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Financial Statement Analysis

Financial statement analysis involves the assessment and evaluation of the firm's past performance, its present
condition, and future business potentials. The analysis serves to provide information about the following:
1. Profitability of the business firm;
2. The firm's ability to meet its obligations;
3. Safety of the investment in the business;
4. Effectiveness of management in running the firm; and
5. Over-all company marketability


1. Analysis of variation in gross profit and net income
2. Cash flow statement
3. Vertical analysis (common size statements)
4. Horizontal analysis (trend ratios and percentages)
5. Financial ratios (ratio analysis

HORIZONTAL ANALYSIS- involves comparing figures shown in the financial statements of two or more consecutive

Percentage Most recent value - Base period value
Change = -------------------------------------
Base period value

VERTICAL ANALYSIS- the process of comparing figures in the financial statements of a single period. It involves
converting the figures in the statements to a common base i.e. ratios, percentages. Converted financial statements are
called Common Size Financial Statements.

RATIO ANALYSIS- involves the development of mathematical relationships between accounts in the financial


A. TESTS OF LIQUIDITY (Liquidity refers to the company's ability to pay its short-term current
liabilities as they fall due).

1. Current Ratio = Current Assets / Current Liabilities

- (Or banker's ratio or working capital ratio) measures the number of times that the current
liabilities could be paid with the available current assets.

2. Acid Test Ratio = Quick Assets* / Current Liabilities

- (Or quick ratio) measures the number of times that the current liabilities could be paid with the
available cash and near cash assets. *Cash + marketable securities + receivables.

3. Working capital activity ratios (turnovers):

a. Receivable Turnover= Net Credit Sales* / Ave. Receivables
- The time required to complete one collection cycle-from the time receivables are recorded,
then collected, to the time new receivables are recorded again.

a. Average age of receivables = No. Of working days in yr. / Receivables turnover

- (Or days’ sales in receivables or average collection period) indicates the average number of
days during which the company must wait before receivables are collected.

b. Inventory Turnover:
Merchandising Firms

Inventory Turnover = Cost of goods sold / Ave. Mdse. Inventory

- Measures the number of times that inventory is replaced during the period.

Average Age of Inventory = Number of Working Days / Inventory Turnover

- Indicates the average number of days during which the company must wait before
inventories are sold.

Operating Cycle = Ave. Age of Rec. + Ave. Age of Invent.

c. Trade Payables Turnover = Net Credit Purchases / Ave. Trade Payables

Ave. age of trade payables = No. Of working days / Payables Turnover
- Indicates the length of time during which payables remain unpaid

d. Cash flow cycle = Operating cycle - Ave. age of trade payables

e. Current Assets Turnover = Cost of Sales + Operating Expenses (excluding depreciation and
amortization) / Average Current Assets
o Measures the movement and utilization of current assets to meet operating

4. Working Capital to total assets = Working Capital / Total Assets

- Indicates relative liquidity of total assets and distribution of resources employed.

5. Working Capital Turnover = Net Sales / Average Working Capital

- Indicates adequacy and activity of working capital.
6. Working Capital= current asset-current liabilities

B. TESTS OF SOLVENCY (solvency refers to the company's ability to pay all its debts, whether such
liabilities are current or non-current)

1. Times Interest Earned =Income before tax + Interest expense / Interest Expense
- Determines the extent to which operations cover interest expense

2. Debt-Equity Ratio = Total Liabilities / Total Owners' or Stockholders' equity

- Proportion of assets provided by creditors compared to that provided by owners.

3. Debt Ratio = Total Liabilities / Total Assets

- Proportion of total assets provided by creditors.

4. Equity Ratio = Total Owner's or Stockholders' Equity / Total Assets

- Proportion of total assets provided by owners.

5. Fixed Assets to Long-term Liabilities = Fixed Assets / Long-term liabilities

- Reflects extent of the utilization of resources from long-term debt. Indicative of sources
of additional funds.

6. Fixed assets to Total Equity = Fixed Assets / Total Equity

- Measures the proportion of owners' equity to fixed assets. Indicative of over or under
investment by owners; also weakness in "trading on the equity".

7. Fixed assets to Total Assets = Fixed Assets (Net) / Total Assets

- Indicates possible over expansion of plant and equipment.

8. Sales to fixed assets (plant turnover) = Net Sales / Fixed Assets (Net)
- Test roughly the efficiency of management in keeping plant properties employed.

9. Book value per share on common stock = Common stock equity / # of outstanding common
- Measures recoverable amount in the event of liquidation if assets are realized at their book

10. Times Preferred Dividend requirements = Net income After Taxes / Preferred Dividend
- Indicates ability to provide dividends to preferred stockholders.

11. Times Fixed Charges Earned

= Net income before taxes and fixed charges /
Fixed charges (rent + interest + Sinking fund payment before taxes)
- Measures ability to meet fixed charges.

12. Sinking fund payments bef. Tax = Sinking fund payment after taxes / 1 - Tax Rate


1. Return on Sales = Income after tax/ Net Sales

- Determines the amount of income earned on each peso sales.

Gross Profit Ratio = Gross Profit / Net Sales

2. Return of Total Assets (ROA) = Income before Interest & Taxes / Average total assets
- Efficiency with which managers use total assets to operate the business.
3. Return on Owners' equity = Income after tax / Ave. Owners' Equity
- Measures the amount earned on the owners' or stockholders' investment.

4. Earnings Per Share = Net Income - Preferred Dividends (in any) /

Weighted Ave. Number of Common Shares
- Measures the amount of net income earned buy each common share.

5. Rate of Return on Current Assets = Net Income / Average Current Assets

- Measures the profitability of current assets invested.

6. Rate of Return Per turnover of current Assets

= Rate of Return on Ave. Current Assets / Current Assets Turnover
- Shows profitability of each turnover of current assets.


1. Price/Earnings Ratio (P/E) = Price Per Share / Earnings Per Share

- Indicates the number of pesos required to by P1 of earnings

2. Dividend Yield = Ordinary Dividend Per Share / Price Per Share

- Measures the rate of return in the investor's common stock investments.

3. Dividend Pay-out = Ordinary Dividend Per Share / Earnings Per Share

- Indicates the proportion of earnings distributed as dividends.