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Financial Statement

Analysis and Financial


Ratios

John Carlos S. Wee, CPA


Fin 211
Financial Management Part I

The Annual (Stockholders) Report

Annual (Stockholders) Report is a report issued


annually by a corporation to its stockholders
summarizing the events and activities, including
financial activities, of the corporation during the past
year/period.

Sections of the Annual Report:


Verbal Section, describing the corporations operating
result during the past year and discussion of new
developments that will affect future operations; and
Quantitative Data, summarizing the financial results of
operation and the analyses of such results.

The Financial Statements

Financial Statements are structured representation


of the financial position of and the transactions
undertaken by an enterprise.

Objective: To provide information on the financial


position, performance and cash flows, as well as
their changes, to a wide range of users in making
econmic decisions.

The Financial Statements

Basic Financial Statements:


Balance Sheet (Statement of Financial Position)
Income Statement (Statement of Comprehensive Income)
Statement of Shareholders Equity
Statement of Cash Flows

Notes to the Financial Statement

The Financial Statements Analysis

Financial Statement Analysis is the process of


extracting information from financial statements to
better understand a companys current and future
performance and financial condition.

It involves:

Comparing the firms performance to that of other firms in the same


industry (cross-sectional analysis), and
Evaluating trends in the firms financial position over time (time-series
analysis).

Objective:

To identify an organizations financial strengths and


weaknesses.

The Financial Statements Analysis

Limitations:

Information derived by the analysis are not absolute


measures of performance in any and all of the areas of
business operations. They are only indicators of degrees
of profitability and financial strength of the firm.

There are inherent limitations in the accounting data which


the analyst is working with brought about by (a) variation
and lack of consistency in the application of accounting
principles, policies and procedures, (b) too condensed
presentation of data, and (c) failure to reflect change in
purchasing power.

The Financial Statements Analysis

Limitations:

Performance measures or tools and techniques


(Quantitative Measurements) are not absolute measures
but should be interpreted relative to the nature of the
business and in the light of past, current and future
operations.

Analysts should be alert to the potential for management


to influence the outcome of financial statements in order to
appeal creditors, investors and other stakeholders.

The Financial Statements Analysis

Steps:
1.
2.
3.
4.

Establish objectives of the analysis.


Study the industry in which firm operates and relate industry
climate to current and projected economic development.
Develop knowledge of the firm and quality of management.
Evaluate financial statements using any of the techniques
below:
a.
b.
c.

5.

Horizontal Analysis/Trend Analysis


Vertical Analysis
Financial Ratios

Summarize findings based on analysis and reach conclusions


about firm relevant to the established objectives.

Horizontal Analysis

Horizontal analysis is the percentage analysis of changes


in comparative financial statements.

Steps:
1.
2.

Compute the peso amount of the change from the base


(earlier) period to the later period, and
Divide the peso amount of change by the base-period amount.
This, however, is not done if the base year figure is negative
or zero.

Horizontal Analysis

Example:
The

comparative financial
statements of Golden Garments,
Inc. are presented on the next
pages. Analyze and evaluate the
statements using the horizontal
analysis

Answers:

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1,2011and2010 Increase(D
e
c
r
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a
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e
)
2
0
1
1
2
0
1
0
A
m
o
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A
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a
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3
9
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4
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t
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1
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9
7
8
IP
nrvee
n
t
o
r
y
2
2
3
,
2
4
2
1
9
7
,
0
9
7
Current
Year
Balance

Base
Year
Balance
= Difference
p
a
i
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x
p
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s
6
7
,
7
1
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7
6
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5
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T
o
ta
la
C
u
rE
eq
ntuA
sm
se
tn
st70,392 - 579
,68,250
893 526,867= 2,142
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(
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,
9
8
7
TotalA
ssets
670,396 637,854
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E
qui8
ty
%
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TotalE
quity
271,510 242,950

Answers:

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1,2011and2010 Increase(D
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c
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a
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)
2
0
1
1
2
0
1
0
A
m
o
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%
A
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C
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A
ssets
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3
9
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5
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2
3
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1
%
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R
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(
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)
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5
4
9
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4
,
9
7
8
IP
nrvee
n
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y
2
2
3
,
2
4
2
1
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7
,
0
9
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p
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x
p
e
n
s
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s
6
7
,
7
1
0
6
,
5
4
2
Difference
/7
Base
Year = %
T
o
t
a
l
C
u
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t
A
s
s
e
t
s
5
7
9
,
8
9
3
5
2
6
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6
7
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q
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t
(
n
e
t
)
9
0
,
5
0
3
1
1
0
,
9
8
7
2,142
/ 68,250
TotalA
ssets
670,396 637,854= 3.1%
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Long
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ia
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tie
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E
qui8
ty
%
P
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s
1
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TotalE
quity
271,510 242,950

Answers:

G
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G
a
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P
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o
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1,2011and2010 Increase(D
e
c
r
e
a
s
e
)
2
0
1
1
2
0
1
0
A
m
o
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%
A
s
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t
s
C
urrC
en
tsh
A
ssets
a
7
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3
9
2
6
8
,
2
5
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3
.
1
%
A
c
c
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R
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v
a
b
l
e
(
n
e
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)
2
1
8
,
5
4
9
1
8
4
,
9
7
8
3
3
,
5
7
1
1
8
.
1
%
IP
nrvee
n
t
o
r
y
2
2
3
,
2
4
2
1
9
7
,
0
9
7
2
6
,
1
4
5
1
3
.
3
%
p
a
i
d
E
x
p
e
n
s
e
s
6
7
,
7
1
0
7
6
,
5
4
2
(
8
,
8
3
2
)
1
1
.
5
%
T
o
ta
la
C
u
rE
eq
ntuA
sm
se
tn
st
579,893 526,867 53,026 10.1%
P
rop
e
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y
n
d
i
p
e
P
r
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p
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r
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y
a
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n
t
(
n
e
t
)
9
0
,
5
0
3
1
1
0
,
9
8
7
(
2
0
,
4
8
4
)
1
8
.
5
%
TotalA
ssets
670,396 637,854 32,542 5.1%
L
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3
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1
3
5
1
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0
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9
1
3
.
7
%
B
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1
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6
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9
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4
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9
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3
2
6
.
3
%
C
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P
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N
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s
P
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3
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3
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0
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0
0
.
0
%
T
o
t
a
l
C
u
r
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L
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a
b
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l
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t
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s
2
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9
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4
3
3
,
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8
2
1
5
.
0
%
Long
-o
te
rm
L
ia
bb
illie
tie
s1%
N
t
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s
P
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y
a
(
1
)
1
3
9
,
0
0
0
1
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9
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(
3
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,
0
0
0
)
1
7
.
8
%
T
o
t
a
l
L
i
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s
3
9
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8
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6
3
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4
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9
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4
3
,
9
8
2
1
.
0
%
E
qui8
ty
%
P
r
e
f
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h
a
r
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s
,
P
1
0
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r
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0
.
0
%
O
rd
irn
aP
ryre
S
hia
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1par
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,,0
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,,0
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-- 0
..0
%
S
h
a
e
m
u
9
0
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0
0
9
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0
0
0
0
0
%
R
e
t
a
i
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d
E
a
r
n
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n
g
s
1
0
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,
5
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0
7
2
,
9
5
0
2
8
,
5
6
0
3
9
.
2
%
TotalE
quity
271,510 242,950 28,560 11.8%

Answers:

G
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e
FortheYearsEndedD
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:
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4
%
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M
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9
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3
6
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.
3
%
LessS
:O
p
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.
8
%
A
d
m
i
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s
t
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1
3
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(
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0
0
0
)
2
.
8
%
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3
.
8
%
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p
e
r
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2
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0
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1
8
.
4
%
IIn
tnceorm
esetB
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ctoIm
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a
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8
8
,
2
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5
2
5
.
9
%
ncom
e
74,160 58,904 15,256 25.9%

Trend Percentages

Trend Percentages are index numbers showing relative


changes in financial data resulting with the passage of time.
They state several years financial data in terms of a base
year.

Steps:
1.
2.

3.

Convert the amount of each item in the comparative


statements in the chosen base year to 100%.
Compute the percentage relationship that each statement item
bears to the same item in the base year by simply dividing
each value by the base year.
Compare the trends of related financial and operating data to
form an opinion as to whether favorable or unfavorable
tendencies are reflected by the data.

Vertical Analysis

Vertical Analysis is a percentage analysis used to show the


relationship of each component to the base total within a
single statement.

Common Size Financial Statements are statements which


amounts were translated from peso amounts to percentages,
indicating the relative sizes of an item in proportion to the
whole. Thus, common size balance sheet shows assets,
liabilities and equity as a percentage of total assets, while
common size income statements express revenue and
expenses as a percentage of sales.

Vertical Analysis

Conversion Procedures
a.
b.

For the balance sheet, each item therein is converted to


percentage by dividing it by total assets.
In income statement, each item is restated as a percentage of
net sales by dividing the former by the latter.

Example: Using the same data for Golden Garments,


present a common-size financial statement for 2010 and
2011.

Answers:

o
ld
etn
G
an
rm
efnF
tsin
,a
In
cc.ialP
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om
parD
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tic
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em
ber31,2011and2010
2
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A
s
s
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t
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C
urre
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ssets
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a
h
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(
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y
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T
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a
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C
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8
7
%
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3
%
P
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ty
arn
da
E
q
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tent(net)
P
p
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d
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q
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1
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%
1
7
%
TotalA
ssets
100% 100%
L
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N
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o
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uirae
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bilities
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Long
-N
toe
r
m
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P
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qui8
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d
E
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n
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g
s
1
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%
1
1
%
TotalE
quity
40% 38%

Answers:

G
o
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.
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e
FortheYearsEndedD
ecem
ber31,2011and2010
2
0
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1
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a
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s
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0
%
L
e
s
s
:
C
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f
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7
4
%
7
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%
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r
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s
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a
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g
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6
%
2
7
%
LessS
:O
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a
t
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g
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s
e
s
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g
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%
1
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%
A
d
m
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i
s
t
r
a
t
i
v
e
7
%
8
%
T
o
t
a
l
O
p
e
r
a
t
i
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g
E
x
p
e
n
s
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s
1
9
%
2
1
%
O
p
e
r
a
t
i
n
g
I
n
c
o
m
e
7
%
7
%
IIn
tnceorm
esetB
E
x
p
e
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s
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s
1
%
2
%
e
f
o
r
e
T
a
x
e
s
6
%
5
%
IN
ne
ctoIm
e
T
a
x
e
s
(
3
5
%
)
2
%
2
%
ncom
e
4% 3%

Interpretation Guidelines Vertical Analysis

Balance Sheet

A common-size balance sheet shows the percent of total


assets that has been invested in each type or kind of assets.
These percentages may be compared with those of a
competitor or the industry to determine whether or not the firm
has over- or underinvested in one or more assets.
The common-size statement will also show the distribution of
liabilities and equity, i.e., the source of capital invested in the
assets.
The percentage of current assets may also be related to the
percentage of current liabilities to determine the liquidity of the
company.

Interpretation Guidelines Vertical Analysis

Income Statement

The common-size income statement shows the amount or


percentage of the sales that has been absorbed by each
individual cost or expense item and the percentage that
remains as net income.
Comparison of year-to-year income statement common-size
ratios will show whether a larger or smaller relative amount of
net sales was used to meet particular costs or expenses.
Comparison of the gross profit percentage from year-to-year
may also reveal success or failure efficiency in the
procurement and merchandising policies.

Financial Ratio Analysis

Financial Ratio is a comparison in fraction,


proportion, decimal or percentage form of two
significant figures taken from financial statements.
It expresses the direct relationship between two or
more quantities in the statement of financial position
or statement of comprehensive income.
It involves methods of calculating and interpreting
financial ratios to analyze and monitor the firms
performance.

Cautions About Using Financial Ratio


Analysis
1.
2.

3.

Ratios that reveal large deviations from the norm


merely indicate the possibility of a problem.
A single ratio does not generally provide sufficient
information from which to judge the overall
performance of the firm. One or two ratios,
however, will suffice if analysis is concerned with
certain specific aspects of the firm only.
Ratios being compared should be calculated using
financial statements dated at the same point in
time.

Cautions About Using Financial Ratio


Analysis
4.
5.
6.

It is preferable to use audited financial statements


for ratio analysis.
The financial data being compared should have
been developed in a consistent manner.
Inflation may distort ratio analysis results.

Categories of Financial Ratios


Liquidity

Ratio
Activity Ratio
Debt Ratio
Profitability Ratio
Market Ratios

Liquidity Ratio

Liquidity Ratio measures the firms ability to pay


off debts maturing within a year or within the next
operating cycle.

Basic Liquidity Ratios:

Current Ratio
Quick Ratio

Current Ratio

Current Ratio measures the firms ability to meet


its short-term obligations. It is the primary test of
solvency to meet current obligations using current
assets as a going concern, and it measures the
adequacy of working capital.

Formula:
Current Ratio =

Current Assets
Current Liabilities

Net Working Capital

Working Capital (Current Assets) represents that


portion of investments that circulates from one form
to another in the ordinary course of business.

Net Working Capital is the difference between the


firms current asset and its current liabilities.

Formula:
Net Working Capital = Current Assets - Current Liabilities

Quick (Acid-Test) Ratio

Quick (Acid-Test) Ratio measures the firms


ability to meet its short-term obligations using its
quick assets. It severely tests the companys
immediate ability to be solvent/liquid.

Formula:
Quick Ratio =

Cash & Cash Equivalent + Marketable


Securities + Net Accounts Receivable
Current Liabilities

Activity Ratio

Activity Ratio measures the efficiency of the


company in converting its resources into sales or
cash (operations).

Basic Activity Ratios:

Trade Receivable Turnover


Average Collection Period (Number of Days Sales in
Receivable)
Inventory Turnover
Days Supply in Inventory
Payable Turnover
Average Payment Period (Average Age of Accounts Payable)
(Total) Asset Turnover

Trade Receivable Turnover

Accounts (Trade) Receivable Turnover


measures the firms velocity of collection of trade
accounts. This tests the companys efficiency in
collection of accounts.

Formula:
Accounts Receivable Turnover =

Net (Credit) Sales


Average Accounts Receivable

Average Collection Period

Average Collection Period (Days Sales in


Receivable/Average Age of Accounts
Receivable) evaluates the companys accounts
receivable liquidity and its credit and collection
policies.

Formula:
__ 360 days __
AR Turnover

Ave. Collection Period =

Or
Ave. Collection Period =

*Average Sales Per Day = Net Sales / 360 days

Accounts Receivable
Average Sales Per Day*

Inventory Turnover

Inventory Turnover measures the firms efficiency


in managing and selling its inventories.

Formula:
Inventory Turnover =

Cost of Sales
Ave. Inventory

Days Supply in Inventory

Days Supply In Inventory measures the average


number of days to sell or consume the average
inventory

Formula:
Days Supply in Inventory =

___ 360 days ___


Inventory Turnover

Accounts Payable Turnover

Accounts Payable Turnover measures the firms


efficiency in meeting its accounts payable.

Formula:
Accounts Payable Turnover =

__ Net Purchases __
Ave. Accounts Payable

Average Payment Period

Average Payment Period (Average Age of


Accounts Payable) evaluates the companys
payment policies.

Formula:
Ave. Payment Period =

__ 360 days __
AP Turnover

Or
Ave. Collection Period =

__ Accounts Payable__
Ave. Purchases Per Day*

*Average Purchases Per Day = Net Annual Purchases / 360 days

(Total) Asset Turnover

(Total) Asset Turnover measures the firms


efficiency in using its available resources (assets)
to generate sales.

Formula:
(Total) Asset Turnover =

__ Net Sales __
Ave. Total Asset

Plant Assets Turnover

Plant Assets Turnover tests roughly the efficiency


of management in keeping plant properties
employed.

Formula:
Plant Assets Turnover =

_____ Net Sales______


Ave. Fixed Assets (Net)

Debt (Management) Ratio

Debt (Management) Ratio measures how risky


the firm is and how much of its operating income
must be paid to creditors than to shareholders.

Basic Debt (Management) Ratios:

Debt Ratio
Debt-to-Equity Ratio
Times Interest Earned Ratio
Fixed-Payment Coverage Ratio

Debt Ratio

Debt Ratio measures the proportion of total assets


financed with debt.

Formula:
Debt Ratio =

__ Total Liabilities_ __
Total Assets

Debt to Equity Ratio

Debt to Equity Ratio measures debt relative to


amounts of resources provided by owners.

Formula:
Debt to Equity Ratio =

_ Total Liabilities __
Total Equity

Times Interest Earned Ratio

Times Interest Earned Ratio (Interest Coverage


Ratio) measures the firms ability to make
contractual interest payments. It measures how
many times interest expense is covered by
operating profit.

Formula:
Times Interest Earned Ratio =

_ Operating Income/Profit* __
Interest Expense

*Operating Income/Profit = Income Before Interest and Income Tax

Fixed Payment Coverage Ratio

Fixed Payment Coverage Ratio measures the


firms ability to meet all fixed payment obligations.
This simply expands the coverage of times interest
earned ratio by including other fixed payments.

Formula:
Fixed Payment Coverage Ratio =

Operating Income/Profit
____+ Lease Payments ___
Fixed Charges*

*Fixed Charges = Interest + Lease Payments + Other Fixed Charges

Profitability Ratio

Profitability Ratio shows how profitable the


company is in its operations and usage of
resources.

Basic Profitability Ratios:

Gross Profit Margin


Operating Profit Margin
Net Profit Margin
Earnings Per Share (EPS)
Return on Assets (ROA/ROI)
Return on Equity (ROE)

Gross Profit Margin

Gross Profit Margin (GPM) measures the


proportion of earnings to the sales after the cost of
sales were paid.

Formula:
Gross Profit Margin =

__ Gross Profit_ __
Net Sales

Operating Profit Margin

Operating Profit Margin (OPM) measures the


proportion of earnings to the sales after all costs
expenses other than interest and taxes were paid.

Formula:
Operating Profit Margin =

__ Operating Profit_ __
Net Sales

Net Profit Margin

Net Profit Margin (NPM) measures the proportion


of earnings to the sales after all costs expenses
were paid.

Formula:
Net Profit Margin =

__ Net Profit_ __
Net Sales

Earnings Per Share

Earnings Per Share (EPS) measures the peso


return on each ordinary share.

Formula:
Net Income after Preference
Earnings Per Share = ______Dividend Requirement_ ____
No. of Ordinary Shares Outstanding

Return on Asset

Return on Asset (ROA), often called Return on


Investment (ROI) measures the overall
effectiveness of the management in generating
profits with its available assets.

Formula:
Return on Asset =

__ Net Income_ __
Ave. Total Asset

Or
Return on Asset =

Asset Turnover X Net Profit Margin

Return on Equity

Return on Equity (ROE) measures the return


earned on the shareholders investment in the firm.

Formula:
Return on Equity =

__ Net Income_ __
Ave. Ordinary Equity

Or
Return on Equity = ROA X Financial Leverage Multiplier*

*Financial Leverage Multiplier (FLM) = Total Assets / Ordinary Share Equity

Market Ratio

Market Ratio relates the firms market value, as


measured by its current share price, to certain
accounting values. It gives insight into how
investors in the marketplace feel the firm is doing in
terms of risk and return.

Basic Market Ratios:

Price/Earnings (P/E) Ratio


Market/Book (M/B) Ratio
Dividend Yield Ratio

Price/Earnings Ratio

Price/Earnings Ratio measures the amount that


investors are willing to pay for each dollar of a
firms earnings. The level of this ratio indicates the
degree of confidence of the investors in the
companys future performance.

Formula:
Price/Earnings Ratio =

_ Market Price Per Share __


Earnings Per Share

Market/Book Ratio

Market/Book Ratio provides an assessment of


how investors view the firms performance. It
relates the market value of the firms share to its
book value.

Formula:
Market/Book Ratio =

_ Market Price Per Share __


Book Value Per Share

Dividend Yield Ratio

Dividend Yield Ratio shows the rate earned by


shareholders from dividend relative to current price
of stock..

Formula:
Dividend Yield Ratio =

_ Dividends per Share __


Market Value Per Share

Other Financial Ratio

Other Basic Financial Ratios are listed below:

Equity Ratio
Dividend Payout Ratio

Equity Ratio

Equity Ratio measures the proportion of assets


provided by owners.

Formula:
Equity Ratio =

_ Total Equity __
Total Assets

Dividend Payout Ratio

Dividend Payout Ratio shows the percentage of


earnings paid to shareholders.

Formula:
Dividend Payout Ratio =

_ Dividends per Share __


Earnings Per Share

DuPont System of Analysis

DuPont System of Analysis is used to dissect the


firms financial statements and to assess its financial
condition.
It merges the income statement and balance sheet
into two summary measures of profitability, the ROA
and the ROE.

DuPont System of Analysis

The DuPont system first brings together the net profit


margin, which measures the firms profitability on sales,
with its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales.
ROA = Net profit margin Total asset turnover

Substituting the appropriate formulas into the equation


and simplifying results in the formula given earlier,

DuPont System of Analysis

The modified DuPont Formula relates the firms


return on total assets to its return on common
equity. The latter is calculated by multiplying the
return on total assets (ROA) by the financial leverage
multiplier (FLM), which is the ratio of total assets to
common stock equity:
ROE = ROA X FLM
Substituting the appropriate formulas into the
equation and simplifying results in the formula given
earlier,

References

Cabrera, M.E.B., Management Accounting Concepts &


Applications 2007 Edition, Conanan Educational Supply,
C.M. Recto Avenue, Manila
Cabrera, M.E.B., Financial Management Part I, Conanan
Educational Supply, C.M. Recto Avenue, Manila
Cabrera, M.E.B., Financial Accounting and Reporting:
Theory and Application Part I, Conanan Educational
Supply, C.M. Recto Avenue, Manila
Gitman, L.J. and Zutter, C.J., Principles of Managerial
Finance 13th Edition, Prentice Hall, USA