Notes: Financial Statement Analysis (Unit 5)

Unit 5: Interpreting and Analyzing Financial Statements

• This unit covers techniques for interpreting and analyzing financial statements to support decision-making.
• It emphasizes two primary comparative methodologies: vertical analysis and horizontal analysis, along with an introduction to ratio analysis.
• The material uses a mix of explanations, examples, and practice tasks focused on a single proprietorship (ABM_FABM12-Ig-h-13).

Introduction

• Purpose of financial statements: not only to report data but to provide information users can analyze to make sound decisions.
• Financial statement analysis provides a more comprehensive view of a business’s financial health and performance.
• The lesson introduces methods of financial statement analysis and highlights how insights can help a business grow.

Learning Objectives

• Define financial statement analysis in business.
• Perform the steps required in vertical and horizontal analysis.
• Explain the importance of vertical and horizontal analysis.
• Competency: Perform vertical and horizontal analyses of financial statements of a single proprietorship.

Quick Look (Illustrative Idea)

• Analyzing expenses and allowances over time using a month-to-month comparison demonstrates how presenting data side-by-side clarifies changes.
• Example (conceptual): Compare two months’ spending to identify which items increased or decreased and how much of the budget is consumed by each item in the second month.
• Key takeaway: Using a common denominator (e.g., total allowance) helps in understanding relative emphasis and planning future spending.

Learn the Basics

• Financial statement analysis is the process of evaluating a company’s financial statements for decision-making purposes.
• It uses indicators and ratios to relate one amount to another (as a decimal or percentage).
• Meaningful analysis requires comparison to baselines such as desired results, previous results, other companies, or industry norms.
• Goals: determine whether performance is better, worse, or as expected; support decisions to improve liquidity, profitability, etc.
• Two main comparative methodologies:
  • Vertical analysis: analyzes each line item as a percentage of a base figure within the same statement.
  • Horizontal analysis: analyzes changes across periods (monetary and percentage changes).
• Ratio analysis (not deeply covered here) separates performance metrics for each statement and enables data merging across accounts.

Financial Statement Analysis (Overview)

• Definition: Analyzing a company’s financial statements for decision-making purposes to assess past, current, and future performance.
• Users: Internal and external stakeholders use the same methodologies (horizontal, vertical, and ratio analysis).
• Horizontal analysis:
  • Compares specific financial information from one period to another to identify trends.
  • Changes can be shown in monetary terms and/or percentages.
  • Also called trend analysis.
• Vertical analysis:
  • Each line item is presented as a percentage of a base figure within the same statement (e.g., total income or total assets).
  • Also called common-size analysis.
  • Facilitates cross-company and cross-time comparisons and helps assess profitability and expense structure.
• Ratio analysis:
  • A quantitative way to evaluate liquidity, efficiency, and profitability.
  • Useful for benchmarking against industry averages.
  • Detailed steps are covered in the next lesson.

Horizontal Analysis

• Definition: Calculation of monetary and/or percentage changes from one period to the next for items on the financial statements.
• Purpose: To analyze trends and observe direction and magnitude of changes across periods.
• Base concept: Use a base year or base period for comparison.
• Key formulas:
  • Monetary change (Peso change):
    $ext{Change (Peso)} = ext{Current Year} - ext{Base Year}$
  • Percentage change:
    $ext{Percentage Change} = \frac{ ext{Current Year} - ext{Base Year}}{ ext{Base Year}} \times 100\%$
• Closer Look (Illustrative Example):
  • Suppose total income for 2020 is ₱167,000 and for 2021 is ₱203,000.
  • Monetary change: $₱203{,}000 - ₱167{,}000 = ₱36{,}000$
  • Percentage change: $\frac{₱36{,}000}{₱167{,}000} \approx 21.6\%$
• Practical use: Identify which line items drive overall revenue or expense changes and by how much (monetary and/or percentage).

Closer Look: Horizontal Analysis (Emilia Santos Case)

• Emilia Santos Car Rental Services (three-year data: 2019, 2020, 2021)
• Revenue (Rent Income) and Total Income:
  • 2019: ₱87,115
  • 2020: ₱91,811
  • 2021: ₱98,000
• Horizontal analysis using 2019 as base year (illustrative):
  • 2020 change: ₱4,696; 5%
  • 2021 change: ₱10,885; 12%
• Expenses (Salaries and Wages, Electricity & Water, Rent, Depreciation) show varying changes across years; the summary shows how net income changes from ₱15,444 (2019) to ₱42,992 (2021) due to shifts in both revenues and expenses.
• Takeaway: Horizontal analysis can reveal significant shifts in expense structure (e.g., depreciation and salaries) that impact profitability.

Vertical Analysis

• Definition: Each line item is shown as a percentage of a base figure within the same statement (e.g., as a % of total income).
• Purpose: Facilitate comparison across companies and time by standardizing line items.
• Base figures:
  • Income statement base: Total Income (or Revenue) for percentages of expenses and net income.
  • Balance sheet base: Total Assets or Total Liabilities + Equity for percentages of assets or equity items.
• Example: Daryl Rodriguez Furniture Repair Services (March)
  • Total Income (base): ₱35,000
  • Total Expenses: ₱23,000 (65.71%) of total income
  • Net Income: ₱12,000 (34.29%) of total income
• Benefits: Easier comparison across companies and periods; shows expense composition and profitability relative to base.
• In the example, depreciation expense is a large 22% of total income, while electricity and water are 6%.

Vertical Analysis: Daryl Rodriguez Example (Income Statement)

• Base: Total Income = ₱35,000 (100%)
• Items and percentages:
  • Total Income: ₱35,000 → 100%
  • Total Expenses: ₱23,000 → 65.71%
  • Net Income: ₱12,000 → 34.29%
• Interpretation: Expenses summarize to 66% of income; net income is 34% of income; depreciation is a notable expense (not itemized in this quick view, but other slides show its breakdown).

Ratio Analysis (Introduction)

• Definition: A quantitative way to gain insights into liquidity, operating efficiency, and profitability by examining relationships between financial statement items.
• Uses:
  • Assess liquidity (e.g., current ratio, quick ratio).
  • Evaluate profitability (e.g., gross margin, net profit margin).
  • Compare against industry averages and prior periods.
• Note: The detailed steps for calculating specific ratios are covered in the next lesson.

Financial Analysis of a Single Proprietorship (Vertical Analysis)

• Emilia Santos Car Rental Services — Income Statement for year ending March 31, 2022
• Revenue and Total Income:
  • Revenue: ₱98,000
  • Total Income: ₱98,000 (100%)
• Expenses:
  • Salaries and Wages: ₱20,880 (21%)
  • Electricity and Water Expense: ₱5,760 (6%)
  • Rent Expense: ₱7,200 (7%)
  • Depreciation Expense: ₱21,168 (22%)
  • Total Expenses: ₱55,008 (56%)
• Net Income: ₱42,992 (44%)
• Observation: Depreciation at 22% is the largest single expense in this vertical analysis; electricity and water are the smallest at 6%.

Horizontal Analysis of a Single Proprietorship

• Emilia Santos Car Rental Services — Income Statement (2019 to 2021)
  • Revenue (Rent Income): 2019 ₱87,115; 2020 ₱91,811; 2021 ₱98,000
  • Total Income: same as Revenue
  • Expenses: Salaries and Wages, Electricity and Water, Rent, Depreciation; Total Expenses; Net Income
• Task: Conduct horizontal analysis with 2019 as base year; calculate monetary and percentage changes for each line item and net income.
• Result (illustrative from data):
  • Revenue changes: 2020 + ₱4,696 (≈ +5%); 2021 + ₱10,885 (≈ +12%)
  • Net Income: 2019 ₱15,444; 2020 ₱16,406; 2021 ₱42,992; substantial rise in 2021 due to revenue growth and expense reductions in some categories.
• Takeaway: Horizontal analysis across years highlights profitability improvements and the impact of cost changes on net income.

Uses of Financial Statement Analysis in Business

• Provides insights to internal and external stakeholders to support informed and timely decisions.
• Stakeholders and their primary interests:
  • Management: Profitability, liquidity, solvency, stability; measure effectiveness of decisions; take corrective actions.
  • Investors: Profitability and future growth; evaluate security of investments and expected returns.
  • Creditors: Liquidity and solvency position.
  • Government/regulators: Taxability and regulatory compliance.
  • Customers: Longevity and reliability of the company.
  • Employees: Progress, job security, stability.

Benefits and Drawbacks of Horizontal and Vertical Analysis

• Core difference:
  • Horizontal analysis focuses on changes over time (multi-year perspective).
  • Vertical analysis focuses on the composition of a single period (single-period perspective).
• Combined use: Using both analyses helps address weaknesses and provides a fuller picture.
• Horizontal Analysis – Advantages:
  • Helps evaluate current position, growth prospects, and past performance; reveals trends; useful for benchmarking against competitors.
• Horizontal Analysis – Disadvantages:
  • Depending on the selected periods, the current period may appear unusually good or bad.
  • Aggregation issues: shifting between accounts over time can cause discrepancies in comparisons.
• Vertical Analysis – Advantages:
  • Simplifies correlation among line items when expressed as percentages; helps set goal thresholds and compare to industry standards.
• Vertical Analysis – Disadvantages:
  • Focusing on individual line items rather than aggregates may lack a standardized basis for comparison.
  • Does not directly emphasize liquidity.
• Check Your Progress prompts you to discuss how to address drawbacks of horizontal and vertical analyses in business.

Case Study

• 2022 Automotive NFC Market: Trend Analysis, Financial Insights and Growth Factors (Industry overview used to illustrate the application of horizontal analysis to identify opportunities).
• Key points:
  • Market growth projections and key players (e.g., Sony, NXP, Broadcom, STMicroelectronics, Samsung).
  • Revenue projections: market growing from US$742.6 million in 2021 to US$337.6 million by 2028 (note: the 2028 figure appears inconsistent with typical growth figures in the snippet and may reflect a formatting error; interpret with caution in your notes).
  • Emphasis on using horizontal analysis as the basis for forecasting opportunities in the automotive NFC market.
• Practical takeaway: Horizontal analysis can help identify trends that guide strategic decisions in emerging markets.

Keep in Mind (Key Takeaways)

• Financial statements are foundational to financial statement analysis.
• Financial statement analysis is used to inform decision-making.
• Horizontal analysis uses comparisons across periods and is also called trend analysis; formulas include monetary and percentage changes.
• Vertical analysis expresses each line item as a percentage of a base figure within the same statement (income statement: base could be total income; balance sheet: base could be total assets).

Formulas (From the Text)

• Horizontal analysis (monetary change):
  $ext{Change (Peso)} = ext{Current Year} - ext{Base Year}$
• Horizontal analysis (percentage change):
  $ext{Change} \,\% = \frac{ ext{Current Year} - ext{Base Year}}{ ext{Base Year}} \times 100\%$
• Vertical analysis (income statement):
  $ext{Item \% of Total Income} = \frac{ ext{Item}}{ ext{Total Income}} \times 100\%$
• Vertical analysis (balance sheet):
  $ext{Item \% of Total Assets} = \frac{ ext{Item}}{ ext{Total Assets}} \times 100\%$

Try This (Practice Matching and True/False)

• A. Matching Type
  • Column A vs Column B:
  1. It is also known as trend analysis. -> c. Horizontal analysis
  2. It is used to gain insights into a company’s liquidity, operational efficiency, and profitability. -> b. Financial statement analysis
  3. It is equal to the amount in comparison year less amount in base year. -> d. Horizontal analysis (monetary value)
  4. It is another term used for vertical analysis. -> a. Common-size analysis
  5. It is making assessments and conclusions that meet the needs of stakeholders. -> b. Financial statement analysis
• B. True or False
  1. The horizontal analysis calculates the monetary and percentage changes from one year to another. → True
  2. An advantage of vertical analysis is that it contributes to understanding liquidity. → False
  3. The common-size analysis relates line item values to a common base figure. → True
  4. The horizontal analysis only uses absolute values to describe comparisons. → False
  5. Horizontal analysis is valuable because it allows analysts to evaluate the company's current financial position, growth prospects, and past performance. → True

Practice Your Skills (Three-Year Assessment: Patricia Joy Cakes and Pastries)

• Data (Income Statement):
  • 2018: Revenue ₱145,760; Total Income ₱145,760; Salaries and Wages ₱26,755; Utilities ₱13,777; Supplies ₱33,890; Internet ₱4,900; Rent ₱13,500; Depreciation ₱9,580; Total Expenses ₱102,402; Net Income ₱43,358
  • 2019: Revenue ₱124,481; Total Income ₱124,481; Salaries and Wages ₱13,834; Utilities ₱19,701; Supplies ₱30,836; Internet ₱5,254; Rent ₱20,508; Depreciation ₱9,580; Total Expenses ₱99,713; Net Income ₱24,768
  • 2020: Revenue ₱207,707; Total Income ₱207,707; Salaries and Wages ₱37,040; Utilities ₱18,558; Supplies ₱53,557; Internet ₱4,382; Rent ₱20,350; Depreciation ₱12,580; Total Expenses ₱146,467; Net Income ₱61,240
• Tasks:
  1) Compute the percentage change in rent expense from 2018 to 2020.
  2) Compute the monetary change in Cakes and Pastries Income from 2018 to 2019.
  3) Compute the percentage share of Supplies Expense from the Total Expense for the year 2020.
  4) Prepare a horizontal analysis for the three-year data.
• Illustrative solutions (based on the provided data):
  • 1) Rent expense: 2018 = ₱13,500; 2020 = ₱20,350; Change = ₱20,350 - ₱13,500 = ₱6,850; Percentage change = $\frac{6{,}850}{13{,}500} \times 100\% \approx 50.7\%$
  • 2) Cakes and Pastries Income 2018→2019: Change = ₱124{,}481 - ₱145{,}760 = -₱21{,}279
  • 3) 2020 Supplies Expense as % of Total Expenses: = \frac{53{,}557}{146{,}467} \approx 0.3657 \approx 36.6\%
  • 4) Horizontal analysis (base year 2018):
  • 2019 changes (relative to 2018): Revenue -14.6%; Total Income -14.6%; Salaries -38.9%; Utilities +42.1%; Supplies +5.8%; Internet -6.0%; Rent +52.2%; Depreciation 0%; Total Expenses +?; Net Income -42.3%
  • 2020 changes (relative to 2018): Revenue +42.5%; Total Income +42.5%; Salaries +38.4%; Utilities +34.7%; Supplies +58.1%; Internet -10.6%; Rent +50.4%; Depreciation +31.3%; Total Expenses +43.1%; Net Income +41.2%
• Note: These are illustrative calculations based on the data; you will practice creating a formal table with percentages for each line item.

Vertical Analysis (Practice: 2020 with Total Income as Base)

• Patricia Joy Cakes and Pastries — Vertical Analysis (2020)
  • Base: Total Income = ₱207,707 (100%)
  • Items (as % of Total Income):
  • Cakes and Pastries Income: ₱207,707 → 100%
  • Salaries and Wages: ₱37,040 → 17.85%
  • Utilities Expense: ₱18,558 → 8.94%
  • Supplies Expense: ₱53,557 → 25.81%
  • Internet Expense: ₱4,382 → 2.11%
  • Rent Expense: ₱20,350 → 9.80%
  • Depreciation Expense: ₱12,580 → 6.06%
  • Total Expenses: ₱146,467 → 70.56%
  • Net Income: ₱61,240 → 29.44%
• Purpose: See how each expense item contributes to total income and compare expense structure to peers or industry norms.

Challenge Yourself

• Three items to consider:
  1) The asset-related question: Given assets (e.g., Cash, Accounts Receivable, Prepaid Expenses, Inventory, Property & Equipment), determine what portion of Total Assets Prepaid Expenses represents and interpret the result.
  2) Inter-period asset changes: Given two companies’ asset mixes across years, compute monetary and percentage changes in Total Assets and interpret the implications.
  3) Horizontal analysis accuracy check: Given a multiyear data set, identify if the staff’s reported percentage changes are calculated correctly, and explain what might be wrong if results seem inconsistent.
• These challenges reinforce understanding of horizontal and vertical analysis concepts with real-number practice.

Bibliography (References in the Unit)

• Dauderis, Henry, and Annand David. Introduction to Financial Accounting (Version 2017-Revision C). Athabasca, Canada: Valley Educational Services Ltd., 2017.
• Gilbertson, Claudia, Mark Lehman, and Debra Gentene. Century 21 Accounting. Ohio: South-Western Cengage Learning, 2016.
• Jonick, Christine. Principles of Financial Accounting. Dahlonega, Georgia: University of North Georgia Press, 2018.
• Hermanson, Roger H., James Don Edwards, and R. F. Salmonson. Accounting Principles. Homewood, IL: BPI-Irwin, 1989.

Notes on Formulas and Concepts (Recap)

• Horizontal analysis compares data across periods to identify trends.
• Vertical analysis expresses each line item as a percentage of a base figure within the same statement.
• Key bases:
  • Income statement: Total Income as the base for percentages of expenses and net income.
  • Balance sheet: Total Assets as the base for percentages of assets, liabilities, and equity.
• Common pitfalls to avoid:
  • Mixing base-year choices without clear justification can distort trend interpretation.
  • Over-reliance on percentages without context (e.g., industry norms) can mislead when absolute amounts are large or small.

Final Reminders

• Practice applying horizontal and vertical analyses using real data from statements to build intuition.
• Use both methods in tandem for robust analysis and decision-making.