ENTREP 226 ACCOUNTING 1: MANAGEMENT ACCOUNTING Lecture 4

FINANCIAL STATEMENT ANALYSIS, ITS OBJECTIVES AND GENERAL APPROACH

BASIC FINANCIAL STATEMENTS

1. Statement of Financial Position (Balance Sheet) – shows the financial position – assets, liabilities and
owner’s equity of the firm on a particular date
2. Statement of Financial Performance (Income Statement) – represents the result of operations –
revenues, expenses, net profit or loss for the accounting period.
3. Statement of changes in equity – summarized the changes in a company’s equity for a period of time
(generally one year)
4. Cash flow statement – provides information about the cash inflows and outflows from operating,
financing and investing activities during an accounting period.
5. Accompanying Notes to Financial Statements

FINANCIAL STATEMENT ANALYSIS

 Also known as analysis and interpretation of financial statements which refers to the process of
determining financial strengths and weaknesses of the firm by establishing strategic relationship
between the items of the balance sheet, profit and loss account and other operative data.
 It is also an attempt to determine the significance and meaning of the financial statement data so that
forecast may be made of the future earnings, ability to pay interest and debt maturities (both current
and long-term) and profitability of a sound dividend policy.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

1. Assessment of Past Performance
Past performance is a good indicator of future performance. As investors you should be
interested in the trend of past sales, operating expenses, net income, cash flows and return on
investment, among others. These trends offer a means for judging management's past performance and
are possible indicators of future performance.
2. Assessment of Current Position
Analysis of the current position indicates where the business stands today. Such analysis will
show the types of assets owned by a business enterprise and the different liabilities due against the
enterprise, the company’s cash position as well as the debt the company has in relation to equity,
among others.
3. Prediction of profitability and growth prospects
The financial statement analysis helps in predicting the earning prospects and growth rates in
the earnings which are used by investors while comparing investment alternatives and other users
interested in judging the earning potential of business enterprises. Investors also consider the risk or
uncertainty associated with the expected return.
4. Prediction of bankruptcy and business failures
After being aware about probable failure, both managers and investors can take preventive
measures to avoid/minimize losses. Corporate managements can effect changes in operating policy,
reorganize financial structure or even go for voluntary liquidation to shorten the length of time losses.
Managers may use the ratios prediction model to assess the solvency position of their firms and thus
can take appropriate corrective actions.
5. Assessment in Operational Efficiency
Financial statement analysis helps to assess the operational efficiency of the management of a
company. The actual performance of the firm which are revealed in the financial statements can be
compared with some standards set earlier and the deviation of any between standards and actual
performance can be used as the indicator of management efficiency.

GENERAL APPROACH TO FINANCIAL STATEMENT ANALYSIS

1. Background Study and evaluation of firm industry, economy, and outlook

2. Short-term solvency analysis

Refers to the analysis of the company’s ability to meet near- term demand for cash and normal
operating requirements.

Indications that a company enjoys a satisfactory short-term solvency position:

a. Favorable credit position
b. Satisfactory proportion of cash to the requirements of the current volume
c. Ability to pay current debts in the regular course of business
d. Ability to extend more credit to customers
e. Ability to replenish inventory promptly

Instructor: Danica M. Almario, CPA 1

ENTREP 226 ACCOUNTING 1: MANAGEMENT ACCOUNTING Lecture 4

3. Capital Structure and long-term solvency analysis

It pertains to the evaluation of the amount and proportion of debt in a firm’s capital structure to
assess its ability to service debt.

Factors indicating that the company has a satisfactory long-term financial position
a. Maintained a well-balanced relationship between borrowed funds and equity
b. Effectively employ borrowed funds and equity
c. Declare satisfactory amount of dividends to shareholders
d. Withstand adverse business conditions
e. Engage in research and development to provide new products or improve old products, method
or processes.
f. Meet their commitment to borrowers and owners.

4. Operating Efficiency and Profitability Analysis

Involves evaluation of how well assets have been employed by management in terms of
generating revenues and maximizing return in such resources.

Indicators of managerial efficiency in the use of the resources are:

a. Ability to earn a satisfactory return on its investment of borrowed funds and equity.
b. Ability to control operating costs within reasonable limits.
c. Optimum level of investment in assets.

5. Other considerations
I. QUALITY OF EARNINGS
A. Reasons for manipulating the reported earnings:
 Meet internal earnings target
 Meet external expectations
 To even-out income
 Provide “window dressing” for an IPO or a Loan

Income Smoothing – practice of carefully timing the recognition of revenues and expenses to even out
the amount of reported earnings.

Window Dressing – measures taken by the management to make the company appear as strong and
profitable as possible in its statement of financial position, income statement, and cash flow statement.

Most common techniques used to manage earnings:

1. Strategic Matching – involves timing its transactions so that large one-time gains and losses
occur in the same period resulting in a smooth upward trend in reported earnings.
2. Change in methods with little or no disclosure
3. Departure from accounting standards – often-used techniques to show more favorable results
is “fraudulent reporting” or deliberate violation of accounting rules. (eg. Capitalization of
expenses, no provision of uncollectible, no recognition of PPE)
4. Fictitious Transactions – deliberate recording of nonexistent revenue transactions and
customers.

II. QUALITY OF ASSETS AND RELATIVE AMOUNT OF DEBT

 Looking into the liquidity, timing of repayment of liabilities and the total amount of debt
outstanding.

III. TRANSPARENT FINANCIAL REPORTING: The Best Practice

 Transparency is the extent to which investors have ready access to required financial
information about a company such as price levels, market depth and audited financial
reports. Transparency helps reduce price volatility because all market participants can base
decisions of value on the same data. Companies also have a strong motivation to provide
disclosure because transparency is rewarded by the stock's performance.

STEPS IN FINANCIAL STATEMENT ANALYSIS

1. Establish objectives of the analysis
2. Study the industry in which the firm operates and relate industry climate to current and projected
economic development.
3. Develop knowledge of the firm and the quality of management.

Instructor: Danica M. Almario, CPA 2

ENTREP 226 ACCOUNTING 1: MANAGEMENT ACCOUNTING Lecture 4

4. Evaluate financial statements using any of the techniques below.

 Horizontal Analysis
 Vertical Analysis
 Financial Ratios Analysis
5. Summarize findings based on analysis and reach conclusions about firm relevant to the established
objectives.

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

1. Dependence on historical costs − Transactions are initially recorded at their cost. This is a concern when
reviewing the balance sheet, where the values of assets and liabilities may change over time. Some
items, such as marketable securities, are altered to match changes in their market values, but other
items, such as fixed assets, do not change. Thus, the balance sheet could be misleading if a large part of
the amount presented is based on historical costs.
2. Inflationary effects − If the inflation rate is relatively high, the amounts associated with assets and
liabilities in the balance sheet will appear inordinately low, since they are not being adjusted for
inflation. This mostly applies to long-term assets.
3. Intangible assets not recorded − Many intangible assets are not recorded as assets. Instead, any
expenditure made to create an intangible asset is immediately charged to expense. This policy can
drastically underestimate the value of a business, especially one that has spent a large amount to build
up a brand image or to develop new products.
4. Based on specific time period − A user of financial statements can gain an incorrect view of the financial
results or cash flows of a business by only looking at one reporting period. Any one period may vary
from the normal operating results of a business, perhaps due to a sudden spike in sales or seasonality
effects. It is better to view a large number of consecutive financial statements to gain a better view of
ongoing results.
5. Not always comparable across companies − If a user wants to compare the results of different
companies, their financial statements are not always comparable, because the entities use different
accounting practices. These issues can be located by examining the disclosures that accompany the
financial statements.
6. Subject to fraud − the management team of a company may deliberately skew the results presented.
This situation can arise when there is undue pressure to report excellent results, such as when a bonus
plan calls for payouts only if the reported sales level increases. One might suspect the presence of this
issue when the reported results spike to a level exceeding the industry norm.
7. No discussion of non-financial issues − The financial statements do not address non-financial issues,
such as the environmental attentiveness of a company's operations, or how well it works with the local
community. A business reporting excellent financial results might be a failure in these other areas.
8. Not verified − If the financial statements have not been audited, this means that no one has examined
the accounting policies, practices, and controls of the issuer to ensure that it has created accurate
financial statements. An audit opinion that accompanies the financial statements is evidence of such a
review.
9. No predictive value − the information in a set of financial statements provides information about either
historical results or the financial status of a business as of a specific date. The statements do not
necessarily provide any value in predicting what will happen in the future. For example, a business could
report excellent results in one month, and no sales at all in the next month, because a contract on which
it was relying has ended.

TYPES OF FINANCIAL STATEMENT ANALYSIS

1. Horizontal Analysis
Also known as “trend analysis” or “comparative financial statement analysis” is a financial
statement analysis technique that shows changes in the amounts of corresponding financial statement
items over a period of time. It is a useful tool to evaluate the trend situations. Horizontal analysis can
either use absolute comparisons or percentage comparisons, where the numbers in each succeeding
period are expressed as a percentage of the amount in the baseline year, with the baseline amount
being listed as 100%. This is also known as base-year analysis.

Computation:

Instructor: Danica M. Almario, CPA 3

ENTREP 226 ACCOUNTING 1: MANAGEMENT ACCOUNTING Lecture 4

2. Vertical Analysis
It is a technique in which the relationship between items in the same financial statement is
identified by expressing all amounts as a percentage a total amount. This method compares different
items to a single item in the same accounting period. The financial statements prepared by using this
technique are known as common size financial statements.
The line items on an income statement can be stated as a percentage of gross sales, while line
items on a balance sheet can be stated as a percentage of total assets or liabilities, and vertical analysis
of a cash flow statement shows each cash inflow or outflow as a percentage of the total cash inflows.

3. Financial Ratio Analysis

This is mathematical comparisons of financial statement accounts or categories. These
relationships between the financial statement accounts help investors, creditors, and internal company
management understand how well a business is performing and of areas needing improvement. Ratios
are just a raw computation of financial position and performance.
Ratios allow us to compare companies across industries, big and small, to identify their
strengths and weaknesses. Financial ratios are often divided up into five main categories: liquidity,
solvency, efficiency, profitability, and market prospect.

A. Liquidity Ratios
They analyze the ability of a company to pay off both its current liabilities as they become due
as well as their long-term liabilities as they become current. In other words, these ratios show the cash
levels of a company and the ability to turn other assets into cash to pay off liabilities and other current
obligations.
Liquidity is not only a measure of how much cash a business has. It is also a measure of how
easy it will be for the company to raise enough cash or convert assets into cash. Assets like accounts
receivable, trading securities, and inventory are relatively easy for many companies to convert into cash
in the short term.

I. Quick Ratio/Acid Test Ratio

This measures the ability of a company to pay its current liabilities when they come due with
only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in
the short-term. Cash, cash equivalents, short-term investments or marketable securities, and
current accounts receivable are considered quick assets.

II. Current Ratio

This is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term
liabilities with its current assets. The current ratio is an important measure of liquidity because
short-term liabilities are due within the next year.

III. Times Interest Earned Ratio

This is sometimes called the interest coverage ratio, is a coverage ratio that measures the
proportionate amount of income that can be used to cover interest expenses in the future. In some
respects the times interest ratio is considered a solvency ratio because it measures a firm’s ability to
make interest and debt service payments.

IV. Accounts Payable Turnover Ratio

This shows a company’s ability to pay off its accounts payable by comparing net credit purchases
to the average accounts payable during a period. In other words, the accounts payable turnover ratio is
how many times a company can pay off its average accounts payable balance during the course of a
year. This ratio helps creditors analyze the liquidity of a company by gauging how easily a company can
pay off its current suppliers and vendors.

Instructor: Danica M. Almario, CPA 4

ENTREP 226 ACCOUNTING 1: MANAGEMENT ACCOUNTING Lecture 4

B. Solvency Ratios
They analyze the ability of a company to pay off both its current liabilities as they become due as
well as their long-term liabilities as they become current. In other words, these ratios show the cash levels
of a company and the ability to turn other assets into cash to pay off liabilities and other current obligations.
Liquidity is not only a measure of how much cash a business has. It is also a measure of how easy it
will be for the company to raise enough cash or convert assets into cash. Assets like accounts receivable,
trading securities, and inventory are relatively easy for many companies to convert into cash in the short
term.

I. Debt to Equity Ratio

This is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt
to equity ratio shows the percentage of company financing that comes from creditors and investors. A
higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor
financing (shareholders).

II. Equity Ratio

This is an investment leverage or solvency ratio that measures the amount of assets that are
financed by owners’ investments by comparing the total equity in the company to the total assets.
Companies with higher equity ratios show new investors and creditors that investors believe in the
company and are willing to finance it with their investments.

III. Debt Ratio

This measures a firm’s total liabilities as a percentage of its total assets. In a sense, the debt
ratio shows a company’s ability to pay off its liabilities with its assets. In other words, this shows how
many assets the company must sell in order to pay off all of its liabilities. This ratio measures the
financial leverage of a company. Companies with higher levels of liabilities compared with assets are
considered highly leveraged and more risky for lenders.

IV. Debt to Asset Ratio

This measures the amount of total assets that are financed by creditors instead of investors. In
other words, it shows what percentage of assets is funded by borrowing compared with the percentage
of resources that are funded by the investors. Basically it illustrates how a company has grown and
acquired its assets over time.

C. Efficiency Ratios
These also called activity ratios measure how well companies utilize their assets to generate
income. Efficiency ratios often look at the time it takes companies to collect cash from customer or the time
it takes companies to convert inventory into cash—in other words, make sales. These ratios are used by
management to help improve the company as well as outside investors and creditors looking at the
operations of profitability of the company.

I. Accounts Receivable Turnover Ratio

This measures how many times a business can turn its accounts receivable into cash during a
period. In other words, the accounts receivable turnover ratio measures how many times a business can
collect its average accounts receivable during the year. This ratio shows how efficient a company is at
collecting its credit sales from customers. Some companies collect their receivables from customers in
90 days while other takes up to 6 months to collect from customers.

Instructor: Danica M. Almario, CPA 5

ENTREP 226 ACCOUNTING 1: MANAGEMENT ACCOUNTING Lecture 4

II. Asset Turnover Ratio

This measures a company’s ability to generate sales from its assets by comparing net sales with
average total assets. In other words, this ratio shows how efficiently a company can use its assets to
generate sales. The total asset turnover ratio calculates net sales as a percentage of assets to show how
many sales are generated from each peso of company assets.

III. Inventory Turnover Ratio

This shows how effectively inventory is managed by comparing cost of goods sold with average
inventory for a period. This measures how many times average inventory is “turned” or sold during a
period. In other words, it measures how many times a company sold its total average inventory dollar
amount during the year.

IV. Days Sales in Inventory Ratio

This is also called days inventory outstanding or simply days in inventory, measures the number
of days it will take a company to sell its entire inventory. In other words, the day’s sales in inventory
ratio show how many days a company’s current stock of inventory will last. This calculation also shows
the liquidity of inventory. Shorter day’s inventory outstanding means the company can convert its
inventory into cash sooner. In other words, the inventory is extremely liquid.

D. Profitability Ratios
These compare income statement accounts and categories to show a company’s ability to generate
profits from its operations. Profitability ratios focus on a company’s return on investment in inventory and
other assets. These ratios basically show how well companies can achieve profits from their operations.
These can be used to judge whether companies are making enough operational profit from their
assets. In this sense, profitability ratios relate to efficiency ratios because they show how well companies are
using their assets to generate profits.

I. Gross Margin Ratio

This compares the gross margin of a business to the net sales. This ratio measures how
profitable a company sells its inventory or merchandise. In other words, the gross profit ratio is
essentially the percentage markup on merchandise from its cost. This is the pure profit from the sale of
inventory that can go to paying operating expenses.

II. Profit Margin Ratio

This is also called the return on sales ratio or gross profit ratio, is a profitability ratio that
measures the amount of net income earned with each dollar of sales generated by comparing the net
income and net sales of a company. In other words, the profit margin ratio shows what percentage of
sales are left over after all expenses are paid by the business.

III. Return on Assets Ratio

This is often called the return on total assets, is a profitability ratio that measures the net
income produced by total assets during a period by comparing net income to the average total assets. In
other words, the return on assets ratio or ROA measures how efficiently a company can manage its
assets to produce profits during a period.

Instructor: Danica M. Almario, CPA 6

ENTREP 226 ACCOUNTING 1: MANAGEMENT ACCOUNTING Lecture 4

IV. Return on Equity Ratio

This measures the ability of a firm to generate profits from its shareholders investments in the
company. In other words, the return on equity ratio shows how much profit each peso of common
stockholders’ equity generates. ROE is also an indicator of how effective management is at using equity
financing to fund operations and grow the company.

E. Market Prospect Ratios

These used to compare publicly traded companies’ stock prices with other financial measures like
earnings and dividend rates. Investors use market prospect ratios to analyze stock price trends and help
figure out a stock’s current and future market value.
These show investors what they should expect to receive from their investment. They might receive
future dividends, earnings, or just an appreciated stock value. These ratios are helpful for investors to
predict how much stock prices will be in the future based on current earnings and dividend measurements.

I. Earnings Per Share

This is also called net income per share, is a market prospect ratio that measures the amount of
net income earned per share of stock outstanding. In other words, this is the amount of money each
share of stock would receive if all of the profits were distributed to the outstanding shares at the end of
the year. This is also a calculation that shows how profitable a company is on a shareholder basis.

II. Price Earnings Ratio

This is often called the P/E ratio or price to earnings ratio, is a market prospect ratio that
calculates the market value of a stock relative to its earnings by comparing the market price per share by
the earnings per share. In other words, the price earnings ratio shows what the market is willing to pay
for a stock based on its current earnings. The PE ratio helps investors analyze how much they should pay
for a stock based on its current earnings. This is why the price to earnings ratio is often called a price
multiple or earnings multiple.

III. Dividend Payout Ratio

This measures the percentage of net income that is distributed to shareholders in the form of
dividends during the year. In other words, this ratio shows the portion of profits the company decides to
keep funding operations and the portion of profits that is given to its shareholders. Investors are
particularly interested in the dividend payout ratio because they want to know if companies are paying
out a reasonable portion of net income to investors.

IV. Dividend Yield Ratio

This measures the amount of cash dividends distributed to common shareholders relative to the
market value per share. The dividend yield is used by investors to show how their investment in stock is
generating either cash flows in the form of dividends or increases in asset value by stock appreciation.
Investors can use the dividend yield formula to help analyze their return on investment in stocks.

Instructor: Danica M. Almario, CPA 7