Financial

Statements: Tools for

Decision-making
Dr. Mary Joy Catipay-Teodosio, LPT
 The Analytical Process
• Financial analysis – deals with the understanding of the
relationship between financial concepts and daily
decision-making.
• “Financial analysis is both analytical and a judgmental
process which helps answer questions that have been
carefully posed in a managerial context.” Helfer, 1994
• The end purpose of financial analysis is to help people
make sound decisions and judgments.
 Suggested points to review and consideration before
any financial analysis task is started (Helfert, 1994)

1. What is the exact nature and scope of the issue to be analyzed? Has the
problem and its relative importance in the overall business context been
clearly spelled out, including the relevant alternatives to be considered?
2. Which specific factors, relationships, and trends are likely to be helpful
in analyzing the issue? What is the order of their importance? In what
sequence should they be addressed?
3. Are these possible ways to obtain a quick “ballpark” estimate of the
likely result to help decide on (a) what critical data and steps might be
and (b) how much effort should be spent on refining these?
4. How precise an answer is necessary in relation to the
importance of the problem itself? Would additional
refinement be worth the effort?
5. How reliable are the available data? How is this
uncertainty likely to affect the range
6. What limitations are inherent in the tools to be applied?
How are these likely to affect the range of results? Are the
tools chosen truly appropriate to the problem?
7. How important are qualitative judgments in the context
of the problem? What is the order of their significance?
What analytical steps might be obviated by such
considerations?
 The Analytical Process
• Effective financial analysis is more than mere
manipulation of financial data.
• Economic trade-offs between benefits and costs are
always involved in any financial or economic decision.
• All businesses have a common goal – profit maximization
to increase owner’s wealth and company value.
• Trade-offs must be effectively and efficiently managed on
a consistent basis to achieve long-run profitability.
 Basic Decision Areas

• Operation
• Investment
• Finance
 Operating Decision
• It deals with the day-to-day operations/activities of the
firm. This includes decisions that are relevant to pricing,
selecting markets, choosing appropriate production
processes and technology, outsourcing payroll,
outsourcing maintenance, and janitorial services among
others.
• Operating leverage – involves the determination of the
profitable level and the proportion of fixed costs of
operation versus the amount and nature of variable costs
(changes with volume) incurred in manufacturing, trading,
and service operations.
 Operating Decision
• The financial analyst uses operating ratio as well as
determines variances between budget and actual
performance.
• Break-even analysis is used to determine the volume of
business a company needs to reach where the income
equals expenses.
 Investing Decision
• It refers to deciding what assets to acquire, be they current assets as
marketable securities or non-current assets as property, plant, or equipment
and long-term investments in stocks and bonds.
• Current available resources and new funding obtained can be utilized to
fund:
1. Working capital – it is equal to current assets minus current liabilities,
working capital budget
2. Property, Plant, and Equipment – these are non-current assets of the firm,
capital budgeting
3. Major Spending Programs
 Financing Decision
• It refers to decision that involves funding investment and operations over the
long run.
• It includes decisions that relate to the company’s capital structure, debt-equity
mix, funding resources, dividend policies, cost of capital, among others.
• Management has to decide whether borrowing directly from a bank, issuing
bonds, or issuing stock is the best and most fitted means of financing a certain
need.
• Financial analyst use profitability ratios such as ROI (return on investment),
ROA (return on assets), price-earnings ratios, and value per share, which are
all important to stockholders and potential investors and long-term creditors.
 Steps in Analyzing the Financial
Statements
1. Understanding the information provided in the financial statements
- full understanding of the information contained in the financial statements is
essential for one to be able to draw conclusion and make logical decisions
2. Drawing logical conclusion based on the data presented
3. Making the appropriate decision on the course of action to take
- The manager or user of the financial statements is now able to determine the
course of action to take to correct what needs correction and the steps
necessary to redirect company efforts toward the goals that the company has
set to achieve.
 Horizontal Analysis
• Analysis of the financial statements can be done
comparatively to show performance and financial
condition in prior years as compared to the current year.
• This reveals if the profitability and the financial condition
of the firm are improving or not.
• Trend analysis – involves analysis of significant changes in
absolute amounts and percentages, including an analysis
of changes in the ratios used in ratio analysis.
 Horizontal Analysis
• Comparative Income Statement
- it shows the changes that occur in the different elements
of the income statement in absolute money value and
percentage of increase/ (decrease) to see if the performance
of the company is improving or not.
• Comparative Balance Sheet
 Vertical Analysis
• It refers to the type of analysis where one number is
compared to another to identify significant relationships.
• Common-size statements or percentage analysis – is a
type of ratio analysis that shows relationship between
items in a single statement, either in the balance sheet or
in the income statement.
- it shows the percentage relationship of an element of
the financial statement to a significant total amount in the
financial statement.
 Ratio Analysis
• It basically shows two types of relationships:
1. relationships within one period as done in common-size
statements
2. relationships between periods
 Profitability Ratios
1. Return on Owner’s Investment (ROI)
2. Profit Margin/ Return on Sales (ROS)
3. Return on Assets (ROA)

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 Return on Owner’s Investment
(ROI)
• Means return on owner’s equity; hence, it is sometimes
referred to as ROE.
• It relates income or profit after income tax to the total
stockholder’s equity, preferably on the average
stockholders’ equity.

ROI = Income After Income Tax

Average Stockholders’ Equity
 Profit Margin/Return on
Sales (ROS)
• The ratio of income to net sales

Profit Margin = Income

Net Sales
 Return on Assets (ROA)
• This is to show how effectively the company has utilized
its assets. It is a measure of asset utilization.

ROA = Income
Average Total Assets
 Liquidity Ratio
• It focuses on the current assets and current liabilities of
the firm.
• It refers to the ability of the firm to meet its current
obligations.
1. Current Ratio
2. Quick Ratio (Acid-Test Ratio)
3. Working Capital
 Current Ratio
• It relates current assets to current liabilities and shows
the immediate solvency and liquidity of a firm.
• It tells how much current assets is available to meet the
current liabilities.
• If the current ratio is 2:1, it means the company has Php2
worth of current assets to meet every peso of current
liability.
Current Ratio = Current Assets
Current Liabilities
 Quick Ratio (Acid-Test Ratio)
• It uses only the “quick assets,” the more liquid assets
(those that can easily be converted into cash; hence,
inventories and prepaid expenses should not be included
because it may take some time to convert inventories into
cash for they generally converted into receivables first
before being converted to cash upon collection.
Quick Ratio = Quick Assets
Current Liabilities
 Working Capital
• It is not a ratio but the excess of current assets over
current liabilities, it is a special measure of short-term
debt-paying ability, much like the current ratio.
• It referred to as net working capital because others use
current assets to mean working capital.
Working Capital = Current Assets – Current Liabilities
 Limitations of Financial
Statements Analysis
1. Data are reported at historical costs.
2. Data are all in monetary terms.
3. Financial statements use estimates.
4. Financial statements use judgments.
5. Financial statements are interim in nature.
6. Financial statements assume stable monetary unit.