Analysis of Interpretation of Financial Statements

CHAPTER 5: Analysis of Interpretation of Financial Statements
Financial Statement Analysis

 is the process of evaluating risks performance, financial health, and future prospects
of a business by subjecting financial statement data to computational and analytical
techniques with the objective of making economic decisions.
 profitability of the firm (owners and shareholders)
 ability of the firm to meet the company's obligation (solvency), ability to produce
cash (liquidity)
 it involves evaluation of the past performance, present conditions, and business
potential of the business
Three Basic Tools of Financial Statement analysis:

1. Horizontal Analysis
 also called trend/index analysis, is a technique for evaluating a series of financial
statement data over a period of time with the purpose of determining the increase or
decrease that has taken place.
 base period value= balance of the prior year/previous year
 if the base period value is 0 or negative you should not compute for the percentage
change, only the monetary change can be computed.
Peso change= Balance of current year- balance of prior year
Percentage change= (balance of current year- balance of prior year)/ balance of prior year
2. Vertical Analysis
 also called common-size analysis, is a technique that express each financial
statement item as a percentage of a base amount.
 For the SFP (balance sheet), the base amount is Total Assets. balance of account/
total assets
 For the SCI (income statement), the base amount is Net sales
3. Ratio Analysis
 expresses the relationship among selected items of financial statement data.
 the relationship is expressed in terms of a percentage, a rate, or simple proportion.
 profitability of the firm
 liquidity status of the business
 solvency status of the business, the asset is greater than liability
 checking the ability of the company to pay its long-term liability.
 efficiency status of the business
PROFITABILITY RATIO
 measure the ability of the company to generate income from the use of its assets
and invested capital as well as control its cost.
 ability of the company to enhance owners’ wealth through generation of income or
revenue
GROSS PROFIT RATIO

 reports the peso value of the gross profit earned for every peso of sales.
Gross Profit Ratio= Gross profit x 100
Net sales
Gross Profit= Net sales-COGS
1. Operating Income Ratio

 it measures the percentage of profit earned from each peso of sales in the
company's core business operations.
Operating Profit= Net sales- COGS-operating expenses (income tax expense, interest
expense is excluded in the determination of operating income)
Operating Margin Formula = Operating Profit x 100
Net Sales
2. Net Profit Ratio

 relates the peso value of the net income earned to every peso of sales
Net Profit Margin Formula = Net Profit x 100
Net Sales
Net Profit Ratio= Net sales- COGS- operating expenses- interest expense-income tax
expense
3. Return on Asset (ROA)

 measures the peso value of income generated by employing the company's assets.
Return on Assets = Net Income
(ROA) Formula Average Total Assets
 If the ratio or the formula requires data from 2 report which is the income statement
and balance sheet. In the balance sheet component or balance sheet account it
should be always in the average.
Average Balance Sheet Account= Beginning Balance+ Ending Balance /2
4. Return on Equity (ROE)

 measures the return (net income) generated by the owner's capital invested in the
business
Return on Average = Net Income
Equity (ROE) Average Shareholder's Equity
OPERATIONAL EFFICIENCY RATIO (ACTIVITY RATIO)

 measures the ability of the company to utilize its assets. Operational efficiency is
measured based on the company’s ability to generate sales from the utilization of its
assets, as a whole or individually. The turnover ratios are primarily used to measure
operational efficiency.
1. Asset Turn over

 measures the peso value of sales generated for every peso of the company's assets.
The higher the turnover rate, the more efficient the company is in using its assets.
Asset Turnover= Net Sales
Average Asset
2. Fixed Asset Turnover

 is indicator of the efficiency of fixed assets in generating sales.
Fixed Asset Turnover= Net Sales
Average Fixed Assets
3. Inventory turnover
 is measured based on cost of goods sold and not sales. As such both the numerator
and denominator of this ratio are measured at cost. It is an indicator of how fast the
company can sell inventory. An alternative to inventory turnover is “days in
inventory”. This measures the number of days from acquisition to sale.
Inventory turnover= Cost of goods sold
Average Inventory
Days in Inventory= 360
Inventory turnover
4. Accounts receivables turnover

 it measures the number of times the company was able to collect on its average
accounts receivable during the year. An alternative to accounts receivable turnover is
“days in accounts receivable”. This measures the company’s collection period which is
the number of days from sale to collection.
Accounts Receivable Turnover= Net Credit Sales (Net Sales)
Average Accounts Receivable
Days in Accounts Receivable= 360
Accounts Receivable turnover
FINANCIAL HEALTH RATIOS

 look into company's solvency and liquidity ratios. Solvency refers to the company’s
capacity to pay their long-term liabilities. On the other hand, liquidity ratio intends to
measure the company’s ability to pay debts that are coming due (short term debt).

SOLVENCY MEASURES
1. Debt Ratio
 indicates the percentage of the company’s assets that are financed by debt. A high
debt to asset ratio implies a high level of debt.
Debt Ratio = Total Debt (Liability)
Total Assets
2. Equity Ratio
 indicates the percentage of the company’s assets that are financed by capital. A high
equity to asset ratio implies a high level of capital.
Equity Ratio=Total Equity
Total Assets
3. Debt to equity ratio

 indicates the company’s reliance to debt or liability as a source of financing relative
to equity. A high ratio suggests a high level of debt that may result in high interest
expense.
Debt to equity ratio= Total Debt
Equity
4. Interest coverage ratio/ Times interest earned ratio

 measures the company’s ability to cover the interest expense on its liability with its
operating income. Creditors prefer a high coverage ratio to give them protection that
interest due to them can be paid.
Interest coverage ratio= Operating Income
Interest expense
LIQUIDITY MEASURES
1. Current Ratio
 is used to evaluate the company’s liquidity. It seeks to measure whether there are
sufficient current assets to pay for current liabilities. Creditors normally prefer a
current ratio of 2.
Current Ratio= Current Assets
Current Liabilities
2. Quick Ratio
 is a stricter measure of liquidity. It does not consider all the current assets, only those
that are easier to liquidate such as cash and accounts receivable that are referred to
as quick assets.
Quick Ratio= Quick Assets
Quick Liabilities

Analysis of Interpretation of Financial Statements

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CHAPTER 5: Analysis of Interpretation of Financial Statements

Financial Statement Analysis

Three Basic Tools of Financial Statement analysis:

GROSS PROFIT RATIO

1. Operating Income Ratio

2. Net Profit Ratio

3. Return on Asset (ROA)

4. Return on Equity (ROE)

OPERATIONAL EFFICIENCY RATIO (ACTIVITY RATIO)

1. Asset Turn over

2. Fixed Asset Turnover

4. Accounts receivables turnover

FINANCIAL HEALTH RATIOS

3. Debt to equity ratio

4. Interest coverage ratio/ Times interest earned ratio

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