MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Module No – Title : MO1 – Financial Statement Analysis
for Planning and Control
Time Frame : 1 week – 6 hrs
1. Overview
This learning material deals with the use of financial information in looking forward and trying to
determine what impact decisions have on the overall performance of the company by analyzing the
financial statements.
2. Desired Learning Outcomes
After studying this module, you should be able to:
1. Perform vertical analysis
2. Perform horizontal analysis
3. Perform cash flow analysis
4. Perform gross profit variance analysis (price, cost and volume factors)
5. Determine the financial ratios (liquidity, solvency, profitability, market and other ratios)
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
3. Content/Discussion
Many interested parties, including shareholders, the government, and creditors, want to know if
the firm is doing better or worse than it has in the past, how fast the business is growing, and whether the firm
will survive. These data are presented in the financial statements. At this point in time, you know already your
complete set of financial statements as well as how to prepare them.
While accounting is primarily concerned with historical statements, it may be useful for the company to create
pro-forma statements as predictions about how the firm’s statements will look in the future. These analyses and
projections are used to help the company make strategic decisions; for example, will introducing a new product
really increase shareholder value? The accuracy of the pro-forma statements depends on the accuracy of the
inputs.
Lesson 1. Vertical Analysis
Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of a
base figure within the statement. Thus, line items on an income statement can be stated as a percentage of gross
sales, while line items on a balance sheet can be stated as a percentage of total assets or liabilities, and vertical
analysis of a cash flow statement shows each cash inflow or outflow as a percentage of the total cash inflows.
• Vertical analysis makes it easier to understand the correlation between single items on a balance sheet
and the bottom line, expressed in a percentage.
• Vertical analysis makes it much easier to compare the financial statements of one company with another
and across industries. This is because one can see the relative proportions of account balances. It also makes it
easier to compare previous periods for time series analysis, in which quarterly and annual figures are compared
over a number of years, in order to gain a picture of whether performance metrics are improving or
deteriorating.
• For example, by showing the various expense line items in the income statement as a percentage of sales,
one can see how these are contributing to profit margins and whether profitability is improving over time. It thus
becomes easier to compare the profitability of a company with its peers.
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Illustration
Suppose XYZ Corporation has gross sales of P5 million and cost of goods sold of P1 million, and general and
administrative expenses of 1.2 million, selling expenses of P800,000 and a 30% tax rate, its income statement will
look like this if vertical analysis is used:
Sales 5,000,000 100%
Cost of goods sold 1,000,000 20%
Gross profit 4,000,000 80%
General and Administrative Expenses 1,200,000 24%
Selling Expenses 800,000 16%
Operating Income 2,000,000 40%
Taxes (30%) 600,000 12%
Net income 1,400,000 28%
Lesson 2. Horizontal Analysis
Horizontal analysis is used in financial statement analysis to compare historical data, such as ratios or line items
over a number of accounting periods. Horizontal analysis can either use absolute comparisons or percentage
comparisons, where the numbers in each succeeding period are expressed as a percentage of the amount in the
baseline year, with the baseline amount being listed as 100%. This is also known as base-year analysis.
• Horizontal analysis is used in the review of a company's financial statements over multiple periods.
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
• It is usually depicted as a percentage growth over the same line item in the base year.
• Horizontal analysis allows financial statement users to easily spot trends and growth patterns.
Generally accepted accounting principles (GAAP) are based on consistency and comparability of financial
statements. Consistency is the ability to accurately review one company's financial statements over a period of
time because accounting methods and applications remain constant. Comparability is the ability to review side-
by-side two or more different companies' financials. Horizontal analysis not only improves the review of a
company's consistency over time directly, but it also improves comparability of growth in a company to that of its
competitors as well.
Horizontal analysis allows investors and analysts to see what has been driving a company's financial
performance over a number of years, as well as to spot trends and growth patterns such as seasonality. It enables
analysts to assess relative changes in different line items over time, and project them into the future. By looking
at the income statement, balance sheet, and cash flow statement over time, one can create a complete picture of
operational results, and see what has been driving a company’s performance and whether it is operating
efficiently and profitably.
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Illustration:
Absolute % in Change
Particulars
2019 2018 Change
Sales 5,000,000 4,700,000 300,000 6.38%
Cost of goods sold 1,000,000 900,000 100,000 11.11%
Gross profit 4,000,000 3,800,000 200,000 5.26%
General and
1,200,000 1,150,000 50,000 4.35%
Administrative Expenses
Selling Expenses 800,000 750,000 50,000 6.67%
Operating Income 2,000,000 1,900,000 100,000 5.26%
Taxes (30%) 600,000 570,000 30,000 5.26%
Net income 1,400,000 1,330,000 70,000 5.26%
Lesson 3. Cash Flow Analysis
Cash is the lifeblood of a company, and the company’s statement of cash flows records what money has gone into
and out of a firm because of its operations. It is an important element for business, which is required for the
functioning of a business; some investors give more importance to cash flow statements than other financial
statements.
The cash flow statement is an important document that helps interested parties to have an insight into all the
transactions that go through a company. Profitable companies can fail to adequately manage cash flow, which is
why the cash flow statement is a critical tool for companies, analysts, and investors. The cash flow statement is
broken down into three different business activities: operating, investing, and financing.
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Cash flows from operating activities (CFO) - the first section of the cash flow statement which includes
transactions from all operational business activities. It begins with the net income, then reconciles all noncash
items to cash items involving operational activities. In other words, it is the company's net income, but in a cash
version.
Cash flows from investing (CFI) - the second section of the cash flow statement shows the result of investment
gains and losses. This section also includes cash spent on property, plant, and equipment. This section is where
analysts look to find changes in capital expenditures (capex).
Cash flows from financing (CFF) - the last section of the cash flow statement. This section provides an overview of
cash used in business financing. It measures cash flow between a company and its owners and its creditors, and
its source is normally from debt or equity.
A past statement of cash flows shows where the firm’s money came from and how it was used. Were these good
sources and uses? In other words, did sources include substantial net profits, or did the firm need to borrow
heavily because its profits were low? Are there any sources or uses that stand out? For example, did the firm
greatly increase its cash? If so, why?
While earnings and cash flows are highly correlated, they are not necessarily the same. Cash flows are used to
provide the information for wealth-increasing decisions. Profits must be converted into cash flows in order to
make company investment decisions. Cash flow pertains to how much cash actually moves through a business.
How this cash flow is managed can mean the success or failure of any enterprise.
If a company's cash generation is positive, it's a strong indicator that the company is in a good position to avoid
excessive borrowing, expand its business, pay dividends, and weather hard times.
Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally
produced cash from a company's operations and monitors the use of cash for capital expenditures.
What is Free Cash Flow?
Free cash flow (FCF) is often defined as the net operating cash flow minus capital expenditures. Free cash flow is
an important measurement since it shows how efficient a company is at generating cash. Investors use free cash
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
flow to measure whether a company might have enough cash, after funding operations and capital expenditures,
to pay investors through dividends and share buybacks.
FCF can be calculated by starting with Cash Flows from Operating Activities on the Statement of Cash Flows
because this figure will have already adjusted earnings for non-cash expenses and changes in working capital.
The income statement and balance sheet can also be used to calculate FCF.
1. Free cash flow = OCF – D FA – (DCA – DCL)
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Illustrative case.
SMG Industries
Assets Dec 31, 2019 Dec 31, 2018
Cash P 3,500 P 3,000
Marketable securities 3,800 3,200
Accounts receivable 4,000 3,800
Inventories 4,900 4,800
Total current assets P16,200 P14,800
Gross fixed assets P31,500 P30,100
Less: Accumulated
depreciation 14,700 13,100
Net fixed assets P16,800 P17,000
Total assets P33,000 P31,800
Liabilities and Shareholders’ Equity Dec 31, 2019 Dec 31, 2018
Accounts payable P 3,600 P 3,500
Notes payable 4,800 4,200
Accruals 1,200 1,300
Total current liabilities P 9,600 P 9,000
Long-term debt 6,000 6,000
Total liabilities P15,600 P15,000
Common stock P11,000 P11,000
Retained earnings 6,400 5,800
Total shareholders’
equity P17,400 P16,800
Total liabilities and
shareholders’ equity P33,000 P31,800
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Income Statement Data (2019, in millions)
Depreciation expense P1,600
Earnings before interest and taxes (EBIT) 4,500
Taxes 1,300
Net profit after taxes 2,400
• The firm’s operating cash flow (OCF) for the year ended December 31, 2019
Operating cash flow = EBIT – Taxes + Depreciation
= P4,500 – P1,300 + P1,600
= P4,800
• The firm’s free cash flow (FCF) for the year ended December 31, 2019
Free cash flow = OCF – D CAPEX – (DCA – DCL)
= 4,800 – (31,500 – 30,100) – [(16,200 – 14,800) – (9,600-9,000)]
= P2,600
Operating cash flow (OCF) is higher than free cash flow (FCF) because operating cash flow does not account for
investments made during the year. Free cash flow not only looks at operations but also considers whether the
company has added assets or reduced liabilities (uses of cash) or reduced assets and increased liabilities (sources
of cash).
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Lesson 4. Gross Profit Variance Analysis
Gross profit is the difference between net sales and cost of goods sold, and is computed as a part of income
statement or profit and loss account of a business.
Gross profit analysis is the procedure of finding the causes of changes in gross profit percentage from budgeted
to actual or from one period to another period. The major purpose of gross profit analysis is to reveal the
unexpected changes in gross profit and their causes so that they can be brought to the attention of management
in a timely manner. A change in gross profit usually occurs due to one or more of the following reasons:
1. Price variance. Changes in total revenue for the period due to changes in selling prices of goods and
services.
2. Volume Variance. Changes in total revenue for the period due to changes in quantity of goods and services
sold during the period.
3. Cost Variance. Changes in basic manufacturing cost elements i.e., direct materials, direct labor and
manufacturing overhead.
Illustrative Case
The Steward Company manufactures two products – product A and product B. The budgeted and actual data for
the last month is provided below:
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Product A
Product A
Budgeted Actual
Sales in Units 8,000 7,500
Sales Price 20.00 21.00
Sales 160,000 157,500
Cost in Units 16.00 16.50
Cost of Sales 128,000 123,750
Gross Profit 32,000 33,750
Using the data of Steward Company given above, compute:
1. Sales price variance
2. Sales volume variance
3. Cost price variance
4. Cost volume variance
5. Analysis of Change in Gross Profit
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Solution
1. Sales price variance = DPrice x Actual Units sold
=21-20 (7,500)
= P7,500 favorable sale price variance
2. Sales volume variance = DVolume x Budgeted Selling Price
=7,500-8,000 (20)
=P10,000 unfavorable sales volume variance
3. Cost price variance = DCost Price x Actual Units sold
= 16.50-16 (7,500)
= P3,750 unfavorable cost price variance
4. Cost volume variance = DVolume x Budgeted Cost Price
= 7,500-8,000 (16)
= P8,000 favorable cost volume variance.
5. Analysis of Change in Gross Profit
Sales price variance 7,500 Favorable
Sales volume variance (10,000) Unfavorable
Cost price variance -3750 Unfavorable
Cost volume variance 8000 Favorable
Change in Gross Income 1,750 Favorable
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Lesson 5. Financial ratio Analysis.
Financial ratio analysis is the use of ratios to analyze financial statements. They can be used to determine the
company’s strengths and weaknesses, its historical performance and its present financial condition. Ratios are
used to make it easier to make comparisons – between the company’s past and its present, and between the
company and its competitors. Managers use ratios to improve the company’s performance (Activity Ratios).
Creditors use ratios to see whether the firm will be able to repay its debts (Liquidity and Debt Ratios), while
shareholders want to predict what future dividends and earnings will be (Profitability Ratios).
1. Activity Ratio - broadly describes any type of financial metric that helps investors and research analysts
gauge how efficiently a company uses its assets to generate revenues and cash. Activity ratios may be utilized to
compare two different businesses within the same sector, or they may be used to monitor a single company's
health over time.
• Accounts Receivable Turnover Ratio. This determines an entity's ability to collect money from its
customers. Total credit sales is divided by the average accounts receivable balance for a specific period. A low
ratio suggests a deficiency in the collection process.
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
• Merchandise Inventory Turnover Ratio. This measures how often the inventory balance is sold during an
accounting period. The cost of goods sold is divided by the average inventory for a specific period. Higher
calculations suggest that a company can move its inventory with relative ease.
Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
• Total Assets Turnover Ratio. This measures how efficiently an entity uses its assets to tender a sale. Total
sales is divided by total assets to decipher how proficiently a business uses its assets. Smaller ratios may indicate
that a company is struggling to move its products.
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Strategic Cost Management
Institute of Accountancy
MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Asset Turnover = Net Sales Revenue / Average Total Assets
2. Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off
current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt
obligations and its margin of safety through the calculation of metrics including the current ratio and quick ratio.
• Current Ratio- measures a company's ability to pay off its current liabilities (payable within one year)
with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the
company's liquidity position.
Current Ratio= Current Assets / Current Liabilities
• The Quick Ratio. This measures a company's ability to meet its short-term obligations with its most liquid
assets, and therefore excludes inventories from its current assets. It is also known as the "acid-test ratio"
Quick ratio= (Current assets - inventory - prepaid expenses)/ Current liabilities
• Debt Ratio is a financial ratio that measures the extent of a company’s leverage. The debt ratio is defined
as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the
proportion of a company’s assets that are financed by debt.
Debt ratio= Total debt/ Total assets
3. Profitability Ratios are a class of financial metrics that are used to assess a business' ability to generate
earnings relative to its revenue, operating costs, balance sheet assets, or shareholders' equity over time, using
data from a specific point in time.
• Profit Margin. Different profit margins are used to measure a company's profitability at various cost levels,
including gross margin, operating margin, pretax margin, and net profit margin. The margins shrink as layers of
additional costs are taken into consideration—such as the cost of goods sold (COGS), operating expenses, and
taxes.
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
• Return on Assets. Profitability is assessed relative to costs and expenses and analyzed in comparison to
assets to see how effective a company is deploying assets to generate sales and profits.
Return on Equity=Net Income/ Total Assets
• Return on Equity. This is a performance measure on the revenues raised from shareholder equity. ROE is
calculated by dividing net income by all outstanding shares in the market.
Return on Equity=Net Income/ Average Shareholders’ Equity
Please take note that it is difficult to tell if a ratio is bad or good without additional information.
Illustrative Case
The partially complete 2019 balance sheet and income statement for Challenge Industries are given below,
followed by selected ratio values for the firm based on its completed 2019 financial statements. Use the ratios
along with the partial statements to complete the financial statements.
Hint: Use the ratios in the order listed to calculate the missing statement values that need to be installed in the
partial statements.
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Challenge Industries, Inc.
Balance Sheet
At December 31, 2019
(in thousands)
Assets
Current assets
Cash P 52,000
Marketable securities 60,000
Accounts receivable 200,000
Inventory ?
Total current assets ?
Fixed assets (gross) ?
Less: Accumulated depreciation 240,000
Net fixed assets ?
Total assets ?
Liabilities and Equity
Current liabilities
Accounts payable P150,000
Notes payable ?
Accruals 80,000
Total current liabilities ?
Long-term debt 425,000
Total liabilities ?
Shareholders’ equity
Preferred stock ?
Common stock (at par) 150,000
Paid-in capital in excess of par ?
Retained earnings 390,000
Total shareholders’ equity ?
Total liabilities and shareholders’ equity ?
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Strategic Cost Management
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MARY THE QUEEN COLLEGE OF PAMPANGA INC.
Gapan-Olongapo Road, Guagua, Pampanga 2003
Assignment.
For the self-regulated assessment of what you had learned from this module, please
accomplish the progress check/activity posted in our LMS and submit it on or before due date.
A. References
Ma. Elenita Balatbat Cabrera , Gilbert Anthony Balatbat Cabrera, Strategic Cost Management 2019-2020
edition, , GIC Enterprise & Co., Inc., Manila.
www.investopedia.com
https://courses.lumenlearning.com/managacct/chapter/criteria-used-in-managerial-decision-making/
https://courses.lumenlearning.com/managacct/chapter/criteria-used-in-managerial-decision-making/
https://strategicmanagementinsight.com/tools/value-chain-analysis.html
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