Analysis and Interpretation of Financial Statements I

Financial Statement Analysis

➢ Is the process of selecting related data from financial statements to evaluate the entities
past financial position and operating performance and predict the outcome of future
operations.
➢ It is the process of reviewing and evaluating a company's financial statements (such as
the balance sheet or profit and loss statement), thereby gaining an understanding of the
financial health of the company and enabling more effective decision making.
Financial statement (FS) analysis is the process of evaluating risks, performance, financial
health, and future prospects of a business by subjecting financial statement data to
computational and analytical techniques with the objective of making economic decisions (White
et.al 1998). There are four kinds of FS analysis techniques:
1. Horizontal analysis
2. Vertical analysis
3. Trend analysis
4. Financial ratios
Nature of Horizontal Analysis or Comparative Approach
➢ Is an analytical tool that evaluates the present performance of an entity compared to last
year`s. The analysis reflects the differences in absolute amount and in percentage
between two periods only, namely the present year and the previous year.
➢ The primary objective of horizontal or comparative analysis is to determine the present
status of the business in terms of financial position, result of operation, and cash flows
against the preceding year only.
➢ It is a powerful analytical tool used by investors and financial market players to assess
the operating performance and long-term potentials of business entities.
➢ There are two methods of performing horizontal or comparative analysis: absolute
amount comparison and percentage method of comparison.
Absolute Amount Comparison
➢ The absolute amount of each item appearing in the financial statements is determined
by deducting the amount of the current date financial statements from the amount of the
immediately preceding year. This method will identify the items the change the most.

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Percentage Method of Comparison

➢ This works on the percentage of change which is determined by dividing the absolute
amount of change by the base figure.

Guidelines in Performing Horizontal Analysis

1. Present the current year and the last year’s financial statements in comparative format.
2. Compute the absolute amount of change or difference. The difference can either be an
increase or decrease. For example, the cash and cash equivalents in 2018 and 2017
amounted to ₱150,000 and ₱180,000, respectively; the absolute amount of change is
₱30,000. (This is for the absolute amount comparison.)

3. Express the difference in percentages by dividing the amount of change by the base.
The percentage of change of cash and cash equivalents above is a decrease of 16.67%.
(This is for percentage comparison.)
Percentage of change = (₱30,000)/ ₱180,000
= (16.67%)

4. The computation of percentage of change will not apply if the base amount is negative or
zero.

5. Interpret the change of an item by relating it with the change or movement of other
related items. For example, the change in current assets would be related to the change
in current liabilities, or the change in trade accounts and notes receivable will be
interpreted by considering the changes in sales.

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 Analysis and Interpretation of Financial Statements I

Nature of Vertical Analysis or Common Size Approach

➢ Is an analytical tool that determines the size or proportion of an item in the financial
statements in relation to the total.
➢ For example: If cash and cash equivalents on December 31, 2018 are analyzed using
the vertical analysis method, the amount shall be evaluated against the chosen base of
2018 accounting period. No other reference accounting period shall be used in the
evaluation process, except that of year 2018 only.
➢ For example, the businesses is set to maintain an average cash and cash equivalents
equal to 4 percent of total assets based on its regular requirements and past years’
experience. If the total assets of the business is ₱8,000,000, then the expected amount
of cash and cash equivalents at the end of the year would be more or less ₱320,000.
➢ It is very useful in determining the proportion of each item in the different sections of the
financial statements.
➢ It also serves as a guide in the management of the resource allocation policy.
➢ For example, a merchandising business is expected to allocate more resources to
inventory. However, if it has been determined using the vertical analysis that 60 percent
of the funds or resources of a particular merchandising concern are in short-term
investments, then it would be safe to conclude that the business is not operating as a
merchandising entity. Rather, it is engaged in the buy and sell of securities where it will
realize more income than from the buy and sell of goods.
Performing Vertical Analysis
1. Convert the absolute peso amount of the items in the financial statements into
percentages by dividing each item by the base. The base shall be equal to 100 percent.
2. The base to be used shall be as follows:
a. for statement of financial position - total assets and total liabilities and owner's
equity
b. for statement of comprehensive income - total or net sales
c. for statement of cash flows - total cash available for use
3. Make a conclusion on the allocation and indications of possibilities.
a. For the SCI, the base amount is Net Sales.
b. Balance of Account / Total Sales.
c. This will reveal how “Net Sales” is used up by the various expenses.

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d. Net income as a percentage of sales is also known as the net profit margin.
e. For the SFP, the base amount is Total Assets.
f. Balance of Account / Total Assets.
g. From the common-size SFP, the analyst can infer the composition of assets and
the company’s financing mix.

➢ The use of common-size financial statements allows the comparison of two companies
of different sizes. This is because the SFP and SCI comparative information are
standardized as a percentage of assets and sales, respectively.

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 Analysis and Interpretation of Financial Statements I

Nature of Trend Analysis

➢ Used to analyze the financial statements that extend beyond two years through the use
of index numbers of percentage and converting the absolute peso value into percentage.
➢ Another term of trend analysis is trend percentage.
➢ Makes a comparative study of operating performance of the business over a number of
years.
➢ The base year must be a representative of normal year. The base year carries an index
of 100 percent.
Key Points in Performing Trend Analysis
➢ The trend of the analysis may either be upward or downward.
➢ An upward trend indicated increasing financial performance, and a downward trend
indicates a decreasing operating performance.
➢ The reader of the financial statements should be cautioned that an upward trend does
not necessarily indicate favorable financial performance.
➢ The trend in one account of the financial statements should be cross-referenced to other
accounts that directly or indirectly affected it in forming a conclusion.
Steps of Trend Analysis
1. Present in tabular format the financial statements covering several years. The
arrangement is usually in ascending order.

2. Select a base year. This is purely judgmental but it should, however, serve as a normal
operating activity of an entity. Normally, the base year is the earliest year used in the
analysis and has the index of 100 or 100%.
3. Divide each absolute amount by the base year in order to determine the relationship of
each item with the base year. Multiply the results by 100 in order to express the data in
percentage.

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 Analysis and Interpretation of Financial Statements I

Example of Trend Analysis

We will analyze the Statement of Financial Position of Jenny Merchandising for the years 2014
to 2018 using trend analysis.

After performing trend analysis, the results will be shown as:

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 Analysis and Interpretation of Financial Statements I

If the amounts and the results will be presented side by side, the Statement of Financial Position
will be displayed like this:

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 Analysis and Interpretation of Financial Statements I

Now, using the Statement of Financial Performance of Jenny Merchandising for the years 2014
to 2018, we will use trend analysis:

After performing the trend analysis, this will yield us with the results below:

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 Analysis and Interpretation of Financial Statements I

If the amounts and percentage are comparatively presented beside each other, it will be seen in
this manner:

Reference:
Commission on Higher Education. (2016). Teaching Guide for Senior High School, Fundamentals of Accountancy, Business, and Management 2.
Quezon City, EC-TEC Commercial.
Aduana, N. (2017). Fundamentals of Accountancy, Business, and Management 2. Quezon City, C & E Publishing, Inc.

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