06: FINANCIAL STATEMENT ANALYSIS

F/S ANALYSIS – involves the assessment and evaluation of the firm’s past performance,
its present condition and future business potentials. The analysis
serves to provide information about the following:
 Probability of the business firm
 Ability to meet its obligation
 Safety of investment in the business
 Effectiveness of management in running the firm

F/S ANALYSIS TOOLS AND TECHNIQUES

1. Vertical analysis (common-size statement or percentage composition statements)
2. Horizontal analysis (trend percentages or index analysis)
3. Financial ratios (ratio analysis)
4. Gross profit variation analysis
5. Cash flow statement

HORIZONTAL ANALYSIS
Horizontal or index analysis involves comparison of figures shown in the
financial statements of two or more consecutive periods. The difference between the
figures of the two periods is calculated, and the percentage change from one period to
the next is computed using the earlier period as the base.
Formula:

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

Base Period Value

Comparison may be:

1. Actual vs. Budget (base)
2. Present period vs. Previous period (base)

VERTICAL ANALYSIS
The 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 total or net sales (in the income
statement). These converted statements are called common-size statements or percentage
composition statements.

Percentage composition statements are used for comparing:

1. Multiple years of data from the same firm
2. Companies that are different in size
3. Company to industry averages

RATIO ANALYSIS
Ratio analysis involves development of mathematical relationships between
accounts in the financial statements. Ratios calculated from these statements provide
users and analysis with relevant information about the business firm’s liquidity,
solvency, profitability and Market Test.

CALCULATION RULES AND LIMITATIONS

1. When calculating a ratio using balance sheet number only, the numerator and
denominator should be from the SAME balance sheet date, not different time
periods. The same is true with ratios using only income statement numbers.
EXCEPTION: calculation of growth ratios.
2. When an income statement number and a balance sheet number are both used, the
balance sheet number should be an average (simple) for the time period
represented by the income statement number. 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.
 3. Generally, the number of days in a month or year are 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 or 300 working days.
4. Limitation for percentage change calculations: if a negative or a zero amount
appears in the base year, percentage change cannot be computed.

FINANCIAL RATIOS

 TESTS OF LIQUIDITY (Liquidity refers to the company’s ability to pay its current
liabilities as they fall due.)
Current Ratio It is a measure of
(Banker’s Ratio) Current Assets adequacy of working
(Working Capital Current Liabilities capital.
Ratio) It is the primary test
of solvency to meet
current obligations from
current assets.
Quick Ratio Quick Assets It measures the number
(Acid Test Ratio) Current Liabilities of times that the
current liabilities
could be paid with the
available cash and near-
cash assets (i.e., cash,
accounts receivable and
marketable securities.

Working Capital Activity Ratios (TURNOVERS)

It is the time required
to complete one
Receivables Turnover Net Credit Sales collection cycle from
Average Receivables the time receivables are
recorded, then
collected, to the time
new receivables are
recorded again.
Average Age of It indicates the average
Receivables 360 days number of days during
(Average Collection Receivable Turnover which the company must
Period) wait before receivables
(Days’ Sales in are collected.
Receivables)
Cost of Goods Sold It measures the number
Inventory Turnover Ave. Merchandise Inventory of times that the
inventory is replaced
during the period.
Average Age of 360 days It indicates the average
Inventory Inventory Turnover number of days during
which the company must
wait before the
inventories are sold.
Raw Materials Turnover Cost of Materials Used
Average Raw Materials Inventory

Goods in Process Cost of Goods Manufactured

Turnover Average Work in Process Inventory

Finished goods Cost of Goods Sold

Turnover Average Finished Goods Inventory

(Days in) Operating Sum of average ages of receivables, raw materials, goods in
Cycle process, and finished goods inventories (for manufacturing
firms)
Trade Payable Turnover Net Credit Purchases
Ave. Trade Payables

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 360 days It indicates the length
Average Age of Trade of time during which
Payable Payables Turnover payables remain unpaid.

Current Asset Turnover

Cost of Sales + Operating Expenses It measures the movement
(excluding depreciation and and utilization of
amortization) Ave. Current Assets current assets to meet
operating requirements.
 TESTS OF SOVENCY (Solvency refers to the ability to pay its debts, current or non-
current)
Time Interest Earned ____EBIT___ It determines the extent
Interest Expense to which operations
cover interest expense.
Debt-Equity Ratio Total Liabilities Proportion of assets
Total SHE provided by creditors
compared to that
provided by owners.
Debt Ratio Total Liabilities Proportion of total
Total Assets assets provided by
creditors
Equity Ratio Total SHE Proportion of total
Total Assets assets provided by
owners.
 TESTS OF PROFITABILITY
Return on Sales Income Determines the amount of
(Net Profit Margin) Net Sales income by owners
Return on Total Assets Income Efficiency with which
Ave. Total Assets assets are used to
operate the business

What income figure should be used?

1. Net income from continuing operations, excluding extraordinary items, disposals of
segments of business, and cumulative effects changes in accounting principles.
2. Include dividends and interest earned on investments in net income, if the said
investments are included in asset base.
3. Use income before interest and tax if the intention is to measure operational
performance.
4. Use net income (after interest and tax) if the intention is to evaluate total
managerial effort.

Return on Owner’s Net Income Measures the amount

Equity Ave. Owner’s Equity earned on the owners’ or
stockholders’
investments.
Net Income – preferred Dividends
_____(if any)_____
Earnings per Share Weighted Ave. Common Shares Measures the amount of
Outstanding net income earned by
each common share.

 MARKET TESTS
Price-Earnings Ratio Price Per Share It indicates the number
(P/E) Earning Per Share of pesos required to buy
P1 of earnings.
Dividends Yield Dividends per Share Measures the rate of
Price per Share return in the investor’s
common stock
investments.
Dividends Pay-Out Common Dividends per Share____ It indicates the
Earnings per Share proportion of earnings
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 distributed as
dividends.

True/False Questions

1. Vertical analysis of financial statements is accomplished through the preparation of

common-size statements.
2. The gross margin percentage is computed by dividing the gross margin by net income
before interest and taxes.
3. If a company's return on assets is substantially higher than its cost of borrowing,
then the common stockholders would normally want the company to have a relatively
high debt/equity ratio.
4. The dividend yield ratio is calculated by dividing dividends per share by earnings
per share.
5. Financial leverage is positive if the interest rate on debt is lower than the return
on total assets.
6. To compute the return on total assets, net income should be adjusted by adding after
tax interest expense and preferred dividends.
7. When computing the return on common equity, the income available for common
stockholders is determined by deducting preferred dividends from net income.
8. Issuing common stock will increase a company's financial leverage.
9. Book value per share is the key to predicting a company's future income producing
ability.
10. The book value per share of common stock reflects the balance sheet carrying
value of already completed transactions.
11. A company's acid-test ratio will always be less than or equal to its current
ratio.
12. A company could improve its acid-test ratio by selling some equipment it no
longer needs for cash.
13. As the accounts receivable turnover ratio decreases, the average collection
period decreases.
14. Payment of interest owed would decrease the inventory turnover ratio.
15. When computing the times interest earned ratio, earnings before interest expense
and income taxes is used in the numerator.

MULTIPLE CHOICE QUESTION

1. The gross margin percentage is equal to:

A. (Net operating income + Operating expenses)/Sales
B. Net operating income/Sales
C. Cost of goods sold/Sales
D. Cost of goods sold/Net income

2. The book value per share of common stock is usually significantly different from the
market value of the common stock because of:
A. the omission of total assets from the numerator in the calculation
of the book value per share.
B. the use of the matching principle in preparing financial
statements.
C. the omission of the number of preferred shares outstanding in the
calculation of the book value per share.
D. the use of historical costs in preparing financial statements.

3. A company's current ratio is greater than 1. Purchasing raw materials on credit

would:
A. increase the current ratio.
B. decrease the current ratio.
C. increase net working capital.
D. decrease net working capital.

4. Norton Inc. could improve its current ratio of 2 by:

A. paying a previously declared stock dividend
B. writing off an uncollectible receivable.

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 C. selling merchandise on credit at a profit.
D. purchasing inventory on credit.

5. Stern Company has 100,000 shares of common stock and 20,000 shares of preferred
stock outstanding. There was no change in the number of common or preferred shares
outstanding during the year. Preferred stockholders received dividends totaling
P140,000 during the year. Common stockholders received dividends totaling P210,000.
If the dividend payout ratio was 70%, then the net income was:

A. P200,000 C. P500,000
B. P300,000 D. P440,000

6. The Seabury Company has a current ratio of 3.5 and an acid-test ratio of 2.8.
Inventory equals P49,000 and there are no prepaid expenses. Seabury Company's
current liabilities must be:
A. P70,000 C. P49,000
B. P100,000 D. P125,000

7. Neelty Corporation has interest expense of P16,000, sales of P600,000, a tax rate of
30%, and after-tax net income of P56,000. What is the firm's times interest earned
ratio?
A. 6.0 C. 4.5
B. 5.0 D. 3.5

8. Whitney Company has a times interest earned ratio of 3.0. The company's tax rate is
40% and its interest expense is P21,000. The company's after-tax net income is
closest to:
A. P63,000 C. P21,000
B. P25,200 D. P42,000

9. Falmouth Company's debt to equity ratio is 0.6. Current liabilities are P120,000,
long term liabilities are P360,000, and working capital is P140,000. Total assets of
the company must be:
A. P600,000 C. P800,000
B. P1,200,000 D. P1,280,000

Question Nos. 1 through 3 are based on the data taken from the balance sheet of Nomad
Company at the end of the current year:
Accounts payable P145,000
Accounts receivable 110,000
Accrued liabilities 4,000
Cash 80,000
Income tax payable 10,000
Inventory 140,000
Marketable securities 250,000
Notes payable, short-term 85,000
Prepaid expenses 15,000

10. The amount of working capital for the company is:

A. P351,000 B. P361,000 C. P211,000 D. P336,000

11. The company’s current ratio as of the balance sheet date is:
A. P2.67:1 B. P2.44:1 C. P2.02:1 D. P1.95:1

12. The company’s acid-test ratio as of the balance sheet date is:
A. P1.80:1 B. P2.40:1 C. P2.02:1 D. P1.76:1

13. A fire has destroyed many of the financial records of R. Son & Company. You are
assigned to put together a financial report. You have found the return on equity to
be 12% and the debt ratio was 0.40. What was the return on assets?
A. 5.35% B. 8.4% C. 6.60% D. 7.20%

14. Recto Co. has a price earnings ratio of 7, earnings per share of P2.20, and a pay
out ratio of 80%. The dividend yield is
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 A. 80% B. 39.3% C. 11.4% D. 31.4%

15. Dividend yield is 12% while price-earnings ratio is set 5 times. Determine the
retention or plowback ratio.
A. 2.4%
B. 40.0%
C. 41.7%
D. 60%

16. The Delta Company projects the following for the upcoming year:
Earnings before interest and taxes P40 million
Interest expense P 5 million
Preferred stock dividends P 4 million
Common stock dividend payout ratio 20%
Average number of common shares outstanding 2 million
Effective corporate income tax rate 40%
The expected dividend per share of common stock is
A. P1.70 B. P1.86 C. P2.10 D. P1.00

17. The following were reflected from the records of War Freak Company:
Earnings before interest and taxes P1,250,000
Interest expense 250,000
Preferred dividends 200,000
Payout ratio 40 percent
Shares outstanding throughout 2003
Preferred 20,000
Common 25,000
Income tax rate 40 percent
Price earnings ratio 5 times
The dividend yield ratio is
A.. 0.50 B. 0.40 C. 0.12 D. 0.08

18. Calumpang Company has a total assets turnover of 0.30 and a profit margin of 10
percent. The president is unhappy with the current return on assets, and he thinks
it could be doubled. This could be accomplished (1) by increasing the profit margin
to 12 percent, and (2) by increasing the total assets turnover. What new asset
turnover ratio, along with the 12 percent profit margin, is required to double the
return on assets?
A.. 25% B. 36% C. 50% D. 60%

19. JayR has debt ratio of 0.50, a total asset turnover of 0.25, and a profit margin
of 10%. The president is unhappy with the current return on equity, and he thinks it
could be doubled. This could be accomplished: (1) by increasing the profit margin to
14%; and, (2) by increasing debt utilization. Total asset turnover will not change.
What new debt ratio, along, with 14% profit margin is required to double the
return on equity?
A. 0.75 B. 0.70 C. 0.65 D. 0.55

20. Glo expects sales for 2002 to be P2,000,000, resulting in a return on sales of
10%. The dividend payout rate is 60%. Beginning stockholders’ equity was P850,000
and current liabilities are projected to be P300,000 at the end of 2002. What are
the total equities available if the ratio of long-term debt to stockholders’ equity
is 60%?
A. P1,788,000 B. P1,980,000 C. P2,046,000 D. P858,000

21. Assume you are given the following relationships for the Marhya Company:
Sales/total assets 1.5X
Return on assets (ROA) 3%
Return on equity (ROE) 5%
The Marhya Company’s debt ratio is
A. 40% B. 60% C. 35% D. 65%

22. In which of the following cases may a percentage change be computed?

A. The trend of the amounts is decreasing but all amounts are positive.
B. There is no amount in the base year.

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 C. There is a negative amount in the base year and a negative amount in the
subsequent year.
D. There is a negative amount in the base year and a positive amount in the
subsequent year.

23. Horizontal analysis is a technique for evaluating a series of financial statement

data over a period of time
A. that has been arranged from the highest number to the lowest number.
B. that has been arranged from the lowest number to the highest number.
C. to determine which items are in error.
D. to determine the amount and/or percentage increase or decrease that has taken
place.

24. Trend analysis allows a firm to compare its performance to:

A. other firms in the industry C. other industries
B. other time periods within the firm D. none of the above

25. Which of the following generally is the most useful in analyzing companies of
different sizes?
A. comparative statements C. price-level accounting
B. common-sized financial statements D. profitability index

26. Statements in which all items are expressed only in relative terms (percentages
of a base) are termed:
A. Vertical statements C. Funds Statements
B. Horizontal Statements D. Common-Size Statements

27. The percent of property, plant and equipment to total assets is an example of:
A. vertical analysis C. profitability analysis
B. solvency analysis D. horizontal analysis

28. Vertical analysis is a technique that expresses each item in a financial

statement
A. in pesos and centavos.
B. as a percent of the item in the previous year.
C. as a percent of a base amount.
D. starting with the highest value down to the lowest value.

29. In performing a vertical analysis, the base for prepaid expenses is

A. total current assets. C. total liabilities.
B. total assets. D. prepaid expenses in a previous year.

LEVERAGE

ITEM 30 to 32 ARE BASED ON THE FOLLOWING INFORMATION:

Following is the income statement of Annabelle Corporation for the year indeed December
31, 200A:
ANNABELLE CORPORATION
Income Statement
For the year ended December 31, 200A
Sales (500,000 units at P100 each) P50,0000,000
Less variable cost (500,000 at P80 each) 40,000,000
Contribution Margin 10,000,000
Less Fixed costs 6,000,000
Operating income (or EBIT) 4,000,000
Less Interest expense 1,000,000
Income before tax 3,000,000
Less Income tax (30%) 900,000
Income after tax P2,100,000

30. What is Annabelle Corporation’s degree of operating leverage (DOL)?

A. 2.50 B. 3.33 C. 4.90 D. 7.35

31. What is Annabelle Corporation’s degree of financing leverage (DFL)?

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 A. 1.7 B. 2.50 C. 2.00 D. 1.33

32. What is Annabelle Corporation’s degree of total leverage (DTL)?

A. 4.00 B. 3.325 C. 1.25 D. 0.80

33. To acquire additional capital while attempting to maximize earning per share, a
company should normally
A. Select debt over equity initially.
B. Select equity over debt initially.
C. Issue both bonds and stock in equal proportion
D. Discontinue paying dividends and use current cash flows to raise capital funds.
34.Which of the following statements is most correct?
A. When a company increases its debt ratio, the costs of equity and debt capital both
increase. Therefore, the weighted average cost of capital (WACC) must also
increase.
B. The capital structure that maximizes stock price is generally the capital
structure that also maximizes earnings per share.
C. All else equal, an increase in the corporate tax rate would tend to encourage a
company to increase its debt ratio.
D. Statements a and b are correct.
35. A company has an EBIT of P4 million, and its degree of total leverage is 2.4. The
firm’s debt consists of P20 million in bonds with a 10 percent yield to maturity. The
company is considering a new production process that will require an increase in fixed
costs but a decrease in variable costs. If adopted, the new process will result in a
degree of operating leverage of 1.4. The president wants to keep the degree of total
leverage at 2.4. If EBIT remains at P4 million, what amount of bonds must be
outstanding to accomplish this (assuming the yield to maturity remains at 10 percent)?
A. 16.7 million C. P19.2 million
B. P18.5 million D. P19.8 million

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