STUDY GUIDE

BUSINESS FINANCE
Chapter 2 – Unit 3
Financial Statement Analysis

Table of Contents

Profitability Ratios 2
Return on Equity (ROE) 2
Return on Assets (ROA) 5
Gross Profit Margin 5
Operating Profit Margin 6
Net Profit Margin 7
Liquidity Ratios 8
Current Ratios 8
Acid-Test Ratio 9
Leverage Ratios 9
Debt Ratio 10
Debt to Equity Ratio 11
Interest Coverage Ratio 11
Efficiency Ratios or Turnover Ratios 12
Total Asset Turnover Ratio 12
Fixed Assets Turnover Ratio 12
Accounts Receivable Turnover Ratio 13
Inventory Turnover Ratio 14
Accounts Payable Turnover Ratio 15
Operating Cycle and Cash Conversion Cycle 16
Vertical and Horizontal Analysis 17
Vertical Analysis 17
Horizontal Analysis 19
Quality of Earnings 20
Limitations of Financial Statement Analysis 20

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There are different users of financial statements. Financial statement analysis

can be used by managers, equity investors, creditors, regulators, labor unions,
employees, the public, and potential investors and creditors. Financial statement
analysis is used for investment and credit decisions. It is also used for regulating
companies such as what the Energy Regulatory Commission does for power
distribution companies and other energy companies.

Financial statement analysis is definitely used by management for monitoring

performance and for identifying strategies to further improve the company’s
operations.

For this chapter, the following financial ratios will be discussed:

1. Profitability ratios
2. Efficiency ratios
3. Liquidity ratios
4. Leverage ratios

PROFITABILITY RATIOS
Profitability ratios are a class of financial metrics that are used to assess a
business ability to generate earnings relative to its revenue, operating costs,
balance sheet assets, or shareholders’ equity over time using data from a specific
point in time.

The following ratios are used to measure the profitability of a company.

1. Return on equity (ROE)
2. Return on assets (ROA)
3. Gross profit margin
4. Operating profit margin
5. Net profit margin

1. RETURN ON EQUITY (ROE)

ROE is a profitability measure that should be of interest to stock market
investors. It measures the amount of net income earned in relation to stockholders’
equity. ROE is computed as follows:

ROE = Net Income ÷ Stockholders’ Equity

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In computing ROE, different approaches are observed. There are analysts who
use the average of the stockholders’ equity for two accounting periods while others
simply use the year-end balances. Whichever formula is used, consistency must be
applied.

Examples:
Exhibit 2.1: JSC Foods Corporation
Statement of Profit or Loss
For the Years Ending December 31, 2010-2014

  2014 2013 2012 2011 2010

52,501,08 47,345,22 42,174,28 38,340,25 35,336,64
Net Sales
5 3 3 7 3
41,954,73 37,988,62 33,980,17 31,439,01 29,329,41
Cost of Sales
0 8 4 1 3
10,546,35
Gross Profit 9,356,595 8,194,109 6,901,246 6,007,230
5
Operating
6,497,659 6,196,804 5,393,621 4,926,723 4,505,422
Expense
Operating
1,189,760 3,159,791 2,800,488 1,974,523 1,501,808
income
Interest expense 250,000 250,000 250,000 450,000 300,000
Income before
939,760 2,909,791 2,550,488 1,524,523 1,201,808
taxes
Taxes 1,139,609 872,937 765,146 457,357 360,542
2,659,08 2,036,85 1,785,34 1,067,16
Net Income 841,266
7 4 2 6

To illustrate, let us use the financial statements of JSF Foods Corporation in

2014.

ROE = (Net Income ÷ Stockholders’ Equity) x 100%

ROE = (2,659,087 ÷ 12,478,559) x 100%
ROE = 21.31%

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Exhibit 2.2: JSC Foods Corporation

Statement of Financial Position
December 31, 2010 – 2014

2014 2013 2012 2011 2010

ASSETS
Current Assets
Cash 1,062,527 996,904 777,415 766,805 883,416
Trade Receivables 2,300,500 1,921,799 1,722,513 1,454,426 1,396,639
Inventories 4,849,304 4,499,998 3,797,668 3,293,030 3,351,933
Other Current Assets 1,050,000 983,746 984,786 735,608 998,763
9,262,331 8,402,447 7,282,382 6,249,869 6,630,751
Non-current Assets
Property, Plant, and Equipment, Net 12,200,000 11,300,000 9,050,000 9,350,000 9,500,000
Other non-current assets 835,689 925,681 896,842 876,235 827,490
13,035,689 12,225,681 9,946,842 10,226,235 10,327,490
Total Assets 22,298,020 20,628,128 17,229,224 16,476,104 16,958,241
LIABILITIES & EQUITIES
Current Liabilities
Trade payables 5,050,810 4,746,252 4,137,815 3,298,699 2,874,911
income taxes payable 433,051 283,705 267,801 149,441 115,330
Current portion of long-term debt 2,250,000 2,500,000 1,000,000 2,000,000 2,000,000
Other current liabilities 85,600 28,700 40,990 30,688 37,890
7,819,461 7,558,657 5,446,606 5,478,828 5,028,131
Non-current liabilities
Long-term debt, net of current portion 2,000,000 1,250,000 1,000,000 3,000,000
Total liabilities 9,819,461 8,808,657 5,446,606 6,478,828 8,028,131
Stockholders' Equity
Capital Stock 8,000,000 8,000,000 8,000,000 8,000,000 8,000,000
Retained earnings 4,478,559 3,819,472 3,782,618 1,997,276 930,110
Total stockholders' equity 12,478,559 11,819,472 11,782,618 9,997,276 8,930,110
Total Liabilities & Stockholders' Equity 22,298,020 20,628,129 17,229,224 16,476,104 16,958,241

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2. RETURN ON ASSETS (ROA)

Return on assets measures the ability of a company to generate income out of

its resources. Below is formula for computing ROA:

ROA = (Operating Income ÷ Total Assets) x 100%

This ratio can be useful in making investment decisions. For example, if a

company has an opportunity to expand and is not sure how finance the expansion,
the ROA can be used in making a decision. If the borrowing rate is greater than
ROA, then it does not make sense to borrow for expansion. However, if the
expected ROA with the expansion is greater than the borrowing rate, then
management may consider borrowing to finance expansion. It must be noted at this
point that this comparison of borrowing cost and ROA is not the only factor
considered in expansion.

To illustrate, refer to Exhibits 2.1 and 2.2 and let us compute JSC’s ROA in
2014.
ROA = (Operating Income ÷ Total Assets) x 100%
ROA = (4,048,696 ÷ 22,298,020) x 100%
ROA = 18.16%

The 18.16% ROA means that in 2014, JSC Foods Corporation generated
₵18.16 for every ₱1.00 of asset in the company.

3. GROSS PROFIT MARGIN

The formula for computing gross profit margin is shown below:

GROSS PROFIT MARGIN = (Gross Profit ÷ Sales) x 100%

Gross profit margin is a profitability ratio that measures the ability of a

company to cover its cost of goods sold from its sales. To illustrate, let us compute
the gross profit margin of JSC Foods Corporation in 2014.

Gross Profit Margin = (Gross Profit ÷ Sales) x 100%

Gross Profit Margin = (10,546,355 ÷52,501,085) x 100%
Gross Profit Margin = 20.09%
This ratio means that for every ₱1.00 of sale the company generates, it earns
₵20.09 in gross profit. Companies in a very competitive industry have to watch out
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for this gross profit margin because stiff competition can be substantially bringing
down this margin. If the manager of a company wants to improve its gross profit
margin, two things can be done:
1. Raise prices
2. Find ways to bring down production cost. For trading or merchandising
companies, find a supplier which can sell finished goods to the company at
low prices.
Both approaches are not easy to do. Raising prices is possible if your company
is the only seller or provider of this product in the area. If there are many sellers,
however, raising prices can make your products appear relatively more expensive
and buyers may go to companies who offer their products at cheaper prices. As the
saying goes, if you set your prices too high, you may be pricing yourself out of the
market.
The second approach which is to bring down production costs may not also be
easy to achieve because this may require investment in technology. It may also
require identifying cheaper sources of raw materials. Trying to make the production
more efficient can also help. For example, similar products have to be produced in
batches to save on manufacturing overhead costs.

4. OPERATING PROFIT MARGIN & NET PROFIT MARGIN

Operating profit margin measures the amount of income generated from the
core business of a company. It is computed as the difference between revenues and
the sum of cost of revenues or sales and operating expenses. The formula for
computing operating profit margin ratio is shown below:

OPERATING PROFIT MARGIN = (Operating Income ÷ Sales) X 100%

Operating profit margin measures the ability of the company to generate from
the core business or main operation. In the case of our illustrative example, JSC
Foods Corporation, you want to find out how much income does this company
generates from its food business. Below is the computation of JSC’s operating profit
margin.
Operating Profit Margin = (Operating Income ÷ Sales) x 100%
Operating Profit Margin = (4,048,696 ÷ 52,501,085) x 100%
Operating Profit Margin = 7.71%

The 7.71% operating profit margin means that out of ₱1.00 sales or revenues
that JSC Foods Corporation generated in 2014, the company earned ₵7.71 after
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deducting cost of sales and operating expenses. This amount is before the effects of
income taxes.

5. NET PROFIT MARGIN

Net profit margin measures how much net profit a company generates for
every peso of sales or revenues that it generates. The formula for computing net
profit margin is shown below:

NET PROFIT MARGIN = (NET INCOME ÷ SALES) x 100%

Net income is the amount left after all expenses including income taxes are
deducted from sales or revenues.
To illustrate, let us compute the net profit margin of JSC Foods Corporation in
2014.
Net Profit Margin = (Net Income ÷ SALES) x 100%
Net Profit Margin = (2,659,087 ÷ 52,501,085) x 100%
Net Profit Margin = 5.06%
In 2014, JSC Foods Corporation earned ₵5.06 for every ₱1.00 of revenues
generated.
An analyst of statement of profit or loss should compare the operating profit
margin and the net profit margin. A company can have a high operating profit
margin but may end up with a low or even a negative net profit margin if the
company is heavily [Link] situation was observed with many local cement
companies after the 1997 Asian Financial crisis where cement companies were
reported positive operating margins but reported negative net profit margin. This
situation indicates that the core business is good but the financing may not be
appropriate because the cement companies relied too much on borrowed funds to
finance their expansions before the 1997 Asian financial crisis.

It is also important to note if the net profit used in computing the ratio is
substantially due to core operations or the main business of the company or is it
due to some nonrecurring transactions. An example of a nonrecurring transaction is
gain from the sale of equipment where the company is not in the business of selling
equipment.

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LIQUIDITY RATIOS
Liquidity ratios measure the ability of a company to pay maturing obligations
from its current assets. Two commonly used liquidity ratios will be discussed in this
section. These are the current ratio and the acid-test ratio or sometimes called
quick asset ratio.

1. CURRENT RATIO
The formula for computing current ratio is shown below:

CURRENT RATIO = CURRENT ASSETS ÷ CURRENT LIABILITIES

Current assets include cash and other assets which are expected to be
converted to cash within 12 months such as accounts receivable and inventories.
Current assets also include prepayments such as prepaid rent and prepaid
insurance.
Current liabilities include obligations that are expected to be settled or paid
within 12 months. These include accounts payable, accrued expenses payable such
as accrued salaries, and current portion of long-term debt. Current portion of long-
term debt is the principal amount of a long-term loan expected to be paid within the
next 12 months from the balance sheet date.

To illustrate, let us compute the current ratio of JSC Foods Corporation in

2014.
Current Ratio = Current Assets ÷ Current Liabilities
Current Ratio = 9,262,331 ÷ 7,819,461
Current Ratio = 1.18

The current ratio of 1.18 means that for every ₱1.00 of current liabilities that
JSC Foods Corporation has, it has ₱1.18 current assets as of December 31, 2014.

A high current ratio provides comfort that a company will be able to pay
obligations on time, but does not guarantee that no liquidity problems or payment
problems will arise. The ability of a company to pay on time also depends on the
quality of receivables and inventories. For example, a company with a current ratio
of 2.5 may end up having difficulty paying on time. Perhaps, it is because the
accounts receivable takes 90 days, on the average, to be collected or its inventories
take months to be sold.

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2. ACID-TEST RATIO OR QUICK ASSET RATIO

Below is the formula for quick asset ratio:

QUICK ASSET RATIO = (CASH+ACCOUNTS RECEIVABLE + SHORT-TERM

MARKETABLE SECURITIES) ÷ CURRENT LIABILITIES

Common to both current ratio and the quick asset ratio is the accounts
receivable. The real test of a company’s ability to meet its maturing obligations
largely depends on the quality of its receivables. Even if a company has a high quick
asset ratio, a company is not assured that no liquidity problems will arise if the
collection of accounts receivable takes too long.

To illustrate, let us compute the quick asset ratio of JSC Foods Corporation in
2014.
Quick Asset Ratio = (Cash + Accounts Receivable + Short-Term Marketable
Securities) ÷ Current Liabilities
Quick asset Ratio = 1,062,527 + 2,300,500) ÷ 7,819,461
Quick Asset Ratio = 0.43

This ratio means that for every ₱1.00 current liability, it has ₵0.43 quick
assets. Is this something to be alarmed about? The answer depends on the quality
of accounts receivable which can be determined by its collection period.

LEVERAGE RATIOS
Leverage ratios show the capital structure of a company, that is how much of
the total assets of a company is financed by debt and how much is financed by
stockholders’ equity. Leverage ratios can also be used to measure the company’s
ability to meet long-term obligations.
A question may be raised as to what an appropriate capital structure is that is
a combination of debt and equity for a company. The capital structure of a company
is influenced by the following factors:
1. Nature of business – If a company is in a risky business and operating cash
flows are uncertain like mining operations, it has to be more conservatively
financed.
2. Stage of business development – A company which is just starting its
operations may encounter difficulties borrowing from banks.
3. Macroeconomic conditions – If macroeconomic conditions are good as
measured by gross domestic product (GDP) and this trend is expected to

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continue I the foreseeable future, then management can take a more

aggressive stance in financing the company’s operations to take advantage of
the opportunities.
4. Prospects of the industry and expected growth rates – If the industry
where the company operates has good prospects and growth rates are
expected to be high, management can consider borrowing more to expand
operations.
5. Bond and stock market conditions – The ability of a company to raise
more funds from the stock market and the bond market also depends on how
bullish players are in these markets.
6. Financial flexibility – Financial flexibility refers to the ability of a company to
raise funds, be it the stock market or the bond market, when the need for
cash arises.
7. Regulatory environment – These are operations which are heavily
regulated such as banks which are monitored by the Bangko Sentral ng
Pilipinas (BSP).
8. Taxes – Interest expense tax shield while cash dividend does not provide tax
shield. Interest expenses are allowed to be deducted from operating income
to compute taxable income.
9. Management style – Some managers are aggressive and some are
conservative.

The following are leverage ratios:

1. Debt ratio
2. Debt to equity ratio
3. Interest coverage ratio

1. DEBT RATIO
Debt ratio measures how much of the total assets are financed by liabilities.
Below is the formula for debt ratio:

DEBT RATIO = TOTAL LIABILITIES ÷ TOTAL ASSETS

Let us compute the debt ratio of JSC Foods Corporation in 2014.

Debt Ratio = Total Liabilities ÷ Total Assets
Debt Ratio = 9,819,461 ÷ 22,298,020
Debt Ratio = 0.44

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The debt ratio of less than 0.50 means that the company has less liabilities as
compared to its stockholders’ equity. If the debt ratio is 0.50, this means that the
amount of total liabilities is exactly equal to stockholders’ equity.

2. DEBT TO EQUITY RATIO

Debt to equity ratio is a variation of the debt ratio. A debt to equity ratio of
more than one means that a company has more liabilities as compared to
stockholders’ equity. The formula for debt to equity ratio is shown below:

DEBT TO EQUITY RATIO = TOTAL LIABILITIES ÷ TOTAL STOCKHOLDERS’ EQUITY

Shown below is the computation of debt to equity ratio for JSC Foods
Corporation in 2014.

Debt to Equity Ratio = Total Liabilities ÷ Total Stockholders’ Equity

Debt to Equity Ratio = 9,819,461 ÷ 12,478,559
Debt to Equity Ratio = 0.79

Since the company’s debt ratio is less than one, it is expected that the debt to
equity ratio is less than one.

3. INTEREST COVERAGE RATIO

Interest coverage ratio provides information if a company has enough

operating income to cover interest expense. Below is the formula for interest
coverage ratio.

INTEREST COVERAGE RATIO = EBIT ÷ INTEREST EXPENSE

EBIT stands for earnings before interest and taxes.

Interest Coverage Ratio = EBIT ÷ Interest Expense

Interest Coverage Ratio = 4,048,696 ÷ 250,000
Interest Coverage Ratio = 16.19

The interest coverage ratio of 16.19 means that JSC Foods Corporation has
more than enough operating income or earnings before interest and taxes to cover
its interest expense.

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EFFICIENCY RATOS OR TURNOVER RATIOS

Efficiency ratios, otherwise known as turnover ratios, are called as such
because they measure the management’s efficiency in utilizing the assets of the
company. The following efficiency ratios will be discussed:
1. Total asset turnover ratio
2. Fixed asset turnover ratio
3. Accounts receivable turnover ratio
4. Inventory turnover ratio
5. Accounts payable turnover ratio

From the accounts receivable turnover ratio, inventory turnover ratio, and
accounts payable turnover ratio, operating cycle and cash conversion cycle can be
computed.

1. TOTAL ASSET TURNOVER RATIO

Total asset turnover ratio measures the company’s ability to generaterevenues
for every peso of asset invested. It is an indicator of how productive the company is
in utilizing its resources. The formula is shown below:

ASSET TURNOVER RATIO = SALES ÷ TOTAL ASSETS

In computing asset turnover ratio, ending balances for total assets or the
average of total assets for the accounting period can be used.

Asset Turnover Ratio = Sales ÷ Total Assets

Asset Turnover Ratio = 52,501,085 ÷ 22,298,020
Asset Turnover Ratio = 2.35

The asset turnover ratio of 2.35 means that for every ₱1.00 of asset JSC
Foods Corporation has in 2014, it is able to generate sales of ₱2.35.

2. FIXED ASSET TURNOVER RATIO

If a company is heavily invested in property, plant, and equipment (PPE) or fixed
assets, it pays to know how efficient the management of theses assets is. This can
be applied to companies which are characterized by high PPE such as utility
companies, like telecom companies, power generation and distribution
accompanies, and water distribution companies. It is also be applied to
manufacturing companies.
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FIXED ASSET TURNOVER RATIO = SALES ÷ PPE

Let us compute the fixed asset turnover for JSC Foods Corporation in 2014.

Fixed Asset Turnover Ratio = Sales ÷ PPE

Fixed Asset Turnover Ratio = 52,501,085 ÷ 12,200,000
Fixed Asset Turnover Ratio = 4.30

In 2014, JSC Foods Corporation was able to generate ₱4.30 for every ₱1.00 of
PPE that it has.
Ending balance of PPE or average PPE for the accounting period can be used.
Consistency, however, must be applied in the application of the formula.

3. ACCOUNTS RECEIVABLE TURNOVER RATIO

Accounts receivable turnover ratio measures the efficiency by which accounts
receivable are managed. A high accounts receivable turnover ratio means efficient
management of receivables. The formula for accounts receivable turnover ratio is
shown below:

ACCOUNTS RECEIVABLE TURNOVER RATIO = SALES ÷ ACCOUNTS

RECEIVABLE

If there are different types of receivables, consider only the trade account
receivable. These are the accounts receivable created in the ordinary course of
business. Also, if there are allowances for doubtful accounts, use the gross amount
of trade accounts receivable. This amount is generally found in the notes to financial
statements where more information about accounts receivable is disclosed.

Some analysts use average accounts receivable, instead of the ending

accounts receivable. Whichever approach is used, consistency must be applied.

Let us compute the accounts receivable turnover ratio for JSC Foods Corporation in
2014.

Accounts Receivable Turnover Ratio = Sales ÷ Accounts Receivable

Accounts Receivable Turnover Ratio = 52,501,085 ÷ 2,300,500
Accounts Receivable Turnover Ratio = 22.82

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The accounts receivable turnover ratio becomes more meaningful when

converted to days’ receivable or average collection period. In our illustrative
example, this 22.82 accounts receivable turnover ratio can be converted to days by
dividing 360 days (if information is based on annual data and use 90 days if based
on quarterly data) 16 days, on the average, to collect its accounts receivable.

Average Collection Period = 360 days ÷ 22.82

Average Collection Period = 15.78 or 16 days

In 2014, JSC Foods Corporation had an average of 16 days collecting its accounts
receivable. This means that from the day the sale was made, it took the company
16 days, on the average, to collect its accounts receivable.

4. INVENTORY TURNOVER RATIO

Inventory turnover ratio measures the company’s efficiency in managing its
inventories. Trading and manufacturing companies and companies that are dealing
with highly perishable products and those that are prone to technological
obsolescence must pay close attention to this ratio to minimize losses. The formula
for computing inventory turnover ratio is shown below:

INVENTORY TURNOVER RATIO = COST OF SALES ÷ INVENTORIES

Just like the computation of accounts receivable turnover ratio, either ending
balance of the inventories or the average inventories for the accounting period can
be used. Whichever number is used, consistency must be observed.
For manufacturing companies that may have three types of inventories-
finished goods, work in process, and raw materials inventories, all must be included
in the computation. This is to measure the company’s level of efficiency in managing
this account. Let us compute the inventory turnover ratio of JSC Foods Corporation
in 2014.

Inventory Turnover Ratio = Cost of Sales ÷ Inventories

Inventory Turnover Ratio = 41,954,730 ÷ 4,849,304
Inventory Turnover Ratio = 8.65

The inventory turnover ratio becomes more meaningful when converted to

days’ inventories. To convert, simply divide 360 days by the inventory turnover
ratio if annual data are used. Otherwise, use 90 days if quarterly data are used.
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Days’ Inventories = 360 ÷ Inventory Turnover Ration

Days’ Inventories = 360 ÷ 8.65
Days’ Inventories = 41.62 or 42 days

This 42 days’ inventories means that in 2014, JSC Foods Corporation took 42
days, on the average, to sell its inventories from the time they were bought.

5. ACCOUNTS PAYABLE TURNOVER RATIO

The accounts payable turnover ratio provides information regarding the rate
by which trade payables are paid. Any operating company will prefer to have a
longer payment period for its accounts payable but this should be done only with
the concurrence of the suppliers. The formula below shows the computation for the
accounts payable turnover ratio:

ACCOUNTS PAYABLE TURNOVER RATIO = COST OF SALES ÷ TRADE

ACCOUNTS PAYABLE

The accounts payable turnover ratio of JSC Foods Corporation in 2014 is 8.31
computed as follows:

Accounts Payable Turnover Ratio = Cost of sales ÷ Trade Accounts Payable

Accounts Payable Turnover Ratio = 41,954,730 ÷ 5,050,810
Accounts Payable Turnover Ratio = 8.31

Ideally, purchases should have been the numerator in the formula, but this
amount is not readily available in the income statement. A close substitute for
purchases is the cost of sales or sometimes called cost of goods sold. Purchases are
definitely a function of sales and cost of sales is a function of sales. Given this line
of reasoning, cost of sales can be a very good substitute for purchases.
From the accounts payable turnover ratio, days’ payable can be computed.
For JSC Foods Corporation, days’ payable in 2014 is 43.32 days or 43 days
computed as follows:

Days’ Payable = 360 ÷ Accounts Payable Turnover Ratio

Days’ Payable = 360 ÷ 43.32 or 43 days

This number suggests that in 2014, the average payment period of the
company for its trade accounts payable was 43 days.
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OPERATING CYCLE AND CASH CONVERSION CYCLE

By adding the average collection period and days’ inventories, the operating
cycle can be computed. This operating cycle covers the period from the time the
merchandise is bought to the time the proceeds from the sale are collected.
Managers of companies will prefer to have a short operating cycle as compared to a
long one. In 2014, JSC Foods Corporation had an operating cycle of 58 days
computed as follows.

Operating Cycle = Days’ Inventories + Days’ Receivable

Operating Cycle = 42 + 16
Operating Cycle = 58 days

When JSC Foods Corporation bought the merchandise, did it already pay the
merchandise bought? Chances are the company was given credit terms. As our
days’ payable suggests, payment to suppliers averaged 43 days in 2014. If we are
interested to find out how long it takes the company to collect receivables from the
time the cost of the merchandise sold was actually paid, a cash conversion cycle or
sometimes called net trade cycle can be computed. The formula is shown below:

CASH CONVERSION CYCLE = OPERATING CYCLE – DAYS’ PAYABLE

For JSC Foods Corporation, its cash conversion cycle is 15 days computed as
follows:

Cash Conversion Cycle = Operating Cycle – Days’ Payable

Cash Conversion Cycle = 58 days – 43 days
Cash Conversion Cycle = 15 days

The cash conversion cycle is inversely related to the operating cash flows. If
the cash conversion cycle is low, expect more operating cash flows and the reverse
is true.

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VERTICAL ANALYSIS AND HORIZONTAL ANALYSIS

VERTICAL ANALYSIS
Vertical analysis or something called common-size analysis is an important
financial statement analysis tool. With vertical analysis, all accounts in the
statement of financial position are presented as a percentage of total assets while
all accounts in the statement of profit or loss are presented as a percentage of sales
or revenues.
Found in Table 2.1 and 2.2 are the common-size statements of profit or loss
and statements of financial position of JSC Foods Corporation from 2010 to 2014.

Table 2.1: JSC Foods Corporation

Common- Size Statements of Profit or Loss
For the Years Ending December 31, 2014-2010

2014 2013 2012 2011 2010

Net Sales 100% 100% 100% 100% 100%
Cost of Sales 80% 80% 81% 82% 83%
Gross Profit 20% 20% 19% 18% 17%
Operating Expense 12% 13% 13% 13% 13%
Operating income 8% 7% 7% 5% 4%
Interest expense 0% 1% 1% 1% 1%
Income before taxes 7% 6% 6% 4% 3%
Taxes 2% 2% 2% 1% 1%
Net Income 5% 4% 4% 3% 2%

Vertical analysis is a method of financial statement analysis in which each line

item is listed as a percentage of a base figure within the statement. Thus, line items
on an income statement can be stated as a percentage of gross sales, while line
items on a balance sheet can be stated as a percentage of total assets or liabilities,
and vertical analysis of a cash flow statement shows each cash inflow or outflow as
a percentage of the total cash inflows.

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Table 2.2: JSC Foods Corporation

Common-Size Statements of Financial Position
December 31, 2014-2010

2014 2013 2012 2011 2010

ASSETS
Current Assets
Cash 5% 5% 5% 5% 5%
Trade Receivables 10% 9% 10% 9% 8%
Inventories 22% 22% 22% 20% 20%
Other Current Assets 5% 5% 6% 4% 6%
Total Current Assets 42% 41% 42% 38% 39%
Non-current Assets
Property, Plant, and Equipment, Net 55% 55% 53% 57% 56%
Other non-current assets 4% 4% 5% 5% 5%
Total Noncurrent Assets 58% 59% 58% 62% 61%
Total Assets 100% 100% 100% 100% 100%
LIABILITIES & EQUITIES
Current Liabilities
Trade payables 23% 23% 24% 20% 17%
Income taxes payable 2% 1% 2% 1% 1%
Current portion of long-term debt 10% 12% 6% 12% 12%
Other current liabilities
Total Current Liabilities 35% 37% 32% 33% 30%
Non-current liabilities
Long-term debt, net of current portion 9% 6% 0% 6% 18%
Total Liabilities 44% 43% 32% 39% 47%
Stockholders' Equity
Capital Stock 36% 39% 46% 49% 47%
Retained earnings 20% 19% 22% 12% 5%
Total stockholders' equity 56% 57% 68% 61% 53%
Total Liabilities & Stockholders' Equity 100% 100% 100% 100% 100%

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HORIZONTAL ANALYSIS
Horizontal or trend analysis is a financial statement analysis technique that
shows changes in financial accounts over time. Changes can be shown both in
absolute peso amounts and in percentage.
To compute for the change, simply get the difference from one period to
another. The earlier period is used as the base period. To illustrate, let us compute
the change in the sales of JSC Foods Corporation from 2013 to 2014.

Peso Change = (Sales 2014 – Sales 2013)

Peso Change = 52,501,085 – 47,345,223
Peso Change = 5,155,862
% Change = ((Sales 2014 – Sales 2013) ÷ Sales 2013) x 100%
% Change = (5,155,862 ÷ 47,345,223) x 100%
% Change = 10.89%

These changes for the different accounts are important to identify trends. This
horizontal analysis can be done for the different accounts from statement of
financial position, statement of profit or loss, and statement of cash flows.

Presented in Table 2.3 are the changes in the statement of profit or loss
accounts of JSC Foods Corporation from 2011 to 2014 in peso amounts while Table
2.4 shows the changes in the statements of profit or loss accounts in percent.

Table 2.3: JSC Foods Corporation

Annual Changes in the Statement of Profit or Loss Accounts in Peso
From 2011 to 2014
2014 2013 2012 2011
Net Sales 5,155,862 5,170,940 3,834,026 3,003,615
Cost of Sales 3,966,102 4,008,454 2,541,163 2,109,598
Gross Profit 1,189,760 1,162,486 1,292,863 894,017
Operating Expense 300,855 803,183 466,898 421,301
Operating income 888,905 359,303 825,965 472,716
Interest expense - - (200,000) 150,000
Income before taxes 888,905 359,303 1,025,965 322,716
Taxes 266,672 107,791 307,789 96,815
Net Income 622,234 251,512 718,175 225,901

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 STUDY GUIDE

Table 2.4: JSC Foods Corporation

Annual Changes in the Statement of Profit or Loss Accounts in %
From 2011 to 2014

2014 2013 2012 2011

Net Sales 11% 12% 10% 8%
Cost of Sales 10% 12% 8% 7%
Gross Profit 13% 14% 19% 15%
Operating Expense 5% 15% 9% 9%
Operating income 28% 13% 42% 31%
Interest expense 0% 0% -44% 50%
Income before taxes 31% 14% 67% 27%
Taxes 31% 14% 67% 27%
Net Income 31% 14% 67% 27%

QUALITY OF EARNINGS
In analyzing a statement of profit or loss, how can you tell whether the
earnings are good or not? There are information in the financial statements that
should be looked into. Among these are the following:
1. Is the income coming from the core business?
2. How much of the net income translates into cash flows?
3. Is the income stable?

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

While financial statement analysis is a very powerful tool in understanding a
company, it has its limitation, too. Among them are follows:
1. Financial analysis deals only with quantitative data
2. Management can take short-run actions to influence ratios.
3. Different companies may use different accounting principles through they
come from the same industry.
4. Different formulas can be used in computing financial ratios.
5. The amounts found in the financial statements are already part of historical
data.
6. A financial ratio standing alone is useless.

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