VALUATION AND METHODS

FS ANALYSIS

1) What is Financial Statement (FS) analysis?

Answer:
a. To provide information that allows decision makers to understand and evaluate the results of business
decisions. In short, it is to provide information in order to make decisions. Managers analyze financial
statements to evaluate past financial performance and make future decisions.

b. Involves the evaluation of an entity’s past performance, present condition, and business potentials by way of
analyzing the financial statement to obtain information about (among others):

1. Profitability of the business firm

2. Ability to meet company obligations
3. Safety of investment in the business
4. Effectiveness of management in running the firm

c. Three basic tools in financial statement analysis

1. Horizontal analysis (a.k.a. trend analysis)

2. Vertical analysis (a.k.a. common size analysis)
3. Ratio analysis
4. Cash Flow Analysis (refer to next Chapter)

2) What is Horizontal Analysis?

Answer:
▪ A technique for evaluating a series of financial statement data over a period of time. Its purpose is to
determine the increase and decrease that has taken place, expressed either an amount or a percentage.

▪ Involves comparison of amounts shown in the FS of two or more consecutive periods. The difference and
percentage change of the amounts are calculated using the EARLIER period as the BASE PERIOD.

To determine the increase and decrease expressed in percentage, the formula is:

Current Year Value – Base Year Value

= Percentage of Change (%)
Base Year Value

3) What is Vertical Analysis

Answer:
▪ Vertical analysis is the process of comparing figures in the FS of a single period. It involves conversion of
amounts in the FS to a common base. This is accomplished by expressing all figures in the FS as
percentages of an important item such as total assets (in the balance sheet) or net sales (in the income
statement). These converted statements are called common-size statements or percentage composition
statements.

▪ Stated otherwise,
➢ When preparing common-size statement for the balance sheet, the various items on the balance sheet
are typically stated as a percentage of total assets.

➢ When preparing common-size statement for the income statement, the various items on the income
statement are typically stated as a percentage of net sales pesos.
4) What is Ratio Analysis

Answer: This technique establishing relationship among financial statement accounts at given date or period of
time. These ratios analyze firm’s liquidity, the use of leverage, asset management, cost control, profitability,
growth, and valuation.

1. Liquidity ratio.

Provides information about the firm’s ability to pay its current obligations and continue operations.

Ratio Formula Purpose

Current Asset To evaluate company’s liquidity and

Current Ratio
Current Liabilities ability to pay current obligations.

Quick assets are cash, short term

investments and accounts receivable.
Quick Asset This ratio is a much more stringent test
Acid Test Ratio
Current Liabilities of short term liquidity. It measures the
(a.k.a. Quick Ratio)
number of times that the current
liabilities could be paid with the available
cash and near-cash asset.

2. Activity ratio.

Measures the firm’s use of assets to generate revenue and income. These ratios evaluate liquidity because
they indicate how quickly assets are turned into cash.
Ratio Formula Purpose

It measures the number of times

Receivable Net Credit Sales
receivables are recorded and collected
Turnover Average Receivables during the period.

It indicates the average number of days

360 days during which the company must wait
Average Age of
before receivables are collected.
Receivable Receivable Turnover
(a.k.a. Average Collection period)
(a.k.a. Days’ Sales in Receivable)

Inventory Cost of Goods Sold It measures the number of times that the
Turnover Average Merchandise Inventory inventory is replaced during the period.

360 days It indicates the average number of days

Average Age
during which the company must wait
of Inventory Inventory Turnover
before the inventories are sold.

Net Credit Purchases It measures the number of times

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

Average Age of Inventory Measures the average number of days to

Operating Cycle
+ Average Age of Receivable convert inventories to cash.

Total Asset Net Sales Measures the level of capital investment

Turnover Average Total Asset relative to sales volume.

Net Sales It indicates how much revenue the

Fixed Asset
company generates for each peso
Turnover Average Net Fixed Asset
invested in fixed assets.

Indicates adequacy of working capital to

Net Sales support operations (sales)
Working Capital
Turnover Average Working Capital
Working capital = Current Asset –
Current Liabilities

3. Solvency ratio

Relate to the company’s long-run survival. It shows the company’s ability to repay lenders when debt
matures and to make the required payments prior to the date of maturity.

Ratio Formula Purpose

Total Liabilities
Debt Ratio Proportion of total provided by creditors
Total Asset

Total Shareholders’ Equity Proportion of total assets provided by

Equity Ratio
Total Asset owners

Total Liabilities Proportion of assets provided by

Debt to Equity
creditors compared to that provided by
Ratio Total Shareholders’ Equity
creditors
 Times Interest Earnings Before Interest & Tax (EBIT) It determines the extent of which
Earned Ratio Interest Expense operations cover interest expense

4. Profitability ratio.

Relate to the company’s performance in the current period. It shows the company’s ability to generate
income. Measure earnings in relation to some base, such as assets, sales or capital.

Ratio Formula Purpose

Net Profit Margin Represents the percentage of revenue

Ratio Net Income that ultimately makes it into net income,
(a.k.a. Return on Net Sales after deducting expenses. It determines
Sales) the amount of income by owners.

Net Sales – Cost of Goods Sold In indicates how much profit was made,
Gross Profit
on average, on each peso of sales after
Percentage Net Sales
deducting the cost of goods sold.

Basic Earning EBIT

Indicates overall profitability of assets.
Power Total Asset

Return on Net Income Efficiency with which assets are used to

Total Asset Average Total Asset operate the business.

Return on Net Income Measures the amount earned on the

Equity (ROE) Average Shareholders’ Equity owners’ or stockholders’ investment

Return on Net Income – Preference Dividends Measures the profitability of common

Common Equity Average Common Equity equity.

Price Earnings (PE) Price Per Share It indicates the number of pesos
Ratio Earnings Per Share required to buy P1 of earnings.
 Dividend Per Share Measures the rate of return in the
Dividend Yield
Price Per Share investor’s common stock investments.

Dividend Pay-Out Dividend Per Share It indicates the proportion of earnings

Ratio Earnings Per Share distributed as dividends

Net Operating Profit after Taxes Shows the amount of current investment
Economic Value
Less: Total Cost of Capital that was “financed” by depreciation and
Added (EVA)
increase in retained earnings
EVA

Liquidation Value of PS + Unpaid

Preference Share Dividends Amount that each PS will receive upon
Book Value Per
Outstanding and Subscribed PS liquidation of the Company
Share

Total SHE – [Liquidation Value of PS +

Ordinary Share Unpaid Dividends] Amount that each OS will receive upon
Book Value Per
Outstanding and Subscribed OS liquidation of the Company
Share

Net Income – PS Dividend The amount of earnings per year of each

EPS
Weighted Average Outstanding OS Ordinary Shares

5. Not Commonly Asked Ratio.

Ratios that are not frequently asked in examinations.

Cash + Cash Equivalents A more conservative variation of Quick

+ Marketable Securities Ratio. It tests short term liquidity
Cash Ratio
Current Liabilities without having to rely on receivables and
inventory.

Cash + Cash Equivalents

Cash to Current + Marketable Securities
Measures the liquidity of current assets.
Asset Ratio Current Assets
 Operating Cash Flow Shows the significance of cash flow for
Cash Flow Ratio settling current obligations as they
Current Liabilities
become due.

Cash Equivalent + Net Receivables

Defensive Internal + Marketable Securities Reflects the percentage of near cash
Ratio Daily Operating Cash Flow items to the daily operating cash flow.

Increase in Retained Earnings

Shows the amount of current investment
Investment + Depreciation
that was “financed” by depreciation and
Financing Current Investment increase in retained earnings

Weighted Non Cash Current Asset A measure of liquidity of current assets

Liquidity Index stated in days. It shows the period-to-
Current Asset
period changes in an entity’s liquidty.

EBIT + Interest portion of Operating

Fixed Charge Leases Indicates the margin of safety for
Coverage Ratio Interest + Interest portion of Operating payment of all fixed charges
Leases

Operating Cash Operating Cash Flow Measures the portion of total liabilities
Flow to Total Debt that can be paid out of the cash flows
Total Debt
Ratio from operations.

Amount Available for Reinvestment Measures the percentage of net income

Plowback Ratio available for investment. A high rate
Net Income
means less external financing

Labor Cost Measures the percentage of labor cost

Labor Cost Ratio
Net Sales to sales.

Used as a measure of operational

Employment Average Number of Workers growth. It is compared with the
Growth Rate Number of Works at the Beginning of the investment rate to determine whether
Year capital is being substituted for labor.
 Ratio of Operating Net Cash provided by Operation Measures the ability to pay dividend
Cash Flows to
Cash Dividends from current operating sources.
Cash Dividends

Internal Growth Amount of Retained Earnings Measures the percentage increase in

Rate Asset Base assets kept in the business

Financial Statement Analysis Limitations.

1. Financial statements contain numerous estimates.

2. Traditional financial statements are based on cost and are not adjusted for price level
changes.
3. The use of different generally accepted accounting principles may distort comparison.
4. Ratio analysis may be affected by seasonal factor
5. Diversification limits comparability
6. Management may window dress financial statements.
7. Accounting policies among different companies may widely vary.

Final reminder.

1. In horizontal analysis, percentage of change is not computed if the base is zero or

negative.
2. In vertical analysis, only percentages are presented.
3. When calculating a ratio using balance sheet (BS) amounts only (i.e., numerator
and denominator is balance sheet items), both the numerator and denominator
should be based on amounts as of the same balance sheet date (i.e., not averaged,
not the balance of previous balance sheet). Same rule will apply when it comes to
using income statement (IS) amounts only.
4. If one income statement and one balance sheet item is used at the same ratio
(i.e., numerator is income statement item while denominator is BS item), the balance
sheet amount should be expressed as an average [(Beginning + Ending)  2].
5. When using average BS amounts and the beginning balance (previous year BS) is
not available, use ending balance now will represent the average (unless the
beginning balance can be computed or work backed).
6. When computing for a turnover ratio (e.g., AR turnover), sales and purchases are
assumed to be on account unless otherwise stated.
7. When computing for a ratio involving the number of days in a year, use 360 days,
unless otherwise stated that 365 days will be used.
8. The term “net income” is assumed to be after deducting all expenses and that
includes interest and taxes, unless otherwise stated.

DuPont Formula.

Return on Sales X Asset Turnover = Return on Asset

Net income Sales Net income

Sales X Average asset = Average Asset

Price – Earnings Ratio X Dividend Yield Ratio = Dividend Pay-out Ratio

Price Per Share Dividend Per Share Dividend Per Share

Earnings Per Share X Price Per Share = Earnings Per Share