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Chapter 5

Financial StatementAnalysis

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Nature

Year-to-year comparisons and trend analyses areuseful in understanding an organizations performance.

But as the size of an organization changes, year-to-year comparisons of peso amounts can be misleading.Comparisons with competing organizations of differentsizes are also difficult to interpret with only pesoamounts. Thus, to adjust to size differences, analysts

and accountants have developed common-sizefinancial statements.

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Common-size financial statements

Translate peso amounts to percentages, which indicatethe relative size of an item in proportion to the whole.

Common-size balance sheets show assets,liabilities and owners equity as a percentage of total

assets.

Common-size income statements - express revenueand expenses as a percentage of sales revenues.

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Purposes

Common-size statements which are also known ascomponentpercentage or 100 percent statementsenable analyst to:

Comprehend or visualize the changes in individualitems that have taken place from year to year inrelation to the total assets, total liabilities and ownersequity or total net sales.

Compare statements of two or more companies orstatement of one company with the statements for anentire industry and evaluate their current financialposition and operating results.

Point out efficiencies and inefficiencies that mightotherwise go unnoticed.

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Conversion Procedures

For the balance sheet, each item therein is converted topercent by dividing it by total assets.

In the income statement, each item is restated as apercentage of net sales or net operating revenue bydividing the former by the latter.

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Balance Sheet

Guidelines in the Interpretation ofCommon-size Statements

A common-size balance sheet shows the percent oftotal assets that has been invested in each type or

kind of asset. These percentages may be comparedwith those of a competitor or the industry todetermine whether or not the firm has over orunderinvested in one or more of its assets.

The common-size statement will also show thedistribution of liabilities and equity, i.e..the sources ofthe capital invested in the assets.

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The percentage of current assets may also berelated to the percentage of current liabilities to

determine debt-paying capacity of the company.Income Statement

The common-size income statement shows the amountor percentage of the sales that has been absorbed byeach individual cost or expense item and the

percentage that remains as net income. A comparison of year-to-year income statement

common-size ratios will show whether a larger orsmaller relative amount of net sales was used to meetparticular costs or expenses. These percentages mayalso be compared with a competitors statements todetermine in order effect a higher profit margin.

Comparison of the gross profit percentages from yearto year may also reveal success or failure in thecompany efforts to increase efficiency in theprocurement and merchandizing policies ,etc.

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Illustrative Problem 5.1

Financial StatementAnalysis Using

Common-size Statement

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Items December 31ASSETS 2002 2003 2004 2005 2006Current Assets

Cash 2.6 4.3 4.0 4.7 5.2Marketable securities 9.7 2.9 2.7 2.5 2.8Trade & receivable, net 24.1 14.9 15.6 17.1 18.2Inventory 18.2 16.1 16.4 17 15.8Other Current Assets 5.6 3.7 3.5 3.3 2.2

Total Current Assets 60.2 41.9 42.2 44.6 44.2Land,building & equipment, net 39.4 50 46.8 45.3 44.9Other assets 0.4 8.1 11 10.1 10.9

Total Assets 100.0 100.0 100.0 100.0 100.0LIABILITIES AND EQUITYCurrent Liabilities

Accounts payable 17.3 13.3 11.7 9.6 10.0Notes Payable 5.2 7.7 6.0 3.9 2.7Other current liabilities 6.8 1.4 1.7 2.2 1.8

Total current liabilities 29.3 22.4 19.4 15.7 14.5Long-term Liabilities(4%) 15 19.5 16.3 14.5 12.5

Total Liabilities 44.3 41.9 35.7 30.2 27.0Equity

Share Capital (P100 par) common 39.2 38.5 42.0 39.3 38.7Capital paid in excess of par value 6.5 8.8 10.8 10.1 10.0Retained Earnings 10.0 10.8 11.5 20.4 24.3

Total Equity 55.7 58.1 94.3 69.8 73.0Total Liabilities & Equity 100.0 100.0 100.0 100.0 100.0

Percent (%)

Gilbert CompanyComparative Balance Sheet-Common-Size Percentages

As of December 31

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Gilbert CompanyComparative Income Statement-Common-Size Percentages

For the Years Ended December 31, 2002 to 2006

Percent2002 2003 2004 2005 2006

Net Sales 100.0 100.0 100.0 100.0 100.0Cost of goods sold 73.1 73.0 71.7 71.9 70.9Gross Margin on Sales 26.9 27.0 28.3 288.1 29.3Operating expenses

Selling expenses 13.5 13.5 15.2 15.7 17.0General and administrative 5.8 6.3 6.6 6.1 6.2expenseTotal Operating expenses 19.3 19.8 281. 21.8 23.2

Operating income 7.6 7.2 6.5 6.3 6.1Other income and expenses, (1.2) (1.00 (1.1) (0.80 (0.5)

net (deduct)Income before taxes 6.4 6.2 5.4 5.5 5.6Less: Income taxes 3.0 3.1 2.7 2.0 2.1Net Income 3.4 3.1 2.7 3.5 3.5

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The Gilbert Companys balance sheets showed thatthere had been substantial changes in the proportions ofcurrent and fixed assets and current and long-termliabilities during the period from Dec. 31, 2002 to Dec.31, 2006. the percentages showed a declining liquidity in

the companys assets accompanied by a consistentreduction in liabilities over the five-year period.

It can be observed that Cash Balance and accountsreceivable as a percentage of total assets had beenincreasing while investment in inventory in relation tototal assets had been decreasing. Considering that thevolume of sales was increasing, these changes can beviewed as beneficial to the company.

Evaluation of the Financial Position

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Selling expenses in relation to sales however, showincreasing percentages from 2002 to 2006 while

administrative expenses had more or less remainedconstant. Better control over the selling expensesshould be instituted to further improve theprofitability of the company.

Decrease in the percentage of other expenses tonet sales is traceable to the decreasing amount ofnotes payable and long-term debts.

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Is a comparison in fraction, proportion, decimal orpercentage form of two significant figures takenfinancial statements. It expresses the directrelationship b/w two or more quantities in the balancesheet and income statement of business firm.

Financial Ratio Analysis

Purpose

Through ratio analysis, the financial statements usercomes into possession measures w/c provide insight

into the profitability of operations, the soundness of thefirms short-term and long-term financial condition andthe efficiency with w/c management has utilized theresources entrusted to it.

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Ratios must be used only as financial tools, that is, asindicators of weakness or strength and not to beregarded as good or bad per se.

Financial ratios are generally computed directly fromthe companys financial statements, without

adjustment. Conventional financial statementsprepared in accordance w/ GAAP have a number ofweakness that managers must consider if the ratios areto be meaningful.

Ratios are composite of many different figures somecovering a time period, others are instant time and stillothers representing averages.

Limitations of Financial Ratios

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Ratios to be meaningful should be evaluated with theuse of certain yardsticks. The most common of these

are: Company's own experience (prior years)

Other companies in the same industry (industryaverages)

A standard set by management ( a budget)

Rules of thumbFinancial Ratio Analysis

Liquidity ratios are ratios that measure the firmsability to meet cash needs as they arise( payment ofaccounts payable, bank loans and operating costs)

Activity ratios - are ratios that measure the liquidity ofspecific assets and efficiency in managing assets suchas accounts receivable, inventory and fixed assets.

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Leverage ratios are ratios that measure theextent of the firms financing, with debt relative to

equity and its ability to cover interest and otherfixed charges such as rent and sinking fundpayments

Profitability ratios are ratios that measure the

overall performance of the firm and its efficiencymanaging assets, liabilities and equity.

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Illustrative Problem 5.2

Financial RatioAnalysis

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2006 2005Assets

Current AssetsCash 2030.5 11981.0Marketable securities 2636.0 4002.0Accounts Receivable 4704.0 48383.5Allowance for doubtful accounts -224.0 -208.5Inventories 25520.5 18384.5Prepaid expenses 256.0 379.5

Total current assets 32923.0 28132.0Property, Plant, Equipment

Land 405.5 405.5Buildings and leasehold improvements 9136.5 5964.0Equipment 10761.5 6884.0

20303.5 13523.5Less Accum. Depreciation & amortization -5674.0 -3765.0Net property, plant,equipment 14539.5 9488.5

Other Assets 186.5 334.0Total Assets 47649.0 37488.5

EBC Enterprises, Inc.Balance Sheet at December 31, 2006 and 2005

(In thousands)

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Liabilities and EquityCurrent Liabilities

Accounts payable 7147.0 3795.5notes payable 2807.0 3006.0current maturities of long-term debt 9842.0 758.0Accrued liabilities 2834.5 2656.5

Total Current liabilities 13730.5 10216.0Deferred Income Taxes 421.5 317.5

Long -term debt

10529.5

8487.5

Total Liabilities 24681.5 19021.0Equity

ordinary shares par value P 1, authorized10,000,000 shares; issued 2,297,000 shares in2006 and 2,401,500 shares in 2005 2401.5 2297.0Additional paid- in capital 478.5 455.0Retained earnings 20087.5 16181.5

Total Equity 22967.5 18933.5Total Liabilities and Equity 47649.0 37954.5

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2006

2005

2004

NetSales 107,800.0 76,500.0 70,350.0Cost of Goodssold 64,682.0 45,939.5 40,803.0

Gross Profit 43,118.0 30,560.5 29,547.0

Selling and Administrative expenses 16,332.0 13,191.0 12,749.0Advertising 7,129.0 5,396.0 47,770.5Lease Payments 6,529.0 3,555.5 3,633.5Depreciation and amortization 1,999.0 1,492.0 1,250.5Repairs and maintenance 1,507.5 1,023.0 1,515.5

Total 33,496.5 24,657.5 23,919.0Operating Profit 9,621.5 5,903.0 5,628.0

EBC Enterprises, Inc.Income Statement and Retained Earnings

Fro the Years Ended December 31, 2006, 2005, and 2004

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Other income (expenses)Interest income 211.0 419.0 369.0interest expense (1,292.5) (1,138.5 ) (637.0 )

Earnings before income taxes 8,540.0 5,183.5 5,360.0

Income taxes 3,843.0 2,228.5 2,412.0Net Income 4,697.0 2,955.0 2,948.0

Earnings per common share 2.0 1.29 1.33Statements of retained EarningsRetained earnings at beginning of year 16,181.5 14,157.5 13,130.0Net Income 4,697.0 2,955.0 2,948.0Cash dividends (2006-0.33 per share;2005-0.41 per share) (791.0) (931.0) (920.5 )Retained earnings at the end of year 20,087.5 16,181.5 14,157.5

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Summary of mostCommonly Used Ratios :

Their Formulas and BasicSignificance

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Ratios Used To Evaluated Short-Term Financial Position

( Short-Term Solvency And Liquidity )

NAME FORMULA SIGNIFICANCECurrent Ratio total current assets primary test of solvency to meet current

total current liabilities obligations from current assets as agoing concern; measure of adequacy ofworking capital

Acid-test ratio or total quick assets a more severe test of immediate solvencyquick ratio total current liabilities test of ability to meet demands

from current assetsWorking capital working Capital indicates relative liquidity of total assetsto total assets total assets and distribution of resources employed

Working capital current assets lesscurrent liabilities

Cash flow liquidity ratio Cash + marketable securities+ measures short-term liquidity by consideringcash flow from operating activities as cash resources (numerator)cash plus cash

current liabilities flow from operating activities

Defensive interval ratio quick assets measures length of time in days the firm can projected daily operational expenses operate on its present liquid resources

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NAME FORMULA SIGNIFICANCEtrade receivable

turnover net credit sales velocity of collection of trade accountsandaverage tradereceivable(net) notes;test of efficiency of collection

average collection period ornumber of day's 360 days evaluates the liquidity of accountssalesuncollected receivable turnover receivable and firm's credit policies

oraccounts receivable

net sales/360inventoryturnovera) merchandize turnover cost of goods sold measures efficiency of the firm

ave.merchandize inventory in managng and selling inventoriesb) finished goods inventory cost of goods sold

ave. finished goodsinventory

Ratios Used To Evaluate the Asset Liquidityand Management Efficiency

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c) goods in processturnover cost of goodsmanufactured measures efficiency of thefirm in managing

ave.goods-in process

inventory and selling

inventories

raw materials usedd) raw materialsturnover number of times rawmaterials inventoryaverage raw materials

inventory was used and replenishedduring the periode) days supply ininventory 360 days measures average number ofdays to sell

inventory turnover or consume in the averageinventory

working capital turnover net salesindicates adequacy and

activity

ave. working capital of workingcapitals

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percent of each amount of each currentassets indicates relative investment incurrent assets to total current assets each current asset

total current assets

current assetsturnover cost of sales + measures movement and utilization

operating expenses + of current resources to meet

income taxes + operating requirementsother expenses (net)

(excluding depreciationand amortization)

ave. current assetspayable turnover net purchases measure efficiency of the company in

average accounts payable meeting trade payableoperating cycle average conversion measures the length of time required

period of inventories + to convert cash to finished goods;average collection period

of then to receivable and then back tocashreceivable + days cash

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Free cash flow net cash from operatingactivities excess of operating cash flowless cash used for investing over basic needs

activities and dividendsinvestment or net sales measures efficiency of the firm

assets turnover ave. total investment in managing all assetsor total assets

sales to fixed assets net sales tests roughly the efficiency of(plant assets

turnover) ave. fixed assets management in keeping plantproperties(net) employed

capital intensity ratio total assets measures efficiency ofnet sales the firm to generate sales through

employment of its resources

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NAME FORMULA SIGNIFICANCEDebt Ratio total liabilities shows proportion of all assets

total assets that are financed with debt

Equity ratio total equity indicates proportion of assetsprovidedtotal assets by owners. Reflects financialstrength

and caution to creditors

Debt to equity ratio total liabilities measures debt relative toamountstotal equity of resources provided byowners

Ratios Used To Evaluate Long-Term Financial Position OrStability/Leverage

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Fixed Assets to fixed assets (net) reflects extent of investment inlong-term liabilities total long-term liabilities long-term assets financed from

long-term-term debtFixed assets to fixed assets (net) measures the proportion of

total equity total equity owner's capital invested in fixedassets

fixed assets to fixed assets (net) measures investment in long-termtotal equity total Assets capital assets

book value per shareof ordinary shareholder'sequity measures recoverable amount intheordinary shares no. of outstanding event of liquidation if assets arerealized

ordinary shares at their book values

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times interest earned net income before measures how many timesinterestinterest and taxes expense is covered by operatingprofit

annual interest chargestitmes prefered

dividend net income after taxes indicates aboilty to providedividendsrequirement earned preferred dividends req. for preference shareholderstimes fixed changes

earned net income before taxes measures coverage capabilitymoreand fixed charges broadly than times interest

fixed charges earned by including other fixedcharges(rent+interest+

sinking fund paymentbefore taxes

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NAME FORMULA SIGNIFICANCE

Gross profit margin gross profit measures profitgeneratednet sales

after considering of cost

of product sold

Operating profitmargin Operating profit measures profit generated after

net sales consideration of operating profits

Net profit margin net profit measures profit generated after(rate of return on net

sales net sales consideration of allexpensesand revenues

Ratios Used To Measure Profitability AndReturns To Investors

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Cash flow margin Cash flow for measures ability of the firm totranslateoperating activities sales to cash

net salesRate of return on

assets (ROA) Net Profit measures overall efficiency of thefirmAve. Total Assets in managing assets andgenerating profits

alternative formula:asset turnover

x

net profit marginRate of return on

equity net income measures rate of return onresourcesave. ordinary equity

provided byowners

Earnings per share net income lesspreference peso return on each ordinaryshare.dividends requirement indicative of ability to paydividendsave. ordinary shares

outstanding

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Price/earnings ratio market value per share measures relationshipb/wof ordinary shares price of ordinary sharesin the

earnings per share ofordinary open market and profit earned onpershares share basis

Dividend Payout dividend per share shows percentage of earnings paidtoearnings per share shareholders

Dividend Yield Annual Dividends pershare shows the rate earned byshareholdersmarket value per share of from dividends relative to current

ordinary shares price of stock

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net income + (interest expense (1 - Tax rate))average total assets

ROE = return on assets x equity multiplierEquity multiplier = 1 /Equity Ratio

If there is interest-bearing debt, rate of return on assetsis computed as follows:

a measure of theproductivity ofassets regardlessof how the assets

are financedmay also be computed as follows:

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Dividends per share Dividends Paid/Declared Shows portion income distributedOrdinary shares

outstanding to shareholders on a per sharebasis

Rate of return onaverage Net Income Measures theprofitability of

current assets Ave. Current Assets current assets investedRate of return per

turnover Rate of return on Shows profitability of eachturnover

of current assets

Ave. current assets of current

assets

Current Assets turnover

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Financial Ratios Analysis

I. Analysis of Liquidity or Short-Term Solvency

II. Analysis of Asset Liquidity and Asset ManagementEfficiency

III. Analysis of Leverage : Debt Financing and Coverage

IV. Operating Efficiency and Profitability

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Current Ratio is widely regarded as a measureof short-term debt-paying ability.

Quick or Acid test ratio is a much more rigorous

test of a companys ability to meet in short termdebts.

Cash flow liquidity ratio considers cash flowfrom operating activities in addition to the truly liquid

assets, cash and marketable securities.

I. Analysis of Liquidity or Short-TermSolvency

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Accounts Receivable Turnover roughlymeasures how many times a companys accounts

receivable have been turned into cash during theyear.

Average Collection Period helps evaluate theliquidity of accounts receivable and the firms

credit policies.

Inventory Turnover measures the efficiency ofthe firm in managing and selling inventory.

II. Analysis of Asset Liquidity and Asset

Management Efficiency

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Average sale period the number of days being

taken to sell the entire inventory one time, iscomputed by dividing 365 days by the inventoryturnover period.

Fixed Asset Turnover is another approach toassuring managements effectiveness in

generating sales from investments in fixed assetsparticularly for a capital-intensive firm.

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Debt Ratio measures the proportion of allassets that are financed with debt.

Debt Equity Ratio measures the riskiness of thefirms capital structure in terms of relationship

between the funds supplied by creditors (debt) andinvestors (equity).

III. Analysis of Leverage : Debt Financingand Coverage

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Times interest earned ratio is the most common

measure of the ability of a firms operations toprovide protection to long-term creditors.

Fixed Charge Coveragemeasures the firmscoverage capability to cover not only interest

payments but also the fixed payment associatedwith leasing which must be met annually.

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Gross Profit Margin which shows the relationshipbetween sales and the cost of products sold,measures the ability of a company both to controlcosts and inventories or manufacturing of products

and to pass along price increases through sales tocustomers.

Operating Profit Margin is a measure of overalloperating efficiency and incorporates all of theexpenses associated with ordinary or normal

business activities

IV. Operating Efficiency and Profitability

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Net Profit Margin measures profitability after

considering all revenue and expenses, includinginterest, taxes and non operating items such asextraordinary items, cumulative effect ofaccounting change, etc.

Cash Flow Margin is another important measureor perspective on operating performance.

ROA and ROE are two ratios that measure theoverall efficiency of the firm in managing its totalinvestment in assets and in generating return toshareholders.

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Summary ofFinancial

Statements

Analysis of EBC,Inc.

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Short term liquidity analysis is of particularsignificance to trade and short-term creditors,management and other parties concerned with theability of a firm to meet near- term demands for

cash.EBCs current and quick ratios decreased indicating a

deterioration of short-term liquidity. However, thecash flow liquidity ratio improved in 2006 after a

negative cash generation in 2005.

Short Term Liquidity and Activity

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The average collection period for accounts receivableand the inventory turnover improved in 2006 which

could indicate improvement in the quality ofaccounts receivable and liquidity of inventory. Theincrease in inventory level has been accomplishedby reducing holdings of cash and cash equivalents.This represents a trade-off of highly liquid assets forpotentially less liquid assets. The efficientmanagement of inventories is critical for the firmsongoing liquidity.

Presently, there appears to be no major problems withthe firms short-term liquidity position.

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The debt ratios for EBC show a steady increase I theuse of borrowed funds. Total debt has increasedrelative to total assets, long term debt hasincreased as a proportion of the firms permanentfinancing and external or debt financing has risen

relative to internal financing.Why has debt increased? The statement of cash flows

shows that EBC has substantially increased itsinvestment in capital or fixed assets and theirinvestments have been financed largely byborrowing especially in 2005 when the firm had arather sluggish operating performance and nointernal cash generation.

Long-Term Solvency

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Given the increased level of borrowing the timesinterest earned and fixed charge coverage

improved slightly in 2006. these ratios shouldhowever be monitored closely in the futureparticularly if EBC continues to expand.

As noted earlier, EBC has increased its investment infixed asset as a result of store expansion. Theasset turnover in 2006, the progress traceable to

improved management of inventories andreceivable. There has been substantial sale growthwhich suggests future performance potential.

Operating Efficiency and Profitability

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The gross profit margin was stable, a positive sign inthe light of new store openings featuring discounted

and sale items to attract customers. The firm alsomanaged to improved its operating profit margin in2006 principally due to the firms ability to controloperating costs. The net profit margin alsoimproved despite increased interest and taxexpenses and a reduction in interest income frommarketable security investment.

Return on assts and return on equity increasedconsiderably in 2006. these ratios measure the

overall success of the firm in generating profits fromits investment and management strategies.

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It appears that EBC Enterprises, Inc. is well positionedfor future growth. Close monitoring the firmsmanagement of inventories is important consideringthe size of the companys capital tied up in it. Theexpansion in their operation may necessitate a

sustained effort to advertised more, to attractcustomers to both new and old areas. EBC hasfinanced much of its expansion with debt, and so far,its shareholders have benefited from the use of debt

through financial leverage. The company shouldhowever be cautious of the increased risk associatedwith debt financing.

Conclusion

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REVIEW QUESTIONS

1. What is the basic purpose for examining trends in acompanys financial ratios and other data? What otherkinds of comparisons might an analyst make?

2. In financial analysis , why does analyst compute

financial ratios rather than simply studying raw financialdata? What are the limitations in the use of ratios?

3. Assume that two companies in the same industry haveequal earnings. Why might these companies havedifferent price-earnings ratios? If a company has a

price-earnings ratio of 20 and reports earnings pershare for the current year of P4, at what price would youexpect to find the stock selling on the market.

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True or False

1. The asset turnover rate multiplied by the rate of netincome earned on sales equals the rate on totalassets.

2. If the information were available, financial analystswould be interested in knowing the sales volumevolume at the break-even point for a businessenterprise.

3. If the amount of current assets exceeds the

amount of current liabilities, a decrease in currentassets with a corresponding decrease in currentliabilities increases the current ratio.

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Bienna MarieBSBA II

Preparedby: