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Content Standards
The financial planning process, including budget preparation, cash management, and working capital
management

Performance Standards

The learners will be able to:

1. illustrate the financial planning process
2. prepare budgets such as projected collection, sales budget, production budget, income projected
statement of comprehensive income, projected of financial position, and projected cash flow
statement
3. describe concepts and tools in working capital management

The learners shall be able to:

identify the steps in the financial planning process
ABM_BF12-IIIc-d-10

illustrate the formula and format for the preparation of budgets and projected financial statement
explain tools in managing cash, receivables, and inventory
ABM_BF12-IIIc-d-11

explain tools in managing cash, receivables, and inventory

ABM_BF12-IIIc-d-12

Specific Learning Outcomes

At the end of this lesson, the learners will be able to:
1. To know the information found in the different financial statements
2. To know how to compute different financial ratios such as liquidity, leverage, efficiency or
turnover, and profitability ratios
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Week 3

CHAPTER 2

Review of Financial Statement Preparation, Analysis, and Interpretation

The Accounting Equation

1. The basic accounting equation is:

ASSETS = LIABILITIES + OWNER’S EQUITY

This means that the whole assets of the company comes from the liability, or debt of the
company, and from the capital of the owner of the business, and the income it generated from the
business operations. This reflects the double-entry bookkeeping, and shown in the balance sheet.

Double entry bookkeeping tells us that if we add something from the one side, which is asset,
we must add the same amount to the other side to keep them in balance.

For example, if we were to increase cash (an asset) we might have to increase note payable (a
liability account) so that the basic accounting equation remains in balance.

ASSETS = LIABILITIES + OWNER’S EQUITY

P 500.00 P 500.00

In double-entry bookkeeping, there is the concept of debit (dr) and credit (cr). Debit is the left, and
credit is the right.

• There is also a concept of normal balances. A normal balance, either a debit normal balance or a
credit normal balance, is the side where a specific account increases.

• In the accounting equation, asset is on the left side, while liabilities and equity is on the right side.
Therefore, asset has a debit normal balance, meaning that cash as an asset is debited to increase,
while credited to decrease.
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• On the other hand, liabilities and owners’ equity have a credit normal balance. This means that a
liability account is credited to increase, while debited to decrease. The accounting equation provides
the foundation for what eventually becomes the balance sheet.

2. T-Account Analysis

In double-entry bookkeeping, the terms debit and credit are used to identify which side of the
ledger account an entry is to be made. Debits are on the left side of the ledger and Credits are on the
right side of the ledger. It does not matter what type of account is involved.

• The debit to cash increases the Cash Account by PHP500 while the credit to Accounts Payable
increases this liability account by the same PHP500.

• In the above example, we analyzed the accounting equation in terms of assets, liabilities, and
owners’ equity. These are called Real or Permanent Accounts. These accounts remain open and
active for the life of the enterprise.

• In contrast, there are accounts that reflect activities for a specific accounting period. These are
called Nominal or Temporary Accounts. After the end of the specific period and the start of a new
period, the balance of the nominal accounts are zero.

• Using the accounting equation, we can now expand the analysis that will include both real and
nominal accounts. All nominal accounts will be then closed to a Retained Earnings account at the end
of the period, which is an owner’s equity account.
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3. Nominal Accounts

There are two major categories of nominal accounts: Expense and Revenue accounts.

• Expense Accounts

- A resource, when not yet used up for the current period, is considered an Asset and will provide
benefits at a future time.

- On the other hand, a resource that has been used for the current period is called an Expense. At the
end of each accounting period, expenses are closed out to the Retained Earnings Account which
decreases the Owners’ Equity. Since expenses decrease the owners’ equity, those expense accounts
carry a normal debit balance.

• Revenue Accounts

- Revenue Accounts reflect the accumulation of potential additions to retained earnings during the
current accounting period.

- At the end of the accounting period accumulation of revenues during the period are closed to the
Retained Earnings Account which increases Owners’ Equity.

- Therefore revenue accounts carry a normal credit balance meaning the same balance as the
Retained Earnings Account.
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Journal Entry

The Accounting Cycle

• Because accounting is all about getting data and putting them into the accounting equation, the end
products are financial statements such as a balance sheet and income statements, the process of
accounting follows a cycle called the Accounting Cycle.

• It starts with the identification of whether a transaction is accountable or can be quantified, and ends
with a post-closing trial balance.

The Process:
Step 1: Analyze Business Transactions.
• In this step, a transaction is analyzed to find out if it affects the company and if it needs to be
recorded.
• Personal transactions of the owners and managers that do not affect the company should not be
recorded.
• In this step, a decision may have to be made to identify if a transaction needs to be recorded in
special journals such as a sales or purchases journal.
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Therefore, what you should do is:
A. Carefully read the description of the transaction to determine whether an asset, a liability, an
owner’s equity, a revenue, an expense, or a drawing account is affected.
B. For each account affected by the transaction, determine whether the account increases or
decreases.
C. Determine whether each increase or decrease should be recorded as a debit or a credit, following
the rules of debit and credit.

Illustrative Example:
• N. Juna resigned from Company X. This does not affect any asset, liability, or the owner’s equity
account.
• B. Cano purchased PHP500 cash worth of supplies at Ace Hardware. This affects cash and
supplies, both asset accounts.

Step 2. Record This in the Journal.

• Using the rules of debit and credit, transactions are initially entered in a record called a Journal and
the entry made is called a Journal Entry.
• The journal serves as a record of when transactions occurred and were recorded.
• For repetitive transactions or high volume transactions (e.g. one thousand sales transactions in one
day), Special Journals are made. These special journals include sales journal, purchases journal,
cash receipts journal, and cash disbursements journal.

The Source Document is the file or document (i.e. official receipt, purchase order, contract) that will
provide a basis or reason for a journal entry.
For example, an official receipt issued by the business will tell you that a sale transaction occurred
and will be reflected by the journal entry.

Illustrative Example:
• M. Jaya resigned from Company X. No journal entry.
• C. Danto purchased PHP500 cash worth of supplies to Ace Hardware. Debit Supplies PHP500,
Credit Cash PHP500.

Step 3. Post the Transactions on a Ledger.

• A transaction is first recorded in a journal. Periodically, the journal entries are transferred to the
accounts in the ledger.
• The process of transferring the debits and credits from the journal entries to the accounts is called
Posting.
• Ledgers provide chronological details as to how transactions affect individual accounts. There are
two types of ledgers: the General Ledger and Subsidiary Ledger. The general ledger is a summary of
the different Subsidiary Ledgers and can serve as a control account.
• For example, a general ledger for accounts receivable summarizes the balances found in the
different subsidiary ledgers for different customers.

Illustrative Example:
J. Gaya, a CPA, is an independent auditor with only two clients. The Accounts Receivable ledger
account has a balance of PHP100,000. His two clients are A. Rania, and X. Campos. The subsidiary
ledger of A. Rania has a balance of PHP25,000. X. Campos’s ledger balance is PHP75,000.
The sum of subsidiary ledgers must total the general ledger or else there must be an investigation to
identify the source of discrepancies.
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Posting in the subsidiary ledgers can be done anytime and the balances are summarized at the end
of an accounting period. Posting in the general ledger is done at the end of an accounting period.

Step 4. Prepare an Unadjusted Trial Balance.

• Errors may occur in posting debits and credits from the journal to the ledger. One way to detect such
errors is by preparing a trial balance.
• Double-entry accounting requires that debits must always equal credits. The trial balance verifies
this equality.
• The steps in preparing a trial balance are as follows:
1. List the name of the company, the title of the trial balance, and the date the trial balance is
prepared.
2. List the accounts from the ledger and enter their debit or credit balance in the Debit or Credit
column of the trial balance.
3. Total the Debit and Credit columns of the trial balance.
4. Verify that the total of the Debit column equals the total of the Credit column.

Step 5. Make adjustments. Journalize adjusting entries.

• At the end of the accounting period, many of the account balances in the ledger can be reported in
the financial statements without change.
• For example, the balances of the cash and land accounts are normally the amount reported on the
balance sheet. However, some accounts in the ledger require updating.
• This updating is required for the following reasons:
1. Some expenses are not recorded daily. For example, the daily use of supplies would require many
entries with small amounts. Also, managers usually do not need to know the amount of supplies on
hand on a day-to-day basis.
2. Some revenues and expenses are earned as time passes rather than as separate transactions. For
example, rent received in advance (unearned rent) expires and becomes revenue with the passage of
time. Likewise, prepaid insurance expires and becomes an expense with the passage of time.
3. Some revenues and expenses may be unrecorded. For example, a company may have provided
services to customers that are has not billed or recorded at the end of the accounting period.
Likewise, a company may not pay its employees until the next accounting period even though the
employees have earned their wages in the current period.
The analysis and updating of accounts at the end of the period before the financial statements are
prepared is called the Adjusting Process.
The journal entries that bring the accounts up to date at the end of the accounting period are called
Adjusting Entries.
• The following are normally adjusted at the end of a period:
- Accruals. These include unpaid salaries for the accounting period, unpaid interest expense, or
unpaid utility expenses.
- Prepayments. If a company has prepaid expenses such as prepaid rent or prepaid insurance then
the correct balances for these accounts have to be established at the end of each accounting period
to reflect their correct balances.
- Depreciation and amortization expenses. Depreciation expenses are recognized at the end of each
accounting period through adjusting entries. If there are intangible assets such as franchise, the
allocation of their costs which is called amortization expense, is also recognized at the end of each
accounting period through adjusting entries.
- Allowance for uncollectible accounts. Bad debt expense from accounts receivable is also recognized
through adjusting entries.

Step 6. Prepare an Adjusted Trial Balance.

An adjusted trial balance is prepared after taking into consideration the effects of the adjusting entries.
Again, this is to ensure that the total debit balances equal the credit balances after posting and
journalizing adjusting entries made.
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Step 7. Prepare the financial statements.
From the adjusted trial balance, the financial statements can then be prepared. These are the
statement of financial position, statement of profit or loss, and the statement of cash flows.

Step 8. Make the closing entries.

In the discussion about accounts, it was discussed that nominal accounts (revenue and expense
accounts) are closed to retained earnings, or an owner’s capital account because these accounts
refer only to a specific accounting period. Actually, these accounts to be closed are accounts that can
be seen in the income statement.
Upon closing:
- If the revenues exceed expenses during an accounting period, retained earnings will increase.
- The reverse is true which means that if the expenses exceed revenues, the retained earnings will
decrease.
In closing temporary accounts:
- Revenue account balances are transferred to an account called Income Summary Account
(sometimes profit or loss summary).
- Expense account balances are also transferred to the Income Summary Account.
- The balance of the Income Summary (net income or net loss) is transferred to the owner’s capital
account.
- The balance of the owner’s drawing account is transferred to the owner’s capital account.

Step 9. Make a Post-Closing Trial Balance.

A Post-Closing Trial Balance shows the accounts that are permanent or real. These are the accounts
that can be seen in your balance sheet.

The post-closing trial balance is prepared to test if the debit balances equal the credit balances after
closing entries are considered.

How financial statements helps in business transaction?

A financial statement is basically a summary of all transactions that are carefully recorded and
transformed into meaningful information. It also shows the company’s permanent and temporary
accounts.

Basic Financial Statements

A. The Statement of Financial Position

What are the important concepts we need to know about the STATEMENT OF FINANCIAL
POSITION?

The Statement of Financial Position provides information regarding the liquidity position and capital
structure of a company as of a given date. Since 2009 formerly known as the Balance Sheet in the
IASB (International Accounting Standard Board)

 It must be noted that the pieces of information found in this report are only true as of a given
date.
 Liquidity refers to the ability of a company to pay maturing obligations.
 Capital structure provides information regarding the amount of assets financed by debt or
liabilities and equity.`
 This provides information regarding the liquidity position and capital structure of a company
as of a given date.
 It must be noted that the information found in this report are only true as of a given date.
 It shows a list of the assets, liabilities, and owner’s equity of a business entity as of a specific
date, usually at the close of the last day of a month or a year.

Liquidity refers to the ability of a company to pay maturing obligations.

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B. Income Statement

What are the important concepts we need to know about the STATEMENT OF PROFIT OR
LOSS?

The Statement of Profit or Loss provides information regarding the revenues or sales, expenses, and
net income of a company over a given accounting period, a period which may be for a month, a
quarter, or a year.

 In analyzing earnings performance, a comparison with the previous periods and with other
companies, especially those coming from the same industry, is a must. Such comparison will
not be made possible without knowing the accounting periods covered in the statement of
profit or loss.
 In analyzing Statement of Profit or Loss, it is important to identify how much of the income
comes from core business (the main business of the company) and how much comes from
the non-core business.
 These are also known as the Profit/Loss Statement, Statement of Comprehensive Income, or
Statement of Income.
 This is a summary of the revenue and expenses of a business entity for a specific period of
time, such as a month or a year.

There are two options in presenting the Statement of Profit or Loss:

 The first option is to present it as a separate financial statement; and

 The second option is to present it together with other comprehensive income (OCI), which
represents transactions that are not reported in the profit or loss statement but affects the
stockholders’ equity.
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C. Statement of Cash Flows

• The statement of cash flows reports a company’s cash inflows and outflows for a period.
• This is used by managers in evaluating past operations and in planning future investing and
financing activities.
• It is also used by external users such as investors and creditors to assess a company’s
profit potential and ability to pay its debt and pay dividends.

What are the important concepts we need to know about the STATEMENT OF CASH FLOWS?

The Statement of Cash Flows provides an explanation regarding the change in cash balance from
one accounting period to another.

The Cash Flows are classified into three main categories:

 Operating;
 Investing; and
 Financing.

The Cash Flows are classified into three main categories:

 Operating. In the cash flows from operating activities, the income reported from the statement
of profit or loss which is based on accrual principle is converted to cash.
 Investing. The cash flows from investing activities provide information regarding the future
direction of the company; it shows how much investment the company is making over a given
accounting period.
 Financing. The cash flows from financing activities provide information whether there is a
proper matching of investing and financing activities.

D. Statement of Owner’s Equity

• These are also known as the Statement of Changes in Equity.

• This reports the changes in the owner’s equity over a period of time.
• It is prepared after the income statement because the net income or net loss for the period
must be reported in this statement.
• Similarly, it is prepared before the balance sheet since the amount of owner’s equity at the
end of the period must be reported on the balance sheet.
• Because of this, the statement of owner’s equity is often viewed as the connecting link
between the income statement and balance sheet.
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What are the important concepts we need to know about the STATEMENT OF CHANGES IN
STOCKHOLDERS’ EQUITY?

The Statement of Changes in Stockholders’ Equity provides information that explains the changes in
the stockholders’ equity account from one accounting period to another.

The changes may be due to the following:

 Profit or loss for the accounting period;

 Cash dividend declaration;
 Issuance of new shares of stocks; and
 Other transactions that affect the stockholders’ equity such as other comprehensive income,
treasury stocks, and revaluation of assets.

NOTES TO FINANCIAL STATEMENTS

What are the additional pieces of information that the NOTES TO FINANCIAL STATEMENTS
provide?

 Brief Description of the Company

Information may include the nature of business of the company and the owners behind the company.

 Summary of Significant Accounting Policies

This is very important because the existing generally accepted accounting principles provide
alternative accounting policies to companies. It is therefore important to find out what specific
accounting policies are used by the company.

 Breakdown of Amounts Found in the Financial Statements

The company’s property, plant, and equipment (PPE) account may have too many components.
Putting all the details on the face of the balance sheet may make the balance sheet too long. An
alternative presentation is to provide a single amount on the face of the balance sheet for PPE but the
breakdown of PPE can be presented in the notes to financial statements.
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Week 4

CHAPTER 2
Review of Financial Statement Preparation, Analysis, and Interpretation

Financial Statement Analysis

Uses of Financial Statement Analysis

What are the USES of FINANCIAL STATEMENT ANALYSIS?

 It is used for investment and credit decisions.

 It is also used for regulating companies.

 It used by management for monitoring performance.

 It is used in identifying strategies to further improve the company’s operations.

Financial Ratios
1. Profitability ratios
2. Liquidity ratios
3. Leverage ratios
4. Efficiency ratios

Different Profitability Ratios

1. Return on Equity (ROE)
2. Return on Assets (ROA)
3. Gross Profit Margin
4. Operating Profit Margin
5. Net Profit Margin

(Let us use Exhibit 2.1 for the illustrative examples in financial statements analysis)
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1. Profitability Ratios

The following Ratios are used to measure the profitability of a company:

1. Return on Equity (ROE)

It is profitability measure that should be of interest to stock market investors. It measures the
amount of net income earned in relation to stockholder's equity.

 The formula for computing ROE is:

ROE = Net Income / Stockholder's Equity

To Illustrate, let us use the financial statements of JSC Foods Corporation in 2014.

ROE = (Net Income / Stockholder's Equity) x 100%

ROE = (2,659,087.00 / 12,478,559.00) x 100%

ROE = 21.31%

Return on Assets (ROA)

Return on Assets measures the ability of a company to generate income out of its resources.
ROA = (Operating Income / Total Assets) x 100%

To illustrate, refer to Exhibits 2.1 and 2.2 and let us compute JSC'c ROA for 2014.

ROA = (4,048,696.00 / 22,298,020.00) X 100%

ROA = 18.16%

Interpretation: The 18.16% ROA means that in 2014, JSC Foods Corporation Generated 18.16
for every Php1.00 of asset in the company.

Gross Profit Margin

It is a profitability ratio that measures the ability of a company to cover its cost of good sold
from its sales.
Gross Profit Margin = (Gross Profit / Sales) x 100%
To illustrate, let us compute the gross profit margin of JSC Foods Corporation in 2014
Gross Profit Margin = (10,546,355.00 / 52,501,085) x 100%
Gross Profit Margin = 20.09%

Interpretation: This means that for every Php1.00 of sale the company generates, it earns 20.09
in gross profit.

Operating Profit Margin and Net Profit Margin

Operating Profit Margin measures the amount of income generated from the core business of
a company. it is computed as the difference between revenues and the sum of cost of revenues or
sales and operating expenses.

Operating Profit Margin = (Operating Income / Sales) x 100%

Operating profit Margin measures the ability of the company to generate income from its core
business or main operation.

to illustrate, let us compute JSC's Operating Profit Margin

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Operating Profit Margin = (4,048,696.00 / 52,501,085.00) x 100%

Operating Profit Margin = 7.71%

Interpretation: The 7.71% operating profit Margin means that out of Php1.00 sales or revenues
that JSC Foods Corporation generated in 2014, the company earned 7.71 after deducting cost
of sales and operating expenses.

Net Profit Margin

Net Profit Margin measures how much net profit a company generates for every peso of sales
or revenues that it generates.

Net Profit Margin = (Net Income / Sales) x 100%

Net income is the amount left after all expenses including income taxes are deducted from
sales of revenues.

To illustrate, let us compute the net profit margin of JSC Foods Corporation in 2014.

Net Profit Margin = (2,659,087.00 / 52,501,085.00) x 100%

Net Profit Margin = 5.06%

Therefore, in 2014 JSC Foods Corp. earned 5.06 for every Php1.00 of revenues generated.

2. Liquidity Ratio
Liquidity refers to the company’s ability to satisfy its short-term obligations as they
come due. It also measures the ability of a company to pay maturing obligations from its
current assets.

Types of liquidity ratio

Current ratio and quick ratio.

Current ratio

Current Ratio = Current Assets / Current Liabilities

Current assets include cash and other assets which are expected to be converted to cash
within 12 months such as accounts receivable and inventories. Current assets also include
prepayments such as prepaid rent and prepaid insurance.

Current Liabilities include obligations that are expected to be settled or paid within 12 months.
These include accounts payable, accrued expenses payable such as accrued salaries, and currnt
portion of long-term debt.

To Illustrate, let us compute the current ratio of JSC Food Corporation in 2014

Current Ratio = 9 262 331 / 7 819 461

= 1.18

Interpretation: The Current Ratio of 1.18 means that for every P1.00 of current liabilities that
JSC Foods Corporation has, it has P1.18 current assets as of December 31, 2014.

Acid Test Ratio or Quick Asset ratio = (Cash + Current Account Receivable + Short term
Marketable Securities) + Current Liabilities
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The Quick Asset Ratio is a stricter measure of company’s liquidity position. There are some
textbooks which compute quick assets as current assets less inventories. With this definition, quick
asset ratio can also be computed as follows:

Quick asset ratio = (Current assets – Inventories) / Current Liabilities

To Illustrate, let us compute the quick asset ratio of JSC Foods Corporation in 2014

Quick Asset Ratio = (1 062 527 + 2 300 500) / 7 819 461

= 0.43

Interpretation: This ratio means that for every P1.00 current liability, it has P0.43 quick assets.
Is this something to be alarmed about? The answer depends on the quality of accounts
receivable which can be determined by its collection period.

3. Leverage ratio

Leverage Ratios show the capital structure of a company, that is, how much of the total
assets of a company is financed by debt and how much is financed by stockholder’s equity.
Leverage ratios can also be used to measure the company’s ability to meet long-term obligations.

The capital structure of a company is influenced by the following factors:

1. Nature of Business. If a company is in a risky business and operating cash flows are
uncertain like mining operations, it has to be more conservatively financed. Conservative
financing means there should be more stockholders’ equity.
2. Stage of business development
3. Macroeconomic conditions
4. Prospects of the industry and expected growth rates.
5. Bond and stock market conditions.
6. Financial flexibility.
7. Regulatory environment
8. Taxes
9. Management style

The following leverage ratios will be discussed in this chapter:

1. Debt ratio
2. Debt to equity ratio
3. Interest coverage ratio

Debt Ratio
Measures how much of the total assets are financed by liabilities.

Debt ratio = Total liabilities/Total assets

Example: Debt ratio = 9 819 461 / 22 298 020
= 0.44
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Interpretation: The debt ratio of less than 0.50 means that the company has less
liabilities as compared to its stockholders equity. If debt ratio is 0.50, this means that
the amount of total liabilities is exactly equal to stockholders equity.

Debt to equity ratio

It is a variation of the debt ratio. A debt to equity ratio of more than one means that a
company has more liabilities as compared to stockholders equity.
Debt to equity ratio = Total Liabilities / Total stockholders equity

Example: Debt to equity ratio = 9 819 461 / 12 478 559

= 0.79
Interpretation: Since the company’s debt ratio is less than one, it is expected that the
debt to equity ratio is less than one.

Interest coverage ratio

It provides information if a company has enough operating income to cover interest
expense.
Interest coverage ratio = EBIT / Interest Expense

EBIT stands for Earnings before interest and taxes

Example: Interest coverage ratio = 4 048 696 / 250 000

= 16.19
Interpretation: The interest coverage ratio of 16.19 means that JSC food Corporation
has more than enough operating income or earnings before interest and taxes to cover
its interest expense.

4. Efficiency ratios

Efficiency refers to a company’s ability to be efficient in its operations. Specifically, it

refers to the speed with which various current accounts are converted into sales, and
ultimately, cash. It is also known as turnover ratios because they measure the management’s
efficiency in utilizing the assets of the company.

1. Total asset turnover

2. Fixed asset turnover ratio
3. Account receivable turnover ratio
4. Inventory turnover ratio
5. Accounts payable turnover ratio

Total asset turnover

Total asset turnover ratio measures the company's ability to generate revenues for every
peso of asset invested. It is an indicator of how productive the company is in utilizing its resources.
The formula is shown below:

Asset Turnover Ratio = Sales / Total Assets

Let us compute the asset turnover ratio of JSC Foods Corporation in 2014.

Asset Turnover Ratio = 52 501 085 / 22 298 020

Asset Turnover Ratio = 2.35

Interpretation: The asset turnover ratio of 2.35 means that for every P1.00 of asset JSC Foods
Corporation has in 2014, it is able to generate sales of P2.35.
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In computing asset turnover ratio, ending balances for total assets or the average of total
assets for the accounting period can be used. Whichever formula is used, consistency must be
applied.

Fixed Asset Turnover Ratio

If a company is heavily invested in property, plant, and equipment (PPE) or fixed assets, it
pays to know how efficient thee management of these assets is. This can be applied to companies
which are characterized by high PPE such as utility companies, like telecom companies, power
generation and distribution companies, and water distribution companies. lt can also be applied to
manufacturing companies. The formula for computing fixed asset turnover ratio is shown below:

Fixed Asset Turnover Ratio = Sales / PPE

Let us compute the fixed asset turnover for JSC Foods Corporation in 2014.

Fixed Asset Turnover Ratio = 52 501 085 / 12 200 000

Fixed Asset Turnover Ratio = 4.30

Interpretation: In 2014, JSC Foods Corporation was able to generate P4.30 for every PL.00 of PPE
that it has.

Ending balance of PPE or average PPE for the accounting period can be used. Consistency,
however, must be applied in the application of the formula.
Accounts Receivable Turnover Ratio

Accounts receivable turnover ratio measures the efficiency by which accounts receivable are
managed. A high accounts receivable turnover ratio means efficient management of receivables.

The formula tor accounts receivable turnover ratio is shown below:

Accounts Receivable Turnover Ratio = Sales / Accounts Receivable

If there are different types of receivables, consider only the trade account receivable. These
are the accounts receivable created in the ordinary course of business. Also, if there are allowances
for doubtful accounts, use the gross amount of trade accounts receivable. This amount is generally
found in the notes to financial statements where more information about accounts receivable is
disclosed.

Some analysts use average accounts receivable, instead of the ending accounts receivable.
Whichever approach is used, consistency must be applied.

Let us compute the accounts receivable turnover ratio for |SC Foods Corporation in 2014.

Accounts receivable Turnover Ratio = 52 501 085 / 2 300 500

Accounts Receivable Turnover Ratio = 22.82

Interpretation: The accounts receivable turnover ratio becomes more meaningful when
converted to days receivable or average collection period. ln our illustrative example, this
22.82 Accounts receivable turnover ratio can be converted to days by dividing 360 days (if
information is based on annual data and use 90 days if based on quarterly data) by the
accounts receivable turnover ratio.

Average Collection Period = 360 / 22.82

Average Collection Period = 15.78 or 16 days

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Interpretation: In 2014, JSC Foods Corporation had an average of 16 days collecting its
accounts receivable. This means that from the day the sale was made, it took the company 16
days, on the average, to collect its accounts receivables.

Inventory Turnover Ratio

Inventory turnover ratio measures the company's efficiency in managing inventories. Trading
and manufacturing companies and companies that are highly perishable products and those that are
prone to technological obsolescence must pay close attention to this ratio to minimize losses. The
formula tor computing turnover ratio is shown below:

Inventory Turnover Ratio = Cost of Sales / Inventories

Just like the computation of accounts receivable turnover ratio, either ending balance of the
inventories or the average inventories for the accounting period can be used. Whichever number is
used, consistency must be observed.

For manufacturing companies that may have three types of inventories-finished goods, Work
in process, and raw materials inventories--all must be included in the computation. This is to measure
the company's level of efficiency in managing this account.

Let us compute the inventory turnover ratio of JSC Foods Corporation in 2014.

Inventory Turnover Ratio = 41 954 730 / 4 849 304

Inventory Turnover Ratio = 8.65

The inventory turnover ratio becomes more meaningful when converted to days inventories.
To convert, Simply divide 360 days by the inventory turnover ratio if annual data are used. 0therwise,
use 90 days if quarterly data are used.
Days Inventories = 360 / Inventory Turnover Rato
Days Inventories = 360 / 8.65
Days inventories = 41.62 or 42 days

Interpretation :This 42 days' inventories means that in 2014, JSC Foods Corporation took 42
days, on the average, to sell its inventories from the time they were bought
Accounts Payable Turnover Ratio

Accounts payable turnover ratio

The accounts payable turnover ratio provides information regarding the rate by which trade
payables are paid. Any operating company will prefer to have a longer payment period for its
accounts payable but this should be done only with the concurrence of the suppliers.
The formula below shows the computation for the accounts payable turnover ratio

Accounts Payable turnover Ratio = Cost of Sales / Trade Accounts Payable

The accounts payable turnover ratio of SC Foods Corporation in 2014 is 8.31 computed as follows

Accounts Payable Turnover Ratio = 41954 730 / 5 050 810

Accounts Payable Turnover Ratio = 8.31

Ideally, purchases should have been the numerator in the formula, but this amount is not
readily available in the income statement. A close substitute for purchases is the cost of sales or
sometimes called cost of goods sold. Purchases are definitely a function of sales and cost of sales is
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a function of sales. Given this line of reasoning cost of sales can be a very good substitute for
purchases.

Interpretation: From the accounts payable 201 turnover ratio, day’s payable can be computed.
For JSC Food Corporation, days' payable in 2014 is 43.32 day or 43 days computed as follows:

Days' Payable = 360 / Accounts Payable Turnover Ratio

Days' Payable = 4332 or 43 days

This number suggests that in 2014, the average payment period of the company for its trade
accounts payable was 43 days.

Operating Cycle and Cash Conversion cycle

By adding the average collection period and days inventories, the operating cycle can be
computed. This operating cycle covers the period from the time the merchandise is bought to the time
the proceeds from the sale are collected. Managers of companies will prefer to have a short operating
cycle as compared to a long one.

In 2014, JSC Foods Corporation had an operating cycle of 58 days computed as follows:

Operating Cycle = Days inventories + Days Receivable

Operating Cycle = 42+16
Operating cycle = 58 days

When JSC Foods Corporation bought the merchandise, did it already pay the merchandise
bought? Chances are the company was given credit terms. As our days payable suggests, payment
to suppliers averaged 43 days in 2014. If we are interested to find out how long it takes the company
to collect receivables from the time the cost of the merchandise sold was actually paid, a cash
conversion cycle or sometimes called net trade cycle can be computed. The formula is shown below

Cash Conversion Cycle = Operating Cycle - Days' Payable

For JSC Food Corporation, its cash conversion cycle is 15 days computed as follows:

Cash Conversion Cycle = 58 days - 43 days

Cash Conversion Cycle = 15 days

The cash conversion cycle is inversely related to the operating cash flows. If the cash
conversion cycle is low, expect more operating cash flows and the reverse is true.

As previously discussed in liquidity ratios, attention must be given to the quality of receivables
and inventories which can be measured by their turnover ratios. So, when analyzing the liquidity
position of a company, it is not enough to look at the current and the quick asset ratio, check the
average collection period or days' receivable and days’ inventories as well. It may also be good to
check the operating cash flows.

Note that in the computation of total asset turnover ratio, accounts receivable turnover ratio,
inventory turnover ratio, and accounts payable turnover ratio, some references use average balances
in the denominators. For example, in the computation of total asset turnover ratio, instead of using
the ending balance for the total asset, average total asset turnover ratio, total assets can be used
which is computed as follows;

Average Total Assets = (Total Assets, Beginning / Total Assets, Ending) / 2

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Whichever formula is used, consistency must be observed.

VERTICAL ANAYSIS

It is sometimes called common-size analysis is an important financial statement analysis tool.

With vertical analysis, all accounts in the statement of financial position are presented as a
percentage of total assets while all accounts in the statement of profit or loss are presented as a
percentage of sale or revenues.

Table 2.1 JSC Foods Corporation

Common Size Statement of Profit or Loss
For the years Ending December 31, 2014 - 2010
2014 2013 2012 2011 2010
Net Sales 100% 100% 100% 100% 100%
Cost of Sales 80% 80% 81% 82% 83%
Gross Profit 20% 20% 19% 18% 17%
Operating Expenses 12% 13% 13% 13% 13%
Operating Income 8% 7% 7% 5% 4%
Interest Expense 0% 1% 1% 1% 1%
Income before Taxes 7% 6% 6% 4% 3%
Taxes 2% 2% 2% 1% 1%
Net Income 5% 4% 4% 3% 2%
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Table 2.2 JSC Foods Corporation
Common Size Statement of Profit or Loss
December 31, 2014 – 2010
2014 2013 2012 2011 2010
Assets
Current Assets
Cash 5 5 5 5 5
Trade Receivables 10 9 10 9 8
Inventories 22 22 22 20 20
Other Current Assets 5 5 6 4 6
Total Current Assets 42 41 42 38 39
Non Current Assets
Property and Equipment, Net 55 55 53 57 56
Other Non Current Assets 4 4 5 5 5
Total Non Current Assets 58 59 58 62 61
Total Assets 100 100 100 100 100

Liabilities and Equity

Current Liabilities
Trade Payables 23 23 24 20 17
Income Taxes Payable 2 1 2 1 1
Current Portion of Long-term Debt 10 12 6 12 12
Other Current Liabilities
Total Current Liabilities 35 37 32 33 30
Non Current Liabilities
Long-term Debt, Net of Current
9 6 - 6 18
Portion
Total Liabilities 44 43 32 39 47
Stockholders Equity
Capital Stock 36 39 46 49 47
Retained Earnings 20 19 22 12 5
Total Stockholder's Equity 56 57 68 61 53
Total Liabilities and Stockholder's
100 100 100 100 100
Equity
(Note: Figures are express in Percentage)

HORIZONTAL ANALYSIS

It is also called trend analysis is a financial statement analysis techniques that shows
changes in financial statement accounts over time. Changes can be shown both in absolute peso
amounts and in percentage.

PESO CHANGE = (Sales of 2014 - Sales of 2013)

Peso Change = 52 501 085 - 47 345 223

Peso Change = 5 155 862

% Change = ((Sales of 2014 - Sales of 2013) / Sales of 2013) x 100%

% Change = (5 155 862 / 47 345 223) x 100%

% Change = 10.89%
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Table 2.3 JSC Foods Corporation
Annual Changes in the Statement of Profit or Loss Accounts in Pesos
From 2011 to 2014

2014 2013 2012 2011

Net Sales 5,155,862.00 5,170,940.00 3,834,026.00 3,003,614.00
Cost of Sales 3,966,102.00 4,008,454.00 2,541,163.00 2,109,598.00
Gross Profit 1,189,760.00 1,162,486.00 1,292,863.00 894,016.00
Operating Expenses 300,855.00 803,183.00 466,898.00 421,301.00
Operating Income 888,905.00 359,303.00 825,965.00 472,715.00
Interest Expense 0.00 0.00 -200,000.00 150,000.00
Income before taxes 888,905.00 359,303.00 1,025,965.00 322,715.00
Taxes 266,672.00 107,791.00 307,789.00 96,815.00
Net Income 622,233.00 251,512.00 718,176.00 225,900.00
Table 2.4 JSC Foods Corporation
Annual Changes in the Statement of Profit or Loss Accounts in Pesos
From 2011 to 2014

2014 2013 2012 2011

Net Sales 11 12 10 8
Cost of Sales 10 12 8 7
Gross Profit 13 14 19 15
Operating Expenses 5 15 9 9
Operating Income 28 13 42 31
Interest Expense 0 0 -44 50
Income before taxes 31 14 67 27
Taxes 31 14 67 27
Net Income 31 14 67 27
(Note: Figures are express in Percentage)

Quality of Earnings

In analysing a statement of profit or loss, how can you tell whether the earnings are good or
not? There are information in the financial statements that should be looked into.

1. Is the Income coming from the core business?

Is the income coming from the core business? If so, then it is good. But if income
comes from nonrecurring transaction such as sale of equipment when the company is not in
the business of selling equipment, then the income is not of good quality because this income
is not expected to happen again or at least, not in the foreseeable future.

2. How much of the net income translates into cash flows?

Recognition of revenues is based on the accrual principle so not all the revenues
recognized during the period are necessarily collected. The same is true for expenses. As
analyst however, it is important to know it the net income reported in the statement of profit or
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loss translates into cash flows. This information can be found in the first section of the
statement of cash flows, the cash flows from operating activities.

3. Is the income stable?

The stability of earnings is influenced by the nature of business the company is in.
Utility companies which provide basic services such as power distribution companies are
supposed to be more stable. Food companies which cater to the masses such as Jollibee
Food Corporation can also be considered stable. Mining and oil companies whose prices of
the commodities they sell fluctuate a lot can be considered more unstable.

Limitations of Financial Statements Analysis

1. Financial analysis deals only with quantitative ideas.

We know that behind the Success ot every company are important personalities. For
example, Mr. Manuel Pangilinan is behind successful companies like PLDT, Smart, and
Meralco, among others. Mr. Henry Sy is behind the SM Group of Companies which includes
the SM malls, Banco De Oro and recently, the City of Dreams, a casino operation near SM
Mall of Asia. The value of these personalities is not reported in the statement of financial
position. This is why in analysing a company; it is not enough to just look at their financial
statements. One has to figure out the controlling stockholders and the top executives behind
these companies.
2. Management can take short-run actions to influence ratios.
Managers’ behaviour is influenced by how their performance as managers is
appraised. If one of the major performance appraisal measures is return on assets, managers
will tend to defer important capital investments even if in the long run, these long-term
investments will benefit the company a lot. Why will they deter these investments? Because in
the short-run, such investments will increase the asset base but contributions to income may
come much later. So, the effect is a lower ROA.
3. Different companies may use different accounting principles though they come from
the same industry.
This makes comparison with other companies more difficult. For example, one
company may use straight-line method of depreciation but a competing company may use
one form of accelerated method of depreciation such as the double-declining depreciation
method.
4. Different formulas can be used in computing financial ratios.
For example, with ratios that use both accounts from the statement of profit or loss
and statement of financial position, some use the ending balances while other analysts use
the average balances. The difference in formulas will lead to different computations.
5. The amounts found in the financial statements are already part of historical data.
The future may not necessarily be the same as the present or the past. 1o make
more sense with historical data, it pays to know the evolution of the company over time. It
pays to know whether the line of businesses the company is currently engaged in will be the
same as the future based on corporate plans. A good example of this situation is San Miguel
Corporation (SMC). For many years in the past, SMC has always been known as a leading
fo0d and beverage company. But if you now look at the businesses SMC is engaged in,
power generation is presently its biggest business segment. It has also gone into oil refinery
and distribution through Petron Corporation and has been actively participating in
infrastructure projects.
6. A financial ratio standing alone is useless.
There has to be a benchmark. If the competitor's or competitors' financial statements
are available, they can serve as good benchmarks. But the best benchmarks are the
company's own projected financial statements because these represent the goals of the
corporation.