MANAGEMENT SERVICES

FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis involves the evaluation of an entity’s past performance, present condition, and business
potentials by way of analyzing the financial statements to obtain information about, among others, profitability of the
business firm, ability to meet company obligations, safety of investment in the business, and effectiveness of management
in running the firm.

Objectives of FS Analysis
The primary purpose of FS analysis is to evaluate and forecast the company’s financial health. Interested parties can identify
the company’s financial strengths and weaknesses and know about the:
a. Profitability of the business firm;
b. Firm’s ability to meet its obligations;
c. Safety of the investment in the business; and
d. Effectiveness of management in running the firm.

Techniques Used in FS Analysis

1. Horizontal analysis (trend ratios and percentages)
2. Vertical analysis (common-size statements)
3. Ratio analysis
4. Cash flow analysis

Horizontal Analysis shows changes of corresponding FS items over a period of time. Changes in the value of a particular
FS item can be analyzed in terms of amount or in percentage. The percentage change of the amounts is calculated using the
earlier period as the base period.
Comparisons can be made between an actual amount and a budgeted amount, with the latter serving as basis or pattern of
performance. However, if a zero or negative amount appears in the base year, percentage change cannot be computed.
Trend or Index Analysis, a subset of horizontal analysis, uses an index number of 1.00 for the base period and
converts all FS items in the subsequent period as percentage of the base in order to facilitate better understanding
of performance over multiple periods.

Illustration 1:
In 2024, XYZ Corporation’s net income was P800,000 and in 2025, it was P200,000. What percentage increase in net
income must XYZ achieve in 2026 to offset the 2025 decline in net income?

Illustration 2:
The following common size income statements are available for Magenta Corporation for the two years ended December
31, 2025 and 2026:
2026 2025
Sales 100% 100%
Cost of sales 55 70
Gross profit 45 30
Operating expenses including tax 20 18
Net income 25% 12%
The trend percentages for sales are as follows:
2024 130%
2023 100%

What is the trend percentage for gross profit on sales for 2026?

Illustration 3:
X Corporation had net income of P2million in 2024. Using the 2024 financial elements as the base data, net income
decreased by 70 percent in 2025 and increased by 175 percent in 2026.
Requirements:
1. Net income reported in 2025
2. Net income reported in 2026
Vertical Analysis is the process of comparing figures in the FS of a single period. This is accomplished by expressing all
figures in the FS as percentages of a common base such as total assets (in the balance sheet) or net sales (in the income
statement). These converted statements are called common-size statements or percentage composition FS, often used for
comparing multiple years of data from the same firm, companies of different size, and company-to-industry averages.

Illustration 4:
The following shows the data on the balance sheet of Freezer Corporation for the calendar year 2026:

Cash P 150,000 Accounts payable P 250,000

Accounts receivable 260,000 Long-term debt 750,000
Inventory 540,000 Total liabilities P 1,000,000
Prepaid expenses 100,000 Common stock 1,200,000
Total current assets P 1,050,000 Retained earnings 600,000
Equipment 670,000 Total equity P 1,800,000
Accumulated depreciation 120,000 Total liabilities and equity P 2,800,000
Land 1,200,000
Total assets P 2,800,000

Prepare the 2026 common-size balance sheet.

Cash Flow Analysis is a detailed study in the net change in cash and cash equivalents as a result of operating, investing and
financing activities during the period.
• Operating Activities are principal revenue-producing activities of the entity and generally relate to changes in
current assets and current liabilities involved in company’s normal operations.
• Investing Activities are acquisition and disposal of long-term assets and investments not included in cash
equivalents and generally relate to changes in a company’s non-current assets.
• Financing Activities are result in changes in the size and composition of the contributed equity and borrowings of
the entity and generally relate to changes in long-term liabilities and equity accounts.

Financial Ratios are relationships among accounts found in the FS that provide information about the firm’s liquidity,
solvency, stability, profitability and other aspects of financial situation and potential. Major categories of financial ratios are
• Liquidity Ratios - measure an entity’s ability to meet short-term obligations and provide insights on present cash
solvency. Common examples include net working capital, current ratio and quick ratio.
• Solvency Ratios (Leverage Ratios) - measure an entity’s long-term financial viability. Common examples included
debt ratio, debt-equity ratio and times interest earned ratio.
• Activity Ratios (Asset Utilization Ratios or Efficiency Ratios) - measure an entity’s ability to use its assets and
manage its liabilities effectively in the current period; how quickly various accounts are converted into sales or
cash. Common examples include turnover ratios and conversions periods.
• Profitability Ratios (Performance Ratios) - used to determine how well an entity can generate profits from its
operations. Common examples include margin ratios and return ratios.
• Market Value Ratios (Market Prospect Ratios) - used to help potential investors make equity investment
decisions through the use of trends in earnings, dividends and stock prices. Common examples include dividend
payout ratio, dividend yield and price-earnings ratio.

LIQUIDITY RATIOS
a) Net Working Capital = Current Assets – Current Liabilities

b) Current Ratio = Current Assets ÷ Current Liabilities

c) Acid Test Ratio = Quick Assets ÷ Current Liabilities

d) Cash Ratio = (Cash + Marketable Securities) ÷ Current Liabilities

SOLVENCY RATIOS (LEVERAGE RATIOS)

a) Debt Ratio = Total Liabilities ÷ Total Assets

b) Equity Ratio = Total Equity ÷ Total Assets

c) Debt-Equity Ratio = Total Liabilities ÷ Total Equity

 d) Equity Multiplier = Average Total Assets ÷ Average Total Equity
= 1 ÷ Equity Ratio

e) Times Interest Earned = EBIT ÷ Interest Payments

(Interest Coverage Ratio)

f) Fixed Assets to Long-Term Liabilities = Fixed Assets ÷ Long Term Liabilities

g) Fixed Assets to Total Equity = Fixed Assets ÷ Total Equity

h) Fixed Assets to Total Assets = Fixed Assets ÷ Total Assets

i) Sales to Fixed Assets = Net Sales ÷ Net Fixed Assets

(Plant Turnover)

j) Times Preferred Dividend Requirements = NIAT ÷ Preferred Dividend

k) Times Fixed Charges Earned = EBT and Fixed Charges ÷ Fixed Charges

ACTIVITY RATIOS (ASSET UTILIZATION RATIOS/EFFICIENCY RATIOS)

a) Receivable Turnover = Net Credit Sales ÷ Average Receivables

b) Average Age of Receivable = Average Receivables ÷ Average Daily Credit Sales

(Receivable Collection)
= No. of Working Days in a Year ÷ Receivable Turnover

Average Age of Receivable is also known as Days Sales Outstanding, Number of Days Sales in Receivable, or
Days Receivable.

c) Inventory Turnover = Cost of Goods Sold ÷ Average Merchandise Inventory

d) Average Age of Inventory = Average Inventory ÷ Average Daily COGS

(Average Sale Period)
= No. of Working Days in a Year ÷ Inventory Turnover

e) Operating Cycle = Average Age of Receivable + Average Age of Inventory

f) Trade Payable Turnover = Net Credit Purchases ÷ Average Trade Payable

g) Average Age of Trade Payable = Average Accounts Payable ÷ Average Daily Credit Purchases
(Payable Deferral Period)
= No. of Working Days in a Year ÷ Trade Payable Turnover

h) Cash Flow Cycle = Operating Cycle – Average Age of Trade Payable

(Cash Conversion)

i) Current Assets Turnover = (COGS + OpEx) ÷ Average Current Assets

Operating Expenses should exclude depreciation and amortization.

PROFITABILITY RATIOS (PERFORMANCE RATIOS)

a) Return on Sales = Net Income ÷ Net Sales

b) Gross Profit/Margin Ratio = Gross Profit ÷ Net Sales

c) Return on Total Assets (ROA) = EBIAT ÷ Average Total Assets

d) Return on Equity (ROE) = Net Income ÷ Average Owner’s Equity

e) Return on Common Equity = (Net Income – Preferred Dividends) ÷ Average Common Equity
 f) Earnings Per Share (EPS) = (Net Income – Preferred Dividends) ÷ W.A. No. of Common Shares

g) Rate of Return on Current Assets = Net Income ÷ Average Current Assets

h) Rate of Return Per Turnover of Current Assets = Rate of Return on CA ÷ Current Assets Turnover

MARKET VALUE RATIOS (MARKET PROSPECT RATIOS)

a) Price to Earnings Ratio (P/E) = Price Per Share ÷ Earnings Per Share

b) Dividend Yield = Ordinary Dividend Per Share ÷ Price Per Share

c) Dividend Payout Ratio = Ordinary Dividend Per Share ÷ Earnings Per Share

d) Plowback Ratio = 1 – Payout Ratio

e) Earnings Yield = Earnings Per Share ÷ Price Per Share

f) Earnings Per Share (EPS) = (Earnings After Tax – Preferred Dividends) ÷ W.A. No. of Common Shares

g) Rate of Return on Current Assets = Earnings After Tax ÷ Average Current Assets

h) Rate of Return Per Turnover of Current Assets = Rate of Return on CA ÷ Current Assets Turnover

Illustration 5:
DEF Co. has 1,000,000 common shares outstanding, with each share priced at P8.00. In 2026, the company declared
dividends of P0.10 per share. The balance sheet at the end of 2026 showed approximately the same amounts as that at the
end of 2025. The financial statements for DEF Co. are as follows:

DEF Company
Balance Sheet
As of December 31, 2026
Assets Liabilities and Shareholder’s Equity
Cash P 350,000 Accounts payable P 400,000
Accounts receivable 640,000 Accrued expenses 290,000
Inventory 800,000 Total Current Liabilities P 690,000
Total Current Assets P 1,790,000 Long-term debt 1,500,000
Plant and Equipment 3,710,000 Common stock 1,810,000
Accumulated depreciation (1,000,000) Retained Earnings 500,000
Total Assets P 4,500,000 Total Liabilities and SHE P 4,500,000

DEF Company
Income Statement
December 31, 2026
Sales P3,125,000
Cost of goods sold 625,000
Gross profit P2,500,000
Operating expenses:
Depreciation P 250,000
Others 1,490,000 1,740,000
Income before interest and taxes P 760,000
Interest expense 80,000
Income before taxes P 680,000
Income taxes 204,000
Net Income P 476,000

Requirements:
1. Current ratio 11. EPS
2. Acid test ratio 12. P/E ratio
3. Accounts receivable turnover 13. Dividend yield
4. Inventory turnover 14. Payout ratio
 5. Operating cycle 15. Debt ratio
6. Cash ratio 16. Equity ratio
7. Operating profit margin 17. Equity multiplier
8. Return on sales 18. Times interest earned
9. Return on assets 19. Operating profit margin
10. Return on equity 20. Cash conversion cycle

Du Pont Analysis is a useful technique used to decompose the different drivers of Return on Equity (ROE).
• Operating Efficiency is represented by Net Profit Margin.
• Asset Use Efficiency is measured by the Asset Turnover Ratio.
• Leverage is measured by the Equity Multiplier.
Du Pont Equation = Net Profit Margin x Asset Turnover x Equity Multiplier

Du Pont Equation = Net Income x Total Sales x Average Total Assets

Total Sales Average Total Assets Average Equity

Illustration 6:
The following information pertains to Y Company:
Return on sales - 10%
Return on assets - 15%
Return on equity - 30%.
The company has no preferred stock.

Required: Using Du Pont technique, determine the following:

a. Asset turnover
b. Equity ratio
c. Equity multiplier
d. Debt-equity ratio

FS Analysis helps in making financial forecasts, particularly the required Additional Funds Needed (AFN), determined
based on entity’s capital requirements and from a variety of financial ratios.
AFN is a way of calculating how much new funding will be required so that the firm can realistically look at whether or not
they will be able to generate the additional funding and therefore be able to achieve the higher sales level.

Projected Increase in Assets xx [Δ Sales x (Assets ÷ Sales)]

Spontaneous Increase in Liabilities (xx) [Δ Sales x (Liabilities ÷ Sales)]
Any Increase in Retained Earnings (xx) (Earnings After Tax – Dividend Payment)
Additional Funds Needed xx

AFN may alternatively be computed using the following formula:

AFN = Total Changes in Equity – Internal Financing
AFN = (Assets – Liabilities) (%∆ Sales) – (Projected Sales x Profit Margin x Plowback Ratio)

Illustration 7:
ABC Co. reported sales of P1,000,000 in the previous year. Earnings after tax is P200,000 and the payout ratio is 70%.
Assets directly related to sales amount to P700,000 and spontaneous liabilities amount to P300,000. Sales are expected to
increase 20% for the coming year. How much is the additional funds needed for the coming year?

Reference:
Lee C., Arañas E., Manuel K. The Review School of Accountancy.
Roque R., Review in Management Advisory Services. GIC Enterprise and Co., Inc.