Financial Statement Analysis 2

Financial statements inform the readers of a companys financial position, results of operations, cash flows and changes in equity.
However these information are not sufficient to help readers make decision s about the business.
Financial statement analysis is the process of evaluating risks, performance, financial health, and future prospects of a business using
computational and analytical techniques with the objective of making economic decisions.

I. FINANCIAL RATIOS

A financial ratio is composed of a numerator and a denominator. It expresses relationship between specific financial data. The resulting
ratio may be interpreted as a percentage, a rate or a proportion.

Example, A company with a sales of P1,000,000 and net income of P100,000, if we take the ratio of net income divided by sales, the result is
10%. We can understand this as net income is 10% of sales. We can also look at it as a rate or proportion. For every P1.00 of sales that the company
generates, it earns P0.10 of net income.

Our understanding of this companys operations has already improved significantly. Previously, we only know the monetary value of sales and
net income. Now we know how much income the company gets for every peso of sales. This ratio is called net profit margin.

To organize our study of financial ratios, we will this topic based on the performance indicator being measured namely profitability, operational
efficiency and financial health.

TABLE 1: Profitability Ratios

Name of Ratio Formula

Gross profit margin Gross Profit

Gross profit rate Net Sales
Net Sales-Cost of Goods Sold
Net Sales

Operating income margin Operating income

Net Sales

Net profit margin Net Income

Net Sales

Return on assets Net Income

Average Assets

Return on equity Net Income

Average Equity
Gross Profit Margin expresses gross profit as a percentage of sales It can be interpreted as the peso value of the gross profit earned for every
peso of sales. We can infer the average pricing policy from the gross profit margin. We can also measure the companys ability to control its cost from
gross profit margin. Therefore, between two companies in the same competitive industry, the one with a better gross profit margin is the one who has
better control of its cost.

Operating Profit Margin Expresses operating income as a percentage of sales. It is the peso value of the operating income earned for every
peso of sales. Operating income is computed as gross profit less operating expenses. Therefore, between two companies with the same gross profit
margin, the company with the better operating income margin has leaner operations. In business, leaner operations imply lower operating expenses as a
percentage of sales.

Net Profit Margin Expresses net income as a percentage of sales. It can be interpreted as the peso value of the net income earned for every
peso of sales. A company with a higher net profit margin is considered more profitable. Therefore, between companies with the same level of operating
profit margin, the company with the higher net profit margin may have lower interest expense (other expense) or higher other income (as a percentage of
sales).

Return on Assets Also known as ROA, is computed as net income divided by average total assets. ROA can also be computed using the
ending balance of total assets instead of average total assets. It is a popular measure of the profitability of the companys assets. It also measures the
companys efficiency to generate income by employing its assets. In comparing companies, the company with a higher ROA is judged to be more profitable.

Return on Equity also known as ROE is computed as net income divided by average total equity. Lie return on assets, ROE can also be
computed using the ending balance of equity. It measures the return (net income) generated by the capital invested by the owner in the business. Like the
ROA, the company with a higher ROE is judged to be more profitable.

II. OPERATIONAL EFFICIENCY

Operational efficiency measures the ability of the company to utilize its assets. Assets are generally acquired for the purpose of generating
sales. Operational efficiency is measured based on the companys 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.

Table 2: Operational Efficiency Ratios

Ratio Formula

Asset Turnover _Net Sales__

Average Asset

Fixed Asset Turnover Net Sales____

Average Fixed Asset

Inventory Turnover Cost of Goods Sold

Average inventory
 Days inventory 365_______
Inventory Turnover

Accounts Receivable Turnover Net Sales__________

Average Accounts Receivable

Days in accounts receivable average collection period 365___________

Accounts Receivable Turnover

Asset Turnover Asset turnover ratio is an indicator of the efficiency with which the company is utilizing all of its assets. It measures the peso
value of sales generated for every peso of the companys assets. The higher the turnover rate, the more efficient the company is in using its assets.

Fixed Asset turnover This ratio is similar to asset turnover, except that it is focused on fixed assets only. Fixed asset is composed of property,
plant and equipment. It is an indicator of the efficiency of fixed assets in generating sales.

Inventory Turnover Inventory turnover is measured based on cost of goods sold and not sales. This is because inventory, upon sale, is
transferred to cost of goods sold. It makes both the numerator and denominator measured at cost. This ratio is an indicator of how fast the company can
sell its inventory. Assume that a company will restock merchandise only when all inventory in the warehouse are sold. This means inventory is zeroed out
before purchasing a new batch. Inventory turnover measures the number of times the company restock inventory. Company A, with an inventory turnover
of 3x, means that it made three purchases during the year. The company with a 7x inventory turnover outperformed Company A.

Days in Inventory This ratio computes the average number of days that inventories are held until sold. Days inventory can be easily derived
from inventory turnover by multiplying 365 days by 1/Inventory Turnover.

Average Inventory________
Average Daily Cost of Goods Sold

Where:

Average Inventory = Inventory beginning + Inventory end

2

Average Daily Cost of Goods Sold = Cost of Goods Sold

365
Accounts Receivable Turnover/Days in Receivable Accounts receivable turnover measures the number of times the company can convert
accounts receivable to cash during the year. Basically, the ratio asks how many times the company was able to collect on its average accounts receivable
during the year.
Another measure of the companys collection effectiveness is days in receivables. It can be computed from the turnover ratio or computed on
its own. Days in receivable is a more visual indicator as compared to accounts receivable turnover.it computes for the average number of days from date
of sale to date of collection.

Days in Accounts Receivable = __________365_____________

Accounts Receivable Turnover

Days in Accounts Receivable = Average Accounts Receivable

Average Daily Sale
Where:

Average Accounts Receivable = Accounts Receivable beg. + Accounts Receivable end

2
Average Daily Sales = Sales
365

III. FINANCIAL HEALTH

To evaluate the financial health of a business, we will look into the companys solvency and liquidity ratios. Solvency refers to the
companys capacity to pay their long-term liabilities. On the other hand, liquidity ratio intend to measure the companys ability to pay debts that are coming
due (current liabilities). Liquidity is a more urgent issue as compared to solvency. Creditors look at both solvency and liquidity ratios to evaluate the
companys ability to pay back their debts as well as pay interests.

Table 3: Solvency and Liquidity Ratios

Ratio Formula

Solvency Measures

Debt to equity ratio Total Debt

Equity

Debt ratio Total Debt

Total Assets

Interest coverage ratio Operating Income

Interest Expense
 Liquidity

Current ratio Current Assets__

Current Liabilities

Quick ratio Quick Assets__

Current Liabilities

Debt to Equity Ratio Indicates the companys 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. A debt to equity ratio of greater than 1 implies that that the companys debt exceeds its capital.
Debt Ratio Similar to debt to equity ratio. It indicates the percentage of the companys assets that are financed by debt. A high debt to asset
ratio implies a high level of debt.

Interest Coverage Ratio This ratio measures the companys ability to cover the interest expense on its liability with its operating income. A
ratio greater than 1 means the companys operating income can meet its interest expense. But 1 is a very low ratio. Creditors prefer a high coverage ratio
to give them protection that interest can be repaid from income.

Current Ratio This ratio is used to evaluate the companys liquidity. Basically, we want to know whether there are sufficient current assets to
pay for current liabilities. A ratio of 1 means current assets can fully cover current liabilities. However, creditors want a margin of safety. Some creditors
require a current ratio of 2.
An alternative measure of liquidity is the net working capital. This refers to current assets less current liabilities. A positive
net working capital means that not only is current liabilities fully covered by current assets, there are excess current assets that the company can use for
other purposes. On the other hand a negative net working capital means that current assets are not sufficient to pay liabilities that are coming due.

Quick Ratio This ratio is stricter than current ratio. It suggests that not all current assets can be easily liquidated to pay for the short-term
liabilities. Current assets such as inventory will take a longer time to liquidate. There are also items like prepaid expenses that are not convertible to cash.
Quick assets include only current assets that can be quickly turned into cash such as cash and cash equivalents, accounts receivable and marketable
securities.

IV. USES AND LIMITATIONS OF FINANCIAL ANALYSIS

Financial statement analysis does not end with the computation of trends. Common-size financial statements and financial ratios. The next step
to financial analysis is benchmarking. A company is evaluated against industry average, specific competitor, its historical performance and established
forecasts or targets. Only then can a company be assessed to be performing better or worse than the benchmark. Based on the results of benchmarking,
the company can make plans to improve their operations. For example, the companys collection period is computed at 50 days. The industry average is
40 days. This means the company can endeavor to improve its collection period. However, it may not be a good idea to make the collection period shorter
than the industry average because this might bring about customer dissatisfaction that may decrease sales.

Financial ratios can also be used for forecasting. Assuming the company expects to maintain the relationships between accounts, ratios
computed based on historical numbers can be used to prepare forecasted financial statements. Financial ratios can also be used to check the
reasonableness of targets.

Financial ratios re widely used by potential creditors and investors. Potential creditors want to know the companys ability to pay its debts when
they are due. Investors want to know whether the company can bring an acceptable return on their investments. Even employees perform financial
statement analysis to determine whether the company can afford to pay wages and benefits. However, users should be aware of the limitations of financial
statement analysis.

Financial statement analysis is used to support business decisions that will have an effect on future time period. For creditors, can the company
repay principal and interest in the future? For investors, will the companys future operations bring about an acceptable rate of return on an investment to
be made today? Remember that horizontal analysis, common-size financial statements and financial ratios are based on historical financial statements.
Historical performance may provide an indication but will not ensure future performance.

Another limitation of the financial statement analysis is the financial statement itself. A good financial analysis will be worthless if the financial
statements are erroneous or fraudulent. As they say, garbage in and garbage out. Therefore, the first step to financial statement analysis should be to
determine the credibility of the financial statements. It should be free from material errors and biases.

Some financial statements are not directly comparable because of differences in accounting policies. Accounting standards sometimes allow
alternative treatments for same transactions. As a result, two companies that account for same transactions differently are not directly comparable. There
is a solution to this problem of comparability but it is beyond the scope of high school accounting. It is sufficient that you know that this is a limitation to
financial statement analysis.