FINANCIAL STATEMENT ANALYSIS

Financial statement analysis – involves careful selection of data from financial statements in order to assess and evaluate the
firm’s past performance, its present condition and future business proposals.

What is the purpose of financial statement analysis?

The objective of financial statements analysis is to determine the extent of a firm’s success in attaining its financial goals,
namely: (1) to earn maximum goals; (2) to maintain solvency and (3) to attain stability.

The three major financial statement user groups and what they hope to learn from financial statement analysis:
1) Creditors – want to be assured of receiving prompt payments from the company
a) Short-term creditors – include trade creditors and lending institutions
b) Long-term creditors – lending institutions and corporate bondholders
2) Equity investors – want to determine if the company will be able to distribute dividends in the future and if its shares will
rise in value
3) Management – objective is to monitor the company’s overall performance

There are at least four traditional techniques of interpreting financial statements, namely:
1) HORIZONTAL (COMPARATIVE ANALYSIS) – presents the differences in absolute amount and in percentage between
two periods (i.e., years, quarters etc..), two companies, actual and budgeted date, and other bases of analyses. The
difference could either be an increase or a decrease both in amount and in percentage. the percentage change is computed as
follows:
PERCENTAGE CHANGE = AMOUNT OF CHANGE / BASE

TREND ANALYSIS – the purpose of trend analysis is to track down what happened in the past and provide on what may
happen in the coming years. It uses indexes and ratios to simplify the visible complications and annoying presentation of
numbers contained in the financial reports. Financial data expressed in indexes and ratios are easily readable than those
presented in terms of millions.

Indexes are expressed in hundreds while ratios are expressed in normal decimal places

2) VERTICAL ANALYSIS (common size analysis) – gets the proportional component of each of the variables in the
financial statements in relation to a chosen base. As in horizontal analysis, the financial statements are treated individually
and each is analyzed independent of the others.

FINANCIAL STATEMENT BASES (100%)

• Income statement Net sales
• Balance sheet Total assets
• Statement of cash flows May be the total cash available for use

3) FINANCIAL MIX RATIOS

In the horizontal, trend and vertical analysis, each financial statement is considered a stand-alone report. The truth is, these
financial statements are interrelated and interlocked with one another. Examples contained in the income statement are directly
related with information contained in the balance sheet and cash flows as shown in the diagram:

Income Balance sheet Statement of Cash flow

statement
Cash; trade receivables Operating activities
Net sales Cash; trade payables Operating activities
Cost of goods sold
Cash; Prepaid expenses Operating activities
Operating Accrued expenses
expenses Accumulated
depreciation Operating activities,
Cash; Bonds payable Investing activities and
Other items Discount/Premium on Financing activities
bonds, non-current
assets Operating activities,
Income tax Cash; Deferred income Investing, Financing and
tax; Property and Operating activities
equipment *non-cash items are
Long-term debt; Material excluded
cash shortage; Cash
surrender value of life
insurance,
Since the financial statements are fundamentally-related, theetc...
information contained in one statement could be related to the
information found in another. This is the essence of financial mix ratio analysis. In computing the financial mix ratios, the amount
used from the income statement is the net figures (i.e., net sales) while that from the balance sheet is the average amount (i.e.,
average inventory, etc.)

Four classification of financial mix ratio analysis:

• Profitability ratios – ability of the business to generate profit. It measures the ability of the business to generate profit in
relation to sales, investments, assets, equities or common shares outstanding.
• Growth ratios – are indicative of the organization’s potential and attractiveness as an investment option.
• Liquidity ratios – refers to the ability of the business to pay its obligations in cash as they mature. Therefore, the focal point of
the liquidity analysis is cash. It includes the ability of the management to convert its current assets into cash in a quick, stable
1
 and regular manner. It also deals with the ability of management to use trade credits and stretch the payments to trade credits
in financing operating activities. In short, the liquidity position of an organization is directly related to its operating activities and
determines the speed of revolving cash in the operating cycle.
• Financial Leverage ratios – refers to the use of debt to increase shareholders’ equity. Using debt to finance business activities
would mean greater exposure to the risk of insolvency. The more leveraged the business, the higher the risk of insolvency is.
Financial leverage is a measure of risk.

SUMMARY OF FINANCIAL MIX RATIOS

RATIOS FORMULAS COMMENTS

 PROFITABILITY RATIOS – measures earnings in relation to some base, such as assets, sales or capital
 COST MANAGEMENT RATIOS – measures how well a firm controls its costs
 Return on Sales Net income / Net sales ✓ Also called as net profit rate; net profit margin;
measures profit percentage per peso sales
 Gross profit rate Gross profit / Net sales ✓ Measures gross profit percentage on sales to recover
operating expenses
Net income + Interest expense
(net of tax)
Average total assets

 Return on total assets Net Income ✓ Measures overall asset profitability; indicates how
Average total assets well assets have been employed by management

Earnings Before Interest and

Taxes
Average total assets
 Return on stockholders’ Net income ✓ Measures percentage of income derived for every
equity Average stockholders’ equity peso of owners’ equity.
 Return on common Net income ✓ Earnings available to common stockholders’ equals
stockholders’ equity Average common stockholders’ net income less preferred dividends; this ratio
equity measures percentage of profit derived for every peso
of common equity money used; when compared to
the return on total assets; it measures the
percentage of profit derived for every peso of
common equity money used; when compared to the
return on total assets, it measures the extent to
which financial leverage is working for or against
common stockholders.
 Operating leverage Contribution margin ✓ Measures the number of times profit will increase or
Earnings before interest and decrease in relation to change in net sales.
taxes (Operating income)
 Times preferred dividend Net income ✓ Measures the adequacy of current earnings to meet
earned Preferred dividend requirements preferred dividend payments.
 LIQUIDITY RATIOS – provides information about the firm’s ability to pay its current obligations and continue operations
 ASSET MANAGEMENT RATIOS – measure how the firm uses its assets to generate revenue and income
 Operating turnover Collection period + Inventory ✓ Measures the speed of the business cycle; the
days number of days cash was invested in the normal
business operations until it was recovered back
 Inventory turnover Cost of goods sold ✓ Indicates the number of times inventories were
Average Inventory acquired and sold during the period
 Inventory days number of days in a year ✓ Indicates the length of time spent before the average
inventory turnover inventory is sold to customers.
✓ (note: know what will be the number of days to
be considered)
 Receivable turnover Net CREDIT sales ✓ Indicates the efficiency in credit and collection
Average trade receivables policies; trade receivables include open account and
on notes
 Collection period Number of days in a year ✓ Measures quickness in collecting trade receivables
Receivable turnover
 Payable turnover Net credit purchases ✓ Measures effectiveness in using trade credit facility
Average trade payables from suppliers
 Payable days Number of days in a year ✓ Indicates the number of days spent before paying
Payable turnover liabilities to merchandise suppliers
 Materials turnover Materials USED ✓ Indicates the number of times materials were used
Average materials inventory on the average during the period
 Work-in-process inventory Cost of goods MANUFACTURED ✓ Indicates the number of times average work-in-
turnover Average work-in-process process inventories is converted to finished goods
inventory
 Finished goods inventory Cost of goods SOLD ✓ Indicates the number of times average finished
turnover Average finished goods inventory goods is sold during the period
 Cash turnover Cash operating expenses ✓ Measures the ability of the business to meet
Average cash balance operating expenses payments given a particular cash
balance

2
 Days to pay operating Number of days in a year ✓ Indicates the number of days spent before meeting
expenses Cash turnover operating expense payments
 Working capital turnover Net sales ✓ Measures the adequacy and effective use of working
Average working capital capital; indicates reasonableness of the amount of
current assets
 Asset turnover Net sales ✓ Measures effectiveness of assets utilization
Average total assets
 Current assets turnover Net sales (excluding depreciation ✓ Indicates the reasonableness of the amount of
and amortization) current assets
Average current assets
 Net working capital Current assets – Current ✓ Indicates the amount invested by the business to
liabilities operate its normal business activities
 Current ratio Current assets ✓ Rough estimate on the ability of the business to
Current liabilities meet its currently maturing obligations; this ratio
varies in great disparity from one industry to another
 Quick assets ratio Quick assets ✓ A more severe test of immediate liquidity to meet
 (acid test ratio) Current liabilities currently maturing obligations
 Quick assets include: cash, marketable
securities and receivables
 Defensive interval ratio Defensive assets ✓ Measures the number of days defensive assets are
Average daily expenditures available to meet daily cash expenses
 Defensive assets include: cash, marketable
securities and trade receivable
 GROWTH RATIOS – measure the changes in the economic status of a firm over a period of time
 VALUATION RATIOS – measure the shareholder value as reflected in the price of the firm’s stock
 Earnings per share (Net income – Preferred ✓ Perhaps the most frequently quoted ratio of earnings
dividends) and growth performance; measures the value of
Average common shares common stock by attributing to it a portion of the
outstanding company’s earnings
 Price-earnings ratio Market price per share ✓ Measures the number of period investment in stock
Earnings per share will be recovered; measures the profitability of the
firm in relation to the market value of the stock;
measures investors’ beliefs on the growth potential
of the stock
 Dividend yield ratio Dividend per share ✓ Measures rate of cash return to investment in stock
Market price per share
 Dividend payout ratio Dividend per share ✓ Represents the percentage of net income distributed
Earnings per share as dividends; a low ratio may indicate the
reinvestment of profits by a growth-oriented firm
 Book value per share Stockholders’ equity ✓ Indicates the value of the stock on cost perspective;
Average shares outstanding the relevance of this ratio diminishes when the
balance sheet valuation does not approach fair
market values; may be computed for both common
and preferred stocks
 LEVERAGE RATIOS (Solvency ratios or Stability ratios) – B measures the company’s use of debt to finance assets and
operations.
 Financial leverage – the use of debt to finance assets and operations; it is advisable to trade on equity when earnings
from borrowed funds exceed the cost of borrowing.

(1)As leverage increases, the risk borne by creditors as well as the risk that the firm may not be
able to meet its maturing obligation increases. (2) Since interest expense is tax deductible,
leverage increases the company’s return when it is profitable

 Debt-to-equity ratio Total debt ✓ Measures the use of debt to finance operations;
Net stockholders’ equity provides a measure of the relative amount of
resources contributed by the creditors and owners
 Debt-to-assets ratio (debt Total debt ✓ Measures the relative shares of creditors over the
ratio) Total assets total resources of the firm
 Equity-to-assets ratio Net stockholders’ equity ✓ Measures the amount of resources provided by the
(equity ratio) Total assets owners in the firm
 Equity multiplier Total assets (equity) ✓ Indicates the number of times owners’ equity is
Net stockholders’ equity multiplied
Or
1/ equity ratio
 Times interest earned Earnings before Interest and ✓ Measures the long-term debt paying ability of the
Taxes (EBIT) firm; a high number of times interest is earned ratio
Interest expense indicates that the business is under-leveraged and
its return on common equity could still be improved.
 Financial leverage Earnings before interest and ✓ Measures the risk associated in using debt to finance
taxes (EBIT) investments
(EBIT – Interest expense –
Preferred dividends before tax

3
  Total (combined) leverage Degree of operating leverage x ✓ Measures the overall leverage of the business; it
Degree of financial leverage indicates the variability of the stockholders’ equity
with respect to changes in contribution margin,
earnings before interest and taxes, interest expense
and preferred dividends before tax
 Fixed charges rate Cash flows before fixed charges ✓ Measures the ability to meet fixed charges by cash
Total fixed charges  Examples of fixed charges: rent, insurance,
taxes and depreciation

 Total assets-to-total Total assets ✓ Rough estimate of the firm’s ability to meet interest
liabilities ratio Total liabilities payments to creditors
 Non-current assets-to- Non-current assets ✓ Shows the capability to meet non-current liabilities
long-term liabilities ratio Long-term liabilities using non-current resources
CASH FLOW RATIOS
 Earning power – The capacity of the firm’s operations to produce cash inflows
RATIOS FORMULAS
 Cash flow adequacy Cash from operations + Long-term debt paid +
Purchases of assets
 Long-term debt payment Long-term debt payments
Cash from operations
 Dividend payout on cash from operations Dividends
Cash from operations
 Reinvestment Purchase of assets
Cash from operations
 Total debt coverage Total liabilities
Cash from operations
 Depreciation-amortization impact Depreciation + Amortization
Cash from operations
 Cash flow to sales Cash from operations
Sales
 Cash flow to net income Cash from operations
Income from ordinary operations
 Cash flow return on sales Cash from operations
Total assets
 Cash flow liquidity ratio Cash + Marketable securities + Cash flow from
operating Activities
Current liabilities
OTHER RATIOS
OPERATING CYCLE Average collection period of receivable + Average conversion
(liquidity & management efficiency) period of Inventories + Days Cash
CAPITAL INTENSITY RATIO Total Assets
(liquidity & management efficiency) Net sales
SALES TO FIXED ASSETS (PLANT ASSET Net sales
TURNOVER) Average Fixed Assets (net)
(liquidity & management efficiency)
Net income
Average Owners’ equity
RATE OF RETURN ON OWNERS’ EQUITY Or
(solvency) Return on Assets x Equity multiplier
DIVIDENDS PER SHARE Dividends paid/declared
(stability) Common shares outstanding

RATE OF RETURN ON AVERAGE CURRENT Net Income

ASSETS Average Current Assets
(stability)
DAYS CASH Average cash balance
(liquidity and management efficiency) Cash operating costs
Number of days in a year
PERCENT OF EACH CURRENT ASSETS TO Amount of each current assets
TOTAL CURRENT ASSETS Total current assets

One of the most popular representation of cash from operations is the EBITDA or EARNINGS BEFORE INTEREST,
TAX, DEPRECIATION AND AMORTIZATION.

FINANCIAL GEARING RATIOS – measure the financial risk of a company’s financial structure. Business risk can be calculated by
calculating a company’s operational gearing.
TWO GEARING RATIOS:
 Financial gearing ratio
4
  Ways to compute financial gearing ratio:
1) FGR = Prior Capital Charged / Equity Capital
2) FGR = Prior Capital Charged / Total capital employed
*Prior capital charged – capital employed in the business which has the right to receive interest and preference dividends before
any distribution is made to ordinary (common) shareholders (e.g. preference shares, interest-bearing long-term capital, and interest-
bearing short-term debt capital). In an alternative calculation of prior capital charged, the interest-bearing short-term
debt capital may be excluded.
*Equity capital – refers to the interest of the ordinary shareholders include that of the share capital, share premium and retained
earnings
*Total capital employed – sum of the non-current assets and net working capital.
 Operating gearing ratio – same as operating leverage (Contribution Margin / Operating Income or EBIT)

EXERCISES

1. Which of the following is not a limitation of financial statement analysis?

a. Cost basis c. Diversification of firms
b. Use of estimates d. Availability of information

2. Horizontal analysis is also known as

a. Linear analysis c. Trend analysis
b. Vertical analysis d. Common size analysis

3. Ratios are used as tools in financial analysis

a. Instead of horizontal and vertical analysis
b. Because they can provide information that may not be apparent from inspection of the individual components
of a particular ratio
c. Because even single ratios by themselves are quite meaningful
d. Because they are prescribed by GAAP

4. A drop in the market price of a firm’s common stock will immediately affect its:
a. return o common stockholders’ equity c. dividend payout ratio
b. current ratio d. dividend yield ratio

5. Issuing new shares of stock in a five-for-one split of common stock would

a. decrease the book value per share of common c. increase total stockholders’ equity
stock d. decrease total stockholders’ equity
b. increase the book value per share of common
stock

6. If current assets exceed current liabilities, prepaying an expense on the last day of the year will
a. decrease the current ratio c. decrease the acid test ratio
b. increase acid test ratio d. increase the current ratio

7. A company’s current ratio and acid test ratios are both greater than 1. issuing bonds to finance purchase of an
office with the first instalment of the bonds due in the current year would
a. decrease net working capital c. decrease the acid test ratio
b. decrease the current ratio d. affect all of the above as indicated

8. Assume the current ratio is greater than 1. What is the effect of the collection of accounts receivable on the
current ratio and net working capital, respectively?
a. b. c. d.
Current ratio No effect Increase Increase No effect
Net working capital No effect Increase No effect Increase

9. What is the effect of a purchase of inventory on account on the current ratio and on working capital, respectively?
(assume a current ratio greater than one prior to this transaction)
a. b. c. d.
Current ratio Decrease No effect Decrease No effect
Working capital No effect Decrease Decrease No effect

10. At the beginning of the year, a company’s current ratio is 2.2 to 1 and its acid test ratio is 1.0 to 1. At the end of
the year, the company has a current ratio of 2.5 to 1 and an acid test ratio of 0.8 to 1. Which of the following
could help explain the divergence in the ratios from the beginning to the end of the year?
a. an increase in credit sales in relationship to c. an increase in the collection rate of accounts
cash sales receivable
b. an increase in inventory levels during the d. selling marketable securities at a price below
current year cost

11. A company’s current ratio and acid test ratio are both greater than 1. The collection of a current accounts
receivable of P29,000 would
a. increase the current ratio c. not affect the current ratio or the acid test
b. decrease the current ratio ratio
d. decrease the acid test ratio

5
12. Angel Corporation has a current ratio of 2 to 1 and an acid test ratio of 1 to 1. A transaction that would change
Angel’s acid test ratio but not its current ratio is
a. sale of short term marketable securities for c. collection of accounts receivable
cash that results in a profit d. payment of accounts payable
b. sale of inventory on account at cost

13. Assuming stable business condition, an increase in the accounts receivable turnover ratio would be explained by
a. stricter policies with respect to the granting of c. slowdown in the collecting accounts receivables
credit to customers from customers
b. easing of policies with respect to the granting d. none of these
of credit to customers

14. KC had net income of P 2million in 2006. using the 2006 financial elements as the base data, net income
decreased by 70 percent in 2007 and increased by 175 percent in 2008. the respective net income reported by KC
for 2007 and 2008 are:
a. P600,000 and P5,500,000 c. P1,400,000 and P3,500,000
b. P5,500,000 and P600,000 d. P1,400,000 and P5,500,000

15. Assume that Princess reported a net loss of P50,000 in 2006 and net income of P250,000 in 2007. the increase in
income of P300,000
a. can be stated as 0% c. cannot be stated as a percentage
b. can be stated as 100% increase d. can be stated as 200% increase

16. Bea Company is preparing common-size financial statements. Bea has provided the following information:
Accounts receivable P10,000 Retained earnings P7,000
Inventory 20,000 Sales revenue 75,000
Total current assets 35,000 Cost of goods sold 62,000
Total assets 84,000 Income taxes expense 22,000
Bonds payable 21,000
1) How would Bea’s inventory appear on a common size balance sheet?
a. 11.9% b. 23.8% c. 57.15% d. 65.3%
2) How would Bea’s retained earnings appear on a common size balance sheet?
a. 8.3% b. 9.4% c. 20.0% d. 33.3%

17. Financial statements for Maja Company for the most recent year appear below:
Maja Company
Balance sheet
December 31
(in thousands)
Cash P90 Accounts payable P150
Accounts receivable 150 Accrued expense payable 25
Inventories 150 Income tax payable 20
Prepaid expenses 10 Interest payable 5
Plant and equipment 300 Long-term bonds payable 100
Accumulated depreciation (110) Common stock (P1 par) 20
Patents 10 Additional paid in capital 120
Retained earnings 160
Total assets P600 Total liabilities and equity P 600
Maja Company
Income statement
For the year ended December 31
(in thousands)
Sales P1,200
Cost of goods sold 750
Gross profit P450
Operating expenses 340
Net operating income P110
Interest expense 10
Net income before income tax P100
Income tax 40
Net income P60
The balances in the cash, accounts receivable, inventory, bonds payable, common stock, and additional paid in
capital accounts are unchanged from the beginning of the year. A P0.75 per share dividend was declared and paid
during the year. On December 31, Maja Company’s common stock was trading at P24 per share.
3) Maja Company’s current ratio at December 31 was closest to
a. 1.95 to 1 b. 2.67 to 1 c. 1.33 to 1 d. 2.00 to 1
4) Maja Company’s times interest earned ratio for the year was closest to
a. 11.0 to 1 b. 10.5 to 1 c. 12.0 to 1 d. 22.0 to 1
5) Maja Company’s quick ratio at December 31 was closest to
a. 0.45 to 1 b. 0.83 to 1 c. 2.00 to 1 d. 1.20 to 1
6) Maja Company’s inventory turnover ratio for the year was closest to
a. 8x b. 3x c. 5x d. 7.5x
7) Maja Company’s average collection period (age of receivables) for the year was closest to (use 365 days)
a. 72 days b. 8 days c. 120 days d. 46 days
8) Maja’s price earnings ratio at December 31 was closest to
a. 3 b. 8.25 c. 8 d. 7.25
9) Maja Company’s book value per share at December 31 was closest to

6
 a. P7 b. P15 c. P24 d. P30
10) Maja Company’s dividend payout ratio for the year was closest to
a. 75% b. 25% c. 5% d. 3.125%
11) Maja Company’s debt to equity ratio at December 31 was closest to
a. 0.33 to 1 b. 0.50 to 1 c. 0.67 to 1 d. 1.00 to 1
12) Maja Company’s dividend yield ratio for the year was closest to
a. 3.125% b. 12.500% c. 9.125% d. 25.000%

18. Selected financial data from Iza Company for the most recent year appear below:
Sales P100,000 Interest expense P8,000
Cost of goods sold 60,000 Operating expenses 18,000
Dividends declared and paid 5,000
The income tax rate is 30 percent.
1) Net operating income as a percentage of sales was closest to: a. 0.14 b. 0.17 c. 0.22 d. 0.09
2) Net income as percentage of sales was closest to a. 0.22 b. 0.14 c. 0.40 d. 0.10
3) Gross margin as a percentage of sales was closest to a. 0.40 b. 0.45 c. 0.35 d. 0.22

19. Financial statements for Karylle Company appear below:

Karylle Company
Statement of Financial Position
December 31, 2002 and 2001
(in thousands)
2002 2001 2002 2001
Current assets: Current liabilities:
Cash & marketable securities P160 P150 Accounts payable P100 P130
Accounts receivable (net) 200 190 Accrued liabilities 80 80
Inventory 200 190 Notes payable (short-term) 110 130
Prepaid expenses 40 40 Total current liabilities P290 P340
Total current assets P600 570 Non-current liabilities:
Non-current assets: Bonds payable P450 P500
Plant & equipment (net) P1,360 P1,360 Total liabilities P740 P840
Shareholders’ equity:
Preferred stock P5 par 15% P100 P100
Common stock P15 par 180 180
Additional paid in capital-common stock 180 180
Retained earnings 760 630
Total stockholders’ equity P1,220 P1,090
Total assets P1,960 P1,930 Total liabilities and stockholders equity P1,960 P1,930
Karylle Company
Income statement
For the year ended December 31, 2002
(in thousands)
Sales (all on account) P2,780
Cost of goods sold 1,940
Gross margin 840
Operating expenses 330
Net operating income P510
Interest expense 50
Net income before taxes P460
Income tax (30%) 138
Net income P322
Dividends during 2002 totaled P192 thousand, of which P15 thousand were preferred dividends. The market price
of a share of common stock on December 31, 2002 was P310.
1) Karylle’s earnings per share of common stock for 2002 was closest to
a. P1.60 b. P25.58 c. P26.83 d. P38.33
2) Karylle’s dividend yield ratio on December 31, 2002 was closest to
a. 0.3% b. 5.2% c. 4.8% d. 4.4%
3) Karylle’s return on total asset for 2002 was closest to
a. 0.173 b. 0.166 c. 0.148 d. 0.184
4) Karylle’s current ratio at the end of 2002 was closest to
a. 0.39 to 1 b. 0.49 to 1 c. 1.31 to 1 d. 2.07 to 1
5) Karylle’s accounts receivable turnover for 2002 was closest to
a. 14.5x b. 14.3x c. 9.9x d. 9.6x
6) Karylle’s average sale period for 2002 was closest to (use 365 days)
a. 25.6 days b. 36.7 days c. 25.6 days d. 36.9 days
7) Karylle’s times interest earned for 2002 was closest to
a. 10.2x b. 16.8x c. 6.4x d. 9.2x

20. Kathryn Company is calculating its earning power ratios for the year ended December 31, 2013. here is the
relevant information:
Net income P500,000 Interest expense P30,000
Tax rate 40 percent Total dividends paid – common 120,000
Total dividends paid – preferred P42,500 Market price – common share 40
Market price – preferred share 110 Total shares outstanding – common 120,000 shares
Total shares outstanding – preferred 85,000 shares Beginning total assets P6 million
Ending total assets P7 million Beginning common stockholders’ equity P2 million
Ending stockholders’ equity P2.5 million
Kathryn’s preferred stock is convertible. Each share of preferred stock is convertible into two shares of common
stock. Compute for the following:
7
 1) Earnings per share? a. P2.44 b. P3.81 c. P4.17 d. P5.38
2) Fully diluted earnings per share? a. P1.58 b. P1.72 c. P2.44 d. P2.94
3) Dividend yield ratio? a. 0.9% b. 1.5% c. 2.5% d. 4.0%

21. Toni Company has an acid rest ratio of 2.5 to 1. it has current liabilities of P40,000 and non current assets of
P70,000. If Toni’s current ratio is 3.1 to 1, its inventory and prepaid expenses must be
a. P12,400 b. P24,000 c. P30,000 d. P40,000

22. Anne Company has an acid test ratio of 1.5 to 1 and a current ratio of 2.5 to 1. current assets equal P200,000 of
which P10,000 is prepaid expenses. Anne’s inventory must be:
a. P30,000 b. P110,000 c. P70,000 d. P80,000

23. Coleen Company has a current ratio of 3.2 to 1 and an acid test ratio of 2.4 to 1. there are no prepaid expenses
and inventory equals P40,000. Coleen’s current liabilities must be
a. P40,000 b. P120,000 c. P50,000 d. P32,000

24. Julia Corporation asked you to interpret the following ratios provided by its accountant:
Acid test ratio 1.2 Inventory turnover 6 times
Times interest earned 8 Debt to equity ratio 0.9:1
Gross margin ratio 40% Ratio of operating expenses to sales 15%
Total stockholders equity on December 31, 2013 was P900,000. Gross margin for 2012 amounted to P600,000.
Beginning balance of merchandise inventory was P200,000. the company’s long-term liabilities consisted of bonds
payable with interest at 15 percent. You decided to reconstruct the company’s financial statements based on the
limited information given to serve as basis for further analysis.
1) Operating income was computed at: a. P525,000 b. P300,000 c. P375,000 d. none of these
2) Bonds payable totalled: a. P312,500 b. P350,000 c. P400,000 d. none of these
3) Total current liabilities would be: a. P462,500 b. P497,500 c. P504,500 d. none of these
4) The company’s total asset amounted to:
a. P317,000 b. P597,000 c. P697,000 d. none of these

LONG PROBLEMS WITH SOLUTIONS

1) (VERTICAL ANALYSIS) A comparative statement is given below for Jessy Company:
2002 2001
Amount Percentage Amount Percentage
Sales P5,000,000 P4,000,000
Cost of sales (3,160,000) (2,400,000)
Gross margin P1,840,000 P1,600,000
Selling expenses P900,000 P700,000
Administrative expenses 680,000 584,000
Total expenses P(1,580,000) P(1,284,000)
Net operating income P260,000 P316,000
The president is concerned that net income is down in 2002 even though sales have increased during the year.
The president is also concerned that administrative expenses have increased since the company makes a
concerned effort during 2002 to “fat” out the organization. Required: Express each year’s income statement in
common-size percentages. Carry computations into one decimal place.
Answer: 2.4 million/ 4 million
2002 2001
Amount Percentage Amount Percentage
Sales P5,000,000 100% P4,000,000 100% Income
Cost of sales (3,160,000) 63.20% (2,400,000) 60% statement base
Gross margin P1,840,000 36.8% P1,600,000 40% amount under
Selling expenses P900,000 18.00% P700,000 17.5% vertical
Administrative expenses 680,000 13.6% 584,000 14.6% analysis is the
Total expenses P(1,580,000) 31.6% P(1,284,000) 32.1% SALES or Net
Net operating income P260,000 5.2% P316,000 7.9% Sales

2) (HORIZONTAL ANALYSIS) Gretchen’s sales, current assets and current liabilities (all in thousands of pesos) have
been reported as follows over the last four years (Year 4 is the most recent year):
Year 4 Year 3 Year 2 Year 1
Sales P5,400 P4,950 P4,725 P4,500
Current assets 1,448 1,332 1,368 1,280
Current liabilities 318 324 330 300
Express all of the assets, liabilities and sales data in trend percentages (show percentages in each item). Use year
1 as the base year and carry computations to one decimal place.
Answer: (P4,725,000 / 4,500,000) * 100
Year 4 Year 3 Year 2 Year 1
Sales 120 110 105 100
Current assets 113.1 104.1 106.9 100
Current liabilities 106 108 110 100

3) (FINANCIAL RATIOS) You have just been hired as a loan officer at Cristine Security Bank. Your supervisor has
given you a file containing a request from Jodi Company, a manufacturer of auto components, for a P1 million
five-year loan. Financial statement data on the company for the last two years are given below:
Jodi Company
Comparative balance sheet
This year Last year
Assets
Current assets

8
 • Cash P320,000 P420,000
• Marketable securities 0 100,000
• Accounts receivable (net) 900,000 600,000
• Inventory 1,300,000 800,000
• Prepaid expenses 80,000 60,000
Total current assets P5,700,000 P4,960,000
Liabilities and stockholders’ equity
Liabilities
• Current liabilities P1,300,000 P920,000
• Bonds payable, 10% 1,200,000 1,000,000
Total liabilities P2,500,000 P1,920,000
Stockholders’ equity
Preferred stock 8% P30 par value P600,000 P600,000
Common stock P40 par value 2,000,000 2,000,000
Retained earnings 600,000 440,000
Total stockholders’ equity P3,200,000 P3,040,000
Total liabilities and stockholders’ equity P5,700,000 P4,960,000
Jodi Company
Comparative income statement
This year Last year
Sales (all on account) P5,250,000 P4,160,000
Cost of goods sold (4,200,000) (3,300,000)
Gross margin P1,050,000 P860,000
Operating expenses (530,000) (520,000)
Net operating income P520,000 P340,000
Interest expense (120,000) (100,000)
Net income before tax P400,000 P240,000
Income tax (30%) (120,000) (72,000)
Net income P280,000 P168,000
Dividends paid:
• Preferred stock P48,000 P48,000
• Common stock 72,000 36,000
Total dividend paid P(120,000) P(84,000)
Net income retained P160,000 P84,000
Retained earnings – beginning of year P440,000 P356,000
Retained earnings – end of the year 600,000 P440,000
Bea Rose Santiago, who just two years ago, was appointed president of Jodi Company, admits that the company
has been “inconsistent” in its performance over the past several years. But Bea argues that the company has its
costs under control, and is now experiencing strong sales growth as evidenced by the more than 25 percent
increase in sales over the last year. Bea also argues that investors have recognized the improving situation at Jodi
Company as shown by the jump in the price of its common stock from P20 per share last year to P36 per share
this year. Bea believes that with strong leadership and modernized equipment that the P1 million loan will permit
the company to buy, profits will be even stronger in the future. Anxious o impress your supervisor, you decide to
generate all the information you can about the company. You determine that the following ratios are typical of
companies in Jodi Company:
Current ratio 2.3:1 Acid test ratio 1.2:1
Average age of receivables 31 days Inventory turnover 60 days
Return on assets 9.5% Debt to equity ratio 0.65 to 1
Times interest earned 5.7 Price-earnings ratio 10
Determine the following ratios for this year:
a) Return on total assets j) Working capital
b) Return on common equity k) Current ratio
c) Is the company’s leverage positive or negative? l) Acid-test ratio
d) Earnings per share m) Accounts receivable turnover
e) Dividend yield ratio for common n) Average age of receivables (assume 365 days)
f) Dividend payout ratio o) Inventory turnover
g) Price earnings ratio p) Inventory conversion period (assume 365 days)
h) Book value per share common q) Debt to equity ratio
i) Gross margin percentage r) Number of times interest was earned
Answer:
a. Return on total assets: Answer
• Net income + [Interest x (1-tax rate)] P280,000 + [(1,200,000 x 0.10) x (1-0.30)] 0.068
Average total assets [(5,700,000+4,960,000) / 2]
• Net income / Average total assets P280,000 / [(5,700,000+4,960,000)/2] 0.0525
• Operating income / Average total assets P520,000 / [(5,700,000+4,960,000)/2] 0.0976
b. Return on common equity:
• (Net income – Preferred dividends) [P280,000 – (P600,000 x 0.08)]
Average Stockholders’ equity-common [(3,200,000+3,040,000)/2]-600,000 0.092
c. Leverage is positive for this year, since the return on common equity is greater than the return on
total asset .
d. Earnings per share:
• (Net income – Preferred dividends) P232,000 / (P 2 million / P40 par value) P4.64
Average # of common shares
outstanding
e. Dividend yield ratio
• Dividend per share / market price per (P72,000 / 50,000 shares) / P36 0.04
share
f. Dividend payout ratio
• Dividend per share / earnings per share (P72,000 / 50,000 shares) / P4.64 0.31
g. Price earnings ratio
• Market price per share / Earnings per P36 / P4.64 7.8
share

9
 h. Book value per share
• Common stockholders’ equity (P3,200,000 – 600,000) / 50,000 shares P52
Number of common shares outstanding
i. Gross margin percentage
• Gross margin / sales P1,050,000 / P5,250,000 0.20
j. Net working capital
• Current assets – Current liabilities P2,600,000 – P1,300,000 P1,300,000
k. Current ratio
• Current assets / Current liabilities P2,600,000 / P1,300,000 2:1
l. Acid-test ratio
• Quick assets / Current liabilities P1,220,000 / P1,300,000 0.94 to 1
m. Accounts receivable turnover
• Net credit sales / Average receivable P5,250,000 / [(900,000+600,000)/2] 7 times
n. Average age of receivables:
• Number of days in a year 365 days / 7 times 52 days
Accounts receivable turnover
o. Inventory turnover
• Cost of sales / Average Inventory P4,200,000 / [(1,300,000+800,000)/2] 4 times
p. Inventory conversion period
• Number of days in a year 365 days / 4 times 91 days
Inventory turnover
q. Debt to equity ratio
• Total liabilities / Stockholders’ equity P2,500,000 / 3,200,000 0.78:1
r. Times interest earned
• Earnings before Interest and Taxes P520,000 / P120,000 4.3 times
Interest expense

4) (EFFECTS OF TRANSACTIONS ON VARIOUS FINANCIAL RATIOS) Selected amounts from Alex Company’s balance
sheet from the beginning of the year follow:
Cash P70,000 Marketable securities P12,000
Accounts receivable (net) 350,000 Inventory 460,000
Prepaid expenses 8,000 Plant and equipment (net) 950,000
Accounts payable 200,000 Accrued liabilities 60,000
Notes due within one year 100,000 Bonds payable in 5 years 140,000
During the year, the company completed the following transactions:
a) Purchased inventory on account, P50,000 h) Sold inventory costing P70,000 for P100,000, on
b) Declared cash dividends P30,000 account
c) Paid accounts payable P100,000 i) Wrote off uncollectible accounts in the amount of
d) Collected cash on accounts receivable P80,000 P10,000. The company uses the allowance method of
e) Purchased equipment for cash P75,000 accounting for bad debts.
f) Paid a cash dividend previously declared P30,000 j) Issued additional shares of capital stock for cash,
g) Borrowed cash on a short-term note with the bank P200,000
P60,000 k) Paid off all short-term notes due P160,000

Required:
1. Compute the following ratios as of the beginning of the year: Working capital, Current ratio and Acid-test ratio
Answer:
• Working capital P900,000 – P360,000 P540,000
• Current ratio 900,000/ 360,000 2.5 to 1
• Acid test ratio 432,000 / 360,000 1.2 to 1

2. Indicate the effect of the transactions given above on working capital, current ratio and acid test ratio. Give
the effect in terms of INCREASE, DECREASE or NONE.
Answer: The best way in
Effect on answering the effects
Entry Working capital Current ratio Acid test ratio of every transaction
a) Merchandise Inventory None Decrease Decrease on ratio is by making
Accounts payable an entry
b) Retained earnings None Increase Increase
Dividends payable
c) Accounts payable None None None
Cash
d) Cash None None None
Accounts receivable
e) Equipment Decrease Decrease Decrease
Cash
f) Dividends payable None Increase Increase
Cash
g) Cash None Decrease Decrease
Notes payable due 1 year
h) Accounts receivable Increase Increase Increase
Sales
Cost of sales
Merchandise inventory
i) Allowance for bad debts None None None
Accounts receivable
j) Cash Decrease Decrease Decrease
Loss on sale of MS
Marketable securities
k) Cash Increase Increase Increase
Common stock
l) Notes payable None Increase Increase
Cash
10
5) (CONSTRUCTION OF FINANCIAL STATEMENTS USING RATIOS) Financial analysis may b used to test the fairness
of the relationship among current financial data against those of prior financial information. Given established
financial relationships and few key amounts, a CPA could also prepare projected financial statements. Jessy
Corporation has in recent prior years maintained the following relationships among data on its financial
statements:
Net income rate on net sales 5 percent Gross income rate on net sales 35 percent
Ratio of selling expenses to net sales 15 percent Acid test ratio 2:1
Current ratio 3:1 Accounts receivable turnover 5 times
Inventory turnover 5 times Composition of quick assets:
Asset turnover 1 per year Cash 10 percent
Ratio of total assets to intangible assets 20:1 Marketable securities 30 percent
Ratio of accounts receivable to accounts 1.5:1 Accounts receivable 60 percent
payable Ratio of total liabilities to stockholders’ equity 1.4:1.6
Ratio of working capital to stockholders’ 1:1.6 Ratio of accumulated depreciation to cost of 1:3
equity fixed assets
Number of times interest earned 2
For 2013, the company projects to have a net income of P150,000 which will result to P10 per share of common
stock. Additional information includes the following:
 Common stock has a par value of P50 per share and was issued at 20% premium
 8% preferred stock has a par value of P50 per share and was issued 10% premium
 Preferred dividends paid in 2012, P10,000 the same amount will be paid in 2013
 The company’s purchases and sales are all “on account”. For projection purposes, it is assumed that the above relationships
among the data on the financial statements of Jessy Corporation shall also hold true for 2013.
Required: Prepare a projected balance sheet for the year 2013 and a projected income statement for the ended
December 31, 2013. ignore income tax
Answer:
Jessy Corporation
Projected Income statement
For the year ended December 31, 2013
Net sales 0.05 = P150,000 / net sales P 3,000,000
Net sales = P150,000 / 0.05 ~ P3,000,000
Cost of goods sold P3,000,000 – P1,950,000 ~ P1,950,000 (1,950,000)
Gross margin 0.35 = Gross margin / P3,000,000 P1,050,000
Gross profit: P3,000,000 x 0.35 ~ P1,050,000
Expenses:
Selling expenses P3,000,000 x 0.15 P450,000
Administrative expenses P1,050,000 – (P150,000+450,000+150,000) 300,000
Interest 2 = (P150,000 + Interest) / Interest 150,000
2 Interest = P150,000 + interest
Since the problem
Interest = P150,000
does not state the
Total expenses P(900,000)
beginning balance
Net income (GIVEN) P150,000
of AR, it is
Jessy Corporation
Projected balance sheet assume that the
As of December 31, 2013 600,000 is the
ASSETS: ending balance of
Current assets: the accounts
 Cash A/R = 60% of quick assets P100,000 receivable. There
Quick assets = P600,000 / 0.60 ~ P1,000,000 is no need to
Cash = P1,000,000 x 0.10 ~ P100,000 multiply it by 2
 Marketable securities P1,000,000 x 0.30 ~ P300,000 300,000 since there is no
 Accounts receivable 5 = P3 million / Accounts receivable 600,000 data concerning
Accounts receivable = P3,000,000 / 5 ~ P600,000 the beginning
 Inventory 5 = P1,950,000 / Inventory 390,000 balance of AR
Inventory = P1,950,000 / 5 ~ P390,000
 Prepaid expenses P1,500,000 – (P1,000,000+390,000) 110,000
Total current assets 3 = Current assets / P500,000 P 1,500,000
Current assets = P500,000 x 3 ~ P1,500,000
Fixed assets
Land, building and equipment 1,350,000 / (1 – 1/3) ~ P2,025,000 P2,025,000
Accumulated depreciation P2,025,000 x 1/3 (675,000)
Land, building and equipment P3,000,000 – (1,500,000+150,000) ~ P1,350,000 P1,350,000
(net)
Intangible assets 20 = P3,000,000 / Intangible assets 150,000
Intangible assets = P3,000,000/20 ~ P150,000
Total assets 1= P3,000,000 / total assets P3,000,000
Total assets = P3,000,000 x 1 ~ P3,000,000
Liabilities and Stockholders’ equity
Liabilities
Current liabilities:
 Accounts payable 600,000 / 1.5 ~ P400,000 P400,000
 Miscellaneous payable 500,000 – 400,000 + 100,000 100,000
Total current liabilities 2= P1,000,000 / Current liabilities P500,000
Current liabilities = P1,000,000 / 2 ~ P500,00
Bonds payable P900,000
Total liabilities P1,400,000
Stockholders’ equity
 8% preferred stock P125,000

11
  Common stock 700,000
 Premium on stock (140,000+125,000) 152,500
Retained earnings 622,500
Total liabilities and SHEquity P3,000,000

12