FINANCIAL ANALYSIS

Financial analysis is needed to make the financial statements useful, primarily to

management, and to other interested parties. After completing the financial statements,

accountants need to fulfill the last accounting function, interpretation. Interpretation needs

analysis tools. Despite the use of accounts recommended by PAS guidelines, readers may still

find difficulty in understanding the financial statements. Hence, financial analysis can be a big

help to users.

OBJECTIVE OF ANALYSIS

Primarily, the objective in analyzing the financial statements is to assess the over-all

performance of the business for a given period of time. This can serve as the basis for the owner

or management in making present and future plans or decisions. The results of the analysis can

also be used to evaluate the performance of the managers of the different departments or units of

the company.

Financial analysis can uncover the strengths and weaknesses of the business. The analysis

should likewise be able to determine the liquidity, solvency, stability, profitability, and

efficiency of the business.

Analysis and interpretation

Analysis of financial statements requires computation of financial ratios whereas the

interpretation function demands explanation of the significance of those ratios.

Several rules are suggested by academicians to be observed when conducting analysis and

interpretation. If these rules are ignored, misleading interpretation or conclusion may be made.

First, develop a group of related financial ratios. A single ratio is meaningless because it is an

isolated ratio. It only becomes meaningful if related to other allied ratios. Next, make
comparison. In the analysis and the interpretation of financial statements, comparison is a must.

No interpretation can or should be made without first making a comparison. The financial ratios

developed can be compared with the past (this is called time-series analysis)

After developing a group of financial ratios and making comparisons, the analyst must

also take into consideration the limitations of the financial statements being analyzed before

making an interpretation or inference.

Meanwhile, financial statements have several limitations which serve as constraints to

financial analysis: The financial statements are not exact in the sense that there are estimated

figures incorporated in the statements. (Examples are depreciation, impairment loss, etc.) The

financial statements are not yet final. The amounts are subject to change from period to period.

They are merely interim financial statements. The final statements are the statements on the date

the business will be liquidated. The effect of inflation is ignored. The financial statements are

historical in nature. They are the results of past activities and the past may not resemble the

future. The financial statements are quantitative rather than qualitative.

Analytical tools

Foremost among the financial ratio is the ratio of one item in the financial statement to

another item in the same financial statement. There are four kinds of financial ratios: statement

of comprehensive income ratio; statement of financial position ratio; inter-statement ratio; and

trend ratio.

Statement of Comprehensive Income Ratio is the ratio of one item in the Statement of

Comprehensive Income to another item in the same SCI. An example is Return on Sales (ROS)

which is the ratio of the net income to net sales.

 Statement of Financial Position Ratio is the ratio of one item in the SFP to another item

in the same SFP. An example is the Current Ratio which is the ratio of the total current assets to

the total current liabilities.

Inter-Statement Ratio is the ratio of one item in the SCI to another item in the SFP. An

example is Accounts Receivable Turnover which is the ratio of net credit sales to the average

accounts receivable. The SFP item must be the average of the beginning and ending balances.

Trend Ratio is the ratio of one item to the same item of different periods. An example is

the ratio of sales this year to the sales last year.

Ratio analysis has the following uses:

a) It shows the business’s financial strengths and weaknesses which should be

related to the other techniques of analyzing financial statements.

b) It can be used in making future plans.

c) It can be used for performance evaluation.

As mentioned earlier, the results of the analysis of the financial statements should also be

able to determine liquidity, solvency, stability, and profitability.

The concepts liquidity, solvency, stability, and profitability

The focus of this module is the measure of performance of a business based on the

financial statements. Aside from the profit or loss and the growth in the proprietor’s capital,

liquidity, solvency, stability, and profitability of a business can be assessed. Liquidity pertains

to the capability of the business to meet payments for its short-term debts. It also means the

ability to convert non-cash current asset into cash. On the other hand, solvency is the ability to

pay liabilities on time. A business which cannot pay on time is said to be “technically insolvent”.

Solvency is of two types, short-term solvency which is the ability to pay current liabilities on
time and long-term solvency which is the ability to pay the amortization of the long-term

abilities plus the interest. Long-term solvency is the ability of the company to continue as a

going concern over a long period of time. It is concerned with the track record of the company

in handling its long-term loans. Meanwhile, profitability refers to the efficiency of the business

in generating profits from its assets, which are funded by both creditors and the proprietor. It

also refers to the ability of the management to generate adequate profits to sustain the operations

of the business and earn satisfactory return for the owners. On the other side, stability is the

ability to withstand financial reverses. It can also be equated with survivability in the event of

financial crisis.

Computation of financial ratios and their use in financial analysis

To understand financial analysis, you must understand how to compute and interpret

financial ratios. Among the financial ratios, liquidity is the simplest ratio. It is measured using

working capital and four ratios: current ratio, acid test or quick assets ratio, accounts receivable

turnover and inventory turnover. Working capital is the difference between current assets and

current liabilities. It shows the cycle from accounts payable /receivable to cash. Current ratio

refers to the capability of the entity to settle its current liabilities by using its current assets.

Another liquidity ratio is the acid test or quick assets ratio. The acid test or quick assets ratio

involves the ability to pay current liabilities with the assets that are most readily convertible into

cash. Accounts receivable turnover is the number of times that receivables on credit sales are

collected. It measures the efficiency of credit and collection procedures. Inventory turnover is

the number of times that inventory is sold during the accounting period. It indicates whether the

company holds excessive stocks of inventory.

 Moving on, you must tackle next, the solvency or stability ratio. It is used to check

whether the entity can survive over a long period of time. The questions asked here, by the long-

term creditors and the proprietor; pertain to the ability of the company to pay the regular

amortizations of interest and to repay the principal on maturity date. Solvency/stability is

assessed through the times interest earned ratio, debt ratio, equity ratio, and debt-equity ratio.

Times interest earned ratio is the ability to source interest payments from net profits in regular

business operations. It is computed by dividing net profit before interest expense and income

taxes by annual interest expense. Debt ratio shows the percentage of assets provided by

creditors. Equity ratio indicates the percentage of assets coming from the owner. Debt-to-equity

ratio shows the proportion of liabilities to owner’s equity in financing company resources.

Another ratio that may be applicable to stability is the ratio of total debt to total capitalization

(i.e. long-term debt + equity). This ratio gives the degree of significance of long-term debt as

part of the business capitalization.

Profitability ratios assess the efficiency of the business in generating profits from its

assets. The proprietor must benchmark its profit ratios with rival companies in its industry to

better assess its performance. Different profit ratios are used to assess the various components of

the company’s net income or loss. These are gross profit margin, net profit margin, return on

assets and return on equity. Gross Profit Margin refers to the ratio of Gross Profit to Net Sales.

This ratio is applicable to merchandising business wherein management efficiency is assessed in

setting up the selling price of its products. Focusing downward in the SCI, gross profit margin is

the remaining proportion of net sales that can absorb operating expenses of the business.

Another measure of profitability is the net profit margin. Net Profit Margin is equal to the ratio

of Net Profit after Taxes to Net Sales or Revenues. It gives the remaining profits of the firm
after deducting all expenses and income taxes. This ratio is crucial to a business for its

continuity as a going concern. Another helpful ratio is Return on Assets. Return on Assets is

computed as the ratio of Net Profit after Taxes to Total Assets. Similar to Net Profit Margin, the

numerator here is net profit after all expenses and taxes; however, the denominator is Total

Assets. Return on Assets measures net profit generated from total assets. Last among the

profitability ratios is the Return on Equity. Return on Equity is equal to the ratio of Net Profit

after Taxes to Owner’s Equity. Return on Equity shows the profits accruing to the owner of the

business (after all expenses and taxes). Thus the owner should focus on this ratio in order to

maximize his wealth.

Mechanics of vertical/horizontal analysis and analysis of comparative statements

Comparative Statements. The presentation of comparative financial statements for the

current period and previous period allows the user or reader to compare and analyze the changes

in the individual items in financial statements.

Horizontal Analysis. Horizontal analysis refers to getting the growth trend over several

periods, of certain items or ratios in the financial statements. An example of a line item is

accounts receivable. You may get the increase or decrease in accounts receivable for three

succeeding years, say 2013, 2014, and 2015. In a similar way, you may compare the gross profit

ratio of a company for the past three years. Horizontal analysis can be better appreciated when

shown in a line or bar graph which clearly shows an uptrend or a downtrend.

Vertical Analysis. Under the technique, the ratio of each item in the financial statement

to a certain base item is obtained and expressed in percentage. In the Statement of

Comprehensive Income, the base item is the net sales. In the Statement of Financial Position, the

base item is the total assets. The resulting statement expressed in percentages is called a
common-size statement. Vertical analysis highlights the components of the statement which

merit further investigation.

Application of financial analyses and their interpretation on sample financial statements

Given the following financial statements, prepare an analysis using financial ratios.

Kleene Car Park

Comparative Statements of Financial Position
As of Dec. 31, 2018 and 2017

Account 2018 2017

Current Assets:
Cash P 394,500 P 460,500
Accounts Receivable 38,000 29,000
Prepaid Expenses 65,000 35,000
497,500 524,500
Non-Current Assets 1,211,000 1,315,500
Total Assets P 1,708,500 P 1,840,000
Liabilities & Owner's Equity
Current Liabilities:
Trade & Other Payables P 230,000 P 225,000
Non-Current:
Loans Payable 475,000 725,000
Total Liabilities 705,000 950,000
Clinton, Capital 1,003,500 890,000
Total Liabilities & Capital P 1,708,500 P 1,840,000

Kleene Car Park

Comparative Statements of Comprehensive Income
For the years ended December 31, 2018 and 2017

Account 2018 2017

Revenues:
Parking Fees P 1,705,700 P 1,760,700
Car Wash and Cleaning 89,700 50,700
1,795,400 1,811,400
Expenses:
 Rent 595,700 595,700
Salaries 295,700 275,700
Depreciation (Note 1) 110,200 110,200
Utilities 111,200 108,250
Supplies 80,700 85,700
Insurance 55,700 70,700
Advertising 60,200 45,700
Taxes & Licenses 80,700 90,700
Repairs and Maintenance 11,200 3,700
1,401,300 1,386,350
Operating income 394,100 425,050
Interest expense 130,500 0
Net income P 263,600 P 425,050

2018 2017

A. Liquidity ratios:

1. Current ratio = Current assets / Current Liabilities

497,500 / 230,000 = 2.16:1 524,500 /225,000 = 2.33:1

2. Acid test ratio = Quick assets / Current Liabilities

Quick assets are items under current assets that are easily converted into cash, such as

accounts receivable (net), and trading account securities.

432,500 / 230,000 = 1.88:1 489,500 / 225,000 = 2.18:1

3. Working capital = Current assets less Current liabilities

497,500 – 230,000 = 267,500 524,500 – 225,000 = 299,500

Remark: The business is liquid in both years.

4. Accounts receivable turnover = Net Credit Sales / Average Accounts Receivable

1,795,400 / 33,500 = 53 times

Average accounts receivable refers to the average of beginning and ending balances of

accounts receivable.
Remark: There is a high receivable turnover which increases the profits of the company.

5. Inventory turnover = Cost of Sales / Average Inventory

None for this company because it is not a merchandising business

6. Operating cycle = Collection Period (days) + Average Age of Inventory (days)

Note: Collection Period = 360 days / Accounts Receivable Turnover

Average Age of Inventory = 360 days / inventory turnover

None for this company because it is not a merchandising business.

B. Solvency ratios

1. Debt ratio = Total liabilities / Total Assets

705,000 / 1,708,500 = 0.41:1 950,000 / 1,840,000 = 0.52:1

2. Equity ratio = Owner’s equity / Total Assets

1,003,500 / 1,708,500 = 0.59:1 890,000 / 1,840,000 = 0.48:1

3. Debt-to-equity ratio = Total debt / Owner’s equity

705,000 / 1,003,500 = 0.70:1 950,000 / 890,000 = 1.07:1

Remark: The company is highly leveraged in 2017at 1.07:1 debt-equity ratio.

4. Equity-Debt ratio = Owner’s Equity / Total Long-term debt

1,003,500 / 475,000 = 2.11 times 890,000 / 725,000 = 1.23 times

5. Times interest earned ratio = net profit before interest and income taxes / annual interest

exp.

394,100 / 130,500 = 3 times

Remark: The interest coverage ratio is high. It assures long-term creditors that interest and

principal can be settled by the company.

 6. Debt-Service Coverage Ratio = Net Profit before interest / Payments on Principal and

Interest

2018 > 394,100 / [130,500 + (725,000 – 475,000)] = 1.04 times

2017 > Not applicable. No interest/principal payments.

Note: To be more useful, the computed stability ratios can be compared with industry ratios

(average financial ratios for companies comprising a specific industry e.g. toiletries industry and

canned goods manufacturing industry).

7. Debt to capitalization ratio = Total debt / (total long-term debt + equity)

705,000 / 1,478,000 = 0.48:1 950,000 / 1,615,000 = 0.59:1

Remark: To be more useful, the above stability ratios can be compared to industry ratios.

C. Profitability ratios:

1. Gross profit margin ratio = Gross profit / Net Revenues or Net Sales

None for this illustration because it is a service business.

2. Net profit margin ratio = Net Profit after taxes / Revenues or Net Sales

263,600 / 1,795,400 = 15% 425,050 / 1,811,400 = 23%

3. Return on assets = Net Profit after taxes / Total Assets

263,600 / 1,708,500 = 15% 425,050 / 1,840,000 = 23%

4. Return on Sales or Net Profit Margin Ratio = Net Profit after Taxes / Net Revenues or

Net Sales

263,600 / 1,795,400 = 15% 425,050 / 1,811,400 = 23%

5. Return on equity = Net Profit after taxes / Owner’s equity

263,600 / 1,003,500 = 26% 425,050 / 890,000 = 48%

Remarks: For the profitability ratios, compare the computed ratios with industry ratios to check

whether the resulting ratios are weak, strong or within industry average. They may also be

compared with market interest rates (prevailing interest rates on bank deposits or on loans). For

instance, if offered rates to investors averaged at 15%, then the return on equity of 26% in 2018

is quite rewarding.

Using the same data for Kleene Car Park, presented below is the horizontal analysis.

Kleene Car Park

Statement of Financial Position- Horizontal Analysis
Dec. 31, 2018 and 2017

Increase (Decrease)
2018 2017 Amount Percent
Current Assets:
Cash P 394,500 P 460,500 P(66,000) (14%)
Accounts Receivable 38,000 29,000 9,000 31%
Prepaid Expenses 65,000 35,000 30,000 86%
497,500 524,500 (27,000) (5%)
Non-Current Assets 1,211,000 1,315,500 (104,500) (8%)
Total Assets P 1,708,500 P1,840,000 (131,500) (7%)

Liabilities & Owner's Equity

Current Liabilities:
Trade & Other Payables 230,000 225,000 5,000 2%
Non-Current Liabilities:
Loans Payable 475,000 725,000 (250,000) (34%)
Total Liabilities 705,000 950,000 (245,000) (26%)
Clinton, Capital 1,003,500 890,000 113,500 13%
Total Liabilities & Capital P 1,708,500 P1,840,000 (131,500) (7%)

Note: Decrease in loans payable was significant at 34% and contributed to the 7% decline in

total assets.

Kleene Car Park

 Statement of Comprehensive Income - Horizontal Analysis
For the year ended Dec. 31, 2018 and 2017
Change
2018 2017 Amount %
Revenues:
Parking Fees P1,705,700 P1,760,700 ( P 55,000) -3%
Car Wash and Cleaning 89,700 50,700 39,000 77%
Total revenues 1,795,400 1,811,400 (16,000) -0.90%
Expenses:
Rent 595,700 595,700
Salaries 295,700 275,700 20,000 7%
Depreciation (Note 1) 110,200 110,200
Utilities 111,200 108,250 2,950 3%
Supplies 80,700 85,700 -5,000 -6%
Insurance 55,700 70,700 (15,000) -21%
Advertising 60,200 45,700 14,500 32%
Taxes & Licenses 80,700 90,700 (10,000) -11%
Repairs and
11,200 3,700 7,500 203%
Maintenance
Total expenses 1,401,300 1,386,350 14,950 1%
Net operating income 394,100 425,050 (30,950) (7%)
Interest expense 130,500 0 130,500
Net Income P 263,600 P 425,050 (P161,450) -38%

Remark: The decrease in revenues by 0.9% and increase in expenses by 1% plus the interest
expense of P130,500 contributed to the 38% decrease in net income.

Prepare also a vertical analysis.

Kleene Car Park

Statement of Financial Position - Vertical Analysis
Dec. 31, 2018 and 2017
2018 2017
Current Assets:
Cash 23% 25%
Accounts Receivable 2% 2%
Prepaid Expenses 4% 2%
Non-Current Assets 71% 71%
Total Assets 100% 100%
Liabilities & Owner's Equity
Current Liabilities:
Trade & Other Payables 13% 12%
Non-Current:
Loans Payable 28% 40%
Total Liabilities 41% 52%
Clinton, Capital 59% 48%
Total Liabilities & Capital 100% 100%

Remarks: As a service business, a major portion (71% in both 2018 and 2017) of the company’s

assets are non-current assets - property and equipment. In 2018, after payment of a huge portion

of long-term liability, the owner’s equity rose to 59% from 48% in 2017.

Kleene Car Park

Statement of Comprehensive Income - Vertical Analysis
For the year ended Dec. 31, 2018

2018 2017
Revenues:
Parking Fees 95% 97%
Car Wash and Cleaning 5% 3%
100% 100%
Expenses:
Rent 33% 33%
Salaries 16% 15%
Depreciation 6% 6%
Utilities 6% 6%
Supplies 4% 5%
Insurance 3% 4%
Advertising 3% 3%
Taxes & Licenses 4% 5%
Repairs and Maintenance 1% 0.20%
76% 77.2%
Operating income. 24% 22.8%
Interest expense 7%
Net income 17% 22.8%
Note: For 2018, a sizeable portion of expenses is rent at 33%. Interest expense is substantial at 7%. Net
income declined to 17% of total revenues due to the huge interest expense.

Illustration of inventory turnover calculation

The proprietor of a doll shop wants to evaluate its task on inventory management. To assist the

proprietor, you gathered the following information from his accounting records:

Merchandise inventory, Jan. 1, 2018 P325, 000

Merchandise inventory, December 31, 2018 263, 000

Cost of Sales 1,524,000

Inventory turnover = Cost of sales / average inventory

= 1,524,000 / 294,000 = 5 times

To determine whether the inventory turnover is high, it must be compared with the

turnover rates of other companies within its industry.