ANALYSIS OF FINANCIAL

STATEMENTS: TRADITIONAL
APPROACHES
Financial statement analysis

-is the process of selecting related data from financial statements to

evaluate the entity’s past financial position and operating performance and
predict the outcome of future operations.
The information provided in the financial statements, along with the other
information in the notes, assist users in predicting the entity’s future cash flows
and, in particular, their timing and certainty. The data can also reflect the
financial strengths and weaknesses of an entity.
The financial statements become more meaningful, understandable, and
relevant to the users if the pieces of information contained therein are analyzed
and interpreted. In most instances, the analysis of financial statements involves
the process of evaluating the trend of a particular accounting value in relation to
that of other accounting values. The movement of the other accounting values
that directly or indirectly affects a specific accounting value are considered.
The type of information provided by the financial statements focus primarily on the
following areas:
a. financial position
b. result of financial operation
c. cash flow
d. management stewardship of resources
The basic objectives of financial statement analysis is to assist the different users in
the decision-making process.
The following procedures may be adopted in analyzing financial statements:
1. establish the objective of the financial statement analysis
2. gather complete information about the firm and the industry in which the
firm operates
3. perform mathematical analysis using the applicable tools
4. make conclusion relative to the established objectives
 Objectives of Financial Statement
Analyses
Fundamentally, analyses are set to answer a wide-range of questions of users. These users have
diverse concerns, and objectives. Hence, they have different priorities. However, all these users have
common requirements where the very objective of financial statement analyses originate.
The analyses done aims to probe the company’s:
• Profitability. This pertains to the ability of the firm to yield a sufficient amount of return on
company sales assets and invested capital. It also refers to he firm’s capacity to generate
earnings vis-ἁ-vis its expenses and other relevant costs incurred during a specific period of
time.
• Liquidity and Stability. Liquidity is also referred to as working capital position or
short-term financial position. It is the ability of the firm to meet or pay its current or
short-term maturing obligation.
• Asset utilization or Activity. This pertains to how efficient the company is in managing its
resources. It also refers to the firm’s speed or pace in turning over accounts receivable,
inventory and long-term assets. This reveals the frequency of the firm in selling its products
or in collecting its receivable. In so far as fixed or long-term assets are concern, it reveals
how the company uses their fixed asset to yield revenue.
• Debt-utilization or Leverage. This pertains to the overall debt status of the company. It
measures the degree of how the firms is financed. The debt is evaluated using other
variables like assets, equity and earning power.
 Limitations of Financial Statement
Analyses
The primary purpose of financial statement analysis is to examine the present, as well as past, financial position
(SFP) and result of operation (Income Statement) of the firm in order to determine the best suitable estimate and
predict the future state and performance of the company. With this in mind, it would be fair to state that
interpretations of financial ratios are not ultimately conclusive. Results from the analysis are refutable.
In addition to this, the main object (the financial statement) used for the analysis is also subject to limitations.
These limitations, if not carefully considered, can ultimately bring about wrong decisions. The inherent limitations of
the financial statement among other things may stem from:
1. Its failure to consider changes in the purchasing power, inconsistencies as well as dissimilarities in the
accounting principles, policies and procedures used by the firms in the industry.
2. Its failure to consider changes in the purchasing power of currencies.
3. The age of financial statement is a limitation. The older it gets, the less reliable it becomes thus, considered as
a risk management tool.
4. Failure to read and understand the information in the Notes to the financial statements may obscure managers
in evaluating the degree of risk.
5. Financial statement that have not undergone external auditing procedures may or may not conform with the
Generally Accepted Accounting Principles (GAAP) and standard thus, usage of this statement may lead to
erroneous analysis, and ultimately erroneous decisions.
6. Financial statement that not have undergone external auditing
procedures may prove to be inaccurate or worse, fraudulent hence, do
not fairly present the company’s financial condition. Financial
measurement from the analysis of these companies are not dependable
and not conclusive.
7. Audited financial statements do not guaranty accuracy.
 Practical Steps Proposed in
Analyzing Financial Statement
These are the various ways by which the analysis of financial statements can be done. The following proposed
steps in carrying out the analysis may be used:
1. Determine which of the following objectives, just discussed, would be the coverage of the analysis. Is it to
evaluate profitability, liquidity, asset activity, or debt-utilization? Or are you going to evaluate all of
them?
2. As mentioned in the chapter prologue, the analysis may cover not only the subject firm but could involve
other firms belonging to the same industry. It would be wise to learn about the retrospective, current, as
well as the prospective conditions of the industry. Other external variables that may have a bearing or
significant effect on the industry may also be considered. This may include socioeconomic and political
variables. New laws or mandates, financial in nature, changing or modifying the industrial requirements
may also be considered. Knowledge of average prices, or market values of commodities, shares of stocks
and debt instruments in the industry may be considered.
3. Get to know the firm you are analyzing. Know their mission and vision. It may prove to have a bearing on
your financial analysis. Know their strategic plans. Know where the company wishes to be. Know their
current status in the industry. Know the company financial projections. Know all the things about the firm
which you consider relevant and may have a bearing on your analysis.
4. ASSESS/ANALYZE the financial statement. The analyses should cover the salient areas namely, the
profitability, liquidity or solvency, stability, and operational efficiency of the firm. One may employ the
following methods:
► Horizontal Analysis or also known as dynamic measure or trend ratios. This involves the
comparison and measurement of financial statement of two or more periods. This statements
showing both absolute (monetary amounts) and relative (percentage) changes, financial trends
for successive statements, and special analysis of absolute changes in the financial statement.
► Vertical Analysis or also known as static measure or structural ratios. This includes the
comparison of financial data for only one period. It involves comparing and establishing
relationship of the components of the financial statements. For instance, cash and all other
assets are individually compared to the liabilities and shareholders’ equity. Financial ratios for
the statement of financial position and/or income statement are done. Do common size
statements.
5. After finishing the “dirty” work of computing the trends and ratios, comes the more important task.
INTERPRET the results of the computations an ratios.
6. Draw CONCLUSIONS from the interpretations made in step five. The conclusion must take into
consideration the objectives you have set up in step number 1.
The methods of analyzing the financial statements
include the following:

1. Horizontal or comparative approach

2. Vertical or common-size approach
3. Trend approach
Horizontal or comparative approach
The horizontal or comparative analysis approach is an analytical tool that
evaluates the present performance of an entity compared to last year’s. The
analysis reflects the differences in absolute amount and in percentage between
two periods only, namely the present year and the previous year.
The primary objectives of horizontal or comparative analysis is to determine
the present status of the business particularly in terms of financial position,
result of operation, and cash flow against last year’s only.
Horizontal or comparative analysis is conducted on financial statements with
the same day and month (but of different years). The findings and evaluations
made on financial statements with different dates as to the day and month do
not provide meaningful information. Thus, horizontal or comparative analysis of
financial statements ending December 31,2018 with interim financial statements
ending June 30,2017 cannot be done. The financial statements ending December
31,2018 can be compared and evaluated against those ended December 31,2017.
Horizontal Analysis of Comparative
statement

Percentage of change = Amount of growth/reduction or change x 100

Amount in the base year or previous year

Evaluation of financial statement through horizontal analysis:
1. Liquidity and solvency
2. Stability or long-term financial position
3. Operating efficiency and profitability
Vertical Analysis using Common Size
Statements
Vertical analysis uses percentages/ratio that presents the relationship of the different
account or items in the financial statements. The analyst chooses the base figure or amount
equal to 100 percent and calculates each item percentage. For the statement of financial
position the base used is the total assets, and for the income statement the net sales or net
revenue is the base. In essence, vertical analysis present the relative size of an account or
item in proportion to the whole (which is the base). The outcome of the percentage is
presented in the common-size statement.
The common-size statements are sometimes called component percentage or 100 percent
statement.
Through the common-size statements, management can have a better understanding of
the changes to the total asses ( for SFP) or net sales/net operating revenue ( for income
statement) that have transpired from one period to the next. This statement also aids the
management to asses the financial position as well as the result of operation by comparing
their statement with other companies belonging in the same industry.
Practical Tips in Assessing the Financial Statement
1. The distribution or allocation of assets stated in percentage form is disclose in the
common-size statement of financial position. The percentages, which show the relationship of
an account to another (base), may also be compared to competitors belonging to the same
industry. This would help the analyst determine whether or not the firm has over or
under-invest in an item in the SFP.
2. This method would also show the firm’s capital structure by presenting the percentage
allocation of assets in terms of how much percent was borrowed and how much percent the
owners invested.
3. For working capital analysis, the current asset percentage may be compared with the current
liability percentage to ascertain the firm’s liquidity or solvency.
4. This method would also present the percentage relationship of sales to all other items in the
income statement. The cost of good sold ratio, the gross profit ratio and net profit ratio are
among the salient ratios revealed using the common-size statement. Doing a longitudinal
analysis of these ratios can help management improve efficiency in terms of controlling cost
and expenses and improving revenue.
Trend analyses

A more longitudinal and modification of the horizontal and vertical

analysis is the trend analysis. Under this method, the percentage
changes are determine for several successive periods instead of the
typical two-year period horizontal analysis. This method is more
thorough than the garden-variety two-year period horizontal analysis
because it presents a view in the long run of the company’s progression
or regression as the case maybe. Items not seen in the two-year period
analysis may surface in a longer based study such as the trend analysis.
In computing the trend, the base period (oldest year) amounts are
written as 100%. The percentage relationship of each account in the
statements is then computed by dividing each amount by the base year
figure. A trend is then determined by comparing percentage
relationships. Based on the trends, interpretation, conclusions, and
implications are drawn.