Analysis and Interpretation of Financial Statements

1. Analysis and Interpretation of
Financial Statements 1
Learning Objective:
• At the end of this lesson, the learners will submit a horizontal and vertical analysis evaluation
of sample company.
Components of a complete set of financial statements:
1. The Statement of Financial Position (SFP) reports the balances of assets, liabilities and equity
of the business as of a point in time.
2. The Statement of Comprehensive Income (SCI) shows the results of operations of the business
by reporting the revenue and expenses for the specific accounting period.
3. The Statement of Cash Flows (SCF) / Cash Flows Statement (CFS) reports the actual cash
inflows and outflows for the period that are classified into the three main business activities,
namely, operating, investing and financing activities.
4. The Statement of Changes in Equity (SCE) reports all the changes, whether increases or
decreases to the owner’s interest on the company during the period.
5. The Notes to Financial Statements discussed the nature of the company’s operations, its
accounting policies, basis for estimates, components of the accounts and significant
transactions.

2. Financial Statement (FS) Analysis
• is the process of evaluating risks, performance,
financial health, and future prospects of a
business by subjecting financial statement data to
computational and analytical techniques with the
objective of making economic decisions (White
et.al 1998).There are three kinds of FS analysis
techniques:
1. Horizontal analysis
2. Vertical analysis
3. Financial ratios

3. 1. Horizontal analysis
• also called trend analysis, is a technique for evaluating a series of financial statement data over
a period of time with the purpose of determining the increase or decrease that has taken place
(Weygandtet.al 2013). This will reveal the behavior of the account over time. Is it increasing,
decreasing or not moving? What is the magnitude of the change? Also, what is the relative
change in the balances of the account over time?
• Horizontal analysis uses financial statements of two or more periods.
• All line items on the FS may be subjected to horizontal analysis.
• Only the simple year-on-year (Y-o-Y) growth is covered in this lesson.
• Changes can be expressed in monetary value (peso) and percentages computed by using the
• following formulas:
• Peso change=Balance of Current Year-Balance of Prior Year
• Percentage change= (Balance of Current Year-Balance of Prior Year)/(Balance of Prior Year)x100
Example: 2015 2014
Sales P 250,000 P 175,000
• ✓Peso change = P250,000 - P175,000 = P75,000
• ✓Percentage change = (P250,000 - P175,000) / P175,000 x 100 = 42.86%
• ✓This is evaluated as follows: Sales increased by P75,000. This represents growth of 42.86%
from 2014 levels.

4. 2. Vertical analysis
• also called common-size analysis, is a
technique that expresses each financial
statement item as a percentage of a base
amount.
-For the SFP, the base amount is Total Assets.
• Balance of Account / Total Assets.
• From the common-size SFP, the analyst can
infer the composition of assets and the
company’s financing mix.

5. Example:
% of assets
Cash P 200,000 200,000/1,400,000 = 14.3%
Accounts Receivable 400,000 400,000/1,400,000 = 28.6%
Inventory 250,000 250,000/1,400,000 = 17.9%
Equipment 550,000 550,000/1,400,000 = 39.3%
Total Assets P1,400,000 Sum of the components is 100%
Accounts Payable 300,000 300,000/1,400,000 = 21.4%
Notes Payable 400,000 400,000/1,400,000 = 28.6%
Owner, Capital 700,000 700,000/1,400,000 = 50.0%
Total Liabilities and P 1,400,000 Sum of the components is 100%
Equity
✓The above may be evaluated as follows: The largest component of
asset is Equipment at 39.3%. Cash is the smallest component at 14%.
On the other hand, 50% of assets are financed by debt and the other
half is financed by equity.

6. - For the SCI, the base amount is Net
Sales.
•Balance of Account / Total Sales.
•This will reveal how “Net Sales” is used up by the various
expenses.
•Net income as a percentage of sales is also known as the net
profit margin.
•Example:
% of assets
Net Sales P 900,000
Cost of Goods Sold 400,000 400,000/900,000 = 44.4%
Gross Profit 500,000 500,000/900,000 = 55.5%
Operating Expenses 200,000 200,000/900,000 = 22.2%
Net Income 300,000 300,000/900,000 = 33.3%

7. ✓The above may be evaluated as follows:
•The cost of goods sold is 44% of sales. The company has a gross profit
rate of 55.5%. Operating expenses is 22% of sales.
•The company earns income of P 0.33 for every peso of sales. Gross
profit generated for every peso of sale is P 0.555.
-The use of common-size financial statements allows the comparison of
two companies of different sizes. This is because the SFP and SCI
comparative information are standardized as a percentage of assets and
sales, respectively.
•Horizontal analysis is performed when one compares the Current Year’s
Total Assets to that of Prior Year’s Total Assets. So the directional
movement of the analysis is horizontal or between two columns.
•Vertical analysis is performed when one determines the percentage of
cash in relation to the company’s total assets. Notice that the direction of
the analysis is vertical. Cash and total assets are on the same column.
Hence, the direction of the analysis is vertical.

8. Guide Questions for your Analysis &
Interpretation:
• What is the asset growth in 2014?
• Is the asset composition in 2014 the same as that
in 2013?
• Compare the financing mix (portion of assets
financed by debt and equity, respectively) of JFC
in 2013 and 2014 and determine if there is a
significant change.
• Is the revenue growth in 2014 better than that in
2013?
• Is the net income growth in 2014 better than that
in 2013?

9. Group Activity:
• Divide the class into three (3) groups
• Download the 2014 JFC (Jollibee Foods
Corporation) Annual Report
• Perform horizontal and vertical analyses of the
SFP and the SCI of JFC using Spreadsheet or
MS Excel.
• Print your output and prepare a creative
presentation of your output.

10. Analysis and Interpretation of
Financial Statements 2
Learning Objectives:
At the end of this lesson, the learners shall be able to:
1. Solve exercises and problems that require
computation and interpretation using various
financial ratios.
2. Using the downloaded sample financial
statements, compute various financial ratios and
interprets the level of profitability, efficiency and
financial health (liquidity and solvency) of the
business.

11. 3. Ratio analysis - expresses the relationship among selected items of financial
statement data. The relationship is expressed in terms of a percentage, a rate, or a
simple proportion (Weygrandt et.al. 2013). A financial ratio is composed of a
numerator and a denominator. For example, a ratio that divides sales by assets will
find the peso amount of sales generated by every peso of asset invested. This is an
important ratio because it tells us the efficiency of invested asset to create
revenue. This ratio is called asset turnover. There are many ratios used in business.
These ratios are generally grouped into three categories: (a) profitability, (b)
efficiency, and (c) financial health.
a. Profitability ratios measure the ability of the company to generate income from
the use of its assets and invested capital as well as control its cost. The following
are the commonly used profitability ratios:
Gross profit ratio reports the peso value of the gross profit earned for every peso
of sales. We can infer the average pricing policy from the gross profit margin.
Operating income ratio expresses operating income as a percentage of sales. It
measures the percentage of profit earned from each peso of sales in the
company’s core business operations (Horngren et.al. 2013). A company with a high
operating income ratio may imply a lean operation and have low operating
expenses. Maximizing operating income depends on keeping operating costs as
low as possible (Horngren et.al. 2013).

12. Net profit ratio relates the peso value of the net income earned to
every peso of sales. This shows how much profit will go to the owner
for every peso of sales made.
Return on asset(ROA) measures the peso value of income
generated by employing the company’s assets. It is viewed as an
interest rate or a form of yield on asset investment. The numerator
of ROA is net income. However, net income is profit for the
shareholders. On the other hand, asset is allocated to both creditors
and shareholders. Some analyst prefers to use earnings before
interest and taxes instead of net income. There are also two
acceptable denominators for ROA – ending balance of total assets or
average of total assets. Average assets is computed as beginning
balance + ending balance divided by 2.
Return on equity(ROE) measures the return (net income)
generated by the owner’s capital invested in the business. Similar to
ROA, the denominator of ROE may also be total equity or average
equity.

13. Sample Financial Statements to be used for the computations:
Cash 200,000
Accounts Receivable 400,000
Inventory 250,000
Equipment 550,000
Total Assets 1,400,000
Accounts Payable 300,000
Notes Payable 400,000
Owner, Capital 700,000
Total Liabilities and equity 1,400,000
Sales 900,000
Cost of Goods Sold 400,000
Gross Profit 500,000
Operating Expenses 200,000
Operating income 300,000
Interest Expense 20,000
Net Income 280,000