Handout 7 - Business Finance

Business Finance Frederick Alfred D.
Abao, CPA
II – CTHM Handout 7
Financial Analysis
The purpose of financial analysis is to diagnose the current and past financial condition of the firm to give some clues about
its future condition. The output of financial analysis is a useful tool in decision-making. It may be defined as the process of
interpreting the past, present, and future financial condition of the company.
 Types of Analysis
1. Single-period analysis – comparisons and measurements based upon the financial data of a single period.
2. Comparative or trend analysis – compares and measures items on the financial statements of two or more
fiscal periods.
Financial Ratios
The relationship between two quantities on a firm’s financial statements, which is derived by dividing one quantity by
another.
 Functions of Financial Ratios

 As a starting point for detailed financial analysis
 To help diagnose a situation
 To monitor performance
 To help plan forward
 The reduce the amount of data to workable form and to make the data more meaningful
 Classes of Financial Ratios

1. Liquidity – refers to the ability of the firm to pay its bills on time or to meet its current obligations.
 Current ratio – indicates the margin of safety by which a firm can meet its obligations falling due
within the year from such assets easily convertible into cash within the year.
Formula: Current ratio = Current Assets/Current Liabilities
 Acid Test Ratio – also called the quick ratio, is the ratio of cash assets to current liabilities. It is
calculated by excluding inventories from current assets and dividing the remainder by current
liabilities.
Formula: Acid test ratio = Current Assets minus Inventories/Current Liabilities
2. Activity - to measure how effectively the firm employs the resources at its command.
 Receivable turnover – velocity of collection of trade receivables; test of efficiency of collection
Formula: Receivable turnover = Net credit sales/Average Trade Receivables
 Inventory turnover – Measures efficiency of the firm in managing and selling inventories
Formula: Inventory turnover = Cost of Goods Sold/Average Merchandise Inventory
 Inventory to Net Working Capital Ratio – shows the proportion of net current assets tied up in
inventory, indicating the potential loss to the company in the event of decline in inventory values.
Formula: Inventory to net working capital ratio = Inventories/Current assets minus current
liabilities
3. Profitability – ratios that measure management’s effectiveness as shown by returns generated on sales and
investment.
 Profit Margin – measures profit generated after consideration of all expenses and revenues.
Formula: Profit margin = Net income/Sales
 Return on equity – measures the rate of return on the owner’s investments.
Formula: Return on Equity = Net income/Average Net Worth/Equity
 Return on Assets – Measure the return on total investment in the firm.
Formula: Return on Assets = Net income/Average Total Assets
4. Solvency – refers to the ability of the firm to pay its debt eventually, if it is not paid in time.
 Debt to Net Worth Ratio – shows the relative proportion of debt to equity. In effect, it measures
the debt exposure of the firm.
Formula: Debt to Net Worth Ratio = Total liabilities/Total Net Worth/Equity
 Debt Ratio – Proportion of all assets that are financed by debt.
Formula: Total liabilities/Total Assets
Sample Problem
ILLUSTRATIVE BALANCE SHEETS
ABAO CORPORATION
Balance Sheet as of
December 31, 2017 and 2018
2017 2018
ASSETS
Current Assets:
Cash P 87,700,000 P 110,900,000
Accounts Receivable 92,600,000 146,200,000
Inventories 88,800,000 129,500,000
Prepaid Expenses 2,800,000 6,200,000
Advances from customers 5,300,000 2,800,000
Total Current Assets 272,200,000 395,600,000
Property, plant, and equipment (net) 114,000,000 163,800,000
Other Assets 3,100,000 4,200,000
TOTAL ASSETS P389,300,000 P563,600,000
LIABILITIES AND NET WORTH

Current Liabilities:
Accounts Payable P 43,400,000 P 62,900,000
Income Tax Payable 36,700,000 44,000,000
Accrued pension and profit sharing 27,100,000 38,400,000
Other Accruals 21,900,000 31,200,000
Current portion of long-term debt 2,100,000 -
Total Current Liabilities 131,200,000 176,500,000
Debentures (9% due 2025) - 94,000,000
Other Long-term debt 7,800,000 4,100,000
Deferred Income Tax 5,200,000 7,600,000
Common Stock (P1.00 par) 10,100,000 10,200,000
Paid-in Surplus 25,100,000 27,200,000
Retained Earnings 209,900,000 224,000,000
TOTAL LIABILITIES AND NET WORTH P389,300,000 P563,600,000
ILLUSTRATIVE INCOME STATEMENTS
ABAO CORPORATION
Income Statement
For the Years Ending
December 31, 2017 and 2018
2017 2018
Net Sales P655,100,000 P872,700,000

Cost of Goods Sold 460,900,000 616,100,000
Gross Profit 194,200,000 256,600,000
Selling, General and Administrative Expenses 98,300,000 125,200,000
Employee Profit Sharing and Retirement 26,900,000 38,700,000
Operating Profit 69,000,000 92,700,000
Other Income 1,100,000 1,800,000
Interest Paid 1,000,000 7,400,000
Provision for Income Taxes 31,800,000 40,100,000
Net Profit P 37,300,000 P 47,000,000
Compute for the following:

1. Current ratio
2. Acid Test Ratio
3. Receivable Turnover
4. Inventory Turnover
5. Debt Ratio
6. Profit Margin
7. Debt Ratio
8. Debt to Net Worth Ratio
9. Return on Equity
10. Return on Assets
11. Profit Margin

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Business Finance Frederick Alfred D.

 Functions of Financial Ratios

 Classes of Financial Ratios

Formula: Current ratio = Current Assets/Current Liabilities

Formula: Acid test ratio = Current Assets minus Inventories/Current Liabilities

 Receivable turnover – velocity of collection of trade receivables; test of efficiency of collection

Formula: Receivable turnover = Net credit sales/Average Trade Receivables

Formula: Inventory turnover = Cost of Goods Sold/Average Merchandise Inventory

Formula: Profit margin = Net income/Sales

 Return on equity – measures the rate of return on the owner’s investments.

Formula: Return on Equity = Net income/Average Net Worth/Equity

 Return on Assets – Measure the return on total investment in the firm.

Formula: Return on Assets = Net income/Average Total Assets

Formula: Debt to Net Worth Ratio = Total liabilities/Total Net Worth/Equity

 Debt Ratio – Proportion of all assets that are financed by debt.

Formula: Total liabilities/Total Assets

ILLUSTRATIVE BALANCE SHEETS

LIABILITIES AND NET WORTH

ILLUSTRATIVE INCOME STATEMENTS

Net Sales P655,100,000 P872,700,000

Compute for the following:

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