FI NANCI AL

STATEMENT
ANALYSIS
 • THE FINANCIAL STATEMENTS

• LIMITATIONS OF THE FINANCIAL

STATEMENTS

• FINANCIAL STATEMENT ANALYSIS

• THE ROLE OF FINANCIAL ANALYSIS

IN DECISION- MAKING

• TOOLS AND TECHNIQUES IN

FINANCIAL ANALYSIS

• LIMITATIONS OF RATIO ANALYSIS

• THE CASH FLOW STATEMENTS

FINANCIAL
STATEMENT
• Fi nanc i al state me nt i s the su mmari z e d data of a c omp any’ s asse ts, l i ab i l i ti e s,
and e q u i ti e s i n the b al anc e she e t and i ts re v e nu e and e xp e nse s i n the i nc ome
state me nt.
• Fi nanc i al manage rs u se the se state me nts i n fi nanc i ng, i nv e sti ng, and
formu l ati ng di v i de nd p ol i c y de c i si ons. The y are c onc e rne d p ri mari l y wi th the
standi ng of the c omp any and i ts p rofi tab i l i ty that l e ads to maxi mi z ati on of
stoc k hol de rs’ we al th.
• The y u se fi nanc i al state me nts as the i r fi rst- hand i nformati on ab ou t the
c omp any’ s p e rformanc e i n the p ast and i ts p rosp e c ts i n the fu tu re .
• Fi nanc i al i nsti tu ti ons u se the fi nanc i al state me nts as a tool i n asc e rtai ni ng the
c omp any’ s c ap ab i l i ty to p rodu c e c ash i n mak i ng p ayme nts.
 LIMITATIONS OF
FINANCIAL STATEMENTS
• There are variations in the application of
accounting principles.
• Financial statements are interim in
nature.
• Financial statements do not reflect
changes in the purchasing power of the
peso.
• Financial statements do not contain all
the significant facts about the business.
 FINANCIAL STATEMENT
ANALYSIS

Financial statement analysis is an

evaluation of the past and current
performance of the firm and its
forecast in the future (Palepu et al.,
1996). It allows comparison of one
company with another.
 THE ROLE OF FINANCIAL
STATEMENT ANALYSIS IN
DECISION-MAKING

Fi nanc i al rati o i s one of the me thods u se d to anal yz e a

c omp any’ s fi nanc i al state me nts.

Fi nanc i al anal ysts, throu gh the he l p of fi nanc i al rati os,

foc us on a com pa ny ’s fi na nc i a l strength, l i qui di ty, safety of
i nvestm ent, effec ti veness of m a na gem ent, a nd profi ta bi l i ty
grow th rates to a sc er ta i n i ts va l u e or c redi t wor thi ness . Growth
rate s are u su al l y a fu nc ti on of i ndu stry growth rate s,
c omp e ti ti v e adv antage s, and c orp orate strate gy.
 TOOLS AND TECHNIQUES IN
FINANCIAL ANALYSIS

The fi na nc i a l a na l y st’ s e xp e ri e nc e , ju dgme nt, and te mp e ra me nt affe c t the e v al u ati on of

fi na nc i a l state me nts (M e jora da , 20 0 0 ).

Hori z ontal Anal ysi s: Thi s i s u se d to e v al u ate the tre nd i n the ac c ou nts ov e r the ye ars. It i s
u su al l y shown i n c omp arati v e fi nanc i al state me nts.

• Comp arati v e State me nts: Comp are d are fi nanc i al data of two ye ars showi ng the i nc re ase s
or de c re ase s i n the ac c ou nt b al anc e s wi th the i r c orre sp ondi ng p e rc e ntage s.
• Tre nd Rati o: A fi rm’ s p re se nt rati o i s c omp are d wi th i ts p ast and e xp e c te d fu tu re rati os to
de te rmi ne whe the r the c omp any’ s fi nanc i al c ondi ti on i s i mp rov i ng or de te ri orati ng ov e r
ti me . It i s si mi l ar to c omp arati v e state me nts e xc e p t that se v e ral c onse c u ti v e ye ars we re
u se d showi ng the b e hav i or of fi nanc i al data.
6000 / Y E AR 5000 / Y E AR
 TOOLS AND TECHNIQUES IN
FINANCIAL ANALYSIS

V er tical Analysis: I t u ses a significant item on the financial st at em ent as a b ase v alu e. All
other financial item s on the st at em ent s ar e com p ar ed w ith it .
• Common Si ze State me nt. Each accou nt in the financial st at em ent s is ex p r essed b y d iv id ing
t hem t o a com m on b ase accou nt (t ot al asset s, liab ilities and eq u it y, sales or net sales).
• Fi n a n ci a l Rati os. T his is classified into fiv e gr ou p s:
• L iq u id ity r atio - is a com p any’s ab ilit y to m eet its m at u r ing shor t -ter m ob ligations.
• Act iv it y or asset u t iliz at ion r atio - is u sed to d eter m ine how q u ick ly v ar iou s accou nt s
ar e conv er t ed into sales or cash.
• L ev er age r atio (solv ency) - is the com p any’s ab ilit y to m eet its long t er m -ob ligations as
t hey b ecom e d u e.
• Pr ofit ab ilit y r atio - show s the p r ofitab ility of the op er ations of t he com p any. I t
highlights the fir m ’s effect iv eness in hand ling its op er ations.
• Mar k et v alu e r atio - r elates the fir m ’s st ock p r ice to its ear nings.
Tools and Techniques in Financial
Analysis: Horizontal Analysis for
Comparative Statements

Comparativ e S tatements ar e us ed to
evalu ate the chang es o r behavio r
patterns o f the d if f erent acco u nts in
the f inan cial s tatements f or tw o or
mo r e y ear s .

= L as t y ear - Bas e y ear

X 100%
Bas e y ear

= % increas e or
d ecreas e of an accou nt
Tools and Techniques in Financial
Analysis: Horizontal Analysis for
Comparative Statements

Belo w is an illu s tr atio n o f h o w

horiz ontal analy s is is d one in
co mparative f inancial s tatements :

Total assets = Last year - Base year

Base year X 100%

Total assets = P445,000 - P380,000 X 100% = 17.11%

P380,000
 Increase or (Decrease) Percentage of Increase (or Decrease)

2014-- 2013-- 2013--

2014 2013 2012 2013 2012 2013 2012

ASSETS

Current
assets

P65,000 P70,000 P75,000 P (5,000) P (5,000) -7.14% -6.67%

Cash

Accounts receivable 40,000 35,000 20,000 5,000 15,000 14.29% 75.00%

40,000 35,000 10,000 5,000 25,000 14.29% 250.00%

Marketable securities

Inventory 100,000 80,000 100,000 20,000 (20,000) 25.00% -20.00%

245,000 220,000 205,000 25,000 15,000 11.36% 7.32%

Total current assets

Plant assets 200,000 160,000 170,000 40,000 (10,000) 25.00% -5.88%

Total Assets P445,000 P380,000 P375,000 P65,000 P5,000 17.11% 1.33%

LIABILITIES

Current
110,800 105,000 104,000 5,800 1,000 5.52% 0.96%
liabilities

Long-term liabilities 160,000 145,000 140,000 15,000 5,000 10.34% 3.57%

Total
P270,000 P250,000 P244,000 P20,800 P6,000 8.32% 2.46%
Liabilities
 Tools and Techniques in Financial
Analysis: Horizontal Analysis for
Comparative Statements with Trend
Ratios

W he n u si ng tre nd rati os, the fi rm mu st c hoose a ye ar

thatre p re se nts the fi rm's ac ti v i ty b ase . Indi v i du al
ac c ou nts i n the fi nanc i al state me nts of the b ase
ye ar i s assi gne d an i nde x of 1 0 0 . The i nde x for e ac h
re sp e c ti v e ac c ou nt i n the su c c e e di ng ye ars i s
de te rmi ne d b y di v i di ng the ac c ou nt's amou nt b y the
b ase ye ar amou nt and mu l ti p l y the q u oti e nt b y 1 0 0 .

For the year after the base year, the Year 1 X 100%
formula is: Base year

Two years after the base year, the Year 2 X 100%

formula is: Base year
 Tools and Techniques in Financial
Analysis: Horizontal Analysis for
Comparative Statements with Trend
Ratios

Belo w is an illu s tration of how trend

an aly s is is d one in co mparative f inancial
s tatements :
Cash Ratio(2013)

=70,000 X 100% = 93.33%

75,000

Cash Ratio(2014)

=65,000
X 100% = 86.67%
75,000
 TOOLS AND TECHNIQUES IN FINANCIAL ANALYSIS: VERTICAL
ANALYSIS FOR COMMON-SIZE STATEMENTS
Illustration 6 Common-size analysis of the balance sheet of FMA Company for 2012-2014

FMA COMPANY
Balance Sheet
December 31, 2014, 2013, and 2012

Common-size Analysis
2014 2013 2012 2014 2013 2012
ASSETS
Current Assets
Cash P 65,000 P 70,000 P 75,000 14.61% 18.42% 20.00%
Account Receivable 40,000 35,000 20,000 8.99% 9.21% 5.33%
Marketable securities 40,000 35,000 10,000 8.99% 9.21% 2.67%
Inventory 100,000 80,000 100,000 22.47% 9.21% 26.67%
Total current assets 245,000 220,000 205,000 55.46% 57.89% 54.67%
Plants assets 200,000 160,000 170,000 44.94% 42.11% 45.33%
Total Assets P 445,000 P380,000 P375,000 100.00% 100.00% 100.00%
LIABILITIES
Current Liabilities P 110,800 P105,000 P104,000 24.90% 27.63% 27.73%
Long-term liabilities 160,000 145,000 140,000 35.96% 38.16% 37.33%
Total liabilities P 270,800 P 250,000 P244,000 60.85% 65.79% 65.07%

STOCKHOLDERS’ EQUITY
Common stock,P5 per value, P 100,000 P 100,000 P 100,000 24.47% 26.32% 26.67%
20,000 shares
Retained earnings 74,200 30,000 31,000 16.67% 7.89% 8.27%
Total stockholders’ equity 174,200 130,000 131,000 39.15% 34.21% 34.93%

Total Liabilities and

Stockholders’ Equity P 445,000 P 380,000 P 375,000 100% 100% 100%
 TOOLS AND TECHNIQUES IN FINANCIAL
ANALYSIS: VERTICAL ANALYSIS FOR
COMMON-SIZE STATEMENTS
In a c ommon- si z e state me nt, a si gni fi c ant i te m on a fi nanc i al state me nt
i s u se d as the b ase v al u e , and al l othe r i te ms on the fi nanc i al state me nt
are c omp are d wi th i t. In p e rformi ng c ommon- si z e anal ysi s for the
b al anc e she e t, total asse ts are assi gne d as the b ase ac c ou nt wi th a
p e rc e ntage of 1 0 0 . An i ndi v i du al asse t ac c ou nt i s e xp re sse d as a
p e rc e ntage of total asse ts.

C om m on-si ze a na l ysi s i s u se d to show the i nte rnal

stru c tu re of an e nte rp ri se . It re fl e c ts the e xi sti ng
re l ati o nshi p of e ac h ac c ou nt i n the b al anc e she e t that
wo u l d he l p the fi rm de te rmi ne p ossi b l e i mp rov e me nts i n
the di stri b u ti o n of re sou rc e s.
 TOOLS AND TECHNIQUES IN
FINANCIAL ANALYSIS:
FINANCIAL RATIOS

I n assessing the significance of v ar iou s financial st at em ent

d ata, ex p er t s engage in financial r atios analysis, the
p r ocess of d eter m ining and ev alu at ing financial r atios. A
financial st at em ent r atio is a r elationship that ind icates
som et hing ab ou t a com p any’s act iv it ies.

T her e ar e sev er al p oints to k eep in m ind ab ou t r atios:

• F inancial r atios ind icate ar eas of st r engt h or w eak ness.
• T her e is no single cor r ect v alu e for a r atio.
• A financial r atio is m eaningfu l only w hen it is com p ar ed
w ith som e st and ar d , su ch as an ind u str y tr end , a r atio
tr end , a r atio tr end for the sp ecific com p any b eing
analyz ed , or a st at ed m anagem ent ob j ectiv e.
Tools and Techniques in Financial
Analysis:
Financial Ratios

Financial ratios provide two points of comparison:

Industry Comparison
Financial ratios are computed and compared with
the industry average. Through industry
comparison, the company may be able to compare
their performance against the competitor and how
they fare with them.

Trend Analysis
The firm’s financial ratios are computed and
compared with their past performance. By the
trends, the company will know if their financial
performance is improving or not over the years. It
is a very powerful tool in deciding the actions
that a company should take in the future.
 Tools and Techniques in Financial
Analysis:
Financial Ratios

Liquidity Working
Ratios Capital Working capital = Current assets - current
liabilities
Li q u i di ty rati os are
The FMA Company's working capital for the
p ri me c onc e rn of W ork i ng c ap i tal or years 2012 to 2014 are as follows:
short- te rm c re di tors ne t work i ng c ap i tal i s
b e c au se the se 2014
the di ffe re nc e
P 245,000 - P110,800
p rov i de i nsi ght of b e twe e n the fi rm’ s = P 134,200
the fi rm’ s c ap ab i l i ty c u rre nt asse ts and
to p ay i ts c u rre nt c u rre nt l i ab i l i ti e s. 2013
ob l i gati ons. The P 220,000 - P105,000
= P 115,000
fi rm’ s l i q u i di ty al so
affe c ts i ts c ap ac i ty 2012
to b orrow. P 205,000 - P104,000
= P 101,000
 TOOLS AND TECHNIQUES IN FINANCIAL
ANALYSIS: FINANCIAL RATIOS

Cu rre nt Rati o
The c u rre nt rati o i s c omp u te d b y di v i di ng c u rre nt
asse ts b y the c u rre nt l i ab i l i ti e s. Thi s rati o i s
p rob ab l y the most fre q u e ntl y u se d me asu re of The current ratio for 2014,
2013, and 2012 are:
l i q u i di ty. It asse sse s the l i ab i l i ty of the fi rm to
me e t i ts c u rre nt l i ab i l i ti e s as p ai d b y i ts c u rre nt 2014
= P245,000
asse ts.
P110,800
= 2.21

2013
Cu rre nt rati o = Cu rre nt Asse ts = P220,000
Cu rre nt Li ab i l i ti e s P105,000
= 2.10

2012
= P205,000
P104,000
= 1.97
 Quick Ratio
Like the current ratio, it reflects the firm's ability to pay its short-
term obligations. Thus, the higher the quick ratio, the more liquid the
firm is.

Quick ratio = Cash + Marketable Securities + Accounts Receivable

Current Liabilities

The quick ratio for 2014, 2013, and 2012 are:

2014
= P 65,000 + P40,000 + P40,000
P110,800
=1.31

2013
= P70,000 + P35,000 + P35,000
P 105,000 NEIL
= 1.33
T R AN
2012
= P75,000 + P20,000 + P10,000 Co ntent
P104,000 D e p a rtm e nt
= 1.01
Cash Position Ratio
As mentioned under the quick asset ratio, there is
a possibility of encountering problems with
accounts receivable. Accounts which are not
properly managed will take some time to be
converted into cash (if they are still collectible),
making them not liquid. The cash position ratio is
a step closer to pure liquidity by removing the
accounts receivable from the quick ratio.

Cash position ratio = Cash + Marketable Securities

Current liabilities
The FMA Company’s average accounts receivable for 2014 and
2013 are:

2014
=P 40,000 + P35,000
2
= P 37,500

2013
P35,000 + P 20,000
2
= P 27,500

The accounts receivable turnover ratio for 2014 and 2013 are:

2014
= P 160,000/ P 37,500
=4.27

2013
= P 165,000/ P 27,500
= 6.73
A ctivity R atios
A ctivity ratios or as s et man ag emen t ratios meas u r e
the f irm’ s ef f iciency in man ag in g its as s ets . Thes e
activity ratios ar e u s ed to d etermine how rapid
vario u s acco u n ts ar e co nverted into s ales or cas h.

Ac c ou nts Re c e i v ab l e Tu rnov e r
Thi s e sti mate s how fast the ac c ou nts
re c e i v ab l e i s c onv e rte d i nto c ash du ri ng the
ye ar. Av e rage ac c ou nts re c e i v ab l e is
ob tai ne d b y addi ng the b e gi nni ng and e ndi ng
ac c ou nts re c e i v ab l e and the n di v i di ng the
su m b y two. If the re i s no ne t c re di t sal e s
i nformati on, ne t sal e s c an b e u se d.
The FMA Company’s average accounts receivable for 2014 and
2013 are:

2014
=P 40,000 + P35,000
2
= P 37,500

2013
P35,000 + P 20,000
2
= P 27,500

The accounts receivable turnover ratio for 2014 and 2013 are:

2014
= P 160,000
P 37,500
=4.27

2013
= P 165,000
P 27,500
= 6.73
Average Collection Period
This ratio measures the efficiency of the firm's
collection policy by computing the number of days
to collect a receivable.
Average Collection Period = 360
Accounts Receivable Turnover

The FMA Company's average collection period for

2014 and 2013 are:

2014
=360
4.27
=84.31 days

2013
=360
6.73
=53.49 days
Inventory Turnover
This shows the efficiency of the firm in handling its inventory. It
measures how fast the inventory is turned into sales.

It can be computed as: Cost of Goods Sold/Average Inventory

Average inventory is determined by adding the beginning and

ending inventories and dividing the sum by two.

The inventory turnover of the FMA Company in 2014 and 2013

are:

2014
= P 100,000
P 90,000
= 1.11

2013
= P 115,625
P 90,000
= 1.28
Av er age Age of I nv entor y
T his show s the efficiency of the fir m in selling
its inv entor y. I t m easu r es how m any d ays d oes
it tak e for the fir m to sell its inv entor y.

Av er age age of I nv entor y = 36 0

I nv entor y T u r nov er

T he av er age age of inv ent or y in 2 0 1 4 and 2 0 1 3

ar e:

2014
=36 0
1.11
=32 4 .32 d ays

2013
=36 0
1.28
=2 8 1 .2 5 d ays
Operating cycle
The operating cycle measures the time it takes to convert the
inventories and receivables to cash. Hence, a short operating cycle
is desirable.

Operating Cycle = Average collection period + Average age of

inventory

The operating cycle for the FMA Company in 2014 is:

2014
= 84.31 days + 324.32 days
= 408.63 days

2013
= 53.49 days + 281.25 days
= 334.74 days
 TOOLS AND TECHNIQUES IN FINANCIAL
ANALYSIS: FINANCIAL RATIOS

Fi xe d- asse t tu rnov e r
Fi xe d asse ts c omp ri se of p rop e rty, p l ant, and The FMA Company's fixed-
asset turnover ratio for the
e q u i p me nt. It i s c onsi de re d as the most i mp ortant past two years are as
l ong- te rm asse t of the fi rm i n the b al anc e she e t. follows:
Fi xe d- asse t tu rnov e r rati o me asu re s how we l l the
2014
fi rm u se s e v e ry p e so of fi xe d asse t i nv e ste d to = P160,000
ge ne rate sal e s. The amou nt of sal e s ge ne rate d b y (P200,000 + P 160,000)/
a p e so i nv e ste d i n fi xe d asse t i s me asu re d b y the 2
=88.89%
rati o:
2013
= P185,000
(P160,000 + P 170,000)/
Fi xe d Asse t Tu rnov e r = Sal e s 2
Av e rage Ne t Fi xe d Asse ts = 112.12%
Tools and Techniques in Financial
Analysis:
Financial Ratios

Total Asset Turnover

The total asset turnover ratio measures the firm’s ability
to generate sales successfully.

Total Asset turnover = Net Sales

Average total assets
 The average total assets of the FMA Company is:

2014
= P 445,000 + P 380,000
2
= P 412,500

2013
= P 380,000 + P 375,000
2
= P 377,500

The total asset turnover ratio of the firm for 2014 and 2013
are:

2014
= P 160,000
P 412,500
= 38.79 %

2013
= P 185,000
P 377,500
= 49.01%
Leverage ratios

Leverage ratios indicate up to what extent the firm has financed its
investments by borrowing. Firms that use debt financing rather than
equity financing increase the risk of the firm. The more debt they incur,
the higher their leverage ratio is and the higher the financial risk they
face.
Debt Ratio
It is computed by dividing the total liabilities of the firm by its
total assets. This ratio shows the portion of the total assets
financed by the creditors.

Debt ratio = Total liabilities

Total assets

The debt ratio of the FMA Company for 2014, 2013, and 2012 are:

2014
= P 270,800/ P 445,000
= 60.85%

2013
= P 250,000/ P 380,000
= 65.79%

2012
= P244,000/ P 375,000
= 65.07%
 Tools and Techniques in Financial
Analysis:
Financial Ratios

Debt-to-Equity Ratio
This measures the proportion of the total liabilities to the
invested capital.

Debt to Equity ratio = Total liabilities

Total Stockholder's Equity

2014
= P270,000/P 174,200
= 1.55x

2013
= P250,000/P130,000
= 1.92x

2012
= P244,000/P 131,000
= 1.86x
Times Interest Earned Ratio
Reflects the number of times the earnings before tax and interest
expense cover the interest expense. It measures how capable the firm
is in paying its interest obligations.

Times Interest earned = Earnings before interest and taxes (EBIT)

Interest expense

The time interest earned ratio for 2014, 2013, and 2012 are as follows:

2014
= P36,000
P 4,000
= 9x

2013
= P 34,875
P 3,500
= 9.96x

2012
= P 23,500
P 3,000
=7.83x
Profi ta bi l i ty R ati os
The se are i ndi c ators of good fi nanc i al
he al th and e v al u ate how e ffe c ti v e l y the
fi rm is b e i ng manage d to e arn a
sati sfac tory p rofi t and re tu rn on
i nv e stme nt. P rofi tab i l i ty rati o me asu re s
manage me nt e ffe c ti v e ne ss i n te rms of rate
of re tu rn to sal e s, asse ts, and e q u i ty.
Gross Profit Margin
It is a measurement of a company’s manufacturing and distribution efficiency
during the production process.

Gross Profit margin = Gross Profit

Net sales

The gross profit margins of the FMA Company from 2012 to 2014 are as follows:

2014 = P60,000
P 160,000
= 37.50%

2013 = P 69,375
P 185,000
= 37.50%

2012
= P 44,000
P 94,000
= 46.81%
 Tools and Techniques in Financial
Analysis:
Financial Ratios

Profit Margin
The profit margin is another measurement of management’s efficiency.
It is the ratio of net income to net sales. It compares the quality of a
company’s operations with that of its competitors.

Profit margin = Net income after interest and taxes

Net sales

The FMA Company's profit margins from 2012 to 2014 are as follows:

2014
= P20,000/P160,000
= 13.00%

2013
= P20,294/P 185,000
=11.02%

2012
= P 13,325/P 94,000
=14.18%
Return on Investment (ROI)
ROI measures the income generated for every peso investment made in
the firm. The higher the income generated per peso investment, the
better.

The return on total assets measures the income generated for every peso
invested in the assets.

Return on Total Assets = Net income after interest and taxes

Average Total Assets

The returns on total assets of the FMA Company in 2014 and 2013 are:

2014
= P 20,800
P 412,500
= 5.04%

2013
= P 20,394
P377,500
= 5.40%
 DuPont Analysis
The DuPont formula is an integrative approach in explaining and looking
at the differences in return on total assets. It is another way of computing
the return on assets by getting the product of the profit margin and the
total asset turnover.

Return on Total Assets = Profit margin x Total Asset Turnover

By expanding the previous formula, one can derive that

Return on Total Assets = Net income after interest and taxes = Net income after taxes x Net Sales
Average Total Assets Net Sales Average Total Assets

For 2014 and 2013, the figures of the FMA Company

are:

2014
x 2013
x
=P 20,800 P 160,000 = P 20,394 P 185,000
P 160,000
= 5.04%P 412,500 P 185,000 P= 377,500
5.40%
 The retu rn on co mmo n s tock equ ity meas u r es the rate
of retu rn earned on co mmo n s tock equ ity .
S tockhold ers inves t in a f irm w ith the ex pectatio n of
a retu rn on their mo n ey . R OE is d etermined by
d ivid ing net income af ter tax by the aver ag e co mmo n
s tockhold ers ’ equ ity .

Return on Equity = Net income after tax - Preferred stock dividend requirement
Average Stockholders Equity - Preferred stock
Composition of Return of Equity Using the DuPont Formula
The net profit margin, asset turnover, and equity multiplier are the components
to compute for the return on equity using the DuPont model (Ross et al., 2008).
By looking at the formula, one can identify the sources of a company’s return on
equity. The profit margin and asset turnover were already mentioned.

Equity multiplier is a measure of financial leverage that allows investors to

examine the contribution of debt on the return to equity

Equity multiplier = Average total assets

Average common equity

Firms with a huge amount of debt will have a high equity multiplier. To compute
for ROE using the DuPont formula,

Return on equity = Net income after tax Net Sales x Average Total Assets
Net Sales
x Average total Average common
assets equity
 Tools and Techniques in Financial
Analysis:
Financial Ratios

To compute for the ROE using the DuPont formula for 2014 for FMA
Company,
Return on equity = Net income after tax Net Sales Average Total Assets
Net Sales
x x
Average total assets Average common equity

Market Value Ratios

The market value ratio is a measure of the firm’s performance as perceived by the
general market. Investors value the firm through its stock price traded in the stock
exchange. The higher the stock price, the better the performance as perceived by the
market. Profitability, safety, quality of top management, future projects, and other
factors are reflected in the firm’s stock price.
 Earnings per Share
This measures the income generated per common stock held. It is computed by
dividing net income after tax minus the preferred stock dividend requirement by
the number of shares of common stock outstanding. Earnings per share is a useful
indicator of the firm’s profitability. However, earnings per share tends to be lower
when there are more common shares issued.

Earnings per share (EPS) = Net income after interest and taxes - Preferred stock dividend
requirement
Common Stock Outstanding

The EPS of the FMA Company for 2014, 2013, and 2012 are as follows:
2014 2013 2012
= P 20,800 = P20,394 = P 13,325
20,000 20,000 20,000
= P 1.04 = P 1.02 = P 0.67
Price/Earning(P/E) Ratio.

P/E ratio is a useful indicator of the investor’s perception about the firm’s
prospects. A firm’s P/E ratio depends primarily on two factors: The future
growth in the earnings and the risk directly associated with expected
earnings. As the price of the firm’s stock rises, the P/E ratio also increases.
This indicates that the investors see improvement in the firm's future
earnings. Risk, on the other hand, has an opposite effect.
P
E ratio = Market price per
share
Earnings per share
The market price per share of FMA Compay stock is P10 on
December 31, 2014, P 12 on December 31, 2013 and P12.50 on
December 31, 2012. Therefore, the P/E ratio in 2014 is:

2014 2013 2012

= P10.00 = = P
P1.04 P12.00 12.50
=9.62 P 1.02 P 0.67
=11.76 =P 18.66
Tools and Techniques in Financial
Analysis:
Financial Ratios

Book Value per Share

Book value per share of common stock is the total of common stock,
premium on paid in capital, and retained earnings less treasury
stock minus preferred stock divided by the common shares
outstanding. Book value is the value of the firm on the perspective
accounting while market value signifies the market valuation of the
firm’s equity.
Book value per share = Total stockholder's equity - Preferred
stock
Common shares outstanding

2014
= P 174,200/20,000
= P 8.71

2013
= P130,000/20,000
= P 6.50

2012
= P 131,000/20,000
= P 6.55
Market-to-Book Value Ratio
It is the value of the firm's security as perceived by the market in relation
the value of the firm. A high market-to-book value ratio means that
investors are more optimistic about. The market value of the firm's
resources, capabilities of the top management, and expected growth of the
firm. The formula for the market-to-book value ratio is:

Market to Book value ratio = Market price per share/ Book value per share

2014
= P 8.00/P 8.71
= 0.92

2013
= P 7.50/P 6.50
= 1.15
Dividend Ratios
These are ratios measuring the percentage of dividends declared by
the book of directors to their stockholders.

Dividend Yield. This ratio reflects the relationship between the

dividends earned per share and the market price of the stock.

Dividend yield = Dividend per share

Market price per share

2014
= P 1.00/P 8.00
= P 0.125 per share

2013
= P 0.90/P 7.50
= P 0.12 per share
Dividend Payout Ratio. This measures how much of
the earnings per share was declared as dividend. The
dividend payout ratio is computed as:

Dividend payout ratio = Dividends per

share
Earnings per share
 Limitations of Ratio Analysis

• Variation in the practices and methods in the application of

accounting from one firm may result in a meaningless comparison
of financial ratios

• While financial ratios have predictive value, they are still static
and a mere estimate of the future.

• Transactions are recorded based on acquisition costs and excludes

the effect of inflation.

• Financial ratio analysis is essential in comparing firms belonging

to the same industry, thus it may be hard to classify a firm with a
well-diversified business to a specific industry.
 Limitations of Ratio Analysis

• Although industry averages are published, it is difficult to use

them because of the complexities of the different sectors within
the industry. It is more appropriate to obtain information and
compute for financial ratios of major competitors

• A ratio does not show its major components; thus, it is misleading

to interpret a ratio without considering the major components.
The Cash Flow Statement

The cash flow statement analyzes changes in cash and cash equivalents
(CCE) during a period. CCE comprise cash-in-hand and demand deposits,
together with short-term, highly liquid investments that are readily
convertible to a known amount of cash and subject to an insignificant
risk of changes in value.

Along with financial ratio analysis, cash flow statement is a valuable tool
to finance managers. The cash flow statement is used to evaluate the cash
inflows (sources) and cash outflows (uses) of a firm during a specified
period of time.
The cash flow statement can be used to answer the following
questions?
• How did the firm finance its plant and equipment?
• Where did its net income go?
• What were the investment activities of the firm?
• Did it give dividends to its stockholders?
• Did the firm generate enough cash for the succeeding year?
The Cash Flow Statements: Its Purpose
and Functions

• It provides relevant information about the cash receipts and cash

payments of the enterprise as on a given period.

• It states the changes in the financial position of the firm.

• It presents information on the structural health, liquidity, and

profitability of the firm.

• It gives insights on the different activities of the firm.

• It determines the capability of the firm to produce cash and cash

equivalents
 The Cash Flow Statements

Main Sections of the Statement of Cash Flows

1. Cash flows from operating activities

2. Cash flows from investing activities

3. Cash flows from financing activities