Course Code and Title: FINP1 – Financial Management

Lesson Number: 6
Topic: Assessment of the Firm's Operating Efficiency and Financial Position Through
Financial Statements Analysis
Learning Objectives:
After studying Chapter 6, you should be able to:
1. Define financial statements analysis.
2. Understand the need to analyze the broader business environment.
3. Know the basics of profitability analysis.
4. Realize the limitations of financial statements.
5. Analyze a business firm’s short-term financial position, asset liquidity and management, long-
term financial position and profitability using financial ratios.
6. Apply the Dupont Disaggregation Analysis.
Pre-assessment:

Write T if the statement is true and F if the statement is false.

T 1. Financial statement analysis is the process of extracting information from financial

statements to better understand a company’s current and future performance and financial
condition.
F 2. The primary goal of financial management is to minimize shareholders’ wealth.
F 3. Financial statements are used by mangers to improve the firm’s stock price.
F 4. Financial analysis does not involve evaluating trends in the firm’s financial position.
T 5. Managers shall consider the limitation of financial statement analysis.
 CHAPTER 6
ASSESSMENT OF THE FIRM’S OPERATING EFFICIENCY AND FINANCIAL POSITION
THROUGH FINANCIAL STATEMENTS ANALYSIS
Financial statement analysis is the process of extracting information from financial statements
to better understand a company's current and future performance and financial condition.
ANALYZING THE BROADER BUSINESS ENVIRONMENT
Quality analysis depends on an effective business analysis. The broader business
context in which a company operates must be assessed as its financial statements are read and
interpreted. A review of financial statements which reflect business activities is contextual and
can only be effectively undertaken within the framework of a thorough understanding of the
broader forces that impact company performance. Some of these questions about a company's
business environment are:

 Life cycle. At what stage in its life is this company? Is it a startup, experiencing growing
pains? Is it strong and mature, reaping the benefits of competitive advantages? Is it
nearing the end of its life, trying to milk what it can from stagnant product lines?
 Outputs. What products does it sell? Are 'its products new, established or dated? Do its
products have substitutes? How complicated are its products to produce?
 Buyers. Who are its buyers? Are buyers in good financial condition? Do buyers have
substantial purchasing power? Can the seller dictate sales terms to buyers?
 Inputs. Who are its suppliers? Are there many supply sources? Does the company
depend on a few supply sources with potential for high input costs?
 Competition. In what kind of markets does it operate? Are markets open? Is the market
competitive? Does the company have competitive advantages? Can it protect itself from
new entrants? At cost? How must it compete to survive?
 Financing. Must it seek financing from public markets? Is it going public? Is it seeking to
use its stock to acquire another company? Is it in danger of defaulting on debt
covenants? Are there incentives to tell an overly optimistic story to attract lower cost
financing or to avoid default on debt?
 Labor. Who are its managers? What are their backgrounds? Can they be trusted? Are
they competent? What is the state of employee relations? Is labor unionized?
 Governance. How effective is its corporate governance? Does it have a strong and
independent board of directors? Does a strong audit committee of the board exist, and is
it populated outsiders? Does management have a large portion of its wealth tied to the
company's stock?
 Risk. Is it subject to from competitors or shareholders? Is it under investigation by
regulators? Has it changed auditors? If so, why? Are its auditors independent? Does it
face environmental and/or political
We must assess the broader business context in which a company operates read and
interpret its financial statements. A review of financial statements, which reflect business
activities, cannot be undertaken in a vacuum. It is contextual and can only be effectively
undertaken within the framework of a thorough understanding of the broader forces that impact
company performance.
BASICS OF PROFITABILITY ANALYSIS
The primary goal of financial management is to maximize shareholders' wealth, not accounting
measures such as net income or earnings per share (EPS). However' accounting data influence
stock prices and this data can be used to see why a company is performing the way it is and
where it is heading.
The previous section described the key financial statements and should how they
change as a firm's operations change.
In the succeeding section, we shall show the statements are used by managers to improve the
firm's stock price; by lenders to evaluate the likelihood that borrowers will be able to pay off
loans; and by security analysts to forecast earnings, dividends and stock prices. If management
is to maximize a firm's value, it must take advantage of the firm's strengths and correct its
deficiencies and weaknesses.
Financial Analysis involves

 comparing the firm's performance to that of other firms in the same industry, and
 evaluating trends in the firm's financial position over time.
These studies help managers identify deficiencies and take corrective actions.
LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS
Although financial statement analysis is a highly useful tool, the analyst should consider
its limitations. The limitations involve the comparability of financial data between companies and
the need to look beyond ratios. These limitations are:
1. Information derived by the analysis are not absolute measures of performance in any
and all of the areas of business operations. They are only indicators of degrees of
profitability and financial strength of the firm.
2. Limitations inherent in the accounting data the analyst works with. These are brought
about by among others: (a) variation and lack of consistency in the application of
accounting principles, policies and procedures, (b) too-condensed presentation of data,
and (c) failure to reflect change in purchasing power.
3. Limitations of the performance measures or tools and techniques used in the analysis.
Quantitative measurements are not absolute measures but should be interpreted
relative to the nature of the business and in the light of past, current and future
operations. Timing of transactions and the use of averages can also affect the results
obtained in applying the techniques in financial analysis.
4. Analysts should be alert to the potential for management to influence the Outcome of
financial statements in order to appeal to creditors, investors and others.
Limitations of analysis may be overcome to some extent by finding appropriate benchmarks
used by most analysts such as the performance of comparable components and the average
performance of several companies in the same industry.
FINANCIAL RATIO ANALYSIS
There are a number of different ways to analyze financial statements. The most applied
is the financial ratio. Financial ratio is a comparison in fraction, proportion, decimal or
percentage of two significant figures taken from financial statements. It expresses the direct
relationship between two or more quantities in the statement of financial positions and
statement of comprehensive of a business firm.
The ratio can be categorized as follows:
1. Liquidity ratios. These ratios give us an idea of the firm's ability to pay off debts that are
maturing within a year or within the next operating cycle. Satisfactory, liquidity ratios are
necessary if the firm is to continue operating.
2. Asset management ratios. These ratios give us an idea of how efficiently the firm is
using its assets. Good asset management ratios are necessary for the firm to keep its
costs low and thus, its net income high.
3. Debt management ratios. These ratios would tell us how the firm has financed its
assets as well as the firm's ability to repay its long-term debt. Debt management ratios
indicate how risky the firm is and how much of its operating income must be paid to
bondholders rather than stockholders.
4. Profitability. These ratios give us an idea of how profitability the firm is operating and
utilizing its assets. Profitability ratios combine the asset and debt management
categories and show their effects on return on equity.
5. Market book ratios. These ratios which consider the stock price give us an idea of what
investors think about the firm and its future prospects Market book ratios tell us what
investors think about the company and its prospects.
All of the ratios are important, but different ones are more important for some companies
than for others. For example, if a firm borrowed too much in the past and its debt now threatens
to drive it into bankruptcy, the debt ratios are the key.
Similarly, if a firm expanded too rapidly and now finds itself with excess inventory and in
manufacturing capacity, the asset management ratios take center stage. The ROE is always
important, but a high ROE depends on maintaining liquidity, on efficient asset management, and
on the proper use of debt. Managers are, of course, vitally concerned with the stock price, but
managers have little direct control over the stock market's performance while they do have
control over their firm's ROE. So ROE tends to be the main focal point.
A summary of the ratios, their formula and significance is presented in Figure 6-1.
REQUIRED:
Using the financial rations, evaluate the company’s financial position and operating
results for years 20X4 and 20X3.
Solution: EBC enterprises, Inc.
I. Analysis of Liquidity or Short-Term Solvency
Current ratio

Current ratio is widely regarded as a measure of short-term debt-paying ability. Current

liabilities are used as the denominator because they are considered to represent the most
urgent debts requiring retirement within one year or one operating cycle. A declining ratio could
indicate a deteriorating financial condition or it might be the result of paring of obsolete
inventories or other stagnant current assets. An increasing ratio might be the result of an unwise
stock piling of inventory or it indicate an improving financial situation. The current ratio is useful
tricky to interpret and therefore, the analyst must look closely at the individual assets and
liabilities involved.
Some analysts eliminate prepaid expenses from the numerator they are not potential
sources of cash but, rather, represent future obligations that have already been satisfied.
EBC's current ratio indicates that at year-end 20X4 current assets covered current
liabilities 2.4 times down from 20X3. Its significance could be best evaluated by comparing this
with industry competitors or the company's trend of liquidity over a longer period.
As a measure of short-term liquidity, the current ratio is limited by the nature of the
component. The liquidity of the assets may vary considerably from the date on which the
statement of financial position is prepared. Furthermore, it could have a relatively high current
ratio but not be able to meet the demands for cash because the accounts receivable are of
inferior quality or the inventory is saleable only at discounted price.
Quick or Acid test ratio
 The acid-test (quick) ratio is a much more rigorous test of a company’s ability to meet its
short-tern debts. Inventories and prepaid expenses are excluded from total current assets
leaving only the more liquid assets to be divided by current liabilities. This is designed to
measure how well a company can meet its obligations without having to liquidate or depend too
'heavily on its inventory. Since inventory is not an immediate source of cash and may not even
be saleable in times of economic stress, it is generally felt that to be properly protected; each
peso of liabilities should be backed by at least P1 of quick assets.
EBC's quick ratio indicates deterioration between year 20X4 and year 20X3. An analyst
might be quite concerned about several disquieting trends revealed in rising short-term debts
and increasing inventories. The acid-test ratio must also be examined in relation to other firms in
the same industry.
Cash-Flow Liquidity Ratio

The cash flow liquidity ratio considers cash flow from operating activities (from the
statements of cash flows) in addition to the truly liquid cash and marketable securities.
EBC's current ratio and acid-test ratio both decreased between 20X3 and 20X4 which
could be interpreted as a deterioration of liquidity. But cash flow ratio increased indicating an
improvement in short-term solvency. Furthermore, the reason for the decline in the current ratio
acid-test ratio could be traced to the 88% increase in accounts payable which could actually be
a plus if it means that EBC, Inc. strengthened its ability to obtain supplier credit. Also, the firms
cash flow from activities turned around from negative to positive amount contributed to the
stronger short-term solvency in 20X4.
II. Analysis of Asset Liquidity and Asset Management Efficiency
Accounts Receivable Turnover

*When available, credit sales can be substituted for net sales since credit sales produce receivable.
**Assumed average for 20X3.

The accounts receivable turnover roughly measures how many times a company's
accounts receivable have been turned into cash during the year. EBC, Inc. converted accounts
receivable into cash 24.9 times in 20X4, up from 18 times in 20X3. The turnover if receivable
has improved and this may indicate better quality of receivable and improvement of the firm's
collection and credit policies. Generally, a high turnover is good because it could indicate
efficiency in the collection of receivable, but a very high turnover may not be favorable because
it may indicate that credit and collection policies are overly restrictive.

The average collection period helps evaluate the liquidity of accounts receivable and the
firm's credit policies. The long collection period may be a result of the presence of many old
accounts of doubtful collectability, or it may be the result of poor day-to-day credit management
such as inadequate checks on customers or perhaps no follow-ups are being made on slow
accounts. There could be other explanations such as temporary problem caused by a
depressed economy.
The average collection period of accounts receivable is the average number of days
required to convert receivable into cash. The ratios for EBC, Inc. indicate that during 20X4, the
firm collected its accounts in 15 days on average, an improvement over the 20-day collection
period in 20X3. Whether the average of 15 days taken to collect an account is good or bad
depends on the credit terms EBC is offering its customers. If the credit terms are 10 days, then
a 15-day average collection period would be viewed as good. Most customers will tend to
withhold payment for as long as the credit terms will allow and may even go over a few days.
This actor, added to ever-present problems with a few slow-paying customers, can cause the
average collection period to exceed normal credit terms by a week or so and should not cause
great alarm.
Inventory Turnover

The inventory turnover measures the efficiency of the firm in managing and selling
inventory. It is computed by dividing the cost of goods sold by the average level of inventory on
hand. The ratio is sometimes calculated with net sales as the numerator and the average level
of inventory as the denominator. The inventory turnover of EBC, Inc. was 3.09 time 20X4 an
improvement over 20X3's 2.50 times.
Generally a high turnover is preferred because it is a sign of efficient inventory
management and profit for the firm. But a high turnover could also mean underinvestment in
inventory and lost orders, a decrease in prices, a shortage of materials or more sales than
planned. A relatively low turnover could mean that the company is carrying too much inventory
or it has obsolete, slow-moving or inferior inventory stock.
The inventory turnover varies, from industry to industry. Flowers and vegetable sellers
would have a relatively high inventory turnover because they deal with perishable products but a
jewelry store would have lower turnover but high profit margin.
Average Sale Period

The number of days being taken to sell the entire inventory one time (called the average
sale or conversion period) is computed by dividing 365 days by the inventory turnover period.
Generally, the faster inventory sells, the fewer funds are tied up in inventory and more profits
are generated. EBC's average sale or conversion period decreased from 146 day in 20X3 to 1
18 days in 20X4. This is evidence of efficiency in managing the inventories in 20X4.
Fixed Asset Turnover:

*Assumed average for 20X3

The fixed asset turnover is another approach to assessing management's effectiveness
in generating sales from investments in fixed assets particularly for a capital-intensive firm. For
EBC, Inc. the fixed asset turnover improved slightly because of the 41% in sales as compared
with 26% increase in average fixed assets. This occurrence however should be further
examined within the framework of the overall analysis of the company as well as that of the
industry.
Total Asset Turnover

*Assumed average for 20X1

The total asset turnover is a measure of the efficiency of management to generate sales
and thus earn profit tor the thrill. When the asset turnover ratios are low relative to the industry
of the firm’s historical record, it could mean that either the investment in assets is too heavy or
sales are sluggish. There may however be justification for the low turnover. For example, the
firm may have undertaken an extensive plant modernization or placed in assets is service at
year-end will generate positive results in the long-tern).
For EBC, Inc. the total asset turnover has improve primarily because of the improvement
in fixed assets, inventory and accounts receivable turnover.
III. Analysis of Leverage: Debt Financing and Coverage
Debt Ratio
 The debt ratio measures the proportion of all assets that are financed with debt.
Generally, the higher the proportion of debt, the greater the risk because creditors must be
satisfied before owners in the event of bankruptcy
The use of debt involves risk because debt carries a fixed obligation in the form of
interest charges and principal repayment. Failure to satisfy the fixed charges associated with
debt will ultimately result in bankruptcy.
EBC's debt ratios in 20X4 and 20X3 indicate relatively heavy reliance on borrowed
capital and they have reached the generally considered maximum ratio of 50% debt and 50%
equity. Too much debt would pose difficulty in obtaining additional debt financing when needed
or that credit is available only at extremely high rates of interest and most onerous terms.
Debt Equity Ratio

The amount and proportion of debt and equity in a company's capital structure are
extremely important to the financial analyst because of the trade-off between risk and return.
While debt implies risk, it also provides the potential for increased benefits to the firm's owners.
When debt is used successfully, operating earnings exceed the fixed charges associated with
debt, the return to the stockholders are magnified through financial leverage or “trading on the
equity.”
The debt to equity ratio measures the riskiness of the firm's capital structure in terms of
relationship between the funds supplied by creditors (debt) and investors (equity). EBC's debt to
equity ratio has increased between 20X4 and 20X3, implying a slightly riskier capital structure.
Time Interest Method
 Times interest earned ratio is the most common measure of the ability of a firm's
operations to provide protection to long-term creditors. The more times a company can cover its
annual interest expense from operating earnings, the better off will be the firm's investors.
While EBC, Inc. increased its use of debt in 20X4, the company improved its ability to
cover interest payment from operating profits.
Fixed Charge Coverage

The fixed charge coverage measures the firm's coverage capability to cover not only
interest payments but also the fixed payment associated with leasing which must be met
annually. This ratio is particularly important for firms that operate extensively with leasing
arrangements whether operating leases or capital leases.
EBC, Inc. experienced a significant increase in the amount of annual lease payment in
20X4 but was still able to improve its fixed charge coverage.
IV. Operating Efficiency and Profitability
Gross Margin Profit
 Gross profit margin which shows the relationship between sales and the cost of products
sold, measures the ability of a company both to control costs and inventories or manufacturing
of products and to pass along price increases through sales to customers.
EBC 9 s gross profit margin for both 20X4 and 20X3 have been stable which is considered a
positive sign even if the company had to offer probably discounted items to attract customers or
feature “sale” to hasten up inventory turnover.
Operating Profit Margin

The operating profit margin is a measure of overall operating efficiency and incorporates
all of the expenses associated with ordinary or normal business activities.
EBC's operating profit margin improved from 7.7% in 20X3 to 8.9% in 20X4. This is
favorable because it indicates ability of the company to control its operating expenses while
sharply increasing sales.
Net Profit Margin

Net profit margin measures profitability after considering all revenue and expenses,
including interest, taxes and non-operating items such as extraordinary items, cumulative effect
of accounting change, etc.
EBC's net profit margin slightly increased despite increased interest and tax expenses
and a reduction in interest revenue for marketable security investment.
Cash Flow Margin
 Cash flow margin is another important measure or perspective on operating
performance. This measures the ability of the firm to translate sales to cash to enable it to
service debt, pay dividends or invest in new capital assets.
EBC's cash flow margin in 20X4 was higher than the operating margin. This indicates a
strong positive generation of cash. The performance 20X4 represents a solid and impressive
improvement over 20X3 when the firm failed to generate cash from operations and had a
negative cash flow margin.
Return on Investment on Assets (ROA)

If the firm has interest-bearing debt, ROA is computed using the following formula:

Return on Equity (ROE)

 Return on assets and return on equity are two ratios that measure the overall efficiency
of the firm in managing its total investment in assets and in generating return to shareholders.
These ratios indicate the amount of profit earned relative to the level of investment in total
assets and investment of common shareholders.
These ratio will also measure how effectively the company is using financial leverage.
The Financial Leverage Index (FLI) is computed as follows:

If the FLI is greater than 1 indicating the return on equity exceed return on assets, the
firm is using debt effectively. If FLI is less than 1, the financial leverage is negative which means
that the firm is no using debt successfully.
EBC’s registered a solid improvement in 20X4 of both return ratios. Financial Leverage
Index is calculated as follows:

EBC’s FLI of 2.06 and 1. 73 in 20X3 indicates a successful use of financial leverage
although borrowing increased. The firm has generated sufficient operating returns to more than
cover the interest payments on borrowed funds.
Other Ratios used to Measure Returns to Investors
a) Earnings per share (EPS)
 The Diluted EPS need not be computed because there are no potential diluters (e.g.,
convertible bonds, convertible preference shares or stock options and warrants) outstanding.
PAS 33 issued by the ASC in 2008 is used to compute the Earnings per share.
EBC's earnings per ordinary share increased from P1.29 in 20X3 to P2.00 in 20X4 which
is a clear indication in the improvement on the investment return of ordinary shareholders.
b) Price Earnings Ratio (P/E)

The P/E ratio relates earnings per ordinary share to the market price at which the stock
trades, expressing the "multiple" which the stock market places on a firm's earnings. It is a
combination of a number of factors such as the quality of earnings, future earnings, potential
and performance history of the company.
EBC's price to earnings ratio is higher in 20X4 than in 20X3. This could be because the
market is reacting favorably to the firm's good year.
c) Dividend payout ratio
 A low dividend yield would indicate that an investor would choose EBC, Inc. as an
investment more for its long-term capital appreciation than for its dividend yield.
Summary of Financial Statements Analysis of EBC, Inc.
Short-Term Liquidity and Activity
Short-term liquidity analysis is of particular significance to trade and short* term
creditors, management and other parties concerned with the ability of a firm to meet near-term
demands for cash.
EBC's current and quick' ratios decreased indicating a deterioration of short term
liquidity. However, the cash flow liquidity ratio improved in 20X4 after a negative cash
generation in 20X3.
The average collection period for accounts receivable and the inventory turnover
improved in 20X4 which could indicate improvement in the quality of accounts receivable and
liquidity of inventory. The increase in inventory level has been accomplished by reducing
holdings of cash and cash equivalents. This represents a trade-off of highly liquid assets for
potentially less liquid assets. The efficient management of inventories is critical for the firm's
ongoing liquidity.
Presently, there appears to be no major problems with the firm's short-term liquidity
position.
Long-Term Solvency
The debt ratios for EBC show a steady increase in the use of borrowed funds. Total debt
has increased relative, to total assets, long-term debt has increased as a proportion of the firm's
permanent financing and external or debt financing has risen relative to internal financing.
Why has debt increased? The statement of cash flows shows that EBC has substantially
increased its investment in capital or fixed assets and their investments have been financed
largely by borrowing especially in 2013 when the firm had a rather sluggish operating
performance and no internal cash generation.
Given the increased level of borrowing, the times interest earned and fixed charge
coverage improved slightly in 20X4. These ratios should however be monitored closely in the
future particularly if EBC continues to expand.
Operating Efficiency and Profitability
 As noted earlier, EBC has increased its investment in fixed asset as a result of store
expansion. The asset turnover increased in 20X4, the progress traceable to improved
management of inventories and receivable. There has been substantial sales growth which
suggests future performance potential.
The gross profit margin was stable, a positive sign in the light of new store Openings
featuring discounted and “sale” items to attract customers. The firm also managed to improve its
operating profit margin in 20X4 principally due to the firm's ability to control operating costs. The
net profit margin also improved despite increased interest and tax expenses and a reduction in
interest income from marketable security investment.
Return on assets and return on equity increased considerably in 20X4. These ratios
measure the overall success of the firm in generating profits from its investment and
management strategies.
Conclusion: It appears that EBC Enterprises, Inc. is well positioned for future growth. Close
monitoring the firm's management of inventories is important considering the size of the
company's capital tied up in it. The expansion in their operation may necessitate a sustained
effort to advertise more, to attract customers to both new and old areas. EBC has financed
much of its expansion with debt, and so far, its shareholders have benefited from the use of
debt through financial leverage. The company should however be cautious of the increased risk
associated with debt financing.
THE DUPONT DISAGGREGATION ANALYSIS
DuPont Equation is the formula that shows that the rate of return on equity can be found
as the product of profit margin, total assets turnover and the equity multiplier. It shows the
relationships among asset management, financial leverage management and profitability ratios.
Disaggregation of return on equity (ROE) was initially introduced by E. I. DuPont de
Nemours and Company to help its managers in performance evaluation.
The basic DuPont model disaggregates ROE as follows:

These three components are described as follows:

1. Profit Margin is the amount of profit that the company earns from each peso of sales. A
company can increase its profit margin by increasing its gross profit margin (Gross profit
 + Sales), and/or by reducing its expenses (other than cost of sales) as a percentage of
sales.
2. Asset Turnover is a productivity measure that reflects the volume of sales that a
company generates from each peso invested in assets. A company can increase its
asset turnover by increasing sales volume with no increase in assets and/or by reducing
asset investment without reducing sales.
3. Financial Leverage measures the degree to which the company finances its assets with
debt rather than equity. Increasing the percentage of debt relative to equity increases the
financial leverage. Although financial leverage increases ROE (when performance is
positive), debt must be used with care as it increases the company's relative riskiness.
The profit margin and asset turnover relates the company operations and combine to yield on
assets (ROA) as follows:

Return on assets measures the return on investment for the company without regard to
how it is financed (the relative proportion of debt and equity in its capital Structure). Operating
managers of a company typically grasp the income statement. They readily understand the
pricing of products, the management of production costs and importance of controlling overhead
costs« However, many mangers do not appreciate the importance of managing the statement of
financial position.
The ROA approach to performance measurement encourages managers to also focus on the
returns that they achieve from the invested capital under their control. Those returns are
maximized by a joint focus on both profitability and productivity.
1. Profitability. It is measured by the profit margin (Net income/Sales). Analysis of
profitability typically examines performance over time relative to benchmarks such as
competitors' or industry performance, which highlight trends and abnormalities. When
abnormal performance is discovered, managers either correct suboptimal performance
or protect superior performance. The two general areas of profitability analysis are:
 Gross profit margin. It measures the gross profit (Sales less Cost of goods
sold) for each sale. Gross profit margin (Gross profit — Sales) is affected by both
the selling prices of products and their manufacturing cost.
  Expense management. Managers focus on reducing manufacturing and
administrative overhead expenses to increase profitability. Manufacturing
overhead refers to all production expenses (e.g. utilities, depreciation and
administrative costs) other than labor and materials. Administrative overhead
refers to all expenses not in cost of goods sold (e.g., administrative salaries and
benefits, research and development, marketing, legal and accounting).
2. Productivity. It refers to the volume of sales resulting from invested in assets. When a
decline in productivity is observed, managers have two avenues of attack:
 Increase in sales volume from the existing asset base, and
 Decrease the investment in assets without reducing sales volume.
Illustrative Case 6-2.
OR Company is a subsidiary of Pure Business Sense, Inc. and was acquired several years ago
as explained in the following note to the Pure Business Sense, Inc. annual report:
On May 23, 20X2, OR Company acquired Pure Business Sense, Inc., a distributor of
grocery and food products to retailers, convenience stores and restaurants. Results of Pure
Business Sense, Inc. operations are included in OR Company's consolidated results beginning
on that date. Pure Business Sense, Inc. revenues in 20X4 totaled P24.1million compared to
P23.4 million in 20X3 and approximately P22.0 million for the full year of 20X2. Sales of grocery
products increased about 5% in 20X4 and were partially offset by lower sales to food service
customers. Pure Business Sense, Inc. business is marked by high sales volume and very low
profit margins. Pretax earnings in 20X4 of P217 million declined P11 million in 20X3. The gross
margin percentage was relatively unchanged between years. However, the resulting increased
gross profit was more than offset by higher payroll, fuel and insurance expenses.
Approximately, 33% of Pure Business Sense, Inc. annual revenues currently derive from sales
to Savemore. Loss or curtailment of purchasing by Savemore could have a material adverse
impact on revenues and pre-tax earnings of Pure Business Sense, Inc.
Analysis
Pure Business Sense, Inc. is a wholesaler of food products; it purchases food products
in finished and semi-finished form from agricultural and food-related businesses and resells
them to grocery and convenience food stores. The extensive distribution network required in this
business entails considerable investment. The business analysis of Pure Business Sense, Inc.
financial results includes the following observations:

 Industry competitors. Pure Business Sense, Inc. has many competitors with food
products that are difficult to differentiate.
 Bargaining power of buyers. The note above reveals that 33% of Pure Business
Sense, Inc. sales are to Savemore, which has considerable buying power that limits
seller profits; also, the food industry is characterized by high turnover and low profit
margins, which implies that cost control is key to success.
 Bargaining power of suppliers. Pure Business Sense, Inc. is large (P24 million in
annual sales), which implies its suppliers are unlikely to exert forces to increase its cost
of sales.
 Threat of substitution. Grocery items are usually not well differentiated; this means the
threat of substitution is high, which inhibits its ability to raise selling prices.
  Threat of entry. High investment costs, such as warehousing and logistics, are a barrier
to entry in Pure Business Sense, Inc. business; this means the threat of entry is
relatively low.
Our analysis reveals that Pure Business Sense, Inc. is a high-volume, low-margin company.
Its ability to control costs is crucial to its financial performance, including its ability to fully utilize
its assets. Evaluation of Pure Business Sense, Inc. financial statements should focus on that
dimension.

Activity:

Write T if the statement is true an F if the statement is false.

F 1. Accounting data does not influence stock prices.
T 2. Financial analysis does involve comparing the firm’s performance to that of other firms in
the same industry.
F 3. In analyzing financial statements, financial ratios are not one of methods used.
T 4. The Dupont Equation shows the rate of return on equity is the product of profit margin,
total assets turnover and the equity multiplier.
F 5. Asset Turnover measures to the degree to which the company finances its assets with
debt rather than equity.

Reinforcement:

Choose the letter of the correct answer:

1. Which of the following is not a category within financial ratio analysis?
a. Debt Management ratios
b. Liquidity Ratios
c. Solidity Ratios
d. Asset Management ratios
2. The formula for Current Ratio is:
a. Total Non-Current Assets / Total Current Liabilities
b. Total Non-Current Assets / Total Non-Current Liabilities
c. Total Current Assets / Total Current Liabilities
d. Total Current Assets / Total Non-Current Liabilities
3. One of the following is not used for determining short-term solvency and liquidity:
a. Acid Test ratio
b. Working Capital to Total Assets
c. Cash Flow Liquidity Ratio
d. Inventory Turnover
4. One of the following is not used for determining asset liquidity and management
efficiently:
a. Cash Flow Liquidity Ratio
b. Inventory Turnover
c. Working Capital Turnover
d. Trade Receivable Turnover
5. The formula for Capital Intensity Ratio is:
a. Total Assets / Net Expenses
b. Total Assets / Net Sales
 c. Total Assets / Total Liabilities
d. Total Assets / Total Equity
6. One of the following is not used for determining long-term solvency and liquidity:
a. Debt Ratio
b. Equity Ratio
c. Quick Ratio
d. Book value per share of ordinary shares
7. The formula for Times Fixed Charges earned is:
a. Net Income before Taxes and Fixed Charges / Fixed Charges (Rent + Interest +
Sinking Fund payment before taxes)
b. Net Income after Taxes and Fixed Charges / Fixed Charges (Rent + Interest +
Sinking Fund payment after taxes)
c. Gross income before Taxes and Fixed Charges / Fixed Charges (Rent + Interest +
Sinking Fund payment before taxes)
d. Gross income before Taxes and Fixed Charges / Fixed Charges (Rent + Interest +
Sinking Fund payment after taxes)
8. What ratio to use if you need to know the percentage of earnings paid to shareholders?
a. Dividend Yield
b. Dividends per Share
c. Dividend Payout
d. Price/earnings ratio
9. What ratio to use if you need to measure the profit generated after consideration of all
expenses and revenues?
a. Gross Profit Margin
b. Net Profit Margin
c. Cash Flow Margin
d. Operating Profit Margin
10. Which of the following is the correct formula for Return on Equity?
a. Cash Flow Margin x Asset Turnover x Financial Leverage
b. Profit Margin x Inventory Turnover x Financial Leverage
c. Profit Margin x Asset Turnover
d. Profit Margin x Asset Turnover x Financial Leverage