CHAPTER 6

Financial statement analysis- is the process of extracting information from financial statements to
understand company’s performance and financial condition.
Quality analysis- depends on an effective business analysis.
Financial analysis- involves comparing the firm’s performance to that of other firms in the same industry
and evaluating firm’s financial position over time.
Financial Ratio- comparison in fraction, proportion, decimal or percentage
Liquidity ratios- idea of the firm’s ability to pay off debts that are maturing within a year
Asset management ratios – idea how efficiently the firm is using its assets
Debt management ratios- how the firm has financed its assets as well as the firm’s ability to repay its
long-term debt. Indicate how risky the firm is and how much of its operating income must be paid to
bodholders.
Profitability- how profitability the firm is operating and utilizing its assets
Market book ratios- consider the stock price give us an idea of what investors think about the firm.
Current ratio- test of solvency to meet current obligation, widely regarded as measure of short-term debt
paying ability.
Current liabilities- are used as the denominator because they are considered to represent the most urgent
debts
Declining ratio – could indicate a deteriorating financial condition
Increasing ratio- might be the result of an unwise stock piling of inventory
Acid-test ratio or quick ratio- more severe test of immediate solvency, is as much more rigorous test of
a company’s ability to meet its short-term debts.
Working capital to total assets- relatives liquidity of total assets
Cash flow liquidity ratio- measures short-term liquidity by considering as cash resources, considers cash
flow from operating activities in addition to the truly liquid assets, cash and marketable securities.
Defensive interval ratio- Measures length of time in days.
Trade receivable turnover- velocity of collection of trade accounts and notes
Average collection period or number of days’ sales uncollected- liquidity of accounts receivable
Merchandise turnover- measures efficiency of the firm in managing and selling inventories.
Finished goods inventory- do
Goods in process turn over- measures efficiency of the firm in managing and selling inventories
Raw materials turnover- number of times raw materials inventory was used.
Days supply in inventory- average number of days to sell
Working capital turnover- adequacy and activity of working capital
Percent of each current asset to total current assets- Indicates relative investment in each current asset.
Current assets turnover- Movement and utilization of current resources
Payable turnover- efficiency of the company in meeting trade payable
Operating Cycle- length of time required to convert cash to FG
Days Cash- Availability of cash to meet average daily cash requirement
Free Cash flow- excess of operating cash flow over basic needs
Investment or assets turnover- measures efficiency of the firm in managing all assets.
Sales to fixed assets- test roughly the efficiency of management in keeping plant properties.
Capital intensity ratio- measures efficiency of the firm to generate sales
Debt Ratio- proportion of all assets that are financed with debts
Equity ratio- proportion of assets provided by owners
Debt to equity- Measures debt
Fixed Assets to long-term liabilities- reflects extent investment in long term
Fixed assets to total equity- measures the proportion of owners’ capital invested in fixed assets.
Fixed assets to total equity- measures investment in long-term capital assets.
Book value per share of ordinary shares- Measures recoverable amount in the event of liquidation if
assets are realized at their book values.
Times interest earned- measures how many times interest expense is covered by operating profit.
Times preferred dividend requirement earned- Indicates ability to provide dividends for preference
shareholders.
Times fixed changes earned- Measures coverage capability more broadly than times interest earned by
including other fixed charges.
Gross profit margin- measures profit generated after consideration of cost of product sold.
Operating profit margin- Measures profit generated after consideration of operating costs.
Net profit margin- Measures profit generated after consideration of all expenses and revenues.
Cash flow margin- measures ability of the firm to translate sales to cash
Rate of return on equity- measures rate of return on resources provided by owners.
Sinking fund payment before taxes=sinking fun payment after taxes/1-Tax rate
Earnings per share- peso return on each ordinary share
Price/earnings ratio- measures relationship between price of OS in open market
Dividend payout-shows percentage of earnings paid to shareholders.
Dividend Yield- shows rate earned by shareholders
Dividends per share- shows portion of income distributed to shareholders.
Rate of return on average current assets- profitability of current assets invested
Rate of return per turnover of current assets- profitability of each turnover of current assets
Liquidity ratios- ability to meet cash needs as they arise A/P. bank loans and Operating Cost
Activity ratios- liquidity of specific assets and efficiency in managing assets as AR, inventory and fixed
assets.
Leverage ratios- extent of a dirm’s financing with debt relative to equity and its ability to cover interest
Profitability ratios- measures overall performance of the firm and efficiency in managing A,L,E
Accounts Receivable turnover- AR turns into cash

REVIEW QUESTIONS AND PROBLEMS

1. Financial ratio analysis is conducted by three main groups of analysts: credit analysts, stock
analysts and managers. What is the primary emphasis of each group, and how would that
emphasis affects the ratios they focus on?
ANSWER:

The emphasis of the various types of analysts is by no means uniform nor should it be.
Management is interested in all types of ratios for two reasons. First, the ratios point out
weaknesses that should be strengthened; second, management recognizes that the other
parties are interested in all the ratios and that financial appearances must be kept up if the firm
is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are
interested primarily in profitability, but they examine the other ratios to get information on the
riskiness of equity commitments. Credit analysts are more interested in the debt, TIE, and
 EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors emphasize
liquidity and look most carefully at the current ratio.

2. Why would the inventory turnover ratio be more important for someone analyzing a
grocery store chain than an insurance company?
ANSWER:

The inventory turnover ratio is important to a grocery store because of the much larger
inventory required and because some of that inventory is perishable. An insurance company
would have no inventory to speak of since its line of business is selling insurance policies or
other similar financial products—contracts written on paper and entered into between the
company and the insured. This question demonstrates that the student should not take a
routine approach to financial analysis but rather should examine the business that he or she is
analyzing.

3. Profit margins and turnover vary from one industry to another. What differences would
you expect to find between the turnover ratios, profit margins, and DuPont equations for
grocery chain and a steel company?
ANSWER:

Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover
ratios to vary among industries. For example, a steel company needs a greater number of
dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins
and turnover ratios may vary due to differences in the amount of expenses incurred to produce
sales. For example, one would expect a grocery store chain to spend more per dollar of sales
than does a steel company. Often, a large turnover will be associated with a low profit margin,
and vice versa.

4. If a firm’s ROE is low and management wants to improve it, explain how using more debt
might help.
ANSWER:

ROE is calculated as the return on assets multiplied by the equity multiplier. The equity
multiplier, defined as total assets divided by common equity, is a measure of debt utilization;
the more debt a firm uses, the lower its equity, and the higher the equity multiplier. Thus, using
more debt will increase the equity multiplier, resulting in a higher ROE.

5. Explain in general terms the concept of return on investment. Why is this concept
important in the analysis of financial performance?
ANSWER:
Return on investment relates to income earned on the capital invested in the business firm.
Unsatisfactory ROI could possibly lead to withdrawal of capital provided by investors which
could result to the demise of the business.
6. a. Explain how an increase in financial leverage can increase a company’s ROE.
ANSWER:
At an ideal level of financial leverage, a company's return on equity
increases because the use of leverage increases stock volatility, increasing its level
of risk which in turn increases returns. However, if a company is financially over-
leveraged a decrease in return on equity could occur.

b. Given the potentially positive relation between financial leverage and ROE, why don’t we
see companies with 100% financial leverage (entirely nonowner financed)?
ANSWER:
Using debt to finance 100% company operation is not a good business management practice
because unlike equity, debt must at some point be repaid with interest. Companies with high
cost of servicing debt find it difficult to grow

7. When might a reduction in operating expenses as a percentage of sales denote a short-term

gain at the cost of long-term performance?
ANSWER:
 when a company decide to manage expenses by not investing in R & D, marketing and sales
activities of its business
8. Explain the concept of liquidity and why it is crucial to company survival.
ANSWER:
Liquidity is the firm’s ability to meet cash needs as they arise such as payment of accounts
payable, bank loans and operating expenses. Liquidity is crucial to the firm’s survival because if
the company is unable to fulfill its obligations, operations could be disrupted that could result to
its closure

9. If we divide users of ratios into short-term lenders, long-term lenders and stockholders,
which ratios would each group be most interested in, and for what reasons?
ANSWER:

Short-term lenders – liquidity because their concern is with the firm’s ability to pay short-term
obligations as they come due.

Long-term lenders – leverage because they are concerned with the relationship of debt to total
assets. They also will examine profitability to insure that interest payments can be made.

Stockholders – profitability because they are concerned with the secondary consideration given
to debt utilization, liquidity and other ratios. Since stockholders are the ultimate owners of the
firm, they are primarily concerned with profits or the return on their investment.

10. If the accounts receivable turn-over ratio is decreasing, what will be happening to the
average collection period?
ANSWER:

If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a
longer period of time. This means the average collection period will be increasing.

11. What advantage does the fixed charge coverage ratio offer over simply using times interest
earned?
ANSWER:

The fixed charge coverage ratio measures the firm’s ability to meet all fixed obligations rather
that interest payments alone, on the assumption that failure to meet any financial obligation will
endanger the position of the firm.

12. Is there any validity in rule-of-dumb ratios for all corporations, for example, a current ratio
of 2 to 1 or debt to assets of 50 percent?
ANSWER:
No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between
industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do
offer some initial insight into the operations of the firm, and when used with caution by the
analyst can provide information
13. Inflation can have significant effects on income statements and statement of financial
positions, and therefore on the calculation of ratios. Discuss the possible impact of inflation
on the following ratios, and explain the direction of the impact based on your assumptions.
a. Return on investment
ANSWER:

Return on investment = Net income/Total assets

Inflation may cause net income to be overstated and total assets to be understated. Too
high a ratio could be reported.

b. Inventory turnover
ANSWER:

Inventory turnover = Sales/Inventory

 Inflation may cause sales to be overstated. If the firm uses FIFO accounting,
inventory will also reflect “inflation-influenced” pesos and the net effect will be nil.
If the firm uses LIFO accounting, inventory will be stated in old pesos and too high a
ratio could be reported.
c. Fixed asset turnover
ANSWER:

Fixed asset turnover = Sales/Fixed assets

Fixed assets will be understated relative to sales and too high a ratio could be
reported.

d. Debt-to-assets ratio
ANSWER:

Debt to total assets = Total debt/Total assets

Since both are based on historical costs, no major inflationary impact will take place
in the ratio
14. What effect will disinflation following a highly inflationary period have on the reported
income of the firm.
ANSWER:
Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the
firm’s income statement. This is particularly true for firms in highly cyclical industries where
prices tend to rise and fall quickly.
15. Why might disinflation prove to be favorable to financial assets?
ANSWER:
Because it is possible that prior inflationary pressures will no longer seriously impair the
purchasing power of the peso. Lessening inflation also means that the required return that
investors demand on financial assets will be going down, and with this lower demanded return,
future earnings or interest should receive a higher current evaluation.

CHAPTER 7
Cash debt coverage ratio- information on financial flexibility
Free cash flow- more sophisticated way to examine a company’s financial flexibility
Cash Equivalents- short-term highly liquid investments such as treasury bills, SEC registered.
Operating activities-delivering or producing goods for sale and providing services.
Investing activities- acquiring and selling or otherwise disposing of activities
Financing activities- borrowing from creditors and repaying the principal
Direct method- operating activities enterprises are encouraged to report major classes of gross cash
receipts and gross cash payments
Indirect method- Enterprises choose not to provide major classes of operating cash receipts and
payments by direct method.
REVIEW QUESTIONS:
1. Explain how depreciation generates actual cash flows for the company?
ANSWER:

The only way depreciation generates cash flows for the company is by serving as a tax shield
against reported income. This non-cash deduction may provide cash flow equal to the tax rate
times the depreciation charged. This much in taxes will be saved, while no cash payments occur.

2. What is the difference between net cash flow from operating activities, net cash flow from
investing activities and net cash flow from financing activities?
ANSWER:

Cash Flows from Operating Activities

Cash flows from operating activities arise from the activities a business uses to produce net
income. For example, operating cash flows include cash sources from sales and cash used to
purchase inventory and to pay for operating expenses such as salaries and utilities.

Cash Flows from Investing Activities

Cash flows from investing activities are cash business transactions related to a

business’ investments in long-term assets. They can usually be identified from
changes in the Fixed Assets section of the long-term assets section of the balance
sheet. Some examples of investing cash flows are payments for the purchase of
land, buildings, equipment, and other investment assets and cash receipts from the
sale of land, buildings, equipment, and other investment assets.

Cash Flows from Financing Activities

Cash flows from financing activities are cash transactions related to the business

raising money from debt or stock, or repaying that debt. They can be identified
from changes in long-term liabilities and equity. Examples of financing cash flows
include cash proceeds from issuance of debt instruments such as notes or bonds
payable, cash proceeds from issuance of capital stock, cash payments for dividend
distributions, principal repayment or redemption of notes or bonds payable, or
purchase of treasury stock

3. What are the free cash flows for a firm? What does it mean when a firm’s free cash flow is
negative?
Free cash flow to the firm (FCFF) represents the cash flow from operations available
for distribution after accounting for depreciation expenses, taxes, working capital, and
investments. ... A negative value indicates that the firm has not generated enough
revenue to cover its costs and investment activities.
A positive FCFF value indicates that the firm has cash remaining after
expenses.
CHAPTER 8
Leverage- represent use of fixed costs items to magnify the firm’s results.
CVP ANAYSIS- cost-volume profit- powerful tool and vital in many business decisions because it helps
managers understand the relationships among costs
Contribution margin per unit or marginal income per unit- excess of unit selling price over unit
variable cost and the amount each unit sold contributes toward.
CM per unit=Unit SP- Unit VC
Contribution margin ratio- percentage of contribution margin to total sales-
CM ratio= CM/Sales
Break-even point- level of sales volume where total revenues and total expenses are equal.
Sales Mix- refers to the relative proportions in which a company’s products are sold.
Operating leverage- measure of how sensitive net operating income is to a given percentage change peso
sales.
Degree of operating leverage- measure at a given level of sales, of how a percentage change in sales
volume will affects profits.
Degree of operating leverage- also viewed as the percentage change in operating income
Financial leverage- reflects the amount of debt used in the capital structure of the firm. Affecting the left
hand side of statement of financial position.
Degree of financial leverage-the effect of a change in one variable to another variable. Percentage
change in earnings
Degree combined leverage- use the entire income statement shows the impact of a change in sales or
volume on bottom line earnings per share.

REVIEW QUESTIONS:
1. What is meant by a product’s contribution margin ratio? How is this ratio useful in
planning business operations?
The contribution margin (CM) ratio is the ratio of the total contribution margin to total sales
revenue. It can be used in a variety of ways. For example, the change in total contribution margin
from a given change in total sales revenue can be estimated by multiplying the change in total
sales revenue by the CM ratio. If fixed costs do not change, then a dollar increase in contribution
margin results in a dollar increase in net operating income. The CM ratio can also be used in
target profit and break-even analysis.

2. Often the most direct route to a business decision is an incremental analysis. What is meant
by an incremental analysis?

Incremental analysis focuses on the changes in revenues and costs that will result from a
particular action.

3. What is meant by the term operating leverage?

Operating leverage measures the impact on net operating income of a given percentage change in
sales. The degree of operating leverage at a given level of sales is computed by dividing the
contribution margin at that level of sales by the net operating income at that level of sales.

4. What is meant by term break-even point?

The break-even point is the level of sales at which profits are zero.

5. In response to a request from your immediate supervisor, you have prepared a CVP graph
portraying the cost and revenue characteristics if your company’s product and operations.
Explain how the lines on the graph and the break-even point would change if (a) the selling
price per unit decreased. (b) fixed cost increased throughout the entire range of activity
portrayed on the graph, and (c) variable cost per unit increased.
(a) If the selling price decreased, then the total revenue line would rise less steeply, and the break-
even point would occur at a higher unit volume. (b) If the fixed cost increased, then both the fixed
cost line and the total cost line would shift upward and the break-even point would occur at a
higher unit volume. (c) If the variable cost increased, then the total cost line would rise more
steeply and the break-even point would occur at a higher unit volume.

6. What is meant by the margin of safety?

The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of
sales. It states the amount by which sales can drop before losses begin to be incurred.

7. What is meant by the term sales mix? What assumption is usually made concerning sales
mix in CVP analysis?
The sales mix is the relative proportions in which a company’s products are sold. The usual
assumption in cost-volume-profit analysis is that the sales mix will not change.

8. Explain how a shift in the sales mix could result in both a higher break-even point and
lower net income.
A higher break-even point and a lower net operating income could result if the sales mix shifted
from high contribution margin products to low contribution margin products. Such a shift would
cause the average contribution margin ratio in the company to decline, resulting in less total
contribution margin for a given amount of sales. Thus, net operating income would decline. With
a lower contribution margin ratio, the break-even point would be higher because more sales
would be required to cover the same amount of fixed costs.

9. What factors would a case a difference in the use of financial leverage for a utility company
and an automobile company?
 A utility is in a stable, predictable industry and therefore can afford to use more financial
leverage than an automobile company, which is generally subject to the influences of the
business cycle. An automobile manufacturer may not be able to service a large amount of debt
when there is a downturn in the economy.

10. Explain how the break-even point and operating leverage are affected by the choice of
manufacturing facilities (labor intensive, versus capital intensive).
A labor-intensive company will have low-fixed costs and a correspondingly low break-even point.
However, the impact of operating leverage on the firm is small and there will be little
magnification of profits as volume increases. A capital-intensive firm, on the other hand, will
have a higher break-even point and enjoy the positive influences of operating leverage as
volume increases.

11. What role does depreciation play in break-even analysis based on accounting flows? Based on
cash flows? Which perspective is longer term in nature?
For break-even analysis based on accounting flows, depreciation is considered part of fixed
costs. For cash flow purposes, it is eliminated from fixed costs. The accounting flows perspective
is longer-term in nature because we must consider the problems of equipment replacement.

12. What does risk taking have to do with the use of operating and financial leverage?
Both operating and financial leverage imply that the firm will employ a heavy component of
fixed cost resources. This is inherently risky because the obligation to make payments remains
regardless of the condition of the company or the economy.

13. Discuss the limitations of financial leverage.

Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall
costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The
limitations of using financial leverage tend to be the greatest in industries that are highly cyclical
in nature.

14. How does interest rate on new debt influence the use of financial leverage?
The higher the interest rate on new debt, the less attractive financial leverage is to the firm.

15. Explain how combined leverage brings together operating income and earning sper share.
Operating leverage primarily affects thee operating income of the firm. At this point, financial
leverage takes over and determines the overall impact on earnings per share.

16. Explain why operating leverage decreases as a company increases sales and shifts away from
the break-even point.
At progressively higher levels of operation than the break-even point, the percentage change in
operating income as a result of a percentage change in unit volume diminishes. The reason is
primarily mathematical - as we move to increasingly higher levels of operating income, the
percentage change from the higher base is likely to be less.

17. When you are considering two different financing plans, does being at the level where
earnings per share are equal between the two plans always mean your are indifferent s to
which plan is selected?
The point of equality only measures indifference based on earnings per share. Since, our
ultimate goal is market value maximization; we must also be concerned with how these earnings
are valued. Two plans that have the same earnings per share may call for different price-
earnings ratios, particularly when there is a differential risk component involved because of
debt.
PREAMBLE
This code of Ethics has been formulated impelled by the belief that man has a dignity that must
be respected, and that all the resource of the earth has been created for the growth and
development.

As here presented, this Code is considered a major step in the on-going and changing process of
understanding the growing role of business activity in the development of man and, as much, is
open to further improvement.

The Code seeks to express systematically and coherently the principles of business practices
accepted and professed by the Philippine business at its best, and seeks to apply these to current
and changing needs.
It is the hope that this Code will serve as a general stimulus to renew and develop or amend
existing standards, and that individual entities will expand and adopt it to the specific needs of
their own organizations.

It is general Code intended to be influential rather than coercive. It is hoped that individual
entities will consciously adopt and embrace it as a statement of principles and, having done so,
will be unwilling to incur the sanction of adverse public opinion through failure to live up to
Code.

Finally, it is Code for all people, formulated on the premise that the modern manager must be a
strategist for human development, and that the business of business is to build an enterprise
oriented to the development of man.