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COURSE CODE AND TITLE: ACEL 1 – VALUATION CONCEPTS AND METHODS

TOPIC: EVALUATING FINANCIAL HEALTH OF THE FIRM

I. INTRODUCTION
This topic introduces significance of evaluating the financial health of the firm. We will
enumerate the different level of financial performance and explain how the management
uses them to evaluate financial performance and management control.

II. LEARNING OBJECTIVES

At the end of this module, the learners are expected to:
COGNITIVE
1. Enabling the students to analyze and interpret financial statements using different
financial ratios.
AFFECTIVE
1. To appreciate the significance of evaluating the financial health of the firm.
PSYCHOMOTOR
1. To enable them to perform and analyze financial ratios of the financial statements.

(SCAN QR CODE TO ANSWER PRE-ASSESSMENT)

III. PRE-ASSESSMENT
1. Name 2 common financial ratios used in evaluating the financial statements and
its uses.
2. How do you think it serves the company’s objective?

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 IV. PRESENTATION
LESSON INTRODUCTION
Evaluating the financial health of the firm is imperative for the continuous
monitoring and provides reasonable assurance of financial success of the company.
Various financial ratios were established in order to help the management in running their
business.

FINANCIAL STATEMENTS ANALYSIS

The financial statements of a company record important financial data on every
aspect of a business’s activities. As such they can be evaluated on the basis of past,
current, and projected performance. Financial statement analysis is the process of
analyzing a company's financial statements for decision-making purposes. External
stakeholders use it to understand the overall health of an organization as well as to
evaluate financial performance and business value. Internal constituents use it as a
monitoring tool for managing the finances.
KEY TAKEAWAYS
• Financial statement analysis is used by internal and external stakeholders to
evaluate business performance and value.
• Financial accounting calls for all companies to create a balance sheet, income
statement, and cash flow statement which form the basis for financial statement
analysis.
• Horizontal, vertical, and ratio analysis are three techniques analysts use when
analyzing financial statements.
Financial statements are maintained by companies daily and used internally for
business management. In general both internal and external stakeholders use the same
corporate finance methodologies for maintaining business activities and evaluating
overall financial performance.
When doing comprehensive financial statement analysis, analysts typically use
multiple years of data to facilitate horizontal analysis. Each financial statement is also
analyzed with vertical analysis to understand how different categories of the statement
are influencing results. Finally, ratio analysis can be used to isolate some performance
metrics in each statement and also bring together data points across statements
collectively.

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 Financial analysis involves
• Comparing the firm’s performance to that of other firms in the same industry, and
• Evaluating trends in the firm’s financial position over time

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

Although financial statement analysis is highly useful tool, the analyst should
consider its limitations. The limitations involve the comparability of financial data between
companies and the need to look beyond the ratios. The limitations are:
1. Information derived by the analysis are not absolute measures of performance in
any and all of the areas of business operations. They are only indicators of degrees
of profitability and financial strength of the firm.

2. Limitations inherent in the accounting data the analysis works with. These are
brought about by among others: (a) variation and lack of consistency in the
application of accounting principles, policies and procedures, (b) too-condensed
presentation of data, and (c) failure to reflect change in purchasing power

3. Limitations of the performance measures or tools and techniques used in the

analysis. Quantitative measurements are not absolute measures but should be
interpreted relative to the nature of the business and in the light of past, current
and future operations timing of transactions and the use of averages can also
affect the results obtained in applying the techniques in financial analysis.

4. Analysts should be alert to the potential for management to influence the outcome
of financial statements in order to appeal to creditors, investors and others.
Limitations of analysis may be overcome to some extent by finding appropriate
benchmarks used by most analysts such as the performance of comparable components
and the average performance of several companies in the same industry.

HORIZONTAL AND VERTICAL ANALYSIS

Horizontal analysis compares financial information over time, typically from past
quarters or years. Horizontal analysis is performed by comparing financial data from a
past statement, such as the income statement. When comparing this past information,
one will want to look for variations such as higher or lower earnings.

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 Vertical analysis is a percentage analysis of financial statements. Each line item
listed in the financial statement is listed as the percentage of another line item. For
example, on an income statement each line item will be listed as a percentage of gross
sales. This technique is also referred to as normalization or common-sizing.

FINANCIAL RATIO ANALYSIS

Financial ratios are very powerful tools to perform some quick analysis of financial
statements. Financial ratio is a comparison in fraction, proportion, decimal or percentage
of two significant figures taken from financial statements.
The ratio can be categorized as follows:
1. Liquidity ratios. These ratios give us an idea of the firm’s ability to pay off debts
that are maturing within a year or within the next operating cycle. Liquidity ratios
are necessary if the firm is to continue operating.
2. Asset management ratios. These ratios give us an idea of how efficiently the firm
is using its assets. Good asset management ratios are necessary for the firm to
keep its costs low and thus, its net income high.
3. Debt management ratios. These ratios would tell us how the firm has financed
its assets as well as the firm’s ability to repay its long-term debt. Debt management
ratios indicate how risky the firm is and how much of its operating income must be
paid to bondholders rather than stockholders.
4. Profitability. These ratios give us an idea of how profitability the firm is operating
and utilizing its assets. Profitability ratios combine the asset and debt management
categories and how their effects on return on equity.
5. Market book ratios. These ratios which consider the stock price give us an idea
of what investors think about the firm and its future prospects. Market book ratios
tell us what investors think about the company and its prospects.

I. Ratios Used to Evaluate Short-Term Financial Position (Short-Term Solvency

and Liquidity
1. Current ratio
2. Acid-test ratio or quick ratio
3. Working capital to total assets
4. Cash flow liquidity ratio
5. Defensive interval ratio

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II. Ratios Used to Evaluate Asset Liquidity and Management Efficiency
1. Trade receivable turnover
2. Inventory turnover
3. Working Capital Turnover
4. Percent of each current asset to total current assets
5. Current asset turnover
6. Payable turnover
7. Operating cycle
8. Days Cash
9. Free Cash flow
10. Investment or asset turnover
11. Sales to Fixed assets (plant assets turnover)
12. Capital intensity ratio

III. Ratios Used to Evaluate Long-Term Financial Position or Stability / Leverages

1. Debt ratio
2. Equity ratio
3. Debt to equity ratio
4. Fixed Assets to long-term liabilities
5. Fixed assets to total equity
6. Book value per share of ordinary shares
7. Times interest earned
8. Times preferred dividend requirement earned
9. Times fixed charges-earned.

IV. Ratios Used to Measure Profitability and Returns to urn onetInvestors

1. Gross profit margin
2. Operating profit margin
3. Net profit margin (Rate of return on net sales)
4. Cash Flow Margin
5. Rate of return on assets (ROA)
6. Rate of return on equity
7. Earnings per share
8. Price/earnings ratio
9. Dividend Payout
10. Dividend Yield
11. Dividends per share
12. Rate of return on average current assets
13. Rate of return per turnover of current assets

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 ILLUSTRATIVE CASE 6-1 (Financial Mgt Comp. Vol 2019-2020-E.BALATBAT)
The financial statements of EBC Enterprises, Inc. will be used to illustrate the use
of financial ratios in analyzing the company’s (1) liquidity. (2) activity or efficiency in
managing resources, (3) leverage, and (4) profitability.
Liquidity ratios are ratios that measure the firm’s ability to meet cash needs as
they arise (e.g. payment of accounts payable, bank loans and operating costs).
Activity ratios are ratios that measure the liquidity of specific assets and efficiency
in managing assets such as accounts receivable, inventory and fixed assets.
Leverage ratios are ratios that measure the extent of a firm’s financing the debt
relative to equity and its ability to cover interest and other fixed charges such as rent and
sinking fund payments.
Profitability ratios are ratios that measure the overall performance of the firm and
its efficiency managing assets, liabilities and equity.
The Statements of Financial Position as of December 31, 20X4 and 20X3, Income
Statements and Statements of Cash Flows of EBC Enterprises, Inc. for years 20X4, 20X3
and 20X2 are given below:

EBC Enterprise, Inc.

Statement of Financial Position
as of December 31, 20X4 and 20X3

20X4 20X3
Assets
Current Assets
Cash 2,030,500 1,191,000
Marketable Securities 2,636,000 4,002,000
Accounts Receivable 4,704,000 4,383,500
Allowance for doubtful accounts (224,000) (208,500)
Inventories 23,520,500 18,384,500
Prepaid Expenses 256,000 379,500
Total Current Assets 32,923,000 28,132,000

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 Noncurrent Assets
Property, Plant and Equipment
Land 405,500 405,500
Buildings and leasehold improvements 9,136,500 5,964,000
Equipment 10,761,500 6,884,000
Total 20,303,500 13,253,500
Less: Accumulated depreciation and amortization (5,764,000) (3,765,000)
Net property, plant and equipment 14,539,500 9,488,500

Other Assets 186,500 334,000

Total Noncurrent Asets 14,726,000 9,822,500

Total Assets 47,649,000 37,954,500

Liabilities and Shareholders' Equity

Current Liabilities
Accounts Payable 7,147,000 3,795,500
Notes payable - banks 2,807,000 3,006,000
Current maturities of long-term debt 942,000 758,000
Accrued Liabilities 2,834,500 2,656,500
Total Current Liabilities 13,730,500 10,216,000

Noncurrent Liabilities
Deferred Income Taxes 421,500 317,500
Long-term Debt 10,529,500 8,487,500
Total Noncurrent Liabilities 10,951,000 8,805,000

Total Liabilities 24,681,500 19,021,000

Shareholders' Equity
Ordinary Shares, paar value P1, authorizes 10,000,000 shares;
issued, 2,401,500 shares in 20X4 and 2,297,000 shares
in 20X3 2,401,500 2,297,000
Additional paid-in capital 478,500 455,000
Retained Earnings 20,087,500 16,181,500
Total Equity 22,967,500 18,933,500

Total Liability and Equity 47,649,000 37,954,500

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 EBC Enterprise, Inc.
Income Statements and Retained Earnings
for the Years Ended December 31, 20X4, 20X3 and 20X2

20X4 20X3 20X2

Net Sales 107,800,000 76,500,000 70,350,000
Cost of Goods Sold 64,682,000 45,939,500 40,803,000
Gross Profit 43,118,000 30,560,500 29,547,000

Selling and administrative expenses 16,332,000 13,191,000 12,749,000

Advertising 7,129,000 5,396,000 4,770,500
Lease Payments 6,529,000 3,555,500 3,633,500
Depreciation and amortization 1,999,000 1,492,000 1,250,500
Repairs and Maintenance 1,507,500 1,023,000 1,515,500
Total 33,496,500 24,657,500 23,919,000

Operating Income 9,621,500 5,903,000 5,628,000

Other Income (expenses)

Interest Income 211,000 419,000 369,000
Interest Expense (1,292,500) (1,138,500) (637,000)
Earnings before income taxes 8,540,000 5,183,500 5,360,000

Income Taxes 3,843,000 2,228,500 2,412,000

Net Income 4,697,000 2,955,000 2,948,000

Earnings per common share P 2.00 P 1.29 P 1.33

Statement of Retained Earnings

Retained Earnings at beginning of the year 16,181,500 14,157,500 12,130,000
Net Income 4,697,000 2,955,000 2,948,000
Cash dividends (20X4 - P0.33 per share;
20X3 - P 0.41 per share (791,000) (931,000) (920,500)
Retained Earnings at end of the year 20,087,500 16,181,500 14,157,500

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 REQUIRED:
Using the financial ratios, evaluate the company’s financial position and operating
results for the years 20X4 and 20X3.
Solution: EBC Enterprises, Inc.
I. Analysis of Liquidity or Short-term Solvency
Current ratio
Total Current Assets Primary test of solvency to meet current
Total Current Liabilibilities obligation from current assets as a going concern;
measure of adequacy of working capital.

32,923,000
20X4 = 2.40 times
13,730,500

28,132,000
20X3 = 2.75 times
10,216,000

Quick or Acid test ratio

Quick Assets
(Cash + Marketable Securities + A more severe test of immeadite solvency; test of
Accounts Receivable Net) ability to meet deamnds from current assets.
Total Current Liabilities

9,146,500
20X4 = 0.67 times
13,730,500

9,368,000
20X3 = 0.92 times
10,216,000

This is designed to measure how well a company can meet its obligations without
having to liquidate or depend too heavily on its inventory. Since inventory is not an
immediate source of cash and may not even be saleable in times of economic stress,
it is generally felt that to be properly protected; each peso of liabilities should be
backed by at least P1 of quick assets.

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 Cash Flow Liquidity Ratio
Cash + Marketable Securities
Measures short-term liquidity by considering as
+ Cash Flow from Operating
cash resources (numerator) cash plus cash
Activities
equivalents plus cash flow from operating
Current Liabilities
activities.

2,030,500 + 2,636,000 + 5,012,000

20X4 = 0.70 times
13,703,500

1,191,000 + 4,002,000 + (1,883,500)

20X3 = 0.32 times
10,216,000

II. Analysis of Asset Liquidity and Asset Management Efficiency

Accounts Receivable Turnover
Net Sales*
Fomula =
Ave. Accounts Receivable balance

107,800,000
20X4 = 24.90 times
4,480,000 + 4,175,000
2

20X3 76,500,000 = 18.32 times

4,175,000**

*when available, credit sales can be substituted for net sales since credit sales
produce receivable.
**Assumed average for 20X3.
The accounts receivable turnover roughly measures how many times a
company’s accounts receivable have been turned into cash during the year.

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 Average Collection Period
365 days
Fomula =
Accounts Receivable Turnover
or
Average Accounts Receivable
Average daily sale

365
20X4 = 14.6 days or 15 days
24.9

365
20X3 = 19.9 days or 20 days
18.32

Inventory Turnover
Cost of goods sold
Fomula =
Average Inventory balance

64,682,000
20X4 = 3.09 times
23,520,500 +18,384,500
2

20X3 45,939,500 = 2.50 times

18,384,500*

*assume average for 20X3.

The inventory turnover measures the efficiency of the firm in managing and
selling inventory.

Average Sale Period

365 days
Fomula =
Inventory Turnover

365 days
20X4 = 118 days
3.09

20X3 365 days

= 146 days
2.5

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 The number of days being taken to sell the entire inventory one time (called the
average sale or conversion period) is computed by dividing 365 days by the inventory
turnover period. Generally, the faster inventory sells, the fewer funds are tied up in
inventory and more profits are generated.

Fixed Asset Turnover

Net Sales
Fomula =
Average net property, plant and equipment

107,800,000
20X4 = 8.97 times
14,539,500 + 9,488,500
2

20X3 76,500,000
= 8.06 times
9,488,500 *

*Assumed average for 20X3.

The fixed asset turnover is another approach to assessing management’s
effectiveness in generating sales from investments in fixed assets particularly for a
capital-intensive firm.

Total Asset Turnover

Net Sales
Fomula =
Average Total Assets

107,800,000
20X4 = 2.52 times
47,649,000 + 37,954,500
2

20X3 76,500,000
= 2.02 times
37,954,500*

Total asset turnover is a measure of the efficiency of management to generate

sales and thus earn more profit for the firm.

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III. Analysis of Leverage: Debt Financing and Coverage
Debt Ratio
Total Liabilities
Fomula =
Total Asseets

24,681,500
20X4 = 51.80%
47,649,000

20X3 19,021,000
= 50.10%
37,954,500

The debt ratio measures the proportion of all assets that are financed with debt.
Generally, the higher the proportion of debt, the greater the risk because creditors
must be satisfied before owners in the event of bankruptcy.
The use of debt involves risk because debt carries a fixed obligation in the form of
interest charges and principal repayment. Failure to satisfy the fixed charges
associated with debt will ultimately result in bankruptcy.
Debt to Equity Ratio
Total Liabilities
Fomula =
Total Equity

24,681,500
20X4 = 107.46%
22,967,500

20X3 19,021,000
= 100.46%
18,933,500

The debt to equity ratio measures the riskiness of he firm’s capital structure in
terms of relationship between the funds supplied by creditors (debt) and investors
(equity).
Times Interest Earned
Operating Profit
Fomula =
Interest Expense
9,621,500
20X4 = 7.44 times
1,292,500

20X3 5,903,000
= 5.18 times
1,138,500

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 Times interest earned ratio is the most common measure of the ability of a firm’s
operations to provide protection to long-term creditors. The more times a company can
cover its annual interest expense from operating earnings, he better off will be the firm’s
investors.
Fixed Charge Coverage
Operating Profit + Lease Payments
Fomula =
Interest Expense + Lease Payments

9,621,500 + 6,529,000
20X4 = 2.06 times
1,292,500 + 6,529,000

20X3 5,903,000 + 3,555,500

= 2 times
1,138,500 + 3,555,500

The fixed charge coverage measures the firm’s coverage capability to cover not
only interest payments but also the fixed payment associated with leasing which must
be met annually.

IV. Operating Efficiency and Profitability

Gross Profit Margin
Gross Profit
Fomula =
Net Sales

43,118,000
20X4 = 40%
107,800,000

20X3 30,560,500
= 39.95%
76,500,000

Gross profit margin which shows the relationship between sales and the cost of
goods sold, measures the ability of a company both to control costs and inventories or
manufacturing of products and to pass along price increases through sales to
customers.

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 Operating Profit Margin
Operating Profit
Fomula =
Net Sales

9,621,500
20X4 = 8.9%
107,800,000

20X3 5,903,000
= 7.7%
76,500,000

The operating profit margin is a measure of overall operating efficiency and

incorporates all of the expenses associated with ordinary or normal course of business
activities.
Net Profit Margin
Net Income
Fomula =
Net Sales

4,697,000
20X4 = 4.36%
107,800,000

20X3 2,955,000
= 3.86%
76,500,000

Net profit margin measures profitability after considering all revenue and
expenses, including interest, taxes and nonoperating items such as extraordinary items,
cumulative effect of accounting change, etc.
Cash Flow Margin
Cash Flow from Operating Activities
Fomula =
Net Sales

5,012,000
20X4 = 4.65%
107,800,000

20X3 -1,883,500
= -2.5%
76,500,000

This measures the ability of the firm to translate sales to cash to enable it to
service debt, pay dividends or invest in new capital assets.

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 Summary of Financial Statement Analysis of EBC, Inc.
Short-Term Liquidity and Activity
Short term liquidity analysis is of particular significance to trade and short-
term creditors, management and other parties concerned with the ability of a firm
to meet near-term demands for cash.
EBC’s current and quick ratios decreased indicating a deterioration of short-
term liquidity. However, the cash flow liquidity ratio improved in 20X4 after a
negative cash generation in 20X3.
The average collection period for accounts receivable and the inventory
turnover improved in 20X4 which could indicate improvement in the quality of
accounts receivable and liquidity of inventory. The increase in inventory level has
been accomplished by reducing holdings of cash and cash equivalents. This
represents a trade-off of highly liquid assets for potentially less liquid assets. The
efficient management of inventories is critical for the firm’s ongoing liquidity.
Presently, there appears to be a major problems with firm’s short-term
liquidity position.

Long-Term Solvency
The debt ratios for EBC show a steady increase in the use of borrowed
funds. Total debt has increased relative in total assets, long-term debt has
increased as a proportion of the firm’s permanent financing and external or debt
financing has risen relative to internal financing.
Why has debt increase? The statement of cash flows shows the EBC has
substantially increased its investment in capital or fixed assets and their investment
have been financed largely by borrowing especially in 20X3 when the firm had a
rather sluggish operating performance and no internal cash generation.
Given the increased level of borrowing, the times interest earned and fixed
charge coverage improved slightly in 20X4. These ratios should however be
monitored closely in the future particularly if EBC continues to expand.

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 Operating Efficiency and Profitability
As noted earlier, EBC has increased its investment in fixed asset as a result
of store expansion. The asset turnover increased in 20X4, the progress traceable
to improved management of inventories and receivable. There has been
substantial sales growth which suggests future performance potential.
The gross profit margin was stable, a positive sign in the light of new store
openings featuring discounted and “sale” items to attract customers. The firm also
managed to improve its operating profit margin in 20X4 principally due to the firm’s
ability to control operating costs. The net profit margin also improved despite
increased interest and tax expenses and a reduction in interest income from
marketable security investment.

CONCLUSION
It appears that EBC Enterprises, Inc. is well positioned for future growth.
Close monitoring the firm’s management of inventories is important considering
the size of the company’s capital tied up in it. The expansion in their operation may
necessitate aa sustained effort to advertise more, to attract more customers to
both new and old areas. EBC has financed much of its expansion with debt, and
so far, its shareholders have benefited from the use of debt through financial
leverage. The company should however be cautious of the increased risk
associated with the debt financing.
BREAK-EVEN POINT
The break‐even point represents the level of sales where net income equals zero.
In other words, the point where sales revenue equals total variable costs plus total fixed
costs, and contribution margin equals fixed costs. Using the previous information and
given that the company has fixed costs of $300,000, the break‐even income statement
shows zero net income.

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 This income statement format is known as the contribution margin income
statement and is used for internal reporting only.
The $1.80 per unit or $450,000 of variable costs represent all variable costs
including costs classified as manufacturing costs, selling expenses, and administrative
expenses. Similarly, the fixed costs represent total manufacturing, selling, and
administrative fixed costs.
Break‐even point in dollars. The break‐even point in sales dollars of $750,000 is
calculated by dividing total fixed costs of $300,000 by the contribution margin ratio of
40%.

Another way to calculate break‐even sales dollars is to use the mathematical equation.

In this equation, the variable costs are stated as a percent of sales. If a unit has a
$3.00 selling price and variable costs of $1.80, variable costs as a percent of sales is 60%
($1.80 ÷ $3.00). Using fixed costs of $300,000, the break‐even equation is shown below.

The last calculation using the mathematical equation is the same as the break‐
even sales formula using the fixed costs and the contribution margin ratio previously
discussed in this chapter.
Break‐even point in units.
The break‐even point in units of 250,000 is calculated by dividing fixed costs of
$300,000 by contribution margin per unit of $1.20.

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 The break‐even point in units may also be calculated using the mathematical
equation where “X” equals break‐even units.

Again, it should be noted that the last portion of the calculation using the
mathematical equation is the same as the first calculation of break‐even units that used
the contribution margin per unit. Once the break‐even point in units has been calculated,
the break‐even point in sales dollars may be calculated by multiplying the number of
break‐even units by the selling price per unit. This also works in reverse. If the break‐
even point in sales dollars is known, it can be divided by the selling price per unit to
determine the break‐even point in units.

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 MASTER BUDGET
A master budget consists of a projected income statement (planned operating
budget) and a projected balance sheet (financial budget) showing the organization’s
objectives and proposed ways of attaining them.
A master budget is the central planning tool that a management team uses to direct
the activities of a corporation, as well as to judge the performance of its various
responsibility centers.
The budgets that roll up into the master budget include:

• Direct labor budget

• Direct materials budget

• Ending finished goods budget

• Manufacturing overhead budget

• Production budget

• Sales budget

• Selling and administrative expense budget

GENERALIZATION
Financial ratios give the stakeholders a way of interpreting the financial position
and financial condition of the company that enable them to make sound judgement in
decision making. Despite the help of these financial ratios in assessing a firms’ financial
health, one must understand that decision and judgment cannot be solely relied with this
financial ratio because of risk involvement, limitations and inability to predict future events.

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 APPLICATION
Financial ratio analysis is conducted by three main groups of analysts: credit
analysts, stock analysts and managers. What is the primary emphasis of each group, and
how would that emphasis affect the ratios they focus on?

EVALUATION
Explain the concept of liquidity and why it is crucial to company survival.

ASSIGNMENT / REINFORCEMENT

The Statement of Financial Position for Bryan Corporation is shown below. Sales for the year were
P3,040,000 with 75% of sales on credit.
Bryan Corporation
Statement of Financial Position
as of December 31, 20X4

Asset Liabiliies and Owner's Equity

Cash 50,000 Accounts payable 220,000
Accounts Receivable 280,000 Accrued Taxes 80,000
Inventory 240,000 Bonds payable 118,000
Plant and Equipment 380,000 Common stock 100,000
Paid-in capital 150,000
Retained Earnings 282,000

Total Assets 950,000 Total Liabilities and Owners' Equity 950,000

Required:
a. Compute the current ratio
b. Quick ratio
c. Debt-to-total-assets ratio
d. Asset turnover
e. Average collection period

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 REFERENCES:
• Financial Management Comprehensive Volume 2019-2020 Edition – Ma. Elenita Balatbat
Cabrera
• https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/cost-
volume-profit-relationships/cost-volume-profit-
analysis#:~:text=Cost%2Dvolume%2Dprofit%20(CVP,Total%20fixed%20costs%20are%
20constant.
• https://www.accountingtools.com/articles/2017/5/14/master-budget
• https://courses.lumenlearning.com/sac-managacct/chapter/master-and-fleible-budgets/

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