FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
CHAPTER 4: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
Learning Competencies:
Perform vertical and horizontal analyses of financial statements of a single proprietorship
Compute and interpret financial ratios
Reasons to Analyze and Interpret Financial Statements
The preparation of financial statements is not the end of accounting. The next step is financial
analysis and interpretation. The purpose of financial statement analysis is to transform the data in the
statements into information which is interpreted and used as basis for better economic decisions and
actions. Bankers and creditors analyze statements to determine if it is profitable to lend money to a
particular business. Organized employees look for the stability of their employer and decide whether it is
reasonable to demand increase in wages and other fringe benefits. Various government agencies analyze
the statements to see if the companies are conforming with government regulations. Management
analyzes statements of their own companies to determine past performance, as a means of control and as
a guide for future action.
The users of financial statements have the following reasons to analyze and interpret financial
statements:
a. Investors – to determine to buy, hold or sell their investments in equity ownership in the
business; to assess the ability of the investee to pay dividends or to pay return to investors
b. Employees – to determine stability and profitability of employers; to determine the ability of the
employer to pay salaries and fringe benefits
c. Lenders – to determine the ability of the borrowers to pay the loans granted to them on time
d. Suppliers – to determine the ability of the customer to pay debts as they fall due; to determine the
ability of the customer to remain as a continuing buyer
e. Management – to determine the activities of the enterprise for planning, organizing, leading, and
controlling
f. Customer – to determine the ability of the enterprise to be a continuing source of supply; to
determine the ability of the company to exist over a long period of time
g. Public – to determine the activities of the enterprise; to determine contribution to the economy in
the form of (1) number of employees, (2) ownership of assets, (3) prices of their products, (4)
patronage of local suppliers, and (5) patronage by customers
h. Government Agencies – to determine the capacity of the enterprise to pay taxes and its tax
compliance; to provide the bases for monitoring and regulating the activities of enterprises and
individuals
The statement of financial position (balance sheet) presents the assets, liabilities, and owner’s equity
of the entity as of a specific date. The statement of income presents the sales, cost of sales, selling
expenses, administrative expenses and net income for a period of time. Every item in these financial
reports id of varying importance to the users of financial statements. The value of the individual
information is enhanced through comparative analysis. Comparison may be (1) intracompany, (2)
intercompany, and (3) with industry averages. Intracompany involves comparison within the entity, while
intercompany involves comparison of one entity with those of another entity. Comparison with the
industry’s averages shows the standing of the entity in the industry where it belongs.
Liquidity
Pertains to the company’s ability to meet its currently maturing obligations. In short, it is the
capability to pay for short-term debts.
Solvency
Pertains to the company’s ability to meet its long-term obligations. It provides measures on
whether the company’s assets are sufficient to cover for their liabilities.
Profitability
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
Indicates measures on how well a company performed on their operations. It provides
information as to the performance of the company regarding their income and expenses.
There are various methods of analyzing financial statements such as Horizontal analysis, Vertical
analysis and the use of Financial Ratios.
Horizontal Analysis
Horizontal analysis, also known as the Increase-Decrease method compares financial data from two
consecutive periods. Through the increase or decrease in the accounts, users may gain insights as to the
position and performance of the company for the past two years. The following are the steps in the
horizontal analysis:
1. Select two consecutive years of financial statements. The earlier will be called the base year.
2. Compute for the difference between the base and the current year. The would be current year
minus the base year. A positive difference would indicate an increase in the current year while a
negative difference would indicate a decrease in the current year.
3. Divide the difference with the base year figures.
To illustrate Horizontal Analysis, assume the following financial statements from Equal Company:
Equal Company
Statement of Financial Position
As of December 31, 2015, and 2016
2015 2016
ASSETS
Current Assets
Cash 150,000 190,000
Accounts Receivables, net 75,000 102,000
Inventory 50,000 55,000
Short-term Investments 20,000 20,000
Prepaid Expenses 10,000 8,000
Total Current Assets 305,000 375,000
Non-Current Assets
Land 800,000 800,000
Building, net 490,000 480,000
Machinery, net 295,000 290,000
Furniture and Fixtures, net 98,000 96,000
Long-term Investments 100,000 80,000
Total Non-Current Assets 1,783,000 1,746,000
TOTAL ASSETS 2,088,000
2,121,000
LIABILITIES AND OWNER’S EQUITY
Current Liabilities
Accounts Payable 50,000 55,000
Short-term Liabilities 45,000 50,000
Total Current Liabilities 95,000 105,000
Non-Current Liabilities
Long-term Debts 120,000 100,000
Bonds Payable 90,000 90,000
Total Non-Current Liabilities 210,000 190,000
TOTAL LIABILITIES 305,000 295,000
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
TOTAL OWNER’S EQUITY 1,783,000 1,826,000
TOTAL LIABILITIES & OWNER’S EQUITY 2,088,000 2,121,000
Equal Company
Income Statement
For the year ended December 31, 2015, and 2016
2015 2016
Net Sales 90,000 120,000
Cost of Goods Sold 50,000 60,000
Gross Profit 40,000 60,000
Administrative Expenses 10,000 10,000
Selling Expenses 5,000 6,000
Net Income 25,000 44,000
Using the steps in Horizontal Analysis, the base year for the two periods is 2015 as this is the earlier
period. The difference between the two years can then be computed by deducting from the current year,
the amounts from the base year. The following can be computed:
Equal Company
Statement of Financial Position
As of December 31, 2015, and 2016
2015 2016 Difference
ASSETS
Current Assets
Cash 150,000 190,000 40,000
Accounts Receivables, net 75,000 102,000 27,000
Inventory 50,000 55,000 5,000
Short-term Investments 20,000 20,000 -
Prepaid Expenses 10,000 8,000 (2,000)
Total Current Assets 305,000 375,000 70,000
Non-Current Assets
Land 800,000 800,000 -
Building, net 490,000 480,000 (10,000)
Machinery, net 295,000 290,000 (5,000)
Furniture and Fixtures, net 98,000 96,000 (2,000)
Long-term Investments 100,000 80,000 (20,000)
Total Non-Current Assets 1,783,000 1,746,000 (37,000)
TOTAL ASSETS 2,088,000 2,121,000
33,000
LIABILITIES AND OWNER’S EQUITY
Current Liabilities
Accounts Payable 50,000 55,000 5,000
Short-term Liabilities 45,000 50,000 5,000
Total Current Liabilities 95,000 105,000 10,000
Non-Current Liabilities
Long-term Debts 120,000 100,000 (20,000)
Bonds Payable 90,000 90,000 -
Total Non-Current Liabilities 210,000 190,000 (20,000)
TOTAL LIABILITIES 305,000 295,000 (10,000)
TOTAL OWNER’S EQUITY 1,783,000 1,826,000 43,000
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
TOTAL LIABILITIES & OWNER’S EQUITY 2,088,000 2,121,000
33,000
Equal Company
Income Statement
For the year ended December 31, 2015, and 2016
2015 2016 Difference
Net Sales 90,000 120,000 30,000
Cost of Goods Sold 50,000 60,000 10,000
Gross Profit 40,000 60,000 20,000
Administrative Expenses 10,000 10,000 -
Selling Expenses 5,000 6,000 1,000
Net Income 25,000 44,000 19,000
The negative amounts show a decrease in the accounts and increases in the accounts are represented
as positive figures.
Next, the percentage of the difference will now be computed by dividing the difference with the
amounts from the base year, 2015.
Equal Company
Income Statement
For the year ended December 31, 2015, and 2016
2015 2016 Difference Percentage
Net Sales 90,000 120,000 30,000 33.33%
Cost of Goods Sold 50,000 60,000 10,000 20.00%
Gross Profit 40,000 60,000 20,000 50.00%
Administrative Expenses 10,000 10,000 - 0.00%
Selling Expenses 5,000 6,000 1,000 20.00%
Net Income 25,000 44,000 19,000 76.00%
Vertical Analysis
Vertical analysis analyzes financial statement through finding out the relationship between accounts
within a particular period. Unlike horizontal analysis that compare the position and performance of the
company for two separate periods, vertical analysis computes the percentage of each account with a base
amount for each accounting period.
An example of vertical analysis is the Common Size Financial Statement. This determines the
percentage of an account balance in comparison to the base amount.
To illustrate, the financial statements of Equal Company are once again presented:
Equal Company
Statement of Financial Position
As of December 31, 2015, and 2016
2015 2016
ASSETS
Current Assets
Cash 150,000 190,000
Accounts Receivables, net 75,000 102,000
Inventory 50,000 55,000
Short-term Investments 20,000 20,000
Prepaid Expenses 10,000 8,000
Total Current Assets 305,000 375,000
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
Non-Current Assets
Land 800,000 800,000
Building, net 490,000 480,000
Machinery, net 295,000 290,000
Furniture and Fixtures, net 98,000 96,000
Long-term Investments 100,000 80,000
Total Non-Current Assets 1,783,000 1,746,000
TOTAL ASSETS 2,088,000
2,121,000
LIABILITIES AND OWNER’S EQUITY
Current Liabilities
Accounts Payable 50,000 55,000
Short-term Liabilities 45,000 50,000
Total Current Liabilities 95,000 105,000
Non-Current Liabilities
Long-term Debts 120,000 100,000
Bonds Payable 90,000 90,000
Total Non-Current Liabilities 210,000 190,000
TOTAL LIABILITIES 305,000 295,000
TOTAL OWNER’S EQUITY 1,783,000 1,826,000
TOTAL LIABILITIES & OWNER’S EQUITY 2,088,000 2,121,000
Equal Company
Income Statement
For the year ended December 31, 2015, and 2016
2015 2016
Net Sales 90,000 120,000
Cost of Goods Sold 50,000 60,000
Gross Profit 40,000 60,000
Administrative Expenses 10,000 10,000
Selling Expenses 5,000 6,000
Net Income 25,000 44,000
For the Statement of Financial Position, all accounts are divided against the total assets of the company.
Equal Company
Statement of Financial Position
As of December 31, 2015, and 2016
2015 2016
ASSETS
Current Assets
Cash 7.18% 8.96%
Accounts Receivables, net 3.59% 4.81%
Inventory 2.39% 2.59%
Short-term Investments 0.96% 0.94%
Prepaid Expenses 0.48% 0.38%
Total Current Assets 14.61% 17.68%
Non-Current Assets
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
Land 38.31% 37.72%
Building, net 23.47% 22.63%
Machinery, net 14.13% 13.67%
Furniture and Fixtures, net 4.69% 4.53%
Long-term Investments 4.79% 3.77%
Total Non-Current Assets 85.39% 82.32%
TOTAL ASSETS 100.00% 100.00%
LIABILITIES AND OWNER’S EQUITY
Current Liabilities
Accounts Payable 2.39% 2.59%
Short-term Liabilities 2.16% 2.36%
Total Current Liabilities 4.55% 4.95%
Non-Current Liabilities
Long-term Debts 5.75% 4.71%
Bonds Payable 4.31% 4.24%
Total Non-Current Liabilities 10.06% 8.96%
TOTAL LIABILITIES 14.61% 13.91%
TOTAL OWNER’S EQUITY 85.93% 86.09%
TOTAL LIABILITIES & OWNER’S EQUITY 100.00% 100.00%
On the other hand, for the Income Statement, all accounts are divided by the net sales.
Equal Company
Income Statement
For the year ended December 31, 2015, and 2016
2015 2016
Net Sales 100.00% 100.00%
Cost of Goods Sold 55.56% 50.00%
Gross Profit 44.44% 50.00%
Administrative Expenses 11.11% 8.33%
Selling Expenses 5.56% 5.00%
Net Income 27.78% 36.67%
Financial Ratios
Financial Ratios makes use of the relationship of accounts through ratios and percentages. As a
summary, the following are some ratios that can be used in the analysis:
Liquidity
Current Ratio
Description: Tests the ability of the company to pay for its current obligations
Formula: Total current assets / Total current liabilities
Acid Test Ratio or quick ratio
Description: A more strict test of the company’s ability to pay current obligations
Inventory and pre-paid assets are removed from the equation
Formula: Total quick assets / Total current liabilities
Quick assets: cash + marketable securities + accounts receivable
Working Capital
Description: Excess of current assets after covering the current liabilities
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
Shows the remaining amount of current assets that can be used in
the operations
Formula: Current assets – Current Liabilities
Management Efficiency
Receivable turnover
Description: Test the efficiency of managements’ collection of receivables
Formula: Net credit sales / Average accounts receivable (net)
Inventory turnover
Description: Determines the efficiency of the company in managing
Formula: Cost of goods sold / Average merchandise inventory
Stability
Debt ratio
Description: Shows proportion of all assets that are financed with liabilities
Formula: Total liabilities / total assets
Equity ratio
Description: Shows proportion of assets from owners
Formula: Total equity / total assets
Debt equity ratio
Description: Measures debt about equity
Formula: Total liability / total equity
Profitability
Gross profit margin
Description: Determines the percentage of profit generated after deducting cost of goods sold
Formula: Gross profit / Net sales
Net profit margin
Description: Determines the percentage of profit after adding all income and deducting all
expenses
Formula: Net profit / Net sales
Rate of return on equity
Description: Measures rate of return on resources provided by owners
Formula: Net income / Average ordinary equity
To illustrate the use of financial ratios, the financial statements of Equal Company for the year 2016 is
once again presented below:
Equal Company
Statement of Financial Position
As of December 31, 2016
ASSETS
Current Assets
Cash 190,000
Accounts Receivables, net 102,000
Inventory 55,000
Short-term Investments 20,000
Prepaid Expenses 8,000
Total Current Assets 375,000
Non-Current Assets
Land 800,000
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
Building, net 480,000
Machinery, net 290,000
Furniture and Fixtures, net 96,000
Long-term Investments 80,000
Total Non-Current Assets 1,746,000
TOTAL ASSETS 2,121,000
LIABILITIES AND OWNER’S EQUITY
Current Liabilities
Accounts Payable 55,000
Short-term Liabilities 50,000
Total Current Liabilities 105,000
Non-Current Liabilities
Long-term Debts 100,000
Bonds Payable 90,000
Total Non-Current Liabilities 190,000
TOTAL LIABILITIES 295,000
TOTAL OWNER’S EQUITY 1,826,000
TOTAL LIABILITIES & OWNER’S EQUITY 2,121,000
Equal Company
Income Statement
For the year ended December 31, 2016
Net Sales 120,000
Cost of Goods Sold 60,000
Gross Profit 60,000
Administrative Expenses 10,000
Selling Expenses 6,000
Net Income 44,000
The financial ratios are computed and interpreted as follows:
Liquidity
Current Ratio
Formula: Total current assets / Total current liabilities
Computation: 375,000/105,000
Current Ratio: 3.57:1
Interpretation: This means that for every 1-peso current liability of the company, they have
approximately 3.57 current assets to pay for it.
Acid Test Ratio or quick ratio
Formula: Total quick assets / Total current liabilities
Quick assets: cash + marketable securities + accounts receivable
Computation: 312,000/105,000
Quick Ratio: 2.97:1
Interpretation: This means that even the inventory and prepaid assets are removed, the company
is still able to meet their current obligations. For every 1-peso current liability,
they have an estimated amount of 2.97 pesos to cover for it.
Working Capital
Formula: Current assets – Current Liabilities
Computation: 375,000 – 105,000
Working Capital: 270,000
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
Interpretation: This means that the company has 270,000 pesos’ free current assets that they can
use for the operations of the business.
Management Efficiency
Receivable turnover
Formula: Net credit sales / Average accounts receivable (net)
Computation: 120,000/102,000
Receivable turnover: 1.18 times
Interpretation: The low receivable turnover indicates the inefficiency of the company in
collecting their receivables. This maybe because of poor credit and collection
policies.
Inventory turnover
Formula: Cost of goods sold / Average merchandise inventory
Computation: 60,000/55,000
Inventory turnover: 1.09 times
Interpretation: The low inventory turnover indicates the inefficiency of the management in
managing inventory. This could indicate that the company is storing too much
inventory about its ability to sell.
Stability
Debt ratio
Formula: Total liabilities / total assets
Computation: 295,000/2,121,000
Debt Ratio: 13.9%
Interpretation: This means that 13.9% of the company’s asset are being financed by creditors.
Equity ratio
Formula: Total equity / total assets
Computation: 1,826,000/2,121,000
Equity Ratio: 86.1%
Interpretation: This means that 86.1% of the company’s assets are being financed by the
company’s own capital.
Debt equity ratio
Formula: Total liability / total equity
Computation: 295,000/1,826,000
Debt Equity Ratio: 16.16%
Interpretation: This means that compared to the total equity, the liability represents only around
16.16% of the company’s capital.
Profitability
Gross profit margin
Formula: Gross profit / Net sales
Computation: 60,000/120,000
Gross Profit Margin: 50%
Interpretation: This means that after deducting cost of goods sold, 50% of the net sales is left
and is available for other expenses.
Net profit margin
Formula: Net profit / Net sales
Computation: 44,000/120,000
Net Profit Margin: 36.67%
Interpretation: This means that after all the income and expenses have been considered 36.67%
of the net sales is left for the company.
Rate of return on equity
Formula: Net income / Average ordinary equity
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2
Computation: 44,000/1,826,000
ROE: 2.4%
Interpretation: This means that the owner was able to get returns equivalent to 2.4% of his
investment in the company based on the performance of the company this year.
TOPIC QUESTIONS AND ACTIVITIES
1. What is the purpose of financial statement analysis?
2. Why do the following users analyze financial statement? How does the analysis influence their
decisions?
a. Bankers
b. Investors
c. Government agencies
d. Employees
e. Consuming public
3. What decisions of the internal user (management) are influenced by financial statement analysis?
4. What is the difference between horizontal and vertical analyses?
5. Are analyses the answer to the problems of the business? Explain.
