Module 4: Financial Statement Analysis
Objectives:
1. Identify and explain the basic financial statements used in
business
2. Prepare statement of cash flows
3. Perform trend analysis in interpretation of financial statements
4. Prepare common size financial statements
5. Compute and explain financial ratios of a business
Topics:
Lesson 1: Financial Statements
Lesson 2: Statement of Cash Flows
Lesson 3: Trend Analysis and Common Size Financial Statement
Lesson 4: Financial Ratios
FINANCIAL STATEMENTS
What are Financial Statements?
FINANCIAL STATEMENTS are the accounting reports prepared at the end of an accounting
period. (Usually one year). The basic financial statements are the following:
INCOME STATEMENT or STATEMENT OF COMPREHENSIVE INCOME - a statement
that shows the results of operations for a given period of time. This statement will show
whether the business made a profit or incurred a loss. Income statement includes the
following:
1. Revenues
2. Expenses
3. Resulting profit or loss
It is important to note that when presenting information in the financial statements, we
assume that the statements are prepared primarily for internal management use.
Accordingly, our focus for this course would be on operating profit which could differ from
net income adjusted for income taxes and other extra-ordinary items.
How does cost information appear in the financial statements prepared for
managers?
Cost generally resides in the Statement of Comprehensive Income or popularly known
as INCOME STATEMENT. Let us illustrate three types of income statement as follows:
1. Organization sells service
2. Organization sells a product that it acquires from other organizations or a retailer
3. Organization sells a product that it builds using materials from other organizations or
a manufacturer
Service Organizations
A service company provides customers an intangible product. The examples are
accounting firms, law firms, and other consulting firms. They have the most basic income
statement where all expenses are generally classified as period costs generally called
“operating expenses” and labor cost are the most significant cost category. Their
income statement would appear as follows:
Name of the Company
Income Statement
For the period ended _______
Service revenue Pxxxxx
Less: Operating Expenses
Salaries and Wages Pxxxxx
Rent Expense xxxxx
Advertising Expense xxxxx
Depreciation Expense xxxxx
Utilities Expense xxxxx
Supplies Expense xxxxx xxxxx
Operating Profit Pxxxxx
However, as services increases and changes occur due to modernization and
technology some service firms include an additional line item called “cost of services”
to identify and present separately direct cost of services rendered. The distinction is
based on the nature of work, not who performs the work.
Name of the Company
Income Statement
For the period ended _______
Service revenue Pxxxxx
Less: Cost of services xxxxx
Gross Margin Pxxxxx
Less: Marketing and administrative costs xxxxx
Operating Profit Pxxxxx
Retail/Wholesale or Merchandising Companies
Merchandising companies sell but do not make a tangible product. The income
statement of these companies has an added category of cost information called “Cost
of Goods Sold” to track the cost of the tangible goods they buy and sell. Expense for
merchandising companies are divided into product costs (cost of goods sold) and period
costs (selling and administrative costs).
Name of the Company
Income Statement
For the period ended _______
Service revenue Pxxxxx
Less: Cost of goods sold xxxxx
Gross Margin Pxxxxx
Less: Selling and administrative costs xxxxx
Operating Profit Pxxxxx
Presentation of cost of goods sold will depend on the inventory system (perpetual or
periodic) used by the company. Both inventory systems were discussed during your prior
pre-requisite courses. For purposes of discussion, let us use periodic inventory system
where cost of goods purchased are charged to a purchases account and no adjustment
to inventory is made on every recorded sale. A physical count of goods at the end of the
period is therefore necessary to determine how much inventory is left at the end of the
period. The computation of cost of goods sold is as follows:
Beginning inventory Pxxxxx
Add: Purchases Pxxxxx
Freight-in xxxxx xxxxx
Good available for sale Pxxxxx
Less: Ending inventory xxxxx
Cost of goods sold Pxxxxx
Manufacturing Companies
A manufacturing company has a more complex income statement than a merchandising
company. The retailer/wholesaler purchases goods for sale whereas a manufacturer
makes them. For decision making, it is not enough for manufacturer to know how much
is paid for a good; it must also know the different costs associated with making it. Your
prior financial accounting courses most likely gave examples of income statement of a
merchandising company where unit cost is known because the focus would be on
preparing and presenting statements rather than the computation of unit cost.
The cost of goods sold under a manufacturing concern compared with a merchandising
concern will now include manufacturing costs. In determining the manufacturing cost,
it is important to know the physical flow of the product going through the manufacturing
process. From the VENDOR/SUPPLIERS, goods are received as RAW/DIRECT
MATERIALS. When the materials are used, its cost is added DIRECT LABOR cost and
MANUFACTURING OVERHEAD (all costs related to manufacturing that is not direct
materials and direct labor) costs. These three costs shall comprise WORK-IN-PROCESS
INVENTORY (unfinished goods) until the manufacturing process is done where these
costs will then be classified as FINISHED GOODS INVENTORY.
The format of income statement of a manufacturing company is shown below:
Name of the Company
Income Statement
For the period ended _______
Service revenue Pxxxxx
Less: Cost of goods manufactured and sold xxxxx
Gross Margin Pxxxxx
Less: Selling and administrative costs xxxxx
Operating Profit Pxxxxx
Due to complexity of cost items, additional statement would be necessary to present the
cost of goods manufactured and sold as follows:
Name of the Company
Cost of Goods Manufactured and Sold Statement
For the period ended _______
Direct materials:
Beginning inventory Pxxxxx
Add: Purchases Pxxxxx
Freight-in xxxxx xxxxx
Direct materials available for use Pxxxxx
Less: Ending inventory xxxxx
Direct materials put into production Pxxxxx
Direct labor xxxxx
Manufacturing overhead xxxxx
Total manufacturing costs incurred Pxxxxx
Add: Beginning work-in-process inventory xxxxx
Total work-in-process during the period Pxxxxx
Less: Ending work-in-process inventory xxxxx
Cost of goods manufactured Pxxxxx
Add: Beginning finished goods inventory xxxxx
Finished goods available for sale Pxxxxx
Less: Ending finished goods inventory xxxxx
Cost of goods manufactured and sold Pxxxxx
CAPITAL STATEMENT or STATEMENT OF CHANGES IN EQUITY - a statement that
shows changes in capital and the resulting ending capital for a given period of time. The
capital statement would indicate the following:
1. Beginning capital
2. Additional investments
3. Owner’s withdrawal or drawings
4. Profit or loss
5. Ending capital
BALANCE SHEET or STATEMENT OF FINANCIAL CONDITION – a statement that
shows the financial condition of the business as of a given date. It shows the assets,
liabilities and capital of the business.
Classifications of the STATEMENT OF FINANCIAL CONDITION ITEMS:
Assets – are properties or economic resources controlled by a business. They
are commonly classified as Current Assets and Property, Plant and Equipment.
Current Assets – are cash and those assets that are used up, sold or
converted into cash with one year through the normal operations of the
business. In addition to Cash, current assets of a service business are notes
receivable, accounts receivable, supplies and other prepaid expenses.
Property, Plant and Equipment – or plant assets are long-lived assets that
are used the production or sales of other assets or services over several
accounting periods. Plants assets include land, buildings, delivery
equipment, store equipment and office equipment.
Others Assets – are all other assets not classified as current asset and
Property, Plant and Equipment like intangible assets (Goodwill, Patent etc.)
Liabilities - are amounts owned to creditors and claims of creditors to the assets
of the business. They are commonly classified as Current Liabilities and Long-
term Liabilities.
Current Liabilities – are business obligations that must be paid within one
year or liabilities that are to be paid out of current assets. The most common
current liabilities are notes payable, accounts payable, accrued expenses
(like salaries, rent, taxes, interest, etc.) and unearned income.
Long-term Liabilities – are debts that are not required to be paid within the
next accounting period. Examples are: Long-term bank loan and mortgage
payable.
Owner’s Equity – the owner’s right or claim to the assets of the business. The
owner’s equity is added to the total liabilities, and this total must be equal to the total
assets.
STATEMENT OF CASH FLOWS - a statement that shows the sources or inflows of cash
and uses or outflows of cash for a given period of time. The statement of cashflow
provides information on the three activities of a business namely: (1) Operating activities,
(2) Investing activities, and (3) Financing activities
How do we prepare the Statement of Cash Flows?
In your previous accounting course, focus was made in the preparation of income
statement, capital statement and balance. This time let us prepare the statement of cash
flows. Two methods can be used in preparing the statement of cash flows namely: (1)
Direct Method and (2) Indirect method. For purposes of discussion, we will be using
direct method for this module.
In preparing the statement of cash flows under direct method, consider the following:
1. Identify cash transaction – only cash transactions are included in the statement of
cash flows.
2. Classify the transaction based on three types of activities – statement of cashflow
provides information on the three activities of a business namely: (1) Operating
activities, (2) Investing activities, and (3) Financing activities.
3. Determine the effect of the transaction on the company’s cash account which could
either be (1) cash inflow or (2) cash outflow
4. Compute for net cash inflow or outflow then add cash balance at the beginning to
get ending cash balance. The ending cash balance of the statement of cash flow
should tally with the cash balance as per balance sheet or statement of financial
position
Illustration: On Jan. 3, 2019, ABC Company showed a cash balance of P200,000 and
incurred the following:
2019 Transactions
Jan. 10 Made an additional capital investment, P100,000 cash.
Feb 1 Received proceeds from a bank loan amounting to P300,000.
Mar 31 Sold equipment with a book value of P80,000 for P60,000
April 22 Purchased office supplies on account, P25,000
May 1 Purchased furniture amounting to P150,000, paid P40,000 cash and P70,000
on account.
Jul 1 Rendered P520,000 consulting services: received P220,000 cash, and
P295,000 on account.
Sep 1 Received from all account customers P100,000 payment on their account
balances
Nov 15 Paid 10% of Feb 1 bank loan
Dec 31 Paid P120,000 rental and P80,000 utilities for the year for office space.
Let us use the following table to analyze the above transactions:
Transaction Activity Effect to Cash Amount
Additional capital investment Financing Inflow 100,000
Proceeds from bank loan Financing Inflow 300,000
Sale of equipment Investing Inflow 60,000
Purchase of office supplies on
Not a cash transaction
account
Purchase furniture Investing Outflow 40,000
Rendered consulting services Operating Inflow 220,000
Collection from customers Operating Inflow 100,000
Payment of bank loan Financing Outflow 30,000
Payment of rent Operating Outflow 120,000
Payment of utilities Operating Outflow 80,000
Based on the table above the statement of cash flow is presented below:
ABC Company
Statement of Cash Flows
For the period ending December 31, 2019
Cash flow from operating activities:
Inflows:
Services rendered P220,000
Collection from customers 100,000 P320,000
Outflows:
Rental payment P120,000
Utilities payment 80,000 (200,000) P120,000
Cash flows from investing activities:
Inflows:
Sales of equipment P 60,000
Outflows:
Acquisition of furniture (40,000) 20,000
Cash flows from financing activities:
Inflows:
Capital investment P100,000
Proceeds from loan 300,000 P400,000
Outflows:
Loan payment (30,000) 370,000
Net cash inflow (outflow) P510,000
Add: Cash beginning balance 200,000
Cash ending balance P710,000
FINANCIAL STATEMENTS ANALYSIS
In familiarizing ourself with any organization, we should look into its latest annual reports or
financial statements. The basic financial statements such as Income Statement and Balance
Sheet are sources of helpful data but if not properly used may lead to false interpretation.
FINANCIAL STATEMENT ANALYSIS uses ratios and percentages to determine financial
and operational standing of the firm in relation to its plans and the industry (trends,
competitors and ideal rates) where it belongs. In using the financial statements as one of
the bases in decision making, the following limitations should be borne in mind:
1. Financial statements do not contain all the significant facts about a business. (such
as short-term goals, long-term objectives, quality of products and services, quality of
organization and pending contracts)
2. Financial statements do not reflect changes in the purchasing power of the monetary
unit. (owner’s equity is merely the residual value of assets at historical cost after
deducting creditor’s claims)
3. Financial statements are interim in nature although they give an impression of being
accurate. (estimates are used in determining the results of operations and financial
position)
4. Contents of the financial statements may vary with the variation in the application of
generally accepted accounting principles. (methods and procedures in the
measurement used may vary - example computation of depreciation/costing of
merchandise)
What are the methods of financial statement analysis?
1. Horizontal Analysis or Trend Analysis
2. Vertical Analysis or Common Size Statements
3. Financial Ratios
How do we perform Horizontal analysis or Trend analysis?
Horizontal analysis refers to determining the changes in or behavior pattern of the different
items in financial statements of two or more years. Trend analysis is undertaken to determine
the behavioral patterns of the different account balances. Trend percentages uses the
earliest period presented as base figures (100%) or as divisors.
Illustration: The following figures are taken from the income statement of ABC Trading Co.
for 20A to 20E:
20A 20B 20C 20D 20E
Sales 80,000 96,000 60,000 50,000 84,000
Cost of sales 40,000 50,000 36,000 24,000 44,000
Selling expenses 10,000 12,000 9,000 8,000 15,000
Gen. & Adm.
6,000 9,000 8,000 6,000 7,500
expenses
Net income 24,000 25,000 7,000 12,000 17,500
The figures in 20A, the earliest year, are used as divisors so that with sales for 20B of
P96,000, the trend ratio for 20B is 1.20 or 120% computed at P96,000/P80,000.
The trend ratios are as follows:
20A 20B 20C 20D 20E
Sales 1.00 1.20 .75 .62 1.05
Cost of sales 1.00 1.25 .90 .60 1.10
Selling expenses 1.00 1.20 .90 .80 1.50
Gen. & Adm.
1.00 1.50 1.33 1.00 1.25
expenses
Net income 1.00 1.04 .29 .50 .73
It may be noted that results of operation declined in 20C and 20D and recovered in the fifth
year, 20E. Cost of sales and selling expenses changes in the same direction as pesos sales
although the percentages of increase in selling expenses in 20E far exceeded the increase
in both sales and cost of sales. It may be also noted that general and administrative
expenses do not change with peso sales and do not go lower than the 20A base level.
How do we perform Vertical Analysis or Common-size statements?
Base figures (100%): NET SALES for Income Statement
TOTAL ASSETS for Balance Sheet
Common size statements can be used in analyzing the financial statements of one company
and in comparing those of different companies. In analyzing the statements of one company
using common size statements, the objective could be to determine (1) whether the
component tally with those of what was planned and (2) what are the changes in the
component percentages from one period to another. Common size statements used in
comparing statements of different companies determines the differences in components
percentages in the statements without being misled by the differences in peso amounts. The
comparison is generally prepared for the industry to which the firm belongs.
Illustration (comparing statements of different companies): The following income
statements of ABC Corp. and DEF Co. are converted into common size statement below:
ABC Corp. DEF Co.
Sales 1,500,000 300,000
Less: Cost of sales 900,000 150,000
Gross profit on sales 600,000 150,000
Less: Operating expenses 375,000 90,000
Net income 225,000 60,000
The common size statements are as follows:
ABC Corp. DEF Co.
Sales 1.00 1.00
Less: Cost of sales .60 .50
Gross profit on sales .40 .50
Less: Operating expenses .25 .30
Net income .15 .20
Because of the difference in sizes of the two companies, comparison prior to conversion of
the statements to common size statements would limit the analyst to peso differences. As
may be noted, the second set of statements is more informative and shows the DEF’s net
income per peso sales differs by P.05 of that of ABC and that its advantage is in its lower
cost of sales which is partly offset by higher operating expenses.
How do we compute Financial Ratios?
Financial ratios are the significant relationships between items in the financial statements
expressed in mathematical form. As indicators of profitability, liquidity, leverage, and
stability, they are used to determine the possible areas of weaknesses and strengths of an
organization by comparing the company’s financial ratios with chosen standards such as
industry ratios.
➢ Liquidity ratios – ability of the firm to meet short-term obligation
a. Current ratio = Current assets
Current liabilities
Acid test ratio = Quick assets
Current liabilities
b. Average payment period = 360 or Working days in 1 year
Accounts payable turnover
Accounts payable turnover = Net credit purchases
Accounts payable
Recommendations:
✓ Sale of non-performing assets
✓ Settlement of current obligations
✓ Speed up collection of receivables
✓ Accurate inventory management
➢ Activity ratios – ability of the firm to efficiently utilize its assets
a. Asset turnover = Net Sales .
Total Assets
b. Average collection period = 360 or Working days in 1 year
Accounts receivable turnover
Accounts receivable turnover = Net credit sales_______
Net Accounts receivable
c. Days’ Sales in Inventory = 360 or Working days in 1 year.
(days the inventory is left unsold) Finished goods invty. Turnover
Finished goods inventory turnover = Cost of goods sold .
Finished goods inventory
Recommendations:
✓ Increase sales
✓ Strict credit criteria for customers credit applications
✓ Review discount granted to customers and the causes of sales returns
✓ Speed up collection of receivables
✓ Accurate inventory management
➢ Leverage ratios – measurement of the firm’s solvency or dependence to its
creditors in relation to equity and internal financing
a. Debt to asset ratio = Total liabilities
Total assets
b. Debt to equity ratio = Total liabilities_____________
Owners’ /Stockholders’ Equity
➢ Profitability ratios – ability of the firm to generate profits to be able to
recover its operating expenses
a. Return on assets = Net income after tax
Total assets
b. Return on equity = Net income after tax_______
Owners’ /Stockholders’ Equity
➢ Stability ratios – ability of the firm to pay its long-term obligations and meet
regularly its dividend requirements.
a. Price-earnings ratio = Market price per share
Earnings per share
Earnings per share = Net inc. after tax less preferred dividend
No. of common shares outstanding
b. Dividend payout = Dividends declared for common shares
Net inc. after tax less preferred dividend
