4 KEY ELEMENTS
Balance Sheet- present a summary of the ff:
Asset owned ( Investment)
Equity ( Financing)
Income Statement (Company’s Operating Results)
Cash Flow Statement – (included Activities such as
Operating, investment and financial cash flows)
Statement of Retained Earnings – cash dividends
paid and Net Income from the beginning and the
For any financial professional, it is important to know how to effectively analyze the financial
statements of a firm. This requires an understanding of three key areas:
1. The structure of the financial statements
2. The economic characteristics of the industry in which the firm operates and
3. The strategies the firm pursues to differentiate itself from its competitors.
1. IDENTIFY THE INDUSTRY ECONOMIC
First, determine a value chain analysis for the
industry—the chain of activities involved in the
creation, manufacture and distribution of the firm’s
products and/or services. Techniques such as
Porter’s Five Forces or analysis of economic
attributes are typically used in this step.
2. IDENTIFY COMPANY STRATEGIES
Next, look at the nature of the product/service
being offered by the firm, including the uniqueness
of product, level of profit margins, creation of
brand loyalty and control of costs. Additionally,
factors such as supply chain integration,
geographic diversification and industry
diversification should be considered.
3. ASSESS THE QUALITY OF THE FIRM’S FINANCIAL STATEMENTS
Review the key financial statements within the context of the relevant
accounting standards. In examining balance sheet accounts, issues such as
recognition, valuation and classification are keys to proper evaluation. The
main question should be whether this balance sheet is a complete
representation of the firm’s economic position. When evaluating the income
statement, the main point is to properly assess the quality of earnings as a
complete representation of the firm’s economic performance. Evaluation of
the statement of cash flows helps in understanding the impact of the firm’s
liquidity position from its operations, investments and financial activities
over the period—in essence, where funds came from, where they went, and
how the overall liquidity of the firm was affected.
4. ANALYZE CURRENT PROFITABILITY AND RISK.
This is the step where financial professionals can really add value in the evaluation
of the firm and its financial statements. The most common analysis tools are key
financial statement ratios relating to liquidity, asset management, profitability,
debt management/coverage and risk/market valuation. With respect to
profitability, there are two broad questions to be asked: how profitable are the
operations of the firm relative to its assets—independent of how the firm finances
those assets—and how profitable is the firm from the perspective of the equity
shareholders. It is also important to learn how to disaggregate return measures
into primary impact factors. Lastly, it is critical to analyze any financial statement
ratios in a comparative manner, looking at the current ratios in relation to those
from earlier periods or relative to other firms or industry averages.
5. PREPARE FORECASTED FINANCIAL
Although often challenging, financial professionals
must make reasonable assumptions about the future
of the firm (and its industry) and determine how these
assumptions will impact both the cash flows and the
funding. This often takes the form of pro-formal
financial statements, based on techniques such as
the percent of sales approach.
6. VALUE THE FIRM
While there are many valuation approaches, the most
common is a type of discounted cash flow methodology.
These cash flows could be in the form of projected
dividends, or more detailed techniques such as free
cash flows to either the equity holders or on enterprise
basis. Other approaches may include using relative
valuation or accounting-based measures such as
economic value added.
Financial statement analysis evaluates a company’s
performance or value through a company’s balance
sheet, income statement, or statement of cash flows.
By using a number of techniques such as horizontal,
vertical, or ratio analysis, investors may develop a
more nuanced picture of a company’s financial profile.
Several techniques are commonly used as part of
financial statement analysis. Three of the most
important techniques include horizontal analysis,
vertical analysis, and ratio analysis.
Horizontal analysis compares data horizontally, by
analyzing values of line items across two or more years.
Vertical analysis looks at the vertical effects line items
have on other parts of the business and also the
Ratio analysis uses important ratio metrics to
calculate statistical relationships.
is a technique that expresses each item within a
financial statement as a percentage of a relevant total
base amount. It focuses on the relationship between
various financial items in a given financial statements in
a single period. The financial statements then will be
presented in percentages commonly known as “common -
RULES TO BE OBSERVED
For the balance sheet, total Assets and Total Liabilities and
Capital are both considered 100% on each item in the particular
section are presented as a certain percent of the total.
To increase the effectiveness of vertical
analysis, multiple year’s statements or
reports can be compared, and comparative
analysis of statements can be done. This
analysis makes it easier to compare the
financial statements of one company with
another and across the companies as one
can see the relative proportion of accounts.
(ASSETS) 2020 2020 COMMON SIZE 2019 2019 COMMON SIZE
CASH 500,000 48.88 % 400,000 42.11 %
ACC.RECEIVE… 58,500 5. 49 % 90, 000 9.47 %
SUPPLIES 28,000 2. 63 % 40,000 4.21 %
LAND 360, 000 33. 76 % 300,000 31.58%
EQUIPMENT 120, 000 11.25 % 120,000 12.63 %
TOTAL ASSETS 1,066,500 100 % 950,000 100%
VERTICAL ANALYSIS EXAMPLE
2020 2020 COMMON SIZE 2019 2019 COMMON SIZE
ACC. PAYABLE 151,500 14.21 % 100,000 10.53 %
NOTES PAYABLE 200,000 18.75 % 200, 000 21.05 %
CAPITAL 715,000 67.04 % 650,000 68.42%
1,066,500 100 % 950,000 100%
The entity’s land
comprises of 33.76 % of
the entity's assets in
The entity’s cash
42.11 % of the
entity's assets in
Used to calculate the relative size
of one figure in relation to
another, which can then be
compared to the ratio for a prior
period. The ratios are designed to
show relationship between
financial statement accounts.
Company X might have a debt of Php 5,000,000.00
and interest charges of Php 400,000.00, while company
might have debt of Php 50,000,000.00 and interest
charges of Php 4,000,000.00. Which company is stronger?
The true burden of these debts, and the companies ability
to repay them be ascertained:
By comparing each firm’s debt to its assets and by
comparing the interest it must pay to the income.
It has available payment of interest such comprises are
what we called ratio analysis.
The three major areas that concern the
users of Financial statements are:
• Stability – continuity operation of a company
in a long period of time meet the financial
• Solvency or liquidity – meet the long term
• Profitability – profitable operations the
business firm not loss.
Most Common Ratios used by
a. Liquidity Ratios
• Current Assets – These are ratios that show the relationship
of the company’s cash and other current assets to its
liabilities. Liquidity is the number one concern of most
financial analysts. It indicate whether the firm can meet its
• ( Working Capital = Current Assets minus Current Liabilities)
• Asset Management Ratios
• These are set of ratios, which measures how effectively a firm is managing
its assets. These ratios are also called Asset utilization ratio, which pertains
to how effectively the firm utilized its assets to earn profits.
• Normally companies borrow or obtain capital from other sources to
acquire assets. If a company has too many assets acquired through
borrowings, the interests expenses will be too high and, hence the profits
will be lower. On the other hand if assets are too low, profitable sales
• Therefore, managing these assets, profitability of assets will help the firm
avoid borrowing funds to finance interest.
Most Common Ratios used by
C. DEBT MANAGEMENT RATIOS OR FINANCIAL LEVERAGE
These ratios will measures the extent to which firm uses its debt financing or the so-
called financial leverages.
By raising funds through debt, the owners can maintain control of the firm with limited
Creditors look to be equity, or owner-supplied funds, to provide a margin of safety, that is, if
the owners have provided only a small proportion of the total financing, the risks of the
enterprise are borne mainly by its creditors.
Financial Leverage raises the expected rate of return to stockholders for two reasons;
Since interest is deductible, the use of debt financing lowers the tax and leaves more of the
firms operating income available to its investors.
If the rate of return on Assets Income before tax divided by the Total Assets exceeds the
interest rate on debt, as it generally does, then a company can use debt to finance assets
pay the interest on the debt and have something left over for its stockholders.
High debt ratios are exposed to more risk of losses when the economy is in recession.
But have higher expected returns when the economy booms.
Most Common Ratios used by Financial
Shows the net result of the policies and decisions the
management did in the current period. The combined effects of
liquidity, asset management, and debt management on operating
results will be analyzed using these ratios.
(How profitable the business)
Profit Margin – Net income available to common stock divided by sales
Return on Sales – Net Income divided by Net Sales
Return on Total Assets (ROA)
(Net Income plus Interest Expense net of its Tax Effect) divided by
average Total Assets
Most Common Ratios used by Financial
Financial statement analysis is crucial for complying with business laws
and regulations, while also meeting the needs of stakeholders and various
other parties. But in order to conduct accurate financial statement
analysis, developing skills and intuition is as important as following best
Financial statement analysis can benefit organizations in numerous ways.
It provides internal and external stakeholders with the opportunity to make
informed decisions regarding investing. Financial statement analysis also
provides lending institutions with an unbiased view of a business’s
financial health, which is helpful for making lending decisions. And as top
executives and others in management rely on accounting to provide an
accurate depiction of the effects of their decisions, financial statement
analysis helps with matters of corporate governance as well.
Maintain objectivity by knowing that decisions should be based on more than
numbers listed on financial statements. Accountants should consider intangible
variables as well. For example, employee satisfaction should be considered when
planning for future financial expenditures.
Avoid developing a false sense of security. While financial statements can be used
to show whether a business is stable and profitable, accountants should also use
real-time observations of business activities. For example, a dwindling inventory that
cannot be replaced easily could cause big issues eventually.
Stay focused on relevance. Recent trends should be taken into consideration when
analyzing financial information. For example, while a trend that favors a company’s
product may show higher sales, it won’t necessarily provide a precise comparison with
the company’s competition.
Trust intuition, as the decision to invest in a product should be based on more than
numbers alone. For example, past success anticipating trends should be taken into
consideration when making future investments.
LEAD, EMPOWER, AND A
…where LEADers create
Prepared by: Noel B. Lagaras,LPT
The Seed of Greatness
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