Cebu Technological University – Main Campus

Course Code and Title : N-ABM 2 – BUSINESS FINANCE

Course Instructor : Dr. Alvin C. Estreba, CPA, RCA

Lesson 1 : FINANCIAL STATEMENT ANALYSIS

Ratio Analysis

Objectives of Financial Statement Analysis:

 It attempts to evaluate a business entity for financial and management decision making
purposes.
 It explores some aspect of a firm’s profitability or its risk (Short-term and Long-term
Liquidity), or both.
 It attempts to measure the firm’s operational efficiency and investment provided by
owners and creditors.

How to Analyze Financial Statements:

 Comparative Statements
The presentation of financial information reports for current and prior periods, which
allows the statement user to compare changes in the individual items.

a) Horizontal Analysis
The presentation of financial statement data reports on a percentage basis over time. An
index value of 100 is assigned to each particular base year. In succeeding years, peso
amount of each item is divided by the peso amount of the same item in the base year.
The result is the presentation of the relative growth or decline of each item in terms of
the base year.

b) Vertical Analysis
The presentation of each item on a financial statement reports as a percentage of an
appropriate base amount. Statements presented in this form are known as Common-
size Statements. In an income statement, the base amount is Total Net Sales
expressed as 100%. In the balance sheet, the base amount is Total Assets or Total
Liabilities and Owner’s Equity expressed also as 100%.

 Ratio Analysis/ Financial Ratios

1. It provides an indication of the firm’s financial strengths and weaknesses and should
generally be used in conjunction with other evaluation techniques.

2. Ratios are useful tools of financial statement analysis because they summarize data
in a form easy to understand, interpret, and compare.

Ratios Analysis
1. Liquidity
- The ability of a firm to meet its current obligation as they mature.
- These are ratios that measure the firm’s ability to meet its cash needs as they arise.
 2. Solvency/ Stability/ Debt Utilization/Debt Management/ Leverage
-These are 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 contributions.
-The ability of the firm to meet interest payments, preferred dividends, and the other
charges. Long-term solvency is a required precondition for the repayment of principal.

3. Activity/ Asset Utilization/ Asset Management

- These ratios measure how effectively assets are managed.
- They measure the liquidity of specific assets and efficiency in managing assets.

4. Profitability
- These are ratios that measure the overall performance of the firm and its efficiency
managing assets, liabilities, and owner’s equity.
- The ability of the business entity to generate income and earn satisfactory returns to
shareholders especially common stockholders.

1. Evaluation of Liquidity:
a) Current Ratio

Formula:
Current Assets
Current Liabilites

- Tests the ability of a firm to meet its current maturing obligations through the use of
current assets.

b) Acid-Test Ratio

Formula:
Cash + Marketable Securities +
Net Receivables
Current Liabilites

- A stringent test of a firm’s ability to pay current liabilities.

c) Working Capital to Total Assets Ratio

Formula:

Working Capital
Total Assets

- Indicates relative liquidity in relation to total assets.

 d) Cash Flow from Operations to Current Liabilities or Cash to Current Liabilities
Formula:
Cash Flow from Operations
Current Liabilites
or
Cash
Current Liabilites

- A test of a company’s ability to pay its current debts with cash provided or used from
operations or the cash available from the company.

2. Evaluation of Solvency
a) Debt Ratio or Debt to Asset Ratio
Formula:
Total Liablities
Total Assets

- Shows proportion of all assets that are financed with debt.

b) Equity Ratio

Formula:
Total Owner's Equity
Total Assets

- Shows proportion of assets provided by owners/stockholders.

c) Debt to Equity Ratio

Formula:
Total Liablities
Total Owner's Equity

- Measures debt relative to amounts owner’s equity.

d) Times Interest Earned

Formula:
Income before interest expense
and income taxes
Interest expense

- Measures how many times interest expense is covered by operating profit.

3. Evaluation of Activity
a) Receivable Turnover/ Accounts Receivable Turnover
Formula:
Net Credit Sales

Receivables (Ending or Average)

- Tests the efficiency of credit and collection policies.

b) Age of Receivables/ Number of days’ sales in receivables/ Average Collection Period

Formula:
360 days or 365 days
Receivable Turnover
or

Receivables (Ending or Average)

*Net Credit Sales/ 365 or 360 days

*Average Daily Sales

- Evaluates the quality of accounts receivables.

c) Inventory Turnover
Formula:
Cost of Goods Sold
Inventory (Ending or Average)

- Measures the efficiency in managing inventory.

d) Age of Inventory/ Days’ supply of inventory/ Number of Days of Inventory

Formula:
360 days or 365 days
Inventory Turnover
or
Inventory (Ending or Average)
*Cost of Goods Sold/ 365 or 360
days

*Average Daily Cost of Goods Sold

- Evaluates the quality of inventory.

 e) Working Capital Turnover

Formula:
Net Sales
Average Working Capital

- Evaluates adequacy and effectiveness in the use of working capital.

f) Asset Turnover Ratio

Formula:
Net Sales
Average Total Assets

- Measures how efficiently assets are used to produce sales.

g) Current Asset Turnover

Formula:
Net Sales
Average Current Assets

- Measures movement and utilization of current resources to meet operating

requirements.

4. Evaluation of Profitability
a) Gross Margin Ratio

Formula:
Gross Margin
Net Sales
- Indicates the average mark-up available to cover selling and administrative
expenses.

b) Profit Margin Ratio

Formula:
Net Income
Net Sales

- Measures efficiency of earning net income from sales.

c) Return on Total Assets

Formula:
Net Income + Interest Expense
(Net of Tax)
Average Total Assets

- Measures the productivity of assets to generate income.

d) Return on Owner’s Equity

Formula:
Net Income
Average Owner's Equity

- Measures rate of earnings on resources provided by owners.

e) Return on Common Stockholders’ Equity

Formula:

Net Income - Preferred Dividends

Average of Common Stockholders'
Equity

- Measures return on common stockholders in aggregate.

f) Return on Investment (ROI)

Formula:
Net Income
Investment

- Measures return to owners and potential investors on their investment.

g) Earnings Per Share (EPS)

Formula:

Net Income - Preferred Dividends

Number of Common Shares
Outstanding

- Measures the amount of earnings attributable to each share of common stock.

h) Price-Earnings Ratio

Formula:

Market Price Per Common Share

Earnings Per Share

- Indicates relationship of market price of common stock to net earnings.

i) Pay-out Ratio to Common

Formula:
Common Dividends

Net Income - Preferred Dividends

or

Dividends Per Share

Earnings Per Share

- Measure portion of net income to common shareholders paid out in dividends.

j) Dividends Yield on Common Stock

Formula:
Dividends Per Common Share

Market Price Per Common Share

- Measure cash flow return on common stock investment.

k) Book Value Per Share

Formula:
Common Stockholders' Equity
Number of Common Shares
Outstanding

- Measures net assets applicable to each common share.

 References:
1. Harina, Ricardo M.: Management Advisory Services. Rex Bookstore
2. Accountancy, Business, and Management. Abiva Publishing House, Inc.
3. Management Advisory Services. Excel Professional Services, Inc.
4. Suggested learning “Uniform Resource Locator” or URL
5. Internet video clips (example: Youtube videos)

Quote: “Be a student as long as you still have something to learn, and this will mean all your life.”
– Henry L. Doherty