CHAPTER 2:

Review of Financial
Statement Preparation,
Analysis, and Interpretation
Financial statement (FS) 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. There are three kinds of FS analysis techniques:
- Horizontal analysis
- Vertical analysis
- Financial ratios
Horizontal analysis (Increase - Decrease Method)

also called trend 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. This will reveal the
behavior of the account over time. Is it increasing,
decreasing or not moving? What is the magnitude of the
Changes can be expressed in monetary value
(peso) and percentages computed by using the
following formulas:

• Peso change = Balance of Current Year - Balance of Prior Year

• Percentage change = Peso Change ÷ Balance of the Prior Year
ANSWER KEY:
 Vertical analysis

also called common-size analysis, is a technique that expresses

each financial statement item as a percentage of a base
amount. For the SFP, the base amount used is Total Assets. On
the other hand, sales or net sales is used as base amount for
the SCI.
ANSWER KEY:
 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 and income statement of a business
firm.
PURPOSE:
Through ratio analysis, the financial statements user comes into
possession of measures which provide insight into the
profitability of operations, the soundness of the firm’s short-
term and long-term financial condition and the efficiency with
which management has utilized the resources entrusted to it.
The four main categories of financial ratios:
• Liquidity
• Profitability
• Efficiency
• Leverage
I. Liquidity Ratio – ratios that measure the firm’s ability to meet
cash needs as they arise such as payment of accounts payable, bank
loans and operating costs. Liquidity refers to the company’s ability to
satisfy its short-term obligations as they come due.

l Current Ratio = Current Assets ÷ Current Liabilities

l Quick Ratio = Cash + Marketable Securities + Accounts
Receivables ÷ Current Liabilities
Illustration:
1. Current assets is PHP2,000,
current liabilities is PHP3,500.
What is current ratio?
2. Inventory is PHP150. Accounts
payable is PHP450. Cash and
accounts receivable total
PHP800. What is the current
ratio? Quick ratio?
3. If current ratio is 1.7, what is
the total accounts receivable if
cash is PHP20,000, inventory is
PHP7,500, and accounts payable
is PHP30,000.
Answer Key:
1. Current ratio: 2,000/3,500 = 0.57
2. Current ratio: (800 + 150)/450 = 2.11
Quick ratio: 800/450 = 1.78
3. Total receivables: 1.7= (X+20,000+7500)/ 30,000 = 23,500
II. Activity / Efficiency Ratio

ratios that measure the liquidity of specific assets and

efficiency in managing assets such as accounts receivable,
inventory, and fixed assets.

Refers to a company’s ability to be efficient in its operations.

Specifically, it refers to the speed with which various current
accounts are converted into sales, and ultimately, cash.
l Accounts receivable turnover = Sales ÷ Average Accounts Receivables
l Average collection period, otherwise known as average age of AR, days’
receivable or days sales outstanding
= 365 ÷ Accounts Receivable Turnover
l Inventory turnover = Cost of Goods Sold ÷ Average Inventory
l Average age of inventory or days’ inventory
= 365 ÷ Inventory Turnover
l Accounts payable turnover = Purchases ÷ Average Inventory
l Average age of payables, average payment period, or days’ payable
= 365 ÷ Accounts Payable Turnover
 l Total asset turnover = Net Sales ÷ Average Total Assets
l Operating cycle
= Average Collection Period + Average Age of Inventory
l Cash conversion cycle
= Operating cycle - Average Age of Payables OR Average
Collection Period + Average Age of Inventory - Average Age
of Payables
Illustration:
Answer Key:
(provide that the beginning inventory is P 247,000):
1. Accounts receivable turnover: 44.4x
2. Average collection period: 8.2 days
3. Inventory turnover: 10x
4. Average age of inventory: 36.5 days
5. Accounts payable turnover: 18.57x
6. Average payment period: 19.65 days
7. Total asset turnover: 0.41x
8. Operating cycle: 44.7 days
9. Cash conversion cycle: 25.05 days
III. Leverage Ratio

ratios that measure the extent of a firm’s financing, with debt

relative to equity and its ability to cover interest and other
fixed charges such as rent and sinking fund payment. Refers to
the company’s use of debt. It defines the company’s capital
structure which indicates how much of the total assets are
financed by debt and equity
 l Debt ratio – This ratio measures the proportion of total assets finance
by total liabilities or money provided by creditors (not by the business
owners).
Debt ratio = Total Liabilities ÷ Total Assets

l Debt-to-equity ratio – A variation of debt ratio, shows the proportion of debt

to equity.
Debt-to-equity ratio = Total Liabilities ÷ Total Equaity

l Interest coverage ratio / Times Interest Earned – This ratio shows the
company’s ability to pay its fixed interest charges in relation to its operating
income or earnings before interest and taxes.
Interest coverage ratio = Earnings before interest and taxes (EBIT) ÷ Interest Expense
Illustration:
Additional note:
“Other expenses” in the Statement of Financial Performance is composed solely of interest
expense. Hence, interest expense for the period ended December 31, 2014 is Php 2,800.
Answer Key:
1. Debt ratio = 57.65%
2. Debt-to-equity ratio = 1.3614
3. Interest coverage ratio = 180.7143
IV. Profitability Ratio

ratios that measure the overall performance of the firm and its
efficiency managing assets, liabilities and equity.

Refers to the company’s ability to generate earnings. It is one of

the most important goals of businesses.
 l Return on Equity - measures the amount of net income earned in
relation to stockholders’ equity.
ROE (return on equity) = Net income ÷ Stockholders’ equity

l Return on Assets - measures the ability of a company to generate income

out of its resources/assets.
ROA (return on asset) = Operating income ÷ Total assets

l Gross Profit Margin - shows how many pesos of gross profit is earned for
every peso of sale. It provides information regarding the ability of a company
to cover its manufacturing cost from its sales. Remember that gross profit is
just sales less cost of goods or cost of services.
Gross profit margin = Gross profit ÷ Sales
l Operating Profit Margin - shows how many pesos of operating profit is earned
for every peso of sale. It measures the amount of income generated from the
core business of a company.
Operating profit margin =Operating income ÷ Sales

l Net Profit Margin - measures how much net profit a company generates for
every peso of sales or revenues that it generates.
Net profit margin = Net income ÷ Sales
Illustration:
Additional note:
“Other expenses” in the Statement of Financial Performance is composed solely of interest
expense. Hence, interest expense for the period ended December 31, 2014 is Php 2,800.
Answer Key:
1. Return on equity = 16.98% = 352,240/2,075,000
2. Return on assets = 7.19% = 352,240/4,900,000
3. Gross profit margin = 35% = 700,000/2,000,000
4. Operating profit margin = 25.05% = 501,000/2,000,000
5. Net profit margin = 17.61% = 352,240/2,000,000
The ROE of 16.98% means that for every PHP1 of stockholders’ equity, PHP0.1698 or 16.98
centavos 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
16.98% ROE seems better. However, before a conclusion is made that the 16.98% ROE is
better than the time deposit rate of 2%, the risks associated with this company earning
16.98% has to be assessed. Generally, the 2% time deposit rate is guaranteed while the
16.98% ROE is not. In 2014, ROE of Sample Company was high, but what if in the future, it
will earn a negative ROE. Is this possible for company? Yes! No manager in his/or sound
mind will guarantee a specific rate of return, especially when that rate is relatively high.
Why? Because in business, there are always risks. 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 a losing
company in the future.