Review of Financial Statement

Preparation, Analysis, and

Interpretation (Parts 5 & 6)

Week 8
Part 5 (Efficiency)
Efficiency
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.
efficiency ratios:
• •Accounts receivable turnover
• •Average collection period, otherwise known as
the average age of AR, days’ receivable, or days
sales outstanding
• •Inventory turnover
• •Average age of inventory or days’ inventory
•Average age of inventory or days’ inventory
•Accounts payable turnover
•Average age of payables, average payment period, or
days payable
 •Total asset turnover
 •Operating cycle
•Cash conversion cycle
Formulas:
Account Payable Turnover Formula:

A/P turnover = COGS/Purchase

 Accounts Receivables
Note: To compute for Operating Cycle
= Average Collection Period + Average Age
of Inventory

 +
 Compute for the following ratio using the sample company
Statement of F/S as of December 31, 2014
 Accounts receivable turnover:
 •Average collection period:
 •Inventory turnover:
 •Average age of inventory:
 •Accounts payable turnover:
 •Average payment period:
 •Total asset turnover:
 •Operating cycle:
 •Cash conversion cycle:
Questions:

1. Are high turnover ratios good or bad?

2. If company A has an accounts receivable
turnover of 3.5 while company B has an
accounts receivable turnover of 8.1, which
is a better company? Explain why.
3. What factors affect the inventory turnover
ratio?
4. What factors affect the accounts payable
turnover ratio?
5. Does a shorter or a longer operating cycle
indicate the efficiency of a business? What about
the cash conversion cycle?
 compute the following ratios of the
sample companies:
A. Average collection period
B. Average age of inventory
C. Average payment period
D. Operating cycle
E. Cash conversion cycle
 JFC Petron Globe
Average collection period
Average age of inventory
Average payment period
Operating cycle
Cash conversion cycle
 Part 6
(financial leverage)
Financial leverage refers to the
company’s use of debt. It defines the
company’s capital structure which
indicates how much of the total assets
are financed by debt and equity.
scenario/case
 •Pam has a small restaurant business with current equity of
PHP60,000. With the increasing demand, she is planning to
expand her restaurant space. After much analysis she
determined that an initial investment of PHP50,000 in fixed
assets is necessary. These funds can be obtained in either of two
ways. The first is the no-debt plan, under which she would ask a
relative to become an investor (owner) by investing the full
PHP50,000. The other alternative, the debt plan, involves
borrowing PHP50,000 from the nearby rural bank at 10% annual
interest.
 types of leverage ratios

1. Debt ratio – This ratio

measures the proportion of total
assets financed by total liabilities
or money provided by creditors
(not by the business owners).
2. Debt-to-equity ratio –
A variation of the debt ratio,
shows the proportion of debt to
equity.
3. Interest coverage ratio –
This ratio shows the company’s ability
to pay its fixed interest charges in
relation to its operating income or
earnings before interest and taxes.
Formula:
Another name for the interest
coverage ratio is Times Interest
Earned.
Compute the ratios of the
sample financial statement.
Debt Ratio
Debt-to-Equity Ratio
Interest coverage ratio
Capital Structure refers to the specific mix
of debt and equity used to finance a
company's assets and operations. From a
corporate perspective, equity represents a
more expensive, permanent source of
capital with greater financial flexibility.
 The following are just some of the factors that can influence
management’s decision in setting its capital structure.

•Nature of Business
 If the business is a risk then it has to
be financed conservatively hence, a
lower debt ratio.
State of Business Development – A
newly formed business may have
difficulty borrowing from banks. Banks
usually look for the historical financial
performance of borrowers.
Macroeconomic conditions – If the
overall economy is good then
management can be more aggressive
in taking in risk through increased debt
financing.
Prospects of the industry – A
growing industry makes businesses
more confident to take on more
financial risk.
Taxes - Interest expenses are tax
deductible while cash dividends are not. By
having more debt than equity, businesses
save on taxes as interest expense
(multiplied by the tax rate) decreases
income tax due.
Management style –
Management and the board of
directors can be aggressive or
conservative in terms of taking on
risk.
Questions:

1. Compute the ratios of the sample

companies and ask them to compare the
three companies using the ratios computed.
2. What are the possible reasons why
the sample companies have debt
ratios?
 Activity 8 (30 pts.)
1. In starting a business, is it okay to start with
having debt during the early stages?
2. What dictates the company’s choice of
leverage structure?
3. Give one factor that can influence
management’s decision in setting its capital
structure and explain.