Financial Statement Analysis Financial Statements ‘The goal offinancial managements to maximize the stockholders’ wealth through the current value of the existing stock (Ross et al, 2008). A common mistake in financial management is the belief that the finance manager should maximize the firm's accounting profits. Nonetheless, accounting profits should not be discarded as they directly affect the firms stock price. Inthe same manner that accounting information is presented in the financial statements, i isan important rool o understand why the company is performing the way itis and asa forecasting device as 0 where it is going. ‘The financial statement is the summarized data of a company’s assets, liabilities, and equities in the balance sheet and its revenue and expenses in the income statement, Its objective is to provide information about the financial position, result of ‘operations, and cash flows of an enterprise that is useful for decision-making to a wide range of users. | terson Obectves Atthe end of the chapter, students are ‘expected to be able to” + discuss the elements and limitations of financial statements; + reconstruct balance sheet and income statement through financial ratios, + analyze and interpret trend ratios, + evaluate the past performance of the company through financial ratios, + interpret the changes in the financial structure of the company, + differentiate the various activities of the firm—operating, investing, and financing, and + prepare the statement of cash flows. investing, and formulating dividend policy Financial managers use these statements in fina decisions. They are concemed primarily with the standing ofthe company and its profitability that leads to maximization of stockholders’ wealth, They use financial statements as thee firsthand information shout the company’s performance in the past and its prospects in the future. Managers use the financial Statements to ge information and feedback in assessing the economic progres ofthe fim In particular, they re concerned with the profitability of investments inthe various assets of ee company and the efficiency cof managing its assets. the financial statements as a tool in ascertaining the company’s capability 10 cial health ofa firm places the creditors in a much need of additional capital. ‘inancial institutions use | produce cash in making payments, Knowing the finan safer postion if ever loans are granted to a companyComponents of Financial Statements There are ive basic components of iancial statements They areas fllows 1. Balance Sheet. rsa staement showing the financial postion of the company ata particular ie “The balance sheets composed ofthe company’s asses and abilities and stockholders equiy, first section of the balance sheet lists all the assets of the firm. Current assets are Presented fing "These are the ash and other items suchas accounts receivable and inventories that can be con into cash within one year. Prepaid expenses and accrued income ae also included. Next ro cur ‘assets are the non-current assets. These assets comprise the company’s land, building, machinery equipment, furniture and fixture, transportation vehicle, and many more. The liailies section comprises of current and non-curent liabilities. The current liablig include accounts payable, short-term notes payable accrued expenses, taxes payable, interests pa and other obligations that are due within one yeat. The non-curent liabilities include longterm notes payable, bonds payable, and other obligations which are due beyond one year. “The stockholders’ equity isthe net worth or the residual value ofthe company. Stockholdey quitys further divided into par value stock, addtional paid-in capital, and retained earnings, The par value ofthe stock and the additional paid-in capital ae the proceeds from the sae of stock ¢ the public while che retained earnings represen the build-up of equity from profits that are ploweg back to the firm, Balance of FMA Company for the year 2014 | FMA Company Balance Sheet December 31, 2014 Carrent Assets Liabilities Cash P 65,000 Current liabilities P 110,800 Accounts receivable 40,000 Long-term liabilities 160,000 P 270,809 Marketable securities 40,000 Inventory 100,000 245,000. Stockholder’s Equity 7 ‘Common stock, 5 par value, 20,000 shares P 100,000 Non-current Assets Retained carings 74.200 174200 Plants assets 200,000 ‘Total Liabilities and Total Assets P-445,000 Stockholders’ Equity £445,000 2. Income Statement. Its a formal statement that shows the result of the operations for a certain Period of time. It presents the revenues generated during the operating period, the expenses incurred, and the company’s net earnings. Is used to distinguish four broad classes of expenses: (I) cost of goods sold, which isa direct cost attributable to manufacturing the product sold by the Firm (2) general and administrative expenses, which correspond to overhead expenses, salaries, advertising, and other operating costs that are not directly attributable to production; (3) interest on the firm’ debt; and (4) taxes on earnings owed to the government (see Illustration 2).3. Statement of Stockholders’ Equity, The statement of changes in stockholders’ equity isa required basi statement that shows the movements in the components ofthe equity “The major elements of the statement equity include: a. Issuance of Stocks. These are the common or preferred stocks issued during the year Rerained Earnings. Itis the accumulated income ot loss of the company covering the past years of operations. ¢. Declaration of Cash Dividends. The dividends declared for the year are shown as a deduction from retained earnings. : 4d. Distribution of Stock Dividends. It discloses the stock dividend rate and the amount of stock. dividends distributed to stockholders. This amount is also shown asa deduction from retained earnings. Purchase and Sale of Treasury Stock. It includes the firm’s stocks originally issued but were bought back and were not retired. The sale of treasury stock is shown as an addition to stockholders’ equity while the purchase is shown as a deduction. £ Accumulated Other Comprehensive Income. This category includes unrealized gains and losses on available-for-sale investments and foreign-currency translation adjustments. {g Correction of Errors, It lists errors inthe past but corrected in the current year. Income statement of FMA Company for the year ended Miustretiong December 31, 2014 FMA Company Income Statement For the Year Ended December 31, 2014 Sales P 200,000 Less: Sales returns and allowances 40,000 Net sales P 160,000 Less: Cost of goods sold 100,000 Gross profit P 60,000 Less: Operating expenses Selling expenses P 22,000 General expenses 8,000 30,000 Income from operations P 30,000 ‘Add: Non-operating income 6,000 Income before interest and expenses P 36,000 Less: Interest expense 4,000 Income before tax expense P 32,000 Less: Income taxes (35%) 11,200 ‘Net income P _20,800Tools and Techniques in Financial Analysis judgment, and temperament affect the evaluation of finangy nalyst should be competent enough £0 use the common og, ysis. They are a follows: The financial analyst's experience, statements (Mejorada, 2000). However, the a and techniques used in financial statement anal 1, Horizontal Analysis : “This is used to evaluate the trend in the accounts over the years. Ie is usually shown jy comparative financial statements 4. Comparative Statements. Compared ae financial data of two years showing the increas ddectewes in the account balances with their corresponding percentages. b. Trend Ratio. A firm’s present ratio is compared with its past and expected future ratios decrmine whether the company's financial condition is improving or deteriorating overtime Iris similar to comparative statements except that several consecutive years were used showing the behavior of financial data. 2, Vertical Analysis Te uses a significant item on the financial statement asa base value. All other financial items ‘on the statements are compared with it. Common Size Statement. Each account in the financial statements is expressed by dividing a them to a common base account (total assets, liabilities and equity sles or net sales) b. Financial Ratios. This i classified into five grou + Liquidity ratio ~is a company’s ability to meet its maturing short-term obligations. A company with poor liquidity may have a poor credit risk, perhaps because itis unable ro ‘make timely incerest and principal payments. ‘© Activity or asset utilization ratio ~ is used to determine how quickly various accounts are converted into sales or cash. + Leverage ratio Golvency) ~ isthe company’s ability to mect its long term-obligations as they become due. * Profitability ratio ~ shows the profitability of the operations of the company. It highlights the firm’ effectiveness in handling its operations. Investors will be reluctant co invest ina ‘company that has poor earning capacity. ‘+ Market value ratio ~ relates the firm’s stock price to its earnings. Horizontal Analysis Comparative Statements ‘Comparative statements are used to evaluate the changes or behavior patterns ofthe different accounts in the financial statements for two or more years. In doing the comparison, the earlier year serves as the base year so that the percentage increase or decrease is determined by dividing the difference of the base year figure from the later year figure by the base year figure. = Later year = Base year, 199 Base year = percentage increase or decrease of an accountTes change in the Scout is not limited to a percentage change. Changes in accounts may also be presented in peso amounts for better understanding. Using Illustration 3, the percentage of change in total assets of 17.119 for the year 2014 is: ae ee = £445,000 -P380,000 iggy, 'P380,000 = 1ZU% The same procedure is followed for the other accounts in the financial statements, Because a comparative starement stresses the trends of the various accounts, itis relatively easy to identify areas of wide divergence that require further attention. In the income statement shown in Ilustation 4, the large increase in sales returns and allowances coupled with the decrease in sales forthe period 2013 to 2014 should cause concern. One might compare these results with those of competitors to determine whether the problem is industry-wide or just within a particular company. {cis important to show both the peso amount of change and the percentage of change because either ‘one alone might be misleading. For instance, it is possible that a certain account would increase by 100%, but by looking at the amount, it docs not require further investigation since the amount involved is only £720. In the same manner, the percentage increase or decrease may be insignificant but the amount involved is material and needs further investigation, METESEINEEEN «comparative batance sheet of FMA Company for2012-200 Jf FMA Company ‘Comparative Balance Sheet December 31, 2014, 2013, and 2012 Percentage Increase or of Increase (Decrease) (or Decrease) 20K4- 2013-2014 2013 204 = 2013S 2012, 2013.—S 201220132012 ASSETS Current assets Cash P 65,000 P 70,000 P 75,000 P (5,000) P 5,000) 7.14% 6.67% Accounts receivable 40,000 35,000 20,000 5,000 15,000 14.29% 75.00% Marketable securities 40,000 35,000 10,000 5,000 25,000 14.29% —250,00% Inventory 100,000 _80,000 100.000 20,000 (20.000) 25.00% 20.00% ‘Toral current assets 245,000 220,000 205,000 25,000 15,000 11.36% 7.32% Plant assets 200,000 160,000 170,000 40,000 (10,000) 25.00% — 5.88% Toral Assets 445,000 P 380,000 375,000 P 65,000 P_5.000 17.11% 1.33% LIABILITIES Current liabilities 110,800 105,000 104,000 5,800 1,000 552% += 096% Long-term liabilities 160.000 145,000 140,000 15,000 _ 5.000 10.34% 3.57% “Total Liabilities P 270,800 250.000 F 244,000 F 20,800 P_6000 832% — 2.46% al Statement Analysis 5| AD | riwaNctaL MANAGEMENT| ae STOCKHOLDERS’ EQUITY ‘Common stock, 5 parvalue, 100,900 100,000 100,000 20,000 shares Retained earnings P 24200 F 30000 F 3000 1 44200 F (LOO 733% 3.2% Toul sockholder? equley, 74200 {3000 Ishonn 44200 (L000, 34.00% O76 “Total Liabilities and Stockholdew’ Equiey P-445900 P3en000 7375000 7.000 F 3000 171% 14% Ateneo! Comparative income statement of FMA Company for 2012-2014 I FMA Company Comparative Income Statement December 31,2014, 2013, and 2012 Tncrense or Percentage of Increase (Decrease) (or Decrease) ru 20121201 ator 2012 213-012 Sales 200000 P 210.000 P 190000 P (10000) 110000 476% 10.00% Sales returns andallowances 40,000 25.000 6,000 15,000 _19,000 60.00% 31667 Net sales 160,000 185,000 94,000 (25,000) 91,000 -13.51% — 96.81% Cost of goods sold 100,000 115,625 50,000 (15,625) 65.625 -1351% —131.25% Gross profit P 60,000 P G375 P 44,000 P (9,375) P 25375 -1351% 57.67% Operating expenses Selling expenses P 22000 P 25,000 P 16,000 F (3.000) P 9,000 -12.00% 56.25% General expenses 8,000 _12,000_ 8,000 _(4.000) _4,000 -33.33% 50.00% “Total operating expenses 30,000 37.000 _24,000 (7,000) 13.000 -1892% 54.17% Income from operations 30,000 32.375 20,000 (2,375) 12375 7.34% 61.88% [Non-operating income P6000 P_2,500 P_3500 P_3500 P (1,000) 140.00% — -2857% Income before interest ‘expense and taxes P 36,000 P 34875 P 23500 P 1125 P 11375 3.23% — 48.40% Inxcrest expense 4900 _ 3500 3.000 _500 _500 14.20% 16.6% Income before taxes 32,000 31,375 20,500 625 — 10.875 1.99% 53.05% Tecome taxes (35% rte) 11.200 10981 _7175_219_3806 199% — 5305% Net income 20.800 P 20394 P 13.325 P _406 P _7069 199% 53.05%Trend Ratios = i may become unwieldy. When an analysis coversa span of many years, comparative financial statements may become unit! “To avoid this, the results of a comparative statement may be presented by showing trends Cat? : bar yeat In his method, the fem has o choose a year tha represents the firm's activity a its bas Individut’ Jecounts in the financial statements of the base year are assigned an index of 100. The ine eee respective account in the succeeding years is determined by dividing the account's amount by the base year amount and multiplying the quotient by 100. For the year after the base year, it would be: Yer! , 100% Base year ‘Two years after the base year, it would be: —Near2. 100% Base year Applying the formula for cash in 2013 and 2014 with 2012 asthe base year, the ratio would be as follows. Cash ratio for 2013 is P-70,000 199% 75,000 = 93.33% Cash ratio for 2014 is P.65,000 199% 75,000 = 86.67% ‘A.condensed form of the balance sheet using trend analysis is shown in Illustration 5. Vertical Analysis Common-size Staternent In a common-size statement, a significant item on a financial statement is used as the base value, and all other items on the financial statement are compared with it. In performing common-size analysis for the balance sheet, coral assets are assigned as the base account with a percentage of 100. An individual asset account is expressed as a percentage of total assets. Likewise, the total liabilities and stockholders’ equity is 100%. Individual accounts in the liability and equity is also expressed as a percentage of coral liabilities and stockholders’ equity. In the income statement, net sales are given the value of 100% and all other accounts are evaluated in comparison to ner sales. The resulting figures are chen given in a common-size statement. The common: analysis of FMA Company's balance sheet is shown in Illustration 6.Company for 2012-2014 | MA Tlustration 5 sett analysis the batance sheet of PMA Compaty “Trend Analysis of Balance Sheet Decner 31-2014, 2013, and 2012 ce mus 2012, 2012 na ms 2012 ASSETS Caren ses i rm 9333% 100% Cah 1p 65,000. P 70,000 oe a 175.0% 100% Accu ale ammo 300 Thomo nome 300% 10m Markel seus 3 : lovey 199.000 $0,000 tonoom sa. 190 Talcanet a Beano 220000 upsie 1732 ON pa 00,000 160,000 17.65% 10% Foal Anes 1 as.o00 # 380,000 #375000 1186798 ee LIABILITIES Current liailcies fp 1nogoo #105000 10,000 106.549 100.96% 100% Longer ibis to.000 145000 140,000- 114.29% 103.579 100% “Total Libis sooo F 44000 110.8% 10246% 100% STOCKHOLDERS’ EQUITY Common tock P 5 pa ae, 2.000 shars Prono tooo # 100.000 100.00% — 100.00% 100% Reine carings sang 30000 31,000 239.35% 96.77% 100% Toa schol equity 71200130000 131000 132.989 99.24%. 100% Tal Linhiiien nd Stockholders’ Equity 445000 P 380,000 P 375. 18.67% 10.33% 100% FMA Company “Trend Analysis of Income Statement December 31, 2014, 2013, and 2012 204) 2013/ ae 242013012 22 2012-2012 120,000 £210,000 ¥ 100,000 200.00% 210.00% 100.008 ‘Sales returns and allowances 2 . . ae fea 25,000 6,000 __666.67%_416.67% _ 10.00% 000 185.000 94 5 Parana Teme sto ois00 reat I96etw tows ee i 4625 50,000 200.000 231.259% _100.00% psi 1000 f 69.375 P 44,000 136.369 _157.67% __ 100.00% Seling expenses Pu ‘General expenses a idiseea 16,000 137.50% 156.25% — 100,00% “Focal operating expenses 7) 8,000 __100,00% 150.0% __ 100.00% Income rm operons 000 125.0% 154.7% 100.00 Neos naa a 150.00% 161.88% 100.00% 2500 3500 171.43% 71.43% 100.00%Income before interest expense and taxes ‘P 36,000 P 34,875 f 23,500 153.19% — 148.40% — 100.00% Invert pense —4000_3500__ 3.000 133.3396 _116.67% _100.00% _ Income before tans 32000 31,375 20500 156.10% 153.05% —100.00% Income taes (359 rate) 1420010981 7.175 _156.10% 153.0596 100.009 _ Net income P_20.800 20.594 F 13.325 __156.10% _153.05% 10.00% Lam Common-size analysis of the balance sheet of FMA Company for 2012-2014 FMA Company Balance Sheet December 31, 2014, 2013, and 2012 Common-size Analysis 214 2013.22 20142013, 2012 ASSETS (Current asses Cah P 65,000 F 70,000 P 75,000 14.61% 18.42% 20.00% Accounts receivable 40,000 35,000 20,000 8.99% 9.21% 5.339% Marketable securities 40,000 35,000 10,000 8.99% 9.21% = 2.67% Inventory 100,000 80,000 100,000 22.47% 21.05% 26.67% oral current assets 245,000 220.000 205,000 55.06% 57.89% 54.67% Plants assets 200,000 160, 170,000 44.94% 42.11% 45.33% Tora Asses P 445,000 P 360,000 P 375,000 100,00% 00.00% 10.00% LIABILITIES (Current liabilities 110800 P 105,000 P 104000 24.90% 27.73% Long.term liabilities 160,000 145,000 140,000 35.96% 37.33% ‘Toca Liabilities 270.800 P 250.000 P 244,000 60.85% 65.07% STOCKHOLDERS’ EQUITY ‘Common stock, PS par value, 100,000 F 100,000 F 100000 22.47% 26.32% 26.67% 20,000 shares, Retained earnings 74200 30,000 _31,000 16.67% 7.8986 ‘Total stockholders’ equity 174200 130.000 131,000 39.15% 34.21% Tol Liabilities and P 445,000 P 380,000 P 375.000 100% 100% 100% Stockholders’ Equity FMA Company ‘Trend Analysis of Income Satement For the Years Ended December 31, 2014, 2013, and 2012 214 = 2013, 2012, 2014. S203 2012 Sales 1 200000 P 210,000 100,000 125.00% 13.51% — 106.38% Sales recurns and allowances 40.900 000 6,000 25.00% 13.51% — _6.38% Net sales 160.000 185,000 94,000 100,00% — 100.00% — 100.00%62.50% 115,025 50,000 Cost of ‘sol 100,000 37.50% ae aon ‘ass ne? Sting samo 300160 General expenses 800 12,000 a 18.75% dees Joo 320m 873% Income from operations 30900 32375 faa 375% Now-operating nome som 2500 2.50% Income before interest expense 3600 4875 eoeaee so 30 me inca eae tas mom 31 MIE oo Income aes (35% rt) 1) ON eos Retinoome om muse aS rncernal structure of an enterprise. It ans the exsing s ji 1 firm derermine possible improver, relationship of cach account in the balance shee thar would hep the im >rovemen adhe dus inaries of meources, Wich the peroeneage ofeach acount Inthe Income semerncat ia re to ts nee sles, ce fir can daw better alternatives in maximizing is profs ‘Common-size analysis is used t0 show the i Financial Ratios “The principal idea in analyzing financial ais is that there are several major Financial ratios obtanate from the Finantial statements ofthe firm that reveal its financial health. Financial statement ratio anaiis provides a broader basis for comparison than raw numbers do, However, ratios on their own, withou ye foryear or other industryfirm comparative ratios, are of litle use in judging the health or future of th industrylfiem being analyzed. Inassessing the significance of various financial statement data, experts engage in financial ratios ana the process of determining and evaluating financial ratios. A financial statement ratio isa relationship tha indicates something about a company’s activities, such as the ratio berween the company’s curren aes ‘and current liabilities or berween its accounts receivable and its annual sales. The basic source ofthese ais is the company’s financial statements that contain figures of assets liabilities, profits, and losses. Financ statement analysis ratios are only meaningful when compared with other information, Since they ae mos often compared with industry data, ratios help an individual understand a company’s performance relate to that of its competitors. These are often used to trace performance over time. Ratios analysis can reveal much about a company and its operations. Hlowever, there are several points© keep in mind about ratios. First, financial ratios indicate areas of strength or weakness. One or several tats might be misleading, buc when combined with other knowledge of a company’s management and econosi¢ circumstances, ratio analysis can tell much about a corporation, Second, there is no single correct value ft a ratio. The observation thatthe value of a particular ratio is too high, too low, or just right depends on te perspective of the analyst and on the company’s competitive strategy. Third, a financial ratio is meaning ‘only when ic is compared with some standard, such asan industry trend, a ratio trend, a ratio trend fo specific company being analyzed, or stated management objective.Financial ratios provide two types of comparisons: 1. Industry Comparison Financial ratios are computed and compared with the industry average, Through industry comparison, the company may be able to compare their performance against their competitors and how they fare with them. 2. Trend Analysis . The firm's financial ratios are computed and compared with their past performance. By the trends, the company will know if their financial performance is improving or not over the years. It isa very powerful tool in deciding the actions that a company should take in the futur. Liquidity Ratios For the fitm co remain credible and alive, it must pay its ills. As billing statements are sent, they become payable. Liquidity ratios area prime concern of short-term creditors because these provide insight ofthe firm's capability to pay its current obligations. Liquidity isimportantin conducting the firm's operations especially in times of uncertainty. Firms with good liquidity are able to cushion possible financial contingencies that might arise in case of labor strikes, step price increase of raw materials, or other possible events resulting in the temporary stoppage of operations. Ina profitable situation, liquidity reflects the capacity of the firm to generate cash inflow to offiet cash outflow. The firm's liquidity also affects its capacity to borrow. A low liquidity position of a firm will make Joan applications difficult due to poor credit risk. Although creditors at times are willing to take the risk in lending firms with a poor liquidity position, a trade-off may exist by asking for a higher lending rate. Working Capital. Working capital or net working capital is the difference between the firm's current assets and current liabilities, Working capital = Current assets ~ Curtent liabilities Current assets consist of cash and other assets that are reasonably converted into cash or consumed by the firm within one year from the balance shect date, the normal operating cycle. These include investment, receivables (notes and accounts receivable), inventories, and prepaid expenses. Current liabilities are obligations that are expected to be paid or setled within one year from the balance sheet date, the normal ‘operating cycle. Such obligations normally require the use of current assets or the creation of other current liabilities. Some common current liabilities in the hospitality industry are accounts payable, short-term notes Payable, current portion of long-term debt, income taxes payable, accrued expenses, and uncarned revenue, A positive working capital means the fim is able to meet its current maturing obligation witha safety cushion to meet other unexpected or unrecorded current liabilities. ‘The FMA Company's working capital for the years 2012 to 2014 are as follows 2014 2013 2012 245, 000 - P 110,800 = 220,000 ~ P 105,000 = P 205,000 ~ P 104,000 = 134,200 115,000 101,000 Statement Analysis.| B= | rivanctat MANAGEMENT | Part BR s by the current liabilities, Ty, by dividing current asset ey of the fi is Current Ratio, The current ratio is computed by dividing rte ability of the fm tm tao prob the mos equ bed ae cofmore than one isan indication thr ye its current liabilities as paid by its curren ase. : obligations. firm is liquid and in a good position to meet its currently maturing OP's Si ils to differentiate ber sarement of liquidity i that it fails to atch ner areoromingf the cure 8 en ste assumes that een Ivers and ah ppd ey aoa ee ones receivable, ot marketable securities. A high curent rag vi ompostion fm ay if invemteres and prepaid expenses is possibly not liquid enough to mene whose composition is more of inventories an posi nti caurrent obligation especially if the majority of che inventories are already o Current assets Current liabilities Current ratio = ‘The current ratio for 2014, 2013, and 2012 are: 2013 2012 = P.220,000 P 205,000 105,000 104,000 210 =197 ‘The current ratio of FMA Company improved from 1.97 in 2012 to 2.21 in 2014. At the comparative balance sheet of FMA (Illustration 3), there was an increase in the firm’s accounts receivable and marketable securities amounting to P 20,000 and P 30,000, respectively, from 2012 to 2014. Although, there was a decrease in cash by P 10,000 and an increase in current liabilities by P.6,800 from 2012 to 2014, the firm ‘managed to improve its current ratio. The increase in accounts receivable and marketable securities is accounted by the increase in sales. Quick Ratio. With the known mn of current ratio, a more stringent one is used. That is the quick ratio or acid test ratio. Quick ratio, like the current ratio, reflects the firm's ability to pay its short-term obligations. Thus, the higher the quick ratio, the more liquid the firm is. Quick ratio allows one to focus on a more immediate measure of liquidity by adding cash, accounts receivable, and marketable securities and dividing it by the current liabilities. The quick ratio assumes that che firms accounts receivable are propetty managed and collected in a short period of time. Invemtory is not included because of the length of time needed to convert inventory into cash. Thus, inventory had to be sold frst before becoming cash or accounts receivable. Likewise, prepaid expenses are excluded in the quick ratio because they are not convertible into cash and so are not capable of covering current liabilities, Quick ratio Current liabilities ‘The quick ratio for 2014, 2013, and 2012 are: 2014 20s are 3 65,000 +P 40,000 + P 40,000 = P70,000+P 35,0004 - F110 800 $%35.000+P 35.000 = p75,000 +P20000+? 1000! 131 133 ‘ 101‘The quick ratio improved from 1.01 in 2012 to 1.31 in 2014 due to the increase in accounts receivable nd marketable securities, Cash Position Ratio. As mentioned under the quick asset ratio, there isa possibility of encountering blems with accounts receivable. Accounts which are not properly managed will take some time to be mnverted into cash (if they are still collectible), making them not liquid. The cash position ratio is a step loser to pure liquidity by removing the accounts receivable from the quick ratio. To compute for cash osition ratio, the formula is: Cash Position Ratio = Cash + Marketable secu: uurrent liabilities \ctivity Ratios Activity ratios of asset management ratios measure the fim’ efficiency in managing its assets. These ivity ratios are used to determine how rapid various accounts are converted into sales or cash. Generally, high turnover ratio is associated with good asset management and a low turnover ratio with bad asset ;nagement. However, itis still necessary to evaluate the activity of specific current accounts to avoid being sled. There are other activity ratios that can be used in the analysis, each of which is directed towards a fic type of asset management. Accounts Receivable Turnover. The accounts receivable turnover ratio estimates how fast the accounts civable is converted into cash during the year. Accounts receivable turnover is computed by dividing net lit sales by the average of the beginning and ending balance of the accounts receivable. Average accounts civable is obtained by adding the beginning and ending accounts receivable and then dividing the sum ‘wo. Ifchere is no net credit sales information, net sales can be used. In general, the higher the accounts receivable turnover, the better. It means that the firm’s customers te prompt payers. However, an excessively y ringent, with the company not tapping the potential for profit through sales to customers in higher risk asses. On the other hand, an extremely low accounts receivable turnover means that the company is too in its credit policy. Accounts receivable turnover = Net credit sales ‘Average accounts receivable ‘The FMA Company's average accounts receivable for 2014 and 2013 are: 2014 2013 = P.40,000 + P 35,000 = P.35,000+P 20,000 2 i = P37,500 = P2750 ‘The accounts receivable turnover ratio for 2014 and 2013 are: 2014 2015 = P.160,000 7500 Sie eee ee THE LIBRARY GENEPAL DE JESUS COLLEGES| : 5 ce decline in ratio t0 4.27 in 2014 sinn, In 2013, the accounts receivable turnover ratio was 6.73. The decline ai Signifig a problem in the callecton of accounts receivable. With this financ information already at hang, firm nceds to review its credit policy, which may be too lax, oF to correct its billing and collection syage and implementation. : 1c efficiency of the firm’s collec, Average Collection Period. The average collection period neastrs 7 ace Fthe Bem’ coli, policy by computing the number of days to collect the receivables. Thus, i llection period = 360 fee ae “Recounts receivable turnover The FMA Company's average collection period for 2014 and 2015 are: 2014 ae = 360 = 360 @ 427 ce + east days = 55.49 days 8a stays RE ‘This means that it takes 84.31 days for a sale to be converted into cash in 2014. In 2013, the a collection period was 53.49 days. With significant increase in collection days in 2014 by almost 31 day, there exists a risk that customer's accounts may become uncollectible. One of the possible causes of such an increase is that the company is more lenient in selling on credit to customers. The firm must be abe to check or possibly think of revising its policy with regard to granting credit. For monitoring purposes, an aging schedule which lists the accounts receivable according to the length of time they are outstanding ‘would be helpful ro identify accounts long overdue. Inventory Turnover, The inventory turnover shows the efficiency of the firm in handling ts inventory t measures how fast the inventory is turned into sales. A low inventory turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. As a result, there will bea high carrying cost for storing the goods, as well as a risk of obsolescence. However, a low inventory turnover rate may be appropriate in instances where higher inventory levels occur in anticipation of rapidly rising prices or shortages. On the other hand, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in sales. Two major ratios for evaluating inventory are inventory turnover and average age inventory. Inventory turnover is computed as: Inventory turnover = Cost of goods sold Average inventory Average inventory is determined by adding the beginning and ending inventories and dividing the sum by two. 2014 2013 = P 100,000 + P 80,000 P.80,000 + P 100,000 2 2 520000 = P.90,000‘The inventory turnover of the FMA Company in 2014 and 2013 are: 2014 2013 100,000 P 115,625 90,000 P 90,000 = 111 =128 “The inventory turnover declines from 1.28 in 2013 to 1.11 in 2014. This indicates a problem with regard to stocking of goods. In the income statement, the cost of goods sold declined by P 15,625 from 2013 t0 2014, but the inventory at the end of 2014 rose by P 20,000. It is an indication that there are slow-moving items in the inventory. An attempt should be made to determine whether an increase in the ending inventory is caused by unsalable items, Another possibility of an increase in inventory items is the inclusion of obsolete inventories. These inventories must be removed from the warehouse as these will incur more handling, costs. The average age of inventory is computed as follows: Average age of inventory = 360, Inventory turnover ‘The average age of inventory in 2014 and 2013 are: 2014 2013 = 360 = 360 Lil 128 = _324.32days = 281.25 days In 2013, the average age was 281.25 days. The lengthening of the holding period shows a potentially ‘greater risk of obsolescence. Operating Cycle. The operating cycle measures the time it takes to convert the inventories and receivables to cash. Hence, a short operating cycle is desirable. Operating Cycle = Average collection period + Average age of inventory ‘The operating cycle for the FMA Company in 2014 is: 2014 2013 = 8431 days + 324.32 days = 53.49 days +281 25 days = 408.63 days = 33474 days ‘The operating cycle increased from 334.74 days to 408.63 days. This is an unfavorable trend since an increased operating cycle means that a considerable amount of money is tied up in non-cash assets. The firm must look into the possibility of ducing the operating cycle to improve its liquidity. Too much funds tied in the inventory and receivables ead to an increased cost of doing business due to loans. Fixed-asset Turnover. Fixed assets comprise of property, plant, and equipment. Its considered as the most important long-term aset ofthe firm in the balance sheet. Fixed-assersurnover ratio measures how well the firm uses every peso of fixed asst invested to generate sales. Thus, it becomes a good indicator| Financia mawacemenT | Part = a a peso invested in fixed au, of efficiency in the use ofa fixed asset. The amount of sales generated by a peso invested In Fed agg measured by the ratio: os Sales__— ised Asset Turmover Ratio = Se Ahigh fixed-aset ratio reflects a good fixed-asset management, and 3 low bs ae refleas 5 poor Fixed-asset management, Through the fixed-aset ratio, the frm is 401 ey a ei ‘Was therm able ro manage its inventories well Does the company use mos atu their goods or services? Was there an overinvestment made in fixed assets? c past two years are as follows: ‘The FMA Company's fixed-asset turnover ratios for the past two years 2013 eet Sc (~isiano ¥ 0.00) 2 2014 = P 160,000 (Fzan00. P160.900) 2 ae 12.12% ‘The FMA Company is more efficient in the use of its fixed assets in 2013 than in 2014 a\ shown by , in fixed assets in 2014, the higher fixed-asset turnover ratio, It can be seen that despite an increase in Fi the company ‘was not able to improve its performance. Such a decline should be investigated to increase the efficiency of fixed assets, Total Asset Turnover. The total asset turnover ratio measures the firm’s ability to generate sles successfully. A low asset turnover ratio may be due to many factors, and it is important to identify the underlying reasons. For example, is the value of investment in assets excessive when compared with th value ofthe ourput? Ifo, the company might want to consolidate its present operation, pethaps by sling some of its assets and putting the proceeds in a high-return investment or using them to expand into a more profitable area. To calculate asset turnover, the net sales is divided by the average toral assets forthe period Total asset turnover = Net sales ‘Average toral assets The average total assets of the FMA Company is: 2014 2013 = P.445,000 + P 380,000 P 380,000 + P 375,000 2 2 = P412,500 = P377,500 Ta 00 The total asset turnover ratio of the firm for 2014 and 2013 are: 2014 2013 ra E1500 = 38.79% a ee‘The company’s use of assets declined significantly from 49.01% in 2013 to 38.79% in 2014. Despite the increase in the average total assets, the firm was not able to generate more sales. In principle, a high total aset turnover indicates an efficient asset management, However, since total asset turnover is composed of current and fixed assets, all other ratios like inventory turnover, receivables turnover, and fixed asset turnover are part of the analysis in the total assets turnoves Risk and Return Trade-off Between Liquidity and Activity Ratios & A trade-off exists between liquidity risk and return. Holding a high amount of current assets means les liquidity risk and less returns to the firm. Maintaining a high level of current asets than productive fixed assets isa sign of visk aversion of the firm. The firm would rather have a small return on chortaena investments on current assets rather than generate more income in fixed assets. On the other hand, firme wich invest more on fixed assets are more exposed to liquidity tsk due to funds tied. Firms which succor Feith Fixed asset investments enjoy more economic returns to the firm. Maintaining a proper balance berweca liquidity and return is important to the overall financial health of a business. High profitability will nor always result in a strong cash flow position, The net income may be high but financial difficulty may still exist because of the maturing debts and assets that need replacement, It is Possible that growing firms may experience a decline in liquidity sine the working capital needed ta support che increasing sales is invested in assets that could not be realized in due time to pay its current ebligations. Thus, the effec of earning activities on liquidity is clearly recognized by comparing cash flow from operations to net income. Leverage Ratios "Leverage ratios indicate up to what exten the firm has financed its investments by borrowing, Firms that use deb financing rather than equity financing increase the risk ofthe frm The more debr they incur, ‘he higher cheir leverage ratio is andthe higher the financial isk they fae, ‘When obligation i excessive, additonal financing may alo be obtained from issuance of shares of stocks. ‘Asan alternative, firms may consider stretching the maturity ofthe debe and making staggered payments. Some leverage ratios are as follows: . Debt Ratio. Iris computed by dividing the roral liabilities ofthe fim by its toral assets. This ratio shows the portion of the total assets financed by the creditors. The provider of funds other than the stockholders Debt ratio= — Total ies Total assets Analysis, nancial taBB | ravers manscrnenr en co ‘The debr ratio of the FMA Company for 2014, 2013, and 2012 are: 2014 2013 ees = P270,800 = P 250,000 - Fareaeg 445,000 P 380,000 si = 60.85% = 65.79% = 6507% In 2013, the ratio was 65.79%. There was a slight improvement in the ratio over the year as indicgg by the lower degree of debt to total assets. Debt-to-Equity Ratio. The debt-1o-equity ratio measures the proportion of the total liabilities 4, invested apna A debr-to-equity ratig means thatthe firm Financed the assets mostly by deb, ric debt-to-equity ratio means that the fitm paid for the assets by means of capital infusion by the stockholder, “Thus, a ratio of more than one means that the firm has used more debe chan equity to finance it investmeny, Abiigh degree of debt in the capital structure may make it difficult for the company to meet interest charg, and principal payments at maturity. The deb-to-equity ratio is computed as: Total liabilities ‘Stockholders’ equity The debr-to-equity ratio for 2014, 2013, and 2012 are as follows: 2014 2013, 2o1z = 270,800 P 250,000 = P 244,000 P 174,200 P- 130,000 P 131,000 = 155% = 192x = 1.86x For the FMA Company, the debt-to-equity ratio was 1.55x in 2014, 1,92x in 2013, and 1.86x in 2012. From yeats 2012 to 2014, the toral liabilities increased from P 244,000 to P 270,800. Likewise, the stogkholders’ equity increased from P 131,000 to P 174,200. The ratio remained fairly constant in 2012 and 2013 except in 2014 when it shows an improvement brought about by the increased equity. A desirable debt-to-equity ratio depends on many variables, including the rates of other companies in the industry, the access for further debr financing, and the stability of earnings. ‘Times Interest Earned Ratio. The times interest earned ratio reflects the number of times the earings before tax and interest expense cover the interest expense. It measures how capable the firm is in paying its interest obligations. This ratio is the equivalent of a person taking the combined interest expense from his or her mortgage, credit cards, auro and education loans, and calculating the number of times he or se can pay it ‘or het annual pre-tax income. For bond holders, the times interest earned ratio act 352 safety gauge. It gives a sense of how far a company’s earnings can fall before it starts defaulting om its bond payments. For stockholders, the times interest earned ratio is important because it gives a clear picture of the short-term financial health of a business i ‘The times interest earned ratio is computed as follows: ‘Times interest earned ratio Earnings before interest and taxes (EBIT) : Interest expenseThe times interest earned ratio for 2014, 2013, and 2012 are as follows: 2014 2013 = P 36,000 = P34.875 P 4.000 P3500 = 9x = 996% In 2014, the FMA Company was able to cover its interest expense 9 times; in 2013, interest expense was covered 9.96 times; an 2012, it was covered 7.83 times. The increase on the times interest earned ratio from 2012 to 2014 isa positive indicator that the firm is capable of paying its maturing interest obligation. Profitability Ratios ‘These are indicators of good financial health and evaluate how effectively the firm is being managed to earn a satisfactory profit and return on investment. Profitability ratio measures management effectiveness in terms of rate of return to sales, assets, and equity. Investors would be reluctant to invest in an entity that has poor earning potential since the market price of stock and dividend potential is directly affected. Creditors would decline co entertain companies with deficient profirability since the amounts lent may no longer be paid. Listed below are some of the profitability ratios. Gross Profit Margin. Ic is a measurement of a company’s manufacturing and distribution efficiency during the production process. The gross profit tells the percentage of sales left after subtracting the cost of goods sold. Firms with higher gross profit margin than its competitors in the industry are more efficient. Investors tend to pay more for businesses that have higher efficiency rating than their competitors, as these businesses should be able to make a decent profit as long as ovethead costs are controlled, Gross profit margin = Gross profit Net ales ‘The gross profit margins of the FMA Company from 2012 to 2014 are as follows: 2014 2013 2012 = P_60,000 = P_ 69375, P 44.000 160,000 P 185,000 94,000 = 3750% = 3750% = 46.81% In 2012, the gross profit margin was 46.81%. The decline in this ratio to 37:50% in 2014 indicates thar the business is earning less gross profit on each peso sale. reason for the decline may include a higher relative production cost of the merchandise sold, Profit Margin. The profic margin is another measurement of management’ efficiency, Its the ratio of net income to net sales. It compares the quality of company’s operations with that of its competitors, ‘A business that has a higher operating margin than che industry average tends to have lower fixed caste and a beter gross margin, both of which give the management more flexibility in determining prices, This Pricing flexibility provides an added measure of safety during rough economic times.= (ANAGEMENT |Past J roanciatse ‘Net income, Profit margin = cas follows: ‘The FMA Company's profit margins from 2012 t0 2014 areas 2012 2013 at = P_ 13,325 = P2000 = ansee P9400 P 160,000 ipa = 140% = 13.00% ede sand increase in sales, the profi margin deci naan nel the decline in profit margin sty i net income after Despite an increased nt incon fer inte cs for from 14.18% in 2012 to 13.00% in 2014. inefficiency of the firm in the manufacturing processes. Return on Investment ent (ROD) measures the income generated for every peso investment made inthe Return on investm investment, the better. firm, The higher the income generated per peso it The commonly used return on investment ratios are the return on total assets (ROA) and the return on equity (ROE). “The return on total assets measures the income generated for every peso invested in the assets. Iisa test of how profitable the firm has been in the use of its assets. The formula for the return on total assets Net income after interest and taxes ‘Average total assets Return on total assets ‘The returns on toral assets of the FMA Company in 2014 and 2013 are: 2014 2013 = P_20,800 =P 20,304 P 412,500 P 377500 = 5.04% 5.40% In 2013, the ROA is 5.40%. The productivity of the assets in generating income deteriorated in 2014 Though there was an increase in the net income after tax from 2013 to 2014 by P 406, the ROA declined duc to a higher increase in the average otal assets by P 35,000. This indi * y P 35,000. This indicates that m the required efficiency in the use of the increased assets, penne tention DuPont Analysis. The Du Poot formula isan integrative approach in explaining and looking athe differences in return on total asses. It is another way sf come product ofthe profit margin andthe otal ase urnoner en nS He ftuem on assets by getting he Return on total assets = Profit margin x Total aset curnover