FINANCIAL MANAGEMENT I

FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis – Involves the evaluation of the firm’s past performance, present condition, and
business potentials. The analysis provides information about the following, among others:

 Profitability of the business firm

 Ability to meet company obligations
 Safety of investment in the business
 Effectiveness of management in running the firm

Financial Statement (FS) Analysis Tools and Techniques

1. Horizontal Analysis (Trend Analysis) – involves comparison of figures shown in the financial
statements of two or more consecutive periods.

Percentage Change (%) = (Most Recent Value – Base Period Value) / Base Period Value

Comparisons can be made between an actual amount compared against a budgeted amount, with the
‘budget’ serving as the base or pattern of performance.

Limitation: If a negative or zero amount appears in the base year, percentage change cannot be
computed.

2. Vertical Analysis (Common-Size Analysis) – process of comparing figures in the financial statements
of a single period. It involves conversion of figures in the statements to a common base. This is
accomplished by expressing all figures in the statements as percentages of an important item such as
total assets (in the balance sheet) or net sales (in the income statement).

3. Ratio Analysis – involves development of mathematical relationships among accounts in the financial
statements.

Basic Rules on Ratio Calculations

 When calculating a ratio using balance sheet numbers only, the numerator and denominator
should be from the same balance sheet date. The same is true for ratios using only income
statement numbers. Exception: Calculation of Growth Ratios
 If an income statement account and a balance sheet account are both used to calculate ratio,
the balance sheet account should be expressed as an average for the time period represented
by the income statement account.
 If the beginning balance of a balance sheet account is not available, the ending balance is
normally used to represent the average balance of the account.
 If sales and/or purchases are given without making distinction as to whether made in cash or
on credit, assumptions are made depending on the ratio being calculated:
o Turnover Ratios: Sales and Purchases are made on credit.
o Cash Flow Ratios: Sales and Purchases are made in cash.
 Generally, the number of days in a month or year is not critical to the analysis: a year may
have 360 days, 52 weeks, and 12 months; alternatively, a year may be comprised of 365
calendar days, 300 working days or any appropriate number of days.
Financial Ratios:
 Test of Liquidity
Current Assets
Current Ratio
Current Liabilities
Quick Ratio Quick Assets (Cash & Cash Equivalents, Receivables & Marketable Securities)
(Acid-Test Ratio) Current Liabilities

 Working Capital Activity Ratios or Efficiency Ratios

Income Statement Account No. of days in a year
Turnover Average Age
Ave. Balance Sheet Account Turnover

Net (Credit) Sales

Receivable Turnover
Average Receivables
Average Age of Receivables
360 days
(Average Collection Period)
Receivable Turnover
(Days’ Sales in Receivables)
Cost of Goods Sold
Inventory Turnover
Ave. Merchandise Inventory
Average Age of Inventory*
360 days
(Inventory Conversion Period)
Inventory Turnover
(Days’ Sales in Inventory)
Normal Operating Cycle Average Age of Inventory + Average Age of Receivables
*In some accounting and finance texts, average inventory age is also called as the average sales period.

 Test of Solvency
EBIT
Times Interest Earned
Interest Expense
Total Liabilities
Debt-Equity Ratio
Total Shareholders’ Equity
Total Liabilities
Debt Ratio
Total Assets
Total Shareholders’ Equity
Equity Ratio
Total Assets

 Test of Profitability
Income
Return on Sales
Net Sales
Income + Interest after-tax
Return on Assets
Average Assets
What income figure should be used?
o If the intention is to measure operational performance, income is expressed as before interest
and tax; alternatively, before ‘after-tax’ interest may be used to exclude the effect of capital
structure.
o If the intention is to evaluate total managerial effort, income is expressed after interest and
tax.
o The practice of expressing income after interest but before tax is now being discouraged.
o Income should include dividends and interest earned if the said investments are included in
asset base.
o If used in the Dupont techniques, income must be after interests, taxes and preferred stock
dividends.

Return on Equity = Return on Sales x Assets Turnover x Equity Multiplier

 Income
Return on Equity
Average Equity
Net Income – Preferred Dividends
Earnings Per Share
Weighted Average Common Shares Outstanding

 Market Tests
Price Per Share
Price-Earnings (P/E) Ratio
Earnings Per Share
Dividend Per Share
Dividend Yield
Price Per Share
Dividend Per Share
Dividend Pay-Out
Earnings Per Share

 Other Meaningful Ratios

o Ratios used to evaluate Long-term Financial Position or Stability

Fixed Assets (Net)
Fixed Assets to Total Equity
Total Equity
Fixed Assets (Net)
Fixed Assets to Total Assets
Total Assets
Sales to Fixed Assets Net Sales
(Plant Turnover) Fixed Assets (Net)
Common Shareholders’ Equity
Book Value Per Share
Common Shares Outstanding
Times Preferred Dividend Net Income After Taxed
Earned Preferred Dividends
Total Assets
Capital Intensity Ratio
Net Sales
Net Income before taxes & fixed charges
Time Fixed Charges Earned
(Fixed charges + Sinking Fund payment)*
*Fixed charges shall include rent, interests, and other relevant fixed expenses; sinking fund
payment must be expressed before tax.

o Tests on overall Short-term Solvency or Short-term Financial Position

Net Sales
Working Capital Turnover
Average Working Capital
Current Liabilities
Defensive Interval Ratio
Cash & Cash Equivalent
Net Purchases
Payable Turnover
Average Accounts Payable
Fixed Assets to Long-Term Fixed Assets
Liabilities Long-term Liabilities

o Ratios indicative of Income Position

Rate of Return on Average Income
Current Asset Average Current Assets
Operating Profit
Operating Profit Margin
Net Sales
Operating Cash Flow
Cash Flow Margin
Net Sales