Department of Accounting Education

Mabini Street, Tagum City

Davao del Norte
Telefax: (084) 655-9591, Local 116

Metalanguage
In this section, the most essential terms relevant to the study of curriculum and to
demonstrate ULOc will be operationally defined to establish a common frame of refence as
to how the texts work in your chosen field or career. You will encounter these terms as we
go through the study of taxation. Please refer to these definitions in case you will encounter
difficulty in the understanding educational concepts.
1. Financial Ratio Analysis. Financial ratios measures relationship expressed in
mathematical terms between figures which are connected with each other in
significant manner. A ratio is a statistical yardstick that provides a measure of
relationship between two financial figures.

Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the first two (2) weeks
of the course, you need to fully understand the following essential knowledge that will be laid
down in the succeeding pages. Please note that you are not limited to exclusively refer to
these resources. Thus, you are expected to utilize other books, research articles and other
resources that are available in the university’s library e.g. ebrary, search.proquest.com etc.

I. Advanced Concepts for Analyzing and Appraising Financial and Related

Information

1.0 FINANCIAL RATIO ANALYSIS

It is a process of determining, interpreting and presenting numerical relationships of items
and group of items in the financial statements. Ratios are customarily presented in the
following forms:
I. The first is merely a quotient (Current Liabilities, Proprietors Funds: Total assets etc.)

II. Sometimes ratios are also expressed as rates which refer to ratios over a period of
time (fixed assets turnover ratio, Inventory turnover ratio etc.)

III. Some ratios are presented by per cent. (Gross Profit Ratio, ROI, etc.)
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

“Ratio analysis is a process of analysis of the ratios in such a manner so that the management
can take actions on off standard performances.” The process of Financial Ratio Analysis can
be segregated into:
a. Working of Ratios
b. Interpretation of Ratios
c. Remedial actions on variances with the objective of improvement in
efficiency
1.1 CLASSIFICATION:
Ratios may be classified on the following basis leading to somewhat overlapping
categories:
1. Classification according to the statement from which ratios are derived:
a. Balance – Sheet Ratios
b. Revenue Statement Ratios
c. Inter-Statement or combined Ratios

2. Classification according to Importance:

a. Primary Ratios
b. Secondary Ratios

3. Functional Classification:
a. Cash position ratios
b. Liquidity ratios
c. Working Capital ratios
d. Capital Structure ratios
e. Profitability ratios
f. Debt Service coverage ratios
g. Turnover ratios
h. Other ratios

1.1.1 Liquidity Ratios

Also known as Solvency Ratios, and as the name indicates, it focuses on a company’s
current assets and liabilities to assess if it can pay the short-term debts. The three
common liquidity ratios used are current ratio, quick ratio, and burn rate. Among the
three, current ratio comes in handy to analyze the liquidity and solvency of the start-
ups.
S. No. RATIOS FORMULAS SIGNIFICANCE
1 Current Ratio Current Assets/Current Primary test of solvency to
Liabilities meet current obligations from
current assets as a going
concern; measure of adequacy
of working capital.
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

2 Quick Ratio Liquid Assets/Current A more severe test of

Liabilities immediate solvency; test of
ability to meet demands from
current assets.

1.1.2 Profitability Ratios

These ratios analyze another key aspect of a company and that is how it uses its
assets and how effectively it generates the profit from the assets and equities. This
also then gives the analyst information on the effectiveness of the use of the
company’s operations.
S. No. RATIOS FORMULAS SIGNIFICANCE
1 Gross Profit Gross Profit/Net Sales X Measures profit generated
Ratio 100 after consideration of cost of
product sold.

2 Operating Operating Profit/Net Sales X Measures profit generated

Profit ratio 100 after consideration of
operating costs.

3 Net Profit Net Profit/Net Sales X 100 Measures profit generated

Ratio after consideration of all
expenses and revenues.

4 Dividends per Dividends Paid or Declared/ Shows portin of income

Share Ordinary Shares distributed to shareholders on
outstanding a per share basis.

5 Rate of return Net Profit/ Ave. Ordinary Measures rate of return on

on Equity Equity resources provided by owners.

6 Rate of return Net Profit/ Ave. Total Assets Measures overall efficiency of
on Assets the firm in managing assets
and generating profits.

7 Earnings Per Net Profit After Tax & Peso return on each ordinary
Share Ratio Preference Dividend /No of share. Indicative of ability to
Equity Shares pay dividends.

8 Dividend Pay Dividend Per Equity Shows percentage of earnings

Out Ratio Share/Earning Per Equity paid to shareholders.
Share X 100
9 Earning Per Net Profit after Tax & Peso return on each ordinary
Equity Share Preference Dividend / No. of share. |Indicative of ability to
Equity Share pay dividends.

10 Dividend Yield Dividend Per Share/ Market Shows the rate earned by
Ratio Value Per Share X 100 shareholders from dividends
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

relative to current price of

stock.

11 Price Earnings Market Price Per Share Measures relationship

Ratio Equity Share/ Earning Per between price or ordinary
Share X 100 shares in the open market and
profit earned ona per share
basis.

1.1.3 Working Capital Ratios

Like the Liquidity ratios, it also analyses if the company can pay off the current debts
or liabilities using the current assets. This ratio is crucial for the creditors to establish
the liquidity of a company, and how quickly a company converts its assets to bring in
cash for resolving the debts.
S. No. RATIOS FORMULAS SIGNIFICANCE
1 Trade Net Credit Sales* / Average Velocity of collection of trade
Receivable trade receivable (net) accounts and notes; test of
Turnover efficiency of collection.
*Net Sales if net credit sales
is not available
2 Average 360 days/ Receivable Evaluates the liquidity of
Collection Turnover accounts receivable and the
period/ firms’ credit policies.
Number of Or
Days’ sales
uncollected Accounts Receivable / (Net
Sales/ 360)
3 Merchandise Cost of goods sold/ average Measures efficiency of the firm
Inv. Turnover Merchandise Inventory in managing and selling
inventories.
4 Days in 360 days/ Inventory Measures average number of
Supply Turnover days to sell or consume the
Inventory average inventory

5 Working Net Sales/ Ave. Working Indicates adequacy and

Capital Capital activity of working capital.
Turnover
6 Investment or Net Sales/ (Ave. Assets or Measures efficiency of the firm
Assets Total Assets) in managing all assets.
Turnover
7 Sales to fixed Net Sales/ Ave. fixed Tests roughly the efficiency of
assets (plant Assetd management in keeping plant
turnover) properties employed.
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

1.1.4 Capital Structure Ratios

Each firm or company has capital or funds to finance its operations. These ratios, i.e.,
the Capital Structure Ratios, analyze how structurally a firm uses the capital or funds
S. No. RATIOS FORMULAS SIGNIFICANCE
1 Debt Equity Total Long Term Debts / Shows proportion of all assets
Ratio Shareholders Fund that are financed with debt.

2 Equity Ratio Total Equity/ Total Assets Indicates proportion of assets

provided by owners. Reflects
financial strength and caution
to creditors.

3 Debt to Equity Total Liabilities/ Total Equity Measures debt relative to

Ratio amounts of resources
provided by owners.

4 Book Value Ordinary SHE/ No. of Measures recoverable amount

per share of outstanding ordinary shares in the event of liquidation if
ordinary assets are realized at their
shares book values.

5 Times Interest Net Income before Interest Measures how many times
Earned and Taxes/ Annual Interest interest expense is covered by
charge operating profit.

(Comprehensive Illustration ):
The Statement of Financial Position as of Dec 31, 2011 and 2010, Income Statement and
Statement of Cash Flows of EBC Enterprise, Inc. for years 2011, 2010, 2009 are given
below:
EBC Enterprise Inc.
Statement Of Financial Position at December 31, 2011 and 2010
(In Thousands)
2011 2010
Assets
Current Assets
Cash 2,030.5 1,191.0
Marketable Securities 2,636.0 4,002.0
Accounts Receivable 4,704.0 4,383.5
Allowance for Doubtful Accounts (224.0) (208.5)
Inventories 23,520.5 18,384.5
Prepaid Expenses 256.0 379.5
Total 32,923.0 28,132.0
Non-Current Assets
Land 405.5 405.5
Building and Leasehold Improvements 9,136.5 5,964.0
Equipment 10,761.5 6,884.0
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

20,303.5 13,253.5
Less: Accumulated Depreciation and Amortization (5,764.0) (3,765.0)
Property plant and equipment, net 14,539.5 9,448.5
Other Assets 186.5 334.0
Total Assets 47,649.0 37,954.5

Liabilities and Equity

Current Liabilities
Accounts Payable 7,147.0 3,795.5
Notes Payable – banks 2.807.0 3,006.0
Current Maturities of long term debt 942.0 758.0
Accrued Liabilities 2,834.5 2,656.5
Total 47,649.0 37,954.5
Deferred Income Taxes 421.5 317.5
Long term Debt 10,529.5 8,487.5
Total Liabilities 24,681.5 19,021.0

Equity
Ordinary shares, par value P1, authorized
10,000 shares; issued 2,297,000 shares
in 2011 and 2,401,500 shares in 2011 2,401.5 2,297.0
Additional paid-in capital 478.5 455.0
Retained Earnings 20,087.5 16,181.5
Total Equity 22,967.5 18,933.5
Total Liabilities and Equity 47,649.0 37,954.5
EBC Enterprise Inc.
Income Statement and Retained Earnings
For the year ended December 31, 2011, 2010 and 2009
(In Thousands)
2011 2010 2009
Net Sales 107,800.0 76,500.0 70,350.0
Cost of Goods Sold 64,682.0 45,939.5 40,803.0
Gross Profit 43,118.0 30,560.5 29,547.0
Selling and Administrative Expenses 16,332.0 13,191.0 12,749.0
Advertising 7,129.0 5,396.0 4,770.5
Depreciation and Amortization 1,999.0 1,492.0 1,250.5
Repairs and Maintenance 1,507.5 1,023.0 1,515.5
Total 33,496.5 24,657.5 23,919.0
Operating Profit 9,621.5 5,903.0 5,628.0
Other Income (Expenses):
Interest Income 211.0 419.0 369.0
Interest Expense (1,292.5) (1,138.5) (637.0)
Earnings Before Income Taxes 8,540.0 5,183.0 5,360.0
Income Taxes 3,843.0 2,228.5 2,412.0
Net Income 4,697.0 2,955.0 2,948.0
Earnings Per Share P2.00 P1.29 P1.33
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Statement of Retained Earnings

Retained Earnings, Beginning 16,181.5 14,157.5 12,130.0
Net Income 4,697.0 2,955.0 2,948.0
Cash Dividends (2011-P0.33 per share; 2010-
P0.41 per share) (791.0) (931.0) (920.5)
Retained Earnings at the end of the year P20,087.5 P16,181.5 P14,157.5

EBC Enterprise Inc.

Statement of Cash flows for the years ended December 31, 2011 and 2010
(In Thousands)
2011 2010
Cash Flow From Operating Activities – Direct Method
Cash Received from Customers 107,495.0 74, 830.5
Interest Received 211.0 419.0
Cash paid to supplier for inventory (66,466.5) (49,968.0)
Cash paid to employees (S&A Expenses) (16,332.0) (13,191.0)
Cash paid for other operating expenses (14,864.0) (10,675.0)
Interest Paid (1,292.5) (1,138.5)
Taxes Paid (3,739.0) (2,160.5)
Net Cash Provided (used) by Operating activities 5,012.0 (1,883.5)
Cash Flow From Investing
Addition to Property, Plant and Equipment (7,050.0) (2,386.5)
Other Investing Activities 147.5 0
Net Cash Provided (used) by investing activities ( 6,902.5) (2,386.5)

Cash Flow from Financing Activities

Sales of Ordinary Shares 128.0 91.5
Increase (decrease) in short-term borrowings (15.0) 927.0
(includes current maturities of long term debt)
Addition to long term borrowings 2,800.0 3,941.0
Reductions of long term borrowings (758.0) (796.5)
Dividends paid (791.0) (931.0)
Net cash provided (used) by financing activities 1,364.0 3,232.0
Increase (decrease) in cash & marketable securities (562.5) (1,038.0)

Required:
Use the financial Ratios, evaluate the company’s financial position and operating results for
the years 2011 and 2010.
1. Current Ratio 2011: 32,923 / 13,703.5 = 2.4 times
2010: 28,132 / 10,216 = 2.75 times
Current Ratio is a measure of short-term debt paying ability.
2. Quick or acid test ratio 2011: 9,146.5 / 13, 703.5 = 0.67 times
2010: 9,368 / 10,216 = 0.92 times
Quick Ratio is much more rigorous test of company’s ability to meet its short term debt.
Again, quick assets doesn’t include inventories and prepayments.
3. Accounts Receivable Turnover
2011: 107,800*/ [(4,480+4,175)/2]= 24.9 times
2010: 76,500 / 4,175** = 18.32 times
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Accounts Receivable Turnover measures how many times a company’s accounts

receivable have been turned into cash during the year.
*When net credit sales are not available, use the net sales.
**Assumed Average for 2010 since there’s no 2009 accounts receivable given so
the given in 2010 is assumed to be the average.
4. Ave. Collection Period 2011: 365 / 24.9 = 14.6 or 15 days
2010: 365 / 18.32 = 19.9 or 20 days
Collection Period helps evaluate the liquidity of accounts receivable and the firm’s credit
policy.
5. Inventory Turnover 2011: 64,682 / [(23,520.5+18,384.5)/2]
= 3.09 times
2010: 45,939.5 / 18,384.5* = 2.5 times
*Assumed Average for 2010.
Inventory turnover measures the efficiency of the firm in managing and selling inventory.
6. Inventory days or period
2011: 365 / 3.09 = 118 days
2010: 365 / 2.5 = 146 days
Inventory period is the number of days to sell the entire inventory one time.
7. Total Asset Turnover 2011: 107,800 / [(47,649+37,954.5)/2]
= 2.52 times
2010: 76,500 / 37,954.5* = 2.02 times
*Assumed Average for 2010.
Asset turnover measures the efficiency of management to generate sales and thus earn more
profit for the firm.
8. Debt Ratio 2011: 24,681.5 / 47,649 = 51.8%
2010: 19,021 / 37,954.5 = 50.1%
Debt Ratio measures the proportion of all assets that are financed with debt.
9. Debt to Equity Ratio 2011: 24,681.5 / 22,967.5 = 107.46%
2010: 19,021 / 18,933.5 = 100.46%
Debt to equity ratio measures the riskiness of the firm’s capital structure in terms of
relationship between the funds supplied by creditors (debt) and investors (equity).
10. Times Interest Earned 2011: 9,621.5 / 1.292.5 = 7.44 times
2010: 5,903 / 1,138.5 = 5.18 times
It is the most common measure of the ability of a firm’s operations to provide protection to
long-term creditors.
11. Fixed Charge Coverage
2011: (9,621.5+6,529) / (1,292.5+6,529)
= 2.06 times
2010: (5,903 + 3,555.5) / (1,138.5+3,555.5)
= 2 times
It measures the firm’s coverage capability to cover not only interest payments but also the
fixed payment associated with leasing which must be met annually.
12. Gross Profit Margin 2011: 43,118 / 107,800 = 40%
2010: 30,560.5 / 76,500 = 39.95%
It show the relationship between sales and the cost of products sold, measures the ability of
a company both to control costs and inventories or manufacturing of products and to pass
along price increases through sales to customers.
13. Operating Profit Margin
2011: 9,621.5 / 107,800 = 8.9%
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

2010: 5,903 / 76,500 = 7.7%

It measures the overall efficiency and incorporates all of the expenses associated with
ordinary or normal business activities.
14. Net Profit Margin 2011: 4,697 / 107,800 = 4.36%
2010: 2,955 / 76,500 = 3.87%
It measures the profitability after considering all revenue and expenses, including interest,
taxes, and non-operating items such as extra-ordinary items, cumulative effect of accounting
change, etc.

15. Return on Investment or Asset

2011: {4,697+[(1,292.5)(1-45%]} / 43,802
= 12.35%
2010: {2,955+[(1,138.5)(1-43%]} / 39,955
= 9.02%
16. Return on Equity 2011: 4,697 / [(22,967.5+18,933.5)/2)
= 22.42%
2010: 2,955 / 18,933.5 = 15.60%
Return on Assets and Return on Equity are two ratios that measure the overall efficiency of
the firm in managing its total investment in assets and in generating return to shareholders.

*ROE / ROA = Financial Leverage Index

17. EPS 2011: 4,697,000 / [(2,401,500+2,297,000)/2]

= P2.00
2010: 2,955,000 / 2,297,000 = P1.29
18. Price/Earnings Ratio 2011: 30 / 2 = 15
2010: 17/1.27 = 13.39
Price-earnings ratio relates the EPS to its Market price at which the stock trades, expressing
the “multiple” which the stock market places on firm’s earnings.

19. Dividend Payout 2011: 0.33 / 2 = 16.5%

2010: 0.41 / 1.29 = 31.78%
20. Dividend Yield 2011: 0.33 / 30 = 1.10%
2010: 0.41 / 17 = 2.41%

• Tip: When the ratio is composed of one income statement account and one balance sheet
account, the balance sheet account must be an average balance.

2.0 CASH FLOW ANALYSIS

Funds flow analysis suffers from the major limitation that the liquidity is not fully reflected by
this analysis. The quality of current assets will make the difference, thus, a firm reporting
positive change in funds may still have problems as the current assets are of poor quality.
Cash flow analysis is superior to Funds flow analysis. Also, the cash flows are divided into
three major categories, viz. Operating, investing and financing activities, to have a better
understanding of the liquidity position of the company.
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

2.1 Concept
Cash flow statement indicates the sources and uses of cash flows. The transactions resulting
in cash in-flows are called sources of cash flows; and those transactions that result in cash
out-flows are called uses of cash flows. The information contained in cash flow statement is
more reliable as cash flows are not affected by subjective judgment, estimates and
accounting policies. Cash for the purpose of cash flow includes cash and cash equivalents.
Cash consists of cash in hand and cash at bank. Cash equivalents are short term highly liquid
investments that are readily convertible into known amount of changes in value. These are
having short term maturity period usually not more than three months. The sources and uses
of cash are given below:

Sources of cash (Cash in-flows) Uses of Cash (Cash out-flows)

1. Business operations/operating activities 1. Purchase of Fixed Assets
2. Sale of Fixed Assets 2. Purchase of Investments
3. Issue of Equity & Pref. Shares 3. Redemption of Pref. Shares & Debentures
4. Issue of Debentures 4. Repurchase of Equity Shares
5. Long Term Loans raised 5. Repayment of Loans
6. Interest received in Investments 6. Payment of Interest
7. Dividends received in Investment 7. Payment of Div. on Pref. & Eq. Capital
8. Other Items (Specify) 8. Other Items (Specify)
✓ The cash flows computed are divided into three categories viz. operating; investing
and financing activities. The separate disclosure under these categories helps us to
make proper analysis and have better understanding of the liquidity position of the
firm. The computation of cash flows under each category is discussed below:

2.1.1 Cash flows from operating activities: The cash flow accruing from main operating
activities (also called as revenue producing activities like sale of goods and services) are
called cash flows from operating activities. The net cash flow from operating activities
represent the net cash received from main operations of the business.
The sources of cash or cash in-flows from operating activities are: i) cash receipts from sale
of goods and rendering of services; ii) cash receipts from royalties, fees, commissions, and
other revenues; and iii) refunds of income taxes unless they can be specifically identified with
financing and investing activities.
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

The sources (cash in-flows) and uses of cash (cash out-flows) from operating activities are:
Sources of Cash (Cash in-flows) Uses of Cash (Cash out-flows)
i) Cash receipts from sale of goods i) cash payment to suppliers for goods
and rendering of services; and services;
ii) Cash receipts from royalties, fees, ii) Cash payment to employees;
commissions, and other revenues; iii) cash payments for other expenses
and related to production, establishment
iii) Refunds of income taxes unless they and marketing;
can be specifically identified with iv) Cash payments of income taxes
financing and investing activities. unless they can be specifically
identified with financing and
investing activities.

2.1.2 Cash flows from investing activities: The cash flows accruing from acquisition and
disposal of fixed assets and investments (not included in cash equivalents) are called cash
flows from investing activities. Given below are the sources and uses of cash from investing
activities:
Sources of Cash (Cash in-flows) Uses of Cash (Cash out-flows)
i) Cash receipts from disposal of fixed i) Cash paid for purchase of fixed assets
assets
ii) Cash receipts from sale of ii) Cash paid for purchase of investment
investments iii) Cash advances and loans made to 3rd
iii) Cash receipts towards interest & parties
dividends
iv) Cash receipts from repayment of
loans and advances

2.1.3 Cash flows from financing activities: The cash flows from financing the firm and
repaying debts as well as distribution to owners and payment of interest are called cash flows
from financing activities.

Sources of Cash (Cash in-flows) Uses of Cash (Cash out-flows)

i) Cash receipts from issue of Equity i) Buy-back of shares
shares ii) Redemption of Preference shares
ii) Cash receipts from issue of Pref. iii) Redemption of debentures
shares iv) Repayment of long term loans
iii) Cash receipts from issue of v) Payment of interest and dividends
debentures
iv) Cash receipts from long term loans
raised
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Illustration 1. Selected financial information of a company is given below:

Current Assets: July 1, 2017 June 30, 2018
Stock P. 850,000 P. 900,000
Debtors 500,000 600,000
Accrued Revenues 60,000 40,000
Prepaid Expenses 18,000 20,000
Bills Receivable 22,000 18,000
Cash in Hand & at Bank 34,000 59,000
Current Liabilities:
Sundry Creditors 560,000 440,000
Bills Payable 18,000 20,000
Revenues Received in Advance 42,000 56,000

Other Information: Net income for the year was Rs. 2,750,000 after charging depreciation
and interest of P. 580,000 and P. 350,000 respectively. There was a loss of Rs. 52,000 on
sale of old furniture. In the current year deferred revenue expenses of Rs. 30,000 were written
off. Ascertain cash flow from operating activities for the year.

Solution:
Cash Flows from Operating Activities: Pesos Pesos
Net Income 2,750,000
Add:
Depreciation 580,000
Loss on sale of old furniture 52,000
Interest paid on Debentures 350,000
Def. Rev. Expenses written off 30,000
Decrease in Accrued Revenues 20,000
Decrease in Bills Receivables 4,000
Increase in Bills payable 2,000
Increase in Revenues Received in Advance 14,000
Less:
Increase in stock 50,000
Increase in Debtors 100,000
Increase in Prepaid Expenses 2,000
Decrease in Sundry Creditors 120,000 (272,000)
Net Cash In-flow from operating activities 3,530,000

2.2 Transactions not affecting Funds:

✓ If a transaction does not affect any current asset or current liability, it does not affect funds.

✓ if a transaction affects only current assets (one current asset increases and another
current asset decrease by the same amount) or only current liabilities (one current liability
increases and another current liability decrease by the same amount), then such
transaction does not affect funds.
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

✓ When a transaction affects current assets and current liabilities simultaneously increasing
or decreasing both by the same amount, then such a transaction will not affect funds.
2.3 Transactions affecting Funds:
✓ If a transaction affects Current assets and current liabilities by different amounts, and for
the balancing figure some other account (fixed asset, fixed liability or equity) are affected,
then such transaction will affect the funds. The funds will change by the difference in
amount affecting current assets and current liabilities. If current assets have increased by
more amount than the increase in current liabilities or decreased by lesser amount than
the decrease in current liabilities, it will increase funds and is called ‘Source of Funds’.
On the other hand, if current assets have decreased by more amount than decrease in
current liabilities or increased by lesser amount than the increase in current liabilities, it
will decrease funds and is called ‘Use of Funds’.

✓ If a transaction affects the current assets on the one hand and fixed assets, fixed liabilities
or equity on the other hand, then such transaction will affect funds. If the current assets
have increased, it will increase the funds, and is called ‘Source of Funds’.

✓ If a transaction affects the current assets on the one hand and fixed assets, fixed liabilities
or equity on the other hand, then such transaction will affect funds. If the current assets
have decreased, it will decrease the funds, and is called ‘Use of funds’.

✓ If a transaction affects the current liabilities on the one hand and fixed assets, fixed
liabilities or equity on the other hand, then such transaction will affect funds. If the current
liabilities have decreased, it will increase the funds, and is called ‘Source of funds’.

✓ If a transaction affects the current liabilities on the one hand and fixed assets, fixed
liabilities or equity on the other hand, then such transaction will affect funds. If the current
liabilities have increase, it will decrease the funds, and is called ‘Use of funds’.

3.0 Calculating Cash Flows From Operating Activities

1. Direct Method
Income Statement Accounts Adjustments Cash Flow

{ }
Sales Revenue +Decrease in AR
-Increase in AR Collection From
+Increase in Deferred Revenue Customers
-Decrease in Deferred Revenue
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

{ }
Interest Revenue +Decrease in Interest Receivable
And dividend revenue -Increase in Interest Receivable Interest and
+Amortization of premium on Dividends
Investment in bonds Collected
-amortization of discount on
Investment in bonds

{ }
+Increase in Unearned Revenues
-Decrease in other revenue Other Operating
Other Revenues -Gains on disposal of assets Receipts and -
investment income(equity method) Liabilities

{ }
+increase in Inventory
Cost of Goods Sold -Decrease in Inventory Payments to
+Decrease in Accounts Payable Suppliers
-Increase in accounts payable

{ }
-Depreciation, Depletion and
Selling and Administrative Amortization expense Payments of

Expense +Decrease in Accrued Expense Operating

-Increase in Accrued Expense Expenses

+Increase in Prepaid Expenses

-Decrease in prepaid expenses

{} }
+Decrease in Interest Payable

-Increase in Interest Payable

Interest Expense +Amortization of premium on Payments of Interest

bonds payable

-Amortization of discount on

bonds payable

{ }
Other Expenses -Losses on disposal of

assets and liabilities Other operating

-Investment Loss (equity method) Payments

 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

{ }
+Decrease in income tax payable

Income Tax expense -Increase in income tax payable Payment of

+Decrease in deferred income taxes Income

Payable Taxes
-Increase in Income taxes payable

2. Indirect Method
Net Income after Taxes

Plus

Decrease in current assets (except cash, marketable securities and non-trade accounts)
Increase in current liabilities (except financing or non-operating accounts such as bank
loan, current maturities of long-term debt
Depreciation, Depletion and Amortization Expense
Amortization of discount on bonds payable
Amortization of premium on investment in bonds
Increase in deferred income taxes
Loss (net) on disposal of assets and liabilities
Subsidiary loss under equity method
Interest expense*
Income Taxes*

Minus

Increase in current assets (except cash, marketable securities and non-trade accounts)
Decrease in current liabilities (except financing or non-operating accounts such as bank
loan, current maturities of long-term debt
Amortization of premium on bonds payable
Amortization of discount on investment in bonds
Decrease in deferred income taxes
Gain (net) on disposal of assets and liabilities
Subsidiary gain under equity method

Equals

Net Cash Flow From Operations

Minus

Interest paid
Taxes Paid
=
Net Cash From Operating Activities
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Comprehensive Illustration I:

Kalikasan Company
Condensed Financial Information
__________________________________________________________________
Statement of Financial Position Information
Balances
Accounts Jan. 1, 2012 Dec. 31, 2012
Cash P 3,500 P 5,500
Accounts Receivable 4,400 3,600
Inventory 5,000 6,600
Land 8,200 12,200
Building and Equipment 35,700 48,700
Accumulated Depreciation (6,000) (8,700)
Total Assets P 50,800 P 67,900

Accounts Payable P 5,100 P 3,200

Salaries Payable 1,400 1,800
Bonds Payable, 10% 7,000 15,000
Ordinary shares, P10 par 8,000 9,000
Additional Paid in Capital 16,000 19,000
Retained Earnings 13,300 19,900
Total Liabilities and Equity P 50,800 P 67,900

Income Statement Information for 2012

Sales Revenue P 80,800
Cost of Goods Sold 48,600
Gross Profit P 31,400
Operating Expenses
Depreciation Expense P 3,400
Other Expenses 15,900 19,300
Operating Income P 12,100
Other Revenues and expenses:
Gain on sale of equipment P 600
Interest Expense 700 100
Income before income taxes P 12,000
Income tax expense 3,600
Net Income P 8,400

Retained Earnings Information for 2012

Beginning Retained Earnings P 13,300
Add: Net Income 8,400
Total 21,700
Less: Dividends (1,800)
Ending Retained Earnings P 19,900
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Supplementary Information for 2012

Equipment was purchased for cash at a cost of 15,200. Ten –year bonds payable with face
value of 8,000 were used for 8,000 at the end of the year. Land was acquired through the
issuance of 100 ordinary shares of P10 par shares when stock was selling at a market price
of P40 per share. Equipment with a cost of 2,200 and a book value of 1,500 was sold for
2,100 cash.

Solution:
Kalikasan Company
Statement of Cash Flows
For the year ended December 31, 2012
Net Cash flows from operating activities
Net Income before interest and taxes P 12,100
Add: Depreciation Expense 3,400
Decrease in Accounts Receivable 800
Increase in Salaries Payable 400
Less: Increase in Inventories 1,600
Decrease in Accounts Payable 1,900
Gain on sale of equipment 600
Interest expense 100
Income tax expense 3,600
Net Cash Provided by Operations 8,900
Cash Flow from Investing Activities
Payment for purchase of equipment P (15,200)
Proceeds from sale of equipment 2,100
Net Cash used for investing activities 13,100
Cash Flow from Financing Activities
Proceeds from issuance of bonds P 8,000
Payment of Dividends (1,800)
Net cash provided by financing activities 6,200
Net Increase in Cash 2,000
Cash Balance, January 1, 2012 3,500 Cash
Balance, December 31, 2012 P 5,500

Direct method
Net Cash flow from operating activities:

Cash Flow Operating Activities

Cash Inflows
Collections from customers (80,000 + 800) P 80,800
Cash Outflows
Payment to suppliers (48,600+1,600+1,900) 52,100
Payment of other operating expenses (19,300-3,400-400) 15,500
Payment of Interest expense 700
Payment of Income taxes 3,600
Total P 71,900
Net Cash Flows from Operating Activities P 8,900
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Comprehensive Illustration II:

Prepare Cash Flow Statement from the Balance Sheets and other information given
related to Marie Industries Ltd.
Balance Sheet of National Industries Ltd. as at June 30, 2008
(Pesos in thousands)
Particulars Amount Amount Particulars Amount Amount
Equity Capital 600 700 Land 360 360
Reserves 170 200 Buildings 500 532
P & L App. A/c 140 210 Furniture 50 60
Debentures 150 100 Motor Vehicles 40 52
Sundry Creditors 96 124 Stock 78 96
Bills payable 24 26 Sundry Debtors 112 150
Outstanding 32 20 Cash & Bank 72 130
Expenses ______ ______ ______ ______
TOTAL 1212 1380 TOTAL 1212 1380
_______ ______ ______ ______

Net Income after interest and tax but before dividends was Rs. 160 thousands. Depreciation
charged on: Buildings P10,000, Furniture P4,000 and Motor Vehicles P8,000. No fixed assets
were sold during the year. Interest paid during the year was 18,000, dividends 60,000 and
tax paid was 40,000.
Solution:
CASH FLOW STATEMENT

Cash Flows from Operating Activities: Pesos in ‘000s Pesos in ‘000s

Net Income 160.00
Add Depreciati0n on:
Buildings 10.00
Furniture 4.00
Motor Vehicles 8.00
Interest paid on Debentures 18.00
Income Tax Paid 40.00
Increase in S. Creditors 28.00
Increase in Bills payable 2.00
Less:
Increase in stock 18.00
Increase in Debtors 38.00
Decrease in Outstanding Expenses 12.00 - 68.00
Net Cash In-flow from operating activities 202.00
Less Tax paid - 40.00
Cash In-flow from Operating Activities 162.00
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Cash Flow from Investing Activities:

Cash Out-flows from:
Additions to Buildings - 42.00
Purchase of Furniture - 14.00
Purchase of Motor Vehicles - 20.00
Net Cash Out-flows from Investing Activities - 76.00

Cash Flows from Financing Activities:

Cash In-flow from Issue of Equity Shares 100.00
Cash Out-flows from:
Redemption of Debentures - 50.00
Payment of Interest - 18.00
Payment of Dividends - 60.00
Net Cash Out-flow from Financing Activities - 28.00
Net Increase in Cash Balance over the period 58.00
Opening Cash Balance 72.00
Closing Cash Balance 130.00

Self Help: You can also refer to the sources below to help
you further understand the lesson.

Cabrera, M.E (2017). Management Accounting: Concepts and Applications. GIC Enterprises
& Co.

Bobadilla, D. (2015). Comprehensive reviewer in management advisory services. Manila,

Philippines: Lares Bookstore.

Guia, M. B. M.(2016). Basics of managerial accounting. Ma-a, Davao City: MS Lopez Printing
& Pub.

Let’s Check

Activity 1. True or False (Ratio Analysis)

1. The asset turnover rate multiplied by the rate of net income earned on sales equals
the rate earned on the total assets.
2. If the information were available, financial analysts would be interested in knowing
the sales volume at the break-even point for the business enterprise.
3. If the amount of current assets exceeds the amount of current liabilities, a decrease
in current assets with a corresponding decrease in current liabilities increase the
current ratio.
4. The number of days’ sales in receivable at the end of an accounting period is a better
measure of the quality of receivable than the receivable turnover rate.
5. Window dressing is a violation of generally accepted accounting principles.
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

6. The dept ratio is useful to creditors as well as to stockholders, but each of these
groups’ places somewhat different emphasis on it.
7. Short-term creditors generally are more concerned with vertical analysis then with
horizontal analysis.
8. Horizontal analysis is possible for both an income statement and a balance sheet.
9. Common-size financial statements show peso change in specific items form one year
to the next.
10. A company with a 2.0 current ratio will experience a decline in the current ratio when
a short-term liability is paid.

Activity 2. Classification. (Cash Flow Analysis). Identify which operation the activity
belongs. (Operating, Investing or Financing). Determine as well weather it is a Use of Fund
or a Source of fund.
1. Short-term investment securities were purchased.
2. Equipment was purchased.
3. Accounts payable increased.
4. Deferred taxes decreased.
5. Long-term bonds were issued.
6. Ordinary shares were sold.
7. Interest was paid to long term creditors.
8. A long term mortgage was entirely paid off.
9. A cash dividend was declared and paid.
10. Inventories decreased.

Let’s Analyze
Activity 1. Problem Solving
Bryan Corporation
Statement of Financial Position as of December 31, 2011

Assets Liabilities and Owner’s Equity

Cash P50, 000 Accounts Payable P220, 000
Accounts Receivable 280,000 Accrued Taxes 80, 000
Inventory 240,000 Bonds Payable (Long Term) 118, 000
Plant and Equipment 380,000 Common Stock 100, 000
Paid-in Capital 150, 000
Retained Earnings 282, 000
Total Assets P950,000 Total Liabilities and Equity P950, 000
Assume that Total Net Credit Sales is P300, 000 and Cost of Goods Sold is P150, 000.
Required:
a. Compute the Current Ratio e. Receivable Turnover
b. Quick Ratio f. Average Collection Period
c. Debt-to-total-Assets Ratio g. Merchandise Turnover
d. Average Collection Period h. Debt Ratio
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Activity 2. Problem Solving

Gray Corporation’s financial statements for the last year are shown below. All figures are in thousands
(P000). The firm paid a P1, 000 dividends to its stockholders during the year. Two million shares of
stock are outstanding. The stock is currently trading at a price of P50. There were no sales of new
stock. Lease payments totaling P400 are included in cost and expense.

Balance Sheet
Assets Liabilities & Equity
Cash P2, 000 Accounts Payable P3, 000
A/R 12, 000 Tax Payable 1, 000
Inventory 14, 000 Long Term Debt 10, 000
Fixed Assets 27, 000 Equity 25, 000
Acc. Depreciation (16,000)
Total Assets P39, 000 Total Liabilities & Equity 39, 000

Income Statement Compute for the following:

1. Current Ratio 12. Return on Assets
Sales P100, 000 2. Quick Ratio 13. Return on Equity
Cost of Sales ( 80, 000) 3. Average Collection Period 14. Price Earnings Ratio
Gross Margin 20, 000 4. Inventory Turnover
Expenses (8, 000) 5. Fixed Asset Turnover
Depreciation (1, 600) 6. Total Asset Turnover
EBIT 10, 400 7. Debt Ratio
Interest ( 800) 8. Debt to Equity Ratio
EBT 9, 600 9. Times Interest Earned
Tax ( 2, 600) 10. Return on Sales
Net Income P 7, 000 11. Return on Sales

Activity 3. Problem Solving

Kerwin Corp.'s transactions for the year ended December 31, 2008 included the following:
• Purchased real estate for P550,000 cash which was borrowed from a bank.
• Sold available-for-sale securities for P500,000.
• Paid dividends of P600,000.
• Issued 500 shares of common stock for P250,000.
• Purchased machinery and equipment for P125,000 cash.
• Paid P450,000 toward a bank loan.
• Reduced accounts receivable by P100,000.
• Increased accounts payable P200,000.

Compute for the following:

a. Cash Flows from Operating Activities
b. Cash Flows from Investing Activities
c. Cash Flows from Financing Activities
 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

In a Nutshell

In this part you are going to jot down what you have learned in this unit. The said
statement of yours could be in a form of concluding statements, arguments, or perspective
you have drawn from this lesson.

Now it’s your turn!

1. ________________________________________________________.
2. ________________________________________________________.
3. ________________________________________________________.
4. ________________________________________________________.
5. ________________________________________________________.

Q and A

In this section you are going to list what boggles you in this unit. You may indicate your
questions but noting you have to indicate the answers after your questions is being raised
and clarified. You can write your questions below:

Questions/ Issues Answers

1.
2.
3.
4.
5.

Keywords

✓ Bureau of Internal Revenue (BIR)

✓ Income
✓ Income Tax
✓ Tax Administration
✓ Tax Laws
✓ Taxation
✓ Taxes
✓ Taxpayers