Financial Statement and Ratio Analysi

Instructor: Lionel Sei Boayue
Sr
MSc. MSc.
BBA, PhD Cand. CPA
M-F : 11am – 4pm
Email:
boayue05@gmail.com
Phone: 0777088884 /
0888990004
WhatsApp: 0555310493
Chapter Two
Financial Statements and

Ratios Analysis
Content
1.1 Comparative and Common – Size statements

1.2 Ratio Analysis - Liquidity
1.3 Ratio Analysis – Asset Management
1.4 Ratio Analysis – Debt Management
1.5 Ratio Analysis – Profitability
1.6 Ratio Analysis – Market Performance
1.7 Summary
1.1 Comparative and Common –
Size statements
Comparative analysis of financial statements is the process of
comparing current year with pervious years financials. This is
accomplished meanly by putting these statements side by side
and analyzing the changes in their dollar amounts. Management
can choose to use any of the following three analytical
techniques:
 Dollar and percentage changes on statements – Horizontal
Analysis
 Common-size statements – Vertical Analysis
 Ratios
Items on the balance sheet or income statement are meaningless if
it is a standalone amount with no trend analysis. Let’s say a
companies sales for the year was 250 million dollars. On it’s own,
this information is useless. But to become use information, it most
be match against last year’s sales. To do a thorough financial
statement analysis, the following questions must be answered:
 How does last year’s number stack up against this year?
 How does sales relate to cost of goods sold?

Dollar and Percentage Changes on Statements
Horizontal analysis also know as trend analysis involves analyzing

financial statements over-time, such as computing year-to-year
dollar and percentage changes within a set of financial statements.
The change is expressed as a percentage of the dollar amount for
the previous year. The dollar changes between this year and last
year are expressed as a percentage of the dollar amount for last
year.
Percentage = Change in dollar amount x 100

Last year value
The dollar change are the most important change economically and
the percentage change highlights the changes that are most
Horizontal analysis can be useful when data from a number of
years are used to compute trend percentages. To compute trend
percentages, a base year is selected and data for all other years
are stated as a percentage of that base year.
Trend percentage = Present Year Value x 100

Base Year Value
2002 2003 2004 2005 2006

Sales $ 14,527 $ 16,514 $ 17,889 $ 19,117 $ 20,859
NetIncome $ 893 $ 1,471 $ 2,279 $ 2,602 $ 3,544
Common-Size Statement
Unlike horizontal analysis that focused on changes in financial
statements over time, Vertical analysis focuses on the relationship
between financial statements account at a given point in time. A
common-size financial statement is a vertical analysis in which
each financial account is expressed as a percentage. Each item is
expressed as a percentage of total assets/total liability &
Stockholder’s equity.
In income statements all items are expressed as a percentage of

sales. In balance sheets, all asset items are expressed as a
percentage of total assets and all liability items are expressed as
percentage of total liabilities and stockholder’s equity.
1.2 Ratio Analysis – Liquidity
Liquidity refers to how quickly a company can convert their assets

to cash. Liquid assets can be converted to cash quicker than il-
liquid assets. The amount of liquid assets a company has is
important because it shows their ability to settle short-term debts
such as creditors and suppliers. If a company liquid assets is not
enough to pay off short-term debts it can lead to bankruptcy and
poses a serious managerial issue. The first liquidity ratio we will
talk about is the Working Capital Ratio.
Working Capital Ratio
Working capital is the excess of current assets over current liability.

Mangers must look at working capital from two perspective. On
one hand, having ample working capital provides assurance that
companies can pay off its short-term debt on time and in full. On
the other hand, keeping large amount of working capital is
expensive because they must be finance with long-term debt and
equity. To calculate working capital, numbers from the balance
must be used.
Working Capital = Current Assets – Current Liabilities

Example
Calculate ABC Company’s working capital using information from

the balance for years ended 2016 and 2017.
Working capital = Current Assets – Current Liabilities
= 15,500 – 7,000
= 8,500
Current Ratio
Current ratio is the same as working capital. It measures a
company’s ability to pay off its short-term debts in full and on time.
The current ratio must be interpreted with care. A declining current
ratio signifies a bad financial conditions. An improving current ratio
might indicate an improvement in the company’s financial position.
A current ratio of at least 2 is the general rule of thumb, however
many companies are still successfully operating below 2.

For examples lets consider the below portion of the balance sheet
for XYZ and Cans Companies respectively. To calculate current
ratio, divide current assets by current liabilities.
Current Ratio = Current Assets

Current Liabilities
Calculate current ratios for the XYZ and Cans Company using the
data provided below:
Acid-Test (Quick) Ratio
Like the current ratio and the working capital ratio, the Acid-Test
(quick) ratio also measures the company’s ability to meet its short-
term debts. But this is a more rigorous method of evaluating its
ability because it includes inventories, marketable securities,
account receivables and short-term notes receivables. Inventories
and prepaid expenses are excluded from the calculations of
current ratio and working capital. For most industries, the acid-
test-ratio should be 1.
Acid-Test ratio = Cash +Marketable securities + Account Receivables + Short-term Notes Receivables
Current Liabilities
Calculate ABC’s Acid-Test Ratio using the information provided on

their financial statements.
1.3 Ratio Analysis: Asset Management
A company’s assets are funded by lenders and stockholders,

both of whom expect that those assets will be deployed
efficiently and effectively. Therefore, managers must use ratios
to determine the performance of those assets over time.
Asset management ratios are important part of financial

statement analysis because it allows managers to understand
the overall performance levels and efficiency of a business. The
first Asset management ratio we will look at is the Account
receivable turnover ratio.
Account Receivable Turnover
Ratio
Accounts receivable turnover and average collection period
ratios measure how quickly credits sales can be converted to
cash. The accounts receivable turnover is computed by dividing
sales on account by average account receivable balance for the
year.
Accounts receivable turnover = Sales on account
Average accounts receivable
balance
The accounts receivable turnover can then be divided by 365

days to determine the average number of days required to
collect an account.
Average collection period = 365 days

Account receivable
turnover
Company usually have a credit term with their customers. This
credit term dictates when the company will collect their
outstanding debt owe by customers. Depending on the industry,
credits can range from 10 days to 180 days. But if a company
credit terms are 10 days, and their average collection period
exceeds that, it is worrisome.
Inventory Turnover Ratio
Inventory turnover ratio measures how many times during the
year a company has replaced or sold its inventory. It is computed
by dividing the cost of goods sold by the average level of
inventory (beginning inventory balance + Ending inventory
balance) / 2.
Inventory turnover = Cost of goods sold
Average inventory balance
There number of days needed on average to sell the entire

inventory (Average sale period) can be computed by dividing 365
days by the inventory turnover.
Average sale period = 365 days

Inventory turnover
The average sale period varies by industry. On average, average
sale period of 10 days to 90 days are common. A company might
a higher average sale period because it is holding too much
inventory.
Operating Cycle
The operating cycle of a company is the time it takes to buy or
manufacture goods, sell the goods, and receive payments. In
essence, it measures the elapsed time from when inventory is
received from suppliers to when cash is received from customers.
Operating cycle = Average sale period + Average collection period
The goal of the company is to reduce the operating cycle because

it brings money to the company sooner. The shorter the operating
cycle, the better it is because company’s can collect cash on time
and be able to pay off its debts to suppliers.
Total Assets Turnover
Total Assets turnover is a ratio that calculates and compares total
sales to average total assets. This measures how efficient a
company’s asset is being used to generate sales. This ratio goes
beyond current assets to include noncurrent assets such as
property, plant, and equipment.
Total assets turnover = Sales
Average total assets
The goal of a company is to increase total assets but if it is

decreasing, it simply means that it is not utilizing its noncurrent
assets efficiently.
1.4 Debt Management
Managers need to evaluate their company’s debt management
from the vantage point of the stakeholders, long-term creditors and
common stockholders. Long-term creditors are concern with the
company’s ability to pay its loans over the long run. Stockholders
look at debt from a financial leverage perspective. Financial
leverage refers to borrowing money to acquire assets in an effort to
increase sales and profits.
Under debt management, we will explain three ratios managers

use to calculate the financial leverage of the company.
Times Interest Earned Ratio
Time interest earned is the most common measure of a
company’s ability to provide protection to its long-term creditors
based on current income. Times interest earned is calculated by
dividing earnings before interest expense and income taxes (net
operating income) by interest expense.
Times Interest earned = Earning before interest expense and
Taxes
Interest expense
= 3140 = 4.9
640
Earning before interest expenses and income taxes are used to
calculate this ratio because it is the amount available to use for
making interest payments. A ratio of 1 mean that interest exceeds
the earnings available to pay interest but a ratio of 2 and above is
Debt-to-Equity Ratio
This ratio calculates the proportion of debt to equity at a point in

the company balance sheet. An increasing debt-to-equity ratio
indicate that a company financial leverage is increasing. This means
that the company is using more debt than equity to funds its assets.
Debt-to-equity ratio = Total Liabilities
Stockholders equity
= 14500 = 0.85
17000
This ratio calculation means that at the end of the year, the
creditors were providing 0.85 cents for every $1 being provided by
stockholder. Stockholders will like a lot of debt to finance assets and
creditors will like to see less debt and more equity.
Equity Multiplier
Equity multiplier is another type of leverage ratio that indicate the
portion of a company’s assets funded by equity. Like the debt-to-
equity ratio, an increasing multiplier mean that the company is
relying on a greater proportion of debt rather equity to finance its
assets. The multiplier focuses on average amounts to calculate the
ratio.
Equity Multiplier = Average total assets
Average stockholders equity
= (31500 + 28970)/2
(17000 + 15970)/2
= 1.83
Profitability Ratios
When managers analyze profits, they tend to focus on the amount

of profit earned relative to some other amounts such as sales, total
assets, or total stockholders equity. When profits are stated as a
percentage of another number, it helps managers draw informed
conclusions about how the company is performing over time. In this
section, we will be looking at four profitability ratios commonly used
by managers. These ratios are the gross margin percentage, net
profit margin percentage, return on total assets and return on
equity.
Gross Margin Percentage
Looking at the income statement for ABC company, it is shown

that the cost of goods sold increased from 65.6% last year to
69.2% this year. Or looking at this from a different viewpoint, the
gross margin percentage declined from 34.4% last year to 30.8%
this year.
Gross Margin Percentage = Gross Margin

Sales
The gross margin percentage should be more stable for retailing
companies than for other companies because cost of goods sold in
retailing excludes fixed cost. Sales volume will increase or
decrease when fixed costs are included in cost of goods sold.
Net Profit Margin Percentage
Net profit margin percentage is a profitability ratio that measures

the percentage of change in profit earned by a company in
relations to its revenue. Expressed as a percentage, it indicates
how much profit the company makes for every dollar of revenue
generated.
Net profit margin percentage = Net Income
Sales
Both the gross profit margin and net profit margin percentage state
the gross margin and the net income as a percentage of sales. The
gross margin percentage only focuses cost of goods sold whereas
the net profit margin percentage looks at how selling and
administrative expense, interest expense, and income tax expense
and their impact on performance.
Return on Total Assets
Return on total assets measures the operating performance of a

business over time. Interest expense is added back to net income
to show what earnings would have been if the company had no
debt. With this adjustments, managers can evaluate the
company’s return on assets over time without analyzing the
changes in debt and equity over time.
Return on total assets = Net Income + [Interest expense x (1 – tax rate)]
Average total assets
= 1750 + [640 x (1 – 0.30)]

(31500 + 28970)
= 7.3%
This means that the company earned 7.3% return on their average total
assets employed this year.
Return on Equity
The return on assets looks at profits relative to total assets, whereas
the return on equity looks at profits relative to the book value of
stockholders’ equity.
Return on Equity = Net Income

Average Stockholders’ Equity
ROE is measure of the a company’s financial performance. Because

shareholders’ equity is be equal to a company’s assets minus its
liabilities, ROE is a way of showing a company’s return on net
assets. ROE is considered a gauge of a company’s profitability and
how efficient it generates those profits. The higher the ROE , the
more efficient a company’s management is at generating income
and growth from its equity financing.
The return on equity is also calculate also by multiply Net Profit
margin percentage by Total assets turnover x Equity Multiplier.
Return on Equity = Net Income x Sales x Average total

asset
Sales Average total assets Average stockholders’
equity
This method is called the Dupont method named after E.I. Dupont.
This approach recognizes that return on equity is influenced by
three elements and they are operating efficiency (Net Profit
Margin), asset usage efficiency (Total asset turnover), and financial
leverage (Equity multiplier).
Market Performance
These last set of 5 ratios are used mainly by common shareholders’

to assess a company’s performance. Given that common
stockholders are the ones that own the company, this logically
follows that managers should have a thorough understanding of the
measures that their owner will use to judge their performance.
Earning per Share
An investor buys a stock in the hopes of realizing a return in the
form of either dividends or future increases in the value of the
stock. Because earnings form the basis for the dividend payments
and future increases in the value of the shares, investors are
interested in company’s earning per share. EPS is computed by
dividing net income net income by the average number of
common shares outstanding during the year.
Earnings per share = Net Income

Average number of common shares outstanding
First Calculate the total number of common shares outstanding.

Price-Earnings Ratio
The price-earnings ratio expresses the relationship between a
stock’s market price per share and its earnings per share. If we
assume that ABC company’s stock has a market price of $40 per
share at the end of this year, than its price-earnings ratio would be
computed as follows:
Price-earnings ratio = Market price per share

Earnings per share
A high price-earning ratio means that investors are willing to pay a

premium for the stocks. This because investors believe that the
company is expected to have higher earning growth.
Dividend Payout Ratios
The dividend payout ratio quantifies the amount of current assets
being payout as dividend. It is the total dividends that a company
pays to shareholders relative to net income.
DPR = Dividend per Share
Earnings per Share
Or DPR = Net Income

Total Dividends
There is nothing like a right dividend payout ratio. Most ratios are
within the industry standard.
What is a Budget
A budget is a detail plan for the future that is usually expressed in
formal quantitative terms. Individuals sometimes create household
budgets that balance their income and expenditures for foods,
clothing, housing, and so on while providing for some savings.
Once the budget is established, actual spending is compared to the
budget to make sure the plan is being followed.
Budgets are used for two distinct purposes, planning and control.
Planning involves developing goals and preparing various budgets
to achieve those goals. Control involves gathering feedback to
ensure that the plan is being properly executed or modified as
circumstances change.
Advantages of Budgeting
Organizations realize many benefits from budgeting, including:
 Budgeting communicates management’s plans throughout the

organization.
 Budgets force managers to think about and plan for the future.
In the absence of the necessity to prepare a budget, many
managers would spend all their time dealing with day-to-day
emergencies.
 The budgeting process provides a means of allocating resourses

to those part of the organization where they can be used most
effectively.
Advantages of Budgeting
 The budgeting process can uncover potential bottlenecks before
they occur.
 Budgeting coordinate the activities of the entire organization by

integrating the plans of its various parts. Budgeting helps to
ensure that everyone in the organization is pulling in the same
direction.
 Budgets define goals and objectives that can serve as

benchmarks for evaluating subsequent performance.
Responsibility Accounting
Managers should be held responsible for those items - and only
those items - that they can actually control to a significant extent.
Responsibility accounting enables organizations to react quickly to
deviations from their plans and to learn from feedback. Managers
can understand the sources of significant favorable or unfavorable
discrepancies (not penalize individuals for not achieving targets).
Choosing a Budget Period
Operating budgets normally covers a one-year period
corresponding with the company’s fiscal year. Many companies
divide their budget year into four quarters. The first quarter is then
subdivided into months, and monthly budgets are developed. As
the year progresses, the figures from the second quarter are
broken down into monthly amounts, then the third quarter figures
are broken down, and so forth.
Sometimes a continuous or perpetual budget is used. This means

that as the month closes, the actuals for the first month’s budget
becomes the budget for the second month and so on.
Self-Imposed Budget
A self-imposed budget is a budget that is prepared with the full
involvement and cooperation of all managers at all levels in the
organization. Most managers wants to be empowered to create
their own self-imposed budget is the most effective way to prepare
a budget. Some advantages of self-imposed budgets includes:
 Individuals at all levels of the organization are viewed as

members of the team whose judgments are valued by top
management.
 Budget estimates prepared by front-line managers are often

more accurate than estimates prepared by top managers.
 Motivation is generally higher when individuals participate in

Self-Imposed Budget
 A manager who is not able to meet a budget imposed from
above can claim that it was unrealistic. Self-imposed budgets
eliminate this excuse.
There are also disadvantages of self-imposed budgets:
 Lower-level managers may make suboptimal budgeting

recommendations if they lack the broad strategic perspective.
 Self-imposed budgeting may allow lower-level managers to

create ‘budgetary slacks’, because the managers who create
budgets are held accountable for actual results that deviate from
the budget.
Human factors in Budgeting
The success of a budget program depends on three important
factors:
 Top management must be enthusiastic and committed to the

budget process.
 Top management must not use the budget to pressure

employees or blame them when something goes wrong.
 Highly achievable budget targets are usually preferred when

managers are rewarded based on meeting budget targets.
The Master Budget: An Overview
The Master Budget: An Overview
The master budget consist of a number of separate but

interdependent budgets that formally lay out the company’s sales,
productions, and financial goals. The master budget culminates into
a sales budget, a budgeted income statement, and a budgeted
balance sheet. This simply means that the master budget starts with
a sales budget and ends with a cash budget which includes a
budgeted income statement and budgeted balance sheet.
Seeing the Big Picture
 How much sales revenue will we earn?
 How much cash will we collect from customers?
 How much raw material will we need to purchase?
 How much manufacturing costs will we incur?
 How much cash will we pay to our suppliers and our direct laborers, and
how much cash will we pay for manufacturing overhead resources?
 What is the total cost that will be transferred from finished goods
inventory to cost of good sold?
 How much selling and administrative expense will we incur and how
much cash will be pay related to those expenses?
 How much money will we borrow from or repay to lenders – including
interest?
 How much operating income will we earn?
 What will our balance sheet look like at the end of the budget period?
Budget Estimates and
Assumptions
The master budget we will create will be related to Hampton Freeze, Inc.
Hampton freeze, Inc. Estimates begins with the estimates underlying the
sales budget. Their budgeted quarterly units sales are 10,000, 30,000,
40,000 and 20,000 cases. Its budgeted selling price is $20 per case. The
company expects to collect 70% of it credit sales in the quarter of sale, and
30% in the quarter after sales.
The production budget is based on the assumptions that Hampton’s freeze
will maintain ending finished goods inventory equal to 20% of the next
quarter’s unit sales. In terms of the company’s only direct material, high
fructose sugar, it budgets 15 pounds of sugar per case of popsicles at a cost
of $0.20 per pound. It is expected to maintain ending raw materials
inventory equal to 10% of the raw materials needed to satisfy next
quarter’s production. In addition, the company plans to pay 50% of its
materials purchases within the month of purchase and the remaining 50% in
the following month.
Direct labor assumptions are that 0.40 direct labor-hour will be required per
case of popsicles and direct labor-cost per hour is $15. The manufacturing
overhead budget is based on these three assumptions-the variable overhead
cost per direct labor-hour is $4.00, the total fixed overhead per quarter is
Budget Estimates and
Assumptions
The budgeted variable selling and administrative expense per case of
popsicles is $1.80 and the fixed selling and administrative expenses per
quarter is includes advertising ($20,000), executive salaries ($55,000),
insurance ($10,000), property tax ($4,000), and depreciation expense
($10,000).
The cash budget estimates that the company will maintain a minimum cash
balance each quarter of $30,000; it plans to pay quarterly equipment
purchase of $50,000, $40,000, $20,000 and $20,000; it plans to pay
quarterly dividends of $8,000; and it expects to pay simple interest on
borrowed money of 3% per quarter.
It is important to understand budget assumptions because it simplifies the
process of answering what-if questions. What-if we increase the selling price
per unit by $2 and expects sales to drop by 1,000 units pe quarter, what will
be the impact on profits?
Sales Budget
Sales Budget
For the year, the company expects to sell 100,000 cases of popsicles at a
price od $20.00 per case for total budgeted sales of $2,000,000. The budget
budgeted units of each quarter (10,000, 30,000, 40,000, and 20,000) are in
the assumptions. The company’s expected cash collection are $1,970,000
for 2014. There is an account receivable balance of $90,000 collected in the
first quarter. All cash collections rely on the estimated cash collection
percentages .
Sales Budget
For the year, the company expects to sell 100,000 cases of popsicles at a
price od $20.00 per case for total budgeted sales of $2,000,000. The budget
budgeted units of each quarter (10,000, 30,000, 40,000, and 20,000) are in
the assumptions. The company’s expected cash collection are $1,970,000
for 2014. There is an account receivable balance of $90,000 collected in the
first quarter. All cash collections rely on the estimated cash collection
percentages.
Production Budget
The production budget is prepared after the sales budget. The production
budget lists the number of units that must be produced to satisfy sales
needs and to provide for the desired ending finished goods inventory.
Production needs can be determined as follows:
Budgeted Sales……………………………………………………………..XXX
Add: desired units of ending finished goods inventory……………..XXX
Total needs…………………………………………………………………..XXX
Less: Units of beginning finished good inventory……………………..XXX
Required production in units…………………………………………......XXX
Note the production requirements are influenced by the desired level of the
ending finished goods inventory. Inventories should be carefully planned.
Excessive inventories ties up funds and creates storage problems.
Insufficient inventories can lead to lost sales or last-minute, high-cost
Production Budget
Schedule 2 contains the production budget for Hampton Freeze. The

budgeted sales data comes from the sales budget. The desire ending
finished good inventories for the first quarter of 6,000 cases is computed by
multiplying budgeted sales for the second quarter (30,000 cases) by the
desire ending finished goods inventory percentage of 20%.
The total needs for the for the first quarter (16,000 cases) are determined
by adding together the budgeted sales of 10,000 cases for the quarter and
the desire ending inventory of 6,000 cases. Because the company already
has 2,000 cases in beginning finished goods inventory (see the balance
sheet), only 14,000 cases needs to be produced in the first quarter.
Production Budget
Production Budget
Pay attention to the year column. In some cases (budgeted sales, total
needs, and required production), the amount listed for the year is the sum
of the quarterly amounts for the item. In other cases,(desired units of
ending finished goods inventory, and units of beginning finished good
inventory) is not simply the sum of the quarterly amounts.
From the standpoint of the entire year, the beginning finished goods
inventory is the same as the beginning finished goods inventory for the first
quarter, it is not the sum of the beginning finished goods inventories for all
four quarters.
Similarly, from the standpoint of the of the entire year, the ending finished
goods inventory, which is assumed to be 3,000 units, is the same as the
ending finished goods inventory for the fourth quarter, it is not the sum of
the ending finished goods inventory for all quarters.
The Direct Materials Budget
A direct materials budget is prepared after the production requirements

have been computed. The direct materials budget details the raw materials
that must be purchased to fulfill the production budget and to provide for
adequate inventories. The required purchases of raw materials are
computed as follows:
Required production in units of finished goods . . . . . . . . . . . . . . XXX

Units of raw materials needed per unit of finished goods . . . . . XXX
Units of raw materials needed to meet production . . . . . . . . . . . XXX
Add desired units of ending raw materials inventory . . . . . . . . . . XXX
Total units of raw materials needed . . . . . . . . . . . . . . . . . . . . . . . . XXX
Less units of beginning raw materials inventory . . . . . . . . . . . . . . XXX
Units of raw materials to be purchased . . . . . . . . . . . . . . . . . . . . . XXX
Unit cost of raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Cost of raw materials to be purchased . . . . . . . . . . . . . . . . . . . . . . XXX
Schedule 3 contains the direct materials budget for Hampton Freeze. The first line of
this budget contains the required production for each quarter, which is taken directly
from the production budget (Schedule 2). The second line of the direct materials
budget recognizes that 15 pounds of sugar (see Budgeting Assumptions) are required
to make one case of popsicles. The third line of the budget presents the raw
materials needed to meet production.
For example, in the first quarter, the required production of 14,000 cases is multiplied
by 15 pounds to equal 210,000 pounds of sugar needed to meet production. The
fourth line shows the desired units of ending raw materials inventory. For the first
quarter this amount is computed by multiplying the raw materials needed to meet
production in the second quarter of 480,000 pounds by the desired ending inventory
percentage of 10% as shown in the Budgeting Assumptions. The desired units of
ending raw materials inventory of 48,000 pounds is added to 210,000 pounds to
provide the total units of raw materials needed of 258,000 pounds. However,
because the company already has 21,000 pounds of sugar in beginning inventory.
, only 237,000 pounds of sugar need to be purchased in the first quarter. Because the
budgeted cost of raw materials per pound is $0.20 (see Budgeting Assumptions), the
cost of raw material to be purchased in the first quarter is $47,400. For the entire
year, the company plans to purchase $303,300 of raw materials. Schedule 3 also
shows that the company’s expected cash disbursements for material purchases for
2017 are $301,200. The accounts payable balance of $25,800 that is paid in the first
quarter comes from the beginning balance. All other cash disbursement
computations rely on the estimated cash payment percentages (both of which are
50%) from cells B19 and B20 of the Budgeting Assumptions tab. For example,
Schedule 3 shows that the budgeted raw material purchases for the first quarter
equal $47,400. In the first quarter, Hampton Freeze expects to pay 50% of this
amount, or $23,700. In the second quarter, the company expects to pay the
remaining 50% of this amount, or $23,700.
Ten percent of the next quarter’s production needs. For example, the
second-quarter production needs are 480,000 pounds. Therefore, the
desired ending inventory for the first quarter would be 10% × 480,000
pounds = 48,000 pounds. The desired ending inventory for quarter 4
(22,500 pounds) assumes the first quarter production needs in 2018 are
225,000 pounds (= 225,000 pounds × 10% = 22,500 pounds). 2Cash
payments for last year’s fourth-quarter purchases. See the beginning-of-
year balance sheet in Exhibit 8–3. 3 $47,400 × 50%; $47,400 × 50%. 4
$97,200 × 50%; $97,200 × 50%. 5$102,900 × 50%; $102,900 × 50%.
6$55,800 × 50%. Unpaid fourth-quarter purchases ($27,900) appear as
accounts payable on the company’s end-of-year budgeted balance sheet.
The Direct Labor Budget
The direct labor budget shows the direct labor-hours required to
satisfy the production budget. By knowing in advance how much
labor time will be needed throughout the budget year, the company
can develop plans to adjust the labor force as the situation requires.
Companies that neglect the budgeting process run the risk of facing
labor shortages or having to hire and lay off workers at awkward
times. Erratic labor policies lead to insecurity, low morale, and
inefficiency. The direct labor budget for Hampton Freeze is shown in
Schedule 4. The first line in the direct labor budget consists of the
required production for each quarter, which is taken directly from
the production budget (Schedule 2).
The direct labor requirement for each quarter is computed by
multiplying the number of units to be produced in each quarter by
the 0.40 direct labor-hours required to make one unit (see
Budgeting Assumptions). For example, 14,000 cases are to be
produced in the first quarter and each case requires 0.40 direct
labor-hours, so a total of 5,600 direct labor hours (14,000 cases ×
0.40 direct labor-hours per case) will be required in the first quarter.
The direct labor requirements are then translated into budgeted
direct labor costs, which we will assume are paid in the quarter
incurred. How this is done will depend on the company’s labor
policy. In Schedule 4, Hampton Freeze has assumed that the direct
labor force will be adjusted as the work requirements change from
In that case, the direct labor cost is computed by simply multiplying the
direct labor-hour requirements by the direct labor rate of $15 per hour (see
Budgeting Assumptions). For example, the direct labor cost in the first
quarter is $84,000 (5,600 direct labor-hours × $15 per direct labor-hour).
However, many companies have employment policies or contracts that
prevent them from laying off and rehiring workers as needed. Suppose, for
example, that Hampton Freeze has 25 workers who are classified as direct
labor, but each of them is guaranteed at least 480 hours of pay each
quarter at a rate of $15 per hour. In that case, the minimum direct labor
cost for a quarter would be computed as follows: 25 workers × 480 hours
per worker × $15 per hour = $180,000. Note that in this case the direct
costs shown in the first and fourth quarters of Schedule 4 would have to be
increased to $180,000.
Manufacturing Overhead Budget
The manufacturing overhead budget lists all costs of production

other than direct materials and direct labor. Schedule 5 shows the
manufacturing overhead budget for Hampton Freeze. At Hampton
Freeze, manufacturing overhead is separated into variable and fixed
components. As shown in the Budgeting Assumptions, the variable
component is $4 per direct labor-hour and the fixed component is
$60,600 per quarter. Because the variable component of
manufacturing overhead depends on direct labor, the first line in
the manufacturing overhead budget consists of the budgeted direct
labor-hours from the direct labor budget (Schedule 4).
The budgeted direct labor-hours in each quarter are multiplied by

the variable overhead rate to determine the variable component of
manufacturing overhead. For example, the variable manufacturing
overhead for the first quarter is $22,400 (5,600 direct labor-hours ×
$4.00 per direct labor-hour). This is added to the fixed
manufacturing overhead for the quarter to determine the total
manufacturing overhead for the quarter of $83,000 ($22,400 +
$60,600).
The last line of Schedule 5 for Hampton Freeze shows the budgeted
cash disbursements for manufacturing overhead. Because some of
the overhead costs are not cash outflows, the total budgeted
manufacturing overhead costs must be adjusted to determine the
cash disbursements for manufacturing overhead. At Hampton

Freeze, the only significant noncash manufacturing overhead cost is
depreciation, which is $15,000 per quarter (see Budgeting
Assumptions). These noncash depreciation charges are deducted
from the total budgeted manufacturing overhead to determine each
quarter’s expected cash disbursements. Hampton Freeze pays all
overhead costs involving cash disbursements in the quarter
incurred. Note that the company’s predetermined overhead rate for
the year is $10 per direct labor-hour, which is determined by
dividing the total budgeted manufacturing overhead for the year
($404,000) by the total budgeted direct labor-hours for the year
(40,400).
Ending Finished Goods Inventory Budget
After completing Schedules 1–5, the accountant had all of the data
he needed to compute the absorption unit product cost for the units
produced during the budget year. This computation was needed for
two reasons: first, to help determine cost of goods sold on the
budgeted income statement; and second, to value ending
inventories on the budgeted balance sheet.
The cost of unsold units is computed on the ending finished goods
inventory budget. Schedule 6 shows that Hampton Freeze’s
absorption unit product cost is $13 per case of popsicles—consisting
of $3 of direct materials, $6 of direct labor, and $4 of manufacturing
overhead.
Ending Finished Goods Inventory Budget
Notice that manufacturing overhead has been applied to units of

product using the rate of $10 per direct labor-hour from the
Manufacturing Overhead budget. The budgeted carrying cost of the
ending inventory is $39,000.
Flexible Budgets and
Performance Report
In the last chapter we explored how budgets are developed before a period begins. In
this chapter, we explain how budgets can be adjusted to help guide actual operations
and influence the performance evaluation process. For example, an organization’s
actual expenses will rarely equal its budgeted expenses as estimated at the beginning
of the period.
The reason is that the actual level of activity (such as unit sales) will rarely be the
same as the budgeted activity; therefore, many actual expenses and revenues will
naturally differ from what was budgeted. Should a manager be penalized for
spending 10% more than budgeted for a variable expense like direct materials if unit
sales are 10% higher than budgeted? Of course not. After studying this chapter,
you’ll know how to adjust a budget to enable meaningful comparisons to
actual results.
The Variance Analysis Cycle
Companies use the variance analysis cycle, as illustrated in Exhibit 9–1, to evaluate
and improve performance. The cycle begins with the preparation of performance
reports in the accounting department. These reports highlight variances, which are
the differences between the actual results and what should have occurred according
to the budget. The variances raise questions. Why did this variance occur? Why is
this variance larger than it was last period? The significant variances are investigated
so that their root causes can be either replicated or eliminated.
Then, next period’s operations are carried out and the cycle begins again with the
preparation of a new performance report for the latest period. The emphasis should
be on highlighting superior and unsatisfactory results, finding the root causes of these
outcomes, and then replicating the sources of superior achievement and eliminating
the sources of unsatisfactory performance. The variance analysis cycle should not be
used to assign blame for poor performance.
Managers frequently use the concept of management by exception in conjunction
with the variance analysis cycle. Management by exception is a management system
that compares actual results to a budget so that significant deviations can be flagged
as exceptions and investigated further. This approach enables managers to focus on
the most important variances while bypassing trivial discrepancies between the
budget and actual results.
For example, a variance of $5 is probably not big enough to warrant attention,
whereas a variance of $5,000 might be worth tracking down. Another clue is the size
of the variance relative to the amount of spending. A variance that is only 0.1% of
spending on an item is probably caused by random factors. On the other hand, a
variance of 10% of spending is much more likely to be a signal that something is
wrong.
In addition to watching for unusually large variances, the pattern of the variances
should be monitored. For example, a run of steadily mounting variances should
trigger an investigation even though none of the variances is large enough by itself to
warrant investigation. Next, we explain how organizations use flexible budgets to
compare actual results to what should have occurred according to the budget.
Characteristics of a Flexible Budget
The budgets that we explored in the last chapter were planning
budgets. A planning budget is prepared before the period begins
and is valid for only the planned level of activity. A static planning
budget is suitable for planning but is inappropriate for evaluating
how well costs are controlled. If the actual level of activity differs
from what was planned, it would be misleading to compare actual
costs to the static, unchanged planning budget.
If activity is higher than expected, variable costs should be higher
than expected; and if activity is lower than expected, variable costs
should be lower than expected. Flexible budgets take into account
how changes in activity affect costs. A flexible budget is an
estimate of what revenues and costs should have been, given the
actual level of activity for the period.
Characteristics of a Flexible Budget
When a flexible budget is used in performance evaluation, actual
costs are compared to what the costs should have been for the
actual level of activity during the period rather than to the static
planning budget. This is a very important distinction. If adjustments
for the level of activity are not made, it is very difficult to interpret
discrepancies between budgeted and actual costs.
Deficiencies of the Static Planning Budget
To illustrate the difference between a static planning budget and a
flexible budget, consider Rick’s Hairstyling, an upscale hairstyling
salon located in Beverly Hills that is owned and managed by Rick
Manzi. Recently Rick has been attempting to get better control of
his revenues and costs, and at the urging of his accounting and
business adviser, Victoria Kho, he has begun to prepare monthly
budgets. At the end of February, Rick prepared the March budget
that appears in Exhibit 9–2. Rick believes that the number of
customers served in a month (also known as the number of client-
visits) is the best way to measure the overall level of activity in his
salon. A customer who comes into the salon and has his or her hair
styled is counted as one client-visit.
Note that the term revenue is used in the planning budget rather
than sales. We use the term revenue throughout the chapter
because some organizations have sources of revenue other than
sales. For example, donations, as well as sales, are counted as
revenue in nonprofit organizations. Rick has identified eight major
categories of costs—wages and salaries, hairstyling supplies, client
gratuities, electricity, rent, liability insurance, employee health
insurance, and miscellaneous. Client gratuities consist of flowers,
candies, and glasses of champagne that Rick gives to his customers
while they are in the salon.
Working with Victoria, Rick estimated a cost formula for each cost.
For example, the cost formula for electricity is $1,500 + $0.10q,
where q equals the number of client-visits. In other words,
electricity is a mixed cost with a $1,500 fixed element and a $0.10
per client-visit variable element. Once the budgeted level of activity
was set at 1,000 client-visits, Rick computed the budgeted amount
for each line item in the budget. For example, using the cost
formula, he set the budgeted cost for electricity at $1,600 (=
$1,500 + $0.10 × 1,000). To finalize his budget, Rick computed his
At the end of March, Rick prepared the income statement in Exhibit
9–3, which shows that 1,100 clients actually visited his salon in
March and that his actual net operating income for the month was
$21,230. It is important to realize that the actual results are not
determined by plugging the actual number of client-visits into the
revenue and cost formulas. The formulas are simply estimates of
what the revenues and costs should be for a given level of activity.
What actually happens usually differs from what is supposed to
happen.
The first thing Rick noticed when comparing Exhibits 9–2 and 9–3 is
that the actual profit of $21,230 (from Exhibit 9–3) was substantially
higher than the budgeted profit of $16,800 (from Exhibit 9–2). This
was, of course, good news, but Rick wanted to know more. Business
was up by 10%—the salon had 1,100 client-visits instead of the
budgeted 1,000 client-visits. Could this alone explain the higher net
operating income? The answer is no. An increase in net operating
income of 10% would have resulted in net operating income of only
$18,480 (= 1.1 × $16,800), not the $21,230 actually earned during
the month. What is responsible for this better outcome? Higher
Lower costs? Something else? Whatever the cause, Rick would like
to know the answer and then hopefully repeat the same
performance next month. In an attempt to analyze what happened
in March, Rick prepared the report comparing actual to budgeted
costs that appears in Exhibit 9–4. Note that most of the variances in
this report are labeled unfavorable (U) rather than favorable (F)
even though net operating income was actually higher than
expected.
For example, wages and salaries show an unfavorable variance of
$4,900 because the actual wages and salaries expense was
$106,900, whereas the budget called for wages and salaries of
$102,000. The problem with the report, as Rick immediately
realized, is that it compares revenues and costs at one level of
activity (1,000 client-visits) to revenues and costs at a different
level of activity (1,100 client-visits). This is like comparing apples to
oranges. Because Rick had 100 more client-visits than expected,
some of his costs should be higher than budgeted. From Rick’s
standpoint, the increase in activity was good; however, it appears
to be having a negative impact on most of the costs in the report.
How a Flexible Budget Works
A flexible budget adjusts to show what costs should be for the
actual level of activity. To illustrate how flexible budgets work,
Victoria prepared the report in Exhibit 9–5 that shows what the
revenues and costs should have been given the actual level of
activity in March. Preparing the report is straightforward. The cost
formula for each cost is used to estimate what the cost should have
been for 1,100 client-visits—the actual level of activity for March.
For example, using the cost formula $1,500 + $0.10q, the cost of
electricity in March should have been $1,610 (= $1,500 + $0.10 ×
1,100). Also, notice that the amounts of rent ($28,500), liability
insurance ($2,800), and employee health insurance ($21,300) in the
flexible budget equal the corresponding amounts in the planning
budget (see Exhibit 9–2). This occurs because fixed costs are not
affected by the activity level.
We can see from the flexible budget that the net operating income
in March should have been $30,510, but recall from Exhibit 9–3 that
the net operating income was actually only $21,230. The results are
not as good as we thought. Why? We will answer that question
shortly. To summarize to this point, Rick had budgeted for a profit of
How a Flexible Budget Works
To summarize to this point, Rick had budgeted for a profit of $16,800. The actual
profit was quite a bit higher—$21,230. However, Victoria’s analysis shows that given
the actual number of client-visits in March, the profit should have been even higher—
$30,510. What are the causes of these discrepancies? Rick would certainly like to
build on the positive factors, while working to reduce the negative factors. But what
are they?
Flexible Budget Variances - Activity Variances
Part of the discrepancy between the budgeted profit and the

actual profit is due to the fact that the actual level of activity in
March was higher than expected. How much of this discrepancy
was due to this single factor? Victoria prepared the report in
Exhibit 9–6 to answer this question. In that report, the flexible
budget based on the actual level of activity for the period is
compared to the planning budget from the beginning of the
period.
The flexible budget shows what should have happened at the
actual level of activity, whereas the planning budget shows what
should have happened at the budgeted level of activity.
Therefore, the differences between the flexible budget and the
planning budget show what should have happened solely
because the actual level of activity differed from what had been
expected.
For example, the flexible budget based on 1,100 client-visits

shows revenue of $198,000 (= $180 per client-visit × 1,100
client-visits). The planning budget based on 1,000 client-visits
shows revenue of $180,000 (= $180 per client-visit × 1,000
client-visits). Because the salon had 100 more client-visits than
anticipated in the planning budget, actual revenue should have
been higher than planned revenue by $18,000 (= $198,000 −
$180,000).
This activity variance is shown on the report as $18,000 F
(favorable). Similarly, the flexible budget based on 1,100 client-
visits shows electricity cost of $1,610 (= $1,500 + $0.10 per
client-visit × 1,100 client-visits). The planning budget based on
1,000 client-visits shows electricity cost of $1,600 (= $1,500 +
$0.10 per client-visit × 1,000 client-visits). Because the salon
had 100 more client-visits than anticipated in the planning
budget, the actual electricity cost should have been higher than
the planned cost by $10 (= $1,610 − $1,600).
The activity variance for electricity is shown on the report as $10

U (unfavorable). Note that in this case, the label “unfavorable”
may be a little misleading. The electricity cost should be $10
higher because business was up by 100 client-visits; therefore, it
would be misleading to describe this variance in negative terms
given that it was a necessary cost of serving more customers.
For reasons such as this, we would like to caution you against
assuming that unfavorable variances always indicate bad
performance and favorable variances always indicate good
performance. Because all of the variances on this report are
solely due to the difference between the actual level of activity
and the level of activity in the planning budget from the
beginning of the period, they are called activity variances.
For example, the activity variance for revenue is $18,000 F, the
activity variance for electricity is $10 U, and so on. The most
important activity variance appears at the very bottom of the
report; namely, the $13,710 F (favorable) variance for net
operating income. This variance says that because activity was
higher than expected in the planning budget, the net operating
income should have been $13,710 higher. We caution against
placing too much emphasis on any other single variance in this
report. As we have said above, one would expect some costs to
be higher as a consequence of more business. It is misleading to
think of these unfavorable variances as indicative of poor
performance.
On the other hand, the favorable activity variance for net
operating income is important. Let’s explore this variance a bit
more thoroughly. First, as we have already noted, activity was up
by 10%, but the flexible budget indicates that net operating
income should have increased much more than 10%. A 10%
increase in net operating income from the $16,800 in the
planning budget would result in net operating income of $18,480
(= 1.1 × $16,800); however, the flexible budget shows much
The short answer is: Because of the presence of fixed costs.
When we apply the 10% increase to the budgeted net operating
income to estimate the profit at the higher level of activity, we
implicitly assume that the revenues and all of the costs increase
by 10%. But they do not. Note that when the activity level
increases by 10%, three of the costs—rent, liability insurance,
and employee health insurance—do not increase at all. These
are all entirely fixed costs. So while sales do increase by 10%,
these costs do not increase.
This results in net operating income increasing by more than
10%. A similar effect occurs with the mixed costs, which contain
fixed cost elements—wages and salaries, electricity, and
miscellaneous. While sales increase by 10%, these mixed costs
increase by less than 10%, resulting in an overall increase in net
operating income of more than 10%. Because of the existence of
fixed costs, net operating income does not change in proportion
to changes in the level of activity. There is a leverage effect. The
percentage changes in net operating income are ordinarily
larger than the percentage increases in activity.
Revenue and Spending Variances
In the last section we answered the question “What impact did the
change in activity have on our revenues, costs, and profit?” In this
section we will answer the question “How well did we control our
revenues, our costs, and our profit?” Recall that the flexible
budget based on the actual level of activity in Exhibit 9–5 shows
what should have happened given the actual level of activity.
Therefore, Victoria’s next step was to compare actual results to
the flexible budget—in essence comparing what actually
happened to what should have happened. Her work is shown in
Exhibit 9–7.
Focusing first on revenue, the actual revenue totaled $194,200.
However, the flexible budget indicates that, given the actual level
of activity, revenue should have been $198,000. Consequently,
revenue was $3,800 less than it should have been, given the
actual number of client-visits for the month. This discrepancy is
labeled as a $3,800 U (unfavorable) variance and is called a
revenue variance. A revenue variance is the difference between
the actual total revenue and what the total revenue should have
If actual revenue exceeds what the revenue should have been,

the variance is labeled favorable. If actual revenue is less than
what the revenue should have been, the variance is labeled
unfavorable. Why would actual revenue be less than or more than
it should have been, given the actual level of activity? Basically,
the revenue variance is favorable if the average selling price is
greater than expected; it is unfavorable if the average selling
price is less than expected.
This could happen for a variety of reasons including a change in
selling price, a different mix of products sold, a change in the
amount of discounts given, poor accounting controls, and so on.
Focusing next on costs, the actual electricity cost was $1,550;
however, the flexible budget indicates that electricity costs should
have been $1,610 for the 1,100 client-visits in March. Because the
cost was $60 less than we would have expected for the actual
level of activity during the period, it is labeled as a favorable
variance, $60 F. This is an example of a spending variance
This is an example of a spending variance A spending variance is

the difference between the actual amount of the cost and how
much a cost should have been, given the actual level of activity. If
the actual cost is greater than what the cost should have been,
the variance is labeled as unfavorable. If the actual cost is less
than what the cost should have been, the variance is labeled as
favorable. Why would a cost have a favorable or unfavorable
variance?
There are many possible explanations including paying a higher
price for inputs than should have been paid, using too many
inputs for the actual level of activity, a change in technology, and
so on. In the next chapter we will explore these types of
explanations in greater detail. Note from Exhibit 9–7 that the
overall net operating income variance is $9,280 U (unfavorable).
This means that given the actual level of activity for the period,
the net operating income was $9,280 lower than it should have
been.
There are a number of reasons for this. The most prominent is the
unfavorable revenue variance of $3,800. Next in line is the $2,360
unfavorable variance for client gratuities. Looking at this in
another way, client gratuities were more than 50% larger than
they should have been according to the flexible budget. This is a
variance that Rick would almost certainly want to investigate
further. He may find that this unfavorable variance is not
necessarily a bad thing. It is possible, for example, that more
lavish use of gratuities led to the 10% increase in client-visits.
Exhibit 9–7 also includes a $1,300 unfavorable variance related to
employee health insurance, thereby highlighting how a fixed cost
can have a spending variance. While fixed costs do not depend on
the level of activity, the actual amount of a fixed cost can differ
from the estimated amount included in a flexible budget. For
example, perhaps Rick’s employee health insurance premiums
unexpectedly increased by $1,300 during March. In conclusion,
the revenue and spending variances in Exhibit 9–7 will help Rick
better understand why his actual net operating income differs
from what should have happened given the actual level of activity

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Instructor: Lionel Sei Boayue

Financial Statements and

1.1 Comparative and Common – Size statements

 Common-size statements – Vertical Analysis

 How does sales relate to cost of goods sold?

Horizontal analysis also know as trend analysis involves analyzing

Percentage = Change in dollar amount x 100

Trend percentage = Present Year Value x 100

2002 2003 2004 2005 2006

In income statements all items are expressed as a percentage of

Liquidity refers to how quickly a company can convert their assets

Working capital is the excess of current assets over current liability.

Working Capital = Current Assets – Current Liabilities

Calculate ABC Company’s working capital using information from

Working capital = Current Assets – Current Liabilities

Current ratio is the same as working capital. It measures a

The current ratio must be interpreted with care. A declining current

ratio signifies a bad financial conditions. An improving current ratio

might indicate an improvement in the company’s financial position.

A current ratio of at least 2 is the general rule of thumb, however

many companies are still successfully operating below 2.

Current Ratio = Current Assets

Calculate ABC’s Acid-Test Ratio using the information provided on

A company’s assets are funded by lenders and stockholders,

Asset management ratios are important part of financial

The accounts receivable turnover can then be divided by 365

Average collection period = 365 days

There number of days needed on average to sell the entire

Average sale period = 365 days

The goal of the company is to reduce the operating cycle because

The goal of a company is to increase total assets but if it is

Under debt management, we will explain three ratios managers

This ratio calculates the proportion of debt to equity at a point in

When managers analyze profits, they tend to focus on the amount

Looking at the income statement for ABC company, it is shown

Gross Margin Percentage = Gross Margin

Net profit margin percentage is a profitability ratio that measures

Return on total assets measures the operating performance of a

= 1750 + [640 x (1 – 0.30)]

Return on Equity = Net Income

ROE is measure of the a company’s financial performance. Because

Return on Equity = Net Income x Sales x Average total

These last set of 5 ratios are used mainly by common shareholders’

Earnings per share = Net Income

First Calculate the total number of common shares outstanding.

Price-earnings ratio = Market price per share

A high price-earning ratio means that investors are willing to pay a

Or DPR = Net Income

 Budgeting communicates management’s plans throughout the

 The budgeting process provides a means of allocating resourses

 Budgeting coordinate the activities of the entire organization by

 Budgets define goals and objectives that can serve as

Sometimes a continuous or perpetual budget is used. This means

 Individuals at all levels of the organization are viewed as

 Budget estimates prepared by front-line managers are often

 Motivation is generally higher when individuals participate in

There are also disadvantages of self-imposed budgets:

 Lower-level managers may make suboptimal budgeting

 Self-imposed budgeting may allow lower-level managers to

 Top management must be enthusiastic and committed to the