CHAPTER 4 FINANCIAL STATEMENTS ANALYSIS - I.docx

1. CHAPTER 4
FINANCIAL STATEMENTS ANALYSIS - I
I. Questions
1. The objective of financial statements analysis is to determine the extent of a firm’s success
in attaining its financial goals, namely:
a. To earn maximum profit
b. To maintain solvency
c. To attain stability
2. Some of the indications of satisfactory short-term solvency or working capital position of
a business firm are:
1. Favorable credit position
2. Satisfactory proportion of cash to the requirements of the current volume
3. Ability to pay current debts in the regular course of business
4. Ability to extend more credit to customers
5. Ability to replenish inventory promptly
3. These tests are:
1. Improvement in the financial position
2. Well-balanced financial structure between borrowed funds and equity
3. Effective employment of borrowed funds andequity
4. Ability to declare satisfactory amount of dividends to shareholders
5. Ability to withstand adverse business conditions
6. Ability to engage in research and development in an attempt to provide new
products or improve old products, methods or processes
4. Some indicators of managerial efficiencyare:
1. Ability to earn a reasonable return on its investment of borrowed funds and
equity
2. Ability to control operating costs within reasonable limits
3. No overinvestment in fixed assets, receivables andinventories
5. The techniques used in Financial Statement Analysis are:
I. Verticalanalysis which shows the relationships of the items in the same year:
also referred to as “static measure.”
a. Financial ratios
b. Common-size statements
II. Horizontal analysis which shows the changes or tendencies of an item for 2 or
more years; also referred to as “dynamic measure.”

2. a. Comparative statements - showing changes in absolute amount and
percentages
b. Trend percentages
III. Use of special reports or statements
a. Statements of Changes in Financial Position
b. Gross Profit / Net Income VariationAnalysis
6. Refer to page 133 of the textbook.
7. Horizontal analysis involves the comparison of items on financial statements between
years. Analysis of comparative financial statements or the increase/decrease method of
analysis and trend percentagesare the two techniques thatmay be applied under horizontal
analysis.
Vertical analysis involves the study of items on a single statement for a single year, such
as the analysis of an income statement for some given year. Common-size statement and
financial ratios are techniques used in vertical analysis.
8. Trends can indicate whether a situation is improving, remaining the same or deteriorating.
They can also give insight to the probable future course of events in a firm.
9. Trend percentages represent the expression of several years’ financial data in percentage
form in terms of a base year.
10. Refer to page 133 of the textbook.
11. Observation of trends is useful primarily in determining whether a situation is improving,
worsening, or remaining constant. By comparing current data with similar data of prior
periods we gain insight into the direction in which future results are likely tomove.
Some other standards of comparison include comparison with other similar companies,
comparison with industry standards, and comparison with previous years’ information. By
comparing analytical data for one company with some independent yardstick, the analyst
hopes to determine how the position of the company in question compares with some
standard of performance.
12. Trend percentages are used to show the increase or decrease in a financial statement
amount over a period of years by comparing the amount in each
year with the base-year amount. A component percentage is the percentage relationship
between some financial amount and a total of which it is a part.
Measuring the change in sales over a period of several years would call for use of trend
percentages. The sales in the base year are assigned a weight of 100%. The percentage for
each later year is computed by dividing that year’s sales by the sales in the base year.
13. Expenses (including the cost of goods sold) have beenincreasing at an evenfasterrate than
net sales. Thus Premiere is apparently having difficulty in effectively controlling its
expenses.

3. 14. A corporate net income of P1 million would be unreasonably low for a large corporation,
with, say, P100 million in sales, P50 million in assets,and P40 million in equity. A return
of only P1 million for a company of this size would suggest that the owners could do much
better by investing in insured bank savings accounts or in government bonds which would
be virtually risk-free and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for a corporation
which had sales of only P5 million, assets of, say, P3 million, and equity of perhaps one-
half million pesos. In other words, the net income of a corporation must be judged in
relation to the scale of operations and the amount invested.
II. True or False
1. True 3. True 5. False 7. True 9. True
2. False 4. True 6. False 8. False 10. True