Financial Statements Analysis PDF

FINANCIAL STATEMENTS ANALYSIS Learning Objectives 1. Understand the objectives of financial statement analysis, and its limitations. 2. Use the analytical techniques in financial statements analysis: a. Horizontal analysis b. Tre...

FINANCIAL STATEMENTS ANALYSIS Learning Objectives 1. Understand the objectives of financial statement analysis, and its limitations. 2. Use the analytical techniques in financial statements analysis: a. Horizontal analysis b. Trend analysis c. Vertical analysis d. Ratio analysis 3. Prepare and interpret common- size financial statements. 4. Compute the various financial ratios, turnover and their interpretations and how to use them for profit planning. Introduction Financial statements provide the basic source of information by managers and other interested parties outside the organization regarding its financial conditions and results of operations. Financial statements communicate the firm's financial strengths and weaknesses as well as its performance for the current period. Though financial statements are primarily prepared for external users (stockholders, investors, government agencies, etc.), managers find it equally useful for their making decisions such as performance evaluation, developing operating plans and any other matters related to their operating activities. Although financial statements are based on historical accounting information, which reflects transactions and other events that affected the firm, it would help the users in predicting the future, as indicated by the trend analysis. A potential lender or investor could assess the company's overall financial strength, income and growth potential as well as the financial effects on some matters that required future decisions. The company's ability to repay obligations and distribution of returns on investments are the primary concerns of the potential lenders and investors. Overview of Financial Statements The four key financial statements are: 1. Balance Sheet the purpose of the balance sheet is to present a summary of the assets owned by a firm, its liabilities, and its net financial position at a given point in time. The assets are often referred to as investments and the liabilities and owner's equity as financing. 2. Income Statement provides a financial summary of a company's operating results during a specified period. 3. Cash Flow Statement provides a summary of the firm's operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. It also ties together the income statement and previous and current balance sheets.  4. Statement of Retained Earnings reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year. The basic structure of each of these statements and their relationships: FINANCIAL STATEMENT RELATIONSHIPS Balance Sheet Beginning (12-31-x1) Balance Sheet Ending (12-31-x2) Assets = Liabilities + Capital Assets = Liabilities + Capital Transactions during the period From 12-31-x1 to 12-31-x2 Income Statement For the year ended Dec. 31, 20x2 Revenues earned/Gains - Expenses/Losses = Net Income/Loss Cash Flow Statement For the year ended Dec. 31, 20x2 Cash balance beginning +Cash inflows in 20x2 - Cash outflows in 20x2 = Cash balance ending Cash balance 12-31-x2 - Cash balance 12-31x1 = Change.in.cash in 20x2 In this chapter, analysis will be focused on these two statements, balance sheet and income statements. The most widely used techniques in financial statement analysis are: 1. Comparative analysis a. horizontal analysis b. trend analysis c. vertical analysis 2. Ratio or Component analysis including turnovers. Cautions About Financial Statements Analysis Managers should look beyond the ratios. They should consider the technological changes, industry trends, consumer tastes and various economic factors. Here are some cautions about using financial ratios: 1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. 2. A single ratio does not generally provide enough information from which to judge the overall performance of the firm. 3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year. 4. It is preferable to use audited financial statements. 5. The financial data being compared should have been developed in the same way. 6. Results can be distorted by inflation. Comparative Analysis An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons. Percentage changes and relative ratios are widely used in comparative and trend analyses. Horizontal analysis is comparing two periods and becomes trend analysis if extended to three or more periods having the earliest year as the base period. Vertical analysis, also known as common-size statements is analysis of the component parts of a single statement in a given period. The analyst must have in mind that these percentage changes and ratios are only indicators of the performance or financial condition of the company. No single measure could tell us more. To give a more meaningful interpretation, these financial measures must be compared between periods and between other companies within the same industry but, most preferably, a comparison between companies of the same size and capacities. Using the industry norm or standards could also add sense to the interpretation. Horizontal Analysis Horizontal analysis is a technique for evaluating a series of data over a period time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. The peso changes (increase or decrease) are normally presented in each item as well as their percentage changes. Quantifying peso changes over time serves to highlight the changes that are the most important economically. Quantifying percentage changes over time serves to highlight the changes that are the most unusual. The following simple rules should be observed: 1. To compute for the peso changes, current year less prior year. 2. To compute for the percentage changes, peso change divided by the prior year (serve as the base figure). If there is no amount in prior year, no percentage change will be shown, as a matter of rule in mathematics. 3. To compute for the ratio presentation, current year divided by the prior year. Again, if the base year is zero or no amount in prior year, no ratio will be shown in the analysis, thus, peso amount presentation is important.  JAMES CORPORATION COMPARATIVE BALANCE SHEET DECEMBER 31, Year 2 and Year 1 Changes Increase (Decrease) Year 2 Year 1 Peso % Ratio Amount Assets Current Assets: Cash 2,400 2,100 300 14.3% 1.14 Marketable Securities 1,350 900 450 50.0% 1.50 Accounts Receivable, net 36,000 33,000 3,000 9.1% 1.09 Inventory 60,000 51,000 9,000 17.6% 1.18 Prepaid Expense 750 900 (150) -16.7& 0.83 Total Current Assets 100,500 87,900 12,600 14.3% 1.14 Long - Term Investments 1,500 1,650 (150) -9.1% 0.91 Property and Equipment Land 18,00 18,000 - 0.0% 1.00 Building, net 165,00 156,000 9,000 5.8% 1.06 Equipment, net 75,00 69,000 6,000 8.7% 1.09 Total Property and Equipment 258,000 243,000 15,000 6.2% 1.06 TOTAL ASSETS 360,000 332,550 27,450 8.3% 1.08 LIABILITIES & STOCKHOLDERS’ EQUITY Current Liabilities: Accounts Payable 22,500 21,150 1,350 6.4% 1.06 Accrued Expense 6,600 6,300 300 4.8% 1.05 Notes Payable 10,900 8,700 2,200 25.3% 1.25 Total Current Liabilities 40,000 36,150 3,850 10.7% 1.11 Long Term Liabilities 110,000 108,000 2,000 1.9% 1.02 Total Liabilities 150,000 144,150 5,850 4.1% 1.04 Stockholders’ Equity Preferred Stock, P100 par, 8% 18,000 18,000 - 0.0% 1.00 Common Stock, P10 par value 75,000 72,000 3,000 4.2% 1.04 Additional paid in capital 12,000 11,400 600 5.3% 1.05 Retained Earnings 105,000 87,000 18,000 20.7% 1.21 Total Stockholders’ Equity 210,000 188,800 21,600 11.5% 1.11 TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY 360,000 332,550 27,450 8.3% 1.08 JAMES CORPORATION COMPARATIVE INCOME AND RETAINED EARNINGS STATEMENT FOR THE YEARS ENDED DECEMBER 31, Year 2 and Year 1 Changes Increase (Decrease) Year 2 Year 1 Peso % Ratio Amount Net Sales 261,000 246,000 15,000 6.1% 1.06 Cost of Sales 182,790 169,050 13,740 8.1% 1.08 Gross Profit 78,210 76,950 1,260 1.6% 1.02 Operating Expenses 21,000 20,100 900 4.5% 1.04 Net Operating Income 57,210 56,850 360 0.6% 1.01 Interest Expenses 12,090 11,670 420 3.6% 1.04 Net Income Before Tax 45,120 45,180 (60) -0.1% 1.00 Tax Expenses 11,280 11,400 (120) -1.1% 1.27 Net Income 33,840 33,780 60 0.2% 1.00 Add Retained Earnings, beg. 87,000 68,460 18,540 27.1% 1.27 Total 120,840 102,240 18,600 18.2% 1.18 Dividends 15,840 15,240 600 3.9% 1.04 Retained Earnings, ending 105,000 87,000 18,000 20.7% 1.21  Net Operating Income 33,840 33,780 60 0.2% 1.00 Dividends to Preferred Stock 1,440 1,440 - 0.0% 1.00 Net Income Available to Common 32,400 32,340 60 0.2% 1.00 Dividends to Common Stock 14,400 13,800 600 4.3% 1.04 Net Income 18,000 18,540 (540) -2.9% 0.97 Trend Analysis An extended horizontal analysis could be developed as the so-called "Trend Analysis". Trend percentages state several years' financial data in terms of a base year, which equals 100 percent. Assume in the given financial statements by James Corporation, the following Sales and Net income items for the past six years are as follows: 2018 2017 2016 2015 2014 2013 Sales 261,000 246,000 234,000 224,400 219,000 216,000 Net Income 33,840 33,780 33,000 31,500 30,600 29,700 The trend (in percent) could be developed as follows: 2018 2017 2016 2015 2014 2013 Sales 121* 114** ***108 104 101 100 Net Income 114 114 111 106 103 100 *P261,000/P216,000 = 1.208 or 121 **P246,000/P216,000 = 1.138 or 114 *** P234,000/P216,000 = 1.083 or 108 This trend would serve as what we call "attention-directing" where the analyst would focus his attention on such trends in comparison with the industry standards. For instance, the analyst knows that the industry grew tremendously and yet the company was unable to have a significant sales growth. Using James Corporation's trend analysis, it could be interpreted that the company was unable to convert its sales growth into net income as we compare the trend in 2008 and 2009. A smart financial analyst would try to deeply relate these financial measures and be able to find explanations on the issues. For instance, sales increased by 6% [(P261,000-P246,000)/P246,000] but net income increased by less than 1% [(P33,840-P33,780)/P33,780]. Vertical analysis Vertical analysis is a technique that expresses each item within a financial statement as a percentage of a relevant total or a base amount. It focuses on the relationship between various financial items in a given financial statements in a single period. The financial statements then will be presented in percentages commonly called "common-size statements". Certain rules are also observed: ➤ For the balance sheet, Total Assets and Total Liabilities & Capital are both considered 100% and each item in the particular section are presented as a certain percent of the total. In James Corporation, Cash is 7.8% of total assets while Accounts Payable represents 6.3% of total liabilities and stockholders' equity. ➤ For the Income Statement, Net Sales is considered as the 100%. Each item in the income statement represents a certain percent of sales. In James Corporation, Cost of Sales is 70% of sales. Ratio Analysis Many related items in the balance sheet help the analyst develop his interpretation as to the company's financial strengths and operation's performance. Financial statements report both the firm's position as of a certain period and on its operations for a certain period. As mentioned earlier, the real value of financial statements is in the fact that they can be used to help predict the firm's future earnings and dividends, thus, an analysis of the firm's ratios is generally the first step in a financial analysis. The ratios are designed to show relationships between financial statement accounts. For instance, Company X might have a debt of P5 million and interest charges of P400 thousand, while Company Y might have debt of P50 million and interest charges of P4 million. Which company is stronger? The true burden of these debts, and the companies' ability to repay them can be ascertained (1) by comparing each firm's debt to its assets and (2) by comparing the interest it must pay to the income it has available for payment of interest. Such comparisons are what we called ratio analysis. The three major areas that concern the users of financial statements are: 1. Stability 2. Solvency or liquidity, and 3. Profitability. Analyzing ratios as a whole could be more meaningful, even though they are computed individually, the totality of it could give the final interpretation about the company's financial and operating conditions. The following are the most common ratios used by financial analysts: Analyzing the Balance Sheet A. Liquidity Ratios These are ratios that show the relationship of the company's cash and other current assets to its current liabilities. Liquidity is the number one concern of most financial analysts. This will indicate whether the firm can meet its maturing obligations. The most common liquidity ratios and their procedural computations are:  1. Working Capital = Current assets minus current liabilities This is the excess of current assets over current liabilities. To some, working capital is used to designate current assets only as the amount intended for day to day operations of the business. Thus, the use of the term net working capital is more appropriate. The bigger the net working capital the better as it would mean more current assets are available for operations. 2. Current Asset Ratio = Current assets divided by current liabilities called This is the basic test of liquidity of the firm. This will determine the adequacy of working capital or the ability to meet current obligations. The higher the current asset ratio, the better, as this would mean there are more current assets available for paying its current obligations. 3. Quick (Acid) Test Ratio Quick assets divided by current liabilities Quick or acid test ratio is a more stringent test of ability to pay current obligations as they come due. Quick assets are: Cash and cash equivalents, marketable securities, short-term notes and accounts receivables. In this regard, inventory and prepaid expenses are not included in the computation of quick asset ratio as inventories are typically least liquid among the current assets, while, prepaid expenses are not convertible to cash. Though the analyst must do a careful analysis since accounts receivable could be converted into cash later than inventory. It is in the case of aged accounts receivable which are normally considered as bad debts. The opposite could be observed wherein inventory can be converted to cash earlier than accounts receivable, in the case of cash sales. The higher the quick asset ratio, the better liquidity position of the firm. B. Asset Management Ratios These are set of ratios, which measures how effectively a firm is managing its assets. These ratios are also called asset utilization ratio, which pertains to how effectively the firm utilized its assets to earn profits. These ratios are designed to answer questions like: Does the total amount of each type of asset as reported on the balance sheet seem maintained at a reasonable level? Will too high or too low current assets in relation to the projected or actual operating levels affect profitability? Normally companies borrow or obtain capital from other sources to acquire assets. If a company has too many assets acquired through borrowings, the interest expenses will be too high and, hence the profits will be lower. On the other hand, if assets are too low, profitable sales may be lost. Therefore, managing these assets, particularly current assets will help the firm avoid borrowing funds to finance operations. The most common asset management ratios are. 1. Accounts Receivable Turnover= Net sales on account divided by average A/R *Average A/R (Beg+ End) divided by 2 This will measure the efficiency of collections. How fast collections are being made. Whenever possible, monthly balances of accounts receivable is used in determining average accounts receivable. The net sales used as numerator are assumed to be all credit sales only. The higher the turnover, the better, this would mean a greater number of times receivable is reinvested for more profit. 2. No. of days in A/R or Average collection period = 365 days(in a year) divided by AR Turnover or = Average AR divided by the Average Daily Sales This is to measure the number of days the firm invests in accounts receivable. The shorter the collection period, the better for the company as it could present reinvestment opportunities, which mean additional income. 3. Inventory Turnover = Cost of Sales divided by Average Inventory *Average Inventory = (Beg + End) divided by 2 Similar with accounts receivable, inventory turnovers are used to determine how fast inventory were converted into sales. Whenever possible, monthly average inventory is a better measure. The higher the inventory turnover, the better, as this would mean more number of times inventory is reinvested and more profit will be realized. 4. No. of days in Inventory or Average Selling period =365 days(in a year) divided by Inventory Turnover This determines the number of days' in inventory is held as stock before it will be sold. The shorter the number of days it is held on stock, the better it will be as it means more number times it is reinvested by the firm. For a manufacturing firm, the number of days and turnover will be determined for each item in the inventory, such as the finished goods, the work in process and raw materials inventory. Finished goods turnover is computed by dividing the cost of sales by the average finished goods inventory Work in process turnover is computed by dividing the cost of goods manufactured by the average work in process. Raw materials turnover is computed by dividing the raw materials used by the average raw materials inventory. 5. Fixed Assets Turnover or Fixed Assets Utilization Ratio = Sales divided by Net Fixed Assets 6. Total Assets Turnover = Sales divided by Total Assets These two measures determine the number of times investments in assets are reinvested in sales. The more the number of times it turnover, means the higher profit the company utilized its assets. C. Debt Management Ratios or Financial Leverage These ratios will measure the extent to which firm uses its debt financing or the so-called financial leverage. Some important implications could be raised in managing financial leverage, By raising funds through debt, the owners can maintain control of the firm with limited investment. Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, that is, if the owners have provided only a small proportion of the total financing, the risks of the enterprise are borne mainly by its creditors. Financial leverage raises the expected rate of return to stockholders for two reasons: Since interest is deductible, the use of debt financing lowers the tax and leaves more of the firm's operating income available to its investors. If the rate of return on assets (income before tax divided by the total assets) exceeds the interest rate on debt, as it generally does, then a company can use debt to finance assets, pay the interest on the debt, and have something left over for its stockholders. Normally, firms with relatively high debt ratios are exposed to more risk of losses when the economy is in a recession, but they also have higher expected returns when the economy booms. Conversely, firms with low debt ratios are less risky, but they also forego the opportunity to leverage up their return on equity. The prospects of high returns are desirable, but investors are reluctant to risk. Therefore, decisions about the use of debt require firms to balance higher expected returns against increased risk. Determining the optimal amount of debt for a given firm is a complicated process. That is why this chapter will simply look at the procedures on how to: examine the firm's debt ratio as to the extent to which borrowed funds have been used to finance assets, and review income statement ratios to determine the number of times fixed charges are covered by operating profits. These two ratios are complementary and must be analyzed at the same time. 1. Debt to Total Asset Ratio = Total Debt divided by Total Assets This is the ratio of total liabilities to total assets. As discussed earlier, it measures to what extent that portion of the total assets provided by the creditors. 2. Debt to Equity Ratio = Total Liabilities divided by Total Stockholders’ Equity It measures the resources provided by the owners in the business. It provides information on the equivalent amount provided by creditors for every P1 provided by the owners. 3. Times-Interest-Earned Ratio = EBIT divided by the Interest Charges  *EBIT - Earnings Before Interest and Taxes This measures the ability of the firm to meet its annual interest payments. It will also measure the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Failure to meet this obligation can bring legal action by the firm's creditors, possibly resulting in bankruptcy. Note that earnings before interest and taxes, rather than net income is used in the numerator. This is because interest is a deductible cost, and the ability to pay current interest is not affected by taxes. 4. Fixed Charge Coverage = (EBIT + Fixed Charges) divided by (Interest Charges + Fixed Charges) This ratio is like the "times interest earned ratio", but it is more inclusive in that it recognizes that many firms incur many fixed charges. As many firms lease assets, retirement fund contributions, sinking funds contribution, and incur long-term obligations under lease contracts. Leasing has become widespread in certain industries making this ratio a must to many financial analysts. Fixed charges are defined as interest plus annual fixed charges. 5. Cash Flow Coverage Ratio = (EBIT + Fixed Charges + Depreciation) divided by [Interest Charges + Fixed Charges + (Preferred Stock Dividends/(1-tax rate) + (Debt Repayment/1-tax rate)] This ratio shows the margin by which the firm's operating cash flows cover its financial requirements. Normally, firms with preferred stocks require paying preferred dividends as well as its annual repayments of principal on loans. Depreciation is added back to EBIT, since it was deducted from income to arrive at EBIT without cash outflow. Dividing an after-tax number by (1-tax rate) is often called "grossing up" the net after-tax number. Because preferred dividends and loan payments must be made from income remaining after payment of income taxes, dividing by (1-tax rate) "grossed up" the payments and shows the before-tax amounts necessary to produce a given after-tax amount. For instance, to pay P10,000 of preferred dividends and the tax rate is 40%, we need P16,667 computed as follows: [P10,000/(1-.40)]. To prove, P16,667 earnings before income tax (EBIT) less the tax of P6,667 (P16,667 x 40%) will give us P10,000. 6. Book Value of Securities = Value of each security divided by each number of shares outstanding "Securities are bonds, preferred stocks and common stocks 7. Capitalization Ratios = the proportion of the face value of a particular type of security to the company's total equity (creditors' and owners' equities). This is normally applicable only to long term debts Analyzing the Income Statement D. Profitability Ratios These ratios would show the net result of the policies and decisions the management did in the current period. The combined effects of liquidity, asset management, and debt management on operating results will be analyzed using these ratios. 1. Profit Margin = Net Income available to Common Stock divided by Sales 2. Return on Sales = Net income divided by Net Sales 3. Return on Total Assets (ROA) = Net Income available to Common Stock divided by Average Total Assets or = (Net Income plus Interest Expenses net of its tax effect) divided by Average Total Assets Average Total Assets = (TA beg + TA, end) divided by 2 4. Return on Common Equity (ROE) = Net Income available to Common Stock divided by the Average Common Stock Equity 5. Basic Earning Power = EBIT divided by Average Total Assets This ratio indicates the ability of the firm's assets to generate operating income. This ratio shows the raw earning power of the firm's assets, before the influence of taxes and leverage, and it is useful for comparing firms with different tax situations and different degrees of financial leverage. 6. Earnings Per Share (EPS) or Basic EPS = (Net Income Available to Common Stockholders before Extraordinary Items net of its tax effect) divided by Weighted Average Number of Shares Outstanding 7. Dividend Per Share = Dividends Paid to Common Stock divided by Common Shares Outstanding 8. Dividend Pay-Out Ratio = Dividends Per Share of Common Stock divided by Earnings Per Share This measures the amount of dividend paid for every P1 earnings or the percentage of distributed earnings in relation to EPS. Analyzing the Retained Earnings E. Market Value Ratios This is a set of ratios that relate the firm's stock price to its earnings and book value per share These ratios give the management an indication of what investors think of the company's pay performance and prospects. If the firm's liquidity, asset management, debt management and profitability ratios are all good, then, its market value ratios will be high, and its stock price is expected to be as high it can be. 1. Price-Earnings Ratio = Market Price Per Share of Common Stock divided by EPS This ratio shows the peso amount investors will pay for every P1 of current earnings. 2. Market-Book Ratio = Market Price Per Share divided by Book Value Per Share This ratio of a stock's market price to its book value gives another indication of how investors regard the company. Companies with relatively high rates of return on equity generally sell at higher multiples of book value than those with low returns. 3. Dividend Yield Ratio = Dividends Per Share of Common Stock divided by Market Price Per Share This ratio measures the rate of return on actual dividend distribution to common stockholders. Financial Statements Analysis of James Corporation Year 2 Year 1 1. Working Capital Current Assets P100,500 P87,900 Less, Current Liabilities 40,000 36,150 Working Capital P 60,500 P 51,750 2. Current Asset Ratio Current Assets P100,500 P87,900 Current Liabilities 40,000 36,150 CAR 2.6:1 2.43:1 3. QuickAsset Ratio Quick Assets P39,750 P36,000 Current Liabilities 40,000 36,150 QAR.99:1.99:1  4. Accounts Receivable Turnover Net sales/Ave. A/R P261,000/[(36,000+33,000)/2 = 7.56 times 5. No. of Days in A/R 365 days/7.5648.28 days or Ave. A/R / average daily sales P34,500/(P261,000/365 days) 48.25 days 6. Inventory Turnover =Cost of Sales / Ave. Inventory = P187,790/[(P60,000+ 51,000)/2] = 3.38 times 7. No. of Days in Inventory = 365 days/3.38 108 days or Ave. Inventory / average daily cost of sales P187,790/(P187,790/365 days)= 108 days 8. Debt Equity Ratio Total Liabilities P150,000 P144,150 Total Stockholders' Equity 210,000 188,800 Debt Equity ratio.71:1.76:1 9. Book Value of Securities Preferred Stock = P18,000/(P18,000/P100) = P18,000/180 shares = P100 per share Common Stock = P192,000/(P75,000/P10) = P192,000/7,500 shares = P25.60 per share But if book value is computed to serve as a backing of Long-Term liabilities, Preferred stocks in case of liquidation, computational procedure would be as follows: Total Assets P360,000 Less, Current Liabilities 40,000 Net Assets Backing the claims of bondholders P 320,000 Book Value per Bond/Notes = Net Assets available divided by of Bond Outstanding = P320,000/110 = P2,909 per share of P1,000 bond outstanding Net Assets Backing Bonds P320,000 Less, Bonds Payable/Notes 110,000 Net Assets Backing Preferred Stock P210,000 Book Value Per Share of P / S = Net Assets available divided by No. of P/S Outstanding = P * 210000/180 shares = P 1,667 share of P100 par value Preferred Stock Net Assets Backing Preferred Stock P210,000 Less, Preferred Stock 18,000 Net Assets Backing Common Stockholders P192,000 Book Value Per Share of C / S = Net Assets Available divided by No. of Common Shares Outstanding = P192,000/7,500 shares = P25.60 per share of P10 par common stock Notice that the book value per share in No. 9 is the same at P25.60. 10. Capitalization Ratios, Proportion of the Face Value of a particular security: Amount Percentage Long Term Notes P110,000 34% Preferred Stock 18,000 6% Common Stock 192,000 60% Totals P320.000 100% 11. Return on Sales = Net Income/Net Sales = P33, 840 / P * 261000 = 12.96% 12. Return on Assets = Net Income Before Interest, net of tax / Ave. T.A = ( 33,840 +P8,463)/[(P360,000+P332,550)/2] = (P33 ,840+8,463)/P346,250 = 12.21% Interest net of tax: Interest Expense P12,090 Assume tax rate of30% 3,627 Interest net of tax effects P 8.463 13. Return on Equity = Net income available to CS / Average total SE = (P33,840-P1,440)/[(P192,000+P170,800)/2] = (P33,840-P1,440)/P181,400 = 17.86% 14. Interest Coverage = [Operating Income or EBIT]/Interest Expense = P57,210/P12,090 = 4.73 times 15. Preferred Stock Coverage = (Net Income after Interest and After Tax) Divide by Stated Preferred Stock Dividends = P33,840/P1,440 = 23.50 times 16. Earnings Per Share = Net Income/No. of C/S Outstanding (simple) = (P33,840-P,440)/7,500 shares = P4.32 per share 17. Price Earnings Ratio = Market Value Per Share/EPS = P195/P4.32 = 45.13 18. Dividend Pay Out = Dividend Per Share of CS/EPS = (P14,400/7,500)/P4.32 = 44.44% 19. Dividend Yield = Dividend Per Share/Market Price Per Share = P1.92/P195 = 10% Notes to Financial Statements Published financial statements are accompanied by notes. These narratives provide greater detail of information that is included very concisely in the financial statements. Many people find some notes to be complicated. Nevertheless, they can be extremely important, and should be viewed as an integral part of the financial statements. Information typically disclosed in the notes includes: ➤ Details of the inventory costing and depreciation methods used. ➤ Contingent liabilities and pending lawsuits ➤ Long term leases, if any. ➤ Terms of executive employment contracts, profit sharing programs, pension plans, and stock options granted to employees. Note that if you really want to analyze a set of financial statements thoroughly don't pass over the "Notes to Financial Statements". Limitations of Financial Statement Analysis Financial statements and the financial ratios derived from them are but a single source of information about a company. Like any management accounting information, financial ratios serve only as an attention-directing device. The ratios raise questions more often than they answer them. An analyst must follow up the financial statement analysis with in-depth research on a company's management styles, its history and trends, the industry, and the national and international economies in which the firm operates. Further, as financial statements are historical costs, inflation could badly distort balance sheets particularly depreciation charges and inventory costs which affect profit. Thus, a ratio analysis for one firm for several periods or different companies of different ages must be interpreted with extra care and judgement.  Several factors make financial analysis difficult. One of them is variations in accounting method firms. As in the case of different methods of inventory valuation and depreciation can lead to differences in reported profits for identical firms, and a good financial analyst must be able to adjust for these differences so that he or she can make valid comparisons among companies. Again, analysis will be more meaningful if we make comparisons. Another is timing. An action is taken at one point in time, but its full effects cannot be accurately measured until some later period. As the cash account is the steering wheel of every firm, the effects of the cash flow cycle could be accurately measured at a different time. Cash could be depleted as a result of acquisition of fixed assets to boost production and sales activities and net income was recognized at the same period though collection of cash again could be done at a later period. As such, at that same period, current asset ratio may seem not good, but profit seems better. It is also difficult to generalize whether a particular ratio is "good" or "bad". For instance, a high current ratio may indicate strong liquidity position which in fact illiquid since most of its current asset is in the form of non-moving inventory or in the form of aged accounts receivable. Even excessive cash is not good as cash itself is a non-earning asset. Therefore, financial statement analysis must be interpreted as a whole, co-relating its weaknesses and strengths rather individual ratios.