting entries. Again, this is to ensure that the
total debit balances equal the credit balances.

7. Preparing the financial statements

Once the adjusted trial balance is available,
the financial statements can then be prepared.
These are the statement of financial position,
statement of profit or loss, and the statement of
cash flows.
8. Making the closing entries
Income statement accounts such as revenues
and expenses are closed to prepare the system for
the next accounting period. These income statement
accounts are closed to the retained earnings. If the
revenues exceed expenses during accounting
period, retained earnings will increase. The reverse
is true which means that if the expenses exceed
revenues, the retained earnings will decrease.

9. Post-closing trial balance

The post-closing trial balance is prepared to
test if the debit balances are equal the credit
balances after closing entries are considered. This is
to ensure that the accounting system is working.
Financial Statement Analysis
There are different users of financial
statements. Financial statement analysis can be used
by managers, equity investors, creditors, regulators,
labor unions, employees, the public, and potential
investors and creditors. Financial statement analysis
is used for investment and credit decisions. It is also
used for regulating companies such as what the
Energy Regulator Commission does for power
distribution companies and other energy companies.
Financial statement analysis is definitely used
by management for monitoring performance and for
identifying strategies to further improve the
company’s operations.
For this chapter, the following
financial ratios will be
discussed:
1. Profitability Ratios
2. Efficiency Ratios
3. Liquidity Ratios
4. Leverage Ratios
Vertical and horizontal analysis will
also be discussed. How to evaluate the
quality of earnings a company shall
likewise be discussed in this chapter.
Profitability Ratios
The following ratios are used to
measure the profitability of a
company:
1. Return on equity (ROE)
2. Return on assets (ROA)
3. Gross profit margin
4. Operating profit margin
5. Net profit margin
Return on Equity (ROE)
ROE is a profitability measure that should be of
interest to stock market investors. It measures the
amount of net income earned in relation to
stockholder’s equity. ROE is computed as follows:
ROE = Net Income/ Stockholder’s Equity
In computing ROE, different approaches are
observed. There are analysts who use the average of
the stockholder’s equity for two accounting periods
while others simply use the year- end balances.
Whichever formula is used, consistency must be
applied.

Refer to Exhibits 2.1 to 2.3 for our illustrative examples

 Exhibit 2.1: JSC Foods
Corporation
Statement of Profit or Loss
For the Years Ending December 31, 2010- 2014
2014 2013 2012 2011 2010
52, 501, 47, 345, 42, 174, 38, 340, 35, 336,
Net Sales
085 223 283 257 643
Cost of 41, 954, 37, 988, 33, 980, 31, 439, 29, 329,
Sales 730 628 174 011 413
10, 546,
Gross Profit 9, 356, 595 8, 194, 109 6, 901, 246 6, 007, 229
355
Operating
6, 497, 659 6, 196, 804 5, 393, 621 4, 926, 723 4, 505, 422
Expenses
Operating
4, 048, 696 3, 159, 791 2, 800, 488 1, 974, 523 1, 501, 807
Income
Interest
250, 000 250, 000 250, 000 450, 000 300, 000
Expense
Income
1, 524,
before 3, 798, 696 2, 909, 791 2, 550, 488 1, 201, 807
523
 Exhibit 2.2: JSC Foods
Corporation
Statement of Financial Position
December 31, 2010- 2014
2014 2013 2012 2011 2010
Assets
Current Assets
1, 062,
Cash 996, 904 777, 415 766, 805 883, 416
527
2, 300, 1, 921, 1, 722, 1, 454, 1, 396,
Trade Receivables
500 799 513 426 639
4, 849, 4, 499, 3, 797, 3, 293, 3, 351,
Inventories
304 998 668 030 933
1, 050,
Other Current Assets 983, 746 984, 786 735, 608 998, 763
000
9, 262, 8, 402, 7, 282, 6, 249, 6, 630,
331 447 382 869 751
Noncurrent Assets
Property, Plant, 12, 200, 11, 300, 9, 050, 9, 350, 9, 500,
Equipment, Net 000 000 000 000 000
Other Noncurrent
835, 689 925, 681 896, 842 876, 235 827, 490
Assets
 Liabilities and Equity

Current Liabilities
Trade Payables 5, 050, 4, 746, 4, 137, 3, 298, 2, 874,
Total 12, 478, 11, 819,
810 11, 782,
252 9,815
997, 276 699
8, 930, 911
Stockholde 559
Income Taxes Payable
472
433, 051 618 705
283, 267, 801 110 115, 330
149, 441
r’s Equity
Total Portion22,
Current 298,
of Long-term 20, 628,
2, 250, 17, 229,
2, 500, 1,16, 476, 2, 000,
000, 16, 958,
2, 000,
Liabilities Debt
020 128 000 224 000 104000 241
000 000
and
Stockholde
Other Current Liabilities 85, 600 28, 700 40, 990 30, 688 37, 890
r’s Equity
7, 819, 7, 558, 5, 446, 5, 478, 5, 028,
461 657 606 828 131
Noncurrent Liabilities

Long-term Debt, Net of 2, 000, 1, 250, 1, 000, 3, 000,

Current Portion 000 000 000 000

Total Liabilities 9, 819, 8, 808, 5, 446, 5, 478, 8, 028,

461 657 606 828 131
Stockholder’s Equity

Capital Stock 8, 000, 8, 000, 8, 000, 8, 000, 8, 000,

000 000 000 000 000
 Exhibit 2.3: JSC Foods Corporation
Statement of Cash Flows
For the Years Ending December 31, 2011, 2014
2014 2013 2012 2011

Cash Flows from Operating Activities

Income before taxes 3 798 2 909 2 550 1 524

696 791 488 523
Adjustments:

Depreciation 2 600 2 250 1 000 1 650

000 000 000 000
Changes in following accounts

Decrease (increase) in Accounts Receivable (378 (199 (268 087) (57 787)
701) 286)
Decrease (increase) in Inventories (349 (702 (504 638) 58 903
306) 330)
Decrease (increase) in Other Current Assets (66 254) 1 040 (249 178) 263 155

Increase (decrease) in Accounts Payable 304 558 608 437 839 116 423 788

Increase (decrease) in Other Current Liabilities 56 900 (12 290) 10 302 (7 202)

Income Taxes Paid (990 (857 (646 787) (423 246)

262) 034)
Cash Flows from
Financing Activities
Acquisitions of PPE (3 500 (4 500 (1 500 (1 500
00) 000) 000) 000)
Acquisition of Other 89 992 (28 839) (20 607) (48 745)
Noncurrent Assets
Cash Flows from (3 410 (4 528 (1 520 (1 548
Investing Activities 008) 839) 607) 745)

Cash Flows from

Financing Activities
Payment of Cash (2 000 (2 000
Dividends 000) 000)
Loans, Net of 500 000 2 750 000 (2 000 (2 000
Payments 000) 000)
Cash Flows from (1 500 750 000 (2 000 (2 000
Financing Activities 000) 000) 000)
Net Change in Cash 65 623 219 489 10 609 (116 611)
Cash, Beginning 996 904 777 415 766 805 883 416
Cash, Ending 1 062 527 996 904 777 415 766 805
ROE= ( Net Income/Stockholder’s
Equity) X 100%
ROE= (2 659 087/12 478 559) x 100%
ROE= 21.31%

The ROE of 21.31% means that for every ₱1 of

stockholder’s equity, ₱0.2131or ₵21.31 was earned in
2014. To be more meaningful, this rate of return is
compared with the returns on alternative investments
such as the returns on time deposits and other fixed
income instruments. For example, if the interest on time
deposits is only 2%, then the 21.31% ROE seems better.
However, before a conclusion is made that the 21.31%
ROE is better than time deposit rate of 2%, the risks
associated with this company earning 21.31% have to
be assessed.
 Unless a bank will experience a bank
run, the 2% time deposit rate is guaranteed
while the 21.31% ROE is not. In 2014, ROE
of JSC Foods was high, but what if
previously, it earned negative ROE? Is this
possible for a company? No manager of any
company who is in his sound will guarantee
a specific rate of return, especially when
that rate is relatively high. Why? Because in
business , there are always risk. A company
which is doing so well this year may find
itself with too many competitors in the
future and these competitors may eat its
share of the business in the market and can
make a profitable company today and a
Return on Assets (ROA)
Return on assets measures the ability of a company
to generate income out of its resources. Below is the
formula for computing ROA:
ROA = (Operating Income/Total Assets) x 100%
This ratio can be useful in making investment
decisions. For example, if a company hs an opportunity
to expand and is not sure how to finance the expansion,
the ROA can be used in making a decision. If the
borrowing rate is greater than ROA, then it does not
make sense to borrow for expansion. However, if the
expected ROA with the expansion is greater thsn the
borrowing rate, then management may consider
borrowing to finance expansion.
 It must be noted at this point that this
comparison of borrowing cost and ROA is not
the only factor considered in expansion.
There are other factors which will be
considered in subsequent chapters.
To illustrate , refer to Exhibits 2.1 and
2.2 and let us compute JSC’s ROA for 2014.
ROA = (4 048 696/22
298 020) x 100%
ROA = 18.16%
The 18.16% ROA means that in 2014,
JSC Foods Corporation generated ₵ 18.16 for
every ₱ 1.00 of asset in the company.
 Gross Profit Margin
Gross Profit Margin = (Gross Profit/Sales) x 100%
Gross profit margin is a profitability ratio that measures the
ability of a company to cover its cost of goods sold from its
sales. To illustrate, let us compute the gross profit margin of JSC
Foods Corp. in 2014.
Gross Profit Margin = (10 546 355/52 501 085) x 100%
Gross Profit Margin = 20.09%
This ratio means that for every ₱ 1.00 of sale the
company generates ₵ 20.09 in gross profit. Companies
in a very competitive industry have to watch out for
this gross profit margin because stiff competition can
substantially bring down this margin.
 If the manager of the company wants to
improve its gross profit margin, two things can be
done:
1. Raise prices.
2. Find ways to bring down production cost. For
trading or merchandising companies, find a
supplier which can sell finished goods to the
company at low prices.
Both approaches are not easy to do. Raising
prices is possible if your company is the only seller
or provider of this product in the area. If there are
many sellers, however, raising prices can make
your products appear relatively more expensive and
buyers may go to companies who offer their
products at cheaper price.
 The second approach which is to bring
down production costs may not be also be
easy to achieve because this may require
investment in technology. It may also
require identifying cheaper sources of rw
materials. Trying to make the production
mpre efficient can also help. For example,
similar products have to be produced in
batches to save manufacturing overhead
cost.
 Operating Profit Margin and Net Profit Margin:

Operating profit margin measures

the amount of income generated from
the core business of a company. It is
computed as the difference between
revenues and the sum of cost of
revenues or sales and operating
expense. The formula for computing
operating profit margin ratio is:
Operating Profit Margin = (Operating
Income/Sales) x 100%
 Operating profit margin measures the ability
of the company to generate income from its core
business or main operation. In the case of our
illustrative example, JSC Foods Corp., you want to
find out how much income does tis company
generate from its food business. Below is the
computation of JSC’s operating profit margin.
Operating Profit Margin = (4 048 696/52 501 085) x 100%
Operating Profit Margin = 7.71%
The 7.71% operating profit margin means that
₱ 1.00 sales or revenues the JSC Food Corp.
generated in 2014, the company earned ₵ 7.71
after deducting cost of sales and operating
expenses. This amount is before the effects of
income taxes.
 Net Profit Margin
Net profit margin measures how
much net profit of a company
generates for every peso of sales or
revenues that it generates. The formula
for computing net profit margin is:
Net Profit Margin = (Net Income/Sales) x
100%
Net income is the amount left after
all expenses including income taxes are
deducted form sales or revenues.
 To illustrate, let us compute the
net profit margin of JSC Foods
Corporation in 2014.
Net Profit Margin = (2 659 087/52 501 085)
x 100%
Net Profit Margin = 5.06%
In 2014, JSC Foods Corp. earned ₵
5.06 for every ₱ 1.00 of revenues
generated.
 An analyst of statement of profit or loss
should compare the operating profit margin and
the net profit margin. A company can have a high
operating profit margin but may end up with low
or even a negative net profit margin if the
company is heavily indebted. This situation was
observed with many local cement companies
after the 1997 Asian financial crisis where cement
companies reported positive operating profit
margins but reported negative net profit margins.
This situation indicates that the core business is
good but the financing may not be appropriate
because the cement companies relied too much
on borrowed funds to finance their expansion
before the 1997 Asian financial crisis.
 It is also important to note if the
net profit used in computing the ratio
is substantially due to core operations
or the main business of the company
or is it due to some nonrecurring
transactions. An example of a
nonrecurring transaction is gain from
the sale of an equipment where the
company is not in the business of
selling equipment.
 Liquidity Ratios
Liquidity ratios measure the ability of a
company to pay maturing obligations form its
current assets. Two commonly used liquidity
ratios are the current ratio and the acid-test
ratio or sometimes called quick asset ratio.
Current Ratio
Formula:
Current Ratio = Current Assets/Current Liabilities
Current assets include cash and other
assets which are expected to be converted to
cash within 12 months such as accounts
receivable and inventories.
Current assets also include prepayments
such as prepaid rent and prepaid
insurance.
Current liabilities include obligations
that are expected to be settled or paid
within 12 months. These include accounts
payable, accrued expenses payable such
as accrued salaries, and current portion of
long-term debt. Current portion of long-
term debt is the principal amount of a
long-term loan expected to be paid within
the next 12 months from the balance
sheet date.
To illustrate, let us compute the current
ratio of JSC Foods Corporation in 2014.
Current Ratio = Current Assets/Current
Liabilities
Current Ratio = 9 262 331/7 819 461
Current Ratio = 1.18
The current ratio of 1.18 means
that for every ₱ 1.00 of current
liabilities that JSC Foods Corporation
has, it has ₱ 1.18 current assets as of
December 31, 2014.
 A high current ratio provides comfort that a
company will be able to pay obligations on time,
but does not guarantee that no liquidity
problems or payment problems will arise. The
ability of a company to pay on time also depends
on the quality of receivables and inventories. For
example, a company with a current ratio of 2.5
may end up having difficulty paying on time.
Perhaps, it is because the accounts receivable
takes 90 days, on the average, to be collected.
Or, its inventories take months to be sold.
In evaluating liquidity ratios such as current
ratio, attention must also be made on the quality
of other current assets which will be covered in
the discussion of turnover of efficiency ratios.
 Acid-Test or Quick Asset Ratio
Quick Asset Ratio = (Cash + Current Accounts
Receivable + Short-term Marketable Securities) /
Current Liabilities
The quick asset ratio is a stricter measure of a
company’s liquidity position. There are some
textbooks which compute quick assets as current
assets less inventories. With this definition, quick
asset ratio can also be computed as follows:
Quick Asset Ratio = (Current Assets – Inventories) /
Current Liabilities
Note that the first formula is a stricter measure of
quick asset ratio.
 Common to both current ratio and the
quick asset ratio is the accounts receivable.
The real test of a company’s ability to meet its
maturing obligations largely depends on the
quality of its receivables. Even if a company
has a high quick asset ratio, a company is not
assured that no liquidity problems will arise if
the collection of accounts receivable takes too
long.
To illustrate, let us compute the quick
asset ratio of JSC Foods Corporation in 2014.
Quick Asset Ratio = (1 062 527 + 2 300 500) /
7 819 461
Quick Asset Ratio = 0.43
 This ratio means that for every ₱
1.00 current liability, it has ₵ 0.43
quick assets. Is this something to be
alarmed about? The answer depends
on the quality of accounts receivable
which can be determined by its
collection period.
 Leverage Ratios
Leverage ratios show the capital
structure of a company, that is, how much
of the total assets of a company is financed
by debt and how much is financed by
stockholders’ equity. Leverage ratios can
also be used to measure the company’s
ability to meet long-term obligations.
A question may be raised as to what an
appropriate capital structure is, that is,
combination of debt and equity, for a
company.
The capital structure of a company is influence
by the following factors:
1. Nature of business. If a company is in a risky
business and operating cash flows are
uncertain like mining operations, it has to be
more conservatively financed. Conservative
financing means there should be more
stockholders’ equity. If the business is
characterized by stable operating flows like
what is true for SM malls where cash flows
from rent are almost certain, then a more
aggressive capital structure can be considered.
Stable operating cash flows allow the
company to pay periodic debt amortizations.
2. Stage of business development. A company
which is just starting its operations may encounter
difficulties borrowing from banks. Banks generally
look for the historical performance of a company in
making decisions regarding loan applications. A
new company does not have that historical record.
From the stockholders’ point of view, it is also not
good to start an operation with borrowed funds.
What if the business fails? When a company has
already established its foothold in its market and
there are opportunities to expand, then that may
be a good opportunity to partially use borrowed
funds to finance an expansion. By this time,
management should have been more familiar with
the business and can anticipate possible problems.
3. Macroeconomic conditions. If
macroeconomic conditions are good as
measured by gross domestic product (GDP) and
this trend is expected to continue in the
foreseeable future, then management can take
a more aggressive stance in financing the
company’s operations to take advantage of the
opportunities.

4. Prospects of the industry and expected

growth rates. If the industry where the
company operates has good prospects and
growth rates are expected to be high,
management can consider borrowing to expand
operations. Otherwise, if the prospects are
bleak, it is better to have low debt ratios.
5. Bond and stock market conditions. The ability of
a company to raise more funds from the stock
market and the bond market also depends on how
bullish players are in these markets. Of both
markets are doing well just like what the Philippines
have been experiencing over the last couple of
years where its stock market and bond market are
both expanding, then it is a good opportunity for
the publicly listed companies and even those which
are not listed to tap both markets. Big companies
such as PLDT tapped the bond market in 2014 for
additional financing. In 2015, conglomerates such
as Ayala Corporation ( the conglomerate behind
companies like BPI and Globe Telecom) and Metro
Pacific Investments Corporation ( the conglomerate
behind Maynilad Water Corporation, North Luzon
Expressway, and hospitals like Makati Medical
6. Financial Flexibility. Financial flexibility
refers to the ability of a company to raise
funds, be it the stock market or the bond
market, when the need for cash arises.
Companies which have low leverage
ratios have more financial flexibility as
compared to companies which have
higher leverage ratios.
7. Regulatory environment. There are
operations which are heavily regulated
such as banks which are monitored by
the Bangko Sentral ng Pilipinas (BSP).
Banks, as required by BSP, have to
8. Taxes. Interest expense provides tax
shield while cash dividend does not provide
tax shield. Interest expenses are allowed to
b deducted from operating income to
compute taxable income. Therefore,
interest expenses reduce tax payments.
Cash dividends are not allowed to be
deducted from the operating income in
computing taxable income. Hence, there
are no tax shields from cash dividend
payments.
9. Management Style. Some managers are
aggressive and some are conservative.
Management style definitely contributes to
Leverage Ratios
1. Debt Ratio
2. Debt to equity ratio
3. Interest coverage ratio
Debt Ratio
Debt ratio measures how much of the
total assets are financed by liabilities. Below is
the formula for debt ratio:
Debt Ratio = Total Liabilities/ Total Assets
Les us compute the debt ratio of JSC Foods
Corporation in 2014.
Debt Ratio = 9 819 461/ 22 298 020
Debt Ratio = 0.44
The debt ratio of less than 0.50 means
that the company has less liabilities as
compared to its’ stockholders equity. If the debt
ratio is 0.50, this means that the amount of
Debt to Equity Ratio
Debt to equity ratio is a variation of the
debt ratio. A debt to equity ratio of more than
one means that a company has more liabilities
as compared to stockholder’s equity. The
formula for the debt to equity ratio is shown
below:
Debt to Equity Ratio = Total Liabilities/
Total Stockholder’s Equity
Shown below is the computation of debt to
equity ratio for JSC Foods Corporation in 2014.
Debt to Equity Ratio = 9 819 461/ 12 478
559
Debt to Equity Ratio = 0.79
 Interest Coverage Ratio
Interest coverage ratio provides information if a
company has enough operating income to cover
interest expense. Below is the formula for interest
coverage ratio.
Interest Coverage Ratio = EBIT/ Interest Expense
EBIT stands for earnings before interest and
taxes. Let us compute the interest coverage ratio of
JSC Foods Corporation in 2014.
Interest Coverage Ratio = 4 048 696/ 250 000
Interest Coverage Ratio = 16. 19
The interest coverage ratio of 16.19 means that
JSC Foods Corporation has more than enough
operating income or earnings before interest and taxes
to cover its interest expense. It has EBIT which is a
little more than 16 times its interest expense in 2014.
Effi ciency Ratios or
Turnover Ratios
Efficiency ratios, otherwise known as
turnover ratios, are called as such because they
measure the management’s efficiency in
utilizing the assets of the company.
The following efficiency ratios are:
1. Total asset turnover ratio
2. Fixed asset turnover ratio
3. Accounts receivable turnover ratio
4. Inventory turnover ratio
5. Accounts payable turnover ratio
From the accounts receivable turnover ratio,
inventory turnover ratio, and accounts payable
turnover ratio, operating cycle and cash
 Total Asset Turnover Ratio
Total asset turnover ratio measures the
company’s ability to generate revenues for every peso
of asset invested. It is an indicator of how productive
the company is in utilizing its resources.
Asset Turnover Ratio = Sales / Total Assets
To compute the asset ratio of JSC Foods
Corporation in 2014.
Asset Turnover Ratio = 52 501 085 / 22 298 020
Asset Turnover Ratio = 2.35
The asset turnover ration of 2.35 mens that for
every ₱ 1.00 of asset JSC Foods Corporation has
in 2014, it is able to generate sales of ₱ 2.35
In computing asset turnover ratio, ending
balances for total assets or the average of total
assets for the accounting period can be used.
 Fixed Asset Turnover Ratio
If company is heavily invested in property, plant,
and equipment (PPE) or fixed assets, it pays to know
hoe efficient the management of these assets is. This
can be applied to companies which are characterized
by high PPE such as utility companies, like telecom
companies, power generation and distribution
companies, and water distribution companies. It can
also be applied to manufacturing companies.
Fixed Asset Turnover Ratio = Sales / PPE
To compute the fixed asset turnover for JSC Foods
Corporation in 2014.
Fixed Asset Turnover Ratio = 52 501 085 / 12 200 000
Fixed Asset Turnover Ratio = 4.30
In 2014, JSC Foods Corporation was able to
generate ₱ 4.30 for every ₱ 1.00 of PPE that it
 Ending balance of PPE or average PPE for the
accounting period can be used. Consistency, however,
must be applied in the application of the formula.

Accounts Receivable
Turnover Ratio
Accounts receivable turnover ratio mesures the
efficiency by which accounts receivables are managed.
A high accounts receivable turnover ratio means
efficient management or receivables.
Accounts Receivable Turnover Ratio = Sales / Accounts
Receivable
If there are different types of receivables,
consider only the trade account receivable. These are
the accounts receivable created in the ordinary course
of business. Also, if there are allowances for doubtful
accounts, use the gross amount of trade accounts
 Some analysts use average accounts receivable,
instead of the ending accounts receivable. Whichever
approach is used, consistency must be applied.
To compute the accounts receivable turnover
ratio for JSC Foods Corporation in 2014
Accounts Receivable Turnover Ratio = 52 501 085 / 2
300 500
Accounts Receivable Turnover Ratio = 22.82
The accounts receivable turnover ratio becomes
more meaningful when converted to days’ receivable
or average collection period. In our illustrative
example, this 22.82 accounts receivable turnover ratio
can be converted to days by dividing 360 days (if
information is based on annual data and use 90 days if
based on quarterly data) by the accounts receivable
turnover ratio.
 In 2014, JSC Foods Corporation had an average of
16 days collecting its accounts receivable. This means
that from the day the sale was made, it took the
company 16 days, on the average, to collect its
Inventory Turnover Ratio
accounts receivable.

Inventory turnover ratio measures the

company’s efficiency in managing its inventories.
Trading and manufacturing companies and companies
that are dealing with highly perishable products and
those that are prone to technological obsolescence
must pay attention to this ratio to minimize losses.
The formula for computing inventory turnover ratio is:
Inventory Turnover Ratio = Cost of Sales /
Inventories
Just like the computation of accounts receivable
turnover ratio, either ending balance of the inventories
 For manufacturing companies that may have
three types of inventories – finished goods, work in
process, and raw materials inventories – all must be
included in the computation. This is to measure the
company’s level of efficiency in managing this
account.
This is the computation of the inventory turnover ratio
of JSC Foods Corporation in 2014.
Inventory Turnover Ratio = 41 954 730 / 4 849 304
Inventory Turnover Ratio = 8.65
The inventory turnover ratio becomes more
meaningful when converted to days’ inventories. To
convert, simply divide 360 days by the inventory
turnover ratio if annual data are used. Otherwise, use
90 days if quarterly data are used.
Days’ Inventories = 360 / Inventory Turnover Ratio
 This 42 days’ inventories means that in 2014,
JSC Foods Corporation took 42 days, on the average, to
sell its inventories from the time they were bought.
Accounts Payable
The accounts payable turnover ratio provides
Turnover
information Ratio
regarding the rate by which trade payables
are paid. Any operating company will prefer to have a
longer payment period for its accounts payable but
this should be done only with the concurrence of the
suppliers.
Accounts Payable Turnover Ratio = Cost of Sales /
Trade Accounts
Payable
The accounts payable turnover ratio of JSC Foods
Corporation in 2014 is 8.31 computed as follows:
Accounts Payable Turnover Ratio = 41 954 730 / 5 050
 Ideally, purchases should have been the
numerator in the formula, but this amount is not
readily available in the income statement. A close
substitute for puechases is the cost of sales or
sometimes called cost of goods sold. Purchases are
definitely a function of sales and cost of sales is
afunction of sales. Given this line of reasoning, cost of
sales can be a very good substitute for purchases.
From the accounts payable turnover ratio, days’
payable in 2014 is 43.32 days or 43 days.
Days’ Payable = 360 / Accounts Payable Turnover Ratio
Days’ Payable = 43.32 or 43 days
This number suggests that in 2014, the average
payment period of the company for its trade accounts
payable was 43 days.
 Operating Cycle and Cash Conversion Cycle
By adding the average collection period and
days’ inventories, the operating cycle can be
computed. This operating cycle covers the period from
the time the merchandise is bought to the time the
proceeds from the sale are collected. Managers of
companies will prefer to have a short operating cycle
as compared to a long one.
In 2014, JSC Foods Corporation had an operating cycle
of 58 days computed as follows:
Operating Cycle = Days’ Inventories + Days’
Receivable
Operating Cycle = 42 + 16
Operating Cycle = 58 days
 When JSC Foods Corporation bought the
merchandise, did it already pay the merchandise
bought? Chances are the company was given credit
terms. As our days’ payable suggest, payment to
suppliers average 43 days in 2014. If we are
interested to find out how long it takes the company to
collect receivables from the time the cost of the
merchandise sold was actually paid, a cash conversion
cycle or sometimes called net trade cycle can be
computed. The formula is:
Cash Conversion Cycle = Operating Cycle – Days’
Payable
For JSC Food Corporation, its cash conversion cycle is
15 days computed as follows:
Cash Conversion Cycle = 58 days – 43 days
Cash Conversion Cycle = 15 days
 As previously discussed in liquidity ratios,
attention must be given to the quality of receivables
and inventories which can be measured by their
turnover ratios. So, when analyzing the liquidity
position of a company, it is not enough to look at the
current ratio and the quick asset ratio, check te
average collection period or days’ receivable and days’
inventories as well. It may also be good to check the
operating cash flows.
Note that in the computation of total asset
turnover ratio, accounts receivable turnover ratio, and
accounts payable turnover ratio, some references use
average balances in the denominators. For example,
in the computation of total asset turnover ratio,
instead of using the ending balance for the total
assets, average total asset can be used which
computed as follows:
 Vertical Analysis and Horizontal Analysis
Vertical Analysis
Vertical analysis or sometimes called common-
size analysis is an important financial statement
analysis tool. With vertical analysis, all accounts in the
statement of financial position are presented as a
percentage of total assets while all accounts in the
statement of profit or loss are presented as a
percentage of sales and revenues.
Found in Table 2.1 and Table 2.2 are the
common-size statements of profit or loss and
statement of financial position of JSC Foods
Corporation from 2010 to 2014.
 Table 2.1: JSC Foods Corporation
Common-Size Statements of Profit or Loss
For the Years Ending December 31, 2014-2010
2014 2013 2012 2011 2010

Net Sales 100% 100% 100% 100% 100%

Cost of Sales 80% 80% 81% 82% 83%

Gross Profit 20% 20% 19% 18% 17%

Operating 12% 13% 13% 13% 13%

Expenses
Operating Income 8% 7% 7% 5% 4%

Interest Expense 0% 1% 1% 1% 1%

Income Before 7% 6% 6% 4% 3%
Taxes
Taxes 2% 2% 2% 1% 1%

Net Income 5% 4% 4% 3% 2%
 Table 2.2 JSC Foods Corporation
Common-Size Statements of Financial Position
December 31, 2014-2010
2014 2013 2012 2011 2010
Assets
Current Assets
Cash 5% 5% 5% 5% 5%
Receivables 10% 9% 10% 9% 8%
Inventories 22% 22% 22% 20% 20%
Other Current Assets 5% 5% 6% 4% 6%
Total Current Assets 42% 41% 42% 38% 39%
Noncurrent Assets
Property, Plant, and 55% 55% 53% 57% 56%
Equipment, Net
Other Noncurrent Assets 4% 4% 5% 5% 5%
Total Assets 100% 100% 100% 100% 100%
 2014 2013 2012 2011 2010
Liabilities and Equity
Current Liabilities
Trade Payable 23% 23% 24% 20% 17%
Income-Taxes Payable 2% 1% 2% 1% 1%
Current Portion of Long-term 10% 12% 6% 12% 12%
Debt
Other Current Liabilities
Total Current Liabilities 35% 37% 32% 33% 30%
Noncurrent Liabilities
Long-term Debt, Net of Current 9% 6% 0% 6% 18%
Portion
Total Liabilities 44% 43% 32% 39% 47%
Stockholders’ Equity
Capital Stock 36% 39% 46% 49% 47%
Retained Earnings 20% 19% 22% 12% 5%
Total Stockholders’ Equity 56% 57% 68% 61% 53%
Total Liabilities and 100% 100% 100% 100% 100%
Stockholders’ Equity
Horizontal Analysis
Horizontal or trend analysis is a financial
statement analysis technique that shows changes in
financial statement accounts over time. Changes can
be shown both in absolute peso mounts and in
percentage.
To compute or the change, simply get the
difference from one period to another. The earlier
period is used as the base period. To illustrate, let us
compute the change in the sales of JSC Foods
Corporation from 2013 to 2014.
Peso Change = (Sales2014 – Sales2013)
Peso Change = 52 501 085 – 47 345 223
Peso Change = 5 155 862
% Change = ((Sales2014-Sales2013)/Sales2013)x100%
% Change = (5 155 862/47 345 223)x100%
 These changes for the different accounts are
important to identify trends. This horizontal analysis
can be done for the different accounts from the
statement of financial position, statement of profit or
loss, and statement of cash flows.
Presented in Table 2.3 are the changes in the
statement of profit or loss accounts of JSC Foods
Corporation from 2011 to 2014 in peso amounts while
Table 2.4 shows the changes in the statements of profit
or loss accounts in percent.
 Table 2.3: JSC Foods Corporation
Annual Changes in the Statement of Profit or Loss
Accounts in Peso
From
20142011 to 2014 2012
2013 2011

Net Sales 5 155 862 5 170 940 3 834 026 3 003

615
Cost of Sales 3 966 102 4 008 454 2 541 163 2 109
598
Gross Profit 1 189 760 1 162 486 1 292 863 894 017

Operating Expenses 300 855 803 183 466 898 421 301

Operating Income 888 905 359 303 825 965 472 716

Interest Expense (200 000) 150 000

Income Before Taxes 888 905 359 303 1 025 965 322 716

Taxes 266 672 107 791 307 789 96 815

Net Income 622 234 251 512 718 175 225 901
 Table 2.4: JSC Foods Corporation
Annual Changes in the Statement of Profit or Loss
Accounts in %
From
20142011 to 2014 2012
2013 2011

Net Sales 11% 12% 10% 8%

Cost of Sales 10% 12% 8% 7%

Gross Profit 13% 14% 19% 15%

Operating Expenses 5% 15% 9% 9%

Operating Income 28% 13% 42% 31%

Interest Expense 0% 0% -44% 50%

Income Before Taxes 31% 14% 67% 27%

Taxes 31% 14% 67% 27%

Net Income 31% 14% 67% 27%

 Quality of Earnings
In analyzing a statement of profit or loss,
how can you tell whether the earnings are good
or not? There are information in the financial
statements that should be looked into
Among these are the following:
1. Is the income coming from the core business?
If so, thenit is good. But if income comes from
nonrecurring transaction such as sale of
equipment when the company is not in the
business of selling equipment, then the income
is not of good quality because this income is not
expected to happen again or at least, not in the
2. How much of the net income translate into cash
flows? Recognition of revenues is based on the accrual
principle so not all the revenues recognized during the
period are necessarily collected. The same is true for
expenses. As analyst, however, it is important to know
if the net income reported in the statement of profit or
loss translates into cash flows. This information can be
found in the first section of the statement of cash
flows, the cash flows from operating activities.

3. Is the income stable? The stability of earnings is

influenced by the nature of business the company is in.
Utility companies which provide basic services such as
power distribution companies are supposed to be
more stable. Food companies which cater to the
masses such as Jollibee Food Corporation can also be
 Limitations of Financial Statement Analysis

While financial statement analysis is a very

powerful tool in understanding a company, it
has its limiations, too. Among them are as
follows:
1. Financial analysis deals only with quantitative
data. We know that behind the success of
every company are important personalities. For
example, Mr. Manuel Pangilinan is behind
successful companies like PLDT, Smart, and
Meralco, among others. Mr. Henry Sy is behind
the SM Group of Companies which includes the
SM Malls, Banco De Oro and recently, the City of
Dreams, casino operation near SM Mall of Asia.
This is why in analyzing a company, it is not
enough to just look at their financial statements.
One has to figure out the controlling stockholders
and the top executives behind these companies.

2. Management can take short-run actions to

influence ratios. Managers’ behavior is influence
by how their performance as managers is
appraised. If one of the mojor performance
appraisal measures is return on assets, manager
will tend to defer important capital investments
even if in the long run, these long-term
investments will benefit the company a lot. Why
will they defer these investments? Because in
the short-run, such investments will increase the
3. Different companies may use different
accounting principles though they come from the
same industry. This makes comparison with other
companies more difficult. For example, one
company may use straight-line method of
depreciation but a competing company may use
one form of accelerated method of depreciation
such as the double-declining depreciation
method.

4. Different formulas can be used in computing

financial ratios. For example, with ratios that use
both accounts rom the statement of profit or loss
and statement of financial position, some use the
ending balances while other analysts use the
5. The amounts fond in the financial statements
are already part of historical data. The future may
not necessarily be the same as the present or the
past. To make more sense with historical data, it
pays to know the evolution of the company over
time. It pays to know whether the line of
businesses the company is currently engaged in
will be the same as the future based on corporate
plans. A good example of this situation is San
Miguel Corporation (SMC). For many years in the
past, SMC has always been known as a leading
food and beverage company. But if you look at
the businesses SMC is engaged in, power
generation is presently its biggest business
segment. It has also gone into oil refinery and
6. A financial ratio standing alone is useless.
There has to be a benchmark. If the competitor’s
or competitors’ financial statements re available,
they can serve aas good benchmarks. But the
best benchmarks are the company’s own
projected financial statements because these
represent the goals of the corporation.