FINANCIAL

MANAGEMENT
MIDTERM

PREPARED: CATALINO A. MENDOZA

EXPECTED LEARNING OUTCOMES
Understand how business activities are reported through the financial
statements
Appreciate the general objectives of financial statements.
Know the nature and significance of the financial statements.
Define financial statement analysis
Analyze a business firm’s short term financial position, asset liquidity
and management and profitability using financial ratios .
Apply the DuPont disaggregation analysis
 1
UNDERSTANDING FINANCIAL STATEMENTS
INTRODUCTION
How business activities are reported
To be able to analyze a company effectively or infer its value , it is important
that one must understands the company’s business activities. This can be
accomplished through the financial statements . Financial statement report on
a company’s performance and financial condition and reveal executive
managements privileged information and insights.

Financial statements serve the needs of different users. The operation of the
accounting information system involves application of accounting standards to
produce financial statements that provide the insight on the business activities
of the company under analysis.
Accounting information should be used in the business context in which the
information is created. All companies without exception , plan business
activities, finance those activities, invest in those activities and then engage
in operating in operating activities. Business firms conduct all these activities
while confronting business forces, including market constraints and
competitive pressure.

Financial statements also provide crucial input for strategic planning ,as well
as, information about the relative success of those plans which can be used to
corrective action and make new operating , investing and financing decisions.
GENERAL OBJECTIVES OF FINANCIAL STATEMENTS
The important objectives of the financial statements are:
1. Providing information for economic decisions.
The economic decisions that are taken by the users of financial statements
require an evaluation of the ability of an enterprise to generate cash and
cash equivalent and the timing and certainty of their generation. This ability
ultimately determines the capacity of an enterprise to pay its employees and
suppliers, meet interest payment, repay loans, make distribution to its
owners.

2. Providing information about financial position

The financial position of an enterprise is affected by the economic resources
such as :
a. Information about the economic resources controlled by the enterprise
and its capacity in the past to modify these resources is useful in
predicting the ability of the enterprise to generate cash and cash
equivalents in the future.
b. Information about financial structure is useful in predicting future
borrowing needs and how future profits and cash flows will be distributed
among those with an interest in the enterprise.
c. Information is useful in predicting how successful the enterprise is likely
to be in raising further finance.
d. Information about liquidity and solvency is useful in predicting the ability
of the enterprise to meet the financial commitments as fall due. Liquidity
refers to the availability of cash in the near future after taking account of
financial commitments and solvency refers to the availability of cash over
the longer term to meet financial commitments as they fall due.
 3. Providing information about performance of an enterprise.

Another important objective of the financial statements is that , it provides

information about the performance and in particular its profitability, which is
required in order to assess potential changes in the economic resources that
are likely to control the future. In information about variability of
3
performance is important and useful in predicting the capacity of the
enterprise to generate cash flows its existing resource base , and in forming
judgement about the effectiveness with the enterprise might employ
additional resources.
4.Providing information about changes in financial position
The financial statements provide information concerning changes in the
financial position of an enterprise, which is useful in order to assess its
investing , financing and operating activities during the reporting period. This
information is useful in providing the user with a basis to assess the ability
of the enterprise to generate cash flow and cash equivalent and the needs of
the enterprise to utilize those cash flows.
DEMAND FOR FINANCIAL ACCOUNTING INFORMATION
Decision makers and other stakeholder demand information on the
company’s past and prospective returns and risks to facilitate efficient
contracting and risk – sharing.
1. Managers and employees.
For their own well – being and prospective earnings, potential managers and
employees need accounting information on the financial conditions,
profitability and prospects of their companies as well as comparative
 financial information on competing companies and business opportunities.
Management uses financial statements to raise financing for the company, to
meet disclosure requirement and to serve as basis for executive
remuneration and bonuses, for wage negotiation and to meet disclosure
requirements.

2. Investors and Analysts

Financial statement are used by these parties to decide whether to buy or sell
equity shares. Expectation about future profitability and the ability to generate
cash influence the price of securities and a company’s ability to borrow money
at favorable terms. Other information intermediaries such as, financial press
writers and investment analysts are interested in predicting companies future
performance.
3. Creditors and suppliers
Banks and other lenders need financial accounting information to help
determine loans terms, loan amount, interest rates and required collateral.
Suppliers demand financial data to establish credit terms and to determine
their long term commitment to supply – chain relations. Both creditors and
suppliers use information to monitor and adjust their contractual
requirements and environment with a business firm.

4. Shareholders and directors

Financial accounting information are needed by owners and directors of the
company to assess its profitability and risks , to evaluate managerial
performance and to help make leadership decisions.
5. Regulatory and tax agencies
The SEC, BIR, BSP and other legal institutions demand financial accounting
information to monitor the business firms compliance with laws, for public
protection, price setting and for setting tax and other regulatory policies.

6. Customers and potential strategic partners

Customers both current and potential need accounting information to
evaluate a company’s ability to provide products and services as agreed and
to assess the company’s reliability and staying power. Potential strategic
partners would wish to estimate the firm’s profitability to asses the fairness
of returns on mutual transaction and strategic alliances.
7. Other decision makers
Financial accounting information are required for varied purposes by other
parties from assessing damages for environment abuses to making policy
decisions involving economic, social, taxation and other initiatives.

SOURCES OF INFORMATION ABOUT BUSINESS ENTERPRISE

In general, the quantity and quality of accounting information that
companies supply are determined by manager’s assessment of the benefits
and cost of disclosure. In the Philippines, publicly listed companies must file
financial accounting information with the securities and exchanges
commission (SEC) these are:
1. The audited annual report that included the four financial statements
(statement of financial position or traditionally known as the balance
sheet statement ), statement of comprehensive income, statement of
stockholder’s equity, and statement of cash flow) with explanatory notes
and the management discussion and analysis of financial results,
2. The unaudited quarterly or interim reports that include summary version
of the four financial statements and limited additional disclosure.
All other registered corporation and partnership are likewise required to file
annually audited financial statements with accompanying explanatory notes
with the SEC.
BENEFITS OF DISCLOSURE
The advantages of supplying accounting information extend to a company’s
capital, labor, input and output markets. Companies compete in these
markets. For instance, debt and equity financing are sourced from capital
markets and the better a company’s prospect, the lower will be its cost
 of capital as reflected in higher stock prices or lower interest rate . The same
is true for a company’s recruitment efforts in labor market and its ability to
establish and maintain superior suppliers customer relations in the input and
output markets.
The company’s ability to disclose reliable (audited ) accounting information
about its products, processes and other business activities enable them to
better compete in capital , labor, inputs and outputs markets.

COST OF DISCLOSURE
The preparation and dissemination costs of supplying accounting information
can be substantial , and the possibility for information to produce competitive
disadvantage is high.
Companies are apprehensive that disclosure of their activities such as
products or segment successes or failures, strategic initiatives, technological
or systems innovation could harm their competitive advantages. Companies
also face possible lawsuits when disclosure create expectation that
eventually are not met. Disclosure costs including political costs are high for
highly visible companies such as large telecommunication conglomerate (e.g.
PLDT and Digitel ), oil companies and software companies because they are
favorite targets of public scrutiny.

CONTRAINST ON RELEVANT AND RELIABLE INFORMATION

1. Timeless
If there is undue delay in the reporting of information it may lose its
relevance . Management may need to balance the relative merits of timely
reporting and the provision of reliable information . To provide information on
a timely basis , it may often be necessary to report before all aspects of a
Or other event are known, thus impairing reliability. Conversely , if reporting
is delayed until all aspects are known, the information may be highly reliable
but of little use to little use to users who have had to make decisions in the
interim . In achieving a balance between relevance and reliability , the
overriding consideration is hoe best to satisfy the economic decision making
needs of users.

2. Balance between benefits and cost.

The balance between benefit and cost is a pervasive constraint rather than a
qualitative characteristic. The benefits derived from information should
exceed the cost pf providing it. The evaluation of benefits and costs is
however , substantially a judgmental process.
3. Balance between qualitative characteristics
In practice , balancing or trade –off between qualitative characteristics is
often necessary. Generally , the aim is to achieve an appropriate balance
among the characteristics in order to meet the objective of financial
statements. The relative importance of the characteristics in different cases is
a matter of professional judgment.
4. True fair view or fair presentation
Financial statements are frequently described as showing a true and fair view
of the financial position , performance and changes in financial position of an
enterprise. Although , this framework does not deal directly with such
concept, the application of the principal qualitative characteristics and of
appropriate standards, normally results in financial statements that convey
what is generally understood as a true and fair view of such information.
Financials statement
Business activities are periodically reported by companies using four financial
statement: the Statement of financial Position, Statement of comprehensive
income, statement of stockholders’ equity and the statement of cash flow.
Figure 1.1 shows how these statement are interconnected across time . A
statement of financial position reports on a company’s financial position at
point in time. The statement of comprehensive income , statement of
stockholders’ equity and the statement of cash flow report on performance
over a period of time.
 ss
Statement of cash flow

Statement of
Statement of Statement of Stockholders financial position
financial position Equity
(end – of –
(beginning of period)
period)

Statement of
comprehensive Income
LINKAGE OF FINANCIAL STATEMENTS
The four financial statements are linked with each other and linked across
time. This linkage is also known as articulation . The succeeding section
demonstrates the articulation of financial statements using Orang Inc.
The statement of financial position and statement of comprehensive income
are linked via retained earnings. Retained earning are updated each period
and reflect cumulative income that not yet been distributed to shareholders.
      ORANGE INC    
  Retained Earnings ReconcilIation  
  For the Year Ended September 30, 2021  
  (pesos in million )  
   
Retained earning . Sept 30 2020 P 5,607  
ADD: Net incone 3,496  
Less: Dividends 0  
  other Aadjustment -0.002  
Retained earning . Sept 30 2021 P 9,101  
In the absence of transaction with stockholders (e.g. stock issuance ,
repurchases and dividend payments) the change in stockholder equity
equals income or loss for the period. The income statement, thus measures
the change in the company value as measured in accordance with financial
reporting standards. This is not necessarily company value as measured by
the market . Of course , all value relevant find their way into the income
statement. So , from a long term perspectives, the income statement does
measure change in company value. This is why stock prices react to reported
income and to analysts’ expectations about future income.
FIGURE : 1.2 ARTICULATION OF Orange Inc. Financial Statement
Orange Inc. begins the fiscal year 2020 – 2021 with assets of P 17.205 million
consisting of cash for P 6.392 million and noncash assets for P 10.813 million.
These investment are financed with P 7.221 million from non owner and P
9.984 million from shareholders. The owner financing consist of contributed
capital of P 4.355 million, retained earning of P 5.067 million and other
stockholder’s equity of P22, million.

FIGURE 1.2 : shows statement of financial position at the beginning and end
of Orange Inc. The statement of cash flow explains how operating , investing
and financing activities increase the cash balance by P 2.960 million from P
6.392 million at the beginning of the year to P 9.352 million at the years-
end.
Orange Inc.’s P 3.496 million net income reported on the income statement
is also carried over to the statement of shareholder’s equity. The net income
explains nearly all of the change in retained earnings period in the statement
of shareholder’s equity because Orange Inc. paid no dividends in that year
( other adjustment reduced retained earnings by P.002 million )
There is an order to financial statement preparation . First , a company
prepares its income statement using the statement of comprehensive
income accounts. It then uses the net income number and dividend
information to update the retained earning account. Second , it prepare the
statement of financial position using the updated retained earning
account along with the remaining statement of financial position accounts
from the trial balance. Third, it prepare the statement of stockholder’s
equity. Fourth, it prepare the statement of cash flows using the information
from the cash account and other sources.
STATEMENT OF FINANCIAL POSITION
A Statement of financial Position reports a company’s financial position at a
point in time, the company’s resources ( asset) namely : , what the company
owns and also the sources of asset financing. There are two ways a company
can finance its asset.
1. Owner financing : it can raise money from stockholders.
2. Non owner financing : it can also raise money from banks or other creditor
and suppliers.
This mean that both owners and non owners hold claims on company assets.
Owners claims on asset are referred to as Equity, and non owner claims are
referred to as Liabilities, (or debt). Since all financing must be invested in
something we obtain the following basic relation (investing = financing). The
equality is called the accounting equation which follows: ( ASSETS = Liabilities +
owner’s equity)
Report amounts at a
point in time

Investing

Total Resources

Financing

Non owner claim on

resource

Owner claim on
resource
Financial statement titles sometimes begins with the word consolidated.
This mean that the financial statement includes a parent company and
one or more subsidiaries, companies that the parent company owns.

Investing activities

Statement of financial position is organized like the accounting equation .

Investing activities are represented by the company’s assets. These assets
are financed by a combination of non owner financing (liabilities ) and
owner financing ( equity)

Financing Activities
Asset must be paid for, and funding is provided by a combination of owner
and non owner financing. Owner (or equity) financing includes resources
contributed to the company by its owners along with any profit retained by
 the company. Nonowner (creditor or debt) financing is borrowed money. We
distinguish between these two financing source for a reason: borrowed money
entails a legal obligation to repay amount owed, and failure to do so can result
in severe consequence for the borrower. Equity financing entails no such
obligation for repayment.
o Most asset and liabilities are reported on the statement of financial position
at their acquisition price, called historical cost.

Working capital
Current assets are often called working capital because these assets “turn
over” that is , they are used and then replaced throughout the year.

Net working capital is the difference between current assets minus current
liabilities while net operating working capital is the difference between
current assets and non- interest bearing liabilities.
STATEMENT OF COMPREHENSIVE INCOME
The statement of Comprehensive income report on a company’s performance
over a period of time and list amount for revenues(also called sales), expenses
and other comprehensive income. Revenues less expenses yield the bottom
line net income amount.

REPORT AMOUNT OVER A PERIOD OF TIME

GOODS OR SERVICES PROVIDED TO

CUSTOMERS

COSTS INCURRED TO GENERATE REVENUES

 FIGURE 1.3 shows the company statement of comprehensive income. Refer to
its income statement to verify the following : revenues = P 236.490 million :
expenses = P210.064 million : and net income P26.426 million. Net income
reflects the profits ( also called earnings) to owners for that specific period.
Manufacturing and merchandising companies typically include an additional
expense account called cost of good sold ( or cost of sales), in the statement of
comprehensive income following revenues . It is also common to report a
subtotal called gross profit ( or gross margin), which is revenues less cost of good
sold. The company’s remaining expenses are then reported below gross profit.
This income statement layouts follows:

Revenues
- Cost of good sold Cost of materials , labor, and overhead

= Gross profit Revenue less cost of good sold

- expenses Expenses other than product cost of sales

= Net income (loss)

Operating Activities
Operating activities use company resources to produce, promote and sell its
products and services. These activities extend from input markets involving
suppliers of materials and labor to a company’s output markets involving
customers of products services. Input markets generate most expenses (or cost )
such as inventory , salaries, materials and logistics . Output markets generate
revenues( or sales) to customers. Output market also generate some expenses
such as , marketing and distributing products and services to customers. Net
income arises when revenues exceed expenses. A loss occurs when expenses
exceed revenues.
Difference exist in the relative profitability of companies across industries .
Although effective management can increase the profitability of a company ,
business models paly a large part in determining company profitability.
STATEMENT OF STOCKHOLDERS’ EQUITY
The statement of stockholders’ equity report on changes in key types of
equity over a period of time. For each type of equity, the statement reports
the beginning balance , a summary of the activity in the account during the
year and the ending balance.
Contributed capital represent the cash that the company received from the
sale of stock to stockholders( also called shareholders ), less any funds
expended for the repurchase of stocks. Retained earnings ( also called
earned capital or reinvested capital ) represent the cumulative total amount
of income that the company has earned and that has been retained in the
business and not distributed to shareholders in the form of dividends. The
change in retained earning links consecutive statement of financial position
via the income statement: Ending retained earnings = Beginning retained
earnings + Net income - Dividends .For the Blue Company ,its recent years
retained earnings increase from P 117.824 million to P144.306 million. This
increase of P 26.482 million is explained by net income of P 26.426 millions,
no payment of dividend and P0.056 related to a mandated accounting change.
STATEMENT OF CASH FLOWS
The statement of cash flows report the change ( either an increase or
decrease ) in a company’s cash balance over a period of time. The statement
report on cash inflows and outflows from operating, investing and financing
activities over a period of time.
 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 depend 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 statement 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 advantage ? Is it nearing the end of its life, trying to milk
what it can from stagnant product line?
 Outputs . What product does it sell? Are its product new , established or
dated, how complicated are its products to produce?
 Buyers . Who are its buyers? Are buyers in good financial condition ? Do
buyers have substantial purchasing power?
 Inputs . Who are its suppliers ? Are there many supply sources? Does
company depend on a few supply with potential for high inputs costs.
 Competition . In what kind market does it operate? Are market open? Is the
market competitive? How must it compete to survive?
 Labor . Who are the manager ? What are their background? Can they be
trusted? Are they competent?
 Financing . Must it seek financing from public markets? Is it going public?
Is it in danger of defaulting on debt covenants?
 Governance . How effective is its corporate governance? Does it have a
strong and dependent board of directors? Does management have a large
portion of its wealth tried to the company’s stock?
 Risk. Is it subject to lawsuits from competitors or shareholders? Is it under
investigation by regulators? Does it face environment and or political risks?

Basic of profitability analysis

The primary goal of financial management is to maximize shareholders;
wealth, not accounting measures such as net income or earning 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.
If the management is to maximize a firm’s value, it must take advantage of the
firms strength and correct its deficiencies and weaknesses.
Financial analysis involves
• Comparing the firm’s performance to that other firms in the same industry
• Evaluating trends in the firm’s financial position over time.
These studies help managers identify deficiencies and take position over time.
LIMITATION OF FINANCIAL STATEMENTS ANALYSIS
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 indicator of degree of profitability and financial strength of the firm.
2. Limitation inherent in the accounting data the analyst work with. These are
brought by among others. A. variation and lack of consistency in the
application of accounting principles, policies and procedure, B too
condensed presentation of data, and C. failure to reflect change in
purchasing power.
3. Limitation of the performance measure or tools and technique used in the
analysis. Quantitative measurements are not absolute measure but should be
interpreted relative to the nature of the business and in the light of past,
current and future operation. Timing of transaction and the use of average can
also affect the results obtained in applying the techniques in financial analysis.
4. Analyst should be alert to the potential for management to influence the
outcome of financial statements in order to appeal to creditor, investors and
other.

Limitation of analysis may be overcome to come extent by finding appropriate

benchmark used by most analyst such as the performance of comparable
component and the average performance of several companies in the same
industry.
FINANCIAL RATIO ANALYSIS
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
position and statement of comprehensive income of a business firm.

The ratio can be categorized as follows:

1. Liquidity ratios. These ratios gives 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. Goods 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 effect on return on equity.

5. Market book ratios . These ratios which consider the stock price give us
an idea of what investor think about the firm and its future prospects.
Market book ratios tell us what investors think about the company and its
prospects.
1.Analysis of liquidity or short –term solvency
Current ratio
Formula : Current asset
current Liabilities

2014 : 32,923
2.40 times
13,703.5

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 debt 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 might
 indicate an improving financial situation. The current ratio is useful but tricky
to interpret and therefore, the analyst must look closely at the individual assets
and liabilities involved .
Quick or Acid test ratio
Formula: Quick asset
Current liabilities

2014: 9,146.5
13,703.5 0.67 times

The acid test ( quick ) ratio is a much more rigorous test of a company’s ability to
meet its short term 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 .
II. Analysis of asset Liquidity and assets management Efficiency
Accounts Receivable Turnover
FORMULA : Net sale
Average Account Receivable Balance
2014 : 107,800
( 4,480 + 4,175) / 2 24.90 times

The accounts receivable turnover roughly measures how many times a

company’s account receivable have been turned in to cash during the year.

Average Collection period

Formula : 365 days / Account Receivable turnover

2014 : 365 days / 24.90 = 14.6 days or 15 days

The average collection period helps evaluate the liquidity of accounts
receivable and the firm’s credit policies. The long collection period may be as
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 explanation such as inventory caused by a depressed
economy.

The average collection period of accounts receivable is the average number of

days required to convert receivable into cash .
Inventory Turnover
Formula : Cost of good sold
Average inventory Balance
2014: 64,682
3.09. times
(23,520.5 + 18,384.5) / 2

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 the inventory on hand. The ratio is sometimes calculated
with net sales as the numerator and the average level of the inventory as the
denominator.
Average sale period
Formula: 365days
inventory turnover
2014: 365
118 DAYS
3.09
The number of days being taken to sell the entire inventory one time ( called
the leverage sale or conversion period ) is computed by dividing 365 sells the
fewer funds are tied up inventory and more profits are generated.
Fixed Asset Turnover
Formula: net sales
average net property ,plant, equipment
2014 : 107,800 8.97 times
(14,539.5 + 9,488.5)/2
The fixed asset turnover is a another approach to assessing management’s
effectiveness in generating sales from investments in fixed assets particularly
for a capital –intensive firm.
Total Asset Turnover
Formula : Net sales
Average Total Assets
2014: 107,800
(47,649 + 37,954.5) /2 2.52 times

The total asset turnover is a measure of the efficiency of the management to

generate sales and thus earn more profit for the firm. When the asset
turnover ratios are low relative to the industry or the firm’s historical record, it
could mean that either the investment in asset is too heavy or sales are
sluggish .
III. Analysis of leverage : Debt Financing and coverage
Debt Ratio
Formula : Total Liabilities
Total Assets
2014: 24,681.4 51.8%
47,649

The debt ratio measures the proportion of all assets that are financed with
debt. Generally, the higher the proportion of debt, the greater the risk
because creditors must be satisfied before owners in the event of bankruptcy.
The use of debt involves risk because debt carries a fixed obligation in the form
of interest charges and principal repayment. Failure to satisfy the fixed charges
associated with debt will ultimately result in bankruptcy.
Debt to Equity Ratio
Formula : Total Liabilities
Total Equity
2014: 24,681.5 107.46 %
22,967.5

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.
The debt to equity ratio measures the riskiness of the firm’s capital structure
in term of relationship between the funds supplied by creditors ( debt) and
investor ( equity).
Times interest Earned
Formula : Operating profit
Interest Expense
2014: 9,621.5
1,292.3 7.44 times

Times interest earned ratio is the most common measure of the ability of a
firm’s operations to provide protection to long – term creditor. The more times
a company can cover its annual interest expense from operating earnings, the
better off will be the firm’s investors.
IV. Operating Efficiency and profitability
Gross Profit Margin

Formula : Gross Profit

Net Sales
2014: 43,118
107,800

Gross profit margin which shows the relationship between sales and the cost
of product sold, measure the ability of a company both to control costs and
inventories or manufacturing of product and to pass along price increase
through sales to customers.
Operating Profit Margin
Formula : Operating Profit
Net sales
2014: 9,621.5
8.9%
107,800
The operating profit margin is a measure of overall operating efficiency and
incorporates all of the expenses associated with ordinary or normal business
activities .
Net Profit Margin
Formula: Net income
Net sales
2014: 4,697
4..36%
107,800
Net profit margin measure profitability after considering all revenue and
expenses ,including ,interest, taxes and non operating items such as
extraordinary items, cumulative effect of accounting change ,etc.
OTHER RATIOS USING ANALYSIS

RETURN ON SHAREHOLDERS INVESTMENT OR NET WORTH

FORMULA:RETURN ON SHAREHOLDERS INVESTMENT = ( NET

PROFIT (AFTER INTEREST AND TAX) / SHAREHOLDERS FUNDS X
100
EXAMPLE :
SUPPOSE NET INCOME IN AN ORGANIZATION IS P30,000 WHERE AS
SHAREHOLDERS INVESTMENT OR FUND ARE P 200,000
CALCULATIONS; RETURN ON SHAREHOLDERS INVESTMENT OR
FUND = (30,000/200,000)X100 = 15%
This means that the return on shareholders funds is 15 centavos per
peso

This ratio is one of the most important ratios used for

measuring the overall efficiency of the firm. The ratio is of
great importance to the present and prospective
shareholder as well as the management of the company .
This ratio reveals how well the resource of the firm are
being used and the higher the ratio, the better are the result
.
 Return on equity capital

FORMULA: RETURN IN EC = (NET PROFIT AFTER TAX-

PREFERENCE DIVIDEND ) / EQUITY SHARE CAPITAL )X 100

EXAMPLE :
EQUITY SHARE CAPITAL (P50):P500,000; 9% PREFERENCE SHARE
CAPITAL : P250,000; TAXATION RATE : 35 % OF NET PROFIT : NET
PROFIT BEFORE TAX: P200,000

CALCULATIONS; RETURN ON EQUITY RATIO =(200,000-70,000-

22,500)/500,000)X100= 21%
This ratio is more meaningful to the equity shareholders who are interested
to know profits earned by the company and those profits which can be
made available to pay dividends to them. The ratio is similar to the
interpretation of return on shareholder’s investment and the higher the ratio
the better it is

Dividend yield ratio

FORMULA: DIVIDEND YIELD RATIO = DIVIDEND PER SHARE /
MARKET VALUE PER SHARE

EXAMPLE :
If a company declares dividend at 10 % on its share, each having a
paid up the value of P4.00 and market value of P12.50
CALCULATIONS: DIVIDEND PER SHARE =(10(%ON SHARE)/100) X4=
P0.40
DIVIDEND YIELD RATIO (P0.40/12.50)X100 =3%

EARNING PER SHARE (EPS) RATIO

FORMULA: EARNING PER SHARE (EPS) RATIO = (NET PROFIT
AFTER TAX- PREFERENCE DIVIDEND)/ NO. OF EQUITY
SHARES(COMMON SHARES)

EXAMPLE :
EQUITY SHARE CAPITAL (P100): P1,000,000;9% PREFERENCE SHARE
CAPITAL :P 500,000; TAXATION RATE : 35% OF NET PROFIT;NET
PROFIT BEFORE TAX: P400,000
CALCULATIONS:EPS= (P400,000 -140,000-45,000) /(P1,OOO,OOO /
100)= P215,000 /10,OOO = P 21.50 PER SHARE

The earning per share is good measure of profitability and compared with
EPS of similar companies , it gives a view of the comparative earning
power of the firm
Tools ad technique of financial statement
Analysis
HORIZONTAL ANALYSIS OR TREND ANALYSIS

Comparison of two or more year’s financial data is known as horizontal

analysis or trend analysis. Horizontal analysis is facilitated by showing changes
between years in both peso and percentage form.
 Summary of significance of Financial ratios
Current ratio = primary test of solvency to meet current obligations from
current assets as a going concern, measure of adequacy or working capital.
Acid – test ratio or quick ratio= a more serve test of immediate solvency test
of ability to meet demands from current assets.
Trade receivable turnover = velocity of collection of trade accounts and notes,
test efficiency od collection.
Average collection period or number of days sales uncollected= evaluate the
liquidity of accounts receivable and the firm’s credit policies.

Inventory turnover = measures efficiency of the firm in managing and selling

inventories.
Debt ratio = shows proportion of all assets that are financed with debt.
Equity ratio = indicates proportion of assets provided by owners. Reflects
financial strength and caution to creditors.
Gross profit margin = measures profits generated after consideration of cost
of product sold
Operating profit margin = measures profits generated after consideration of
operating costs.
Net profit margin = measures profits generated after consideration of all
expenses and revenues.
Rate of return on asset = measures overall efficiency of the firm in managing
assets and generating profits.
Rate of return on equity = measure rate of return on resources provided by
owners.
Earning per share = peso return on each ordinary share. Indicative of ability to
pay dividends

Price earning ratio = measure relationship between price of ordinary share in

the open market and profit earned on a per share basis.

Dividend yield ratio = shows the rate earned by shareholders from dividends
relative to current price od stock.

Dividend per share = shows portion income distributed to shareholders on a

per share basis.
HORIZONTAL ANALYSIS OR TREND
ANALYSIS
Horizontal analysis of financial statement can be also be carried out by
computing trend percentage . Trend percentage states several years
financial data in terms of a base year. The base year equal 100% , with all
other years stated in some percentage of this base .
VERTICAL ANALYSIS
Vertical analysis is the procedure of preparing and presenting common size
statement. Common size statement is one that shows the items appearing
on it in percentage form as well as in peso form. Each items is stated as a
percentage of some total of which that item is a part. Key financial
changes and trend can be highlighted by the use of common size
statement.
VERTICAL ANALYSIS FOR BALANCE SHEET
 USES OF FINANCIAL STATEMENT ANALYSIS

Trends

The results given in generally cover at least the previous three

full accounting years therefore any fluctuation in any area can
be easily pinpointed .
BENCHMARKS

The average result for each ratio together with the industry
profile of the average company in the sector can both be
used as benchmarks to compare individuals company
performance.
SIZE
All the major companies in the sector are ranked on the basis of sales , profits,
total asset and employee numbers. The largest and smallest of the key players
can be easily identified , while the relative size of any company can be
assessed.

GROWTH
The average annual growth of each company’s sales ,
profits , total assets and number of employees over the three
– years periods being analyzed is calculated and ranked.
COMPETITOR ANALYSIS

The depth of financial analysis provided on each company in each report

offer you a comprehensive insight into the performance of individuals
businesses over recent years .
ADVANTAGES OF FINANCIAL STATEMENT
ANALYSIS
FIRST: The investor get enough idea to decide about the investment of their
funds in the specific company.
SECONDLY : regulatory authorities like International Accounting Standards .Board can
ensure whether the company is following accounting standards or not.
Thirdly : financial statement analysis can be help the government agencies to
analyze the taxation due to the company .
 LIMITATION OF FINANCIAL STATEMENTS ANALYSIS
A. COMPARISON OF FINANCIAL DATA

Comparison of the company with another can provide valuable clues about
the financial health of an organization. Unfortunately, difference in accounting
methods between companies sometimes make it difficult to compare the
companies’ financial data.
B. The Need to look Beyond Ratios
An inexperienced analyst may assume that ratios are sufficient in themselves as
a basis for judgment about the future . Nothing could be further from the truth.
Conclusion based on ratios analysis must be regarded as tentative. Ratios
should not be viewed as an end , but rather they should be viewed as starting
point , as indicator of what pursue in greater depth. They raise many
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 relationship 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:

ROE = net income net income sales average total

average stockholders sales average asset
equity total assets average
stockholders
Profit margin Asset turnover equity ’
Financial leverage
These three component 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 it profit margin by increasing its
gross profit (gross profit / sales), and or by reducing its expenses ( other
that 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 it asset turnover by increasing sales volume with no increase
in asset and or by reducing asset investment without reducing sales.
3. Financial leverage measure that 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 increase ROE (when performance is positive), debt must be used
with care as it increase the company’s relative riskness.
The profit margin and asset turnover relates the company operation and
combine to yield on asset ( ROA) as follow:

Net income Net income Sales

ROA Average total

Sales
Average total
asset asset

Profit margin Asset turnover

Return on Asset ( ROA)

Return on asset measure the return on investment for the company without
regard to hoe it is financed ( relative proportion of debt and equity in its
capital structure). Operating managers of a company typically grasp the
income statement.
The ROA approach to performance measurement encourage managers to also
focus on the returns that they achieve from the invested capital under their
control. Those return 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
benchmark 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. Two general areas of profitability analysis are.
• Gross profit margin. It measure 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 product 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(
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.
• Decrease the investment in asset without reducing sales volume.

End