Module 2

Module 2: Financial Statement Analysis

Module Objective: At the end of the module, you should be able to:

1. Define Financial Statement Analysis and its purpose 2. Identify the different requirements in conducting financial statement analysis 3. Recognize the limitations of Financial Statement Analysis 4. Evaluate a firm’s progress using trend analysis 5. Distinguish a firm’s focus through common-size financial statement6. Assess a firm’s profitability and risk level using ratio analysis

Financial Statement Analysis It refers to the evaluation of a firm’s over-all performance and financial condition through the examination of the financial statements. Performance refers to a firm’s result of operation as compared to a predetermined benchmark while a firm’s condition is being defined by amount of resources and the claims to such resources by different parties. Although performance is often being related to net income, a deeper analysis will result to the determination of how the firm was effective and efficient in achieving its goals and objectives and if possible, as compared to other firms. Another area in financial statement analysis is the definition of financial condition, which is usually related to the amount of assets and the ratio between the liabilities and equity that has a claim on such assets, however, in evaluating the financial condition of a firm, the ultimate goal is to establish the amount, timing and certainty of future cash flow, both inflows and outflows. When assessing the financial health of a firm, the main concern is how the assets of the firm will be able to, either directly or indirectly, contribute to the firm’s cash inflow in order to address the spending needs of the firm related to the claims, not only of the firm’s creditors and shareholders, but also its operating requirements.

The Financial StatementsAs provided by the conceptual framework, the objective of general purpose financial statements is to provide information about the financial position (resources and claims and the changes on such), performance (income and expenses), and the changes in the financial position (changes through cash flows and equity), that is useful in making economic decision. A complete set of financial statement include a statement of financial position, statement of comprehensive income, statement of cash flows, statement of changes in equity, and the summary of significant summary and supporting schedules.

The Statement of Financial Position Formerly known as the balance sheet, the statement of financial position presents the Assets, Liabilities and Equity of a firm. The statement presents a snapshot of the resources of a firm (assets) and the claims to those resources (liabilities and shareholders’ equity). In financial accounting, assets are resource controlled by a firm that can provide future economic benefit, however, in financial statement analysis, assets will reflect the past investing decisions of the firm and this will include the amount tied up to receivables and inventories. Liabilities under financial accounting are present obligations that will be settled by the firm while equity is the residual value left to the shareholders after deducting the liabilities. In financial statement analysis, liabilities and equity will represent the past financing of the firm, meaning, what the firm had used in acquiring its assets.

The Statement of Comprehensive Income The income statement presents the amount of income earned by the firm that will be helpful in assessing the over-all performance of the firm. However, in financial statement analysis, the income statement will be helpful in assessing how effective and efficient the firm in generating

revenues in order to address all of its financial needs, whether operating, investing or financing in nature. The only drawback for the statement of comprehensive income is the basis for the recognition of income and expenses and that is income is recognized when earned or when services has already been rendered or goods delivered and expense is recognized when incurred that most of the time, does not coincide with the inflow of cash. Hence, if decision makers will literally evaluate the result of the operation, they will be misled as to expecting that there will be cash flowing into the firm when there is net income and vice versa during net loss.

The Statement of Cash FlowThe statement of cash flow presents, for a period of time, the net cash flow (inflows minus outflow) from the three principal business activities; operating, investing, and financing. The main goal of the business is to generate a positive cash flow from its operation however; such operation will be requiring different resources acquired under investing activities which will be possible if there will be funds provided under financing activities. In providing information about the cash flow of the firm and reconciling such to the results of operation can permit the assessment of the certainty, timing and amount of cash that will flow into the firm. As discussed in the previous section profit does not equal to cash inflows due to the fact that the timing of cash flow does not coincide with the timing of recognizing revenues and expenses and this sometimes causes financial difficulties when the retirement of debt or acquisition of properties are done during times of insufficient cash.

Why interpret financial statements?In analyzing the financial statements, management will be able to assess the level of an firm’s success in the past in conducting its activities, its strengths used to avail of the opportunities and lower, if not eliminate, any business threats and the areas wherein the firm is weak that causes the business threats. Also, uncovering the financial condition and performance of the firm will lead to the identification of how the firm has reacted in relation to changes in the business environment. After ascertaining the strengths and weaknesses and the firm’s reaction through financial statement analysis, management can now project its likely future performance by setting goals, formulate strategies that will eventually lead to the construction of the financial budget.

Other usages of the result of financial statement analysis are as follows: 1. For investors when determining what firm to be invest in and the amount of the investment to be

made in a firm’s stocks2. For the creditors and suppliers when extending credit – credit worthiness of the firm being

evaluated. 3. Assessing the operating performance and financial health of suppliers and customers in

determining the level of reliance the firm is going to make and assessing the competitors’ performance and financial health could be used in constructing the goals and strategies to be implemented in the following period.

4. For management consultants and advisers, in terms of valuing another firm being considered as an acquisition candidate – advisers and consultants is likely to consider the income generating power of the firm to be acquired.

5. Forming a judgment about damages sustained in a lawsuit6. For auditors when assessing the nature, extent, and timing of the audit tests in rendering an

opinion. 7. Government regulations – in as far as to the taxes to be levied and restrictions to be imposed, the

government should evaluate the financial impact to key players in the different industry before making a regulation.

8. Employee benefits formulation – assessing the ability of the firm to provide better remuneration, retirement benefits and other monthly benefits should be considered when asking for such.

Requirements in conducting financial statement analysisBefore conducting a financial statement analysis, accountants and management consultants should first identify the economics and current conditions facing the business. Second, identify the strategies that the firm selects to compete in the business. Third, understand the important concepts and principles underlying the financial statements used in computing the financial ratios. Through these understanding, the analyst will be able to develop an expectation of the behavior in account balances and the level of possible net income. After developing the expectations, we can now perform the analysis. Lastly, after finishing the analysis, we need to make a judgment or a conclusion and the related recommendation for the operation’s primary activities. It is to be described that financial Statements serve as score sheet or the report card which is the result of the accounting process which are considered to be a system for measuring the results of a firm’s business transactions and summarizing them in a form that interested parties can understand. But the ultimate key concept in this discussion is the effect of business transactions, which are the key in understanding the financial statements.

Establish the economic and current condition This aspect refers to both the internal and external business environment of the firm. It require scrutinizing even the smallest detail in the industry and general economic environment that may hinder or limit, either directly or indirectly, the firm’s operation that may prevent it from achieving its goals and objective. In this aspect, management is required to ascertain the following:

1. What is the competitive market (output-sales) profile of the industry It is about identifying the key players in an industry, who are the market leader and challenger and who are the followers and firm’s that concentrate on the small portion of the market (niche market). Aside from the direct competitors, management should also look into the product and service substitutes and possible threats of foreign competition.

2. What is the production (input) profile of the industry? In as far as production requirement is concern, the three major production cost, direct materials, direct labor and manufacturing overhead, should be evaluated as to its proportion, constraints, and substitutes among other things. Management need to prevent, and if already existing, find a solution on the following issues:

a. Direct materials – its scarcity and depletion. What are the possible substitutes for the current raw materials being used without affecting the level of quality and product identity? How is the distribution level of such raw materials?

b. Direct Labor – in terms of government regulations on employment such as minimum wage, benefits, and others. The effects of unionized workforce and the fast pace changes in technology, looking at how the firm’s laborer will be able to keep up.

c. Manufacturing Overhead – it is about management’s capacity to evaluate on the different indirect production costs on what are essential and non-essential, what is value adding and non-value adding; and what can or cannot be eliminated.

3. Evaluating the impact of technologies, how the firm’s product and/or services should react on new found technologies, how the firm will be able to maintain the relevance of its product and/or services to society on the fact of Innovations – it is about determining how the features and details of the firm’s product and/or services will change.

4. Growth characteristics of the industry – this refers to the ability of the industry to expand and serve new types of market, it is about the product’s alternative usage and in relation to the previous item, how altering the product’s features might lead the way to new purposes of the product, thus, developing the product’s market anew.

5. As mentioned in the section’s introductory paragraph, government regulations might limit the firm’s actions which in turn affect its status in as far as meeting its short and long term objectives. Government laws and regulations such on taxation, employment,

Set Goals and

Objectives

Formulate the

Stategy

Construct the Action

Plan

Perform Operating, Investing

and Financing Activities

Financial Statements

environmental protection, sanctions, and price control should be considered when evaluating the firm’s risk of probable extinction and profitability level despite of limitations and regulations.

Other factors like demographics (Age group, sex, income brackets, hobbies, lifestyle, etc.) and microeconomics data (GDP, GNP, interest and foreign currency rates, etc.) should also be considered in evaluating the past performance and predicting future operations in line with the result of financial statement analysis.

Corporate Goals, Strategies and Business ActivitiesAs discussed in the previous module, before the operating period began, management will be conducting its planning activities which include setting the goals and objectives of the firm, identifying the related strategies required to meet such goals and objectives, and designing an action plan which contains the time frame, activities to be done, person-in-charge, and the resources needed which will lead to the construction of a budget. In relation to the conduct of the financial statement analysis, understanding the goals of management is vital in interpreting why the result of operation is as such. In analyzing the contents of the financial statement, the analyst should understand the fact that these information are based on the data extracted from the different business transactions the firm has undertaken during the operation period. Such business transactions are executed by management on the basis of the action plan and strategies of the firm. Diagram 2.1 depicts how the different business transactions are determined by the firm’s goal and objective.

Diagram 2.1: Relationship of Goals, Activities and Financial Statements

Goals are the targets or end results toward which a firm directs its energies. The general goals of firms and businesses are to maximize their profit which will increase their business value – that is the value which is measured through the income-generating capacity of the firm in the succeeding periods. Goals can be short term or long-term which has been discussed in the previous module. Other goals of a firm might include contented workforce, supporting the community in which its operation is based through corporate social responsibility activities and promoting government policy. Strategies are the means for achieving such goals – and it has two levels, Company level and product level. Under company level, the firm has to decide whether it will concentrate in a particular industry or to be a diversified firm which offers various products and services. Also, under company strategy, the decision to maintain a domestic operation or to become a multinational company would also be included. Under product level, the three generic strategies are product differentiation, cost leadership, and market focus, which were already discussed in the previous module.

In as far as business activity is concerned, there are three major activities, financing, investing, and operating. Operating activities pertains to the Selling of goods and/or services for a higher price than the cost of the investment made in those goods and services, including the cost of

Financing activities – Obtaining FundsInvesting activities – Acquisition of required resourcesOperating Activities – Purchasing & Selling Goods and services

Repay creditors or declare dividends or acquire additional resources?

financing. Investing activities pertains to the acquisition and disposal of properties, intangibles and other investments and Financing activities refers to obtaining funding from creditors and owners. Diagram 2.2 depicts the relationship of the three activities.

Diagram 2.2 Relationships of Business Activities

Financial Statement Concepts and PrinciplesFinancial Statements serve as score sheet or the report card; it shows management stewardship of the firm’s resources. It is produced through the accounting system which measures the results of a firm’s business transactions and summarizing them in a form that interested parties can understand. In summarizing the effects of business transactions on the firm’s resources and claims to such resources, there are principles and concepts embodied on what is known as the generally accepted accounting principles (GAAP). In analyzing financial statements, analyst should be aware of the principles and policies used in the construction of the financial statements to have a better understanding on the nature of the accounts being used in the analysis. The cost principles which states that assets are recorded at its cost – the cost of acquiring and bringing the assets to its intended use and will be maintained at cost regardless of the purchasing power of the currency being used for valuation. Another principle is the Accrual Basis which states that income and expenses are recognized in the books when earned or incurred regardless whether collected or paid for. In ascertaining the amount, timing and certainty of cash flows, an analyst might be misled of the net income being equal to the net cash inflow that a firm will have since income and expenses are recognized even if there are no cash flows. Another point is the fact that assets are presented at their cost and not their current market values which most of the time, is higher than its costs. It is in this context that we see the results of the financial statement analysis as just rough estimates or a point of reference in the determination of the amount, timing, and certainty cash flow that a firm can generate.

Developing Expectations, Performance and ConclusionIn performing financial statement analysis, the analyst should have developed some level of expectations based on the information derived from the preceding discussions in this section of the module. Such expectations are crucial in a sense that the result of the analysis will either confirm or deny such will be used in generating the over-all conclusion and evaluation.

Limitations of Financial Statement Analysis As with the other business and accounting concepts, financial statement analysis has its own limitations. Aside from the reporting framework policies on valuation and presentation of accounts in the financial statements which could limit the usefulness of the analysis in reflecting current condition of the firm, other limitations of analyzing the financial statement in determining the risk and the over-all profitability

of a company that will be used in planning future operating periods will include other environmental factors.

Strong financial statement analysis does not necessarily mean that the organization has a strong financial future. Although financial statement analysis can provide a rough estimate on the amount, timing and certainty of cash flow of the firm, other factors like bankruptcy of major supplier and customers, or the fast pace change in the product’s life cycle of the firm or the sudden breakdown of equipments and machineries requiring immediate replacement, or the untimely withdrawal of an investor might cause cash flow problems. Hence, in making a conclusion as to the over-all result of the financial statement analysis, caveats should be given to readers as to the areas in which possible cash flow crisis might occur.

Financial statement analysis might look good but there may be other factors that can cause an organization to collapse. In determining the future performance of a firm, the result of the analysis will present the result of operations and financial condition of the firm within a particular economic environment and business situations. The problem lies in the constant changes in the business environment. This would mean that any actions performed in the previous operating period may not be applicable to the current situations and scenarios. Also, after evaluating the risk and profitability of a firm, an analyst might conclude that the firm will be able to face the current business environment in relation to the estimated change in the environment. A change in the country’s political stability, or bankruptcy of a major financial institution can cause the collapse of a firm.

Horizontal Analysis A type of time-series analysis of evaluating what has occurred over a period of time in relation to a particular starting point. It also called Trend Analysis since the main goal of this analysis is to evaluate the progress and changes in the firm’s resources and claims to such resources. It useful in gaining insights about the changes in the amount and structure of the firm’s assets, liabilities, equity, revenues, and expenses which can reveal the firm’s intended actions in the future. Items are expressed as a percentage of a base year or the starting point of the evaluation.

Base Year This is a point in time that will be used as a reference in determining the progress of the firm. It should represent something of great significance in the firm that was expected to result in its advancement. Events like hiring of a new management team or execution of a new strategy or business structure or the introduction of a new product line or business venture, among other things should be the basis in determining where the firm has been and where it intends to go. In answering the question of how many periods from the base year should be included in the analysis will depend on the goals set by management in relation to the particular event that is serving as the basis for determining the progress of the firm. For example, if the newly hired president of the company promises positive results of operation within five (5) years, then a five year analysis should be done.

Also, companies may opt to choose period/s before the significant event has occurred for the purpose of comparing the old and the new situations. Analyst should be cautious in using non-performing years as the base year since it might result in a wrong connotation as to what is a mediocre performance as compared to a maximizing-profit-performance.

Performing Horizontal Analysis In conducting a horizontal analysis, the following formula will be applied in each of the line item in the face of the financial statement:

CurrenYear−BaseYearBase Year

x 100 or 2012 Bal .−2011Bal .

2011Bal .x100

In demonstrating the different analysis, Bulacan Corporation’s financial statements for the past three (3) periods) will be used and is as follows:

2010 2011 2012

AssetsCash and Cash Equivalent ₱ 148,000 ₱ 100,000 ₱ 90,000Accounts Receivable 283,000 410,000 394,000Inventory 322,000 616,000 696,000Other Current Assets 10,000 14,000 15,000Total Current Assets ₱ 763,000 ₱ 1,140,000 ₱ 1,195,000Property, Plant & Equipment (net) 460,000 904,000 974,000TOTAL ASSETS ₱1,223,000 ₱ 2,044,000 ₱ 2,169,000

Liabilities and EquityNote Payable ₱ 290,000 ₱ 295,000 ₱ 290,000Accounts Payable 81,000 94,000 94,000Accrued Expenses 28,000 116,000 116,000Total Current Liabilities 399,000 505,000 500,000Non-Current Liabilities 150,000 453,000 530,000Total Liabilities 549,000 958,000 1,030,000Equity 674,000 1,086,000 1,139,000Total Liabilities and Equity ₱ 1,223,000 ₱ 2,044,000 ₱ 2,169,000

Net Sales ₱ 1,235,000 ₱ 2,106,000 ₱ 2,211,000Cost of Goods Sold 849,000 1,501,000 1,599,000Gross Profit 386,000 605,000 612,000Operating Expenses 180,000 383,000 402,000Operating Income 206,000 222,000 210,000Interest Expense 20,000 51,000 59,000Earnings before tax 186,000 171,000 151,000Income tax expenses 74,000 69,000 60,000Earnings after tax ₱ 112,000 ₱ 103,000 ₱ 91,000

Cash Dividend ₱ 50,000 ₱ 50,000 ₱;50,000

For the first three assets, the determination of the trends using 2010 as the base year will be 2011 2012

2011Bal .−2010 Bal .2010 Bal .

x 1002012 Bal .−2010 Bal .

2010 Bal .x100

For the account Cash and Cash Equivalent, the trend analysis will be as follows:2011 2012

100,000−148,000.148,000

x 10090,000−148,000

148,000x100

= - 32% = -39%This would mean that the company’s cash and cash equivalent balance has been declining since 2010. It decreases by 32% in 2011 and by 39% in 2012. Although the computations are done for each line item independent of each other, interpreting the results should be done considering all the results of the computations. For the account Accounts Receivable, the trend analysis will be as follows:

2011 2012

410,000−283,000.283,000

x100

= 45%

394,000−283,000283,000

x100

= 39%In connection with the previous computation, we can probably connect the decrease in cash to the increase in receivables – which can be connected to the collection policy and processes of the company. However, over-all conclusion cannot be based on two accounts only, it has to be based on the over-all results of computation of the different line items. For the account inventories, the trend analysis will be:

2011 2012

616,000−322,000.322,000

x 100

= 91%

696,000−322,000322,000

x100

= 116%As we can see, the earlier conclusion may not be accurate since another account that may have been the cause of the decline in the cash balance is inventory. Further investigation will give the analyst a better idea on what have causes what. The following table presents the Trend analysis for Bulacan Corporation.

  2010 2011 2012

    Increase/ (Decrease)

  Increase/ (Decrease)Assets

Cash and Cash Equivalent 148,000 100,000 (32%) 90,000 -39%Accounts Receivable 283,000 410,000 45% 394,000 39%Inventory 322,000 616,000 91% 696,000 116%Other Current Assets 10,000 14,000 40% 15,000 50%

Total Current Assets 763,000 1,140,000 49% 1,195,000 57%Property, Plant & Equipment (net) 460,000 904,000 97% 974,000 112%

TOTAL ASSETS 1,223,000 2,044,000 67% 2,169,000 77%

Liabilities and EquityNote Payable 290,000 295,000 2% 290,000 0%Accounts Payable 81,000 94,000 16% 94,000 16%Accrued Expenses 28,000 116,000 314% 116,000 314%

Total Current Liabilities 399,000 505,000 27% 500,000 25%Non-Current Liabilities 150,000 453,000 202% 530,000 253%

Total Liabilities 549,000 958,000 74% 1,030,000 88%Equity 674,000 1,086,000 61% 1,139,000 69%

Total Liabilities and Equity 1,223,000 2,044,000 67% 2,169,000 77%

Net Sales 1,235,000 2,106,000 71% 2,211,000 79%Cost of Goods Sold 849,000 1,501,000 77% 1,599,000 88%

Gross Profit 386,000 605,000 57% 612,000 59%Operating Expenses 180,000 383,000 113% 402,000 123%

Operating Income 206,000 222,000 8% 210,000 2%Interest Expense 20,000 51,000 155% 59,000 195%

Earnings before tax 186,000 171,000 (8%) 151,000 (19%)Income tax expenses 74,000 69,000 (7%) 60,000 (19%)

Earnings after tax 112,000 103,000 (8%) 91,000 (19%)

Presenting the ResultsAside from the tabular form that summarizes the computation done with each of the line item, the users of the analyst’s report will appreciate trend analysis through a line graph that literally highlight the increase and decrease of each of the line item. Each set of line graph should show accounts of the same nature. For example, one set of chart for all assets, then for all liabilities, and then for all income and expenses. Diagram 2.3 shows the line chart of the trend analysis of the asset account.

1 2 3

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

Cash and Cash EquivalentAccounts ReceivableInventory Other Current AssetsProperty, Plant & Equipment (net)

Diagram 2.3: Line Chart of Asset Account Trend Analysis

Interpreting the resultsAside from the stated fact that interpreting trend analysis result should not be done on a per account basis, another limitation of trend analysis is that a large percentage change in one year for a particular item may simply reflect relatively small amount from the previous year that serves as a base, referring to the accrued expense account in the table above, it increases drastically in 2011 but from 2011 to 2012, its balance did not change but it still reflected an increase since the base year was 2010 and not 2011. Also, a large percentage change for a particular item may not be significant if that item represents a small proportion of total assets or total liabilities and equity like the account other current assets which increase 40% during 2011 and 50% during 2012, however this changes will not be that significant since their total amount is almost immaterial as compared to property, plant and equipment balances.

Vertical Analysis This analysis is also called Common Size Financial Statements Analysis. It expresses each balances of account as a percentage of total assets, total liabilities & equity, and total sales. It can be a useful tool for gaining insight about the structure of a firm’s assets, liabilities, equity, and expenses. In using this tool, analyst will be able to ascertain what are the areas of wherein the firm focuses its efforts since it will reveal what are the majority compositions of a particular account balances.

Performing the Analysis In constructing the common size financial statement of a firm, the first step will be the selection of the base amount that will represent the 100% or the item on which other accounts are subject to. Usually for the statement of financial position, it will be total assets for all assets and total liabilities and equities for liabilities and equity. For expenses, it will be total sales. The common size financial statement of Bulacan Corporation follows:

2010 2011 2012AssetsCash and Cash Equivalent 148,000 12% 100,000 5% 90,000 4%Accounts Receivable 283,000 23% 410,000 20% 394,000 18%Inventory 322,000 26% 616,000 30% 696,000 32%Other Current Assets 10,000 1% 14,000 1% 15,000 1%Property, Plant & Equipment (net) 460,000 38% 904,000 44% 974,000 45%TOTAL ASSETS 1,223,000 100% 2,044,000 100% 2,169,00

0 100%

Liabilities and EquityNote Payable 290,000 24% 295,000 14% 290,000 13%Accounts Payable 81,000 7% 94,000 5% 94,000 4%Accrued Expenses 28,000 2% 116,000 6% 116,000 5%Non-Current Liabilities 150,000 12% 453,000 22% 530,000 24%Equity 674,000 55% 1,086,000 53% 1,139,00

0 53%Total Liabilities and Equity 1,223,000 100% 2,044,000 100% 2,169,00

0 100%

Net Sales 1,235,000 100% 2,106,000 100% 2,211,000 100%

Cost of Goods Sold 849,000 69% 1,501,000 71% 1,599,000 72%

Operating Expenses 180,000 15% 383,000 18% 402,000 18%Interest Expense 20,000 2% 51,000 2% 59,000 3%Income tax expenses 74,000 6% 69,000 3% 60,000 3%Earnings after tax 112,000 9% 103,000 5% 91,000 4%

Presenting the resultSince common size financial statement presents the composition of the base account, the best way to present such analysis is through the usage of a pie chart that will literally present the portion being composed of a particular account in as far as the base account is concern which will aid in the immediate

determination of the firm’s focus. In constructing the pie chart, it should be on a base account per year basis. But, the annual pie chart having the same base account should be presented side by side to permit comparison as to the changes in the firm’s focus. The pie chart of the asset accounts for Bulacan Corporation for three years are presented below:

2010 Total Assets

Cash and Cash Equivalent

Accounts Re-ceivable

Inventory

Other Current Assets

Property, Plant & Equipment (net)

2011 Total Assets

Cash and Cash EquivalentAccounts Re-ceivableInventory Other Current AssetsProperty, Plant & Equipment (net)

2012 Total Assets

Cash and Cash EquivalentAccounts Re-ceivableInventory Other Current AssetsProperty, Plant & Equipment (net)

As per the chart, it seems that the company’s asset composition has remained constant for the three year period being analyzed. This could mean that the firm has not been changing its strategies and processes for the past three years.

Interpreting the resultsJust like the horizontal analysis, vertical analysis also has limitations in terms of the interpretation of the results. The first is that percentages of individual accounts are not independent of the percentages for other accounts. This means that any changes in one account may or may not be cause in the movement of such account. For example, the cash account balance may not have change over three years while the account balance of property, plant and equipment has change drastically over the three period, since both are assets and their balances will be presented as part of total assets, the share of the cash account as a percentage of total asset will change due to the movement in property, plant and equipment.

Rationale behind the Common-Size Financial StatementThe horizontal analysis presents a comparative purpose over a period of time by revealing the shift in the firm’s focus (strategy formulation) through the determination of changes in the composition of its resources, claims and expenses. In relation to the results of operation, finding the right mixture of assets and financing that will result to the highest possible profit will be the aim of such analysis while determining the expenses that “eats up” the total revenue of the firm will help management to determine the focus of its cost reduction effort.

Also, in constructing a common size financial statement, the analyst is actually putting different size companies at the same level. This is called competitive analysis. It will try to identify where the competitors, especially the market leader do, focuses their resources and how they are financing such resources as compared to other players in the industry. In such a way, it can give management an idea on how to construct their policies in order to address the competition in the market.

Ratio Analysis In conducting ratio analysis, one is actually presenting the relationships of different accounts with an objective of evaluating the profitability and risks of a firm. In ratio analysis, what we are uncovering is whether the proportion of a particular account in relation to another account is within the acceptable level that can address both the profitability and risks of an enterprise. For example in comparing the amount of current assets and current liabilities, the analyst is actually comparing the assets that are almost realizable into cash versus the amount of liabilities that are almost due, hence, we will be able to determine if the company will be able to pay such maturing liabilities.

There are two areas in ratio analysis; the first area evaluates the firm’s profitability while the second area addresses the firm’s business risks.

Profitability evaluationIn evaluating the firm’s profitability, some will say to focus on a firm’s operating activities, however, in terms of the relationship of business activities, the operation of a firm is highly dependent on its investing activities – the resources available to generate revenues and in connection with investing activities are the financing activities which presents how the resources were acquired – either through debt or investment of owners. In assessing the firm’s profitability, we will focus on two areas, the first area will be determining how effective and efficient the firm in generating income with a given set of resources which will be represented using the return on asset (ROA) evaluation, and the second area will show how the firm utilizes the capital provided by the shareholders in generating income by using the Return on Equity (ROE) computation which indirectly evaluates the effectiveness of the firm in using its debts in its operation.

Return on Asset (ROA) This ratio measure the firm’s effectiveness and efficiency in utilizing its assets to generate income without reference to the financing tool used in acquiring those assets. In terms of ROA, a

lot has been discussing whether to use net income or operating income, whether to use Total Assets or Operating Assets. The ratio’s objective is simple, to present the firm’s ability to generate income through its operation – operational capabilities, hence, operating income and operating assets should be used in the analysis, since net income and some assets includes other items that are not directly related to the firm’s operations. The formula in computing the return on asset is as follows:

ROA= Operating IncomeTotal AverageOperating Assets

In computing the return on assets, and also other ratios involving comparing an income statement account and a balance sheet account, the average balance of the balance sheet account should be use. This is so since the income statement account represents transactions that have occurred in a year while the balance sheet account balance represents a particular day in a year. Computing the average balance of the balance sheet account, which in this case is the total asset of a firm, is as follows:

Average Balance=Beginning Balance+Ending Balance2

Computing Bulacan Corporation’s return on asset for two (2) years – 2011 and 2012 will be as follows:

2011 2012

ROA= P 222,000(1,223,000+2,044,000) /2

R OA=14 %

ROA= P 210,000(2,044,000+2,169,000)/2

ROA=10 %

Whether the result of the computation is good or bad for the firm will depend on predetermined benchmark like industry rates, established objectives at the beginning of the year, and past computations. In this case, it seems that the company’s profitability, in as far as the operation is concerned were unfavorable in 2012 since its ROA drop to 10% from 14% in 2011.

Analyzing the Return on AssetsIn order for a firm to determine how to improve its ROA will require determining the ratios that can help evaluate how effective and efficient the firm was in generating an income through its operation. The Asset Turnover represents how effective the firm in generating revenues using a given set of assets, while Operating Income Margin will show how efficient the firm was in its operation – meaning the ability of the firm to generate operating income at a particular level of sales.

ROA=Asset Turnover x Operating Income Margin

ROA= Total Sal esTotal AverageOperating Assets

xOperating Income

Total Sales

Analyzing the return on asset of Bulacan Corporation for two years:

ROA (2011)= 2,106,000(1,223,000+2,044,000)/2

x222,000

2,106,000

ROA (2011)=1.3×x10.5 %

ROA (2012)= 2,211,000(2,044,000+2,169,000)/2

x210,000

2,211,000

ROA (2012 )=1.04×x9.5 %

Although the company’s sales increased in 2012, its resulting operating income was lower resulting in a lower operating income margin, this mean that the company incurred more expenses in 2012. This could already guide management in formulating a cost reduction policy. Also, the number of times in a year that the firm was able to use its assets to generate sales was lower in 2012 that could mean an under-utilization of assets which is not a good sign due to the fact that the main purpose why an asset is being acquired is to generate revenue. Management should review its asset composition and should disposed assets if necessary.

Return on Equity (ROE)This ratio measures the return provided to the firm’s shareholders. It integrates the result of the firm’s three business activities; operating, investing, and financing. In as far as the shareholders are concerned; the capacity of a company to generate income will be a good source of increasing the value of their investments. However, the firm’s earnings will be shared by both the creditors and the shareholders, the question is, after all the obligations of the firm to its creditors, was it still able to provide a return to its shareholders? The formula to compute the return on equity is as follows:

ROE= Net Income

Total Average Shareholder s ' Equity

Determining the return on equity of Bulacan Corporation for the two year period 2011 and 2012 is as follows:

2011 2012

ROE= P 103,000(674,000+1,086,000)/2

ROE=12 %

ROE= P 91,000(1,086,000+1,139,000)/2

ROE=8 %

In relation to the return on asset, of 14% and 10%, the company was able to return 12% and 8% to its shareholder in 2011 and 2012, respectively. This figure mean that out of the 14% operating income generated by the operating assets of the firm, 12% were returned to its shareholders while 2% were provided to its creditors. Generally, this is a good proportion especially on the side of the shareholders; however, this might impose a problem that since the company did not utilize its debt capital, its operation suffered.

Analyzing Return on Equity and the Du Pont Analysis

The Du Pont Analysis was developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co. The analysis focuses on the three types of business activities, the operating activities represented by the Sales Margin (Net Income/Total Sales), the investing activities represented by the Asset Turnover (Total Sales/Total Average Assets) and the financing activities represented by the capital multiplier (Total Average Assets/Total Average Equity).

The Sales Margin This is just like the Operating Income Margin; the exception is that it will now use the net income since it is focused on the over-all evaluation of the firm. However, the main objective of determining how much was a firm able to earn at a particular level of sales will reflect its efficiency in operation. It is not all about earning an income, more importantly; it is about earning the maximum income possible. Computing the sales margin of Bulacan Corporation for the year period follows:

2011 2012

Sales Margin= 103,0002,106,000

Sales Margin=5 %

Sales Margin= 91,0002,211,000

Sales Margin=4 %

The computation reveals that in 2011, for every P100 of sales that the company is generating, only P5.00 end up with the firm while the other P95.00 is being spent and/or paid to other parties.

Asset TurnoverThere is no difference in the asset turnover computed under the ROA analysis and the Du Pont Analysis. Total Asset Turnover reflects how effective the firm’s investing policies and strategies are. It is about how the assets acquired by the firm were used in generating the sales. Re-presenting the computation of Asset turnover of Bulacan Corporation as follows:

2011 2012

Asset Turnover= 2,106,000(1,223,000+2,044,000)/2

Asset Turnover=1.3׿

Asset Turnover= 2,211,0002,044,000+2,169,000¿

/2¿

Asset Turnover=1.04׿

As what has been discussed, there has been an under-utilization of assets during 2012 since the turnover dropped from 1.3 times to 1.04 times.

The Capital Multiplier Although the formula uses total shareholders’ equity, the capital multiplier is actually a method for evaluating how effective a firm used debt in financing its assets. The ratio shows how much assets per one (1) peso of shareholders’ equity. If the computation resulted in a higher amount, it means that the firm is relying more on debt to finance its assets. To check whether the computation was correct, another way of computing the

capital multiplier is simply the debt to equity ratio (to be discussed later) plus one. Computation of the capital multiplier of Bulacan Corporation follows:

2011 2012

Capital Multiplier=(1,223,000+2,044,000) /2(674,000+1,086,000) /2

Capital Multiplier=1.85 :1

Capital Multiplier=(2,044,000+2,169,000) /2(1,086,000+1,139,000) /2

Capital Multiplier=1.89 :1

This shows that the Bulacan Corporation’s assets is financed more on equity rather debt since for every P1.85 of assets it is financed by P1.00 of equity and only P.85 of debt.

Putting it all togetherIt analyzing the company’s profitability using the du Pont analysis, the aim is to have a deeper understanding of the firm’s return on equity and in what area the firm is not performing well, whether is it about the operations, most especially its operating costs, or it’s investing or financing activities. The following computation shows the du Pont analysis for Bulacan Corporation for the years 2011 and 2012.

ROE=Sales Margin x Asset Turnover xCapital Multiplier

2011 2012

ROE=5 % x 1.3×x1.85

ROE=12 %

ROE=4 % x1.04×x 1.89

ROE=8 %

In interpreting the analysis, we can say that the company was very conservative in utilizing debt in financing its assets, however, its effectiveness in generating revenue using its assets is pretty low and the efficiency of the company – generating revenue at the lowest possible cost so it can have a higher net income – is not that good.

Risk Evaluation Any firm is always subject to risk – that is, there might be events that may or may not result into a positive outcome for the firm. It might be due to unfounded decisions, competitors’ action, general market behavior, or even natural calamities might cause the closure of a firm. However, the main cause of business closure is bankruptcy which is a legal status of a firm that cannot repay the debts it owes to creditors and cannot sustain the cash requirement of the operating, investing, and financing activities of the firm. It usually results from failure to generate sufficient cash internally (through operations –selling goods and providing services) or unable to obtain needed cash from external sources. The next phase of ratio analysis focuses on evaluating the ability of a firm to meet its cash requirements either in the short (liquidity) or long (solvency) period of time.

Evaluating Liquidity

There are two ratios that aim to determine a firm’s liquidity: current ratio and quick ratio. The current ratio indicates the amount of cash and other current assets that the firm expects to turn into cash within one year relative to obligations coming due during the same period. It is computed by dividing total current assets by total current liabilities. Computation of Bulacan Corporation’s current ratio for the three periods (2010 – 2012) follows:

2010 2011 2012

Current Ratio=763,000399,000

Current Ratio=1.91 :1

Current Ratio=1,140,000505,000

Current Ratio=2.26 :1

Current Ratio=1,195,000500,000

Current Ratio=2.39 :1

In interpreting the computed ratio, this would simply mean that during 2010, the company has P1.91 of current assets that are cash or near cash or those that are expected to be converted to cash in a year for every P1 peso of currently maturing debt. Whether a higher or a lower ratio is favorable or unfavorable for the firm will generally depend on the industry practice and general economic conditions. Some limitations of the current ratio includes the following:

1. Inventories are recorded at cost but the cash to be generated will be higher. 2. An increase of equal amount in both current assets and current liabilities results in a

decrease in the current ratio. 3. High current ratio may accompany unsatisfactory business conditions, whereas a falling

ratio may accompany profitable operation. 4. Current ratio is susceptible to window dressing

A variation of the current ratio is the quick ratio or acid-test ratio. It indicates the amount of cash and other current assets that are near cash relative to obligations coming due during the same period. It is computed as follows:

Quick Ratio=Cash+Accounts Receivable+Marketable SecuritiesCurrent Liabilities

Computation of the quick ratio of Bulacan Corporation for the three year period follows:

2010 2011 2012

Quick Ratio=148,000+283,000399,000

Quick Ratio=1.08 :1

Quick Ratio=100,000+410,000505,000

Quick Ratio=1.01 :1

Quick Ratio=90,000+394,000500,000

Quick Ratio=.97 :1

Interpreting the results of the computations shows that Bulacan Corporation is very liquid since it can meet its currently maturing obligation. However, in interpreting the result of the quick ratio, the analyst should consider the following:

1. Some businesses can convert their inventory of merchandise into cash more quickly.2. There could be problems in the collection of receivables.

Evaluating Liquidity – additional tools

As part of determining a firm’s liquidity, an analyst should take a look at how long does it take for a firm to convert inventory into cash or its operating cycle. A longer cycle generally means that it requires a firm longer time to convert inventory back into cash which could also be interpreted as a slower income-generation capabilities while a shorter cycle means shorter time to convert inventories back into cash. A firm’s operating cycle is computed as follows:

Operating Cycle=Days∈ Inventory+Average Collection Period

Days in inventory is computed as 360 or 365 days divided by the inventory turnover while average collection period is 360 or 365 days divided by the receivable turnover. Inventory turnover gives an indication of how soon inventories were sold. It is computed by dividing Cost of Goods Sold by the Average Inventory Balances while Receivable turnover is the rate that indicates how soon does a firm was able to convert receivables into cash. It is determined by dividing Credit Sales by the Average Receivables. The following table shows the computations of Bulacan Corporation’s Operating Cycle for the two year period, 2011 and 2012.

2011 2012Inventory Turnover (ITO)

ITO=Cost of Goods SoldAverage Inventory

ITO= 1,501,000(322,000+616,000)/2

ITO=3.2׿

ITO= 1,599,000(616,000+696,000)/2

ITO=2.4׿

Days in Inventory

Days∈ Inventory= 360ITO

Days∈ Inventory=3603.2

Days∈ Inv .=112.5 days

Days∈ Inventory=3602.4

Days∈ Inv .=150 days

Receivable Turnover (RTO)

RTO= Credit SalesAverage Receivable

RTO= 2,106,000(283,000+410,000) /2

RTO=6.08׿

RTO= 2,211,000(410,000+394,000)/2

RTO=¿ 5.5 times

Days in Receivable

Days∈Receivable= 360RTO

Days∈Receivable= 3606.08

Days∈Rec .=59 days

Days∈Receivable=3605.5

Days∈Rec .=65 days

Operating CycleOperating Cycle=Days∈ Inventory+Days∈ReceivableOp .Cycle=112.5+59

Op .Cycle=171.5 days

Op .Cycle=150+65

Op .Cycle=215 days

The drop in both operating and net income during 2012 can also be attributed to the longer time needed to convert inventories into cash since the company’s operating cycle is 215 days, of that,

the company needed 150 days just to sell the inventories, equivalent to 5 months then another 2 months just to collect the cash from the customers. In as far as the turnover is concern, during 2012, the company was only able to buy and sell an inventory for 2.4 times in a year which can already indicate an inefficient usage of its resources since its total assets increased in 2012. However, in terms of collection, the company was able to collect, on the average, 5.5 times in a year.

Reconciling the liquidity and activity ratioIt is a good thing that the company is very liquid since it has a high current and quick ratio. The problem lies with its operations, it is taking them too long to convert inventory back into cash, which in the long-run can cause cash problems because the company might be tying up too much of its cash to non-cash items. Evaluating Solvency In the previous section, the ability of a firm to meet its current obligations was discussed. However, another component of risk analysis is to evaluate the firm’s ability to meet obligations that will mature in the future. Just like in capital multiplier, an analyst want to ascertain whether the firm is successful in using its debt in generating cash flow because when a firm is using debt, it has to understand the fact that the amount borrowed will have to be repaid with the related interest at a specific time. As a manager, the idea is for the operations should be able to generate enough cash to meet this kind of obligation. There are four ratios in this section, debt ratio and equity ratio which will be used to determine the financial structure of a company, the debt to equity ratio which shows the balance between debt and equity utilized by a company, and lastly, the times interest earned which shows how many times the firm’s operation was able to earn the interest expense – the cost of capital for acquiring debt capital. The table below shows the computation of these ratios for Bulacan Corporation for the two years – 2011 and 2012:

2011 2012Debt Ratio

Debt Ratio=Total LiabilitiesTotal Assets

Debt Ratio= 958,0002,044,000

Debt Ratio=47 %

Debt Ratio=1,030,0002,169,000

Debt Ratio=47 %

Equity Ratio

Equity Ratio=T otal EquityTotal Assets

Equity Ratio=1,086,0002,044,000

Equity Ratio=¿53%

Equity Ratio=1,139,0002,169,000

Equity Ratio=¿53%

Debt to Equity Ratio

DtoE=Total LiabilitiesTotal Equity

DtoE= 958,0001,086,000

DtoE=.88:1

DtoE=1,030,0001,139,000

DtoE=.90:1

Times interest earned

TIE=Operating IncomeInterest Expense

TIE=222,00051,000

TIE=4.35׿

TIE=210,00059,000

TIE=3.56׿

As what was uncovered using du Pont analysis, the company has not been depending on its debt capital and relying more on its equity capital. However, concern should be directed towards the declining rate of times interest earned in 2012 where in the amount of debt capital increased. This might pose an alarm for management in the ability of the firm’s operation to meet cost of debt capital as total debt increases, which could also explain why the firm is not really relying on its debt capital.

Interpreting RatiosIn generating a general conclusion as to the result of ratio analysis, the firm can compare the different ratios to earlier period or with other firms. In using earlier period results as the benchmark for evaluating the over-all performance will permit historical tracking, a type of time-series analysis that will determine the level of progress the firm was able to achieve over the years. However, such analysis might result in a wrong interpretation due to the different improvements over the years. Factors like significant changes in the geographical distribution and operation, product and customer mix, major acquisition and disposal of properties, and change in accounting practice among other things, might cause a misinterpretation of any increase or decrease in the ratios.

When comparing the computed ratios of the firm with other firms or the industry statistics in general, the analyst should consider the firm to use as the comparison whether the firm have similar product, or of the same size or age, or is utilizing the same strategy. Alternatively, in using industry statistics, the analyst should be cautious on how an industry was defined, what does it include and exclude, how the averages were computed and how the mean was distributed, and what are the compositions and variable of a particular ratio.

Analysis Reporting A financial statement analysis report should be complete but concise, accurate, logically patterned to permit understanding of scenarios, but at the same, it has to be objective so as not to influence the conclusions to be made by the reader of the report. The report should present all, to the point possible and cost-beneficial, the scenarios that will give logic to what is being presented. The report should start with the objective of the report to be followed by a company background and analysis of the different business environment that exists during the period being analyzed. In presenting the analysis, computations and charts should be included with reference to business situations that have affected such results and if there are any possible means to improve the situation.

In the last part of the report, the analyst should enumerate the possible events and implications pertaining to the result of the analysis. It should include assumptions and forecast if such assumptions will occur. Also, a listing of crucial factors that in the opinion of the analyst will be essential in meeting its objective should likewise be included. The following table summarizes the different parts of the report and their contents.

Parts ContentReport Objectives & Summary

Purpose State the purpose of the report. (Why is the report being written and

who can benefit from the report and what benefits can they get from it?) 

Scope.  It is a brief description of what the report covers and what the report

does not cover – periods covered, financial statements and concepts used, companies included, and sources of information.

Executive Summary This section might also include a description of what is being

emphasized and what is not being emphasized.

Company Background Basic Information Name, address, products and/or services, management team profile,

establishment (when, where, who and why was it established) Operational Details

Major Suppliers and Customers Number of Headquarters, Branches, Warehouses

Major achievements and set-backs Business Environment Analysis

External Factors Political Economic Social Technological

Internal Factors Marketing (Product, Prices, Promotions, Place) Human Resource Operations/Production Finance

Financial Statement Analysis

Horizontal or Trend Analysis Vertical or Common Size Financial Statement AnalysisRatio Analysis(For each of the computation and charts, if possible, should include the description, the possible causes for such result in the computation, provide a benchmark – other company or industry statistics – and how did the company faired with the benchmark)

Forecasting, Assumptions and Crucial Factors

General Evaluation Positive Results (those that exceeded the benchmark) Negative Results (those that did not meet the benchmark)

Forecasting What could happen in the light of the positive and negative results of

the analysis? Crucial Factors

What are the things that the company should do in order to improve its performance.

Module Summary 1. Define Financial Statement Analysis and its purpose

Financial statement analysis is the evaluation of a firm’s performance and financial condition through the examination of its financial statements. Its purpose may range from an investor

evaluating whether the firm can provide return of and on investments, management evaluating their suppliers, customers, and competitors among other things.

2. Identify the different requirements in conducting financial statement analysis Before conducting an analysis of financial statements, identify the economics and current conditions facing the business then identify the strategies that the firm selects to compete in the business, then, understand the important concepts and principles underlying the financial statements used in computing the financial ratios.

3. Recognize the limitations of Financial Statement Analysis Strong financial statement analysis does not necessarily mean that the organization has a strong financial future. In as far as predicting the future of the firm is concern, the analysis can only provide an estimate or a point of reference on which path the firm should take.

4. Evaluate a firm’s progress using trend analysis Trend analysis or Horizontal analysis is a type of time-series analysis that aims to provide information about the progress of a firm in relation to a chosen base year that should have significance with the firm. This analysis is better presented using a line chart to highlight any increase or decrease in account balances.

5. Distinguish a firm’s focus through common-size financial statementCommon size financial statement or Vertical Analysis presents how a particular total amount is composed of different account balances which can reveal the firm’s focus – what is the majority composition of an amount – which in turn can give information as to what type of strategies and actions the firm is executing or is planning in the future. This type of analysis is best presented using a pie-chart.

6. Assess a firm’s profitability and risk level using ratio analysis In using ratio analysis, there are two aspects, evaluating the risk and profitability of a firm. In assessing the profitability, there is the return of assets and return on equity. Return on asset can be analyzed further using the total asset turnover and operating income margin while return on equity can be analyzed using the du Pont analysis, which requires the computation of the sales margin, asset turnover, and capital multiplier. In assessing the risk of the company, short-term risks are measured by the current and quick ratios and the activity ratios like the inventory turnover and receivable turnover. While, measuring the long-term risk of a firm requires the computation of debt and equity ratios, debt to equity ratio and the times interest earned.

Practice Problem 1: Basic Ratio Analysis

Name: _______________________________________ Section: __________________ Rating: ______

The comparative statement of financial position and the income statement of Tagaytay Corporation follow:

2012 2011 2012 2011Cash and Cash Equivalent P 90 P100 Notes Payable P 290 P 295Accounts Receivable 394 410 Accounts Payable 94 94Inventories 696 616 Accrued Expenses 116 116Prepaid Expenses 15 14 Total Current Liabilities P 500 P 505Total Current Assets P 1,195 P 1,140 Long-Term Debt 530 453Property, Plant & Equipment 1,030 930 Total Liabilities P 1,030 P 958Accumulated Depreciation (329) (299) Capital Shares (P1.00 par) 200 200Investments 50 50 Share Premium 729 729Other Assets 223 223 Retained Earnings 210 157Total Assets P 2,169 2,044 Total Liabilities & Equity P 2,169 P2,044

2012Sales P 2,211Cost of Goods Sold 1,599Gross Profit P 612Operating expenses 402Earning Before Interest & Taxes

P 210

Interest Expense 59Earnings Before Tax P 151Income Taxes 60Earnings After Tax P 91

Tagaytay Corporation’s shares are currently selling at P0.50 per share.

Required: Compute the following ratio: (Use average balances and 360 days whenever possible and required)1. Gross Profit 8. Asset Turnover 15. Equity Ratio2. Return on Sales (Profit Margin) 9. Inventory Turnover 16. Times interest earned3. Return on Assets 10. Days in Inventory 17. Earnings Per share4. Return on Equity 11. Receivable Turnover 18. Capital Multiplier5. Working Capital 12. Days in Receivable6. Current Ratio 13. Debt to Equity Ratio7. Quick Ratio (Acid Test) 14. Debt Ratio

Practice Problem 2: Basic Comprehensive Financial Statement Analysis

Name: _______________________________________ Section: __________________ Rating: ______

The three year comparative financial statements of Bataan Corporation follow:

2010 2011 2012Assets Cash 100,000.00 120,000.00 130,000.00 Receivables 120,000.00 140,000.00 80,000.00 Trading Securities 50,000.00 50,000.00 80,000.00 Inventories 170,000.00 180,000.00 160,000.00 Other Current Assets 25,000.00 20,000.00 20,000.00 Total Current Assets 465,000.00 510,000.00 470,000.00 Property, Plant and Equipment (Net) 300,000.00 320,000.00 400,000.00 Total Assets 765,000.00 830,000.00 870,000.00

Liabilities and EquityAccounts Payable 220,000.00 240,000.00 200,000.00 Accrued Expenses 120,000.00 70,000.00 120,000.00 Total Current Liabilities 340,000.00 310,000.00 320,000.00 Non-Current Liabilities 100,000.00 100,000.00 150,000.00 Total Liabilities 440,000.00 410,000.00 470,000.00 Shareholders' Equity 325,000.00 420,000.00 400,000.00 Total Liabilities and Equity 765,000.00 830,000.00 870,000.00

Sales 1,200,000.00 1,440,000.00 1,584,000.00 Cost of Sales 800,000.00 1,040,000.00 1,144,000.00 Gross Profit 400,000.00 400,000.00 440,000.00 Operating Expenses 150,000.00 120,000.00 140,000.00 Operating Income 250,000.00 280,000.00 300,000.00 Interest Expense 12,000.00 12,000.00 18,000.00 Income before taxes 238,000.00 268,000.00 282,000.00 Taxes (30%) 71,400.00 80,400.00 84,600.00 Net Income 166,600.00 187,600.00 197,400.00

Required: 1. Perform a horizontal analysis using 2010 as the base year for the analysis. 2. Construct the company’s common size financial statements.3. Perform ratio analysis to evaluate the company’s risks and profitability.

Practice Problem 3: Basic Comprehensive Financial Statement Analysis

Name: _______________________________________ Section: __________________ Rating: ______

Comparative date for Laguna Corporation for the three year period 2010, 2011, and 2012 are presented below.

Income Statement 2010 2011 2012Net sales 520,000 480,000 576,000Cost of goods sold 360,000 315,000 346,500Gross margin 160,000 165,000 229,500Operating expenses 128,600 126,000 146,000Net operating income 31,400 39,000 83,500Interest expense 6,400 7,000 7,000Net income before taxes 25,000 32,000 76,500Less income taxes (30%) 7,500 9,600 22,950Net income P 17,500 P 22,400 P 53,550

Assets       Cash P 12,000 P 23,500 24,000 Accounts receivable, net 60,000 40,000 50,000 Inventory 80,000 100,000 95,000 Prepaid expenses 3,000 1,200 1,200 Total current assets 155,000 164,700 170,200 Land 40,000 40,000 40,000 Buildings and equipment, net 120,000 85,000 100,000 Total property and equipment 160,000 125,000 140,000Total assets P 315,000 P 289,700 310,200Liabilities and Stockholders' Equity      

Accounts payable P 67,000 P 44,000 50000 Notes payable 3,000 6,000 6,000 Total current liabilities 70,000 50,000 56,000 Bonds payable, 8% 75,000 80,000 80,000 Total liabilities 145,000 130,000 136,000 Preferred stock 20,000 20,000 20,000 Common stock 60,000 60,000 60,000 Additional paid-in capital 10,000 10,000 10,000Retained earnings 80,000 69,700 84,200 Total stockholders' equity 170,000 159,700 174,200Total liabilities and stockholders' equity P 315,000 P 289,700 310,200

Required: 1. Perform a horizontal analysis using 2010 as the base year for the analysis. 2. Construct the company’s common size financial statements.3. Perform ratio analysis to evaluate the company’s risks and profitability.

Practice Problem 4: Trend Analysis

Name: _______________________________________ Section: __________________ Rating: ______

Part 1: Indicate the peso change and the percentage change for each case below, assuming horizontal analysis:

2012 2011 2012 2011a. 45,000 20,000 f. (30,000) 0b. 20,000 40,000 g. 5,000 (5,000)c. 30,000 0 h. (20,000) 5,000d. 0 40,000 i. (10,000) (10,000)e. (30,000) 10,000 j. 20,000 20,000

Part 2: Sales for the Laguna Corporation for a five year period and an industry sales index for this period are listed below.

2008 2009 2010 2011 2012Sales of Laguna 4,200 4,515 4,355 4,425 4,265Industry Sales index 190 212 210 170 158

Required: Convert both series into indexes employing 2008 as the base year. Comment on the company’s performance during the five year period as compared to the industry statistics.

Part 3: The following common size income statements are available for Zamboanga Corporation for the two years ended December 31, 2011 and 2012.

2012 2011Sales 100% 100%Cost of Sales 55% 70%Gross profit on sales 45% 30%Operating expenses (including income tax expense) 20% 18%Net Income 25% 12%

Trend percentage for sales are as follows:2012 – 130% 2011 – 100%

Required: What should be the trend percentage for gross profit on sales for 2012? Show the computation.

Practice Problem 5: Trend Analysis

Name: _______________________________________ Section: __________________ Rating: ______

1. Condensed balance sheet of three companies is shown below.

Abra Corp.Benguet

Corp.Cagayan

Corp.Assets 6,000,000 10,000,000 15,000,000Liabilities 2,000,000 6,000,000 5,000,000Shareholders’ Equity 4,000,000 4,000,000 10,000,000

Required: Compute for each company:1. Debt Ratio2. Equity Ratio3. Debt to Equity Ratio

2. Give the answer for each by filling in the blank. 1. Debt ratio is 40%, then equity ratio is ________________.2. Equity ratio is 75%, then debt ratio is ________________.3. Debt to Equity ratio is 50%; equity to debt ratio is _______________.4. Debt to Equity ratio is 1/3; equity to debt ratio is ______________.5. If the debt ratio is 60% and liabilities total P300,000, the shareholders’ equity amount to

______________.

3. Net income closed to retained earnings was P 240,000 after tax of 40%. The company had an outstanding loan for the entire year of P 2,000,000 at 9% interest. How many times interest was earned?

4. Below are data supplied by Cebu Corporation:Sales P 1,000,000Cost of Sales 600,000Gross Profit 400,000Operating Expenses 300,000Net income 100,000

Total Assets P 800,000Total Liabilities 200,000Shareholder’s Equity 600,000

The demand for the product is very strong and the best strategy is to expand its geographical distribution in order to double its sales. The company has two options,

Option 1: To sell net shares of stocks for P 700,000.Option 2: Borrow money, P 700,000 @ (a) 12% interest; (b) 30% interest

Required: For the present situation, option 1 and option 2, compute the following:1. Debt Ratio2. Equity Ratio 3. Debt to Equity Ratio4. Return on Assets with analysis (Considering that income statement items will maintain their

ratio)5. Return on Equity with du Pont Analysis

Practice Problem 6: Ratio Analysis

Name: _______________________________________ Section: __________________ Rating: ______

Part 1: The December 31, 2012 statement of financial position of Cavite Corporation is presented below. These are the only accounts in Cavite’s statement of financial position. Amounts indicated by a question mark can be calculated from the additional information given.

Assets Cash P 25,000 Accounts Receivable (net) ? Inventory ? Property, Plant, and Equipment 294,000Total Assets P 432,000

Liabilities and Shareholders’ Equity Accounts Payable ? Income taxes payable - current 25,000 Non-current Liabilities ? Paid-In capital 300,000 Retained Earnings ?Total Liabilities and Shareholders’ Equity ?

Additional information: Current ratio at year-end 1.5 to 1Debt to Equity Ratio 0.8 Inventory turnover based on sales and ending inventory 15 timesInventory turnover based on cost of goods sold and ending inventory 10.5 timesGross profit for 2012 P 315,000

Required:1. What was Cavite’s December 31, 2012 balance in accounts payable?2. What was Cavite’s December 31, 2012 balance in retained earnings?3. What was Cavite’s December 31, 2012 balance in the inventory account?

Part 2: Fill in the blank to complete the balance sheet and sales information for Dapitan Corporation, using the following financial data: Debt/Net Worth 50% Average collection period 30 daysQuick Ratio 1.2% Gross profit margin 30%Total Asset Turnover 2.0 times Sales to inventory turnover 5 times

Cash Accounts PayableAccounts Receivable Paid-In Capital 25,000Inventories Retained Earnings 35,000Property, Plant and EquipmentTotal Assets Total Liabilities and Equity

Sales Cost of Goods Sold

Practice Problem 7: Ratio Analysis

Name: _______________________________________ Section: __________________ Rating: ______

Part 1: The following ratios and other data to the financial statements of Baguio Corporation for the year ended December 31, 2012.

Current ratio at year-end 1.75 to 1Quick Ratio 1.27 to 1Working Capital P 33,000Fixed assets to shareholders’ equity ratio 0.625 to 1Inventory turnover (based on cost of ending inventory) 4 timesGross profit percentage 40%Earnings per share P0.50Average age of outstanding accounts receivable (based on calendar year of 365 days) 73 daysCapital shares outstanding 20,000 no par value sharesEarnings for the year as a percentage of capital shares 25%

The company has no prepaid expenses, deferred charges, intangible assets, or long-term liabilities.

Required: Reconstruct in as much detail as is possible, the company’s statement of financial position and income statement for the year ended December 31, 2012.

Part 2: The following information were contained in the report of a CPA who made an analysis of the statement of financial position of Pampanga Corporation as of December 31, 2012.

1. Working capital ratio, 2.75:12. Ratio of liabilities to assets; 50.5%3. Ratio of net worth of current assets, 90%4. Cash was 25% of, while accounts receivable (net) was 1.5 times, the value of merchandise

inventory; the reserve for doubtful accounts being equal to 10% of the outstanding receivables. 5. The land and building are mortgage to secure a loan maturing in 2017, interest on which has been

paid up to financial statement date. Estimated life of the building is 40 years. It was constructed 5 years prior to financial statement date at a cost four times that of the land, and is being depreciated by the straight-line method without considering any scrap value.

6. Of the current liabilities, 10% covered by non-interest bearing promissory notes issued to trade creditors; the rest represents balance of purchases on accounts.

7. Capital shares consisting of 10,000 shares were originally issued at par P100 per share and a book value of P99 per share at financial statement date.

Required: In order to have a clearer picture of the financial position and other matters, reconstruct the whole statement of financial position considering that there are no other accounts other than those mentioned or implied in the report.