CASH FLOW ANALYSIS

The cash flow statement is sometimes called the funds flow statement
on the statement of the sources and uses of cash on the statement of sources
and uses of funds. It is a detailed study of the net changes in cash as a result
of operating, investing and financing activities during the period.
The Statement of Cash Flows
The basic financial statement prepared and used in analyzing cash
flows. It reports the cash receipts, cash payments and net changes in cash
resulting from operating, investing and financing activities of the firm during
the period.
Cash Flows
Include cash and cash equivalents
Cash Equivalents
Short term, highly liquid investments that are:
1. Readily available to known amounts of cash; and
2. So near their maturity date that their market value is relatively
insensitive to changes in interest rates.

Classification of Cash Flows

1. Operating Activities – cash effects on transaction that create revenues
and expenses. Operating activities generally relate to changes in
current assets and current liabilities.
Examples:
Cash Inflows: sale of goods/ services; interest income received
on loans, dividend income received on equity
securities
Cash Outflows: payment to suppliers; salaries and wages paid to
employees, taxes paid to the government, interest
expense paid to creditors, and payments of
expenses

2. Investing Activities – generally relate to changes in non-current assets

Examples:
 Cash Inflows: Sale of property, plant, and equipment; sale of
debt or equity securities of other firm; collection of
principal of loans
Cash Outflow: Purchase of property, plant and equipment;
purchase of debt or equity of other firm; lending of
money to other firms
3. Financing Activities – relate to changes in long-term liabilities and
stockholder’s equity accounts
Examples:
Cash Inflows: sale of company’s own stocks; issuance of bond or
notes
Cash Outflows: Payment of dividends to stockholders, redemption
of long-term debt, reacquisition of capital stock
Significant Non-Cash Activities
These are not reported in the body of the Statement of Cash Flows.
However, these are reported as a separate schedule at the bottom of the
Statement of Cash Flows or in a separate note or supplementary schedule to
the financial statements.
Format of The Statement of Cash Flows
LESSON 2: FINANCIAL STATEMENT ANALYSIS

Introduction

Business, as we all know, is mainly concerned with the financial

activities. In order to ascertain the financial status of the business, every
enterprise prepares certain financial statements. However, the information as
is provided in the financial statements is not adequately helpful in drawing a
meaningful conclusion unless, financial analysis has been made. Analysis
establishes the relationship between two or more accounting figures which
are meaningful in decision making process. Nevertheless, the analysts must
have knowledge on the limitations of the financial statements and the cautions
in using ratio analysis.

This modules presents the definition of financial information, users of

financial information, reasons of analyzing financial statements, techniques in
analyzing financial statements, tools used in analyzing financial statements,
and limitation of financial statements.

Definition of Financial Information

Financial information refers to the results of business operations

stated in money terms. This information are very important to variety of
people because it is use as a basis for making decision about the firm and
their relationship with it.

Primarily, the financial information is created by an accountant within

the company and reviewed by auditors, but neither accountants nor auditors
guarantee its correctness. This creates a conflict of interest, because
managements invariably want to portray results as favorably possible.

Once prepared, financial information is published to a variety of

audiences, who use it to make decisions about the company.

Users of Financial Information

Financial statements are report on the issuing company’s performance.

There are many who are interested in the financial date of a firm and the
reasons are follows:

Investors are people who are interested in the financial stability of a

firm since they are interested in buying the firm’s stocks or they might be
interested to lend their money. The primary focus of stockholders is more
likely to be its prospects for growth, though sometimes they analyze the
financial statements themselves, hence they rely heavily on the work of a
financial analysts.

Shareholders, whether current and prospective, are interested in the

firm’s current and future level of risk and return, which directly affect their
share price. The higher is the value of their shares the higher is the
investment they can entrust to the firm.

Management are interested with all the aspect of the firm’s financial
situation, the strength and weaknesses of the firm. They attempt to produce
financial ratios that will be considered favorable by both owners and creditor.
Moreover, they are responsible for the fair presentation of the financial
statement, adequate and efficient performance of the operation of the firm.

Creditors/Suppliers are another parties that do business with the firm

on credit. Since they are advancing funds in the form of products, services or
money, they tend to be interested in the liquidity of the firm and its ability to
make interest and principal payment.

Financial Analysts are usually work in large brokerage firms or other

financial institutions whose job is to know as much about a particular company
and its industry as an outsider can and to use that knowledge to predict the
firm’s performance. They could recommend at its investment value, whether
to buy or sell its stocks and whether its debt is safe. His pivotal advisory role,
he can be considered the main audience for investor oriented information.

Employees/Labor Unions are interested in the informative data useful

for negotiating raise in salaries and conducive working condition.
 Government are interested on the accounting records which are
needed to regulate business and for tax collection purposes.

Reasons of Analyzing Financial Statements

A firm’s financial statements can be analyze internally from within the

firm or externally by bankers, investors, customers and other interested
parties. Internal financial analysis is performed by a firm’s own employees.
Non-employees from outside of the firm can likewise perform external
financial analysis.

There are several reasons that internal financial analysis might be done,
namely: to evaluate the performance of employees and determine their pay
raises and bonuses; to compare the financial performance of the firm’s
different divisions; to prepare financial projections, such as those associated
launching of a new product or project; and to evaluate the firm’s financial
performance in light of its competitor’s performance and determine how the
firm might improve its own operations.

Another is when the variety of firms and individuals have an economic

interest in a firm’s financial performance might undertake an external financial
analysis such as: Banks and other lenders deciding whether to loan money to
the firm; suppliers who are considering whether to grant credit to the firm;
credit-rating agencies trying to determine the firm’s creditworthiness;
professional analysts who work for investment companies considering
investing in the firm or advising others about investing; and individual
investors deciding whether to invest in the firm.

Techniques of Financial Statement Analysis

There are two types of ratio comparisons, the cross-sectional analysis

and time-series analysis.

Cross-sectional analysis involves the comparison of different firms’

financial ratios at the same point in time. Analysts are often interest on how
well a firm has performed in relation to

other firms in its industry. Frequently, the firm will compare its ratio values to
those of a key competitor or group of competitors that it wishes to emulate.
This type of cross-sectional analysis, called benchmarking, has become very
popular similarly the comparison to industry averages is also popular.
Analysts have to be very careful when drawing conclusions from ratio
comparisons. It is assume that if one ratio for a particular firm is above the
industry norm, this is a sign that the firm is performing well, at least along the
dimension measured by that ratio. However, ratios may be above or below
the industry norm for both positive and negative reasons, and it is necessary
to determine why a firm’s performance differs from its industry peers. Thus,
ratio analysis on its own is probably most useful in highlighting areas for
further investigation.

Time-series analysis evaluates performance over time. Comparison

of current to past performance, using ratios, enables analysts to assess the
firm’s progress. Developing trends can be seen by using multiyear
comparisons. Any significant year-to-year changes may be symptomatic of a
problem, especially if the same trend is not an industry-wide phenomenon.

Combined analysis is the most information approach to ratio analysis,

both the cross-sectional and time-series analyses are combined. A combined
view makes it possible to assess the trend in the behavior of the ratio in
relation to the trend for the industry.

Tools Used in Financial Statement Analysis

In analyzing and interpreting financial statements of a particular entity, the
analyst must have standards with which he may compare the contents of said
statements. These standards may be the figures, ratios or percentages, or
changes indicated in budgets, industry averages, competitors’ financial
statements, and the company’s own financial statements for prior periods.

The important tools used for analyzing and interpreting financial

statements are horizontal or dynamic analysis, vertical or static analysis, trend
ratio analysis and ratio analysis.

Limitation of Financial Statements

In analyzing financial statements, it is imperative for the users to bear

in mind the limitations of financial statements so that decisions may not be
made based solely on the statements. These limitation s are as follows:

First, financial statements do not contain all the significant facts about a
business. They are prepared based on recorded transactions only so that
other relevant information such as the quality of organization, location, and
quality of and demand for its products are not include therein.

Secondly, they do not reflect changes in the purchasing power of the

monetary unit. They are generally based on historical cost so that the current
market values of assets are not reflected therein and the owners’ equity is
merely the residual value after deducting total liabilities. This is due to the fact
that accounting is primarily a stewardship function whereby the resources
invested in the business are controlled and accounted for to protect the
interest of both the creditors and the owners.

Thirdly, they are interim in nature although they give an impression of

being accurate. The statements are prepared only for an accounting period
and not for the entire life of a business entity. As such, they contain estimates
of the results of operations and financial condition of the business.

Fourth, variations in application of accounting principles. Although financial

statements are prepared in accordance with generally accepted accounting
principles, the application of these principles vary because of the different
methods that may be used in income measurement and in determining the
financial condition of a business. One accountants may be using the first-in,
first-out method of costing while another may be using last-in, first out. Bad
debts may be computed based on credit sales or on an aging of accounts.
Depreciation may be computed based on production volume instead of using
the straight-line method.

LESSON 3: USES AND COMPUTATION OF HORIZONTAL ANALYSIS

Introduction

There are different ways of analyzing the financial statement yet

horizontal analysis is the easiest way of identifying the weak and strong points
of financial statements by comparing account balance from one period to
another period highlighting the increases and decreases in peso amount with
corresponding percentages. However, in trend ratio analysis, four or more
successive periods are compared matching with their corresponding figures of
previous years.

This module indicates the definition of horizontal analysis,

computational guidelines and illustrative presentation.

Horizontal Analysis Defined

Horizontal or dynamic analysis is the comparison of financial
statements across several time periods, showing absolute changes (peso
amounts) and relative changes (percentages). Under this technique, a study
is made of the firm’s financial statements for two or more successive dates or
periods, presenting whether an item has increased or decreased. The
analytical tool used in horizontal analysis is comparative statements.

The FRSC has indicated that comparisons, whether they are made for
the single enterprise or between two or more enterprises, are most
informative and useful if the following conditions are met:

1. The presentations are in the same form, that is, the arrangement
within the statements are identical;
2. The content of the statements is identical, that is, the same items
from the underlying accounting records are classified under the
same captions;
3. Accounting policies are not changed or, if change, the financial
effects of the changes are disclosed; and
 4. Changes in circumstances or in the nature of the underlying
transactions are disclosed.

Computational Guidelines

In preparing statements that reflect horizontal analysis, certain

guidelines should be followed in the computation of the absolute (peso
amount) and relative (percentage) changes. They may be summarized as
follows:

1. To arrive at the peso amount of change, the amount of an item in the

preceding year is deducted from the amount of the same item in the
current year; if the difference is positive, it is an increase and if
negative, a decrease.
2. To compute for the percentage change, the amount of increase or
decrease should be divided by the amount of the item in the preceding
year.
3. If there is no change in an item, no percentage increase or decrease
can be computed.

4. If the amount in the preceding year or base year is zero or negative, a

peso increase or decrease may be calculated but I cannot be
expressed as a percentage.
5. If the amount in the current year is zero or negative, a peso increase or
decrease can be calculated but a percentage change can only be
computed if the amount in the preceding or base year is positive.

Interpreting Financial Statements

While interpreting comparative Balance sheet the interpreter is

expected to study the current financial position and liquidity position by
examining the working capital in both years. Working capital is the excess of
current assets over current liabilities. An increase in current asses is
favorable if current liabilities remain constant or decreased. Since current
assets should be at least twice as much as current liabilities, if follows that
current assets should increase at least twice as much as an increase in
current liabilities if the rule-of- thumb 2-to-1 ratio is to be maintained.

In the long-term financial position, the changes in fixed assets, long-

term liabilities and capital must be examined. Increase in noncurrent assets
should be justified by an increased in profits although this effect may not be
immediately manifested.

Likewise, the comparative balance sheet must identify whether the

profitability has improved or not. The greater the proportion of owner’s equity
to that of creditors’ equity, the higher the margin of safety for the creditors.
However, when owners are furnishing all or nearly all the funds, “trading on
the equity” may not be properly taken advantage of.
 The income statement provides the results of the operations of a
business. Important components of income statement are net sales, cost of
goods sold, selling expenses, office expenses etc. The comparative income
statement gives an idea of the progress of a business over a period of time.
The changes in money value and percentage can be determined to analyze
the profitability of the business.

The analysis and interpretation of income statement involve the

following: The increase or decrease in sales should be compared with the
increase and decrease in cost of goods sold. The cost of goods sold normally
follows proportionately the change in sales; a higher percentage change
would be considered unfavorable and may require further investigation.
An increase in sales revenue should be accompanied by a
corresponding increase in income. Excessive sale returns and allowances
may lead to unprofitable operations and reduced sales. Gross profit must be
sufficient to cover operating expenses and a reasonable net income.
Changes in operating expenses should be correlated to changes in sales:
selling expenses would normally change in the same direction as the change
in sales while administrative expenses usually remain the same. An upward
trend in net income is always favorable but the elements responsible for net
income should be carefully studied. Net income should also be related to
owner’s equity.

The increase or decrease in net profit is calculated that will give an idea about
the overall productivity of the concern.

Illustrative Presentation

In the foregoing comparative statement, the earlier year (19A) is

considered as the base year so that the percentage of increase or decrease is
arrived at by dividing the peso change by the 19A figure. Thus, the
percentage of change in sales of 50% is arrived at by dividing the P160,000
increase by the 19A sales of P320,000.

The percentage of change is also shown because changes in peso

amounts only would be misleading. In the given example, it would be more
meaningful to state that sales increased by 50% or by P160,000: rather than
merely stating that sales “increased by P160,000.
PART 2: USES AND COMPUTATION OF VERTICAL ANALYSIS

Introduction

In the previous module, you have learned the use and computation of
horizontal analysis and this module, you may be interested in analyzing the
financial statements through vertical or static analysis, horizontal or dynamic
analysis, more known as common-size analysis.

This module identifies the definition of vertical or static analysis and

illustrative presentation.

Vertical or Static Analysis Defined

Vertical or static analysis converts amounts of components of

financial statements into percentages of some base item which is set at 100
percent. It analyzes the financial statements of a firm of a given date or
period as to the relative importance of an item in relation to others or to a
total, as if appears on the statement.

The analytical tool used in vertical analysis is the common-size

statement which presents component percentages or common-size
percentages. Compound percentages are the ratios of the peso amount of
each item as related to the total of which it is a part. ‘The base (divisor) is the
total to which each item is related. The following are the normal base items
usually utilized in the preparation of common-size statements.

1. Balance sheet – total assets or total equities

2. Income statement – net sales
3. Retained earnings statement – beginning or ending balance
4. Statement of cash flows – total cash inflows or total cash outflows
5. Statement of cost of goods manufactured – total manufacturing cost
 With respect to the supporting schedules of financial statements, each
item may be expressed as a percentage of the total of the schedule of which it
is a component or of the normal base as enumerated above.
PART 3: USES AND COMPUTATION OF TREND ANALYSIS

Trend Analysis Defined

Trend Analysis is used to analyze the financial statements that extend

beyond two years through the use of index numbers or percentages. It
converts the absolute peso into percentages. Another term for trend analysis
is trend percentage

In horizontal analysis, the present operating performance of a business

is evaluated by comparing it with the performance of the immediate preceding
year. In vertical analysis, the present performance is evaluated by
determining the proportional component of each item in the financial
statements relative to the base covering one period only.

The operating performance of an entity can be evaluated better if the

analysis is not limited within the last two years since there are temporary
items that may not be significant to the long-term operations of the company.
A trend analysis covering more than 5-year business operations present
better perspective of entity’s operating performance than a two-year horizontal
analysis.

Steps in Trend Analysis

The following guidelines may be followed in handling trend analysis:

1. Present the financial statements covering several years in tabular

format. The arrangement is usually in ascending order.

For example, the tabular arrangement of the current assets section of

the statement o financial position for 5 years ending 2015 may appear
as follows:
2. Select a base year which is purely judgmental. The base year should,
however, serve as the normal operating activity of an entity. Normally,
the base year is the earliest year used in the analysis and has an index
of 100 or 100%.

In the example provided above, all the items of the financial

statements in year 2011 will have an index of 100 if year 2011 is
chosen as the base year.

3. Divide each absolute amount by the base year in order to determine

the relationship of each item with the base year. Multiply the result to
100 in order to express the data in percentage.

Using the data above, the relationship of each item over the
based will appear as follows:
PART 4: USES AND COMPUTATION OF FINANCIAL RATIO ANALYSIS

Introduction

Ratios are nothing more than relationships between numbers.

However, it is the most significant management tools available in a financial
institution. It provides a meaningful outcomes when compared with other
financial institutions or industry averages

This module deals primarily on the definition of ratio analysis, cautions

in using ratio analysis and uses, computation, and illustrative presentation of 4
classifications of financial ratio analysis.

Ratio Analysis Defined

Ratio analysis is an analytical tool employing ratio or proportion of a

certain item in the financial statement in relation to other related item in the
same financial statement or other statements to judge comparative
performance. Likewise ratios are generally meaningful when compared with
key a competitors or group of competitors, called benchmarking, similarly,
comparison to industry averages is now popular.

Analysts must be very careful when drawing conclusions from ratio

comparisons. It is tempting to assume that if one ratio for a particular firm is
above he industry norm, this is a sign that the firm is performing well, at least
along the dimension measured by that ratio. However, ratios may be above
or below the industry norm for both positive and negative reasons, and it is
necessary to determine why a firm’s performance differs from its industry
peers. Thus, the ratio analysis on its own is probably most useful in
highlighting areas for further investigation.

Since the ratio is a statement of the relationship between two numbers

and is arrived at by dividing the first number by the second number. The
quotient is expressed in any of four ways, i.e. as a decimal, fraction,
proportion or percentage. Assume, for instance, that the sum of current
assets is P50,000 while the current liabilities is P25,000; the following
relationship between the two numbers may be computed:

Current ratio = P50,000 divided by P25,000

= 2.0 = 2/1 = 2 to 1 = 200%

Cautions in Using Ratio Analysis

The following are cautions about the use of ratio analysis:

First, ratios that reveal large deviations from the norm merely indicate
the possibility of a problem. Additional analysis is typically needed to
determine whether there is a problem and to isolate the cause of the problem.
 Second, a single ratio does not generally provide sufficient information
from which to judge the overall performance of the firm. However, if an
analysis is concerned only with certain specific aspects of a firm’s financial
position, one or two ratios may suffice.

Third, the ratios being compared should be calculated using financial

statements dated at the same point in time during the year. If they are not,
the effects of seasonality may produce erroneous conclusions and decisions.

Fourth, it is preferable to use audited financial statements for ration

analysis. If they have not been audited, the data in them may not reflect the
firm’s true financial condition.

Fifth, the financial data being compared should have been developed
in the same way. The use of differing accounting treatments – especially
relative to inventory and depreciation – can distort the results of ratio
comparisons, regardless of whether cross-sectional or time series analysis is
used.

Lastly, the results can be distorted by inflation, which can cause the
book values of inventory and depreciable assets to differ greatly from their
true values, thereby distorting profits. Without judgments, inflation tends to
cause older firms (older assets) to appear more efficient and profitable than
newer firms (never assets). Clearly, in using ratios, you must be careful when
comparing older to newer firms or a firm to itself over a long period of time.

Classification of Financial Ratios

The four basic classifications of financial ratios are as follows:

1. LIQUIDITY RATIOS

Liquidity (solvency) ratios measure the ability to pay the

obligations when they fall due. These ratios show the relationship of the firm’s
current assets to its current liabilities.

Liabilities are classified as short-term or current obligations when they

are expected to be settled within 12 months after the date of the statement of
financial positions.

The following ratios are commonly used to evaluate the liquidity status
of the business firm:

1. Current ratio
2. Quick or acid test ratio
3. Receivable turnover
4. Average collection period
5. Inventory turnover
6. Average sales period.
 Current Ratio indicates the extent to which current liabilities are
covered by current assets. It is the most commonly used measure of short-
term solvency, because it serves as a single indicator of the extent to which
the claims of short-term creditors are covered by current assets.

The formula to compute the current ratio is:

Current ratio = Current Assets / Current Liabilities

In evaluating whether the current ratio is favorable or unfavorable, the

analyst shall consider the industry average and the individual items
comprising the current assets and current liabilities. A ratio standing alone is
meaningless, and it will never provide valuable information to interested
users.

Generally, a declining trend on current ratio is unfavorable indicator of

the firm’s liability. It may indicate that the business is not liquid or does not
have the capacity to pay currently maturing obligations. Similarly, an
increasing current ratio does not necessarily indicate favorable tendency. The
analyst should evaluate carefully the individual item comprising the current
assets. It may happen that the big slice of the current assets is invested or
receivable or inventory.

Illustrative Presentation

Charm Company provided the following comparative information:

2015 2014
Statement of Financial Position
Current Assets
Cash and cash equivalents P 15,000 P 20,000
Trade and other receivables 227,000 276,000
Inventory 604,000 476,000
Prepaid expenses 20,000 15,000
Total Current assets P 866,000 P 787,000
Non-current assets
Property, plant and equipment P3,000,000 P2,225,000
Investment in stocks 1,000,000 1,000,000
Total non-current assets P4,000,000 P3,225,000
Total Assets P4,866,000 P4,012,000
Current Liabilities
Trade and other payables P 237,000 P 209,000
Other current liabilities 100,000 85,000
Total current liabilities P 337,000 P 294,000
Non-current liabilities
 Bond payable – 10% P1,000,000 P1,000,000
Total Liabilities P1,337,000 P1,294,000
Shareholders’ equity
Share capital, P100 par P2,500,000 P2,000,000
Reserve 500,000 500,000
Retained earnings 529,000 218,000
Total P3,529,000 P2,718,000
Total liabilities and shareholders’ equity P4,866,000 P4,012,000

2015 2014
Statement of Comprehensive Income
Sales P3,270,000 P2,915,000
Expenses:
Cost of sales 2,100,000 1,900,000
Selling expenses 370,000 340,000
Administrative expenses 200,000 215,000
Total P2,670,000 P2,455,000
Operating income 600,000 460,000
Interest expense 100,000 100,000
Income before tax 500,000 360,000
Income tax -30% 150,000 108,000
Income after tax 350,000 252.000

Additional information: The market prices per share were P185.00 and
P130.00 for 2015 and 2014, respectively. The company also paid dividends
per share of P2.80 in 2015 and P2.00 in 2014.

Required: Determine the current ratio and make simple analysis on

the result.

Answer: The current ratios for years ended 2015 and 2014 means
that for every P1.00 current liability, the company has an available amount of
P2.68 current assets.

The current ratio of Charm Co. may be evaluated as follows:

a. The company appears to be liquid since t has more current assets to

pay its current liabilities. In 2015, the company has P2.57 available
current assets for every P1.00 current liability.
b. The current ratio of the company appears to deteriorate in year 2015.
This unfavorable trend may indicate the increase in current liabilities is
faster than the increase in current assets.
c. If the individual item comprising the current assets will be analyzed
closely, it appears that substantial amount is invested on inventory.
This trend may indicate that the company has made an investment on
non-moving or obsolete inventory.
 In order to appreciate the significance of the current ratio, it should be
compared with industry average. If the industry has current ratio of P3.00:1,
then the liability status of the company appears to be unfavorable.

Quick or Acid-Test Ratio is a more stringent measure of the liquidity

status of a business firm. It include the following: cash, trading securities and
trade receivables. Trading securities and trade receivables are convertible
easily to cash without reducing much the value of the assets.

Quick assets = Cash + trading securities + trade receivables

Inventories are excluded in the computation of quick ratio, since they

are the least liquid of a firm’s current assets and of which losses are most
likely to be incurred at the time of liquidation. Prepaid expenses are also
excluded, since they represent future obligation and the possibility of
converting the items to cash is very slim.

The formula to compute quick or acid test ratios is

Quick ratio = Quick assets / Current liabilities

The acid-test ratio of Charm Co. is computed as follows:

2015 (P242,000/337,000) = 0.72:1

2014 (P296,000/294,000) = 1.00:1

After excluding inventories and prepaid expenses from the current

assets, the ratio of current assets to current liabilities of the company has
dropped from 2.57:1 to 0.72:1 in year 2015. This trend is a clear indication
that significant amount of investment is in the inventory.

The quick ratio of the company has dropped in 2015 from P1.00 to
P0.72 for every P1.00 of current liability, and this trend is generally considered
unfavorable. Similarly, it must be evaluated in line with industry standards in
order to appreciate the significance of the indicator.

Receivable Turnover measures the velocity of conversion of trade

receivables into cash during the year. It answers the typical question: How
many times during the year a receivable has been converted into cash?

Receivable turnover is considered an asset management ratio since it

measures the effectiveness of management in handlings its resources. It also
measures the efficiency of the collection effort and credit policy of the
company.
 Generally, it is favorable for the company to have a high receivable
turnover. However, a very high or low receivable turnover may not be a
favorable indicator of the liquidity status.

The formula to compute receivable turnover is:

Receivable turnover = Net credit sales / Average trade

receivables

Average trade receivable is computed as follows:

Average trade receivable = Receivable beg + Receivable end / 2

In computing receivable turnover, the amount of receivable should be net of

allowance for doubtful accounts. In case data on net sales is not provided,
the data on gross sales may be used to compute the turnover.

The receivable turnover of Charm Co. may appear as follows:

2015 = 3,270,000 / (P227,000 + 276,000)/2 = 13.00

times
2014 = 2,915,000 / 276,000 = 10.56 times

Since no available data on the beginning balance of 2014 accounts

receivable, the ending balance serve a denominator.

In 2015, Charm Co. converted its receivable into cash 13 times during
the year against 10.56 times in year 2014. This may indicate two tendencies:

1. The quality of receivable may have improved; and

2. The company may have instituted a better collection strategy.

Average Collection Period is also called the days sales

outstanding, measures the speed of collecting trade receivables. It
represents the average length of time that the business must wait to receive
cash after making a sale.

The average collection period may be computed using the following

formulas:

Average collection period = 360 days / receivable turnover

 Or

Average collection period = Average receivable / Average daily

sales

The average collection period is computed by dividing the annual

sales by 360 days. Conventionally, the computation of collection period is
based on 360-day a year. However, if the company is using 365-day a year,
then such should be followed.

The average collection period of Charm Co. is computed as follows:

2015 - (360 days/13) = 27.69 days or 28 days

2014 - (360 days/10.56) = 34.09 days or 34 days

Using the second formula, the average collection period is computed

as follows:

2015 - [(227,000 + 276,000) / 2] / (P3,270,000/360) = 27.69

days
2014 - (276,000) / (P2,915,000 / 360) = 34.09
days

The ratio reveals that on average, Charm Co. collects its receivable
every 28 days in year 2015. Comparing the current average collection period
from last year, it appears that there is improvements on the trend.
The collection period is usually evaluated by comparison with the terms
of sale. The credit terms extended by the company may be 2/10, n/30 or
1/15, n/30. In 2/10, n/30 credit term, it means that 2% discount will be given
to customer if account is paid within 10 days from the day of sale and account
is payable within 30 days. Under such term, the collection period of Charm in
2015 can be viewed as good since average collection period is within the 30-
day term; however, in 2014 the collection period may be viewed as
unfavorable and may indicate that customers are not paying their account on
time.

Inventory Turnover Ratio measures the number of times

inventories are acquired and sold during the year. Normally, profits are
realized from sale of inventories; hence, the faster the sale of goods, the
higher is the profit.

The analyst shall consider the nature of the business in evaluating

inventory turnover, since it varies from industry to industry. It is expected that
grocery stores have high inventory turnover compared to dealers of heavy
equipment.

The inventory turnover is computed using this formula:

 Inventory turnover = Cost of goods sold / average inventory

Average inventory is computed as follows:

Average inventory = Inventory beg + Inventory end / 2

The inventory of Charm Co. may appear as follows:

2015 = 2,100,000 / (P604,000 + 476,000) /2 = 3.89 times

2014 = 1,900,000 / 2,476,000 = 4.0 times

The inventory turnover of Charm Co. deteriorates in 2015 compared to

2014 performance. Generally, higher inventory turnover is favorable and
preferable over low inventory turnover, since it will indicate management
efficiency in handling its inventory.

Average Sales Period is also called conversion period, measures

the length of time involve to sell the inventory to customers. Generally, low
sales period is favorable to the company since it will indicate that only few
days are needed to sell the inventory.

The formula to compute the average sales period is

Average sales period = 360 days / Inventory turnover

The average sales period of Charm is computed as follows:

2015 – (360 days / 3.89) = 93 days

2014 - (360 days / 4.0) = 90 days

In 2015, the average sales period increases from 90 days to 93 days

which may indicate that the company either has been carrying slow-moving
items or the management has been inefficient in convincing customers to buy
its products.

2. SOLVENCY OR STABILITY RATIOS

Solvency or stability ratios are group of financial ratios that measure

the ability of business firm to settle its financial obligation when they mature
and still remain stable. The different ratios under this category also reflect the
extent to which a firm utilizes debt financing; hence, they are also called
financial leverage ratios. The concept of leverage or an act of increasing from
current status is divided into two: operating leverage and financial leverage.

Operating leverage affects the short-term investment and non-current

assets of an entity or the left-hand side of the statement of financial position.
It is also concerned on how fixed cost influenced the operations of the
company.

Financial leverage primarily affects the right-hand side of the

statement of financial position or the short-term debt, long-term debt and
shareholders’ equity. It reflects the amount of debts utilized in he capital
structure of the business firm.

The following commonly used financial leverage ratios will be

highlighted:

1. Debt ratio
2. Equity ratio
3. Debt to equity ratio
4. Times interest earned

Debt ratio measures the proportion of funds provided by creditors. It

reflects the percentage of total assets that are financed with debts.

It is helpful to remember that there are 2 claims against the assets of

the business: the claims of the creditors and the claims of the owners. Thus,
we have the basic accounting equation: Assets = Liabilities + Owners’ Equity
where liabilities represent the claim of creditors. The debt ratio answers the
query: of the total resources, how much is provided by creditors?

Creditors prefer low debt ratio, because their investments are generally
protected by higher proportion of shareholders’ funds in the event of
liquidation. On the other hand, shareholders prefer to have high leverage
because it will improve the expected return on their investments.

Generally, a debt ratio of 50% debt and 50% equity is considered the
fair maximum level for both creditors and shareholders.

The debt ratio is computed as follows:

Debt ratio = Total liabilities / Total assets

The debt ratio of Charm is computed as follows:

2015 – (P1,337,000 / 4,866,000) = 27.48% or .2748:1.00

2014 – (P1,294,000 / 4,012,000) = 67.75% or .6775:1.00
 Of the total resources in 2015 operation, the analysis reveals that
27.48% has been provided by creditors. The reduction of debt ratio in year
2015 against 2014 operation may indicate that the company does not rely
heavily on funs supplied by creditors. Even the 2014 debt ratio of 32.5% is
considered highly favorable from the perspective of creditors, because it does
not reach the generally considered maximum level.
Equity Ratio determines the proportion of resources provided by
owners of the business firm. The equity ratio presents the financial strengths
of the business, because it provides the margin of safety that the company
affords to creditors.
The equity ratio is computed as follows:

Debt ratio = Total liabilities / Total assets

The equity ratio of Charm may appear as follows:

2015 – (P3,529,000 / 4,866,000) = 72.52%
or .7252:1.00
2014 - (P2,718,000 / 4,012,000) = 67.75%
or .6775:1.00

The equity ratio may also be computed as follows:

Equity ratio = 1 – Debt ratio

In simple terms, the equity ratio of Charm in year 2015 may be

interpreted as follows: For every one peso on company’s total assets, the
shareholders provided 72.52 cents while the creditors supplied 27.48 cents.

The trend in equity ratio may indicate that the company is not highly
dependent on creditor’s funds in financing its operations for year ended 2015
even in 2014 performance since more than 50% of the resources are provided
by the owners.

Debt Equity Ratio measures the proportion of debt and equity in

the capital structure of the company. The measure will also indicate whether
the company favors risk in its capital structure.

When debt to equity ratio is more than 1 or more than 100%, the
company is having riskier capital structure since debts imply payment of
interest.

The formula to compute debt to equity ratio is as follows:

Debt to equity ratio = Total liabilities / Total equity

 The debt to equity ratio of Charm is computed as follows:
2015 – (P1,337,000 / 3,529,000) = 37.89%
or .3789:1.00
2014 - (P1,294,000 / 2,718,000) = 47.61%
or .4761:1.00

The debt to equity ratio in 2015 has decreased against the 2014
operating performance. This trend may indicate that in 2015 shareholders
provided more funds in the business.

In simple terms, the debt to equity ratio may be read as follows: In

2015, for every P1.00 provided by the owners, creditors provided 37.89 cents,
whereas, in 2014 operation, the creditors provide 47.61 cents for every P1.00
provided by owners.

Times Interest Earned is a tool that measures the debt paying

ability of the company. It reflects the degree of protection provided by an
entity to its long-term creditors. It is favorable to investors if the business firm
has higher ratio of times interest earned.

The formula to compute times interest earned (ITIE) is as follows:

Times interest earned = income before interest and taxes / interest

expense

The times interest earned of Charm Co. is computed as follows:

2015 – (600,000 / 100,000) = 6.0 times

2014 - (460,000 / 100,000) = 4.6 times

The ratio may indicate that Charm can cover interest payment from its
operating income 6 times in 2015 against 4.6 times in 2014. The
improvement in the measure gave better protection to the creditors.

3. PROFITABILITY RATIOS

Profitability Ratios are group of ratios hat reflect the combined

effects of liquidity, management efficiency in handling the assets and liabilities
on the operating results of the business. The ratios show the effectiveness of
business operations.

The common measures of profitability that will be discussed are:

1. Gross profit rate

2. Operating profit margin
 3. Net profit margin
4. Return on investments
5. Return on equity
Gross Profit Rate measures the percentage of gross profit to sales.
It indicates the percentage of margin available to cover operating expenses.
Impliedly, the gross profit rate reveals also the percentage of cost of sales to
sales.

The gross profit or gross margin is the difference between sales and
cost of sales. Hence, the ratio may also indicate the measures adopted by
the company to control the elements affecting sales and cost of sales (i.e.
prices, cost and quantity).

The formula to compute gross profit rate is as follows:

Gross profit rate = Gross profit / Net sales

The gross profit rate of Charm is computed as follows:

2015 – (P1,170,00 / 3,270,000) = 35.78%

2014 - (P1,015,00 / 2,915,000) = 34.82%

There is a slight improvement on the gross profit rate of Charm in 2015

operation. The ratio may indicate that in 2015 Charm has 35.78% available
margin to cover operating expenses.

Operating Profit Margin measures the percentage of profit

available after deducting cost of sales and operating expenses from sales. It
reflects the overall efficiency of the management in handling the production,
selling and administrative costs.

The formula to compute the operating profit margin is as follows:

Operating profit margin = Gross profit / Net sales

The operating profit margin of Charm will appear as follows:

2015 - (P600,000 / 3,270,000) = 18.35%

2014 - (P460,000 / 2,915,000) = 15.78%

The operating profit rate increased in 2015 against the 2014 operation.
This favorable trend may indicate that the management was able to control
the company’s operating expenses.
 Net Profit Margin is also called return of sales which measures the
overall operating results of an entity. The measure considers all income
recognized and all expense s incurred during the period.

The formula to compute the net profit margin as follows:

Net profit margin = Net income / Net sales

Applying the formula, the net profit margin of Charm is computed as

follows:

2015 - (P350,000 / 3,270,000) = 10.70%

2014 - (P252,000 / 2,915,000) = 8.64%

The net profit margin of year 2015 operation improved compared with
year 2014 despite of the higher taxes imposed.

Return on Investments is also called return on assets which

measures the amount of net income per peso of investment in a business.
The ratio reflects the profitability of every peso invested.

Generally, the formula to compute return on investment is as follows:

Return on investment = Net income / Average total

assets

However, if he business entity has interest-bearing liabilities, return on

investment is computed as follows:

Return on investment = Net income + (interest [1-tax rate])

Average total assets

Under the second formula, if the business firm has an interest-bearing

debt, the amount of interest net of tax is added back to net income.

The return on investment of Charm, computed using the second

formula because of the presence of interest bearing-bond payable, will appear
as follows:

2015 = P350,000 + [P100,000 (1 – .30)] = 9.46%

(4,866,000 + 4,012,000) /2
 2014 = P252,000 + [P100,000 (1 - .30)] = 10.56 times
276,000

The return on assets slightly increased from 8.03% in 2014 to 9.46% in

2015. This trend may indicate favorable movement on return on investment.

In simple terms, the ratio may be read as follows: There was 9.46 cents
return for every P1.00 invested on the assets of Charm in 2015. However, in
the 2014 operation, the return is only 8.03 cents for every P1.00 investments
on assets.

Return on Equity measures the rate of return on ordinary

shareholders’ investment. The measure is applicable only to ordinary shares,
since preferences shares normally have fixed rate of return.

The formula to compute return on equity is as follows:

Return on investment = Net income applicable to ordinary

shares
Average shareholders’ equity

Assuming the capital structure of Charm is composed of ordinary

shares of only, the return on equity is computed as follows:

2015 – [P350,000 / 3,529,000 + 2,718,000) / 2] =

11.21%
2014 – (P252,000 / 2,718,000) = 9.27%

The trend on return on equity of ordinary shareholders may indicate

improvement in year 2015 compared to the 2014 financial position.

4. GROWTH RATIOS

Growth Ratios is also called market value ratios are group of ratios
that reflect the value of the shares to its earnings, book value per share and
cash flow.

Generally, if the liquidity, solvency, and profitability ratios are favorable

or the trends indicate improvement, then growth ratios will look good to
investors.

The following growth ratios are commonly used:

1. Earnings per share

2. Price-earnings ratio
3. Dividend-yield ratio
 4. Dividend-payout ratio
5. Book value per share

Earnings Per Share measures the value of ordinary shares relative

to earnings of the business firm. Only the net income attributable to ordinary
shares shall be included in the corporation; hence, dividends applicable to
preference shares shall be deducted from net income.

When the preference shares are non-cumulative, only the dividends

declared in respect to the period shall be deducted. However, if the
preference shares are cumulative, all required dividends applicable, whether
declared or not, shall be deducted from the net income.

Two kinds of earnings per share are the following:

1. Basic
2. Diluted

The computation of diluted earnings per share is discussed in higher

accounting subject. The formula to compute the basic earnings per share is
as follows:

Basic earnings per share = Net income applicable to ordinary

shares
Average number of shares
outstanding

The basic earnings per share of Charm assuming that the capital
structure is composed of ordinary shares will be:

2015 - P350,000 / (25,000 + 20,000) / 2 = P15.58

2014 - P252,000 / 20,000 = P12.60

The numbers of shares are computed as follows:

2015 - (P2,500,000 / P100) = 25,000 shares

2014 - (P2,000,000 / P100) = 20,000 shares

The increase in earnings per share in 2015 may indicate that the
operating profit of the company is improving despite additional shares
issuances.

Price-Earnings Ratio measures price per share in relation to the

earnings of the company. This measure also reflects the amount investor is
willing to pay for every 1 peso of current earnings.

The formal to compute price-earnings ratio is as follows:

 Price-earnings ratio - Market price per share / Earnings per
share

The price-earnings ratio of Charm is computed as follows:

2015 – (P185.00 / P15.56) = 11.89

2014 – (P130.00 / P12.60) = 10.32

The price-earnings ratio of Charm improved in 2015, which may

indicate a profitable performance. In 2015, the market value of the shares is
11.89 times the earnings realized. Similarly, the ratio may indicate that in
2015, aninvestor is willing to pay P11.89 for every P1.00 of the company’s
earnings.

Dividend-Yield Ratio measures the amount of dividends in relation

to market. Dividends represent earnings of the company distributed to the
shareholders in proportion to their investments.

The formula to compute dividend-yield ratio is as follows:

Dividend0yield ratio = Dividend per share / Market price per

share

The dividend-yield rations of Charm for 2009 and 2008 are as follows:

2015 – (2.80 / P185.00) = 1.51%

2014 - (2.00 /P130.00) = 1.53%

The trend of dividend payments in relation to the market value of the

shares of stock appears to be relatively constant. This price may indicate that
Charm is returning the earnings to shareholders proportionate to the market
value of the shares.

Dividend-Payout Ratio measures the percentage of dividend

payments in relation to earnings.

The formula to compute dividend payout ratio is as follows:

Dividend-payout ratio = Dividend per share / Earnings per share

The dividend-payout ratio of Charm is computed as follows:

2015 – (P2.80 / P15.56) = 17.99%

2014 – (P2.00 / P12.60) = 15.87%
 The dividend payout ratio may be read as follows: For every P1.00
earnings in 2015, almost 18 cents are returned to shareholders. Impliedly, 82
cents are flowed back to the company for every 1 peso net income.

Book Value Per Share measures the amount payable to each

share based on realized amount of assets in the event of liquidation. The
measure applied to both ordinary shares and preferences shares.

The formula to compute book value per share is as follows:

Book value per share = stockholders’ equity / average number of share

outstanding

The book value of Charm is computed as follows:

2015 = P3,529,000 / (25,000 + 20,000) / 2 = P156.84

2014 = P2,718,000 / 20,000 = P135.90

In the event of liquidation and if the assets are realized based on

amounts appearing on the data of the statement of financial position, the
shareholders will received P156.84 in year 2015 or every share held.