FINANCIAL STATEMENT ANALYSIS Ratio Analysis

Characteristics • A ratio expresses the mathematical relationship

between one quantity and another as either a
o Financial Statement (FS) analysis enables the percentage, rate, or proportion. Ratios can be
financial statement user to make informed decisions classified as:
about a company.
✓ Liquidity ratios—measures of the short-term debt-
o FS analysis involves the evaluation of an entity’s past paying ability.
performance, present condition and business potentials
by way of analyzing the financial statements. ✓ Profitability ratios—measures of the income or
operating success of an enterprise for a given
o When analyzing financial statements, three major period of time.
characteristics of a company are generally
evaluated: ✓ Solvency ratios—measures of the ability of the
enterprise to survive over a long period of time.
✓ Liquidity
• There are four liquidity ratios:
✓ Profitability
✓ Current ratio
✓ Solvency
✓ Acid test ratio
o Comparative analysis may be made on a number of
different bases. ✓ Receivables turnover

• Intracompany basis—Compares an item or ✓ Inventory turnover

financial relationship within a company in the
current year with the same item or relationship in • The current ratio expresses the relationship of
one or more prior years. current assets to current liabilities. It is a widely used
measure for evaluating a company’s liquidity and
• Industry averages—Compares an item or financial short-term debt paying ability.
relationship of a company with industry averages.
• The acid-test or quick ratio relates cash, short-term
• Intercompany basis—Compares an item or investments, and net receivables to current liabilities.
financial relationship of one company with the This ratio indicates a company’s immediate liquidity.
same item or relationship in one or more It is an important complement to the current ratio.
competing companies.
• The receivables turnover ratio is used to assess the
Tools of Financial Analysis liquidity of the receivables. This ratio measures the
number of times, on average, receivables are
o There are three basic tools of analysis: collected during the period.

a. Horizontal • Inventory turnover measures the number of times, on

average, the inventory is sold during the period.
b. Vertical Companies compute the inventory turnover by dividing
cost of goods sold by the average inventory during the
c. Ratio year. One computes the average days in inventory by
dividing the inventory turnover into 365 days.

Horizontal Analysis Profitability Ratios

o Horizontal analysis, also called trend analysis, is a ▪ Profit margin is a measure of the percentage of each peso
technique for evaluating a series of financial of sales that results in net income. Companies compute
statement data over a period of time to determine it by dividing net income by net sales.
the increase or decrease that has taken place,
expressed as either an amount or a percentage. • Asset turnover measures how efficiently a company uses
its assets to generate sales. It is computed by dividing net
o In horizontal analysis, a base year is selected, and sales by average assets.
changes are expressed as percentages of the base
year amount. • An overall measure of profitability is return on assets. One
computes this ratio by dividing net income by average
Vertical Analysis assets.

• Vertical analysis, also called common size analysis, • Return on common stockholders’ equity shows how
expresses each item within a financial statement as a many pesos of net income the company earned for each
percent of a base amount. Generally, the base peso invested by the owners. Companies compute it by
amount is total assets for the balance sheet, and net dividing net income by average common stockholders’
sales for the income statement. equity.
 o When a company has preferred stock, it must (Average the company must
deduct preferred dividend requirements from Collection wait before
net income to compute income available to Period) receivables are
common stockholders. (Days’ in collected.
Receivables)
o Companies deduct the par value of preferred Cost of Goods It measures the
stock (or call price) from total stockholders’ Sold number of times
equity to determine the amount of common Inventory
Average that the inventory
stockholders’ equity used in the denominator. Turnover
Merchandise is replaced during
Inventory the period.
Average Age of It indicates the
• Earnings per share is a measure of the net income earned Inventory* average number of
on each share of common stock. It is computed by dividing (Inventory 360 days days during which
net income by the number of weighted average common Conversion Inventory the company must
shares outstanding during the year. Period) Turnover wait before the
(Days’ in inventories are
• The price-earnings ratio is a measure of the ratio of the Inventory) sold.
market price of each share of common stock to the Net Credit It measures the
earnings per share. One computes it by dividing the Accounts
Purchases speed with which a
market price per share of the stock by earnings per share. Payable
Average Trade company pays its
Turnover
Payables suppliers.
• The payout ratio measures the percentage of earnings It indicates the
distributed in the form of cash dividends. Companies Average Age of 360 days length of time
compute it by dividing cash dividends by net income. Accounts Payables during which
Payable Turnover payables remain
Solvency ratios unpaid.
The time it takes a
• The debt to total assets ratio measures the percentage of company to
the total assets that creditors provide. One computes it by Average Age of acquire inventory,
dividing total debt (both current and long-term liabilities) Normal Inventory + sell that inventory,
by total assets. Operating Cycle Average Age of and receive cash
Receivables from its customers
• Times interest earned (interest coverage ratio) provides an in exchange for the
indication of the company’s ability to meet interest payments inventory sold.
as they come due. Companies compute it by dividing The time
income before interest expense and income taxes by (measured in days)
interest expense. Average Age of it takes for a
Inventory + company to
SUMMARY OF FINANCIAL RATIOS Cash
Average Age of convert its
Conversion
Receivables investments in
LIQUIDITY Cycle
+ Average Age of inventory and
Accounts Payable other resources
It is a measure of into cash flows
adequacy of from sales.
working capital. It
Current Ratio Current Assets is the primary test
Current Liabilities of liquidity to meet PROFITABILITY
current obligations
from current Determines the
assets. Return on Sales Income portion of sales
It measures the (Net Profit Net Sales that went into
number of times Margin) company’s
that the current earnings.
liabilities could be Efficiency with
paid with the Return on Income which assets are
Quick Ratio Quick Assets
available cash and Assets Average Asset used operate the
(Acid Test Ratio) Current Liabilities
near-cash assets business.
(i.e., cash, current Measures the
receivables and amount earned on
marketable Return on Income
the owner’s or
securities). Equity Average Equity
stockholders’
It measures the investment.
number of times Net Income – Measures the
Net Credit Sales
Receivables receivables are Preferred amount of net
Average
Turnover recorded and Earnings Per Dividends income earned by
Receivables
collected during Shares Weighted Ave. each common
the period. Common Shares share.
Average Age of 360 days It indicates the Outstanding
Receivables Receivables average number of Operating Profit Operating Profit Measures profit
Turnover days during which Margin Net Sales generated after
 consideration of
operating costs.
Operating Cash Measures the
Cash Flow Flow ability of the firm
Margin Net Sales to translate sales
to cash.
Price-Earnings Price Per Share It indicates the
(PE) Ratio Earnings Per number of pesos
Share required to buy P1
of earnings.
Dividend Yield Dividend Per Measures the rate
Share of return in the
Price Per Share investor’s common
stock investments.
Dividend Pay- Dividend Per It indicates the
out Ratio Share proportion of
Earnings Per earnings
Share distributed as
dividends.

SOLVENCY

It determines the
Times Interest EBIT extent to which
Earned Interest Expense operations cover
interest expense.
Proportion of
assets provided by
Debt-Equity Total Liabilities creditors
Ratio Total Equity compared to that
provided by
owners.
Proportion of total
Total Liabilities
Debt Ratio assets provided by
Total Assets
creditors.
Proportion of total
Total Equity
Equity Ratio assets provided by
Total Assets
owners.

- - END - -
 FINANCIAL STATEMENT ANALYSIS
THEORY

1. A company has a current ratio of 2 to 1. The ratio will decrease if the company
a. Receives a 5% stock dividend on one of its marketable securities
b. Sells merchandise for more than cost and records the sale using the perpetual inventory method
c. Pays a large account payable which had been a current liability
d. Borrow cash on a six-month note

2. When compared to a debt-to-assets ratio, a debt-to-equity ratio would

a. Be about the same as the debt-to-assets ratio c. Be lower than the debt-to-assets ratio
b. Be higher than the debt-to-assets ratio d. Have no relationship at all to the debt-to-assets
ratio

3. A company issued long-term bonds and used the proceeds to repurchase 40% of the outstanding shares of its
stock. This financial transaction will likely cause the
a. Total assets turnover ratio to increase c. Current ratio to decrease
b. Times-interest-earned ratio to decrease d. Fixed charge coverage ratio to increase

4. How are financial ratios used in decision making?

a. They can help identify the reasons for success and failure in business, but decision making requires
information beyond the ratios
b. They remove the uncertainty of the business environment
c. They aren’t useful because decision making is too complex
d. They give clear signals about the appropriate action to take

5. Which of these ratios are measures of a company’s profitability?

1. Earnings per share 5. Return on assets
2. Current ratio 6. Inventory turnover
3. Return on sales 7. Receivables turnover
4. Debt-equity ratio 8. Price-earnings ratio

a. All eight ratios c. 1, 3, 5, 6, 7, and 8 only

b. 1, 3, 5, and 8 only d. 1, 3, and 5 only

6. Which one of the following is not a characteristic generally evaluated in analyzing financial statements?
a. Liquidity c. Marketability
b. Profitability d. Solvency

7. What type of ratios best measure the short-term ability of the enterprise to pay its maturing obligations and to
meet unexpected needs for cash?
a. Leverage c. Profitability
b. Solvency d. Liquidity.

8. Long-term creditors are usually most interested in evaluating

a. Liquidity and solvency c. Liquidity and profitability
b. Solvency and marketability d. Profitability and solvency

9. Comparisons of financial data made within a company are called

a. Intracompany comparisons c. Intercompany comparisons
b. Interior comparisons d. Intramural comparisons

10. A technique for evaluating financial statements that expresses the relationship among selected items of financial
statement data is
a. Common size analysis c. Ratio analysis
b. Horizontal analysis d. Vertical analysis

11. Which one of the following is not a tool in financial statement analysis?
a. Horizontal analysis c. Vertical analysis
b. Circular analysis d. Ratio analysis

12. Horizontal analysis is also called

a. Linear analysis c. Trend analysis
b. Vertical analysis d. Common size analysis

13. A useful tool in financial statement analysis is the common-size financial statement. What does this tool enable
the financial analyst to do?
a. Evaluate financial statements of companies within a given industry of approximately the same value
b. Determine which companies in the same industry are at approximately the same stage of development
 c. Compare the mix of assets, liabilities, capital, revenue, and expenses within a company over time or
between companies within a given industry without respect to relative size
d. Ascertain the relative potential of companies of similar size in different industries

14. Vertical analysis is also called

a. Common size analysis c. Ratio analysis
b. Horizontal analysis d. Trend analysis

15. Vertical analysis is a technique which expresses each item within a financial statement
a. In pesos and cents
b. In terms of a percentage of the item in the previous year
c. In terms of a percent of a base amount
d. Starting with the highest value down to the lowest value

16. Each of the following is a liquidity ratio except the

a. Acid-test ratio c. Debt to total assets ratio
b. Current ratio d. Inventory turnover

17. The current ratio is

a. Calculated by dividing current liabilities by current assets
b. Used to evaluate a company's liquidity and short-term debt paying ability
c. Used to evaluate a company's solvency and long-term debt paying ability
d. Calculated by subtracting current liabilities from current assets

18. The acid-test (quick) ratio

a. Is used to quickly determine a company's solvency and long-term debt paying ability
b. Relates cash, short-term investments, and net receivables to current liabilities
c. Is calculated by taking one item from the income statement and one item from the balance sheet
d. Is the same as the current ratio except it is rounded to the nearest whole percent

19. The debt to total assets ratio measures

a. The company's profitability
b. Whether interest can be paid on debt in the current year
c. The proportion of interest paid relative to dividends paid
d. The percentage of the total assets provided by creditors

20. A company has just converted a long-term note receivable into a short-term note receivable. The company's
acid-test and current ratios are both greater than 1. This transaction will
a. Increase the current ratio and decrease the acid-test ratio
b. Increase the current ratio and increase the acid-test ratio
c. Decrease the current ratio and increase the acid-test ratio
d. Decrease the current ratio and decrease the acid-test ratio

21. An investor has been given several financial ratios for an enterprise but none of the financial reports. Which
combination of ratios can be used to derive return on equity?
a. Market-to-book-value ratio and total-debt-to-total-assets ratio
b. Price-to-earnings ratio, earnings per share, and net profit margin
c. Price-to-earnings ratio and return-on-assets ratio
d. Net profit margin, total assets turnover, and equity multiplier

22. On December 31, a company collected a receivable due from a major customer. Which of the following ratios
would be increased by this transaction?
a. Inventory turnover ratio c. Receivable turnover ratio
b. Current ratio d. Quick ratio
PROBLEM

1. The balance sheet and income statement shown below are for AJ Company.

Balance Sheet (Millions of P)

Assets 20X0
Cash and securities P1,554.0
Accounts receivable 9,660.0
Inventories 13,440.0
Total current assets P24,654.0
Net plant and equipment 17,346.0
Total assets P42,000.0

Liabilities and Equity

Accounts payable P7,980.0
Notes payable 5,880.0
Accruals 4,620.0
Total current liabilities P18,480.0
Long-term bonds 10,920.0
Total debt P29,400.0
Common stock 3,360.0
Retained earnings 9,240.0
Total common equity P12,600.0
Total liabilities and equity P42,000.0

Income Statement (Millions of P)

P58,800.00
Net sales
Operating costs except depreciation P54,978.0
Depreciation P1,029.0
Earnings before int and taxes (EBIT) P2,793.0
Less interest 1,050.0
Earnings before taxes (EBT) P1,743.0
Taxes P610.1
Net income P1,133.0
Other data:
Shares outstanding (millions) 175.00
Common dividends P509.83
Int rate on notes payable & bonds 6.25%
Income tax rate 35%
Year-end stock price P77.69

Question 1: What is the firm's current ratio?

0.97 c. 1.20
1.08 d. 1.33

Question 2: What is the firm's quick ratio?

0.49 0.73
0.61 0.87

Question 3: What is the firm's days sales outstanding? Assume a 360-day year for this calculation.
a. 48.17 c. 56.19
b. 50.71 d. 59.14

Question 4: What is the firm's total assets turnover?

a. 0.90 c. 1.40
b. 1.12 d. 1.68

Question 5: What is the firm's inventory turnover ratio?

a. 4.38 c. 4.82
b. 4.59 d. 5.06
Question 6: What is the firm's times interest earned (TIE)?
a. 1.94 c. 2.39
b. 2.15 d. 2.66

Question 7: What is the firm's EBITDA coverage?

a. 3.29 c. 3.64
b. 3.46 d. 3.82

Question 8: What is the firm's debt ratio?

a. 45.93% c. 56.70%
b. 51.03% d. 70.00%

Question 9: What is the firm's ROA?

2.70% c. 3.26%
2.97% d. 3.59%

Question 10: What is the firm's ROE?

8.54% c. 9.44%
8.99% d. 9.91%

Question 11: What is the firm's profit margin?

1.40% c. 1.73%
1.56% d. 1.93%

Question 12: What is the firm's dividends per share?

P2.62 c. P3.20
P2.91 d. P3.53

Question 13: What is the firm's cash flow per share?

P10.06 c. P11.15
P10.59 d. P12.35

Question 14: What is the firm's EPS?

P5.84 c. P6.47
P6.15 d. P6.80

Question 15: What is the firm's P/E ratio?

12.0 c. 13.2
12.6 d. 13.9

Question 16: What is the firm's book value per share?

P61.73 c. P68.40
P64.98 d. P72.00
Question 17: What is the firm's market-to-book ratio?

Question 18: What is the firm's equity multiplier?

a. 3.33 c. 3.68
b. 3.50 d. 3.86
2. Veronica Corporation's most recent balance sheet and income statement appear below:

Statement of Financial Position

December 31, Year 2 and Year 1
(in thousands of pesos)

Assets Year 2 Year 1

Current assets:
Cash ................................................................................... P 140 P 130
Accounts receivable .......................................................... 160 140
Inventory ........................................................................... 170 150
Prepaid expenses............................................................... 90 90
Total current assets............................................................... 560 510
Plant and equipment, net ..................................................... 840 900
Total assets............................................................................ P1,400 P1,410

Liabilities and Stockholders’ Equity

Current liabilities:
Accounts payable .............................................................. P 150 P 150
Accrued liabilities .............................................................. 60 60
Notes payable, short term................................................. 60 60
Total current liabilities .......................................................... 270 270
Bonds payable ....................................................................... 230 270
Total liabilities ....................................................................... 500 540

Stockholders’ equity:
Preferred stock, P100 par value, 5% ................................. 200 200
Common stock, P1 par value ............................................. 100 100
Additional paid-in capital–common stock ......................... 100 100
Retained earnings.............................................................. 500 470
Total stockholders’ equity ..................................................... 900 870
Total liabilities & stockholders’ equity .................................. P1,400 P1,410

Income Statement
For the Year Ended December 31, Year 2
(in thousands of pesos)
Sales (all on account) ............................................................ P1,370
Cost of goods sold......................................................................... 800
Gross margin ......................................................................... 570
Selling and administrative expense .............................................. 439
Net operating income ........................................................... 131
Interest expense.................................................................... 31
Net income before taxes ....................................................... 100
Income taxes (30%) ............................................................... 30
Net income ............................................................................ P 70

Dividends on common stock during Year 2 totaled P30 thousand. Dividends on preferred stock totaled P10
thousand. The market price of common stock at the end of Year 2 was P4.86 per share.

Question 1: The gross margin percentage for Year 2 is closest to:

a. 814.3% c. 41.6%
b. 71.3% d. 12.3%

Question 2: The earnings per share of common stock for Year 2 is closest to:
a. P0.60 c. P1.00
b. P0.70 d. P1.31

Question 3: The price-earnings ratio for Year 2 is closest to:

a. 8.10 c. 6.94
b. 3.71 d. 4.86

Question 4: The dividend payout ratio for Year 2 is closest to:

a. 66.7% c. 833.3%
b. 50.0% d. 42.9%
Question 5: The dividend yield ratio for Year 2 is closest to:
a. 75.00% c. 2.06%
b. 8.23% d. 6.17%

Question 6: The return on total assets for Year 2 is closest to:

a. 5.00% c. 6.53%
b. 6.55% d. 4.98%

Question 7: The return on common stockholders' equity for Year 2 is closest to:
a. 6.78% c. 8.76%
b. 7.91% d. 10.22%

Question 8: The book value per share at the end of Year 2 is closest to:
P 0.60 c. P 9.00
P 7.00 d. P 14.00

Question 9: The working capital at the end of Year 2 is:

P 840,000 c. P 290,000
P 560,000 d. P 900,000

Question 10: The current ratio at the end of Year 2 is closest to:
0.36 c. 0.89
0.40 d. 2.07

Question 11: The acid-test ratio at the end of Year 2 is closest to:
1.11 c. 2.07
1.12 d. 1.44

Question 12: The accounts receivable turnover for Year 2 is closest to:
1.14 c. 0.88
8.56 d. 9.13

Question 13: The average collection period for Year 2 is closest to:
1.1 days c. 0.9 days
42.6 days d. 40.0 days

Question 14: The average inventory for Year 2 is closest to:

4.71 c. 5.00
0.88 d. 1.13

Question 15: The average sale period for Year 2 is closest to:
45.3 days c. 213.1 days
77.5 days d. 73.0 days
Question 16: The times interest earned for Year 2 is closest to:
a. 4.23 c. 2.26
b. 6.04 d. 3.23

Question 17: The debt-to-equity ratio at the end of Year 2 is closest to:
a. 0.71 c. 0.56
b. 0.26 d. 0.32
3. Katherine Inc. has the following income
statement (in millions)

Katherine Inc.
Income Statement
For the Year Ended December 31, 20X0
Net Sales P180
Cost of Goods Sold 120
Gross Profit 60
Operating Expenses 33
Net Income P 27

Question 1: Using vertical analysis, what percentage is assigned to Cost of Goods Sold?
67% c. 100%
33% d. None of the above

Question 2: Using vertical analysis, what percentage is assigned to Net Income?

100% c. 15%
85% d. None of the above