REVIEWER.docx - REVIEWER Financial Statement Analysis There...

REVIEWER
Financial Statement Analysis
There are different users of financial statements. Financial statement analysis can be used by
managers, equity investors, creditors, regulators, labor unions, employees, the public, and potential
investors and creditors. Financial statement analysis is used for investment and credit decisions. It is
also used for regulating companies such as what the Energy Regulatory Commission does for power
distribution companies and other energy companies.
Financial statement analysis is definitely used by management for monitoring performance and for
identifying strategies to further improve the company's operations.
For this chapter, the following financial ratios will be discussed:
1. Profitability ratios
2. Efficiency ratios
3. Liquidity ratios
4. Leverage ratios
Vertical and horizontal analysis will also be discussed. How to evaluate the quality of earnings of a
company shall likewise be discussed in this chapter.
Profitability Ratios
The following ratios are used to measure the profitability of a company:
1. Return on equity (ROE)
2. Return on assets (ROA)
3. Gross profit margin
4. Operating profit margin
5. Net profit margin
Return on Equity (ROE)
ROE is a profitability measure that should be of interest to stock market investors. It measures the
amount of net income earned in relation to stockholders' equity. ROE is computed as follows:
ROE = Net Income + Stockholders' Equity
In computing ROE, different approaches are observed. There are analysts who use the average of the
stockholders' equity for two accounting periods while others simply use the year-end balances.
Whichever formula is used, consistency must be applied.
To illustrate, let us use the financial statements of JSC Foods Corporation in 2014.
ROE = (Net Income Stockholders' Equity)
* 100%
ROE = (2 659 087 + 12 478 559) × 100%
ROE = 21.31%
The ROE of 21.31% means that for every P1 of stockholders' equity, P0.2131 or $21.31 was earned in
2014. To be more meaningful, this rate of return is compared with the returns on alternative
investments such as the returns on time deposits and other fixed income instruments. For example, if
the interest on time deposits is only 2%, then the 21.31% ROE seems better. However, before a

conclusion is made that the 21.31% ROE is better than the time deposit rate of 2%, the risks
associated with this company earning 21.31% have to be assessed. Unless a bank will experience a
bank run, the 2% time deposit rate is guaranteed while the 21.31% ROE is not. In 2014, ROE of JSC
Foods was high, but what if previously, it earned negative ROE? Is this possible for a company? No
manager of any company who is in his sound mind will guarantee a specific rate of return, especially
when that rate is relatively high. Why? Because in business, there are always risks. A company which is
doing so well this year may find itself with too many competitors in the future and these competitors
may eat its share of the business in the market and can make a profitable company today and a losing
company in the future.