Financial Statement Analysis

UNDERSTANDING FINANCIAL STATEMENTS

Definition and Components of Financial Statements

According to Philippine Accounting Standards (PAS) 1, Presentation of Financial Statements, financial

statements are structured report showing both financial position and performance which aims to aid users
in making economic decisions. Specifically, the financial statements contain the following:

• Assets
• Liabilities
• Equity
• Income and expenses
• Cash flows

In the most updated accounting standard, the complete set of financial statements comprises the
following reports:

• Statement of financial position (formerly known as the balance sheet)

• Statement of comprehensive income (formerly known as income statement)
• Statement of changes in equity
• Statement of cash flows
• Notes to financial statements, comprising summary of accounting policies
• Comparative information as applicable.

General Characteristic of the Financial Statements

The financial statements described in the preceding sections are for general use of the public. As such,
these financial statements contain high level information to serve the general needs of its users.
Furthermore, it contains absolute amount of assets, liabilities, equity, income, expenses and cash flows of
an entity which provide only limited information on the company’s potential risks and growth areas.

OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

Need for and Definition of Financial Statements Analysis

As the financial statements only contain absolute amount of resources and income, a more detailed
approach in understanding the financial statements must be employed in order to uncover relevant
information in decision making. Such detailed approach is called financial statements analysis which
aims to identify potential risks and growth areas based on the general information disclosed in the
financial statements.

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Importance and Use (Objectives) of Financial Statements Analysis

Financial statements analysis provides more meaning to the figures presented in our financial statements
by answering the following questions:

• Is the firm capable of paying its short term obligations? (Liquidity)

• Are the assets of the company generating sufficient revenue? (Asset Utilization)
• How does the firm generate financing for its operations? (Capital Adequacy)
• Is the company able to provide adequate returns to owners? (Profitability)

Apart from the questions answered above, financial statement analysis help in the following aspects:

• Measuring financial performance in reference to prior year

• Gauging whether the organization is performing within industry norms
• Goal setting with regard to target ratios
• Detection of weaknesses and areas for improvement
• Decision making with regard to their effect on certain financial statement ratios
• Monitoring of loan covenant compliance

METHODS OF FINANCIAL STATEMENTS ANALYSIS

There are various financial statement analyses tools and interpretation. The following are examples of
financial statement analysis tools:

• Comparative Financial Statements or Horizontal Analysis – it is the process of comparing

financial statement line items from prior year’s figure. It may also be a comparison of actual
versus budgeted amounts.
• Trend analysis – trend analysis involves the comparison of financial data using a base year.

• Common-size Financial Statements or Vertical Analysis – it is the process of converting peso

value to percentage of total assets and sales in order to make varying size financial statements to
be more comparable.
• Ratio Analysis – ratio analysis is simply the process of converting financial statement information
in fractional form to identify return and risk areas of the company.

RATIO ANALYSIS

Reminder : When dividing two FS number where one comes from the Income Statement and the
other from the Balance Sheet, the Balance Sheet figure should be converted to average.

Liquidity Ratios

These ratios measure whether the firm currently has available cash to pay its maturing obligations (which
includes both current liabilities and operating expenses).

1. Current Ratio - it measures how many current assets are available to pay current liabilities. It is a
measure of liquidity risk or technical insolvency.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

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 2. Quick Ratio (Acid-Test Ratio) – it measures how much quick assets are available to meet short
term obligations. It refines the current ratio by measuring the amount of most liquid current assets
there are to cover current liabilities. In actual practice, quick assets is defined differently across
companies. However, for purposes of academic discussion, quick assets exclude inventory and
prepaid expenses. It is a strict measure of liquidity risk.

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

3. Cash Ratio – it measures how much cash and near cash items are available to meet short term
obligations. It is an indicator of liquidity in a crisis situation. Near cash assets include marketable
securities than can be converted to cash easily at minimal cost. It is a very strict measure of
liquidity risk.
𝐶𝑎𝑠ℎ 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝑁𝑒𝑎𝑟 𝐶𝑎𝑠ℎ 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

4. Net Working Capital- the residual amount after deducting the total current liabilities from total
current assets. Shows how much current assets will be retained after all its current liabilities are
paid.

Net Working Capital = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 - 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Capital Adequacy Ratios (Leverage Ratios)

These ratios measure how the company finance its assets and operations. These ratios measure how
extensive the company makes use of debt capital and equity capital. Note that companies must strike the
balance between debt financing and equity financing. Too much debt financing may bring forth higher
profits to the company at the expense of solvency while too much equity may protect companies from
insolvency at the expense of profit.

1. Debt Ratio - It indicates how much debt is used to finance company’s assets. Higher ratio means
greater risk for the firm.

𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

2. Equity Ratio - It indicates how much equity is used to finance company’s assets

𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

3. Debt to Equity Ratio - It indicates how much debt is matched by owners’ investments

𝐷𝑒𝑏𝑡 to 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 / 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

4. Equity Multiplier (Capital Multiplier) - it shows the impact of the company’s financing decisions on
return on assets

𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑞𝑢𝑖𝑡𝑦

5. Times Interest Earned - it shows the company’s ability to pay interest expenses

Times Interest Earned = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠 / 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

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 6. Dividend payout ratio - it shows how much of the companies’ earnings are distributed as
dividends

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 / (𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐿𝑒𝑠𝑠 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠)

Asset Utilization Ratios

These ratios measure how the company utilizes its assets. Note that these ratios show whether the
company is using its assets efficiently or not. Also called “activity ratios”.

1. Accounts Receivable Turnover (ARTO) – it measures how fast receivables are collected

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

2. Days Sales Outstanding(DSO) or Average Collection Period (ACP) – it measures how long does
it take for a certain company collect its receivables

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑=360 𝑑𝑎𝑦𝑠 𝑜𝑟 365 𝑑𝑎𝑦𝑠 / 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Generally, higher ARTO (and lower DSO) is favorable as it may mean effective credit and
collection system and that it supports the growth in sales properly. However, it can also mean
possible indicator of very tight credit policy that could lead to lost sales (to competitors having
more lenient terms).

On one hand, lower ARTO (thus higher DSO) means more resources are tied up in AR which
could be a potential indicator of uncollectible receivables because of possible problems in the
credit and collection system.

3. Inventory Turnover – it measures how fast inventories are sold

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

4. Days Sales in Inventory (DSI) – it measures how long inventories are kept before it is sold

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒 𝑃𝑒𝑟𝑖𝑜𝑑=360 𝑑𝑎𝑦𝑠 𝑜𝑟 365 𝑑𝑎𝑦𝑠 / 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Generally, higher ITO (and lower DSI) is favorable as it may mean effective inventory
management. However, it can also mean possible inadequate inventory levels which could result
to inventory shortage and lost sales. On one hand, lower ITO (thus higher DSI) could indicate
slow moving inventory due to technological obsolescence, changes in trends, etc.

5. Accounts Payable Turnover – it measures how fast payables are being paid

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟=𝑁𝑒𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

6. Days Payable Outstanding (DPO) or Average Payment Period (APP) – it measures how long the
company can defer its payment to suppliers

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑=360 𝑑𝑎𝑦𝑠 𝑜𝑟 365 𝑑𝑎𝑦𝑠 / 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

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 Higher APTO (and low DPO) could mean taking advantage of early payment discounts (positive)
or not making full use of abilities to delay payment (negative). Lower APTO (and high DPO) could
mean maximizing lenient payment terms from suppliers (positive) or experiencing liquidity
problems (negative).

7. Operating Cycle - it is the length of time required to convert inventories into cash.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑦𝑐𝑙𝑒=𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑+ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒 𝑃𝑒𝑟𝑖𝑜𝑑

8. Cash Conversion Cycle - it is the length of time required from the purchase of the goods until its
related sale.

𝐶𝑎𝑠ℎ 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝐶𝑦𝑐𝑙𝑒=𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑛𝑑 + 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒 𝑃𝑒𝑟𝑖𝑜𝑑−𝐴𝑣𝑒𝑟𝑎𝑔𝑒

𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑

9. Fixed Asset Turnover – it measures how much peso sales are being generated per peso fixed
asset

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟=𝑆𝑎𝑙𝑒𝑠𝐴𝑣𝑒𝑟𝑎𝑔𝑒 / 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

10. Total Asset Turnover – it measures how much peso sales are being generated per peso total
asset

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟=𝑆𝑎𝑙𝑒𝑠𝐴𝑣𝑒𝑟𝑎𝑔𝑒 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Profitability Ratios

These ratios measure whether the firm is currently earning enough from its assets and invested capital. It
also provides information regarding the firm’s potential earning capacity assuming additional peso of
invested capital will be infused in the organization. Furthermore, profitability ratios may also provide
information about the efficient use of the company’s assets.

1. Return on Sales (ROS) or Net Profit Margin (NPM) or Net Income Ratio – it indicates how much
of the sales are retained as income. It measures the company’s efficiency on controlling
expenses.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆𝑎𝑙𝑒𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠* / 𝑇𝑜𝑡𝑎𝑙 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

*In some books, they use net operating income which requires adding back of interest expense
after tax. This practice is acceptable, however, contemporary approaches makes use of the
corporate bottom line (which is net income after taxes).

2. Return on Assets - It indicates how efficient is the company in generating net income from its
assets.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠* / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

*In some books, they use net operating income which requires adding back of interest expense
after tax. This practice is acceptable, however, contemporary approaches makes use of the
corporate bottom line (which is net income after taxes).

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 3. Return on Equity - it indicates how much net income are generated from every peso of invested
capital.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠* / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑞𝑢𝑖𝑡𝑦**

*In some books, they use net operating income which requires adding back of interest expense
after tax. This practice is acceptable, however, contemporary approaches makes use of the
corporate bottom line (which is net income after taxes).

**Average equity may pertain to total equity, common equity, or preference equity. It depends on
the nature of the item being evaluated.

4. Operating Income Return on Investment (OIROI) - It indicates how efficient is the company in
generating operating profits from its assets.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑

𝑇𝑎𝑥𝑒𝑠 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

5. Basic Earnings per share – it indicates how much earnings are attributable to each stock issued

𝐵𝑎𝑠𝑖𝑐 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠−𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 /

𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔∗∗

**This will be discussed in greater detail in financial accounting topics.

Market Performance

1. Price-earnings ratio – it measures the markets willingness to pay for the companies’ stocks

𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑎𝑡𝑖𝑜 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 / 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

2. Dividend Yield – amount of dividends earned in relation to the current market value of the stock

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 / 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Dupont Analysis of Return on Equity

Dupont analysis recognizes the interrelationships between various ratios to arrive at return on equity. It
breaks down return on equity to various components namely operating efficiency, asset productivity and
capital structure.

• ROE Component 1 (Net Profit Margin or Return on Sales) – It deals with the operating efficiency
particularly on controlling expenses – see formula above
• ROE Component 2 (Total Asset Turnover) – it deals with asset productivity particularly on sales
generation of assets – see formula above
• ROE Component 3 (Equity Multiplier) – it deals with how financing affects return on equity – see
formula above

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 Return on equity = Net profit Margin * Total Asset Turnover * Equity Multiplier
or
Return on equity = Return on Asset * Equity Multiplier

PITFALLS TO AVOID IN FINANCIAL STATEMENT ANALYSIS

➢ The use of a single ratio to analyze financial performance

➢ Lack of data integrity used in financial statement analysis
➢ Information overload due to numerous ratios
➢ Varying accounting policies may distort ratios
➢ Failure to consider unrecorded items

LIMITATIONs OF FS ANALYSIS

➢ Financial statements deal only in numerical and measurable terms

➢ Appropriate industry comparison may not exist
➢ Differences in operating and accounting practices make comparisons difficult and inaccurate
➢ Management may influence ratios by taking short-term actions prior to preparing the financial
statements
➢ Several definitions may exist for some common ratios
➢ Inflation may distort financial ratios
➢ Financial ratios may be misinterpreted

EXERCISES

VERTICAL AND HORIZONTAL ANALYSIS

Following are the financial statements or Clarisse Company:

CLARISSE COMPANY
Condensed Statement of Financial Position
December 31, 2025 (In Thousands)
ASSETS LIABILITIES AND STOCKHOLDERS EQUITY
Cash P 750 Current Liabilities P 500
Non Cash Current 1250 Long Term Debt 1500
Fixed Assets 3000 Capital Stock 2000
Retained Earnings 1000
TOTAL ASSETS 5000 TOTAL LIAB & SHE 5000

For 2025: Net sales totaled P 2,000; CGS, 1,300; Operating Expenses, P 300; Interest and tax changes, P 220.
For 2024: Net sales totaled P 1,600, CGS, P 1,000; Operating Expenses, P 300; Interest and tax charges, P 200.

REQUIRED: Prepare common-size 2025 financial statements and compute (a) current ratio; (b) debt ratio; (c) equity
ratio; (d) gross profit margin; (e) operating profit margin and (f) net profit margin.
Compute trend percentages for the following: (a) net sales; (b) EBIT and (c) net income.

7
LIQUIDITY ANALYSIS

Indicate the effects of each of the following transactions on the company’s (A) current ratio and (B) acid test ratio. There
are three possible answers: (+) increase, (-) decrease, and (0) no effect. Before each transaction takes place, both ratios
are greater than 1 to 1.

Effects on

Transactions: (A) Current Ratio (B) Acid Test Ratio

Example: Sell merchandise for cash + +

1. Buy inventory for cash.

2. Pay an account payable
3. Borrow cash on a short term loan
4. Purchase plant asset for cash.
5. Collect an account receivable
6. Record accrued expense payable

FINANCIAL RATIOS

ABC has 1,000,000 common shares outstanding. The price of the stock is P 8. ABC declared dividends per share of P
0.10. The balance sheet at the end of 2010 showed approximately the same amounts as that at the end of 2011. The
financial statements of ABC Merchandising are as follows:

ABC Company, Income Statement for 2011 (in thousand)

Sales P 4,700
Cost of goods sold 2,300
Gross profit 2,400
Operating expenses:
Depreciation P 320
Other 1,230 1,550
Income before interest and taxes 850
Interest expense 150
Income before taxes 700
Income taxes 280
Net Income 420

ABC Company, Balance Sheet at December 31, 2011 (in thousand)

Assets Liabilities and SHE

Cash P 220 Accounts payable P 190
Accounts Receivable 440 Accrued expenses 180
Inventory 410 Total Current Liabilities 370
Total Current Assets 1,070 Long Term debt 1,960
Plant and Equipment 5,600 Common stock 1,810
Accum. Depreciation (2,100) Retained earnings 430
Total Assets 4,570 Total Liab & SHE 4,570

REQUIRED: Compute the following ratios (round off answers to two decimal places)

8
Comparative Statement Analysis

1. Select information from a company’s year end balance sheet is shown below:

Balance Sheet

As of December 31, Year 1

Cash P50,000
Accounts receivable 120,000
Inventory 75,000
Property, plant and equipment, net 250,000

Total Assets P495,000

Accounts Payable P35,000

Long Term Debt 100,000
Total Liabilities 135,000
Common Stock 300,000
Retained Earnings 60,000
Total Equity 360,000
Total Liabilities and Equity P495,000

Based on the above information, a common-size balance sheet for the company will show

a. Long-term debt at 74%.

b. Property, plant and equipment, net at 69%.
c. Retained earnings at 17%.
d. Accounts receivables at 24%.

2. The peso value of a company’s ending inventory on its balance sheet was P500,000, P600,000,
and P400,000 for Years 1, 2, and 3, respectively. In preparing a horizontal analysis with Year 1
as the base year, the percentage change shown for Year 3 would be

a. (25%)
b. (20%)
c. 20%
d. 80%

3. An abbreviated common-size income statements for Year 1’s actual results and Year 2’s
anticipated results are shown below.

Year 1 Year 2
Sales 100% 100%
Cost of goods sold 50% 50%
Selling and admin expenses 40% ?
Operating income 10% ?

The corporation estimates that units sold will increase by 5% in Year 2 with no price increase to
its customers and no anticipated cost increases from its vendors. Assume selling and
administrative expenses are 5% variable and 95% fixed. If all predictions materialize, the
corporation should expect selling and administrative expenses in Year 2 to be

9
 a. Less than 40% of sales.
b. 40% of sales.
c. Greater than 40% but no more than 42% of sales.
d. Greater than 42% of sales.

4. In assessing the financial prospects for a firm, financial analysts use various techniques. An
example of vertical, common-size analysis is

a. A comparison in financial ratio form between two or more firms in the same industry.
b. Advertising expense increased by 3% over the previous year.
c. An assessment of the relative stability of a firm's level of vertical integration.
d. Advertising expense is 4% of sales.

Liquidity Ratios
5. Given an acid test ratio of 2.0, current assets of P5,000, and inventory of P2,000, the value of
current liabilities is
a. P1,500
b. P2,500
c. P3,500
d. P6,000

6. All of the following are included when calculating the acid test ratio except

a. accounts receivable.
b. six-month treasury bills.
c. prepaid insurance.
d. 60-day certificates of deposit.

7. A firm has gathered financial statement data from three companies applying for credit as new
customers. The company extends credit to customers on the credit terms 2/10, net 30. Prior to
accepting the customers, a financial analyst with the firm performs a liquidity analysis. Summary
data is shown below:

Company F Company G Company H

Cash P 20,000 P 12,850 P130,000
Accounts Receivable 40,000 74,500 100,000
Inventory 170,000 42,240 354,300
Current Assets 230,000 129,590 584,300
Total Assets 567,888 260,400 780,560
Current Liabilities 175,000 63,800 142,100
Total Liabilities 487,120 97,680 364,760
Total Shareholders’ Equity 80,768 162,720 415,800
When evaluating the liquidity of the three potential customers, which one of the following conclusions
is correct?

a. Company H has the highest current ratio but the lowest acid-test ratio, so the firm should
not accept Company H as a new customer.
b. Company G has a low debt to total assets ratio, so the firm should accept Company G as
a new customer.
c. Company F has a low current ratio, so the firm should not accept Company F as a new
customer.

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 d. Company F has a high long-term debt to equity ratio, so the firm should accept Company
F as a new customer.

8. An entity has total assets of P7,500,000 and a current ratio of 2.3 times before purchasing
P750,000 of merchandise on credit for resale. After this purchase, the current ratio will

a. Remain at 2.3 times.

b. Be higher than 2.3 times.
c. Be lower than 2.3 times.
d. Be exactly 2.53 times.

9. All of the following are affected when merchandise is purchased on credit except

a. Total current assets.

b. Net working capital.
c. Total current liabilities.
d. Current ratio.
10. Depoole Company is a manufacturer of industrial products and employs a calendar year for
financial reporting purposes. Assume that total quick assets exceeded total current liabilities both
before and after the transaction described. Further assume that Depoole has positive profits
during the year and a credit balance throughout the year in its retained earnings account.

The early repayment (liquidation) of a long-term note payable with cash affects the

a. Current and quick ratio to the same degree.

b. Current ratio but not the quick ratio.
c. Current ratio to a greater degree than the quick ratio.
d. Quick ratio to a greater degree than the current ratio.
11. CPZ Enterprises had the following account information.

Accounts receivable P200,000

Accounts payable 80,000
Bonds payable, due in ten years 300,000
Cash 100,000
Interest payable, due in three months 10,000
Inventory 400,000
Land 250,000
Notes payable, due in six months 50,000

Prepaid expenses 40,000

The company has an operating cycle of five months.

The current ratio for CPZ Enterprises is

a. 5.00
b. 1.68
c. 2.14
d. 5.29

Solvency and Leverage Ratios

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 12. A firm earned P10,000 before interest and taxes, has a 36% tax rate, and has the following debt
outstanding:

First mortgage bond, 9.0% P 5,000

Debenture, 10.2% 10,000
Subordinated bond, 12.0% 6,000
Total long-term debt P21,000

The annual coverage of the firm’s debt is

a. 4.57 times.
b. 2.92 times.
c. 11.85 times.
d. 3.57 times.

13. A company is considering the early retirement of its 10%, 10-year bonds payable. Before retiring
the bonds, the company's capital structure was

Current liabilities P125,000

Long-term liabilities: Notes payable (due in 5 years) 200,000
Bonds payable 300,000
Premium on bonds payable 25,000
Owner's equity: Common stock (P5 par value) 150,000
Paid-in capital in excess of par 50,000
Retained earnings 450,000

If the bonds can be retired at 103.5%, the

a. Return on owner's equity will decrease.

b. Asset turnover ratio will decrease.
c. Debt-equity ratio will increase.
d. Financial leverage will decrease.

14. For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will

a. Increase pre-tax profits by 3.5%.

b. Decrease pre-tax profits by 3.5%.
c. Increase pre-tax profits by 21%.
d. Increase pre-tax profits by 1.71%.

15. This year, an entity increased earnings before interest and taxes (EBIT) by 17%. During the same
period, net income after tax increased by 42%. The degree of financial leverage that existed
during the year is

a. 1.70
b. 4.20
c. 2.47
d. 5.90

16. The following information has been derived from a company’s financial statements:

Current Assets P640,000

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 Total Assets 990,000
Long-term Liabilities 130,000
Current Ratio 3.2

The company’s debt to equity ratio is

a. 0.5
b. 0.37
c. 0.33
d. 0.13

19. A small but growing product assembler has been able to profitably ride the ups and downs of
several economic cycles, largely due to its low level of long-term assets. The firm relies more
heavily on labor than its competitors and contracts for needed facilities only on a short-term lease
basis. Working capital is largely provided through short-term loans. Although the firm’s variable
costs are much higher than its competitors’ variable costs, its income is much less volatile. All of
the above factors are consistent with the firm having a lower level of financial and operating

a. Margin.
b. Liquidity.
c. Solvency.
d. Leverage.

20. If the ratio of total liabilities to equity increases, a ratio that must also increase is

a. Return on equity.
b. The current ratio.
c. Times interest earned.
d. Total liabilities to total assets.

Activity and Asset Utilization Ratios

21. The following information is for Ali Co. at its fiscal year end:
Liabilities P60,000
Equity 500,000
Shares of common stock and outstanding 10,000
Net Income 30,000

During the year, officers and directors exercised share options for 2,000 shares of stock at an
option price of P10 per share. What was the effect of exercising the share options?

a. Debt-to-equity ratio increased.

b. Earnings per share increased.
c. Asset turnover decreased.
d. No ratios were affected.

22. A company had P6 million in credit sales last fiscal year. The company’s beginning accounts
receivable balance was P1 million and its ending receivable balance was P1.25 million on its
year-end financial statements. If the industry average period for the collection of accounts

13
 receivables is 90 days, the company’s accounts receivable collection period is less than the
industry average by approximately

a. 60 days.
b. 68 days.
c. 52 days.
d. 22 days.

23. A company with an accounts receivable turnover of 8.1 would be most concerned if

a. A best practice analysis indicated an accounts receivable turnover of 13.0.

b. Last year’s days sales outstanding in receivables was 44.9.
c. The accounts receivable turnover for the industry was 10.4.
d. The company’s credit terms with vendors are net 30 days.

24. The year-end financial statements for Queen Bikes reflect the data presented as follows. Ten
percent of Queen’s net sales are in cash.

Year 1 Year 2 Year 3

Net Sales 1,500 units at P100 1,200 units at P100 1,200 units at P125
Ending Inventory 100 units at P50 100 units at P50 100 units at P50
Average Receivables P12,500 P12,000 P14,400
Net Income P18,750 P9,400 P26,350

Queen’s inventory turnover ratios for Year 2 and Year 3 are

a. 24 and 24, respectively.

b. 12 and 18, respectively.
c. 12 and 12, respectively.
d. 18 and 18, respectively.

25. A corporation computed the following items from its financial records for the current year:

Current ratio 2 to 1
Inventory turnover 54 days
Accounts receivable turnover 24 days
Current liabilities turnover 36 days

The number of days in the operating cycle for the current year was

a. 60
b. 90
c. 78
d. 42

26. Spotech Co.'s budgeted sales and budgeted cost of sales for the coming year are P212,000,000
and P132,500,000, respectively. Short-term interest rates are expected to average 5%. If Spotech
could increase inventory turnover from its current 8 times per year to 10 times per year, its
expected cost savings in the current year would be

a. P250,000
b. P331,250

14
 c. P82,812
d. P165,625

27. The assets of Moreland Corporation are presented below.

January 1 December 31
Cash P 48,000 P 62,000
Marketable securities 42,000 35,000
Accounts receivable 68,000 47,000
Inventory 125,000 138,000
Plant & equipment
(net of accumulated depreciation) 325,000 424,000

For the year just ended, Moreland had net income of P96,000 on P900,000 of sales. Moreland's
total asset turnover ratio is

a. 1.50.
b. 1.37.
c. 1.27.
d. 1.48.

Profitability Ratios

28. A firm is experiencing a growth rate of 9% with a return on assets of 12%. If the debt ratio is 36%
and the market price of the stock is P38 per share, what is the return on equity?

a. 7.68%
b. 9.0%
c. 12.0%
d. 18.75%

29. A company’s year-end selected financial data is shown below.

Year 2 Year 1
Current assets P250,000 P175,000
Total assets 600,000 500,000
Total liabilities 300,000 225,000
Net sales 200,000 150,000
Net income 75,000 60,000

The company’s rate of return on assets and rate of return on equity for Year 2 are

a. 12% and 22%, respectively.

b. 36% and 25%, respectively.
c. 13% and 25%, respectively.
d. 14% and 26%, respectively.

30. Selected financial data for the year is shown below:

Beginning of Year End of Year

Assets P9,600,000 P10,000,000
Liabilities P6,200,000 P6,800,000
Shares outstanding 1,400,000 1,500,000
Market Price per Share P2.40 P2.50

15
 Sales P22,000,000
Earnings before interest and taxes P1,700,000
Interest Expense P500,000
Tax Rate 40%

Using the above data the firm’s return on equity using the DuPont model is

a. 15%
b. 19%
c. 22%
d. 36%

31. A construction company is preparing to finalize the financial statements for the most recent year.
Results are sales of P690,000, cost of sales of P378,900, and administrative expenses of
P120,800. The controller has just found a sales invoice for a job completed on the last day of the
year. The revenue and related costs for the job have not yet been recorded in the accounting
system. The job’s revenues are P95,000 with costs totaling P65,000. What is the impact of this
job on year-end profitability?

a. A decrease in the company’s gross profit margin and an increase in the net profit
margin.
b. Increases in the company’s gross profit margin and net profit margin.
c. Decreases in the company’s gross profit margin and net profit margin.
d. An increase in the company’s gross profit margin and a decrease in the net profit
margin.

32. A company’s finished goods inventory was miscounted, and the correct balance is P130,000
lower. Management is concerned about correcting the error because bonuses are only earned if
the minimum gross profit margin is 45%. Selected financial information is shown below.

Revenues P1,000,000
Cost of goods sold 500,000
Salaries 57,000
Accounts receivable 22,000
Cash 43,000

With the corrected inventory, will the bonus target be met?

a. No, the working capital will decrease.

b. Yes, the gross profit margin will not change.
c. Yes, the gross profit margin will increase.
d. No, the cost of goods sold will increase.

33. A company reported the following financial data.

Sales P2,000,000
Cost of goods sold 800,000
Operating expenses 400,000
Interest expense 200,000
Income tax 300,000

The company’s operating profit margin percentage is

16
 a. 30%.
b. 80%.
c. 15%.
d. 40%.

Market Valuation Ratios

34. James Corporation reported earnings for calendar year 20X6 of P3 per common share based on
net income of P3,000,000 and 1,000,000 average shares of common stock outstanding. There
were 1,000,000 common shares outstanding on December 31, 20X6. In 20X7 the common stock
was split on a two-for-one basis, and a 20% stock dividend was distributed in 20X8. The Basic
EPS reported for 20X6 in the 20X9 annual report should be reported as:

a. P1.50.
b. P1.25.
c. P3.00.
d. P2.50.

35. At the beginning of the fiscal year, June 1, 20X0, Boyd Corporation had 80,000 shares of
common stock outstanding. Also outstanding was P200,000 of 8% convertible bonds that had
been issued at P1,000 par. The bonds were convertible into 20,000 shares of common stock;
however, no bonds were converted during the year. The company's tax rate is 34%, and the Aa
bond interest rate has been 10%. Boyd's net income for the year was P107,000. The diluted
earnings per share (DEPS - rounded to the nearest cent) of Boyd common stock for the fiscal
year ended May 31, 20X1 was:

a. P1.20
b. P1.18
c. P1.07
d. P1.12

36. Watson Corporation computed the following items from its financial records for the year
just ended:

Price-earnings ratio 12
Payout ratio 0.6
Asset turnover 0.9

The dividend yield on Watson's common stock is

a. 7.2%
b. 5.0%
c. 10.8%
d. 7.5%

37. At the end of its fiscal year on December 31, 20X0, Merit Watches had total shareholders' equity
of P24,209,306. Of this total, P3,554,405 was preferred equity. During the 20X1 fiscal year,
Merit's net income after tax was P2,861,003. During 20X1, Merit paid preferred share dividends
of P223,551 and common share dividends of P412,917. At December 31, 20X1, Merit had
12,195,799 common shares outstanding and the company did not sell any common shares during
the year. What was Merit Watch's book value per share on December 31, 20X1?

17
 a. P2.20.
b. P1.88.
c. P1.91.
d. P2.17.

38. A company has 100,000 outstanding common shares with a market value of P20 per share.
Dividends of P2 per share were paid in the current year and the company has a dividend payout
ratio of 40%. The price to earnings ratio of the company is:

a. 4
b. 50
c. 2.5
d. 10

39. Baylor Company paid out one-half of last year's earnings in dividends. This year, Baylor's
earnings increased by 20%, and the amount of its dividends increased by 15%. Baylor's dividend
payout ratio for the current year is

a. 78%
b. 47.9%
c. 57.5%
d. 50%

Profitability Analysis and Gross Profit Variation

40. A company has a net profit margin of 5%, an operating profit margin of 10%, and a gross profit
margin of 25%. Sales revenue is P5,000,000. Selling, general, and administrative expenses are
P750,000. What is the cost of goods sold?

a. P3,750,000.
b. P4,250,000.
c. P3,250,000.
d. P4,750,000.

41. Selected data from Sheridan Corporation's year end financial statements are presented below.
The difference between average and ending inventory is immaterial.

Current ratio 2.0

Quick ratio 1.5
Current liabilities P120,000
Inventory turnover (based on cost of goods sold) 8 times
Gross profit margin 40%

Sheridan's net sales for the year were

a. P1,200,000
b. P800,000
c. P480,000
d. P240,000

18
 42. The following information pertains to Bala Co. for the year ended December 31:
Sales P600,000
Income 100,000
Capital investment 400,000

Which of the following equations should be used to compute Bala’s return on investment?

a. (4/6) × (6/1) = ROI.

b. (6/4) × (1/6) = ROI.
c. (4/6) × (1/6) = ROI.
d. (6/4) × (6/1) = ROI.

43. A company’s Year 4 gross profit margin remained unchanged from Year 3. However, the
company’s Year 4 net profit margin increased from Year 3. Which one of the following could
explain the change from Year 3 to Year 4?

a. Preferred dividends increased.

b. Cost of goods sold decreased relative to sales.
c. Sales decreased at a faster rate than operating expenses.
d. Corporate income tax rates decreased.

44. Which one of the following actions undertaken by a technology company’s management will
adversely impact the quality of its earnings?

a. Using conservative estimates for the useful life of the company’s equipment.
b. Recording sales of software prior to installation and acceptance by customers.
c. Immediately expensing product research and development costs.
d. Estimating a low rate of return on the company’s pension plan assets.

45. Westland Corporation provided the following partial income statements and detailed information
for the past two years:

2021 2020 Changes

Sales P360,000 P240,000 P120,000
Cost of Sales 262,500 200,000 62,500
Gross Profit P 97,500 P 40,000 P57,500

Quantity sold 25% increase

Which is not correct applying the gross profit variation analysis?

a. Sales Price Variance is P60,000 favorable

b. Sales Volume Variance is P60,000 favorable
c. Cost Price Variance is P50,000 unfavorable
d. Cost Volume Variance is P50,000 unfavorable

19
Special Issues and Limitations of FS Analysis

46. A corporation’s inventory expressed as a percentage of current assets increased from 25% last
July to 35% this July. The factor that is least likely to cause this increase is that the corporation

a. Is a seasonal company with traditionally higher activity in the summer months.

b. Is beginning to experience high growth.
c. Has inventory that is becoming obsolete.
d. Used a material amount of cash from selling its short-term investments to purchase land.

47. Which of the following is true about the impact of price inflation on financial ratio
analysis?

a. Inflation has no impact on financial ratio analysis.

b. Inflation impacts comparative analysis of firms of different ages, but not financial ratio
analysis for one firm over time.
c. Inflation impacts financial ratio analysis for one firm over time, as well as comparative
analysis of firms of different ages.
d. Inflation impacts financial ratio analysis for one firm over time, but not comparative analysis
of firms of different ages.

48. A corporation's net income as presented on its income statement is usually

a. more than its economic profits because economists do not consider interest payments to
be costs.
b. equal to its economic profits.
c. more than its economic profits because opportunity costs are not considered in calculating
net income.
d. less than its economic profits because accountants include labor costs, while economists
exclude labor costs.

49. A corporation has the option to use either a shorter period or a longer period to amortize a patent,
and it can use either the declining-balance method or the straight-line method to depreciate a
fixed asset. The corporation would be considered to have better earnings quality if it uses the

a. shorter period to amortize the patent and the straight-line method to depreciate the fixed
asset.
b. longer period to amortize the patent and the straight-line method to depreciate the fixed
asset.
c. longer period to amortize the patent and the declining-balance method to depreciate the
fixed asset.
d. shorter period to amortize the patent and the declining-balance method to depreciate the
fixed asset.

50. All of the following are possible limitations in doing financial statements analysis except for:

a. Appropriate industry comparison may not exist

b. Management may influence ratios by taking short-term actions prior to preparing financial
statements
c. Inflation does not necessarily distort the interpretation of financial ratios
d. Differences in operating and accounting practices make comparisons difficult and
inaccurate

20
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