NOTRE DAME OF SALAMAN COLLEGE

Founded in 1965 by the Oblates

Owned by the Archdiocese of Cotabato
Managed by the Diocesan Clergy of Cotabato (DCC)

“Service for the Love of God through Mary”

(B.E.S.T)

Chapter 4. Financial Ratio Analyses and Their

Implications to Management

Learning Objectives
Upon finishing this session, the learner is expected to:
1. Know and explain what a financial ratio is;
2. Know and explain the objectives of financial ratio analyses;
3. Know the explain the limitations of financial ratio analyses; and
4. Perform the steps in doing financial ratio analysis, interpretations, conclusions, and draw the implications based
on the results of the applied ratios.
Learning Contents:
Chapter Prologue
In Chapter 3 we have discussed the analysis of financial statements using horizontal, vertical, and trend analysis.
In this chapter, we shall continue analyzing using financial ratios as a tool.
Ratios present relationships between two variables. Financial ratios, therefore, refer to the relationships between
financial statement items or accounts expressed in mathematical fashion.
In using these ratios, your task is to interpret them as favorable or unfavorable. To do so, you should follow some
standards that would determine the favorableness or unfavorable-ness of the outcome. Some of the standard ratios used
are based on:
1. Company budget for the same period;
2. Those used by the industry to which the firm belongs;
3. Those used by the firm’s successful competitors;
4. Those used by the firm using prior periods; and
5. Those used by the analyst in the past.
Industry ratios are averages developed by a group of experts involved in research. These empirically-based ratios are used
as standards in financial statement analysis. Industries have their own peculiarities hence, experts developed ratios that are
suitable for that industry. Since this task is too tedious, analysts resort to using ratios of competitors, which are readily
available.
There should be consistency in the computation as well as usage of ratios to ensure comparability between results and
prevent their misinterpretations. Just like any financial analysis technique, financial ratios are subject to limitations.
Results from financial ratio analysis are indicators of a firm’s weakness or strength but are not in themselves, good or bad.
This is understandable since the ratios spring forth from financial statements, which as we have mentioned, are subject to
limitations.
Results derived from the computation of ratios could be presented as a percentage (%), a fraction (1/4), a Peso amount
(P25.50), or a relative ratio (2:1).
Illustrative Example: Let’s use the figures of Riel Corporation in Chapter 3.
Assume further that Riel Corporation is a leading department store of fashionable clothes and apparels, with 5 strategic
branches located in the metro.
In this example, the authors provided the computation of the ratios for the current year.
You are tasked to compute the ratio for the previous year.

Riel Corporation
Comparative Statements of Financial Position
December 31, 2015 and 2014

2015 2014
Asset
Current Assets
Cash & Cash Equivalent 106,789 102,375
Trade & Other Receivables 327,611 277,467
Inventory 334,863 297,654
Prepaid Expenses 101,565 114,813
Total Current Assets 870,828 792,309

Non-Current Assets
Property, Plant & Equipment 135,754 166,481
Intangibles 7,500 7,500
Total Noncurrent Asset 143,254 173,981
TOTAL ASSETS 1,014,082 966,290

Liabilities and Shareholders’ Equity

Current liabilities
Trade & Other Payables 238,000 208,703
Unearned Revenues 107,508 82,456
Notes Payable-current 45,000 45,000
Total current liabilities 390,508 336,159

Non-Current Liabilities
Notes Payable – non-current 208,422 253,500
Total Liabilities 598,930 589,659

Shareholders’ Equity
Preference Shares,
P100 par 105,000 105,000
Ordinary Shares, P1 par 15,000 15,000
Premium on Ordinary Shares 135,000 135,000
Total paid-in-capital 255,000 255,000

Retained Earnings 160,152 121,631

Total Shareholders’ Equity 415,152 376,631
TOTAL LIABILITIES & 1,014,082 966,290
SHAREHOLDRS’ EQUITY
 Riel Corporation
Comparative Income Statements
For the period ending December 31, 2015 and 2014

2015 2014
Sales 3,007,887 2,732,712
Less: Cost of goods sold 2,208,520 1,964,865
Gross Profit 799,367 767,847
Less: Selling Expenses 372,000 345,000
Administrative Expenses 207,000 213,000
Total Operating Expenses 579,000 558,000
Operating Income 220,367 209,847
Less: Interest Expense 41,860 43,905
Net Income before taxes 178,507 165,942
Less: Income Tax 62,477 58,080
Net Income after taxes 116,030 107,862

In doing the analysis we shall cover the company status in terms of:
1. Liquidity - pertains to the firm’s ability to pay any immediate and incoming cash disbursements (payment of payables,
and operating costs and expenses).
2. Asset utilization - measures how often is the turn over of accounts receivable, inventory and long-term assets. Stated
differently, we measure the liquidity of assets namely accounts receivable, inventory and long-term assets. Along with
this, we also measure how efficient management uses these assets.
3. Debt-Utilization (Leverage) – estimates the overall debt status of the firm in light of its asset base and earning power.
We measure the degree of company financing in terms of borrowings and investment or equity. We also measure the
company’s ability to pay interest and other fixed charges such as rent and payment of investment funds like sinking funds,
redemptions, pensions, etc.
4. Profitability – this measures the firm’s capacity to earn sufficient return on sales, total assets and owners’ investment.

Solution:
Liquidity/Short-term Solvency
1. Current ratio

Current assets of P870, 828

(2015) =
Current liabilities of P390, 508

Current ratio of 2.23:1 can be interpreted to mean that for every P1.0 of current liability, the company has P2.23
current assets to pay it. This result may at times be considered as favorable and satisfactory. It indicates the Riel is able to
pay their current maturing debts, with P1.23 to spare for every P1 of liability they have.
It is important to remember that no one current ratio is applicable or appropriate for all business. Others may
consider a ratio of 1:1 as satisfactory. A high current ratio does not necessarily mean that the company is able to meet
current maturing debts because the firm’s current asset is composed mainly of inventories. Inventory is considered as a
slow-moving asset in terms of its convertibility into cash.
 Another asset that some analysts do not use in the computation of current ratio is prepaid expense. The reason is
because they are not sources of cash. It represents the consumption or use of future benefits like prepaid rent or prepaid
advertisement. Consumption of these does not entail cash inflow but recognition of expense for the company. So a current
ratio with significant amount of prepaid expenses may not necessarily mean that the firm is capable of paying current
maturing obligations.
On the other hand, a company with a low current ratio may be able to pay current maturing debts, because the
composition of its current asset is easily convertible to cash like having collectible receivables and highly saleable trading
securities.
It is recommended to see whether the said ratio is favorable or not by comparing it with the firm’s competitors or
with the firm’s trend of liquidity over a period of 5 years.
Upward and Downward Movement of Current Ratio
Movements in current ratio components give rise to changes in the current ratio. Ponder on the following
statements and experiment using the figures of Riel Corporation:
a. Increase in current assets or decrease in current liabilities increases the current ratio.

Components Previous current ratio Increase New current ratio

(decrease)
Total current assets P 50, 000 P 10, 000 P 60, 000
Total current liabilities P 25, 000 P 25, 000
Current ratio = 2:1 2.4:1 increase

Components Previous current ratio Increase New current ratio

(decrease)
Total current assets P 50, 000 P 50, 000
Total current liabilities P 25, 000 P (10, 000) P 15, 000
Current ratio = 2:1 3.3:1 increase

b. If the previous current ratio is 1:1 and there is an increase or decrease of the same amount on both the total
current assets and total current liabilities, it shall have no effect on the new current ratio or the new current ratio
will be the same as the previous. To prove this, see the example below.

Components Previous current ratio Increase of equal New current ratio

amounts
Total current asset P 50, 000 P 10, 000 P 60, 000
Total current liabilities P 50,000 P 10, 000 P 60, 000
Current ratio = 1:1 1:1 no effect/
same ratio

c. If the previous current ratio is positive (current assets > current liabilities), and there is an increase by the same amount
in both total current assets and total current liabilities, the ratio shall decrease and vice-versa. The opposite will occur if
the previous current ratio is negative (current liabilities> current assets).

Components Previous current ratio Increase of equal New current ratio

amounts
Total current assets P 50, 000 P 10, 000 P 60, 000
Total current liabilities P 25, 000 P 10, 000 P 35, 000
Current ratio = 2:1 positive 1.71:1 decrease

Components Previous current ratio Increase of equal New current ratio

 amounts
Total current assets P 25, 000 P 10, 000 P 35, 000
Total current liabilities P 50, 000 P 10, 000 P 60, 000
Current ratio = 0.5:1 negative 0.53:1 increase

2. Acid Test Ratio/quick ratio/liquidity ratio

Quick assets or (Cash + Trading Securities + Receivables)

Of P106, 789 + 327, 611
(2015) =
Current liabilities of P 390, 508
= 1.11:1 or 1.11%

(2014) =

The quick ratio is a stricter test of liquidity. This could be interpreted that for every P1.0 liability, the firm has
P1.11 of current assets to pay it. As you can see, Riel is not as liquid as we pictured it to be when the current ratio was
used. As a general rule, the higher the quick ratio, the more liquid the firm is and thus, can pay its current maturing debts.

Note that the inventories are ignored because of its nature being uncertain as to their salability. Another reason for
their exclusion from the formula is its uncertainty as to when the item will be converted into cash. This is more so if the
company is a manufacturing entity where the inventory will be raw materials to work in process to finished goods,
eventually and converted to receivables and eventually collected and converted into cash.

Asset Utilization Liquidity Analysis

1. For Accounts Receivable

Accounts Receivable Turnover

Net Sales of P3, 007, 887

(2015) = = 9.94 times
Average Accounts Receivable
Of 277,467 + 327, 611
2
Note: For the 2014 receivable turnover you may use the ending inventory of 2014 as the average inventory.
Days’ Sales in Average Receivables or Average Collection Period

365 days
(2015) = = 36.7 days
Receivable turnover of 9.94 times
(2014) =

This ratio is used to measure the liquidity of the firm’s receivable. The result of 9.94 times could be interpreted to
mean that the firm is able to collect all their receivables 9.94 times in a year. A high turnover rate means that receivables
are collected in a short period of time. In Riel Corporation’s case, it is able to collect the average receivables every 37
days or approximately every month. This has great bearing on management, since a high receivable turnover, speeds ups
its conversion to cash and thus, management can use it further to enhance company operations and ultimately, increase
company profits.
High receivable turnover rate does not automatically mean good or efficient collection of the company. The high
turnover rate could be caused by any of the following:
a. Price level changes
b. Changes in sales terms
C. Special sales promotions
d. Strikes and plant shutdown during the previous period
e. Higher cash sales
f. The turnover was computed was when most receivables are collected

2. For Inventory
Inventory Turnover Ratio
The inventory turnover rate pertains to the number of times the average inventory is sold (finished goods &
merchandise), or used (raw materials), or processed (work in process). The following formulas are adapted depending on
the nature of the inventory being assessed:

Raw Materials Raw Materials Used

Inventory Turnover =
Average Raw Materials Inventory

Work in Process Cost of Goods Manufactured

Inventory Turnover =
Average Work in Process Inventory

Finished Goods Cost of Goods Sold

Inventory turnover =
Average Merchandise Inventory

Merchandise Cost of Goods Sold

Inventory Turnover =
Average Merchandise Inventory

Beginning Inventory + Ending Inventory

Average inventory =
2

In our example we used Merchandise Inventory, hence the turnover rate is computed as:

Cost of Goods Sold of P2, 208, 520

(2015) = = 6.98 times
Average inventory of P297, 654 + P334, 863
2
(2014) =
Note: Use ending inventory of 2014 to compute 2014 inventory turnover.
The inventory turnover indicates the company’s efficiency in managing and disposing inventory. As a general
rule, the higher the turnover-rate, the better. However, this is not always the case, because a high turnover rate may also
indicate that the firm is under-investing in their inventory or suffering lost orders. It may also mean inventory shortages.
On the other hand, a low inventory turn-over rate may indicate that the firm is has too much inventory in their warehouse
or is harboring too much obsolete inventory. Low inventory turnover may also mean that the company has slow-moving,
or worse, inferior inventory stock. Lastly, it may simply indicate slow and low sales of the firm for the period. As the
analyst, you must account for the result of the turnover when reporting it to management
Again, it is important to mention that financial ratios, including inventory turnover rates vary, depending on the
industry, the firm belongs. Firms that are involved in highly perishable products like vegetables, fresh meat, and other
agricultural produce do have a relatively high inventory turnover. While firm selling wines, jewelry, or automobile have
relatively low inventory turnover rates but higher profit yields.
For purposes of providing an interpretation for Riel Corporation, the result has a relatively slight unfavorable inventory
turnover. A dress store like Riel should be able to able to dispose of their inventory quicker, since fashion is highly
dynamic and the turnover of new clothes are high, a higher turnover for Riel would be more appropriate. Persons in
management should recommend and come up with strategies on improving the inventory turnover ratio.
Number of Days in Inventory or Average Sale Period

365 days
(2015) = = 52.30 days
Inventory Turnover of 6.98 times

(2014) =

The number of days in inventory indicates the number of days the entire inventory is sold. As a general rule, the higher
the result, the better. This indicates that since inventories are sold out quickly, funds used for the inventories are quickly
converted to cash and ultimately translated to more earnings. Riel’s days in inventory of 52.30 days can still be improved.
It would be better if management can dispose of their inventory in shorter number of days.

3. Property, Plant and Equipment (PPE) or Fixed Asset Turnover

Net Sales of P3, 007, 887

(2015) = 19.90:1
Average net PPE of P135, 754 + P166, 481
2

This turnover indicated the firm’s efficiency in using their PPE in generating revenue. The computed ratio of 19.90:1 can
be interpreted that for every P1.0 PPE acquired and used by the company, P19.90 sales revenue is generated. We could
infer that that Riel is efficient in using their PPE.

4. Total Asset Turnover

Net Sales of P3, 007, 887

(2015) = = 3.04:1 or 304%
Average Total Assets of P1, 014, 082 + 966, 290
2
This ratio presents the company’s efficiency in utilizing their total assets to generate revenue. Low turnover rate means
that there is slow or low sales generation or that there is too high investment in assets. Looking at Riel’s asset turnover
rate (3.04:1), we can interpret this to mean that for every P1.0 asset of the company, P3.04 of sales revenue is generated.
Based on this, we can infer that management utilizes its assets efficiently. It can, however, be recommended that the
company instill more asset utilization policies that would further enhance asset usage efficiency.

Debt-Utilization (Leverage) Ratios

The leverage ratios allow the analyst to ascertain how efficient the company manages its financial obligations.
Under this, you need to compare the liabilities and owners’ equity vis-a-vis total assets or total liabilities & owners’
equity.
AS previously mentioned in Chapter 3, the owners’ equity is considered as the margin of safety by the creditors.
This is because the owners’ equity is the amount that can absorb any decline in asset. In other words, in case the assets of
the company decline, the owners’ equity is the amount that can be used to pay the creditors. In Riel corporation, the total
assets may decline by P415, 152 (amount of stockholders’ equity) or P598, 930 and the company will still be able to pay
its creditors.
The following ratios may be used in the analyses:

1. Debt to Equity Ratio

Total Liabilities of P598, 930

(2015) = = 1.44:1 or 144%
Total Stockholders’ Equity of P415, 152

(2014) =

The use of borrowed funds in carrying out the firm’s operation is called trade on equity. This means that the firm
is willing to borrow money and pay fixed interest charges from the loan. The borrowed money will be used to increase
volume of operation and ultimately earn more profit. This is an example of financial leverage.
When a firm borrows fund to be used in the business, the total assets (cash) and total liabilities (bank loan) of the
company increase, however the owners’ equity remains the same. If profits increase, the trading on equity (use of
borrowed money) would increase the debt/equity ratio and rate of return on owners’ equity.
The debt/equity ratio presents the firm’s capital structure and its inherent risk. The liabilities of the company
present a risk. And blessings or benefit on the part of the owners. It is a risk because if the company fails to use the
borrowed money wisely to improve operation the interest expense from their borrowings will be higher than their
operating income (operating loss). It is also a blessing if the company is able to use the money wisely to, improve
operations leading to higher income, and the higher income ultimately increases owners’ equity. The high income exceeds
the interest expense from the borrowings thus, making liabilities a blessing tor the company. This structure indicates the
trade-off between risk and return.
The debt/equity ratio gauges the amount of risks involving the firm’s capital structure in so far as the relationship
of funds provided by the creditors (liabilities) and owners are concerned. The higher the ratio, the riskier the capital
structure.
Riel’s debt/equity ratio (144%) presents a high risk in the firm’s capital structure. Management should be mindful
of the efficient use of the company’s borrowings in improving operations to ensure higher yields.

2. Debt Ratio
 Total Liabilities of P598, 930
(2015) = = 0.59:1 or 59%
Total Assets of P1, 014, 082

(2014) =

The ratio could be interpreted to mean that for every P1.0 asset of the company, PO.59 was borrowed or was
provided by the creditors. It basically presents the proportion of borrowings to total assets. Generally, as explained earlier,
the higher the debt proportion, the higher is the risk. In addition to this, the risk is higher because if the firm gets bankrupt,
the creditors must be paid first. If the assets are not sufficient to pay all the debts, the owners will end up with nothing.
Riel’s debt ratio (599%) presents a relatively high risk on the part of the company. Management should be
mindful of the risk from borrowings. In addition to this, the ratio may bring about some difficulty on the part of
management to borrow when they need it. Low owners’ equity structure decreases the margin of safety for creditors.

3. Number of Times Interest Earned

Net Income before interest and Income tax

Operating Income of P220, 367
(2015) = = 5.36 times
Annual Interest Expense of P41, 860

(2014) =

This ratio indicates the ability or the firm to pay fixed interest charges. It gauges the company’s ability to protect long-
term creditors. Riel’s times interest earned of 5.26 times indicate that the firm is very much capable of paying its fixed
interest charges from its operating income.

Profitability Ratios
1. Gross Profit Ratio

Gross Profit of P799, 367

(2015) = = P0.26 or 0.26:1 or 26%
Net Sales of P3, 007, 887

(2014) =

This presents the gross margin per peso of sales. This used to ascertain if the gross margin or profit is sufficient to
cover the operating expenses and the firm’s desired net income. It also gauges the firm’s ability to control
production/acquisition costs and inventories and including mark ups in the selling of their products. The said mark ups
must be more than adequate to cover not only the inventory related costs but also operating expenses and achieve a
desired profit for a period.
Riel’s gross profit ratio (PO.26) indicates their ability to earn more than adequate sales revenue to cover their cost
of selling the goods. However a 26% gross profit ratio means a 74% cost ratio. This is relatively too high. Management
must come up with more stringent cost control measures to decrease cost of sales thereby increasing the gross margin ratio
in the succeeding years.
 2. Net Profit Ratio or Profit Margin

Net Profit of P116, 030

(2015) = = P0.039:P1 or 3.9%
Net Sales of P3, 007, 887

(2014) =

The ratio can be interpreted to mean that for every P1.0 sales revenue, the firm has PO.39 net income. This
gauges the profitability of the firm after including all revenues and deducting all costs and expenses, and taxes. Rieľ’s net
profit ratio of 39% is positive. However, management should look closely to come up with measures that would increase
revenue and decrease costs in order to ensurę and achieve profit maximization.
3. Return on Assets (ROA)

Net Income of P116, 030

(2015) = = 0.12:1 or 12%
Average total assets of P1, 014, 082 + 966, 290
2
OR
(Du Point Method) = Net Profit ratio of 3.9% x Total asset turnover of 3.04 = 12%

(2014) =

This could be interpreted as every P1.0 asset used by the company to generate revenue, it yielded P0.12 of net income. It
gauges the profitability of the firm in the use of the total assets or total liabilities and total owners’ equity.

4. Return on Equity

Net Income of P116, 030

(2015) = = 0.29: 1 or 29%
Average stockholders’ equity of P415, 142 + P376, 631
2

(2014) =

This could be interpreted to mean that for every P1.0 of invested capital by the owners and used to generate revenue,
it yielded P0.29 of net income. This ratio, just like the ROA, is used to gauge the company’s efficiency in managing its
total assets invested and in coming up with return to shareholders.

5. Du Pont System of Analysis

After seeing and analyzing the ratios, you might think that they are too many. A man by the name of Donald Brown
who happened to be Du Pont’s chief financial officer thought of the same thing. So he came up with the Du Pont Equation
or the Du Pont System Analysis. The Du Pont company emphasized that satisfactory return on assets may be achieved by
having high profit margins/net profit ratio or by having a faster asset turnover, or a good combination of both.
A favorable net profit ratio would indicate that the company has good cost control measures, and a high asset turnover
rate would mean efficient use of assets. Various industries have various operating and financial structures. Companies
belonging to industries with heavy/high capital produce emphasizes high net profit ratio with a relatively low asset
turnover. On the other hand, the food processing industries emphasize low net profit margin and high turnover of assets
indicating a satisfactory return on assets.
The model includes the following formula to compute return on equity:
Return on Assets = Profit margin or Net profit ratio x Asset turnover
Debt Ratio= Total liabilities/ Total Assets
Equity Ratio = 1-Debt ratio

Return on Assets
Return on Equity =
(DU Pont Method) Equity Ratio

Using the analysis for Riel Corporation:

Return on Asset = 12%

(Du Pont)
Debt ratio = 59%

12%
Return on Equity = = 29%
1 – 59%
Ratios Used To Gauge Company Liquidity or Short-term Solvency
The following are the most common ratios to gauge a firm’s liquidity or short-term solvency:

Ratio Formula Significance

Signifies the firm’s capacity to
1. Current ratio Current Assets pay or meet current financial
Current Liabilities obligations.

Note: Some analysts do not

include prepaid expenses in the
computation of the current
assets.

A stricter test of liquidity.

2. Quick ratio Quick Assets
Current Liabilities
QA = cash + trading securities +
trade and other receivables
Suggest the firm’s ability to pay
current financial obligations by
considering more liquid current
assets.

Suggests the relative liquidity of

3. Current Assets to Total assets Current Assets the total assets and shows the
or Working capital to Total Total Assets proportion of current assets to
 assets
4. Each current asset item to
total current assets
5. Cash flow liquidity ratio
Trading Securities + Cash flow
6. Defensive Interval ratio
Ratios Used To Gauge Asset Management Efficiency and Liquidity
The following are the most common ratios to gauge a firm’s ability to efficiently manage their assets and measure
liquidity or short-term solvency:
Ratio
1. Receivable Turnover
2. Average Collection Period or
Number of Days in Receivables
3. Merchandise Turnover
Average Merchandise inventory
4. Finished Goods Turnover
5. Work in Process Turnover
total assets.
Signifies the proportion of each
Each Current Asset item current asset item to total assets
Total Current Assets and the breakdown of each
component.
Gauges the firm’s ability to pay
Cash & cash equivalents + current financial obligations by
considering cash and other cash
Operating Activities equivalents.
Current Liabilities
Indicates the coverage of current
Current liabilities liabilities.
Cash and Cash Equivalents
Formula Significance
Net Sales or Net Credit Sales Signifies the number of times
Average Receivables the average receivables are
collected during the year. It also
measures the firm’s efficiency in
collecting their receivables.
365 days or 360 days This ratio is very much related
Receivable Turnover to accounts receivable turnover.
It indicates the number of days
the firm collects its average
receivables. It implies the
efficiency of the firm in
collecting their receivables.
Cost of goods sold Suggests the number of times
the average inventory was
disposed of during the
accounting period. It also
signifies the over or under
investment of the firm in
inventory.
Cost of goods sold Suggests the number of times
Average finished goods the average inventory was
disposed of during the
accounting period. It also
signifies the over or under
investment of the firm in their
inventory.
Cost of Goods Manufactured Signifies the number of times
Average Work in Process average inventory was produced

6. Raw Materials Turnover
7. Number of Days in Inventory
8. Working Capital Turnover
9. Current Asset Turnover
10. Payable Turnover
11. Operating Cycle (Trading
Concern)
12. Operating Cycle
(Manufacturing Concern)
inventory
Raw Materials Used
Average Raw Materials
inventory
365 days or 360 days
Inventory Turnover
Cost of Goods Sold + Operating
Expenses (excluding charges not
requiring working capital)
OR
Net Sales
Average Working Capital
Cost of Goods Sold + Operating
Expenses + Income taxes +
Other expenses (excluding
charges not requiring current
assets like depreciation and
amortization expenses)
Average Current Assets
Net Credit Purchases or Net
Purchase
Average Trade and Other
Payables or Accounts Payables
Days’ sales in merchandise Measures the length of time in
inventory + No. of days to order to convert cash to
collect receivables inventory to receivables and
back to cash.
No. of days’ usage in raw
materials inventory + No. of
days in production process +
No. of days’ sales in finished
goods inventory + No. of days to
during the accounting period. It
also indicates the time taken to
products.
Measures the number of times
average raw materials inventory
was used during the period. It
also indicates the sufficiency of
the raw materials available.
Indicates the number of days by
which inventories are used or
sold. Implies the firm’s
efficiency in consuming or
selling inventories.
Signifies the pace by which
working capital is used. It also
indicates the adequacy of
working capital in the firm’s
operations.
Signifies the pace by which
current assets are used. It also
indicates the adequacy of
current assets in the firm’s
operations.
Signifies the firm’s ability to
pay trade payables. It also
measures the number of times
the amount of average payables
is paid during the accounting
period.
Measurement the length of time
in order to convert cash to raw
materials inventory to work-in-
process to finished good
inventory to receivables and
back to cash.
 collect receivables
Average Cash Balance

13. Days Cash Cash Operating Costs Indicates the ability of the firm’s
365 days or 360 days cash to pay the average daily
cash obligations.

14. Asset Turnover Net Sales Indicates the firm’s ability to

Average Total Assets efficiency manage their assets to
generate revenue.

15. Property, Plant & Equipment Net Sales Indicates the firm’s ability to
Turnover or Fixed Asset Average PPE Assets efficiency manage their PPEs to
Turnover generate revenue.

Ratios Used to Gauge Firm’s Utilization of Debt and Company Stability

The following are the most common ratios used to gauge a firm’s stability or long-term solvency.

Ratio Formula Significance

1. Debt to Equity Ratio Total Liabilities Measures the relationship or

Owners’ Equity proportion of the capital
provided by creditors to the
capital provided by owners.

2. Equity to Debt Ratio Owners’ Equity Measures the margin of safety of

Total liabilities creditors.

Measures the proportion of the

3. Propriety or Equity Ratio Owners’ Equity firm’s assets coming from its
Total Assets owners. Signifies financial
stability of the firm and cautions
the creditors.

4. Debt Ratio Total Liabilities Measures the proportion of the

Total Assets firm’s assets coming from its
creditors. It also signifies the
extent of trading on equity.

5. Fixed Assets to Total PPE or Fixed Assets (net) Measures the proportion of the
Owners’ Equity Owners’ Equity owners’ equity used to acquire
fixed assets.

6. Fixed Assets to Total PPE or Fixed Assets (net) Signifies whether the firm over
Assets Total Assets or under invested in PPE.

7. Fixed Assets to Total PPE or Fixed assets (net) Measures the extent covered by
 Long- term Liabilities
8. Plant Turnover
9. Book Value per Share
10. Number of Times
Interest Earned
11. Number of Times
Preference Shares
Dividend Requirement
is Earned
12. Number of Times
Fixed Charges are Earned
Ratios Used to Gauge Firm’s Profitability and Return to Owners
The following are the most common ratios used to gauge a firm’s profitability and returns to owners.
Ratio
Total Long-Term Liabilities
Net Sales
Average PPE or Fixed
assets(net)
Ordinary Shareholders’ Equity
Number of Ordinary Shares
Outstanding
Net Income before Interest
and Income Taxes
Annual Interest Charges
Net Income After Tax
Preference Shares Dividend
Requirement
Net Income before Taxes &
Fixed Charges
Fixed Expenses (Rent, Interest,
Sinking Fund Payments before
taxes)
Formula
the carrying value of PPE to
long-term obligations.
Signifies the firm’s efficiency in
using their PPE.
Measures the carrying value of
net assets for every ordinary
share outstanding. It also
indicates the amount which the
shareholders can recover if the
firm sells its assets upon
liquidation or converts them into
cash at their book values.
Signifies the firm’s capacity in
paying fixed interest charges. It
measures the number of times
interest charges is covered by
the firm’s operating income.
Measures the firm’s ability to
pay the preference shareholders’
dividend requirement.
Indicates the firm’s ability to
pay annual fixed charges.
Significance
 1. Return of Return on
Sales or Net Profit
Ratio or Net Profit margin.
2. Rate of Return to Total Return on Sales x Asset
Assets (ROA)
3. Asset Turnover
4. Gross Profit ratio
5. Operating Ratio
6. Cash flow margin
Cash flow from Operating
7. Rate of Return on
Current Assets or
Working Capital
8. Rate of Return on
Net working capital
(Current assets – Average net working Capital
current liabilities
Net Income Measures the amount of net
Net Sales income per peso of sales. It also
shows the proportion of net
income to the firm’s sales
revenue.
Measures the company’s
Turnover OR profitability in using their total
Net Income assets.it indicates the net income
Average Total Assets generated by using the firm’s
total assets. Signifies
management efficiency in using
their assets to earn income.
Signifies management efficiency
Net Sales in using their assets to generate
Average Total Assets sales revenue.
Measures the gross profit per
Gross Profit peso of sales revenue. This ratio
Net Sales is important in ascertaining the
adequacy of gross profit to meet
operating expenses plus their
desired profit.
Operating Income Measures the portion of sales
Net Sales revenue used to cover operating
costs.
Indicates the firm’s ability to
translate sales into cash.
activities
Net Sales
Gauges management efficiency
Net Income in using current assets to
Average Current Assets generate net income.
Measures management
Net Income efficiency in using net working
capital to generate revenue.

9. Rate of Return on Net Income
Owners’ Equity Average Owners’ Equity
10. Earnings Per Share Net Income – Preference share
dividend requirement
No. of Ordinary Shares
Outstanding
11. Price-earnings Ratio Market price per share
Earnings Per Shares
12. Earning-Price Ratio or Earnings Per Share
Capitalization Rate Market Price per Share
13. Dividends Per Share Dividends Paid or Declared
Ordinary Shares Outstanding
14. Payout Ratio or Dividends per Share
Dividends Payout Earnings Per Share
15. Retained Earnings to Retained Earnings
Share Capital Share Capital
16. Market Price to Book Market Price per Share
Value per Share Book Value per Share
Chapter 5. Financial Forecasting, Corporate
Planning and Budgeting
Indicates the amount of return
per peso of owners’ equity.
Gauges management efficiency
in using its invested capital to
generate revenue.
Measures the peso return on
each ordinary share issued.
Signifies the firm’s ability to
pay dividends.
Indicates the relationship
between the market price of
ordinary shares and the earnings
of each ordinary share.
Measures the rate at which the
share market is capitalizing the
value of current earnings.
Indicates the earnings
distributed to the owners on a
per share basis.
Measures the percentage of the
company’s earnings paid to
owners.
Measures the probability of
declaration of dividends by the
firm.
Signifies the under or over-
valuation of sahres.
Learning Objectives:
1. Know and explain the basic concepts involving financial forecasting, corporate planning and budgeting.
2. Know and explain what are pro-forma financial statements and percent-of-sales method.
3. Construct pro-forma statements in designing a financial forecast; and
4. Apply percent-of-sales method in the designing a financial forecast.
Corporate Planning
Corporate planning is defined as a formal, systematic, managerial process,that is organized by responsibility, time
and information to assure that strategic planning, project planning and operational planning are carried out regularly to
enable top management to direct and control the future of the company. Let us discuss the three forms of corporate
planning as seen in the definition.
Strategic Planning. This involves the creation of strategies that are aimed in maximizıng the entity’s future
position taking into consideration the various elements and factors that may pervade the company’s internal and external
environment. A strategy is a design that integrates the corporate objectives, policies and programs in a well-developed
unified whole. The company’s strategic plans serve as a control measure that systematically distributes the scarce
resources of the entity in order to assure the best means of achieving corporate objectives.
Project Planning. Sometimes called as capex planning or capital expenditure planning entails detailed plans
involving acquisition of new property, plant and equipment, creation of new products, modification or acquisition or
adoption of new systems, and acquisition of new entities. In evaluating acquisitions that involve significant capital
expenditures, systematic and scientific methods are used like discounted cash flows (DCF), rate of returns (ROR), and
cost of capital assessment. These are discussed thoroughly in other sections of this book.
Operational Planning. This is much concerned on how to efficiently and effectively utilize the entity’s resources
to achieve the company’s short-term and long-term objectives set up during strategic planning. The short-term as well and
long-term plans are broken down into the differential functional areas of management (operations, marketing, finance,
research, etc). The short range plans of these functional areas are then collated and quantified in the budgeting process of
the entity.
Budgeting
After the creation of the delineated corporate plans, the next equally important step is to be made. This involves
the quantifying of the plans in terms of monetary value. For example, if the corporate plan states that the firm needs to
increase revenue in order to maintain its current market share, budgeting would then quantify this by assigning a figure of,
let us say, increase sales revenue by P 1,200,000 and decreasing administrative expenses by P200, 000. The budget could
be defined as a formal statement of a plan presented in quantitative terms.
The firm’s formed budget serves as a barometer to which the results of the daily operations of the company are
matched, coordinated, evaluated and controlled. This is the budgetary control function of budgets. Management compares
the actual figures of company operations vis-à-vis the budgeted figures and see if there are favorable or unfavorable
differences or variances. The differences or variances are then assessed and accounted for. Accountabilities are pointed
out as to who and/or what caused the favorable or unfavorable of the evaluation.
The firm’s budget is prepared, usually, for one year. This however is delineated with separate budgets presented
on monthly or quarterly basis. The company may also opt to present the budget on a monthly basis for the first 6 months
of the year and the remainder is shown on a quarterly basis. Revisions on the monthly and quarterly budgets may be done
after comparing actual figures from prior month or prior quarter.
A rolling budget may also be done to depending when a company makes a whole year budget then makes new
budgets on a monthly or quarterly basis. For example the company creates a budget for January to December 31, 2015, on
December 2014 the company begins to prepare a budget for January to March 2015, then on March 2015, the company
starts to prepare the budget for the next quarter April to June 2015, and so on.
Reasons for Budgeting
 Budgeting is done for the following reasons:
1. Planning. In the development of operational and project plans, proposed activities (Iike acquisition of new
equipment or system, creation of a new product or product line, or increasing sales volume, etc.) should involve profit
generation. The profit to be generated in the execution of the plan is found in the pro-forma or budgeted income
statements. The budgeted income statement helps management in paving (planning) the way to achieve the desired profit
found in the budgeted income statement.
2. Coordination. Budgeting tends to synchronize the firm’s operations, because the budget serves as a guide as to
what the company should achieve.
3. Control. As mentioned, budgeting provides the barometer or the yardstick against which the firm can measure
and compare their actual results of operations. The differences or variance between budget and actual results are then
assessed so that adjustments may be done if needed.
Budget Manuals
To facilitate budgeting procedures, a budget manual is usually prepared by management an average run of the
mill budget manual may be composed of the following:
1. Objectives;
2. Definition of authority;
3. Responsibilities and duties of persons involved in preparing the budget;
4. Procedures of budgetary control;
5. Time schedule for preparing the budget;
6. forms of schedules;
7. Procedures in obtaining budget approval;
8. Form and nature of performance report; and
9. Advantages of budgetary control

Components of the Master Budget

As mentioned earlier, the different functional areas or sub-units of the firm have their own budgets, these budgets
are then fused to form one company-wide budget referred to as master budget. Igure 5-1 presents the components of a
master budget and its movement as they go through the budgetary process. A typical master budget should contain the
following:
1. Operations Budget/Profit Plan. Composed of a detailed presentation of revenues, expenses and net profit. This
takes the form of the pro-forma or budgeted income statement. The formation of this budgeted income statement
came about by the infusion of the different budgets on:
a. Sales
b. Production volume
c. Cost of raw materials
d. No. of raw materials units to be purchased
e. Cost of direct labor
f. Factory overhead
g. Inventory levels
h. Cost of goods sold
i. Selling expenses
j. Administrative expenses
k. Financing charges
2. Financial Resources Budget. This is mainly made up of:
a. Cash budget
b. Pro-forma or budgeted Statement of Financial Position (SFP)
c. Projected funds flow statement (presented financial management part 2)
3. Capital Expenditures Budget. This involves plans on material modification, acquisition and disposal of property plant
and equipment or material modification, acquisition or renewal of a firm’s computerized accounting information system.
4. Budgeted Financial Ratios. The ratios are taken from the pro-forma or budgeted financial statements prepared. These
are similar to the ones discussed in Chapter 3 and 4. The only difference is that the figures here are estimated and
budgeted.
Process in Preparing the Master Budget
Process can be seen in Figure 5-1. There are various ways by which a budget may be budget: prepared. Below are
the general guidelines on how to prepare the master budget:
1. Formulation of the corporate objectives, plans, policies and assumptions, which will give direction in the
formulation of the budget estimates. This is done by top management.
2. Establish or estimate sales projection or targeted sales. This will serve as a basis in determining the targeted
number of units (volume) to be sold.
3. Individual budgets from the different functional areas as well as sub-units or responsibility centers (example-
production, marketing, research, finance department, etc.) of the company are prepared based on the planned volume of
units to be sold. Heads or supervisors from each of these areas are responsible for the preparation of their individual
budgets. Under this process, the production schedule and the associated use of new raw materials, direct labor and
overhead are done to compute cost of goods sold. (Refer to components of master budget components number 1.a, b, c, d,
e etc.).
4. Consolidation of the individual budgets is done to create a draft master budget the corporate planning
department of a firm can do this.
5. Revision of the preliminary drafted master budget is done to come up with the final draft subject to approval of
top management.
6. Approval and dissemination of final master budget to department heads or supervisors.
Construction of the Pro-forma Statements
In constructing the pro-forma statements we shall be following the budgetary process mentioned above. One of
the most thorough ways in preparing a budget or doing financial forecasting is by creating a series of pro-forma or
projected or budgeted financial statements. We shall focus on the pro-forma income statement, cash budget and statement
of financial position. Inventory, receivables, payable levels and other accounts including desired profit and borrowing or
financing requirements can be derived from these pro-forma statements. Consider figure 5-1 for the preparation of the
pro-forma statements.

Figure 5-1
Process in Preparing Pro-forma Statements
(In reference to the Master budget components and Budgetary Process)

Figure 5-l presents the following steps in the preparation of the pro-forma statements. Be reminded that these
steps are in reference to the components of the master budget and budgetary process topics mentioned. The procedure is
as follows:
1. Establish or estimate sales projection or targeted sales. This will serve as a basis in determining the targeted number of
units (volume) to be sold. The sales budget is considered as the cornerstone of budgeting.
2. Create the production budget schedule, which includes the raw materials costs, direct labor costs, and overhead. This
will help you in determining the gross profit.
3. Create the schedule for selling, administrative, and other expenses.
4. Compute for the net income by preparing the pro-forma income statement
5. Create the pro-forma cash budget schedule where the estimated cash receipts and estimated cash disbursements are
presented.
6. From the pro-forma income statement and cash budget schedule you can now create the pro-forma statement of
financial position.

Estimating Sales
The following methods may be done in estimating or forecasting sales:
1. Sales Trend Analysis. Under this method, the product life cycle is used in making the forecast. The growth
commences at the introduction of the product and accelerates during its middle year and then plateaus then it
declines. A rough plotting of the product life cycle could be presented using the letter “S”

In using sales trend analysis, it is essential that the company estimate what part of the life cycle is the product.
2. Sales Force Composite Method. Under this method, each salesman estimates the sales in his particular territory.
Historical sales may be used by each salesman as basis for estimating the probable sales for the next period.
3. Executive Opinion Method. Under this method, the views of a number of top executives are culled to arrive at a
sales estimate.
4. Industry Trend Analysis Method. Under this method, the relationship between expected industry sales and the
company sales in terms of market share is determined. The growth statistics of the entire industry is assessed and
a forecast is made. The firm’s growth pattern is also determined and compared with that of the industry’s to come
up with the trend. When the trend is determined, a percentage of the expected total market for the budget period is
estimated. This percentage is then multiplied to the estimate of the total industry sales, and the result is considered
the sales forecast of the company.
5. Correlation Analysis Method. This is a more scientific means of forecasting sales by using regression analysis. In
statistics we were taught that linear regression equations are used to determine or predict the movement or existence of a
dependent variable, y (in our case would be sales) depending on the movement or existence of an independent variable, x
(could be anything like personal disposable income of customers or prices of raw materials, etc.). The variables are placed
in the equation and thus, predict what sales would be. The regression equation is used to determine the cause and effect
relationship between sales and the factors affecting it.
6. Multiple Approach Method. This method uses a combination of the various methods discussed.
Cash Budget
 It is important to mention that sales and income generation may not necessarily meant that there is sufficient cash
on hand to meet the financial debts of the entity. Credit sales or charge sales generate revenue however, this transaction
does not generate immediate cash. Because of this, we need to translate the pro-forma income statement into cash flows.
This can be done by dividing the budgeted income statement into smaller time frames in order to appreciate the monthly
trend of net cash flows. The net cash flow is the difference between cash inflow and cash outflow. This is presented in the
comprehensive example below.
In so far as cash outflow is concerned, the usual items that should be taken into consideration would be the
payments made for inventory acquisition, payment of labor and overhead costs, selling and administrative expenses,
interest expense, taxes and dividends.

Comprehensive Example for Pro-Forma Income Statement (adopted from Block and
Hirt):
Assume you are tasked to prepare the pro-forma financial statements of Ocin Corporation, June 30, 2020. Ocin
Corporation is the leading producer and seller of DVD and Blue Ray players in the market. Consider the assumed figures
below to facilitate the preparation of the pro-forma financial statements:
Step 1: Estimate Sales:
Table 1
Assumed Projected Sales of DVD and Blue Players (first 6 months of 2020)

DVD Blue Ray Total

Estimated Sales Volume 300 units 600 units
Estimated sales price/unit P 2, 000 P 3, 000
Sales revenue P600, 000 P 1, 800, 000 P2, 400, 000

Based on the given data, the total sales forecast is P2, 400, 000 (P600, 000+ P1, 800, 000). Let us assume that the method
used by the company in forecasting sales is the sales trend analysis.
Step 2: Estimate Number of Units to be Produced and the Gross Profit

Based on the estimated sales in step 1, we now determine the number of units we need to produce to bring about the sales
estimates. In order to determine the number of units we need to produce, we need the beginning inventory of DVDs and
Blue Ray players, the estimated sales and the desired level of ending inventory for both players let us assume the givens
found in table 2.

Table 2
Assumed Stock of Beginning Inventory
DVD Blue Ray Total
Beginning Inventory 26 units 54 units
Cost per unit P 1, 067 P 1, 714
Total Costs P27, 742 P92, 556
Desired Ending
Inventory ( 10% of 30 units 60 units
estimated sales volume
– see table 1)

Table 3
Computation of estimated number of units to produce
 DVD Blue Ray
Estimated Sales Volume 600 units
Design Ending Inventory 30 units 60 units
Less: Beginning Inventory 26 units 54 units
Estimated Units to be Produced 304 units 606 units

After computing the estimated number of units to be produced, we now compute for the cost of the estimated
number of units to be produced. Assume the givens in table 3.
Table 4
Assumed Cost per unit

DVD Blue ray

Raw materials cost/unit P 567 P 629
Direct Labor cost/ unit 867 1, 214
Overhead cost/unit 200 243
Total production cost/unit P1,634 P2, 086

Table 5
Computation of Estimated Production Costs

DVD Blue Ray Total

Total production cost/unit P1, 634 P 2, 086
Multiplied by estimated units to
be produced 304 units 606 units

Total Production Costs P496, 736 P1, 264, 116 P1, 760, 852

After computing the production cost, we now compute the Cost of Goods Sold and gross Profit. We assume further that
FIFO is used in costing the company’s inventory.
Table 6
Computation of Cost of Goods Sold and Gross Profit

DVD Blue Ray Total

Sales revenue P600, 000 P1, 800, 000 P2, 400, 000
Less: Cost of Goods Sold:
Beginning Inventory 27, 000 92, 556 120, 298
(see Table 2)
Ending Inventory
(remainder)
DVD:
300 units – 26 units
= 274 units x P1, 634/unit
(see Table 4)
Blue Ray:
600 units – 54 units
= 546 units x P2, 086 447, 716 1, 138, 956 1, 586, 672
Cost of Goods Sold 475, 458 1, 231, 512 1, 706, 970
Gross Profit P124, 542 P568, 488 P693, 030
The portion of the ending inventory is derived by getting the total number of units sold and subtracting the beginning
inventory. The difference is actually the amount of sales that has been taken from the current purchases. For the DVD
player, 300 units is to be sold, deduct from this the 24 units which was from last year’s inventory, the result of 274 units
pertains to the number of units sold taken from the current purchases. Multiply to this the production cost/unit of P1, 634,
you will have the cost of the units sold taken from the current purchases amounting to P447, 716. Add to this the
beginning inventory and you will have the cost of goods sold for the DVD player.

Table 7
Computation of the cost of ending inventory

Beginning Inventory (Table 2) P 120, 298

Production costs (Table 5) P1, 760, 852
Total Goods Available for Sale 1, 881, 852
Less: Cost of Goods Sold 1, 706, 970
Ending Inventory P 174, 180

Step 3: Create the Pro-Forma Income Statement

Table 8
Ocin Corporation
Pro-Forma Income Statement
For the 6-month Period Ended June 30, 20200

Sales P 2, 400, 000

Less: Cost of Goods Sold 1, 706, 970
Gross Profit P 693, 030
Less: Selling and Administrative Expenses (assumed figures) 350, 000
Net Income before finance charges 343, 030
Less: Interest Expense (assumed figures) 12, 000
Net Income before taxes 331, 030
Less: Income tax (35%) 115, 861
Net income after tax P 215, 169
Cash Dividends (assumed) 15, 000
Increase in Retained Earnings P 200, 169

Step 4: Prepare the Cash Budget

Assumptions and computations on cash receipts:

1. All sales are credit sales. The P2, 400,000 estimated sales is divided into 6 months.
2. Based on historical data, 20% of the credit sales are collected in the month of sale and 80% is collected in the following
month.
3. Assume the following monthly sales revenue of Ocin Corporation:
Estimated January February March April May June
Sales P360, 000 P240, 000 P360, 000 P600, 000 P360, 000 P480, 000
4. December 31, 2019 sales is P 288,000.

Table 9
Summary of Monthly Cash Receipts

December January February March April May June

Sales P288, 000 P360, 000 P 240, 000 P360, 000 P600, 000 P360, 000 P480, 000

Collections
:
20% of
current 72, 000 48, 000 72, 000 120, 000 72,000 96, 000
sales
80% of
previous 230, 400 288, 000 192, 000 288, 000 480, 000 288, 000
month’s
sales
Total P302, 400 P336,000 P264, 000 P408, 000 552, 000 P384, 000

Note: The total cash receipts is the sum of the total collections. Sales are NOT PART of the computation of the cash
receipts. Sales were placed in the summary ONLY TO SHOW the source in computing the collections.
Assumptions and Computations made on cash payments:
Table 10
Computation of the composition of production costs:

DVD Player Blue Ray Players

Units Unit costs Total costs Units Unit Total costCombined
costs costs
Materials 304 P567 P172, 368 606 P 629 P 381, 174P 553, 542
Labor 304 867 263, 568 606 1, 214 735, 684 999, 252
Overhead 304 200 60, 800 606 243 147, 258 208, 058
P1, 760, 852
The units and unit costs are taken from the Table 3 and Table 4 respectively. The total costs Units x Unit costs. The
combined cost is equal to the total cost of DVD and total costs of Blue Ray players.

Table 11
Computation of the Average monthly production costs

Total costs Time frame Average monthly costs

Total costs Time frame Average monthly costs

A B C = A/B
Materials P553, 542 6 months P 92, 257
Labor 999, 252 6 months 166, 542
Overhead 208, 058 6 months 34, 676

The total cost is taken from Table 10. The average monthly cost is derived by dividing total costs by the time
frame.
Assume that the December 31, 2019 raw material purchases is P75, 500. Assume further that all raw material
purchases are on credit and that full payment is made a month after the purchase. Al expenses will also be divided equally
for 6 months. They are paid on the on the month they were incurred. The 6-month income tax due shall be paid in two
installments (March and June). This is also true with dividends, labor and overhead. Dividends shall be paid on June 2020.
A new equipment will be acquired for cash amounting to P5, 000 in February 2020 and P8, 000 in June 2020.
 Table 12
Summary of the Monthly Cash Payments (in Php)

December January February March April May June

Monthly RM
purchases 75, 500 92, 257 92, 257 92, 257 92, 257 92, 257 92, 257
(Table 11)
Pay’t for material 75, 500 92, 257 92, 257 92, 257 92, 257 92, 257
Labor (Table 11) 166, 542 166, 542 166, 542 166, 542 166, 542 166, 542
Overhead
(Table 11) 34, 676 34, 676 34, 676 34, 676 34, 676 34, 676
Selling and
Administrative 58, 333 58, 333 58, 333 58, 333 58, 333 58, 333
Expenses
(Table 8)
Interest Expense
(Table 8) 2, 000 2, 000 2, 000 2, 000 2, 000 2, 000
Income Tax
(Table 8) 57, 930 57, 930
Cash Dividends
(Table 8) 15, 000
New Equipment
acquisition 5, 000 8, 000
Total 337, 051 358, 808 411, 738 353, 808 353, 808 434, 738

Table 13
Monthly Cash Flow

January February March April May June

Total Receipts P302, 400 P336, 000 P 264, 000 P408, 000 552, 000 P384, 000
( Table 9)
Total 337, 051 358, 808 411, 738 353, 808 353, 808 434, 738
Payments
(Table 12)
Net Cash P(34, 651) P(22, 808) P(147, 738) P54, 192 P198, 000 P(50, 738)
Flow

The main purpose of a cash budget is to aid management in anticipating the need for outside funding at the end of each
month. In this example, let us assume that the company desires to keep a minimum cash balance or P200, 000 at all times.
If the cash balance goes below the minimum level, the firm will borrow funds from the bank. If the cash balance goes
above the minimum level and it still has loan outstanding from the bank, the company will use the excess cash to pay the
loan. Let us further assume that in January 1, 2020, the beginning cash balance is P200, 000 practice is shown in Table 14.

Table 14
Cash Budget (Including borrowing and repayment)
 January February March April May June
Net Cash
Flow P(34, 651) P(22, 808) P(147, 738) P54, 000 P198, 545 P(50, 738)
Beginning
cash balance 200, 000 200, 000 200, 000 200, 000 200, 000 247, 540
Cumulative
Cash 165, 349 177, 192 52, 262 254, 192 398, 545 196, 802
balance
Monthly
loan 34, 651 22, 808 147, 738 (54, 192) (151, 005) 3, 198
(repayment)
Cumulative
loan balance 34, 651 57, 459 205, 197 151, 005 0 3, 198
Ending P200, 000 P200, 000 P200, 000 P200, 000 P200, 000 P200, 000
Cash
balance
JUST BEAR WITH US AND FOLLOW US THROUGH AS YOU READ THE DISCUSSION. USE TABLE 14
TO HELP YOU WITH THE DISCUSSION. ARE YOU READY? GO!

Now let us start to analyze the January column of the cash budget. The net cash flow based on Table 13 is P (34,
651), we then added this to the beginning balance of cash of P200, 000. The difference is P165, 349. Now this cash
balance is below P200, 000. Based on the assumption, the company maintains P200, 000 cash balance at all times. This is
their company policy. In order for them to make their cash balance of P165, 349 to P200, 000 the company borrowed
money from. The bank amounting to P22, 808 (P200, 000 required minimum balance MINUS P165, 349 actual cash
balance). By borrowing P22, 808 the cash balance now of the company is P200, 000, which is the required minimum
balance. The cumulative loan balance of P34, 651 is the monthly loan balance of P34, 651 plus the cumulative loan
balance of zero. This is zero because before the company borrowed, it has no loan balance yet. The ending cash balance of
P200, 000 is the result of adding the cumulative cash balance of P165, 349 plus the monthly loan balance of P34, 651.
Looking at the February column, the beginning cash balance of P200, 000 is the ending cash balance of January.
The net cash flow based on table 13 is P (22,808), we then added this to the beginning balance of cash in February of
P200, 000. The difference is P177, 192. Now this cash balance is below P200, 000. Based on the assumption, the
company maintains P200, 000 cash balance at all times. This is their company policy: In order for them to make their cash
balance of P177, 192 to P200, 000 the company borrowed money from the bank amounting to P22, 808 (P200, 000-
required minimum balance MINUS P177, 192 actual cash balance). By borrowing P22, 808 the cash balance now or the
company is P200, 000, which is the required minimum balance. The cumulative loan balance of P57, 459 is the monthly
loan balance of P22, 808 plus the cumulative loan balance of P34, 651. The ending ne cash monthly balance loan of P200,
000 is the result of adding the cumulative cash balance of P177, 192 plus the monthly loan balance of P22, 808.
Notice that the explanation for the February column figures is almost exactly the same as the January column. The cycle
goes on to March. HOWEVER, if you look at April column figures, the net cash flow of P54, 192 added to the beginning
cash balance of April of P200, 000 gives you a cumulative cash balance of P254, 192. This is greater than P200, 000 of
which P200, 000 which the minimum required cash balance. Based on the assumption given which is the company policy,
any excess of the cash balance to the required minimum balance SHALL BE USED TO PAY any loan balance
outstanding. Therefore P54, 192 was used to pay the cumulative loan balance of P205, 197 from the March column. This
would make the cumulative loan balance of April to P151, 005. The same explanation for April will be used to explain the
May column figures.

Pro-Forma Statement of Financial Position (SFP)

In creating the current pro-forma statement of financial position, the following statements are needed:
1. pro-forma income statement
2. pro-forma cash budget
 3. Prior period pro-forma statement of financial position
In continuing the comprehensive example of the pro-forma income statement, we shall assume the prior-period
SFP below.

Ocin Corporation
Statement of Financial Position
December 31, 2019
Current Assets:
Cash and Cash Equivalents P200, 000
Trade Securities 128, 000
Trade & Other Receivables 230, 400
Inventory (Table 2) 120, 298
Total Current Assets 678, 698
Non-Current Assets:
Property, Plant and Equipment 827, 680
Total Assets P1, 506, 378
Liabilities and Shareholders’ Equity
Accounts Payable P75, 500
Notes Payable 0
Loan Payable – Long-term 447, 440
Ordinary Shares 316, 340
Retained Earnings 667, 098
Total Liabilities & Shareholders’ Equity P1, 506, 378
Items in the pro-forma income statements and cash budgets have effects on some of the items in the pro-forma
SFP for June 30, 2020. The items in the projected SFP are derived from the different tables found in the comprehensive
example. See them on next page.
Ocin Corporation
Pro-forma Statement of Financial Position
June 30, 2020

Current Assets:
Cash and Cash Equivalents (Table 14) P200,000
Trade Securities (assumed) 127, 000
Trade & Other Receivables (P480, 000 x 384, 000
80%
Inventory (Table 7) 174, 180
Total Current Assets P886, 180
Non-Current Assets
Property, Plant and Equipment (assumed) 840, 680
Total Assets P1, 725, 860
Liabilities and Shareholders’ Equity
Accounts Payable (Table 12) P92, 257
Notes Payable (Table 14) 3, 198
Loan Payable – Long-term (assumed) 447, 440
Ordinary Shares (assumed) 316, 340
Retained Earnings 866, 625
Total Liabilities & Shareholders’ Equity P1, 725, 860

The trade and other receivables is 80% of the credit sales (P480, 000) for June 2020. The accounts payable is the
June purchases found in Table 12. The ordinary shares could be accounted for as additional subscriptions. The retained
earnings is a derived figure in creating the SFP. The retained earnings could be accounted for by the various adjustments
(net income, dividends, and other prior period adjustments) made to the account. Let us assume that after all the
adjustments the resulting retained earnings amounted to P866, 625.
Percentage-Of-Sales Method
Another method by which forecasting can be done is through the use of the percentage of sales method. Under
this method, the financial forecaster assumes that the accounts found in the SFP have a percentage relationship with the
company’s sales revenue account. Gillian that even under this method, it is still important to project sales before all other
forecasting is done.
Gillian Corporation
Statement of Financial Position
& Corresponding Percentage of Sales
(In Thousand Pesos for the Value)
Value Percent of Sales P750, 000
Cash and Cash Equivalents P15, 000 2
Trade and Other Receivables 120, 000 16
Merchandise Inventory 75, 000 10
Property, Plant, & Equipment 150, 000 20
Total Assets P360, 000 48
Trade and Other Payables 120, 000 16
Accrued Payable 30, 000 4
Loans Payable 45, 000 6
Ordinary Shares 30, 000 4
Retained Earnings 135, 000 18
Total Liabilities & Shareholders’ Equity P360, 000 48
The P15 million cash balance is assumed to represent 2% of projected sales. The trade and other receivables of
P120 million is 16% of projected sales. This is true with the other accounts.
It is noticeable that the loans payable, ordinary shares and retained earnings do not have corresponding
percentages. This is so because Gillian does not assume that these accounts have direct relationship with sales. We could
also infer based on the figures above that increase in sales will require a 46% increase in Gillian’s total assets. Twenty
percent (16% + 4%) of suchan increase in assets would be financed by trade and other payables and accrued payables.
twenty eight percent (48% 20%) would be financed by income (retained earnings) and’ by other means of financing
(making borrowings or issuance of ordinary shares).
Let us assume that Gillian’s net profit ratio (NPR) IS 5% and that 40% of the profit is used to pay dividends to
shareholders this is dividend payout ratio (DPR). If Gillian is to increase sales to P900 million, Gillian will need
additional funding of about P42 million [(P900 mil - P750 mil) x 28%)]. The twenty eight percent is derived by
subtracting 20% (liability ratio) from 48% (asset ratio). The net profit for Gillian under assumption would be P45 million
[(P750 m+P150 m) x 5%] the dividends paid from this Sales level is P18 million (P45m x 40%)
The formula used to compute for the Required New Funds (RNE) is:
RNF = Asset ratio (Sales) – Liability ratio (Sales) – NPR (new sales) * DPR
= [48% (P150mil)] – [20% (P150 mil)] – [5% (P900 mil)] x 40%
= P 24 million
Or RNF = P 42 million – P 18 million = P 24 million
We could presume that the P24 million would be financed through loans and other sources.
Although this method is much easier than the pro-forma statement method, the results from this is less precise.
The details in so far as month-to-month values of cash flows are not provided under this method.