Overview of Financial Statement Analysis

Accounting is a language of business and communicates through the financial statements. Financial statements provides you a  summary of all the things relating to financial figures and related non-financial information relevant and material to the users of the same. It will provide you information about the properties owned by the business, obligations owed, capitalization made by the owners, results of operations during the period, sources and uses of cash during the period, and related supporting computations. These details are vital to the management and are not decorations, but, is there is for a purpose in understanding about the past, making good the present, and, preparing for the future.

Financial statements are required to be certified by the independent certified public accountant (CPA) to determine whether they are prepared in accordance with the Philippine Financial Reporting Standards (PFRS). It will be filed with the Securities and Exchange Commission (SEC) and or as attachment to the annual income tax return (ITR) to be filed with the Bureau of Internal Revenue (BIR). Of course you will pay for the services of the CPA and as such, it would be best if you will use the same not only for government regulatory compliance. Aside from compliance, audited financial statements could bring more benefits and advantages. Analyzing financial statements could provide you a number of advantages, such as the following:

  1. Your appraisal of its operations with the new policies and strategies implemented;
  2. Your determination of the strength and weaknesses of  your business entity’s financial figures that you may optimize opportunities and remedy weaknesses to prevent wasting of assets and resources;
  3. Your reference in determining its industry position in relation to that of competitors and industry players; and,
  4. As reference for new policies and enhancements in securing the efficiency and effectiveness of future operations.

Your analysis of the audited financial statements could normally be made in three (3) ways – horizontal analysis, vertical analysis, and ratio analysis. You will need a basic calculator but do not worry because computations are simple subtraction, addition, division, and multiplication only. You can easily compute the figures with the aid of readily available formulas, but won’t stop there because you need to give meaning or interpretation on each figure or a combination of figures inter related.

Horizontal analysis

In horizontal analysis, you determine the difference of similar account titles of at least two taxable years measuring the same in terms of peso difference, and in terms of percentage. As such, you need audited financial statements for at least two (2) accounting years – the current year for the later year, and the base year for the older year. You will compute for the peso difference of an account title by subtracting the amount of the base year from the current year (current year less base year figure). If the current year is higher, it is termed as increase and expressed in positive figure, while if the base year is higher, then, the same is termed as decrease and expressed in negative or enclosed in parenthesis.

After you compute for the the increases and decreases in terms of peso and percentages, you will now determine the implications and this is the more challenging part as it will call for the deeper application of your understanding of the interrelation of accounts, and financial accounting in general. An increase in one account may indicate an advantage or a disadvantage.

Example, cash and cash equivalents increased by P2,000,000 or 60% as compared to base year. One, this is an advantage because this means that the current year provides more cash as compared to the base year. However, you have to trace the source of the increase through the cash flow statement, sales, and collections. If the increase in cash came from collections of current sales or even from past due accounts, then, it would be good. If it came from loans or additional investments from the stockholders or investors, then, it may be a negative indication. Also, if the amount seems to be material and will just stay on business vaults, then, the business might be foregoing interest income opportunities and to improve, you may consider investing cash in excess of working capital requirements.

 As you can see, figures are empty without being backed up by your good analysis. You can do this to other accounts.

Vertical analysis

In vertical analysis, you express each account title in the financial statements as a percentage of a base amount-net sales for statement of comprehensive income, total assets for statement of financial condition, total stockholder’s equity for statement of changes in equity, and total cash generated by operating, financing, or investing activities for statement of cash flows. In short, you will apply vertical analysis on a single taxable year, but of course you can do a comparative one for more taxable years. After you determine the percentage of an account in relation to the base figure, you now determine the reasonableness of such account.

Example: Cash accounts for 20% of the total assets. Would this be reasonable, or would this be unreasonable? You may relate the same to industry percentages. If you say reasonable, then, you can maintain in the succeeding years, otherwise, you may improve the same in the succeeding years.

So you will now understand that having so much cash in business is not an advantage. Instead of keeping stagnant cash, you can invest them in income generating accounts like stock exchange, time deposits, loans to subsidiaries for working capital requirements for interest, or at least a savings account for a minimal interest rates.

Ratio analysis

In ratio analysis, you will compute percentages or ratios based on prescribed formulas tending to establish three (3) major areas – profitability, ability to pay obligations maturing in 12 months – liquidity, or ability to pay obligations maturing long-term or solvency. There could be more areas in addition to the three that some analysts would use depending on the area of concentration and preferences. Again, to determine if such percentage is good, you may relate it with the industry percentage or from within the company itself. Of course, your understanding of the meanings of the ratio itself is necessary to determine the advantages to the company. Hereunder are some of the the common ratios.

Liquidity – determines how capable your business in paying obligations that will mature soon.

  • Current ratio
  • Acid-test ratio

Solvency – determines how capable your business in paying obligations that will mature in long-term.

  • Debt-to-asset ratio
  • Debt-to-equity ratio

Profitability – determines how profitable your business operations in several aspects.

  •  Earnings per share (EPS)
  •  Return on assets (ROA)
  • Return on equity (ROE)

The above are only sample ratios and there could be a lot other rations that could be derived depending on the area of preference of the analyst.

Summary

Financial statement analysis is so much fund and is exciting because it drags you understanding of the relationship of the  accounts in your financial statements. It is a good mental exercise for you and it will give you a better appreciation of how to do best in your business operations to more or less, bring out best results in your financials.

 

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Disclaimer: This article is for general conceptual guidance only and is not a substitute for an expert opinion. Please consult your preferred tax and/or legal consultant for the specific details applicable to your circumstances.


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