CHAPTER 12

ANALYSIS OF FINANCIAL STATEMENTS

Financial statement analysis is the process of extracting information from financial

statements to better understand a company’s current and future performance and financial
condition.

ANALYZING THE BROADER BUSINESS ENVIRONMENT

Quality analysis depends on an effective business analysis. The broader business context
in which a company operates must be assessed as its financial statements are read and
interpreted. A review of financial statements which reflect business activities is contextual
and can only be effectively undertaken within the framework of a thorough understanding
of the broader forces that impact company performance. Some of these questions about a
company’s business environment are:

 Life cycle. At what stage in its life is this company? Is it a startup, experiencing
growing pains? Is it strong and mature, reaping the benefits of competitive
advantages? Is it nearing the end of its life, trying to milk what it can from stagnant
product lines?

 Outputs. What products does it sell? Are its products new, established or dated? Do
its products have substitutes? How complicated are its products to produce?

 Buyers. Who are its buyers? Are buyers in good financial condition? Do buyers
have substantial purchasing power? Can the seller dictate sale terms to buyers?

 Inputs. Who are its suppliers? Are there many supply sources? Does the company
depend on a few sources with potential for high input costs?

 Competition. In what kind of markets does it operate? Are markets open? Is the
market competitive? Does the company have competitive advantages? Can it protect
itself from new entrants? At what cost? How must it compete to survive?
  Financing. Must it seek financing from public markets? Is it going public? Is it
seeking to use its stock to acquire another company? Is it in danger of defaulting on
debt covenants? Are there incentives to tell an overly optimistic story to attract
lower cost financing or to avoid default on debt?

 Labor. Who are its managers? What are their backgrounds? Can they be trusted?
Are they competent? What is the state of employee relations? Is labor unionized?

 Governance. How effective is its corporate governance? Does it have a strong and
independent board of directors? Does a strong audit committee of the board exist?
And is it populated with outsiders? Does management have a large portion of its
wealth tied to the company’s stock?

 Risk. Is it subject to lawsuits from competitors or shareholders? Is it under

investigation by regulators? Has it changed auditors? If so, why? Are its auditors
independent? Does it face environmental and/or political risks?

We must assess the broader business context in which a company operates as we read and
interpret its financial statements. A review of financial statements, which reflect business
activities, cannot be undertaken, in a vacuum. It is contextual and can only be effectively
undertaken within the framework of a thorough understanding of the broader forces that
impact company performance.

BASICS OF PROFITABILITY ANALYSIS

The primary goal of financial management is to maximize shareholders’ wealth, not

accounting measures such as net income or earnings per share (EPS). However, accounting
data influence stock prices and this data can be used to see why a company is performing
the way it is and where it is heading.

The previous section described the key financial statement and should how they change as
a firm’s operations change.

In the succeeding section, we shall show the statement are used by managers to improve
the firm’s stock price: by lenders to evaluate the likelihood that borrowers will be able to
pay off loans; and by security analysts to forecast earnings, dividends, and stock prices. If
management is to maximize a firm’s value, it must take advantage of the firm’s strengths
and correct its deficiencies and weaknesses.
Financial Analysis involves

 Comparing the firm’s performance to that of other firms in the same industry, and
 Evaluating trends in the firm’s financial position over time.

These studies help managers identify deficiencies and take corrective actions.

LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS

Although financial statement analysis is a highly useful tool, the analyst should consider
its limitations. The limitations involve the comparability of financial data between
companies and the need to look beyond ratios. These limitations are:

1. Information derived by the analysis are not absolute measures of performance in

any and all of the areas of business operations. They are only indicators of degrees of
profitability and financial strength of the firm.

2. Limitations inherent in the accounting data the analyst work with. These are
brought about by among others: (a) variation and lack of consistency in the application
of accounting principles, policies and procedures, (b) too-condensed presentation of
data, and (c) failure to reflect change in purchasing power.

3. Limitations of the performance measures or tools and techniques used in the

analysis. Quantitative measurements are not absolute measures but should be
interpreted relative to the nature of the business and in the light of past, current and
future operations. Timing of transactions and the use of averages can also affect the
results obtained in applying the techniques in financial analysis.

4. Analysis should be alert to the potential for management to influence the outcome
of financial statements in order to appeal to creditors, investors, and others.

Limitations of analysis may be overcome to some extent by finding appropriate

benchmarks used by most analyst such as the performance of comparable components and
the average performance of several companies in the same industry.

FINANCIAL RATIO ANALYSIS

There are a number of different ways to analyze financial statements. The most applied is
the financial Ratio. Financial ratio is a comparison in fraction, proportion, decimal or
percentage of two significant figures taken from financial statements. It expresses the direct
relationship between two or more quantities in the statement of financial position and
statement of comprehensive income of a business firm.

The ratio can be categorized as follows:

1. Liquidity Ratios. These ratios give us an idea of the firm’s ability to pay off
debts that are maturing within a year or within the next operating cycle.
Satisfactory, liquidity ratios are necessary if the firm is to continue operating.

2. Asset Management Ratios. These ratios give us an idea of how efficiently the
firm is using its assets. Good asset management ratios are necessary for the firm
to keep its costs low and thus, its net income high.

3. Debt Management Ratios. These ratios would tell us how the firm has financed
its assets as well as the firm’s ability to repay its long-term debt. Debt
management ratios indicate how risky the firm is and how much of its operating
income must be paid to bondholders rather than stockholders.

4. Profitability. These ratios give us an idea of how profitability the firm is

operating and utilizing its assets. Profitability ratios combine the asset and debt
management categories and show their effects on return on equity.

5. Market Book Ratios. These ratios which consider the stock price give us an idea
of what investors think about the firm and its future prospects. Market book
ratios tell us what investors think about the company and its prospects.

All of the ratios are important, but different ones are more important for some companies
than for others. For example, if a firm borrowed too much in the past and its debt now
threatens to drive it into bankruptcy, the debt ratios are the key. Similarly, if a firm
expanded too rapidly and now finds itself with excess inventory and manufacturing
capacity, the asset management ratios take center stage. The ROE is always important, but
a high ROE depends on maintaining liquidity, on efficient asset management, and on the
proper use of debt. Managers are, of course, vitally concerned with the stock price, but
managers have little direct control over the stock market’s performance while they do have
control over their firm’s ROE. So ROE tends to be the man focal point.

A summary of the ratios, their formula and significance is presented in Figure 12-1.
I. Ratios Used To Evaluate Short-Term Financial Position (Short-Term Solvency and
Liquidity)

Name Formula Significance

1. Current Ratio Total Current Assets Primary test of
Total Current Liabilities solvency to meet
current obligations
from current assets as
a going concern;
measure of adequacy
of working capital.

2. Acid-test ratio or Total Quick Assets* A more severe test of

quick ratio Total Current Liabilities immediate solvency;
test of ability to meet
demands from current
*Cash + Marketable Securities +Accounts receivable assets.

3. a) Working Working Capital Indicates relative

Capital to Total Assets liquidity of total assets
total assets and distribution of
resources employed.

b) Working Current Assets less

Capital Current Liabilities

4. Cash Flow Cash + Marketable Measures short-term

Liquidity Ratio Securities + Cash Flow liquidity by considering
From Operating as cash resources
Activities (numerator) cash plus
Current Liabilities cash equivalents plus cash
flow from
operating activities.

5. Defensive Interval Quick Assets Measures length of time

Ratio Projected Daily in days, the firm can
Operational Expenses operate on its present
liquid resources.
II. Ratios Used To Evaluate Asset Liquidity and Management Efficiency

Name Formula Significance

1. a) Trade Net credit sales* Velocity of collection of

receivable Average Trade trade accounts and
turnover Receivable(net) notes; test of efficiency
of collection.

b) Average 360 days Evaluate the liquidity

Collection Receivable Turnover of accounts receivable
period or or and the firm's credit
number of Accounts Receivable policies.
days' sales Net Sales /360
uncollected

2. Inventory Turnover

a) Merchandise Cost of Goods Sold Measures efficiency of

turnover Average Merchandise the firm in managing
Inventory and selling inventories.

b) Finished Cost of Goods Sold

goods Average Finished goods -do-
inventory Inventory

c) Goods in Cost of goods Measures efficiency of

process manufactured the firm in managing
turnover Average Goods-in and selling inventories.
Process Inventory

*or Net Sales if net credit sales figure is not available

d) Raw materials Raw Materials Used Number of times raw

turnover Average Raw Materials materials inventory was
Inventory used and replenished
during the period.

e) Days supply 360 days Measures average

in inventory Inventory Turnover number of days to sell
 or consume the average
inventory.

3. Working Capital Net Sales Indicates adequacy and

turnover Ave. Working Capital activity of working
capital.

4. Percent of each Amount of each Indicates relative

current asset to current asset item invenstment in each
total current assets Total Current Assets current asset.

5. Current assets Cost of Sales Measures movement

turnover + and utilization of current
Operating Expenses + resources to meet
Income Taxes operating requirements.
+
Other Expenses (net)
(excluding depreciation
and amortization)
Ave. Current Assets

6. Payable turnover Net Purchases Measure efficiency of

Average Accounts the company in meeting
Payable trade
payable.

7. Operating cycle Average Conversion Measures the length of

Period of Inventories time required to convert
+ casth to finished good;
Average Collection then to receivable and
Period of Receivale then back to cash.
+
Days Cash

8. Days Cash Ave. Cash Balance Measures availability of

Cash operating costs cash to meet average
÷ 360 days daily cash requirement.

9. Free cash flow Net cash from Excess of operating

operating activities - cash flow over basic
 Cash used for investing needs.
activities and Dividends

10. Investment or Net Sales Measures efficiency of

asset turnover Ave. Total Investment the firm in managing all
or Total Assets assets.

11. Sales to fixed Net Sales Tests roughly the

assets (plant Ave. Fixed Assets efficiency of
assets turnover) (net) management in keeping
plant properties
employed.

12. Capital intensity Total Assets Measures efficiency of

ratio Net Sales the firm to generate
sales through
employment of its
resources.

III. Ratios Used to Evaluate Long-Term Financial Position or Stability/Leverage

Name Formula Significance

1. Debt Ratio Total Liabilities Shows proportion of all
Total Assets assets that are financed
with debt.

2. Equity Ratio Total Equity Indicates proportion of

Total Assets assets provided by
owners. Reflects
financial strength and
caution to creditors.

3. Debt to Equity Total Liabilities Measures debt relative

Ratio Total Equity to amounts of resources
provided by owners.

4. Fixed Assets to Fixed Assets (Net) Reflects extent of

Long-Term Total Long-Term investment in long-term
Liabilities Liabilities assets financed from
long-term debt.
5. Fixed Assets to Fixed Assets (Net) Measures the proportion
Total Equity Total Equity of owners' capital
invested in fixed assets.

6. Fixed Assets to Fixed Assets (Net) Measures investment in

Total Equity Total Assets long-term capital
assets.

7. Book Value Per Ordinary Measures recoverable

Share of Ordinary Shareholder's Equity amount in the event of
Shares No. of Outstanding liquidation if assets are
Ordinary Share realized at their book
values.

8. Time Interest Net Income before Measures how many

Earned Interest and Taxes times interest expense
Annual Interest is covered by operating
Charges profit.

9. Time Preferred Net Income Indicates ability to

Dividend After Taxes provide dividends for
Requirement Preferred Dividends preference
Earned Requirement shareholders.

10. Times Fixed Net Income before Measures coverage

Charges Earned Taxes and Fixed capability more broadly
Charges than times interest
Fixed Charges earned by including
(Rent + Interest + other fixed charges.
Sinking Fund payment
before taxes*)
IV. Ratios Used to Measure Profitability and Returns to Investors

Name Formula Significance

1. Gross profit margin Gross profit Measures profit
Net sales generated after
consideration of cost
of product sold.

2. Operating profit Operating profit Measures profit

margin Net sales generated after
consideration of
operating costs.

3. Net profit margin Net profit Measures profit

(rate of return on net Net sales generated after
sales) consideration of all
expenses and
revenues.

4. Cash flow margin Cash flow for Measures ability of the

operating activities firm to translate sales
to cash.
Net sales

______
𝑆𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
* Sinking fund payment before taxes =
1−𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
5. Rate of return on Net profit Measures overall
assets (ROA) * Ave. total assets efficiency of the firm in
managing assets and
generating profits.

Alternative formula:
Asset turnover
x
Net profit margin

6. Rate of return on Net income Measures rate of

equity ** Ave. ordinary equity return on resources
provided by owners.

7. Earnings per share Net income less Peso return on each

preference dividends ordinary share.
requirement Indicative of ability to
pay dividends.
Ave. ordinary shares
outstanding

8. Price/earnings ratio Market value per share Measures relationship

of Ordinary shares between price of
ordinary shares in the
Earnings per share of
open market and profit
Ordinary share earned on a per share
basis

9. Dividend payout Dividends per share Shows percentage of

Earnings per share earnings paid to
shareholders.
 10. Dividend yield Annual Shows the rate earned
Dividends per share by shareholders from
dividends relative to
Market value per share
current price of stock.
of Ordinary shares
______
* If there is interest-bearing debt, Rate of return on assets is computed as follows:
A measure of the
Net income + [Interest expense (1 – Tax rate)] productivity of
Average Total Assets assets regardless of
how the assets are
** May also be computed as follows: financed.
ROE = Return of assets x Equity Multiplier
1
Equity Multiplier =
𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜

11. Dividends per share Dividends Shows portion of

Paid/Declared income distributed to
shareholders on a per
Ordinary shares
share basis.
outstanding

12. Rate of return on Net income Measures the

average current assets Ave. current assets profitability of current
assets invested.

13. Rate of return per Rate of return on Shows profitability of

turnover of current Ave. current assets each turnover of
assets current assets
Current assets
turnover
 Figure 12-1 Summary of Most Commonly Used Ratios: Their Formulas and
Basic Significance
Illustrative Case 12-1

The financial statements of EBC Enterprises, Inc. will be used to illustrate the use of
financial ratios in analyzing company’s (1) liquidity, (2) activity or efficiency in managing
resources, (3) leverage, and (4) profitability.

Liquidity ratios are ratios that measure the firm’s ability to meet cash needs as they
arise. (e.g., payment of accounts payable, bank loans and operating costs).

Activity ratios are ratios that measure the liquidity of specific assets and efficiency
in managing assets such as accounts receivable, inventory and fixed assets.

Leverage ratios are ratios that measure the extent of a firm’s financing, with debt
relative to equity and its ability to cover interest and other fixed charges such as rent
and sinking fund payments.

Profitability ratios are ratios that measure overall performance of the firm and its
efficiency managing assets, liabilities and equity.

The Statements of Financial Position as of December 31, 2014 and 2013, Income
Statements and Statements of Cash Flows of EBC Enterprises, Inc. for years 2014, 2013,
and 2012 are given below:

EBC Enterprises, Inc.

Statement of Financial Position at December 31, 2014 and 2013
(in thousands)

2014 2013
Assets
Current Assets
Cash ₱ 2,030.5 ₱ 1,191.0
Marketable securities 2,636.0 4,002.0
Accounts receivable 4,704.0 4,383.5
Allowance for doubtful accounts - 224.0 - 208.5
Inventories 23,520.5 18,384.5
Prepaid expenses 256.0 379.5
Total current assets ₱ 32,923.0 ₱ 28,132.0
Property, Plant and Equipment
Land 405.5 405.5
Buildings and leasehold improvements 9,136.5 5,964.0
Equipment 10,761.5 6,884.0
20,303.5 13,253.5
Less Accumulated depreciation and amortization - 5,764.0 - 3,765.0
Net property, plant and equipment 14,539.5 9,488.5

Other Assets 186.5 334.0

Total Assets ₱ 47,649.0 ₱ 37,954.5

Liabilities and Equity

Current Liabilities
Accounts payable ₱ 7,147.0 ₱ 3,795.5
Notes payable- Bank 2,807.0 3,006.0
Current maturities of long-term debt 942.0 758.0
Accrued liabilities 2,834.5 2,656.5
Total current liabilities ₱ 13,730.5 ₱ 10,216.0
Deferred Income Taxes 421.5 317.5

Long-term Debt 10,529.5 8,487.5

Total Liabilities 24,681.5 19,021.0

Equity
Ordinary shares, par value P1, authorized 10,000,000
Shares, issued, 2,297,000 shares in 2014 and
2,401,500 shares in 2013 ₱ 2,401.5 ₱ 2,297.0
Additional paid-in-capital 487.5 455.0
Retained earnings 20,087.5 16,181.5
Total equity 22,976.5 18,933.5

Total Liabilities and Equity ₱ 47,658.0 ₱ 37,954.5

 EBC Enterprises, Inc.
Income Statement and Retained Earnings
For the Year Ended December 31, 2014, 2013 and 2012

2014 2013 2012

Net Sales ₱ 107,800.0 ₱ 76,500.0 ₱ 70,350.0
Cost of goods
sold 64,682.0 45,939.5 40,803.0
Gross profit 43,118.0 30,560.5 29,547.0

Selling and administrative

expenses 16,332.0 13,191.0 12,749.0
Advertising 7,129.0 5,396.0 4,770.5
Lease payments 6,529.0 3,555.5 3,633.5
Depreciation and amortization 1,999.0 1,492.0 1,250.5
Repairs and maintenance 1,507.0 1,023.0 1,515.5
Total 33,496.0 24,657.5 23,919.0
Operating profit 9,622.0 5,903.0 5,628.0

Other Income (expenses)

Interest income 211.0 419.0 369.0
Interest expense - 1,292.5 - 1,138.5 - 637.0
Earnings before income 8,540.0 5,183.5 5,360.0

taxes

Income taxes 3,843.0 2,228.5 2,412.0

Net Income 4,697.0 2,955.0 2,948.0

Earnings per common share ₱ 2.00 ₱ 1.29 ₱ 1.33

Statement of Retained Earnings

Retained earnings at beginning of
year 16,181.5 14,157.5 12,130.0
Net Income 4,697.0 2,955.0 2,948.0

Cash dividends (2014 - P0.33 per

share;
2013 - P0.41 per share) - 791.0 - 931.0 - 920.5
Retained earnings at end of year ₱ 20,087.5 ₱ 16,181.5 ₱ 14,157.5
 EBC Enterprises, Inc.
Statements of Cash Flows for the Years Ended December 31,2014 and 2013
(in thousands)

2014 2013
Cash Flow from Operating Activities - Direct Method ₱107,495.0 ₱ 74,830.5
Cash received from customers 211 419
Interest received (66,466.5) (49,968.0)
Cash paid to suppliers for
inventory 16,332.0 (13,191.0)
Cash paid to employees (S&A) expenses) (14,864.0) 10,675.0
Interest paid (1,292.5) (1,138.5)
Taxes paid (3,739.0) (2,160.5)
Net cash provided (used) by operating activities 5,012.0 (1,883.5)

Cash Flow from Investing Activities

Additions to property, plant and equipment (7,050.0) (2,386.5)
Other investing activities 147.5 0
Net cash provided (used) by investing activities (6,902.5) (2,386.5)

Cash Flow from Financing Activities

Sales of ordinary shares 128.0 91.5
Increase (decrease) in short-term borrowing
(includes current maturities of long-term debt) (15.0) 927.0
Additions to long-term
borrowings 2,800.0 3,941.0
Reductions of long-term
borrowings (785.0) (796.5)
Dividends paid (791.0) 931.0
Net cash provided (used) by financing activities 1,364.0 3,232.0
Increase (decrease) in cash & marketable securities (526.5) (1,038.0)

Supplementary Schedule
Cash Flow from Operating Activities - Indirect
Method
Net Income 4,697.0 2,955.0
Noncash revenue and expenses included in net income:
Depreciation 1,999.0 1,492.0
Deferred income
taxes 104.0 68.0
Cash provided (used) by current assets and liabilities:
Accounts
receivable (305.0) 1,669.5
 Inventories (5,136.0) 3,503.0
Prepaid expenses 123.5 147.5
Accounts Payable 3,351.5 (525.5)
Accrued liabilities 178.0 (848.0)
Net cash provided (used) by operations ₱5,012.0 ₱ (1883.5)
Additional information:

Market o[price per share - 2014: ₱30; 2013: ₱17

Required:

Using the financial ratios, evaluate the company’s financial position and operating results
for years 2014 and 2013.

Solution: EBC Enterprises, Inc.

I. Analysis of Liquidity or Short-Term Solvency

Current ratio:

Formula: Current Assets

Current Liabilities

2014: 32,923
= 2.40 times
13,703.5

2013: 28,132
= 2.75 times
10,216

Current ratio is widely regarded as a measure of short-term debt-paying ability.

Current Liabilities are used as the denominator because they are considered to
represent the most urgent debts requiring retirement within one year or one
operating cycle. A declining ratio could indicate a deteriorating financial condition
or it might be the result of paring of obsolete inventories or other stagnant current
assets. An increasing ratio might be the result of an unwise stock piling of inventory
or it might indicate an improving financial situation. The current ratio is useful but
tricky to interpret and therefore, the analyst must look closely at the individual assets
and liabilities involved.
 Some analysts eliminate prepaid expenses from the numerator because they are not
potential sources of cash but, rather, represent future obligations that have already
been satisfied.

EBC’s current ratio indicates that at year-end 2014 current assets covered current
liabilities 2.4 times down from 2013. Its significance could be best evaluated by
comparing this with industry competitors or the company’s trend of liquidity over a
longer period.

As a measure of short-term liquidity, the current ratio is limited by the nature of the
component. The liquidity of the assets may vary considerably from the date on
which the statement of financial position is prepared. Furthermore, it could have a
relatively high current ratio but not be able to meet the demands for cash because
the accounts receivable are of inferior quality or the inventory is saleable only at
discounted price.

Quick or Acid test ratio

Formula: Quick Assets

(Cash + Marketable Securities +
Accounts Receivable, net)
Current Liabilities

2014: 9146.5
= 0.67 times
13703.5

2013: 9,368
= 0.92 times
10,216

The acid-test (quick) ratio is a much more rigorous test of a company’s ability
to meet its short-term debts. Inventories and prepaid expenses are excluded
from total current assets leaving only the more liquid assets to be divided by
current liabilities. This is designed to measure how well a company can meet
its obligations without having to liquidate or depend too heavily on its
inventory. Since inventory is not an immediate source of cash and may not
even be saleable in times of economic stress, it is generally felt that to be
properly protected; each peso of liabilities should be backed by at least ₱1 of
quick assets.
 EBC’s quick ratio indicates deterioration between year 2014 and year 2013.
An analyst might be quite concerned about several disquieting trends revealed
in rising short-term debts and increasing inventories. The acid-test ratio must
also be examined in relation to other firms in the same industry.

Cash- Flow Liquidity Ratio

Formula: (Cash + Marketable securities+ Cash flow from operating

activities)/ Current Liabilities

2014: (2,030.5+ 2,636+ 5,012)/ 13,703.5 = 0.70 times

2015: (1,191+ 4,002+ (1,883.5))/ 10,216 = 0.32 times

The cash flow liquidity ratio considers cash flow from operating activities (from the
statement of cash flows) in addition to the truly liquid assets, cash and marketable
securities.

EBC’s current ratio and acid- test ratio both decreased between 2013 and 2014
which could be interpreted as a deterioration of liquidity. But the cash flow ratio
increased indicating an improvement in short- term solvency. Furthermore, the
reason for the decline in the current ratio and acid- test ratio could be traced to the
88% increase in the accounts payable which could actually be a plus if it means that
EBC, Inc. strengthened its ability to obtain supplier credit. Also, the firm’s cash
flow from operating activities turned around from negative to positive amount
which contributed to the stronger short- term solvency in 2014.

II. Analysis of Asset Liquidity and Asset Management Efficiency

Accounts Receivable Turnover

Formula: Net Sales*/ Average Accounts receivable balance

2014: 107,800/ [(4,480 + 4,175)/ 2] = 24.90 times

2013: 76,500/ 4,175** = 18.32 times

*When available, credit sales can be substituted for net sales since credit sales
produce receivable.

**Assumed average for 2013.

 The accounts receivable turnover roughly measures how many times a company’s
accounts receivable have been turned into cash during the year. EBC, Inc. converted
accounts receivable into cash 24.9 times in 2014, up from 18 times in 2013. The
turnover if receivable has improved and this may indicate better quality of
receivable and improvement of the firm’s collection and credit policies. Generally,
a high turnover is good because it could indicate efficiency in the collection of
receivable, but a very high turnover may not be favorable because it may indicate
that credit and collection policies are overly restrictive.

Average Collection Period

Formula: 365 days

Accounts Receivable
Turnover
or
Average Accounts Receivable
Average daily sales

365
2014:
24.9 = 14.6 days or 15 days

365
2013:
18.32 = 19.9 days or 20 days

The average collection period helps evaluate the liquidity of accounts receivable
and the firm’s credit policies. The long collection period may be a result of the
presence of many old accounts of doubtful collectability, or it may be the result of
poor day-to day credit management such as inadequate checks on customers or
perhaps no follow-ups are being made on slow accounts. There could be other
explanations such as temporary problem caused by a depressed economy.

The average collection period of accounts receivable is the average number days
required to convert receivable into cash. The ratios for EBC, Inc. indicate that during
2014, the firm collected its accounts in 15 days on average, an improvement over
the 20-day collection period in 2013. Whether the average of 15 days taken to collect
an account is good or bad depends on the credit terms EBC is offering its customers.
If the credit terms are 10 days, then a 15-day average collection period would be
 viewed as good. Most customers will tend to withhold payment for as long as the
credit terms will allow and may even go over a few days. This factor, added to ever-
present problems with a few slow-paying customers, can cause the average
collection period to exceed normal credit terms by a week or so and should not cause
great alarm.

Inventory Turnover
Formula: Cost of good sold
Average inventory balance

2014 64,682 = 3.09 times

23,520.5 + 18,384.5
2

2013 45,939.5 = 2.50 times

18,384.5*

 Assumed average for 2013

The inventory turnover measures the efficiency of the firm in managing and selling
inventory. It is computed by dividing the cost of goods sold by the average level of
inventory on hand. The ratio is sometimes calculated with the net sales as the
numerator and the average level of inventory as the denominator. The inventory
turnover of EBC, Inc. was 3.09 times in 2014, an improvement over 2013’s 2.50
times.

Generally a high turnover is preferred because it is a sign of efficient inventory

management and profit for the firm. But a high turnover could also mean
underinvestment in inventory and lost orders, a decrease in prices, a shortage of
materials or more sales than planned. A relatively low turnover could mean that the
company is carrying too much inventory or it has obsolete, slow-moving or inferior
inventory stock.

The inventory turnover varies, from industry. Flowers and vegetable sellers would
have a relatively turnover because they deal with perishable products but a jewelry
store would have lower turnover but high profit margin.
Average Sale Period

Formula: 365 days

Inventory
turnover

2014: 365 days

= 118 days
3.09

2013: 365 days

= 146 days
2.50
The number of days being taken to sell the entire inventory one time (called the
average sale or conversion period) is computed by dividing 365 days by the
inventory turnover period. Generally, the faster inventory sells, the fewer funds are
tied up in inventory and more profits are generated. EBC’s average sale or
conversion period decreased from 146 days in 2013 to 118 days in 2014. The
evidence efficiency in managing the inventories in 2014.

Fixed Asset Turnover

Formula: Net Sales

Average net property, plant and equipment
8.97
2014: 107,800 =
times
14,539.5 + 9,488.5
2

2013: 76,500 8.06

=
9,488.5* times

*Assumed average for 2013.

The fixed asset turnover is another approach to assessing management’s

effectiveness in generating sales from investments in fixed assets particularly for a
capital-intensive firm. For EBC, Inc. the fixed asset turnover improved slightly
because of the 41% in sales as compared with 26% increase in average fixed assets.
This occurrence however should be further examined within the framework of the
overall analysis of the company as well as that of the industry.
 Total Asset Turnover

Formula: Net Sales/ Average Total Assets

2014: 107,800/ [(47,649+ 37,954.5)/2] = 2.52 times

2013: 76,500/ 37,954.5* = 2.02 times

*Assumed average for 2011

The Total asset turnover is a measure of the efficiency of management to generate

sales and thus earn more profit for the firm. When the asset turnover ratios are low
relative to the industry or the firm’s historical record, it could mean that either the
investment in assets is too heavy or sales are sluggish. They may however be
justification for the low turnover. For example, the firm may have undertaken an
extensive plant modernization or placed in asset is service at year-end which will
generate positive results in the long- term.

For EBC, Inc. the total asset turnover has improved primarily because of the
improvement in fixed assets, inventory and accounts receivable turnover.

III. Analysis of Leverage: Debt Financing and Coverage

Debt Ratio

Formula: Total Liabilities

Total Assets

2014: 24,681.5
47,649 = 51.8%

2013: 19,021
37,954.5 = 50.1%

The debt ratio measures the proportion of all assets that are financed with debt.
Generally, the higher the proportion of debt, the greater the risk because creditors
must be satisfied before owners in the event of bankruptcy.

The use of debt involves risk because debt carries a fixed obligation in the form of
interest charges and principal repayment. Failure to satisfy the fixed charges
associated with debt will ultimately result in bankruptcy.
 EBC’s debt ratios in 2014 and 2013 indicate relatively heavy reliance on borrowed
capital and they have reached the generally considered maximum ratio of 50% debt
and 50% equity. Too much debt would pose difficulty in obtaining additional debt
financing when needed or that credit is available only at extremely high rates of
interest and most onerous terms.

Debt to Equity Ratio

Formula: Total Liabilities

Total Equity

2014: 24,681.5
= 107.46%
22,968

2013: 19,021
= 100.46%
18,933.5

The amount and proportion of debt and equity in a company’s capital structure are
extremely important to the financial analyst because of the trade off between risk
and return. While debt implies risk, it also provides the potential for increased
benefits to the firm’s owners. When debt is used successfully, operating earnings
exceed the fixed charges associated with debt, the return to the stockholders are
magnified through financial leverage or “trading on the equity.”

The debt to equity ratio measures the riskiness of the firm’s capital structure in terms
of relationship between the funds supplied by creditors (debt) and investors (equity).
EBC’s debt to equity ratio has increased between 2014 and 2013, implying a slightly
capital structure.

Times Interest Earned

Formula: Operating Profit

Interest Expense

2014: 9,621.5
= 7.44 times
1,292.5
 2013: 5,903
= 5.18 times
1,138.5

Time interest earned ratio is the most common measure of the ability of a firm’s
operations to provide protection to long term creditors. The more times a company
can cover its annual interest expense from operating earnings, the better off will be
the firm’s investors.

While EBC, Inc. increased its use of debt in 2014, the company improved its ability
to cover interest payment from operating profits.

Fixed charge coverage

Formula: Operating profit + Lease payments

Interest Expense + Lease payments

2014: 9,621.5 + 6,529

= 2.06 times
1,292.5 + 6,529

2013: 5,309 + 3,555.5

= 2 times
1,138.5 + 3,555.5

The fixed charge coverage measures the firm’s coverage capability to cover not only
interest payments but also the fixed payment associated with the leasing which must
be met annually. This ratio is particularly important for firms that operate
extensively with leasing arrangements whether operating leases or capital leases.

EBC, Inc. experienced a significant increase in the amount of annual lease payment
in 2014 but was still able to improve its fixed charge coverage.

IV. Operating Efficiency and Profitability

Gross Profit Margin

Formula: Gross Profit

Net Sales

2014: 43,118
= 40%
107,800
 2013: 30,560.5
= 39.95%
76,500

Gross profit margin which shows the relationship between sales and the cost of
products sold, measures the ability of a company both to control the costs and
inventories or manufacturing of products and to pass along price increases through
sales to customers.

EBC’s gross profit margin for both 2014 and 2013 have been stable which is
considered a positive sign even if the company had to offer probably discounted
items to attract customers or feature “sale” to hasten up inventory turnover.

Operating Profit Margin

Formula: Operating Profit

Net Sales

2014: 9,621.5
= 8.9%
107,800

2013: 5,903
= 7.7%
76,500
The operating profit margin is a measure of overall operating efficiency and
incorporates all of the expenses associated with ordinary or normal business
activities.

EBC’s operating profit margin improved from 7.7% in 2013 to 8.9% in 2014. This
is favorable because it indicates the ability of the company to control its operating
expenses while sharply increasing sales.

Net Profit Margin

Formula: Net Income/ Net sales

2014: 4,697/ 107,800 = 4.36%

 2013: 2,955/ 76,500 = 3.87%

Net profit margin measures profitability after considering all revenue and expenses,
including interest, taxes and nonoperating items such as extraordinary items,
cumulative effect of accounting chance, etc.

EBC’s net profit margin slightly increased despite increased interest and tax
expenses and a reduction in interest revenue for marketable security investment.

Cash flow Margin

Formula: Cash flow from operating activities/ Net Sales

2014: 5,012/ 107,800 = 4.65%

2013: (1,883.5)/ 76,500 = (2.5%)

Cash flow margin is another important measure or perspective on operating

performance. This measures ability of the firm to translate sales to cash to enable it
to service debt, pay dividends or invest in new capital assets.

EBC’s cash flow margin in 2014 was higher than the operating margin. This
indicates a strong positive generation of cash. The performance in 2014 represents
a solid and impressive improvement over 2013 when the firm failed to generate cash
from operations and had a negative cash flow margin.

Return on Investments on Assets (ROA)

Formula: Net Income

Average Total Assets
or
Net Profit Margin x Total Asset Turnover

If the firm has interest-bearing debt, ROA is computed using the following
formula:

Net Income + [Interest (1-Tax Rate)]

Average Total Assets

2014: 4,697 + [127.5(1 - 45%)] = 10.88%

43,802
 2013: 2,955 + [1,138.5(1 - 43%)] = 9.02%
39,955

Return on Equity (ROE)

Formula: Net Income

Average Stockholders’ Equity
or
Return on Assets x Financial Leverage or Equity Multiplier

Equity Multiplier = 1
Equity Ratio

2014: 4,697
22,967.5 + 18,933.5 = 22.42%
2

2013: 2,955 = 15.60%

18,933.5

Return on assets and return on equity are two ratios that measure the overall
efficiency of the firm in managing its total investment in assets and in generating
return to shareholders. These ratios indicate the amount of profit earned relative to
the level of investment in total assets and investment of common shareholders.

These ratios will also measure how effectively the company is using financial
leverage. The Financial Leverage Index (FLI) is computed as follows:

Return on Equity

Return on Investment

If the FLI is greater than 1 indicating the return on equity exceeds return on assets,
the firm is using debt effectively. If FLI is less than 1, the financial leverage is
negative which means that the firm is not using debt successfully.

EBC’s registered a solid improvement in 2014 of both return ratios. Financial

Leverage Index is calculated as follows:
 22.42%
2014: = 2.06
10.88%

15.60%
2013: = 1.73
9.02%

EBC’s FLI of 2.06 in 2014 and 1.73 in 2013 indicates a successful use of financial
leverage although borrowing increased. The firm has generated sufficient operating
returns to more than cover the interest payments on borrowed funds.

Other Ratios used to Measure Return to Investors

a) Earnings per share (EPS)

Formula:
Basic EPS = Net income
Weighted Average number of
ordinary shares outstanding

Diluted EPS = Net income (as adjusted)

Weighted Average number of
ordinary shares outstanding and
potential diluters
Basic EPS

2014 4,697,000 = ₱ 2.00

2,401,500 + 2,297,000
2

2013 2,955,000 = ₱ 1.29

2,297,000

The Diluted EPS need not be computed because there are no potential diluters (e.g.,
convertible bonds, convertible preference shares or stock options and warrants)
outstanding, PAS 33 issued by the ASC in 2008 is used to compute the Earnings per
share.
 EBC’s earnings per ordinary share increased from ₱1.29 in 2013 to ₱2.00 in 2014
which is a clear indication in the improvement on the investment return of ordinary
shareholders.

b) Price Earnings Ratio (P/E)

Formula: Market Price of ordinary shares

Earnings per share

2014: 30
= 15
2

2013: 17
= 13.39
1.27

The P/E ratio relates earnings per ordinary share to the market price at which the
stock trades, expressing the “multiple” which the stock market places on a firm’s
earnings. It is a combination of a number of factors such as the quality of earnings,
future earnings, potential and performance history of the company.

EBC’s price to earnings ratio is higher in 2014 than in 2013. This could be because
the market is reacting favorably to the firm’s good year.

c) Dividend payout ratio

Formula: Dividends per share

Earnings per share

2014: 0.33
= 16.5%
2

2013: 0.41
= 31.78%
1.29
 EBC, Inc. reduced its cash dividend payment in 2014. It is particularly unusual for
a firm to reduce dividends during good year. A possible explanation for this through
may be the adoption of a new policy that will lower dividend payments in order to
increase the availability of funds that may be reinvested for expansion purposes.

d) Dividend yield

Formula: Dividends per share

Market value per share

2014 0.33 = 1.1%

30

2013 0.41 = 2.41%

17
A low dividend yield would indicate that an investor would choose EBC, In. as an
investment more for its long-term capital appreciation than for its dividend yield.

Summary of Financial Statements Analysis of EBC, Inc.

Short-Term Liquidity and Activity

Short-term liquidity analysis is of particular significance to trade and short-term

creditors, management and other parties concerned with the ability of a firm to meet
near-term demands for cash.

EBC’s current and quick ratios decreased indicating a deterioration of short-term

liquidity. However, the cash flow liquidity ratio improved in 2014 after a negative
cash generation in 2013.

The average collection period for accounts receivable and the inventory turnover
improved in 2014 which could indicate improvement in the quality of accounts
receivable and liquidity of inventory. The increase in inventory level has been
accomplished by reducing holdings of cash and cash equivalents. This represents a
trade-off of highly liquid assets for potentially less liquid assets. The efficient
management of inventories is critical for the firm’s ongoing liquidity.
 Presently, there appears to be no major problems with the firm’s short-term liquidity
position.

Long-Term Solvency

The debt ratios for EBC show a steady increase in the use of borrowed funds. Total
debt has increased relative to total assets, long-term debt has increased as a
proportion of the firm’s permanent financing and external or debt financing has
risen relative to internal financing.

Why has debt increased? The statement of cash flows shows that EBS has
substantially increased its investment in capital or fixed assets and their investments
have been financed largely by borrowing especially in 2013 when the firm had a
great sluggish operating performance and no internal cash generation.

Given the increased level of borrowing, the times interest earned and fixed charge
coverage improved slightly in 2014. These ratios should however be monitored
closely in the future particularly if EBC continues to expand.

Operating Efficiency and Profitability

As noted earlier, EBC has increased its investment in fixed asset as a result of store
expansion. The asset turnover increased in 2014, the progress traceable to improved
management of inventories and receivable. There has been substantial sales growth
which suggests future performance potential.

The gross profit margin was stable, a positive sign in the light of new store openings
featuring discounted and “sale” items to attract customers. The firm also managed
to improve its operating profit margin in 2014 principally due to firm’s ability to
control operating costs. The net profit margin also improved despite increased
interest and tax expenses and a reduction in interest income from marketable
security investment.

Return on assets and return on equity increased considerably in 2014. These ratios
measure the overall success of the firm in generating profits from its investment and
management strategies.
Conclusion:

It appears that EBC Enterprises, Inc. is well positioned for future growth.
Close monitoring the firm’s management of inventories is important
considering the size of the company’s capital tied up in it. The expansion in
their operation may necessitate a sustained effort to advertise more, to attract
customers to both new and old areas. EBC has financed much of its
expansion with debt, and so far, its shareholders have benefited from the use
of debt though financial leverage. The company should however be cautious
of the increased risk associated with debt financing.

The DuPont Disaggregation Analysis

DuPont Equation is the formula that shows that the rate of return on equity can be found
as the product of profit margin, total assets turnover and the equity multiplier. It shows the
relationships among asset management, financial leverage management and profitability
ratios.

Disaggregation of return on equity (ROE) was initially introduced by E. I. DuPont de

Nemours and Company to help its managers in performance evaluation.

The basic DuPont model disaggregates ROE as follows:

Net Net Average total

Income Income Sales assets
ROE = = x x
Average Averag Average
stockholders’ Sales e total stockholders'
equity assets equity

Profit Asset Financial

Margin Turnover Leverage

These three components are described as follows:

1. Profit Margin is the amount of profit that the company earns from each peso
of sales. A company can increase its profit margin by increasing its gross profit
 margin (Gross profit ÷ sales), and/or by reducing its expenses (other than cost of
sales) as a percentage of sales.

2. Asset Turnover is productivity measure that reflects the volume of sales that a
company generates from each peso invested in assets. A company can increase its
asset turnover by increasing sales volume with no increase in asset and/or by
reducing asset investment without reducing sales.

3. Financial Leverage measures the degree to which the company Finances its
assets with debt rather than equity. Increasing the percentage of debt relative to
equity increases the financial leverage. Although financial leverage increases ROE
(when performance is positive), debt must be used with care as it increases the
company’s relative riskiness.

The profit margin and asset turnover relates the company operations and combine to yield
on assets (ROA) as follows:

Net Net
Sales
Income Income
ROA = = x
Average Sales Average
total total assets
assets

Profit Asset
Margin Turnover

Return On Assets (ROA)

Return on assets measures the return on investment for the company without regard to
how it is financed (the relative proportion of debt and equity in its capital structure).
Operating managers of a company typically grasp the income statement. They readily
understand the pricing of products, the management of production costs and importance of
controlling overhead costs. However, many managers do not appreciate the importance of
managing the statement of financial position.
The ROA approach to performance measurement encourages managers to also focus on
the returns that they achieve from the invested capital under their control. Those returns
are maximized by a joint focus on both profitability and productivity.

1. Profitability. It is measured by the profit margin (Net Income ÷ Sales).

Analysis of profitability typically examines performance over time relative to
benchmarks such as competitors’ or industry performance, which highlight trends
and abnormalities. When abnormal performance is discovered, managers either
correct suboptimal performance or protect superior performance. The two general
areas of profitability analysis are:

 Gross profit margin. It measures the gross profit (Sales less Cost of
goods sold) for each sale. Gross profit margin (Gross profit ÷ Sales)
is affected by both the selling prices of products and their
manufacturing cost.
 Expense management. Managers focus on reducing manufacturing
and administrative overhead expenses to increase profitability.
Manufacturing overhead refers to all production expenses (e.g..,
utilities, depreciation, and administrative costs) other than labor and
materials. Administrative overhead refers to all expenses not in cost
of goods sold (e.g.., administrative salaries and benefits, research and
development and marketing, legal and accounting).

2. Productivity. It refers to the volume of sales resulting from invested in assets.

When a decline in productivity is observed, managers have two avenues of attack:

 Increase in sales volume from the existing asset base, and

 Decrease the investment in assets without reducing sales volume.

Illustrative Case 12-2.

OR Company is a subsidiary of Pure Business Sense, Inc. and was acquired several years
ago as explained in the following note to the Pure Business Sense, Inc. annual report:

On May 23, 2012, OR Company acquired Pure Business Sense, Inc., a distributor of
grocery and food products to retailers, convenience stores and restaurants. Results of Pure
Business Sense, Inc. operations are included in OR Company’s consolidated results
beginning on that date. Pure Business Sense, Inc. revenues in 2014 totaled ₱24.1 million
compared to ₱23.4 million in 2013 and approximately ₱22.0 million for the full year of
2012. Sales of grocery products increased about 5% in 2014 and were partially offset by
lower sales to foodservice customers. Pure Business Sense, Inc. Business is marked by high
sales volume and very low margins. Pretax earnings in 2014 of ₱217 million declined ₱11
million in 2013. The gross margin percentage was relatively unchanged between years.
However, the resulting increased gross profit was more than offset by higher payroll, fuel
and insurance expenses. Approximately, 33% of Pure Business Sense, Inc. annual revenues
currently derived from sales to Savemore, Loss or curtailment of purchasing by Savemore
could have a material adverse impact on revenues and pre-tax earnings of Pure Business
Sense, Inc.

Analysis

Pure Business Sense, Inc. is a wholesaler of food products; it purchases food products in
finished and semi-finished form from agricultural and food-related businesses and resells
them to grocery and convenience food stores. The extensive distribution network required
in this business entails considerable investment. The business analysis of Pure Business
Sense, Inc. financial results includes the following observations:

 Industry competitors. Pure Business Sense, Inc. has many competitors with food
products that are difficult to differentiate.

 Bargaining power of buyers. The note above reveals that 33% of Pure Business
Sense, Inc. sales are to Savemore, which has considerable buying power that limits
seller profits; also, the food industry is characterized by high turnover and low profit
margins, which implies that cost control is key to success.

 Bargaining power of suppliers. Pure Business Sense, Inc. is large (₱24 million in
annual sales), which implies its suppliers are unlikely to exert forces to increase its
cost of sales.

 Threat of substitution. Grocery items are usually not well differentiated; this means
the threat of substitution is high, which inhibits its ability to raise selling prices.

 Threat of entry. High investment costs, such as warehousing and logistics, are a
barrier to entry in Pure Business Sense, Inc. business; this means the threat of entry
is relatively low.

Our analysis reveals that Pure Business Sense, Inc. is a high-volume, low-margin company.
Its ability to control costs is crucial to its financial performance, including its ability to
fully utilize its assets. Evaluation of Pure Business Sense, Inc. financial statements should
focus on that dimension.