Fundamentals of

Accountancy, Business and

Management 2

ACADEMIC SUBJECT
(GRADE 12 FIRST
SEMESTER)

MODULE 5
 ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
INTRODUCTION

Business owners are busy with the day-to-day operations of running a business to
the extent of ignoring any company financial statement analysis. In general, an analysis
of Financial Statements is vital for persons running a business because this analysis tells
the business owners where they stand in their financial environment.

Analysis of Financial Statements is the selection, evaluation, and interpretation of

financial statements data, along with other pertinent information, to assist in investment
and financial decision-making and to show how and where to improve the performance
of the business.

The analysis of Financial Statements is an evaluation of:

 A firm’s past financial performance

 Its prospects for the future

Business owners can use company financial analysis both internally and
externally. They can use them internally to examine issues such as employee
performance, the efficiency of operations and credit policies. They can use them
externally to examine potential investments and the credit worthiness of borrowers,
among other things.

MEASUREMENT LEVELS

Financial ratios are one of the most common tools of managerial decision making.
A ratio is a comparison of one number to another - mathematically, a simple division
problem. Financial ratios involve the comparison of various figures from the financial
statements in order to gain information about a company’s performance. It is the
interpretation rather than the calculation, that makes financial ratios a useful tool for
business managers. Ratios may serve as indicators, clues, or red flags regarding
noteworthy relationships between variables used to measure the firm’s performance in
terms of profitability, asset utilization, liquidity, leverage, or market valuation.

Traditionally financial statements analysis focuses on the following key areas:

1. Liquidity

- it is the simplest ratio. It is measured using working capital and five ratios:
current ratio, acid test or quick ratio, accounts receivable turnover, inventory turnover,
and operating cycle.
 Working capital is the difference of current assets and current liabilities. It shows
the cycle from accounts payable or accounts receivable to cash.

Current ratio refers to the capability of the entity to settle its current liabilities by
using its current assets.

Acid test or quick ratio is the ability to pay current liabilities with the assets that
are most readily convertible into cash.

Accounts receivable turnover is the number of times that receivables on credit

sales are collected. It measures the efficiency of credit and collection procedures.

Inventory turnover is the number of times that inventory is sold during the
accounting period. It indicates whether the company holds excessive stocks of inventory.

Lastly, operating cycle of the business is the number of days it takes to convert
inventory into cash.

2. Solvency or Stability Ratios

- ability of the company to pay the regular amortizations of interest and to repay
the principal on maturity date. It is assessed through the times interest earned ratio, debt
ratio, equity ratio, debt-to-equity ratio, and ratio of total debt to total capitalization.

Times interest earned ratio is the ability to source interest payments from net
profits in regular business operations. It is computed by dividing net profit before interest
expense and income taxes bu annual interest expense.

Debt services or coverage ratio measures whether earnings or net profit before
interest expense is sufficient to cover interest and principal payments on long-term debt.

Debt ratio, on the other hand, shows the percentage of assets provided by
creditors.

Equity ratio is the percentage of assets comes from the owner.

Debt-to-equity ratio shows the proportion of liabilities to owner’s equity to debt

since these two items constitute the company’s capital structure.

Lastly, ratio of total debt to total capitalization is the ratio that gives the degree
of significance of long-term debt as part of the business capitalization.

3. Profitability

- it 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/her business’s performance. Different profit ratios are used to assess the
various components of the company’s net income or loss.

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. Focusing downward in the SCI, gross margin is the remaining proportion
of net sales that can absorb operating expenses of the business.
 Return on sales or net profit margin is equal to the ratio of net profit after taxes
to net sales or revenues. It gives the remaining profits of the business after deducting all
expenses and income taxes. This ratio is crucial to a business for its continuity as a going
concern.

Return on assets, on the other hand, is computed as the ratio of net profit after
taxes to total assets. Similar to net profit margin, the numerator here is the net profit after
all expenses and taxes; however, the denominator is total assets. Return on assets
measures net profit generated from total assets.

Return on equity is equal to the ratio of net profit after taxes to owner’s equity.
Return on equity shows the profits accruing to the owner of the business. Thus, the owner
should focus on this ratio in order to maximize his/her wealth.

Horizontal and Vertical Analyses of Financial Statements

A business owner can use several methods to check the financial health of the
business. The most used methods are:

1. Horizontal Analysis - it analyzes the trend of the company’s financial over a period of
time. Each line item shows the percentage change from the previous period.

2. Vertical Analysis - it compares the relationship between a single item on the Financial
Statements to the total transactions within one given period. It also shows the percentage
of change since the last period. It can be performed on both an Income Statement and a
Balance Sheet.

Application of Financial Analyses and Their Interpretation on Sample Financial

Statements

Given the following financial statement, prepare an analysis using financial ratios.

Kleene Car Park

Statement of Financial Position

As of December 2021 and 2020

Account 2021 2020

Assets

Current Assets:

Cash P 294 500 P 460 500

Accounts Receivable 38,000 29,000

Prepaid Expenses 65,000 35,000

Total Current Assets 497 500 524 500

Non-current Assets: 1 211 000 1 315 500

Total Assets 1 708 500 1 840 000

Liabilities and Owner’s Equity

Current Liabilities:

Trade and Other Payable 230 000 225 000

Non-current Liabilities:

Loans Payable 475 000 725 000

Total Liabilities 705 000 950 000

Clinton, Capital 1 003 500 890 000

Total Liabilities and Owner’s Equity 1 708 500 1 840 000

Kleene Car Park

Statement of Comprehensive Income

For the Year Ended 31 December 2021 and 2020

Account 2021 2020

Revenues:

Parking Fees P 1 705 700 P 1 760 700

Car Wash and Cleaning 89 700 50 700

1 795 400 1 811 400

Expenses:

Rent 595 700 595 500

Salaries 295 700 275 700

Depreciation 110 200 110 200

Utilities 111 200 108 250

Supplies 80 700 85 700

Insurance 55 700 70 700

Advertising 60 200 45 700

Taxes and Licenses 80 700 90 700

Repairs and maintenance 11 200 3 700

1 401 300 1 386 350

Operating Income 394 100 425 050

Interest Expense 130 500 0

Net Income P 263 600 P 425 050

A. Liquidity Ratios

1. Working Capital = Current Assets - Current Liabilities

Year Working Capital

2021 497 500 - 230 000 = 267 500

2020 524 500 - 225 000 = 299 500

Note: The business is liquid in both years.

2. Current ratio = Current Assets / Current Liabilities

Year Current Ratio

2021 497 500 / 230 000 = 2.61

2020 524 500 / 225 000 = 2.33

3. Acid Test Ratio = Quick Assets / Current Liabilities

Year Acid Test Ratio

2021 432 500 / 230 000 = 1.88

2020 489 500 / 225 000 = 2.18

4. Accounts Receivable Turnover - Net Credit Sales / Average Accounts Receivable

Accounts Receivable Turnover = 1 795 400 / (38 000 + 29 000) / 2

= 53 times

Note: There is a high receivable turnover which increases the profits of the
company.

5. Inventory Turnover = Cost of Sales / Average Inventory

None for this company because It it not a merchandising business.

6. Operating Cycle = Collection Period (days) + Average Age of Inventory (days)

Note: Collection Period = 365 days / Accounts Receivable Turnover

Average Age of Inventory = 365 days / Inventory Turnover

None for this company because It it not a merchandising business.

B. Solvency or Stability Ratios

1. Times Interest Earned Ratio = Net Profit before Interest and Income Taxes

Annual Interest Expense

= 394 100 / 130 500

= 3 times

Note: The interest coverage ratio is high. It assures long-term creditors that both
interest and principal can be settled by the company.

2. Debt-Service Coverage Ratio = Net Profit before Interest

Payments on Principal and Interest

Year Debt-Service Coverage Ratio

394 100
2021 =1.04׿
130500+(725 000 −475 000)

2020 Not applicable. No interest/principal payments

3. Debt Ratio = Total Liabilities / Total Assets

Year Debt Ratio

2021 705 000 / 1 708 500 = 0.41

2020 950 000 / 1 840 000 = 0.52

4. Equity Ratio = Owner’s Equity / Total Assets

Year Equity Ratio

2021 1 003 500 / 1 708 500 = 0.59

2020 890 000 / 1 840 000 = 0.49

5. Debt-to-Equity Ratio = Total Debt / Owner’s Equity

Year Debt-to-Equity Ratio

2021 705 000 / 1 003 500 = 0.70

2020 950 000 / 890 000 = 1.07

6. Equity-Debt Ratio = Owner’s Equity / Total Long-term Debt

Year Equity-Debt Ratio

2021 1 003 500 / 475 000 = 2.11 times

2020 890 000 / 725 000 = 1.23 times

7. Debt to Capitalization Ratio = Total Debt / Total Long-term Debt + Equity

 Year Debt to Capitalization Ratio

2021 705 000 / (475 000 + 1 003 500) = 0.48

2020 950 000 / (725 000 + 890 000) = 0.59

C. Profitability Ratios

1. Gross Profit Margin Ratio = Gross Profit // Net Revenue or Net Sales

or Gross Profit / Cost of Sales

None for this illustration because it is a service business.

2. Return on Sales or Net Profit Margin Ratio = Net Profit after Taxes / Net Revenue or
Net
Sales

Year Return on Sales or Net Profit Margin Ratio

2021 263 600 / 1 795 400 = 15%

2020 425 050 / 1 811 400 = 23%

3. Return on Assets = Net Profit after Taxes / Total Assets

Year Return on Assets

2021 263 600 / 1 708 500 = 15%

2020 425 050 / 1 840 000 = 23%

4. Return on Equity = Net Profit after Taxes / Owner’s Equity

Year Return on Equity

2021 263 600 / 1 003 500 = 26%

2020 425 050 / 890 000 = 48%

Using the same data for Kleene Car Park, Presented below is the horizontal analysis.

Kleene Car Park

Statement of Financial Position - Horizontal Analysis

31 December 2021 and 2020

Account 2018 2017 Amount Percentage

Assets
Current Assets:
Cash 394 500 460 500 (66 000) (14%)
Accounts Receivable 38 000 29 000 9 000 31%
Prepaid Expenses 65 000 35 000 30 000 86%
497 500 525 500 (27 000) (5%)
Non-current Assets 1 211 000 1 315 500 (104 500) (8%)
Total Assets P1 708 P1 840 (131 500) (7%)
 500 000
Liabilities and Owner’s Equity
Current Liabilities:
Trade and Other Payable 5 000 2%
Non-current Liabilities: 230 000 225 000
Loans Payable (250 000) (34%)
Total Liabilities 475 000 725 000 (245 000) (26%)
Clinton, Capital 705 000 950 000 113 500 13%
Total Liabilities and Owner’s 1 003 500 890 000 (131 500) (7%)
Equity P1 708 P1 840
500 000

Note: Decrease in loans payable was significant at 34% and contributed to the 7%
declined in total assets.

Kleen Car Park

Statement of Comprehensive Income - Horizontal Analysis

For the Year Ended 31 December 2021 and 2020

Account 2021 2020 Amount Percentage

Revenues:
Parking Fees P1 705 700 P1 760 700 (P55 000) (3%)
Car Was and Cleaning 89 700 50 700 39 000 77%
Total Revenues 1 795 400 1 811 400 (16 000) (0.88%)
Expenses:
Rent 595 700 595 700 0 0
Salaries 295 700 275 700 20 000 7%
Depreciation 110 200 110 200 0 0
Utilities 111 200 108 250 2 950 3%
Supplies 80 700 85 700 (5 000) (6%)
Insurance 55 700 70 700 (15 000) (21%)
Advertising 60 200 45 700 14 500 32%
Taxes and Licenses 80 700 90 700 (10 000) (11%)
Repairs and Maintenance 11 200 3 700 7 500 203%
Total Expenses 1 401 300 1 386 350 14 950 1%
Net Operating Income 394 100 425 050 (30 950) (7%)
Interest Expense 130 500 0 130 500 -
Net Income P263 600 P425 050 (161 450) (38%)

Note: The decrease in revenues by 0.88% and increase in expenses by 1% plus the
interest expense of P130 500 contributed to the 38% decrease in net income.

Below is the vertical analysis of Kleen Car Park

Kleene Car Park

Statement of Financial Position - Vertical Analysis
31 December 2021 and 2020
Account 2021 2020
Assets
Current Assets:
Cash 23% 25%
Accounts Receivable 2% 2%
Prepaid Expenses 4% 2%
Non-current Assets 71% 71%
Total Assets 100% 100%

Liabilities and Owner’s Equity

Current Liabilities:
Trade and Other Payable 13% 12%
Non-current Liabilities:
Loans Payable 28% 40%
Total Liabilities 41% 52%
Clinton, Capital 59% 48%
Total Liabilities and Owner’s Equity 100% 100%

Note: As a service business, a major portion of the company’s assets are non-current
asset-property and equipment. In 2021, after payment of a huge portion of a long-term
liability, the owner’s equity rose to 59% from 48% in 2020.

Kleene Car Park

Statement of Comprehensive Income - Vertical Analysis
For the Year Ended 31 December 2021 and 2020
Account 2021 2020
Revenues:
Parking Fees 95% 97%
Car Was and Cleaning 5% 3%
Total Revenues 100% 100%
Expenses:
Rent 33% 33%
Salaries 16% 15%
Depreciation 6% 6%
Utilities 6% 6%
Supplies 4% 5%
Insurance 3% 4%
Advertising 3% 3%
Taxes and Licenses 4% 5%
Repairs and Maintenance 1% 0.20%
Total Expenses 76% 77.2%
Net Operating Income 24% 22.8%
Interest Expense 7% 0
Net Income 17% 22.8%

Note: For 2021, a sizeable portion of expenses is rent at 33%. Interest expense is
substantial at 7%. Net income declined to 17% of total revenues due to the huge interest
expense.
 MODULE 5 IN FUNDAMENTALS OF ACCOUNTANCY BUSINESS AND
MANAGEMENT 2

NAME: SECTION:

ACTIVITY

A. Answer questions 1 - 3 based on the following information:

Cash P90 000 Furniture and Equipment P80 000

Notes Receivable 54 000 Accounts Payable 252 000
Accounts Receivable 288 000 Accrued Expenses 26 000
Inventories 600 000 Unearned Income 10 000
Prepaid Expenses 12 000 Mortgage Payable 80 000

1. How much is the net working capital?

2. What is the current ratio?

3. What is the quick ratio?

B. Answer questions 4 - 6 based on the following information:

Account Begging Balance Ending Balance

Accounts Receivable P200 000 P250 000
Inventory 125 000 75 000
Sales (all on Credit) 180 000 180 000
Cost of Sales 66 2/3 of sales 66 2/3 of sales
Number of working days 360 360

4. What is the accounts receivable turnover?

5. What is the inventory turnover?

6. What is the operating cycle?

C. Answer questions 7 - 11 based on the following information:

Account Beginning Balance Ending Balance

Total Assets P450 000 P430 000
Mr. O, Capital 140 000 180 000
Sales 255 000 255 000
Sales Returns and Allowance 5 000 5 000
Cost of Sales 80% of net sales 80% of net sales
Expenses (including depreciation
Of P4 000) 20 000 20 000
Interest Expense 8 000 8 000
7. What is the gross profit rate based on sales?

8. What is the gross profit rate based on cost?

9. What is the return on sales or net profit margin ratio?

10. What is the return on sales?

11. What is the return on equity?

D. Answer questions 12 - 16 based on the following information:

Current Liabilities P25 000

*4% Long-term Note Payable 175 000
Mr. O, Capital, ending balance 300 000
Net Profit 77 000
Interest Expense 7 000

*The note payable is payable in 5 equal annual installments.

12. What is the debt ratio?

13. What is the equity-debt ratio?

14. What is the debt-equity ratio?

15. What is the number of times interest is earned?

16. What is the debt-service coverage ratio?