FINANCIAL STATEMENT ANALYSIS
Nature of Financial Statement Analysis
Financial Statement Analysis - a process of selecting related data from financial statements
to evaluate the entity's past financial position and operating performance and predict the
outcome of future operations.
The information provided in the FS:
-assists users in predicting the entity’s future cash flows and in particular, their timing and
certainty
-the data can also reflect the financial strengths and weaknesses of an entity
The analysis of FS involves the process of evaluating the trend of a particular accounting
value in relation to that of other accounting values. The movement of other accounting
values that directly or indirectly affect a specific accounting value are considered.
BASIC objective of FS Analysis – to assist the different users in the decision-making process
Procedures that may be adopted in analyzing FS:
1.
Establish the objective of the FS analysis
2.
Gather complete information about the firm and study the industry in which the firm
operates
3.
Perform mathematical analysis using the applicable tools
4.
Make conclusion relative to the established objectives
Today, we will include the following in analyzing the FS:
1.
Horizontal or Comparative approach
2.
Vertical or common-size approach
3.
Trend approach
Horizontal or Comparative analysis Approach – is an analytical tool that evaluates the
present performance of an entity compared to last year’s. The analysis reflects the
differences in absolute amount and in percentage between two periods only, namely the
present year and the previous year.
Objective: to determine the present status of the business particularly in terms of financial
position, result of operation, and cash flows against last year’s only.
2 Methods of Horizontal or Comparative Analysis:
1.
Absolute amount comparison – the absolute amount of each item appearing in the FS
is determined by deducting the amount of the current date FS from the amount of the
previous year.
2.
Percentage comparison – works on the percentage of change which is determined by
dividing the absolute amount of change by the base figure.
BASIC CONCEPT: to look for significant changes, and to determine their probable causes.
Guidelines in Horizontal or Comparative analysis:
1.
Present the current and previous year’s FS in comparative format.
2.
Compute the absolute amount of change or difference. The difference could be either
an increase or a decrease.
3.
Express the difference in percentage by dividing the amount of change by the base.
4.
The computation of percentage of change will not apply if the base amount is
negative or zero.
5.
Interpret the change of an item by relating it with the change or movement of other
related items.
Vertical or Common-Size Approach – an analytical tool that determines the size or
proportion of an item in the FS in relation to the total. This approach involves the process of
determining the proportional component of each item in the financial statements in relation
to the base. The accounting period involved in the mathematical process is one or single
period only.
BASIC CONCEPT: very useful in determining the proportion of each item in the different
sections of the FS. It also serves as a guide in the management of the resource allocation
policy.
Vertical or common-size analysis becomes more valuable if the common size financial
statements of an entity are compared with the statement of the other entities in the
industry. The result of the analysis assists the management and other interested users in
making economic decision relative to allocation and proper utilization of resources.
Vertical analysis is also a tool that determines whether the business is operating according
to its nature. It is expected that the business allocates more funds for the accounting
element that contributes mainly to corporate profitability, liquidity and solvency.
Guidelines that may be observed in the preparation of Common-size FS:
1.
Convert the absolute peso amount of the items in the FS into percentage by dividing
each item by the base. The base shall be equal to 100%
2.
Use the following as a base:
a.
Total assets for statement of financial position;
b.
Total or net sales for statement of comprehensive income; and
c.
Total cash available for the statement of cash flows
3.
Make a conclusion on the allocation and indications of possibilities.
Trend Percentage Approach – is used to analyze the FS that extend beyond 2 years
through the use of index numbers or percentages. It converts the absolute peso into
percentages.
The trend analysis – makes a comparative study of an operating performance of the
business over a number of years. Data for 3 years are the minimum requirement for this
type of analysis.
A trend analysis covering more than 5-year business operations present a better perspective
of the entity’s operating performance than a two-year horizontal analysis.
In conducting a trend analysis, the base year selected must be a representative of normal
year. A base year that is not representative of the business normal operation will not present
a meaningful trend, and the result of the evaluation becomes meaningless to the users. The
base year carries an index of 100 percent.
An index that is less than 100 signifies that the account has decreased from the base year
while an index more than 100 means that the account has increased from the base year.
The trend of the analysis may be either upward or downward. An upward trend indicates an
increasing financial performance, and a downward trend indicates a decreasing operating
performance.
The trend analysis assumes no change in purchasing power of money. It is likewise assumed
that the changes occurring in the different items of the FS are mainly attributable to the
operating performance of the business and not because of the changes in general price
level.
During inflation, therefore, the absolute peso value of the FS should be adjusted. The data in
the FS over a period of time become incomparable unless adjusted. The most commonly
used price index in adjusting the absolute amount of the FS during this period is the
Consumer Price Index.
Guidelines that may be followed in conducting a Trend Analysis:
1.
Present in tabular format the FS covering several years. The arrangement is usually in
ascending order of the dates.
2.
Select a base year that is purely judgmental. The base year should, however, serve as
the normal operating activity of an entity. Normally, the base year is the earliest year used in
the analysis and has an index of 100 or 100%.
3.
Divide each absolute amount by the base year in order to determine the relationship
of each item with the base year. Multiply the result by 100 in order to express the data in
percentage.