ANALYSIS AND

INTERPRETATION OF
FINANCIAL STATEMENTS
ANALYSIS AND INTERPRETATION OF
FINANCIAL STATEMENT
Analysis of financial statements requires
computation of financial ratios whereas interpretation
demands explanation of the significance of such
ratios. Several rules are suggested by academicians
to be observed when conducting analysis and
interpretation of financial statements. Ignoring these
rules may lead to incorrect or inaccurate
interpretation and conclusion.
ANALYSIS AND INTERPRETATION OF
FINANCIAL STATEMENT
The following are data about Google’s progress.
They depict a three-year trend of revenues and
research and development (R&D).
 01
METHODS OF
ANALYSIS
METHODS OF ANALYSIS
There are two main ways to analyze financial
statement.
1. Horizontal Analysis which provides a year-to-
year comparison of a company’s performance in
different periods.
2. Vertical Analysis, is the standard way to
compare different companies.
HORIZONTAL ANALYSIS
The study of percentage changes in comparative
statements is called horizontal analysis. Computing a
percentage change in comparative statements
requires two steps:
1. Compute the monetary amount of the change from
the earlier period to the later period.
2. Divide the monetary amount of change by the
earlier period amount. We call the earlier period the
base period.
HORIZONTAL ANALYSIS
Illustration: Google Inc.
Google reports revenues. Horizontal analysis is
illustrated for Google Inc. as follows (dollar amounts in
millions):
HORIZONTAL ANALYSIS
Illustration: Google Inc.
Step 1: Compute the dollar amount of change in sales
from 2003 to 2004:

2004 2003 Increase

$3,189 - $1,466 $1,723
HORIZONTAL ANALYSIS
Illustration: Google Inc.
Step 2: Divide the dollar amount of change by the
base-period amount. This computes the percentage
change for the period.

Percentage Dollar amount of change $1,723

= = = 1.175 = 117.5%
change Base − year amount $1,466
HORIZONTAL ANALYSIS OF SCI
HORIZONTAL ANALYSIS OF SFP
TREND PERCENTAGES
These are a form of horizontal analysis. Trend indicate
the direction a business is taking. Trend percentages
are computed by selecting a base year. The base-year
amounts are set equal to 100%. The amounts for each
following year are expressed as a percentage of the
base amount. To compute trend percentages, divide
each item for following year by the base-year amount.
𝐴𝑛𝑦 𝑦𝑒𝑎𝑟 $
Trend % =
𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 $
TREND PERCENTAGES
Illustration: Caterpillar Inc.
TREND PERCENTAGES
You can perform a trend analysis on any item
you consider important. Trend analysis is widely used
to predict the future.
VERTICAL ANALYSIS
Vertical analysis of a financial statement shows
the relationship of each item to its base amount, which
is the 100% figure. Every other item on the statement
is then reported as a percentage of that base. For an
income statement, revenue or net sales is the base.
𝐸𝑎𝑐ℎ 𝑖𝑛𝑐𝑜𝑚𝑒 𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡 𝑖𝑡𝑒𝑚
Vertical Analysis % =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 (𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠)
VERTICAL ANALYSIS OF SCI
VERTICAL ANALYSIS OF SFP
 02
FINANCIAL
RATIOS
FINANCIAL RATIOS
Aside from measuring the profit or loss and the
growth in the proprietor’s capital, financial statements
also help assess the business’s…
1. Liquidity
2. Solvency or stability
3. Profitability.
FINANCIAL RATIOS
FINANCIAL RATIOS
FINANCIAL RATIOS
1. Liquidity Ratios
Liquidity pertains to the capability of the business
to meet payments for its short-term debt. It also means
the ability to convert noncash current assets into cash.
LIQUIDITY
a. Working capital
Working Capital is defined as:
LIQUIDITY
a. Working capital
LIQUIDITY
b. Current Ratio
The most widely used ratio is the current ratio,
which is current assets divided by current liabilities.
The current ratio measures ability to pay current
liabilities with current assets.
LIQUIDITY
b. Current Ratio
LIQUIDITY
c. Acid-Test Ratio
The acid-test (or quick) ratio tells us whether
the entity could pay all its current liabilities if they came
due immediately. To compute the acid-test ratio, we
add cash, short term investments, and net current
receivables and divide this sum by current liabilities.
Inventory and prepaid expenses are not included in
the acid-test because they are least liquid current
assets.
LIQUIDITY
c. Acid-Test Ratio
LIQUIDITY
d. Accounts Receivable Turnover
Accounts receivable turnover measures the
ability to collect cash from credit customers. The
higher the ratio, the faster the cash collections. But a
receivable turnover that is too high may indicate that
credit is too tight, causing the loss of sales to good
customers. To compute accounts receivable turnover,
divide net credit sales by average net accounts
receivable.
LIQUIDITY
d. Accounts Receivable Turnover
LIQUIDITY
e. Inventory Turnover
Inventory turnover measures the number of
times a company sells its average level of inventory
during a year. A high turnover indicates ease in selling
inventory; a low rates indicates difficulty. A value of 6
means that the company sold its average level of
inventory six times – every two month – during the
year. To compute inventory turnover, we divide cost of
goods by the average inventory for the period.
LIQUIDITY
e. Inventory Turnover
LIQUIDITY
f. Operating Cycle
The operating cycle of a business is the number
of days it takes to convert inventory into cash. To
compute operating cycle, we add collection period and
average age of inventory.
LIQUIDITY
f. Operating Cycle
FINANCIAL RATIOS
2. Solvency or Stability Ratios
In terms of solvency or stability ratio, the
questions asked by the long-term creditors and the
proprietor pertain to the ability of the company to pay
the regular amortizations of interest and to repay the
principal on maturity date.
SOLVENCY AND STABILITY
a. Times-Interest-Earned Ratio
Analysts use the times-interests-earned ratio to
relate income to interest expense. This ratio is also
called interest-coverage ratio. It measures the number
of times operating income can cover interest expense.
A high interest-coverage ratio indicates ease in paying
interest expense; a low ratio suggests difficulty. To
compute this ratio, we divide income from operations
(operating income) by interest expense.
SOLVENCY AND STABILITY
a. Times-Interest-Earned Ratio
SOLVENCY AND STABILITY
b. Debt Ratio
Debt ratio shows the proportion of assets
financed with debt. To compute this ratio, we divide
total liabilities by total assets. If the debt ratio is 1, then
all assets are financed with debt. A debt ratio of 0.50
means that debt finances half the assets; the owners
of the business have financed the other half. The
higher the debt ratio, the higher the company’s
financial risk.
SOLVENCY AND STABILITY
b. Debt Ratio
SOLVENCY AND STABILITY
c. Equity Ratio
If the percentage of assets comes from the
owner, then it is equity ratio.
SOLVENCY AND STABILITY
c. Equity Ratio
SOLVENCY AND STABILITY
d. Debt-to-equity Ratio
Debt-to-equity Ratio shows the proportion of
liabilities to owner’s equity in financing company
resources.
SOLVENCY AND STABILITY
d. Debt-to-equity Ratio
SOLVENCY AND STABILITY
e. Equity to Debt Ratio
Equity-debt Ratio refers to the proportion of
owner’s equity to debt since these two items constitute
the company’s capital structure.
SOLVENCY AND STABILITY
e. Equity to Debt Ratio
SOLVENCY AND STABILITY
f. Debt to Capitalization Ratio
Ratio of total debt to capitalization (long-term
debt + equity) is the ratio that gives the degree of
significance of long-term debt as part of the business
capitalization.
SOLVENCY AND STABILITY
f. Debt to Capitalization Ratio
FINANCIAL RATIOS
3. Profitability Ratios
In contrast to liquidity and solvency or stability
ratios, profitability ratios assess the efficiency of the
business in generating profits from its assets. The
proprietor must benchmark its profit ratios with rival
companies in the industry to better assess his or her
business’ performance.
PROFITABILITY
a. Gross Profit Margin Ratio
Gross profit margin refers to the ratio of gross
profit to either net sales/ net revenues or cost of sales.
This ratio is applicable to a merchandising business
wherein management efficiency is assessed in setting
up the selling price and managing the cost of its
products.
PROFITABILITY
a. Gross Profit Margin Ratio
PROFITABILITY
b. Rate of Return on Net Sales
In business, the term return is used broadly as a
measure of profitability. Consider a ratio called the rate
of return on sales, or simply return on sales. This ratio
shows percentage of each sales earned as net
income.
PROFITABILITY
b. Rate of Return on Net Sales
PROFITABILITY
c. Rate of Return on Total Assets
The rate of return on total assets, or simply
return on assets, measures success in using assets to
earn a profit. The sum of interest expense and net
income is thus the return to the two groups that have
financed the company’s assets.
PROFITABILITY
c. Rate of Return on Total Assets
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