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FABM2 Module 5 Analysis and Interpretation of FS
Fluid Mechanics (University of Makati)
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UNIVERSITY OF MAKATI
J. P. Rizal Ext., West Rembo, Makati City
HIGHER SCHOOL NG UMAK
ABM AND LANGUAGE DEPARTMENT
Course Title
Fundamentals of
Accountancy, Business &
Management 2
Title
Module
No.
5
Analysis and Interpretation of Financial Statements (FS)
1. define the measurement levels, namely, liquidity, solvency, stability, and
profitability;
Learning Objectives
2. perform vertical and horizontal analyses of financial statements of a single
At the end of the lesson, the proprietorship; and
students should be able to:
3. compute and interpret financial ratios such as current ratio, working capital, gross
profit ratio, net profit ratio, receivable turnover, inventory turnover, debt-to-equity
ratio, and the like.
FINANCIAL STATEMENT (FS) ANALYSIS
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- Financial statement analysis is a process of evaluating and interpreting an entity’s financial statements to
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assess its financial health for the purpose of making better economic decisions.
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Depending on the objective of the analysis, a financial statement analysis may involve analyzing one or
more of the following:
1. Industry and economic trend – This involves the economic environment where the business
operates. This is necessary because the ability of a business to thrive is affected by various external
forces such as economic climate, competition, demand and supply, market rates, government
regulations, technological changes and the like.
2. Solvency and Capital structure – Solvency refers to the ability of the business to pay its debts and
remain as a going concern. Solvency can be a short-term (liquidity) or long term (solvency). On the
other hand, Capital structure refers to how a business efficiently finances its operations using different
sources of funds, such as debt or equity.
3. Operational efficiency – It refers to how well a business is managing its resources to maximize
earnings.
4. Profitability – Refers to the ability of the business to generate profit.
METHODS OF FINANCIAL STATEMENT ANALYSIS
⮚ The two methods used in analyzing financial statements are as follows:
a. Horizontal and Vertical Analyses
b. Financial ratio analysis
a. Horizontal analysis is the comparison of financial information over two or more reporting periods. The
purpose is to analyze if changes in amounts are unusually high or low, which may entail investigation of
the reason for the unusual change.
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Steps in Horizontal Analysis
1. Compute for the change in the amounts in a baseline year (earlier period) and a later period.
2. Divide the change by the amount in the baseline year.
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Examples of Horizontal Analysis
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Vertical analysis involves the analysis of the financial statements of one reporting period. It is a
proportional analysis whereby each amount in the financial statements is shown as a percentage of another
item.
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Examples of Vertical Analysis
SUMMARY:
b. FINANCIAL RATIO ANALYSIS
- Financial ratio analysis involves the computation of percentages, fractions or proportions using certain
formulas.
- Financial ratios are broadly classified into the following:
1. Liquidity ratios
2. Activity ratios (Asset management ratios)
3. Leverage ratios (Debt management ratios)
4. Profitability ratios
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1. Liquidity ratios - provide a measure of the ability of a business to pay its liabilities. Examples include:
a. Current ratio – the most commonly used ratio in measuring the ability of a business to pay its
short-term debts.
b. Quick ratio (Acid-test ratio) – a much stricter ratio used to measure the ability of a business to
pay its short-term debts.
c. Working capital – similar to current ratio but measures the ability of a business to pay its shortterm debts by the excess or deficiency of current assets over current liabilities.
2. Activity ratios (Asset management ratios) - provide a measure of how efficient a business is utilizing
its resources.
a. Inventory turnover – is a measure of the number of times inventory is sold and replenished during
a period.
b. Days of inventory (Average sale period) – is a measure of the number of days inventory is held
before it is sold.
c. Accounts receivable turnover – is a measure of the number of times accounts receivable have
been collected during a period. It is an indication of the efficiency in collection.
d. Days of receivable (Average collection period) – is a measure of the average time to collect a
receivable.
3. Leverage ratios (Debt management ratios) - provide a measure of the extent a business uses debt
financing or “leverage.”
a. Debt ratio (Debt-to-asset ratio) – measures the proportion of assets financed through debt.
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b. Equity ratio – measures the proportion of assets financed through equity.
c. Debt-to-equity ratio – indicates how much debt is used to finance the assets relative to the amount
pertaining to the owner(s).
4. Profitability ratios - provide a measure of the performance of a business in terms of its ability to
generate profit from its resources.
a. Gross profit ratio – shows the relationship between sales and cost of goods sold.
b. Net profit ratio – measures profitability after considering all income and expenses.
c. Return on assets – measures the profit generated in relation to the total resources available to the
business.
d. Return on equity (Return on net assets) – measures the profit generated in relation to the
resources invested by (or attributable to) the owner(s) of the business.
QUIZ: ACTIVITY
A The comparative statement of financial position and statement of comprehensive income of Entity A
S on December 31, 20x1 are shown below:
S
Entity A
E
Statement of Financial Position
S
As of December 31, 20x1
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M
ASSETS
20x1
20x0
E
440,000
200,000
N Cash and cash equivalents
130,000
120,000
Accounts receivable
T
Inventory
Prepaid assets
120,000
40,000
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480,000
160,000
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Total current assets
730,000
960,000
Property, plant & equipment
Total noncurrent assets
760,000
760,000
440,000
440,000
TOTAL ASSETS
1,490,000
1,400,000
LIABILITIES
Trade and other payables
620,000
560,000
EQUITY
Owner’s capital
870,000
840,000
TOTAL LIABILITIES & EQUITY
1,490,000
1,400,000
Entity A
Statement of Comprehensive Income
For the year ended December 31, 20x1
Sales
Cost of sales
GROSS PROFIT
Rent income
Depreciation expense
Insurance expense
Bad debts expense
Loss on sale of equipment
PROFIT FOR THE YEAR
Other comprehensive income
COMPREHENSIVE INCOME FOR THE YR.
1,000,000
(600,000)
400,000
150,000
(240,000)
(120,000)
(30,000)
(40,000)
120,000
120,000
Requirements: Compute for the following financial ratios for the year 20x1: (round-off answers to two decimal
places)
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
Current ratio
Quick (Acid-test) ratio
Working capital
Inventory turnover
Days of inventory (use 365 days)
Accounts receivable turnover (assume all sales are on credit)
Days of receivable (use 365 days)
Debt ratio
Equity ratio
Debt-to-equity ratio
Gross profit ratio
Net profit ratio
Return on assets
Return on equity
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COMPREHENSIVE PROBLEM:
Directions: Construct a balance sheet statement using the financial ratios provided.
Realeza Corporation has credit sales of 75,000. Given the following ratios, fill in the statement of
financial position below:
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Total Assets Turnover
2.5 times
Accounts Receivable Turnover 10.0 times
Cash to Total Assets
2.0 percent
Inventory Turnover
Debt to Total Sales
Current Ratio
15.0 times
45.0 percent
2.0 times
Realeza Corporation
Statement of Financial Position
As of December 31, 2017
Assets
Cash
________________
Accounts Receivable ________________
Inventory
________________
Total Current Assets _______________
TOTAL ASSETS
Liabilities and Equity
Current Debt ______________
Long Term Debt _______________
Total Debt
_______________
Net worth
_______________
TOTAL LIABILITIES AND EQUITY
.
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R Millan and Ferrer, Fundamentals of Accountancy, Business & Management 2 (2019), Philippines:
E Bandolin Enterprise
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C
E
S
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