Lesson 2.1 & 2.2: Financial Analysis
Lesson 2.1 & 2.2: Financial Analysis
Lesson 2.1 & 2.2: Financial Analysis
If we look at the illustration below showing the line items in a Statement for Financial
Position, all line items on the FS can be subjected to horizontal analysis. Try computing
for peso change and percentage change using the formulas given and check if you will
arrive at the same amounts.
Vertical Analysis
➢ a technique that expresses each financial statement item as a percentage of a base
amount
➢ also called common-size analysis
The formula to be used in analysis is:
When doing vertical analysis on the Statement of Financial Position, the base amount is
Total Assets. In the Statement of Comprehensive Income, the base amount is Sales.
The illustration below shows the line items in a Statement for Financial Position and
their corresponding common size for the current and prior years. If we take the account
'Trade and Other Receivables' to compute for common size, we divide the balance of the
account which is P240,000 by the base which is total assets amounting to P1,793,000.
We have 240,000 ÷ 1,793,000 = 0.13 or 13%. Try dividing other account balances to the
base and see if you arrive at the common size stated below.
The use of common-size financial statements allows the comparison of two companies
of different sizes. This is because the SFP and SCI comparative information are
standardized as a percentage of assets and sales, respectively. Common-size statements
used in analysis are statements where available figures are not peso amounts but
percentages only.
Ratio analysis is a quantitative analysis technique applied by an entity to be able to
assess the company’s liquidity, solvency, operational efficiency (stability) and
profitability through scrutiny of account balances reported in the Statement of Financial
Position and Statement of Comprehensive Income. A financial ratio is composed of a
numerator and a denominator but it can be expressed in terms of a percentage, a rate, or
a simple proportion.
The financial ratios used in business are generally grouped into these categories:
1. Liquidity ratios
2. Solvency Ratios
3. Operational Efficiency Ratios
4. Profitability Ratios
In the sample computations that will follow, we will use the data from Financial
Statements below.
Liquidity Ratios determine whether an entity has the ability to use current assets to
pay for current liabilities as they become due.
1. Current Ratio is used to evaluate the company’s liquidity. It seeks to measure
whether there are sufficient current assets to pay for current liabilities. If the
current ratio is greater than 1, it means that the business can pay its current
liabilities using its current assets. Creditors normally prefer a current ratio of 2.
2. Acid Test/ Quick Ratio is a stricter measure of liquidity. It does not consider
all the current assets, only those that are easier to liquidate such as cash and
accounts receivable, marketable securities and accounts receivable are referred to
as quick assets. If the quick ratio is greater than 1, it means that the business'
quick assets can cover for its current liabilities.
3. Cash Ratio is the strictest measure of liquidity. If the cash ratio is greater than
1, it means that the business' total cash can pay for all current liabilities.
The table below shows the formula for these ratios and the sample computation for
each:
Solvency Ratios determine whether an entity has more ownership than debts. It is
also called leverage ratios and these ratios involve comparisons of debt, asset, equity and
interest.
1. Debt Ratio indicates the percentage of the company’s assets that are financed
by debt. A high debt to asset ratio implies a high level of debt. If Debt Ratio is
greater than 50%, this means that assets are financed more by debt.
2. Debt to Equity Ratio indicates the company’s reliance to debt or liability as a
source of financing relative to equity. A high ratio suggests a high level of debt
that may result in high interest expense.
3. Times Interest Earned Ratio measures the company’s ability to cover the
interest expense on its liability with its operating income. Creditors prefer a high
coverage ratio to give them protection that interest due to them can be paid.
The table below shows the formula for these ratios and the sample computation for
each:
All the ratios in this lesson are summarized in the table below.
Debt to Equity
Acid Test Ratio Inventory Turnover Return on Assets
Ratio