CHAPTER I

INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

INTRODUCTION

This chapter provides a framework and several tools to help us

analyze companies and value their securities. With the aid of financial
statements, it is helpful for a manager to decide whether to acquire another
company or divest of a current division. For the equity and credit analyst,
this may help them to assess and communicant an investment appraisal or
credit-risk report.

HOW BUSINESS ACTIVITIES ARE REPORTED

To be able to analyze a company effectively or infer its value, it is

important that one must understand the company’s business activities.
This can be accomplished through the financial statements. Financial
statements report on a company’s performance and financial condition and
reveal executive management’s privileged information and insights.

Financial statements serve the needs of different users. The operation

of the accounting information system involves application of accounting
standards to produce financial statements that provide the insight on the
business activities of the company under analysis.

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 Accounting information should be used in the business context in
which the information is created. All companies without exception, plan
business activities, finance those activities, invest in those activities and
then, engage in operating activities. Business firms conduct all these
activities while confronting business forces, including market constraints
and competitive pressures.

Financial statements also provide crucial input for strategic planning,

as well as, information about the relative success of those plans which can
be used to corrective action and make new operating, investing and
financing decisions.

OBJECTIVES OF FINANCIAL STATEMENTS ANALYSIS

Financial statement analysis involves careful selection of data from

financial statements in order to assess and evaluate the firm’s past
performance, its present condition and future business potentials.

The primary purpose of financial statement analysis is to evaluate and

forecast the company’s financial health. Interested parties, such as the
managers, investors, and creditors, can identify the company’s financial
strengths and weaknesses and know about the:

1. profitability of the business firm;

2. firm’s ability to meet its obligation;

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 3. safety of the investment in the business; and
4. effectiveness of management in running the firm.

A financial statements user can find answers to the following sample

questions through analysis of the data presented therein together with
other data generated by corporate financial reporting:

- How well does the company compete in its operating environment?

- Would an investment generate attractive returns?
- Should existing investment holdings be continued or liquidated?
- Will cash flows be sufficient to meet interest and principal payments?

DEMAND FOR FINANCIAL ACCOUNTING INFORMATION

Users of financial statements are called stakeholders. A stakeholders

is a person or entity who has a “stake” or interest in the business/ aside
from the owners or investors, the other stakeholders are the managers,
lenders, suppliers, employees, government and customers.

Decision makers and other stakeholders demand information on the

company’s past and prospective returns and risks to facilitate efficient
contracting and risk-sharing.

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The broad classes of users that demand financial accounting information
include the following:

Owner or The one who puts in capital (such as money or property)

Investor in a business endeavor. To minimize risk of losing money,
an owner or investor must read the financial reports and
seek answers to the following questions:
1. Is the business profitable?
2. Has it accumulated sufficient financial wealth to
remain stable?
Analysts Financial statement are used by these parties to predict the
companies future performance.
Manager Responsible for running the business. Financial reports
make it possible to evaluate performance of the business.
Management uses financial statements to raise financing
for the company, to meet disclosure requirement and to
serve as a basis for executive renumeration and bonuses,
for wage negotiations and to meet disclosure
requirements.
1. Are the plans implemented beneficial to the
business?
2. Is the business operating profitably?
Remember a losing business depletes wealth and is a
reflection of an inefficient management.
Lender or A lender or creditor (example Banco de Oro) assesses the
creditor paying ability of the business-borrower by reading the
financial reports. They need financial accounting

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 information to help determine loan terms, loan amounts,
interest rates and required collateral.
1. Will the business be able to pay its debt when it falls
due?
2. Does it have liquid assets?
Supplier A supplier (example Divisoria Textile Store) offers goods
or merchandise on cash basis or on credit term. If it offers
on credit.
1. Will the business who is buying merchandise (such
as T Shirts) in bulk be able to pay its account on the
date it becomes due?
2. Does it have liquid assets?
The accounting information to determine the credit worth
of the business is also based on the financial status of the
buying business.
Governmen The government seeks to answer the following questions
t by reading the accounting reports:
1. Is the business paying the right taxes?
2. Is it filing all the required documents?
The government through its tax agent, the Bureau of
Internal Revenue investigates tax returns and assesses
truthfulness of the reported profit as well as the tax
liability paid by the business.

The SEC, BIR, BSP and other legal institutions demand

financial accounting information to monitor the business

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 firm’s compliance with laws, for public protection, price
setting and for setting tax and other regulatory policies.
Employees The employee wants:
a. Higher wages;
b. Benefits;
c. Good working conditions; and,
d. Security of tenure
Customer The customer assesses the company’s ability to
continuously supply the goods they need at the right price
and right quality.

The customer both current and potential need accounting

information to evaluate a company’s ability to provide
product and services as agreed and to assess the
company’s reliability and staying power/
All the aforementioned stakeholders are classified as external users except
for the owner and manager who are internal users.

GENERAL APPROACH TO FINANCIAL STATEMENTS

1. Evaluation of the environment (industry and economy as a whole)

where the company conducts business.
2. Analysis of the firm’s short-term solvency.
3. Analysis of the company’s capital structure and long-term solvency.

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 4. Evaluation of the management’s efficiency in running the business.
5. Analysis of the firm’s profitability.

PROBLEMS AND LIMITATIONS IN FINANCIAL STATEMENTS

ANALYSIS

1. Comparison of financial data

a. Differences between companies – a ratio that is acceptable to one
company may not be acceptable to another when other factors are
considered.
b. Differences in accounting method and estimates.
c. Valuation problem – financial statements are based on historical
costs and therefore, do not reflect the current market value of the
firm’s assets. Moreso, the effects of price level changes must be
considered.
d. The timing of transactions and use of averages in applying the
various techniques in Financial Statement analysis affect the
results obtained.

2. The need to look beyond ratios

Ratios are not sufficient in themselves as basis for judgments about
the future. Other factors must be considered, such as:
a. Industry trends
b. Changes in technology

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 c. Changes in consumer tastes
d. Changes in the economy as a whole
e. Changes that are taking place within the company itself

STEPS IN FINANCIAL STATEMENTS ANALYSIS

1. Establish the objectives of the analysis to be conducted.

2. Study the industry where the firm belongs.
3. Study the firm’s background and the quality of its management.
4. Evaluate the firm’s financial statements using the evaluation
techniques available.
5. Summarize the results of the studies and evaluation conducted.
6. Develop conclusions relevant to the established objectives.

The four generally accepted financial statements are:

a. Income Statement
b. Statement of Financial Position
c. Statement of Owner’s Equity
d. Statement of Cash Flows

Figure 1.1, CDSL Inc., Income Statement

CDSL Inc.
Income Statements
For the Year Ended December 31, 2016

Net Sales PHP 107,800.00

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 Cost of goods sold 64,682.00
Gross profit 43,118.00

Selling and Administrative expenses 16,332.00

Advertising 7,129.00
Lease payments 6,529.00
Depreciation and amortization 1,999.00
Repairs and maintenance 1,507.50

Total 33,496.50
Operating Profit 9,621.50

Other Income (expenses)

Interest Income 211.00
Interest expense (1,292.50)

Earnings before income taxes 8,540.00

Income taxes 3,843.00

Net Income PHP 4,697.00

Figure 1.2 CDSL Inc., Statement of Financial Position

CDSL Inc.
Statement of Financial Position at December 31, 2016

ASSETS
Current Assets
Cash PHP 2,030.50
Marketable Securities 2,636.00
Accounts Receivable 4,704.00
Allowance for Doubtful Accounts (224.00)
Inventories 23,520.50
Prepaid Expenses 256.00
Total Current Assets PHP 32,923.00

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 Property, Plant and Equipment
Land 405.50
Buildings and Leasehold improvements 9,136.50
Equipment 10,761.50
20,303.50
Less: Accumulated depreciation and
amortization (5,764.00)
Net property, plant and equipment 14,539.50

Other Assets 186.50

Total Assets PHP 47,649.00
Current Liabilities
Accounts Payable PHP 7,147.00
Notes Payable - banks 2,807.00
Current maturities of long term debt 942.00
Accrued Liabilities 2,834.50
Total Current Liabilities PHP 13,730.50
Deferred Income Taxes 421.50

Long-Term Debt 10,529.50

Total Liabilities PHP 24,681.50
Equity
Ordinary shares 2,401.50
Additional paid-in capital 478.50
Retained Earnings 20,087.50
Total Equity 22,967.50

Figure 1.3 CDSL Inc., Statement of Changes in Equity

CDSL Inc.
Statement of Changes in Owner's Equity
For the year ended December 31, 2016

Ordinary shares 2,401.50

Additional paid-in capital 478.50
Retained Earnings 20,087.50

Total Equity 22,967.50

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Exercise 1

Match the following users with the given information. Write the letter
choice on the space before the number.
____1. Owner a. Establishes the right amount of taxes to be paid
____2. Manager b. Assesses the company’s working conditions
____3. Lender c. Interested in whether the business is earning or losing
____4. Customer d. Concerned about the price of the product
____5. Government e. Wants to know the business can pay the loan on time
____6. Employee f. Oversees the day to day activities of the business

Exercise 2
Write T if the statement is correct and False if the statement is wrong.
1. Financial statements report on a company’s performance and
financial condition and reveal executive management’s privileged
information and insights.
2. For the equity and credit analyst, financial statements may help them
to assess and communicant an investment appraisal or credit-risk
report.
3. Financial statement analysis cannot assess nor evaluate the firm’s
past performance, but only its present condition and future business
potentials.
4. The primary purpose of financial statement analysis is to evaluate
and forecast the company’s future performance.
5. Users of financial statements are called stockholders
6. With the aid of financial statements, it is helpful for a manager to
decide whether to acquire another company or divest of a current
division.

ANSWERS:
EXERCISE 1
Answers:

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1. C
2. F
3. E
4. D
5. A
6. B
EXERCISE 2
Answers:
1. T
2. T
3. False
4. False
5. False
6. T

CHAPTER II

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 FINANCIAL STATEMENTS – STATEMENT OF FINANCIAL
POSITION (ASSETS)

FINANCIAL STATEMENTS

Business activities are periodically reported by companies using four

financial statements: the Statement of Financial Position, Statement of
Comprehensive Income, Statement of Stockholder’s Equity and the
Statement of Cash Flows.

A Statement of Financial Position reports on a company’s financial

position at a point in time. The Statement of Comprehensive Income,
Statement of Stockholder’s Equity and the Statement of Cash Flows report
on performance over a period of time.

STATEMENT OF FINANCIAL POSITION

The statement of financial position is also known as the balance sheet.

It shows the state of wealth of the business by enumerating its assets,
liabilities and net worth. This statement lists down the economic resources
being controlled by the assets being controlled by the firm, and from which
its liquidity and solvency are determined. It shows how much of the assets
being funded by the creditors and by the investors (solvency). It helps
predict ability of the firm to withstand pressure and demand to pay for its

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obligations. It shows ability of the firm to pay promptly its short term
obligations (liquidity).

This statement lists in detail the assets and liabilities of the business
and shows the residual interest of the owner as of a specific date. There are
two forms used: Account Form and Report Form. Account form shows
accounts in one straight column: assets first followed by the liabilities and
owner’s equity.

CURRENT AND NON-CURRENT ASSETS

Assets are classified into current assets and non-current assets.

Current Assets include cash and cash equivalents which are not restricted
in use, as well as other assets expected to be realized into cash, or sold or
consumed within the normal operating cycle of the business or one year,
whichever is longer. These include Cash (On Hand and In Bank),
Marketable Securities, Accounts Receivables, Notes Receivable, Inventories
(for merchandisers and manufacturers) and Prepaid Expenses (Supplies,
Insurance, and Rent). The operating cycle is the time required to purchase
or manufacture inventory, sell the product and collect the cash. The
designation “current” refers essentially to those assets that are continually
used up and replenished in the ongoing operations of the business. The
term working capital or net working capital is used to designate the
amount by which current assets exceed current liabilities. The following are
the current assets:
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1. Cash – includes currencies or coins or negotiable instruments such as
a bank check or a postal money order used as a medium of exchange.
Two account titles could be used instead of one:
Cash on Hand for cash items in the custody of the officer-in-charge
or the owner, and;
Cash in Bank for cash deposited in the bank under a current or
savings account.
Cash equivalents are short term, highly liquid investments such as a
three-month time deposit or a three-month government treasury bill,
that are readily convertible to cash and so near their maturity that
they present insignificant risk of changes in value because of change
in interest rates. Only highly liquid investments that are acquired
three months before maturity can qualify as cash equivalents.

2. Marketable securities – these are highly traded securities such as the

stocks and bonds purchased by the enterprise that are to be held for a
short term duration. Like the cash equivalents, they are usually
purchased when the enterprise has temporary idle or excess cash.
They are also cash substitutes, cash that is not needed immediately in
the business and is temporarily invested to earn a return. These
investments are in instruments with short-term maturities (less than
one year) to minimize the risk of interest rate fluctuations. They must
be relatively riskless securities and highly liquid so that funds can be
readily withdrawn as needed. They may also be presented as

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 Investment in Trading Securities or Investment in Securities
Available for Sale.

3. Receivables – these are collectibles from customers, clients and other

persons for the goods, services or money given by the business. The
account title to be used is Accounts Receivable if only an oral or an
implied promise is received from the client or customer. Notes
Receivable is evidenced by a promissory note issued by the debtor.

Accounts Receivable are customer balances outstanding on credit

sales and are reported on the balance sheet at their net realizable
value, that is, the actual amount of the account less an allowance for
doubtful accounts. Management must estimate – based on such
factors as past experience, knowledge of customer quality, the state of
the economy, the firm’s collection policies – the peso amount of
accounts they expect will be uncollectible during the accounting
period. Actual losses are written off against the allowance account,
which is adjusted at the end of each accounting period.

The allowance for doubtful accounts can be important in assessing

earnings quality. The analyst should be alert to changes in the
allowance account – both relative to the level of sales and to the
amount of accounts receivable outstanding and to the justification for
any variations from past practices.

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 Other receivables are: Interest Receivable when interest is collectible
on promissory notes received from clients and customers or Rent
Receivable for rent collectible from tenants. Dividend Receivable is
a dividend collectible by a shareholder from a corporation.

4. Inventories – is an account title used to represent the stock of goods

available for sale by the business.

Inventories are items held for sale or used in the manufacture of

products that will be sold. A retail company, lists only one type of
inventory on the balance sheet: merchandise inventory purchased for
resale to the public. A manufacturing firm, in contrasts, would carry
three different types of inventories: raw materials or supplies, work-
in process, and finished goods.

Given the relative magnitude of inventory, the accounting method

chosen to value inventory and the associated measurement of cost of
goods sold have a considerable impact on a company’s financial
position and operating results. Understanding the fundamentals of
inventory accounting and the effect various methods have on a
company’s financial statements are essential to the user of financial
statement information.

Because the inventory cost-flow assumption has a significant impact

on financial statements – the amount of inventory reported on the

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 balance sheet and the cost of goods sold expense in the income
statement – it is important to know where to find its disclosure. The
method used to value inventory will be shown either on the face of
the balance sheet with the inventory account or, more commonly, in
the note to the financial statements relating to inventory.

5. Prepaid Expenses – these represent advance payments made for

benefits or services to be received by the business in the future.

Certain expenses, such as insurance, rent, property taxes and utilities

are sometimes paid in advance. They are included in current assets if
they will expire within one year or one operating cycle, whichever is
longer. Generally, prepayments are not material to the balance sheet
as a whole.

6. Deductions from current assets are called contra asset accounts. An

example of this is the Allowance for Bad Debts or Allowance for
Doubtful Account which represents customers’ accounts doubtful of
collection. This is deducted from accounts receivable to arrive at its
net realizable value.

Non-current assets are those assets not included in the current assets such
as the property, plant and equipment or fixed assets which are needed to
support the operation of the business over a long period of time and are
not intended for sale.

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Property Plant and Equipment – This category encompasses a company’s
fixed assets (also called tangible, long-lived and capital assets) – those
assets not consumed in annual business operations. These assets produce
economic benefits for more than one year, and they are considered
“tangible” because they have a physical substance. Fixed assets other than
land (which theoretically has an unlimited life span) are “depreciated” over
the period of time they benefit the firm. Depreciation is the method of
allocating the cost of long-lived assets. The original cost less any estimated
residual value at the end of the asset’s life, is spread over the expected life
of the asset. Cost is also considered to encompass any expenditures made
to ready the asset for operating use. On any balance sheet date property,
plant and equipment are shown at book value, which is the difference
between original cost and any accumulated depreciation and any
accumulated impairment losses to date. They may also be carried at a
revalued amount being its fair value at the date of revaluation less any
subsequent depreciation and subsequent accumulated impairment losses.

The following are examples of property, plant and equipment:

1. Land – a lot or real estate owned and used by the business on which
a building could be constructed.

2. Building – structure used to house the office, store or factory.

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 3. Equipment – typewriter, air conditioner, calculator, filing cabinet,
computer, electric fan, trucks, cars used in the business. Specific titles
may be used such as: Office Equipment, Store Equipment and
Delivery Equipment.

4. Furniture and Fixtures – tables, chairs, curtains, lighting fixtures and

wall decors. Specific titles may be used such as: Office Furniture and
Fixtures and Store Furniture and Fixtures.

5. Leasehold or Lease Right – for a fee, a lessee is given the right to use
the property of a lessor over a long period of time.

6. Accumulated Depreciation – a contra asset or off-set account

representing expired cost of the plant, property or equipment as a
result of usage and passage of time. This is a deduction from the
property, plant and equipment account.

Other non-current assets – other assets on firm’s balance sheet can include
a multitude of other noncurrent items such as property held for sale, the
cash surrender value of life insurance policies, and long-term advance
payments.

Additional categories of noncurrent assets frequently encountered are

long-term investments and intangible assets such as goodwill recognized in

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business combination, patents, trademarks, copyrights, brand names, and
franchises. Of the intangible assets, goodwill is the most important for
analytical purposes because of its potential materiality on the balance sheet
of firms heavily involved in acquisitions activity. Goodwill arises when one
company acquires another company (in a business combination accounted
for as a purchase) for a price in excess of the fair market value of the net
identifiable assets (identifiable assets less liabilities assumed) acquired.
This excess price is recorded on the books of the acquiring company as
goodwill. The cost of goodwill is mot amortized but entities are required to
assess it annually for possible impairment.

Figure 2.1 CDSL Inc., Statement of Financial Position – Assets

CDSL Inc.
Statement of Financial Position at December 31, 2016

ASSETS
Current Assets
Cash PHP 2,030.50
Marketable Securities 2,636.00
Accounts Receivable 4,704.00
Allowance for Doubtful Accounts (224.00)
Inventories 23,520.50
Prepaid Expenses 256.00
Total Current Assets PHP 32,923.00

Property, Plant and Equipment

Land 405.50
Buildings and Leasehold improvements 9,136.50
Equipment 10,761.50
20,303.50
Less: Accumulated depreciation and
amortization (5,764.00)
Net property, plant and equipment 14,539.50

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 Other Assets 186.50
Total Assets PHP 47,649.00

SAMPLE PROBLEMS

Problem 2-1 (IFRS)

The general ledger trial balance of Abrigo Company included the following
accounts on December 31, 2016:
Inventory, including inventory expected in the ordinary course of 1,000,000
operations to be sold beyond 12 months amounting to P700,000
Accounts Receivable 1,200,000

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 Prepaid Insurance 100,000
Financial assets held for trading 200,000
Financial assets at fair value through other comprehensive income 800,000
Cash 300,000
Deferred tax asset 150,000
Bank overdraft 250,000
What amount should be reported as total current assets on December 31,
2016?

Problem 2-2 (AICPA Adapted)

Adolfo Company provided the following account balances on December
31, 2016:
Accounts Receivable 1,600,000
Financial assets at fair value through profit or loss 500,000
Financial assets at amortized cost 1,300,000
Cash 1,100,000
Inventory 3,000,000
Equipment and furniture 2,500,000
Accumulated Depreciation 1,500,000
Patent 400,000
Prepaid Expenses 100,000
Equipment classified as held for sale 2,000,000
In the December 31, 2016 statement of financial position, what total amount
should be reported as current assets?
Problem 2-3 (IAA)
Agbada Company provided the following adjusted account balances on
December 31, 2016:
Wages payable 250,000
Cash 200,000
Mortgage payable 1,500,000
Dividends payable 150,000
Prepaid rent 100,000
Inventory 800,000
Sinking Fund 500,000
Short-term investments 300,000
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Investment in associate 2,000,000
Taxes payable 220,000
Accounts payable 240,000
Accounts receivable 350,000

What total amount should be reported as current assets on December 31,

2016?

Problem 2-4 (AICPA)

Alcantra Company provided the following trial balance on December 31,
2016:
Cash overdraft P100,000
Accounts receivable, net P350,000
Inventory 580,000
Prepaid expenses 120,000
Land classified as held for sale 1,000,000
Property plant and equipment, net 950,000
Accounts payable and accrued expenses 320,000
Ordinary share capital 250,000
Share premium 1,500,000
Retained Earnings 830,000
P3,000,00 P3,000,000
0

Checks amounting to P300,000 were written to vendors and recorded on

December 29, 2016, resulting in cash overdraft of P100,000. The checks
were mailed on January 15, 2017. Land classified as held for sale was sold
for cash on January 31, 2017. The entity issued the financial statements on
March 31, 2017. On December 31, 2016, what total amount should be
reported as current assets?

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ANSWERS:
PROBLEM 2-1
Answer: P2,800,000
Inventory 1,000,000
Accounts Receivable 1,200,000
Prepaid Insurance 100,000
Financial assets held for trading 200,000
Cash 300,000
Total Current Assets P2,800,00
0

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In the absence of the statement to the contrary, financial assets at fair value
through other comprehensive income shall be classified as non-current. PAS 1
and PAS 12 provide that deferred tax asset is a non-current asset. The bank
overdraft is classified as current liability.

PROBLEM 2-2
Answer: P8,300,000
Accounts Receivable 1,600,000
Financial assets at fair value through profit or loss 500,000
Cash 1,100,000
Inventory 3,000,000
Prepaid Expenses 100,000
Equipment classified as held for sale 2,000,000
Total Current Assets P8,300,000

The financial assets at amortized cost shall be classified as noncurrent. Financial

assets at amortized cost include investment in bonds and other debt instruments.

Under PFRS 5, a non-current asset classified as held for sale should be reported as
current asset.

PROBLEM 2-3
Answer: P1,750,000
Cash 200,000
Prepaid rent 100,000
Inventory 800,000
Short-term investments 300,000
Accounts receivable 350,000
Total current assets P1,750,00
0
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PROBLEM 2-4
Answer: P2,250,000
Cash (P300,000 – P100,000 overdraft) P200,000
Accounts receivable 350,000
Inventory 580,000
Prepaid expenses 120,000
Land classified as held for sale 1,000,000
Total current assets P2,250,00
0

CHAPTER III

FINANCIAL STATEMENTS – STATEMENT OF FINANCIAL

POSITION (LIABILITIES)

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 Liabilities are classified into current and non-current.

Current Liabilities are those debts or obligations reasonably expected to be

liquidated in the normal course of the enterprise’s operating cycle or paid
within a period of one year by the use of current assets or the creation of
other current liabilities. The following examples of current liabilities:

1. Accounts Payable to trade creditors for purchase of goods or services

on credit supported by the oral or implied promise of the business.
Notes Payables are short-term obligations in the form of promissory
notes to suppliers or financial institution.

2. Loan Payable is a liability to pay a bank or a financing institution for

amount of money borrowed by the business.

3. Utilities Payable is a liability to pay utility companies like PLDT,

Meralco and Manila Water for telephone, electricity and water
services received from them.

4. Current Maturities of Long-term Debt – when a firm has bonds,

mortgages, or other forms of long-term debt outstanding, the portion
of the principal that will be repaid during the upcoming year is
classified as a current liability. The note lists the amount of long-term
debt outstanding, less the portion due currently.

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 5. Accrued Liabilities– result from the recognition of an expense in the
accounting records prior to the actual payment of cash. Thus they are
liabilities because there will be an eventual cash outflow to satisfy the
obligations.

6. Other Payables include Interest Payable which represents additional

charge and obligation to pay for interest-bearing promissory notes
issued by the business and Salaries Payable which represents
obligation to pay employees for services received from them and
Taxes Payable which are obligations due to the government for sales,
earnings, gains and value of property owned/sold by the business.

Obligations with maturities beyond one year are designated on the balance
sheet as noncurrent liabilities. This category can include bonded
indebtedness, long-term notes payable, mortgages, obligations under
leases, pension liabilities, long-term warranties and deferred income taxes.

1. Note Payable which is issued to the creditor and evidenced by a

promissory note.
2. Mortgage Payable which is an obligation secured by the real
property of the business.

3. Bond Payable which is a long-term promise usually from five to ten

or twenty years supported by a formal contract containing the face

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 value of the bond, the interest rate, the interest payment date and
maturity.

4. Deferred tax liabilities are the amounts of income taxes payable in

the future periods in respect of taxable temporary differences.

5. Other liability accounts such as pension and other lease obligation,

can appear under the noncurrent liabilities section of the balance
sheet.

Figure 3.1 CDSL Inc., Statement of Financial Position – Liabilities

Current Liabilities
Accounts Payable PHP 7,147.00
Notes Payable - banks 2,807.00
Current maturities of long term debt 942.00
Accrued Liabilities 2,834.50
Total Current Liabilities PHP 13,730.50
Deferred Income Taxes 421.50

Long-Term Debt 10,529.50

Total Liabilities PHP 24,681.50

SAMPLE PROBLEMS

Problem 3-1 (AICPA)

Alcaraz Company provided the following account balances on December
31, 2016:
Accounts payable 1,500,000
Bonds Payable, due 2017 2,500,000

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Discount on bonds payable 300,000
Dividends payable 800,000
Note payable, due 2018 2,000,000
What total amount of current liabilities should be reported?

Problem 3-2 (AICPA)

Armas Company had the following liabilities on December 31, 2016:
Accounts payable 550,000
Unsecured note payable, 8%, due July 1, 2017 4,000,000
Accrued expenses 350,000
Contingent liability 450,000
Deferred tax liability 250,000
Senior bonds payable, 7%, due March 31, 2017 5,000,000

What amount should be reported as total current liabilities?

ANSWERS:
PROBLEM 3-1
Answer: P4,500,000
Accounts payable 1,500,000
Bonds Payable 2,500,000
Discount on bonds payable (300,000)
Dividends payable 800,000

31 | P a g e
Total current liabilities P4,500,00
0

PROBLEM 3-2
Answer: P9,900,000
Accounts payable 550,000
Unsecured note payable, 8%, due July 1, 2017 4,000,000
Accrued expenses 350,000
Senior bonds payable, 7%, due March 31, 2017 5,000,000
Total current liabilities P9,900,000

CHAPTER IV

FINANCIAL STATEMENTS – STATEMENT OF FINANCIAL

POSITION (EQUITY)

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EQUITY

It is usually represented by four accounts:

1. Name of owner, capital (for investments in assets made) and which

increases the owner’s equity or net worth over the business.

2. Name of owner, drawing (for any withdrawals in assets made

intended for personal use) and which decreases the owner’s equity or
net worth.

3. Revenues – amount charged to customers/clients for service

rendered or for goods sold

4. Expenses – decreases in assets (increase in liabilities) as a result of

services or efforts made by others to the business so it may be able to
operate properly.

For a partnership, each partner has a “name of partner, capital” and “name
of partner, drawing” account. For a corporation, all investments are under
the title “share capital” and “share premium,” while earnings and
dividends (or withdrawals) are under the title “retained earnings.” While
the records show specific name of the owner in a sole proprietorship and
names of the partners in a partnership, it is not so in a corporation. This is
understandable because of the number of investors in a corporation.

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The ownership interests in the company organized as a corporation are
represented in the final section of the balance sheet, stockholder’s equity or
shareholder’s equity. Ownership equity is the residual interest in assets
that remain after deducting liabilities. The owners bear the greatest risk
because their claims are subordinate to creditors in the event of liquidation;
but owners also benefit from the rewards of a successful enterprise.

Share Capital

Ordinary shareholders do not ordinarily receive a fixed return but do have

voting privileges in proportion to ownership interest. Dividends on
ordinary shares are declared at the discretion of a company’s board of
directors. Further, ordinary shareholders can benefit from stock ownership
through potential price appreciation (or the reverse can occur if the share
price declines.)

The amount listed under the share capital account is based on the par or
stated value of the shares issued. The par or stated value usually bears no
relationship to actual market price but rather is a floor price below which
the stock cannot be sold initially.

Additional Paid-In Capital

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This account reflects the amount by which the original sales price of the
stock shares exceeded par value as well as from other sources such as
donated capital, treasury stock transactions, etc.

Retained Earnings

The retained earnings is the sum of every peso a company has earned since
its inception, less any payments made to shareholders in the form of cash
or stock dividends. Retained earnings do not represent a pile of unused
cash stashed away in corporate vaults; retained earnings are funds a
company has elected to reinvest in the operations of the business rather
than pay out to stockholders in dividends. Retained earnings should not be
confused with cash or other financial resources currently or prospectively
available to satisfy financial obligations. Rather, the retained earnings
account is the measurement of all undistributed earnings.

Other Equity Accounts

These include preferred stock, foreign currency translation effects, treasury

stock and the accumulation of unrealized gains or losses on investments in
debt and equity securities that are classified as “noncurrent investments.”

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Figure 4.1 CDSL Inc., Statement of Financial Position – Equity

Equity
Ordinary shares 2,401.50
Additional paid-in capital 478.50
Retained Earnings 20,087.50
Total Equity 22,967.50

SAMPLE PROBLEMS

Problem 4-1 (AICPA)

The unadjusted current assets and shareholder’s equity of Avelino
Company on December 31, 2016 are as follows:
Cash 600,000
Financial assets at fair value (including cost of P300,000 of 1,000,000
36 | P a g e
AvelinoCompnay’s shares
Trade accounts receivable 3,500,000
Inventory 1,500,000
Share capital 5,000,000
Share premium 7,000,000
Retained Earnings 500,000
What amount should be reported as total shareholder’s equity?

Problem 4-2 (AICPA)

The adjusted trial balance of Barnuevo Company on December 31, 2016
included the following accounts:
Share capital 15,000,000
Share premium 5,000,000
Treasury shares, at cost 2,000,000
Actuarial loss recognized through other comprehensive income 1,000,000
Retained earnings unappropriated 6,000,000
Retained earnings appropriated 3,000,000
Revaluation surplus 4,000,000
Cumulative translation adjustment - credit 1,500,000

What amount should be reported as total shareholder’s equity?

Problem 4-3
Jober opened a new business called “KD Talk Foreign”. This is a language
center where lessons are given for foreign languages like Mandarin,
French, Italian, or Japanese. The following business transaction took place
from June 1 to June 30:
(1) The owner invested P250,000 in cash
(2) He applied for a business bank loan and received P250,000 in cash.
(3) Paid cash of P350,000 for office equipment purchased.
(4) Received cash of P120,000 as tuition fee revenues.
(5) Paid cash for the following expenses: salary, P20,000 and utility,
P30,000.

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How much is his capital at the end of the month?

ANSWERS:

PROBLEM 4-1
Answer: P12,200,000
Share capital 5,000,000
Share premium 7,000,000
Retained Earnings 500,000
Cost of Avelino Company’s share (300,000)

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Total Shareholder’s Equity P12,200,00
0

PROBLEM 4-2
Answer: P31,500,000
Share capital 15,000,000
Share premium 5,000,000
Retained earnings unappropriated 6,000,000
Retained earnings appropriated 3,000,000
Revaluation surplus 4,000,000
Cumulative translation adjustment - credit 1,500,000
Treasury shares, at cost (2,000,000)
Actuarial loss recognized through other comprehensive income (1,000,000)
Total shareholder’s equity P31,500,00
0

The credit in the cumulative translation of adjustment account is translation

gain. If the account has debit balance, it is a translation loss.

PROBLEM 4-3

Answer: P320,000
Jober, Capital June 1 P250,000
Add Profit* 70,000
Jober, Capital June 30 P320,000

Revenues from P120,00

Tuition Fees 0
Less: Expenses
Salary Expenses P20,000
Utility Expenses 30,000 (50,000)
*Profit P70,000

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 CHAPTER V

FINANCIAL STATEMENTS – INCOME STATEMENT

INCOME STATEMENT

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It shows how wealth is produced by listing the revenues earned and
expenses incurred by the business. It describes how the business operated
or produced wealth over a given period of time, say one month. It
describes the revenues earned as well as the expensesincurred by the
business.

While profit enhances wealth of the business, loss on the other hand erodes
the resources. Loss occurs when expenses exceed revenues. A loss
decreases the assets which in turn decreases net worth or owner’s equity.

The income statement is usually presented first to determine the profit

which has to be shown in the capital statement then the balance of the
capital account is transferred in the statement of financial position. An
income statement is a summary of revenues earned and expenses incurred
for a certain period of time. There are two presentation forms for cost and
expenses:

1. Based on the nature of the expense; and

2. Based on its function

The natural form presents the expenses according to their nature, for
example depreciation, advertising, transportation, employee benefits. This
is normally used for a simple business such as that of a service provider.
The second form of income statement called the functional form presents
the expenses according to function: cost of sales, selling expenses,

41 | P a g e
administrative expenses and financial expenses, to a few, and is more
applicable for a merchandiser and a manufacturer.

Regardless of the perspective of the financial statement user – investor,

creditor, employee, competitor, supplier, regulator – it is essential to
understand and analyze the earnings statement. But it is also important
that the analyst realizes that a company’s report of earnings and other
information presented in income statement are not complete nor exact
barometers of financial performance. The income statement is one of many
pieces of financial statement package.

Earnings are measured on an accrual rather than a cash basis, which means
that income reported on the income statement is not the same as cash
generated during the accounting period.

The income statement comes on two basic formats and with considerable
variation in detail presented. The earnings statement in a multiple-step
format, provides several intermediate profit measures – gross profit,
operating profit, and earnings before income tax – prior to the amount of
net earnings for the period. The single-step version of the income statement
groups all items of revenue, then deducts all categories of expense to arrive
at a figure for net income.

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Certain special items, if they occur during an accounting period, must be
disclosed separately on an income statement, regardless of format. This
includes discontinuing operations. Discontinuing operations occur when a
firm sells a major portion of its business. The results of continuing
operations are shown separately from the operating results of the
discontinued portion of the business. Any gain or loss on the disposal is
also disclosed separately.

Figure 5.1, CDSL Inc., Income Statement

CDSL Inc.
Income Statements
For the Year Ended December 31, 2016

Net Sales PHP 107,800.00

Cost of goods sold 64,682.00

Gross profit 43,118.00

Selling and Administrative expenses 16,332.00

Advertising 7,129.00
Lease payments 6,529.00
Depreciation and amortization 1,999.00
Repairs and maintenance 1,507.50
Total 33,496.50

Operating Profit 9,621.50

Other Income (expenses)

Interest Income 211.00
Interest expense (1,292.50)

43 | P a g e
 Earnings before income taxes 8,540.00

Income taxes 3,843.00

Net Income PHP 4,697.00

NET SALES

Total sales revenue for each year is shown net of returns and allowances. A
sales return is a cancellation of a sale, and a sales allowance is a deduction
from the original sales invoice price. Since sales are the major revenue
source for most companies, the trend of this figure is a key element in
performance measurement. The remainder of the income statement reveals
management’s ability to translate sales peso into profits.

COST OF GOODS SOLD

The first expense deduction from sales is the cost to the seller of the
products sold to customers. This expense is called cost of goods sold or
cost of sales. Some companies use the LIFO method, which means that the
last purchases made during the year have been charged to expense. The
relationship between cost of goods sold and net sales – called the cost of
goods sold percentage – is an important one for profit determination
because cost of goods sold is the largest expense item for many firms.

GROSS PROFIT

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The difference between net sales and cost of goods sold called gross profit
or gross margin. Gross profit is the first step of profit measurement on the
multiple-step income statement and is a key analytical tool in assessing a
firm’s operating performance. The gross profit figure indicates how much
profit the firm is generating after deducting the cost of products sold.

OPERATING EXPENSES

Operating expenses include selling and administrative, advertising, lease

payments, depreciation and repairs and maintenance among others. These
are all areas over which management exercises discretion and which have
considerable impact on the firm’s current and future profitability. Thus, it
is important to track these accounts carefully in terms of trends, absolute
amounts, relationship to sales, and relationship to industry competitors.

Selling and administrative expenses are expenses that relate to the sale of
products or services and to the management of the business. They include
salaries, rent, insurance, utilities, supplies and sometimes depreciation and
advertising expense.

Advertising costs are (or should be) a major expense in the budgets of
companies for which marketing is an important element of success.

45 | P a g e
Lease payments include the costs of rentals of leased facilities for retail
outlets.

Depreciation and Amortization – The cost of assets other than land that
will benefit a business enterprise for more than a year is allocated over the
asset’s service life rather than expensed in the year of purchase. Land is an
exception to the rule because land is considered to have an unlimited
useful life. The cost allocation procedure is determined by the nature of the
long-lived asset. Depreciation is used to allocate the cost of tangible fixed
assets such as buildings, machinery, equipment, furniture and fixtures, and
motor vehicles. Amortization is the term applied to the cost expiration of
intangible assets such as patents, copyrights, trademarks, licenses,
franchises, and goodwill. The cost of acquiring and developing natural
resources – oil and gas, other minerals, and standing timber – is allocated
through depletion. The amount of expense recognized in any accounting
period will depend on the level of investment in the relevant asset;
estimates with regard to the asset’s service life and residual value; and for
depreciation, the method used.

Depreciation expense is calculated principally by the straight-line method

based upon estimated useful lives for buildings. Estimated useful lives of
leasehold improvements represent the remaining term of the lease in effect
at the time the improvements are made. Other methods may be used such
as sum-of-years’ digits, declining balance method, etc.

46 | P a g e
Repairs and maintenance are the annual cost of repairing and maintaining
the property, plant and equipment. Expenditures in this area should
correspond to the level of investment in capital equipment and to the age
and condition of the company’s fixed assets.

OPERATING PROFIT

Operating profit (also called EBIT or earnings before interest and taxes) is
the second profit determination and measures the overall performance of
the company’s operations: sales revenue less the expense associated with
generating sales. The figure for operating profit provides a basis for
assessing the success of a company apart from its financing and investing
activities and separate from tax considerations.

OTHER INCOME (EXPENSE)

This category includes revenues and costs other than from operations, such
as dividend and interest income, interest expense, gains (losses) from
investments and gains (losses) from the sale of fixed assets.

In the assessment of earnings quality, it is important that the analyst

consider the materiality and the variability of the non-operating items of
income, for example, gains and losses on the sale of major capital assets,

47 | P a g e
investment income from temporary investments in cash equivalents, and
investment income recognized under the equity method.

EARNINGS BEFORE INCOME TAXES

Earnings before income taxes is the profit recognized before the deduction
of income tax expense.

NET EARNINGS

Net earnings or the “the bottom line” represents the firm’s profit after
consideration of all revenue and expense reported during the accounting
period.

EARNINGS PER ORDINARY SHARE

Earnings per ordinary share is the net earnings for the period divided by
the average number of ordinary shares outstanding.

Figure 5.2, Cost of Goods Sold Statement – Manufacturing

Direct materials used

Materials, March 1 50,000
Purchases 400,000
Total available 450,000
Less: Materials, March 31 47,485 402,515
Direct labor 210,000
Factory overhead 140,000
Total manufacturing costs 752,515

48 | P a g e
 Work in process, March 1 102,350
Cost of goods put into process 854,865
Less: Work in process, March 31 117,135
Cost of goods manufactured 737,730
Finished goods – March 1 100,000
Total goods available for sale 837,730
Less: Finished goods – March 31 82,500
Cost of goods sold P755,230

Figure 5.3, Cost of Goods Sold Statement – Merchandising

Inventory – January 1 5,500,000

Purchases 4,500,000
Purchase returns and allowance (500,000)
Goods available for sale 9,500,000
Inventory – December 31 (3,800,000)
Cost of goods sold P5,700,000

SAMPLE PROBLEMS

Problem 5-1 (AICPA)

Baysic Company provided the following information for the current year:

49 | P a g e
Purchases 5,300,000
Purchase discounts 100,000
Beginning Inventory 1,600,000
Ending Inventory 2,150,000
Freight out 400,000
What is the cost of goods sold for the current year?

Problem 5-2 (PHILCPA)

Bernales Company provided the following information for the current
year:
Inventory, January 1 2,000,000
Purchases 7,500,000
Purchase returns and allowances 500,000
Sales returns and allowances 750,000
Inventory on December 31 2,800,000
Gross profit rate on net sales 20%
What is the amount of gross sales for the current year?

Problem 5-3 (IAA)

Cabales Company provided the following information for the current year:
Sales 7,000,000
Sales returns and allowances 100,000
Cost of goods sold 2,800,000
Utilities expense 1,000,000
Interest revenue 150,000
Income tax expense 800,000
Casualty loss due to earthquake 50,000
Finance cost 200,000
Salaries expense 600,000
Loss on sale of investments 50,000
What amount should reported as income from operating continuing
operations?

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Problem 5-4 (IAA)
Cajayon Company provided the following information for the current year:
Sales 5,000,000
Cost of goods sold 2,800,000
Foreign translation adjustment – credit 400,000
Selling expenses 700,000
Unusual and infrequent gain 400,000
Correction of inventory error 200,000
General and administrative expenses 600,000
Income tax expense 150,000
Gain on sale of investment 50,000
Proceeds from sale of land at cost 800,000
Dividends 300,000
What amount should be reported as income from continuing operations?

Problem 5-5 (PHILCPA)

Carcha Company provided the following information for the current year:
Uncollectible accounts expense 2,000,000
Freight out 3,500,000
Cost of sales 40,000,000
Loss on sale of equipment 1,500,000
Loss from typhoon 3,000,000
Sales 90,000,000
Interest income 4,000,000
Administrative expenses 10,000,000
Finished goods inventory, January 1 60,000,000
Sales commissions 7,000,000
Finished goods inventory, December 31 55,000,000
Income tax rate 30%
What amount should be reported as income from continuing operations?

Problem 5-6 (IAA)

Castor Company reported the following data for the current year:

51 | P a g e
 Income from continuing operations 450,000
Net income 405,000
Selling and administrative expenses 2,250,000
Income before income tax 900,000
What amount should be reported as income or loss from discontinued
operations?

Problem 5-7 (IAA)

Clemente Company provided the following for the current year:
Net income 3,500,000
Unrealized gain on derivative contract 250,000
Foreign currency translation adjustment – credit 50,000
Revaluation surplus 1,000,000
What is the comprehensive income for the current year?

Problem 5-8 (IAA)

Alex Company provided the following for the current year:
Net income 3,500,000
Unrealized gain on derivative contract 250,000
Foreign currency translation adjustment – debit 50,000
Revaluation surplus 1,000,000
What is the comprehensive income for the current year?

Problem 5-9(IAA)
Espanueva Company provided the following data for the current year:
Income from continuing operations 8,000,000
Actuarial loss recognized in other comprehensive income 2,000,000
Dividend paid 700,000
Casualty loss (not included in income) 500,000
What is the profit for the current year?

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Problem 5-10
The accounting department of the Nicart Corporation provided the
following data for March 2016:
Sales P1,200,000
Marketing expenses 5% of sales
Administrative expenses 2% of sales
Purchases P400,000
Factory Overhead 2/3 of Direct Labor costs
Direct Labor P210,000

Inventories: March 1 March 31

Finished goods P100,000 P82,500
Work in process 102,350 117,135
Materials 50,000 47,485
1. How much is the Net income?
2. How much is the cost of goods sold?

Problem 5-11
The accounting department of the Hotel and Restaurant Management
Corporation provided the following data for March 2016:
Sales P1,200,000
Marketing expenses 5% of sales
Administrative expenses 1% of sales
Purchases P400,000
Factory Overhead 2/3 of Direct Labor costs
Direct Labor P210,000
Cost of goods sold P755,230

Inventories: March 1 March 31

Finished goods P100,00 P82,500
0
Work in process 102,350 117,135
Materials 50,000 47,485

53 | P a g e
Required: Compute the net income

ANSWERS:
PROBLEM 5-1
Answer: P4,650,000
Beginning Inventory 1,600,000
Purchases 5,300,000

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Purchase discounts (100,000)
Goods available for sale 6,800,000
Ending Inventory (2,150,000)
Cost of goods sold P4,650,000

PROBLEM 5-2
Answer: P8,500,000
Inventory – January 1 2,000,000
Purchases 7,500,000
Purchase returns and allowance (500,000)
Goods available for sale 9,000,000
Inventory – December 31 (2,800,000
)
Cost of goods sold P6,200,00
0
Net sales (6,200,000/80%) 7,750,000
Sales returns and allowances 750,000
Gross sales P8,500,00
0

PROBLEM 5-3
Answer: P1,550,000
Net sales (7,000,000 – 100,000) 6,900,000
Cost of goods sold (2,800,000
)
Gross income 4,100,000
Interest revenue 150,000
Total income 4,250,000
Expenses:
Utilities expense 1,000,00
0
Salaries expense 600,000
Casualty loss 50,000
Loss on sale of investments 50,000
Finance cost 200,000 1,900,000

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Income before income tax 2,350,000
Income tax expense (800,000)
Income from continuing operations P1,550,00
0

PROBLEM 5-4
Answer: P1,200,000
Sales 5,000,000
Cost of goods sold (2,800,000
)
Gross income 2,200,000
Other income (400,000 +50,000) 450,000
Total income 2,650,000
Expenses:
Selling expenses 700,00
0
General and administrative 600,00 1,300,000
expenses 0
Income before income tax 1,350,000
Income tax expense (150,000)
Income from continuing operations P1,200,00
0

The credit balance in the foreign translation adjustment account is a component

of other comprehensive income.

PROBLEM 5-5
Answer: P18,900,000
Sales 90,000,000
Cost of sales (40,000,000
)
Gross income 50,000,000
Interest income 4,000,000
Total income 54,000,000

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Expenses:
Uncollectible accounts 2,000,000
Freight out 3,500,000
Administrative expenses 10,000,00
0
Sales commissions 7,000,000
Loss on sale of equipment 1,500,000
Loss from typhoon 3,000,000 27,000,000
Income before income tax 27,000,000
Income tax (30% x 27,000,000) (8,100,000)
Income from continuing operations P18,900,00
0
PROBLEM 5-6
Answer: P (45,000) loss
Income from continuing operations 450,000
Loss from discontinued operations (45,000)
(SQUEEZE)
Net Income P405,00
0

PROBLEM 5-7
Answer: P4,700,000
Net income 3,500,000
Other comprehensive income:
Unrealized gain derivative contract 250,000
Foreign currency translation loss (50,000)
Revaluation surplus 1,000,00 1,200,000
0
Comprehensive income P4,700,000

PROBLEM 5-8
Answer: P4,700,000
Net Income 3,500,000
Other Comprehensive Income

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 Unrealized gain on derivative 250,000
contract
Foreign currency translation (50,000)
Revaluation surplus 1,000,00 1,200,000
0
Comprehensive income P4,700,00
0

PROBLEM 5-9
Answer: P7,500,000
Income from continuing operations 8,000,000
Casualty loss (500,000)
Profit or net income for the year P7,500,000

PROBLEM 5-10

Answer:

Income Statement
Sales 1,200,0
00
Less: Cost of goods sold 755,230
Gross profit 444,770
Less: Operating expenses
Marketing 60,000
Administrative 24,000 84,000
Net income P360,770

Cost of goods sold statement

Direct materials used
Materials, March 1 50,000
Purchases 400,00
0
Total available 450,00
0

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 Less: Materials, March 31 47,485 402,515
Direct labor 210,000
Factory overhead 140,000
Total manufacturing costs 752,515
Work in process, March 1 102,350
Cost of goods put into process 854,865
Less: Work in process, March 31 117,135
Cost of goods manufactured 737,730
Finished goods – March 1 100,000
Total goods available for sale 837,730
Less: Finished goods – March 31 82,500
Cost of goods sold P755,23
0

PROBLEM 5-11

Answer:

Sales 1,200,00
0
Less: Cost of goods sold 755,230
Gross profit 444,770
Less: Operating expenses
Marketing 60,000
Administrative 12,000 72,000
Net income P372,770

59 | P a g e
 CHAPTER VI

FINANCIAL STATEMENTS – CASH FLOW STATEMENT

STATEMENT OF CASH FLOWS

It is the basic financial statement prepared and used in analyzing cash

flows. It reports the cash receipts, cash payments, and net changes in cash
resulting from operating, investing and financing activities of the firm
during the period.

Cash flow analysis is a detailed study if the net change in cash as a result of
operating, investing and financing activities during the period

OBJECTIVES AND USES

It is management’s responsibility to maintain a proper balance between the

cash collections and the cash disbursements and ensure that only a
sufficient amount of cash is kept on hand by the firm. Too little cash or too

60 | P a g e
much will affect the smooth flow of financial operation. And it is for lack of
proper cash management that some businesses fail.

Some questions cannot be answered just by reading the income statement

or the statement of financial position such as:

a. How was cash obtained by the business?

b. How was cash spent?
c. What caused the increase or decrease in cash?
d. Why was the cash only P20,000 when the net income was
P50,000?

Relevance of this statement:

1. It enlightens how cash is being managed. A business should be able

to generate positive net cash flow specially from operating activities
so that obligations may be paid including cash withdrawals of
owners. Revenues should easily be converted into cash so that
disbursements could easily be paid.
2. Cash flows are vital to the financial health of the business. Too little
cash or too much cash will affect the smooth flow of financial
operation. It is good for business to be able to generate cash from
operation much more than from financing or from investing
activities. For short-run planning, management strictly monitors the
cash to ensure that cash inflow from operating activities is always
more than its cash outflow.
3. Some business fail because of its inability to maintain or proper
balance between receipts and disbursements. Cash flowis either an

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 inflow (source or receipt) or an outflow (use or disbursement) and is
classified as: operating activities, investing activities and financing
activities.

The statement of cash flow when used with other general purpose financial
statements will benefit users and enable them to:

1. Assess the firm’s ability to generate cash in the future and predict
future cash flows;
2. Evaluate the firm’s financial position as to liquidity and solvency;
3. Examine the relationship between the net income (which is normally
is under the accrual basis) and the cash flow from operation;
4. Evaluate changes in the entity’s net assets (assets less liabilities)
5. Evaluate entity’s ability to adopt to pressures and changing
circumstance and opportunities;
6. Assist management in their planning and controlling functions.

CONCEPT OF CASH

The concept of cash covers not only cash but also cash equivalents. Cash
includes cash on hand and demand deposits. Cash equivalents include
treasury and commercial bills, short-term highly liquid investments such as
time deposits readily convertible into cash within three months from
acquisition date.

MAJOR CATEGORIES OF CASH ACTIVITIES

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The change in the cash position is brought about by three kinds of
activities: operating, investing and financing.

1. Operating Activities. These are the principal income producing

activities presented by revenues from sale of goods or services;
receipts for royalties, fees, commissions and other revenues;
payments to suppliers for goods and services (expenses); payments to
employees; payment to government; payment to others for contract
services. These are the cash effects of transactions that create revenue
and expenses. It is generally relate to changes in current assets and
current liabilities.
Example:

Cash Inflows Cash Outflows

Sale of goods/services; Interest Payment to supplier; Salaries and
income received on loans; wages paid to employees; taxes
dividend income received on paid to the government; interest
equity securities expense paid to creditors; and
payments of other expense

2. Investing Activities. These are represented by the acquisition and

disposal of non-current assets such as plant, property and equipment;
payments and receipts from acquisition and sales of bonds and
securities or interest in joint ventures; cash advances/loans of officers
and employee and other parties. It generally relate to changes in non-
current assets.

Cash Inflows Cash Outflows

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 Sale of property, plant and Purchase of property, plant and
equipment; sale of debt or equity equipment; purchase of debt or
securities of other firm; collection equity securities of other firm;
of principal on loans lending of money to other firms

3. Financing Activities. These are represented by the long term

borrowing and repayment of loans made by the enterprise;
contributions and withdrawals of investors or equity participants. It
relate to changes in long-term liabilities and stockholders’ equity
accounts.

Cash Inflows Cash Outflows

Sale of company’s own stocks; Payment of dividends to
issuance of bond or notes stockholders, redemption of long-
term debt, reacquisition of capital
stock

A business should be able to generate sufficient cash from operating

activities so that obligations may be paid including extinguishments of
loans and cash withdrawals or dividends distribution to investors. It is
good for the business to generate more cash from operating activities rather
than from the financing and investing activities. Revenues should easily be
converted into cash so that disbursements could easily be paid. For short
run planning, management strictly monitors cash to ensure that there is no
cash shortage nor overage. This can be done with the right “balance” by
planning how and when cash will be obtained and used. Aside from
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managements, other interested parties in the cash flow statement are the
investors, creditors and suppliers.

A summary of cash flows are given below:

Activities Inflows Outflows

Operating Revenue collections Payment for expenses
Sale of goods or Suppliers for purchase
services; of goods;
Interest on loans Employees for salaries;
granted Government for taxes;
Lenders for interest;
Utility companies for
utilities;
Others for advertising,
delivery.
Investing Sale of plant, property Acquisition of plant,
and equipment, land, property and
building, furniture, equipment, land,
machinery building, furniture,
machinery
Sale of securities such
as bonds and stocks Purchase of securities
acquired from other such as bonds and
companies; stocks acquired from
other companies;
Collection of principal

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 of loans and advances Officers, employees
and outsiders for loans
and advances
Financing Borrowings; Loans Cash paid to creditors
extended by creditors or withdrawn by
or contributions of investors
investors

REPORTING CASH FLOW FROM OPERATING ACTIVITIES

There are two methods of reporting cash flow from operating activities:
direct method and indirect method. Under the direct method major classes
of cash receipts and cash payments are presented in the statement to arrive
at the cash flow from operating activities. The major operating activities
may be classified into three:

a. Collections from clients and customers

b. Payments to suppliers
c. Payments for expenses

Under the indirect method, the major classes of receipts and payment are
not presented. The procedure is to convert the net income from the accrual
basis to cash basis through a series of adjustments for the effects of non-
cash transactions such as the increases or decreases in receivables,
payables, prepayments and deferments of income and expenses.

Rules in preparing the statement of cash flows for the year:

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 1. Determine the increase or decrease in the statement of financial
position accounts related to revenue and expense accounts. Since this
is the first year of operation, the procedure is quite simple. All items
appearing in the statement are deemed to be increased. Receivables
at the end of the year represent increases in uncollected accounts
hence it should be deducted from income to arrive at the cash
actually collected. The same rule applies for payables. Ending
balances represent increases in unpaid accounts and should be
deducted from expenses reported in the income statement to arrive at
expenses actually paid.
2. For investing activities, go over the property and equipment
accounts: increase in property represents acquisition of property and
paid in cash if there is no increase in payable for this; decrease in
property represents sale or disposal of property but you have to add
the gain on disposal (or less loss on disposal) to arrive at the total
proceeds representing cash inflow.
3. For financing activities, go over the loans and owner’s activities
(investments and withdrawals). Increases in loan and investment
represent cash inflows. Decrease in loan and increase in owner’s
drawing represent payment or cash outflows.

The cash balance at the end of the period should reconcile with the
reported cash balance in the statement of financial position.

For the statement of cash flows in a subsequent period the rules are:

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 1. Income + Receivable beginning – Receivable ending = Cash collected
from clients
2. Expenses + Payable beginning – Payable ending = Cash paid for
expenses

SIGNIFICANT NON-CASH ACTIVITIES

These are not reported in the body of the Statement of Cash Flows.
However, these are reported as separate schedule at the bottom of the
Statement of Cash Flows or in a separate note or supplementary schedule
to the financial statements.

In addition, income statements contain several noncash entries, the

largest of which is depreciation. Depreciation attempts to capture the
noncash expense incurred as fixed assets deteriorate from the time of
purchase to the point when those assets must be replaced.

FORMAT OF THE STATEMENT OF CASH FLOWS

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 ALAN LANCELOT CORPORATION
Statement of Cash Flows
December 31, 2016

Cash flows from operating activities

List of individual items xx
Net cash provided (used) by operating activities xx

Cash flows from investing activities

List of individual items xx
Net cash provided (used) by investing activities xx

Cash flows from financing activities

List of individual items xx
Net cash provided (used) by financing activities xx

Net increase (decrease) on cash xx

Cash balance, beginning of period xx
Cash balance, end of period

ANALYZING THE CASH FLOW STATEMENT

Liquidity

Current Cash Debt Coverage Ratio. The formula is Cash from

operating activities / Average Current Liabilities. It is considered a better
measurement of liquidity since it is more realistic as it uses cash from
operation to settle obligations.

Solvency

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 Cash Debt Coverage Ratio. The formula is Cash from operating
activities/ Average Total Liabilities.

Free Cash flow

This measure the ability of the cash from operating activities to fund
expansion (acquisition of properties) and payment of dividends. The
formula is:

Free Cash Flow = Cash from operating activities less Payments for
Dividends and Acquisition of Equipment.

It gives the company much leeway as this extra cash may be used for
unexpected/emergency disbursements of the company.

Adequacy Ratio

This is similar to Free Cash Flow except that it is expressed in a ratio.

For the firm to be considered as having adequate cash from operating
activities, the ratio must be more than 1:

Cash from operating activities / Payments for Dividends + Acquisition of

Equipment.

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Cash Flow to Net Income

This shows the relationship of the cash to the net income earned by
the entity. Or stated in another way, this shows the cash generated by a
peso of sale.

Cash Flow from Operating Activities / Net Income

SAMPLE PROBLEMS

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Problem 6-1
Louis Shop had cash flows from investing activities of P2,567,000 and cash
flows from financing activities of P3,459,000. The balance in the firm’s cash
account was P950,000 at the beginning and P1,025,000 at the end of the
year. Calculate Louis Shop’s cash flow from operations for 2015.

Problem 6-2
The following are selected information of Gantala Internet Cafe for the year
2016:
Cash used for acquisition of PLDT shares P30,000
Cash used for payment of loan due to PNB 20,000
Cash from sale of internet time 80,000
Cash used for operating expenses 48,000
Cash investment of shareholders 200,000
Cash dividends to shareholders 50,000
Proceeds from sale of furniture 20,000
Cash balance, December 31, 2015 85,000
1. How much is the cash flow from operating activities?
2. How much is the cash flow from financing activities?
3. How much is the cash flow from investing activities?
4. How much is the cash balance as at December 31, 2016?

Problem 6-3
Dean Makasiar opened a new business called “School of Hotel and
Restaurant Management”. The following business transaction took place
from August 1 to August 31, 2016:
a) The owner invested P600,000 in cash
b) He applied for a business bank loan and received P350,000 in cash.
c) Paid cash of P450,000 for office equipment purchased.
d) Received cash of P320,000 as tuition fee revenues.
e) Paid cash for the following expenses: salary, P30,000 and utility,
P50,000.
Required:

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 1. Assuming that the tax rate is 30%, how much is the ending capital?
2. How much is the net cash flow?
3. How much is the total liability?
4. How much is the total asset?

Problem 6-4
Alan Lancelot Makasiar opened a new business called “School of Hotel and
Restaurant Management”. The following business transaction took place
from June 1 to June 30, 2016:
a) The owner invested P500,000 in cash
b) He applied for a business bank loan and received P350,000 in cash.
c) Paid cash of P450,000 for office equipment purchased.
d) Received cash of P320,000 as tuition fee revenues.
e) Paid cash for the following expenses: salary, P30,000 and utility,
P50,000.
Required:
1) How much is the beginning capital of Alan Lancelot Makasiar?
2) How much is the ending capital of Alan Lancelot Makasiar?
3) How much is the total expenses?
4) How much is the profit?
5) How much is the cash inflow?
6) How much is the cash outflow?
7) How much is the net cash flow?
8) How much is the total liability?
9) How much is the total asset?
10) Assuming that the tax rate is 30%, how much is the ending
capital?

ANSWERS:
PROBLEM 6-1
Answer: ₱(817,000) Outflow
Cash flow from
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 Operating activities ₱(817,000) Outflow
Investing activities (2,567,000) Outflow
Financing activities 3,459,000 Inflow
Increase in Cash ₱75,000

Cash balance, beginning ₱ 950,000

Cash balance, end 1,025,000
Increase in Cash ₱75,000

Note: The problem did not indicate whether the cash flows from investing and
financing activities represented net inflow or outflow. It is assumed that following
normal course of operations, investments will represent usage or outflow of cash
and financing will represent sourcing or inflow of cash. Hence since the cash
account posted a net increase of ₱75,000, operating activities must have used up a
net cash flow of ₱817,000.

PROBLEM 6-2
Answer:
Cash from operating activities
Cash from sale of internet time 80,000
Cash used for operating expenses (48,000) P32,000
Cash from investing activities
Proceeds from sale of furniture P20,000
Cash used for acquisition of PLDT shares (30,000) (10,000)
Cash from financing activities
Cash investment of shareholders P200,000
Cash dividends to shareholders P(50,000
)
Cash used for payment of loan due to PNB (20,000) 130,000
Cash balance, December 31, 2015 85,000
Cash balance, December 31, 2016 P237,000

PROBLEM 6-3

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Answer:

School of Hotel and Restaurant Management

Capital Statement
For the month ended June 30, 2016
Makasiar, Capital June 1, 2016 P600,000
Add Profit* 168,000
Makasiar, Capital June 30, 2016 P768,000

School of Hotel and Restaurant Management

Income Statement
For the month ended June 30, 2016

Revenues from Tuition Fees P320,000

Less: Expenses
Salary Expenses P30,000
Utility Expenses 50,000 (80,000)
*Profit P240,000
Tax expense (P240,000 x 30%) 72,000
Net Income P168,000

School of Hotel and Restaurant Management

Statement of Cash Flows
For the month ended June 30, 2016
Cash Inflows P600,000
Investment 350,000
Loan 320,000
Services Rendered
Cash outflow
Equipment bought (450,000)
Expenses paid (80,000) (530,000)
Net Cash Flow P740,000

School of Hotel and Restaurant Management

Statement of Financial Position
June 30, 2016

Assets
Cash P740,000
Equipment 450,000
Total Assets P1,190,000

Liability:
Loans Payable P350,000
Owner’s Equity: Makasiar, Capital 840,000
Total Owner’s Equity P1,190,000

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PROBLEM 6-4
Answer:
School of Hotel and Restaurant Management
Capital Statement
For the month ended June 30, 2016
Makasiar, Capital June 1, 2016 P500,000
Add Profit* 240,000
Makasiar, Capital June 30, 2016 P740,000

School of Hotel and Restaurant Management

Income Statement
For the month ended June 30, 2016

Revenues from Tuition Fees P320,000

Less: Expenses
Salary Expenses P30,000
Utility Expenses 50,000 (80,000)
*Profit P240,000

School of Hotel and Restaurant Management

Statement of Cash Flows
For the month ended June 30, 2016
Cash Inflows P500,000
Investment 350,000
Loan 320,000
Services Rendered
Cash outflow
Equipment bought (450,000)
Expenses paid (80,000) (530,000)
Net Cash Flow P640,000

School of Hotel and Restaurant Management

Statement of Financial Position
June 30, 2016

Assets
Cash P640,000
Equipment 450,000
Total Assets P1,090,000

Liability:
Loans Payable P350,000
Owner’s Equity: Makasiar, Capital 740,000
Total Owner’s Equity P1,090,000

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 CHAPTER VII

FINANCIAL STATEMENT ANALYSIS - INTRODUCTION

This chapter is concerned with how the performance of the company

may be reviewed through analysis and interpretation of its financial
statements. First of all, an understanding of the organizational structure of

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the company starting from its vision-mission, goals and objectives, long
range and short range plans, core competencies and limitations enables an
analyst to come up with a correct analysis and interpretation of the
company’s financial performance across periods and across companies.

When reading the income statement, one must get to know the
amount of sales obtained by the firm, its cost of sales, gross profit,
operating expenses and operating profit. When reading the statement of
financial position, one must get to know the amount of assets owned, the
liabilities owed and the residual interest of the owner. Financial
statements are informative reports and nothing else. If you want a
complete picture of whether the company has performed efficiently and
effectively, then financial statements must be analyzed and interpreted.
Questions such as:

1. Is the profit generated by the sales adequate

2. Is the profit a sufficient return on what the owner invested?
3. Are the assets being used efficiently to generate profit?
4. Can the business pay its obligation on time?
5. Is it safe to borrow some more?

These questions can only be answered when you make a good analysis and
interpretation of the company’s financial statements.

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 Financial statement analysis is the process of assessing the financial
condition, operating performance and viability of the enterprise. It is a
powerful and effective measurement tool which with assist all statement
users to make informed judgment and decision.

When analyzing the financial statements, one must get to know about
the profitability, liquidity and solvency of the business. Profitability is not
just simply earning more revenues than costs and expenses. Profitability is
the ability of the business to earn a satisfactory rate of return on owner’s
or investor’s capital. It is the objective of profitability to make sure that
profit is important for it is a ticket to business growth and expansion.
Aside from profitability, other factors that will help predict company’s
success is liquidity and solvency. Liquidity enhances financial position of
the business with reference to its ability to manage its working capital and
pay for its short term obligations. Solvency or stability is long term
liquidity which also enhances financial position of the company with
reference to how it manages all its resources and pay for its long term
obligations. The resources of the business is primarily financed by the
owner/investor. But the company may resort to borrowings when they
need more resources which the owner/investor is incapable of investing.

In analyzing the figures contained in the financial statements, to

make them meaningful, the raw figures must be standardized by reducing
them into ratios, turnovers, and percentages. Only then can these

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ratios/percentages be compared against the previous year’s
ratios/percentages (this is called intracomparability) or against the
competitior’s ratios/percentages (this is called intercomparability or
benchmarking). A ratio is a measure of the relationship of one item against
another item such as net income against net sales (P4,000/P20,000) = .2:1.
To change the ratio into a percentage multiply .2 by 100 = 20%.

To illustrate further, assume the following figures for Alan Company

and Cavin Company:

Figure 7.1.

Alan Cavin
Company Company
Net Sales P3,000,000 P7,500,000
Net Income P500,000 P1,000,000
Average Shareholder’s Equity P2,000,000 P5,000,000

It is easy to draw the conclusion that Alan Company is profitable

because of the net income of P500,000. Then comparing it with B’s net
income of P1,000,000, one might perceive that the Cavin Company is better
than the Alan company. However, reading their income statements further,
one will see that the revenues earned by the Alan Company was P3,000,000
while that of the Cavin Company was P7,500,000. This will show that the
result (net income) of the effort (revenue) of the Cavin Company was only
13.33% (1,000,0000 / 7,500,000 x 100) while that of the Alan Company was
16.67% (500,0000/3,000,000 x 100). If Alan’s profit margin is 16.67%, it
means that cost and expenses is 83.33% (100% - 16.67%) of sales while that
80 | P a g e
of Cavin is 86.67% (100% - 13.33%). Although both are profitable, Alan is
more efficient in generating sales because it can draw out more income
(16.67%) for every peso of sale and minimize its costs and expenses
(83.33%). Efficiency results when pricing policy is good and the activities
are properly monitored and controlled so that less time and effort are used
thus minimizing the costs or expenses of the company. Lastly, the return
on equity was 25% (500,000/2,000,000) for Alan while it was only 20%
(1,000,000/5,000,000) for Cavin. It means that both are profitable but Alan
is more profitable as its shareholders earned 25% net income on their
investments as against only 20% for Cavin’s shareholders.

Using ratio analysis, one will see a clearer picture of the company
and how it performs. The following rules/procedures were used for the
above illustration:

1. Ratios and percentages were determined (Return on Sales, Costs and

Operating Expense Ratio and Return on Equity).
2. Two or more data were used (sales, net income, cost and expenses,
shareholders’ equity).
3. The figures used to form a ratio did not come only from one financial
statement. Since data are interrelated (like Net Income and
Shareholders’ Equity) it could use data from the income statement
and the balance sheet to form a ratio.
4. To make analysis and interpretation more meaningful a comparison
was made between two competitors.

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 From the above discussion, one can draw the following advantages of
analyzing financial statements. Through the use of ratios, percentages
and turnovers it will enable one to:

1. Determine whether or not the company is efficient in its operation

which is the greatest contributing factor to its profitability.
2. Determine whether or not the company’s financial position is strong
considering liquidity and solvency.
3. Determine whether or not the company is efficient in using its
resources which is also a contributing factor to its profitability and
liquidity.
4. Spot trends, weaknesses and potential problems.
5. Use the analyses to forecast expectation on company’s future
performance.
6. Create new plans or revise old plans in accordance to ones goal or
objective depending on whether if one is an owner, manager,
potential investor, creditor, supplier or customer.

CHAPTER VIII

COMPARATIVE FINANCIAL STATEMENTS –

HORIZONTAL ANALYSIS

The first step in analyzing the company’s performance is to place side

by side its financial statements for two periods or the financial statements
of two competing companies. Comparability is one of the qualitative

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characteristics of financial statements which makes the information more
relevant. With the increases or decreases in the financial data, one is able to
spot differences in the performance between two competing companies or
the changes taking the place in the company between two periods. An
example of comparative financial statements are shown below:

Figure 8.1. Jerome Shoes Incorporated, Comparative Statement of Income

JEROME SHOES INCORPORATED

COMPARATIVE STATEMENT OF INCOME
2016 2015
Sales 6,522,500 5,642,000
Cost of Goods Sold 2,275,000 1,886,000
Gross Profit 4,247,500 3,756,000
Less Operating Expenses:
Rent Expenses 1,087,500 945,000
Salary Expenses 900,000 760,000
Gas & Oil Expense 465,200 355,000
Depreciation Expense 340,000 325,000
Utilities Expense 190,000 155,000
Repair Expense 115,000 100,000
Supplies Expense 43,300 75,000
Total 3,141,000 2,715,000
Operating Profit 1,106,500 1,041,000
Less Interest Expense 112,500 135,000
Net Income Before Tax 994,000 906,000
Less Tax Provision of 30% 298,200 271,800
NET INCOME P 695,800 P 634,200

Figure 8.2. Jerome Shoes Incorporated, Comparative Statement of

Financial Position

JEROME SHOES INCORPORATED

COMPARATIVE STATEMENT OF FINANCIAL POSITION

ASSETS
Current Assets: 2016 2015
Cash 850,000 675,000

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 Accounts Receivable 250,000 130,000
Mechandise Inventory 707,500 600,000
Supplies 45,000 17,000
Total Current Assets 1,852,500 1,422,000

Property Plant and Equipment:

Trucks 2,500,000 2,500,000
Less Accumulated Depreciation - Trucks 600,000 300,000
1,900,000 2,200,000
Equipment 450,000 300,000
Less Accumulated Depreciation - Equipment 35,000 10,000
415,000 290,000
Furniture and Fixtures 250,000 250,000
Less Accumulated Depreciation -Furniture and Fixtures 30,000 15,000
220,000 235,000
Total Property, Plant and Equipment 2,535,000 2,725,000

TOTAL ASSETS 4,387,500 4,147,000

LIABILITIES AND SHAREHOLDERS' EQUITY

Current Liabilities
Accounts Payable 110,000 150,000
Rent Payable 100,000
Taxes Payable 298,200 271,800
Utilities Payable 75,000 55,000
Total Current Liabilities 583,200 476,800
Long-term Liability
Loans Payable 1,250,000 1,500,000
Total Liabilities 1,833,200 1,976,800
Shareholder's Equity:
Share Capital 1,750,000 1,536,000
Retained Earnings 804,300 634,200
TOTAL LIABILITIES AND OWNER'S
EQUITY 4,387,500 4,147,000

HORIZONTAL ANALYSIS

There are three tools used in analyzing financial statements –

Horizontal Analysis, Vertical Analysis and Financial Ratio Analysis. The
Horizontal Analysis is important because it enables one to draw a picture

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on what changes (increases and decreases) are taking place in the financial
activities of an enterprise. A horizontal analysis is a comparative analysis
which shows the increases and decreases, in absolute amounts and in
percentages, of financial data for two given periods. Trend analysis shows
the comparison of more than two periods against a base year. The increase
or decrease, specially if material in amount, will trigger an inquisition from
management to determine what caused the change and whether the change
is good for the company. Procedure: get the difference between the figures
for two years to arrive at the absolute amount of change and divide the
difference by the base amount (which is in the year 2015 for the Jerome
Shoes illustration) to arrive at the percentage of change. For example the
cash increased by P175,000 (850,000 – 675,000) with a percentage increase of
25.93% (175,000/675,000).

It involves comparison of figures shown in the financial statements of

two or more consecutive periods. The difference between the figures of the
two periods is calculated, and the percentage change from one period to
the next is computed using the earlier period as the base.

Formula:

Percentage Change = (Most Recent Value – Base Period Value)/Base

Period Value

Example:

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Figure 8.3.

2017 2016 Pesos Percent

Sales P3,280 P2,950 P330 11.19%

Percentage Change = (P3,280 – P2,950)/P2,950 = 11.19%

Figure 8.4. Jerome Shoes Incorporated, Comparative Statement of

Financial Position, Horizontal Analysis

JEROME SHOES INCORPORATED

COMPARATIVE STATEMENT OF FINANCIAL POSITION

ASSETS Increase or Decrease

Current Assets: 2016 2015 In Amount In percentage
Cash 850,000 675,000 175,000 25.93%
Accounts Receivable 250,000 130,000 120,000 92.31%
Mechandise Inventory 707,500 600,000 107,500 17.92%
Supplies 45,000 17,000 28,000 164.71%
Total Current Assets 1,852,500 1,422,000 430,500 30.27%

Property Plant and Equipment:

Trucks, net of accumulated
depreciation 1,900,000 2,200,000 -300,000 -13.64%
Equipment, net of accumulated
depreciation 415,000 290,000 125,000 43.10%
Furniture and Fixtures, net of
accumulated depreciation 220,000 235,000 -15,000 -6.38%
Total Property, Plant and
Equipment 2,535,000 2,725,000 -190,000 -6.97%
TOTAL ASSETS 4,387,500 4,147,000 240,500 5.80%

LIABILITIES AND SHAREHOLDERS' EQUITY

Current Liabilities
Accounts Payable 110,000 150,000 -40,000 -26.67%
Rent Payable 100,000 100,000
Taxes Payable 298,200 271,800 26,400 9.71%
Utilities Payable 75,000 55,000 20,000 36.36%

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 Total Current Liabilities 583,200 476,800 106,400 22.32%
Long-term Liability
Loans Payable 1,250,000 1,500,000 -250,000 -16.67%
Total Liabilities 1,833,200 1,976,800 -143,600 -7.26%
Shareholder's Equity:
Share Capital 1,750,000 1,536,000 214,000 13.93%
Retained Earnings 804,300 634,200 170,100 26.82%
TOTAL LIABILITIES AND
OWNER'S EQUITY 4,387,500 4,147,000 240,500 5.80%

Interpretation:

Note that all current assets increased (an average of P430,500 or

30.27%) specially the cash (P175,000 or 25.93%), accounts receivables
(P120,000 or 92.31%) and supplies (P28,000 or 164.71%). The increasing
amounts and percentages of the current assets signifies a building up of
working capital although the current liabilities increased by 22.32%,
accounts payable however decreased by 26.67%. The increase in cash
should be tested for quality use with a cash flow statement which is in the
next chapter. The increase in accounts receivable and inventory should be
tested also for quality use which is presented in financial ratio analysis
with turnover and holding period. Current assets less current liabilities
represents net working capital. For the company to be able to operate
efficiently it must have adequate working capital. Insufficient working
capital will make it difficult for the business to operate smoothly as money
will be tied up to the demands or creditors/suppliers. On the other hand,
too much working capital, such as inventories, is not good for the firm as it
ties up its resources needlessly.

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 For the non-current assets, there is only a decrease of 6.97%. the net
decrease in trucks and furniture represent increases in accumulated
depreciation. Equipment, however, increased by 43.10% representing
additional acquisition.

The long term liabilities decreased by 16.67%. Share Capital increased

by 13.93% because of additional investments. The increase in retained
earnings by 26.82% represents increase in net income.

Figure 8.5. Jerome Shoes Incorporated, Comparative Statement of

Income, Horizontal Analysis

JEROME SHOES INCORPORATED

COMPARATIVE STATEMENT OF INCOME Increase or Decrease
2016 2015 In Amount In percentage
Sales 6,522,500 5,642,000 880,500 15.61%
Cost of Goods Sold 2,275,000 1,886,000 389,000 20.63%
Gross Profit 4,247,500 3,756,000 491,500 13.09%
Less Operating Expenses:
Rent Expenses 1,087,500 945,000 142,500 15.08%
Salary Expenses 900,000 760,000 140,000 18.42%
Gas & Oil
Expense 465,200 355,000 110,200 31.04%
Depreciation
Expense 340,000 325,000 15,000 4.62%
Utilities
Expense 190,000 155,000 35,000 22.58%
Repair Expense 115,000 100,000 15,000 15.00%
Supplies
Expense 43,300 75,000 -31,700 -42.27%
Total 3,141,000 2,715,000 426,000 15.69%
Operating Profit 1,106,500 1,041,000 65,500 6.29%
Less Interest Expense 112,500 135,000 -22,500 -16.67%
Net Income Before Tax 994,000 906,000 88,000 9.71%

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 Less Tax Provision of 30% 298,200 271,800 26,400 9.71%
NET INCOME P 695,800 P 634,200 61,600 9.71%

Interpretation:

In the income statement, worth noting is the increase in revenues by

15.61% but because cost of sales increased at a much higher rate by 20.63%,
the increase in gross profit is lower at 13.09%. This serves as a caution for
the company to go over its cost of merchandise and ensure that it is
monitored and reviewed as it is much higher than the increase in the
selling price. Expenses have also gone higher (P426,000 or 15.69%) except
for supplies. All these resulted to an unremarkable increase in operating
income at 6.29%. Change in net income has gone higher at 9.71% thanks to
the decrease in interest expense by 16.67%.

Again, it is important to note that there is a connection between

liquidity and profitability. With loans paid, interest expense decreased in
2013 enhancing net income. Recall that the financial statements are
interrelated. The financial ratios affect both the statement of financial
position and the income statement. Working capital in the statement of
financial position is related to all the accounts in the income statement;
shareholders’ equity in the statement of financial position is related to net
income.

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SAMPLE PROBLEMS

Problem 8-1

Here are the comparative income statements of Dannah Soriano

Corporation:

DANNAH SORIANO CORPORATION

Comparative Income Statements
For the Years Ended December 31
2017 2016 2015
Net Sales 550,000 550,000 600,000
Cost of Goods sold 440,000 450,000 500,000
Gross Profit 110,000 100,000 100,000
Operating Expenses 58,000 55,000 30,000

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 Net Income before tax 52,000 45,000 70,000
30% Tax 15,600 13,500 21,000
Net Income 36,400 31,500 49,000

Direction: (Round all computation to 2 decimal places.)

Prepare a trend analysis of the income statement using 2015 as the base
year. (Show the amounts and percentage of increase or decrease). Make an
interpretation on the trend analysis.

Problem 8-2

Here are the comparative statement of financial position of Ogie Alcasid

Corporation:

Ogie Alcasid Corporation

Statement of Financial Position at December 31, 2014 and 2013
2014 2013
ASSETS
Current Assets
Cash PHP 2,030.50 PHP 1,191.00
Marketable Securities 2,636.00 4,002.00
Accounts Receivable 4,704.00 4,383.50
Allowance for Doubtful Accounts (224.00) (208.50)
Inventories 23,520.50 18,384.50
Prepaid Expenses 256.00 379.00
Total Current Assets PHP 32,923.00 PHP 28,131.50

Property, Plant and Equipment

Land 405.50 405.50
Buildings and Leasehold improvements 9,136.50 5,964.00
Equipment 10,761.50 6,884.00
20,303.50 13,253.50
Less: Accumulated depreciation and (5,764.00) (3,765.00)

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 amortization
Net property, plant and equipment 14,539.50 9,488.50

Other Assets 186.50 334.00

Total Assets PHP 47,649.00 PHP 37,954.00

LIABILITIES AND
EQUITY
Current Liabilities
Accounts Payable PHP 7,147.00 PHP 3,795.50
Notes Payable - banks 2,807.00 3,006.00
Current maturities of long term debt 942.00 758.00
Accrued Liabilities 2,834.50 2,656.50
Total Current Liabilities PHP 13,730.50 PHP 10,216.00
Deferred Income Taxes 421.50 317.50

Long-Term Debt 10,529.50 8,487.50

Total Liabilities PHP 24,681.50 PHP 19,021.00

Equity
Ordinary shares 2,401.50 2,297.00
Additional paid-in capital 478.50 455.00
Retained Earnings 20,087.50 16,181.50
Total Equity 22,967.50 18,933.50

Total Liabilities and Equity PHP 47,649.00 PHP 37,954.50

Using Horizontal Analysis, compute the following:

1. The increase amount in percentage of the total current asset in 2013

and 2014
2. The increase amount in percentage of the total liability in 2013 and
2014
3. The increase amount in percentage of the total equity in 2013 and
2014

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Problem 8-3

2017 2016
Net Sales PHP 107,800.00 PHP 76,500.00
Cost of goods sold 64,682.00 45,939.50
Selling and Administrative expenses 16,332.00 13,191.00
Advertising 7,129.00 5,396.00
Lease payments 6,529.00 3,555.50
Depreciation and amortization 1,999.00 1,492.00
Repairs and maintenance 1,507.50 1,023.00
Interest Income 211.00 419.00
Interest expense 1,292.50 1,138.50
Income taxes 3,843.00 2,228.50

Using Horizontal Analysis, compute the increase amount in percentage of

the net income in 2016 and 2017.

ANSWER:

PROBLEM 8-1

Answer:

DANNAH SORIANO CORPORATION

Comparative Income Statements
For the Years Ended December 31
2015-2016 2015-2017
(50,000
Net Sales (50,000) (8.33%) ) (8.33%)
(60,000
Cost of Goods sold (50,000) (10.00%) ) (12.00%)
Gross Profit 0 0.00% 10,000 10.00%
Operating Expenses 25,000 83.33% 28,000 93.33%
(18,000
Net Income before tax (25,000) (35.71%) ) (25.71%)
30% Tax (7,500) (35.71%) (5,400) (25.71%)
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 (12,600
Net Income (17,500) (35.71%) ) (25.71%)

The net sales has been consistently decreasing by 8.33%. But cost of sales has also been
consistently decreasing by a higher percentage of 10% and 12% respectively. Operating
expenses has dramatically increased by 83.33% and 93.33%. It seems company cannot
control its operating expenses. Because of this profit has decreased dramatically by
35.71% and 25.71% respectively.

PROBLEM 8-2

Answer:

1. The increase amount in percentage of the total current asset in 2013 and
2014 (Horizontal Analysis) = (Total Asset 2014 - Total Asset 2013) / Total
Asset 2013
(32,923 – 28,131.50)/28,131.50 = 17.03%
2. The increase amount in percentage of the total liabilities in 2013 and 2014
(Horizontal Analysis)
(24,681.50 – 19,021)/19,021 = 29.76%
3. The increase amount in percentage of the total liabilities in 2013 and 2014
(Horizontal Analysis)
(47,649 – 37,954.50)/37,954.50 = 25.54%

PROBLEM 8-3

Answer: 58.95%

CDSL Inc.
Income Statements
For the Years Ended December 31, 2014 and 2013 Increases or Decrease
2014 2013 In Amount and in Percentage

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 107,800.0
Net Sales 0 76,500.00 31,300.00 40.92%
6 45
Cost of goods sold 4,682.00 ,939.50 18,742.50 40.80%
4 30
Gross profit 3,118.00 ,560.50 12,557.50 41.09%

1 13
Selling and Administrative expenses 6,332.00 ,191.00 3,141.00 23.81%

Advertising 7,129.00 5,396.00 1,733.00 32.12%

Lease payments 6,529.00 3,555.50 2,973.50 83.63%

507.0
Depreciation and amortization 1,999.00 1,492.00 0 33.98%
484.5
Repairs and maintenance 1,507.50 1,023.00 0 47.36%
3 24
Total 3,496.50 ,657.50 8,839.00 35.85%

Operating Profit 9,621.50 5,903.00 3,718.50 62.99%

Other Income (expenses)

(208.00
Interest Income 211.00 419.00 ) -49.64%
( ( (154.00
Interest expense 1,292.50) 1,138.50) ) 13.53%

Earnings before income taxes 8,540.00 5,183.50 3,356.50 64.75%

Income taxes 3,843.00 2,228.50 1,614.50 72.45%

Net Income 4,697.00 2,955.00 1,742.00 58.95%

CHAPTER IX

COMPARATIVE FINANCIAL STATEMENTS – VERTICAL

ANALYSIS

This is another tool used in evaluating the importance (proportion of

individual items to the specific base item which is the gross sales (in the
income statement), total assets and the total equity (in the statement of
financial position). The base item is expressed as 100%. If there are sales

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returns, allowances or sales discount, then we use net sales as the base
item. Over time, when preparing a comparative analysis, it shows changes
in the relative size (importance) of each item to the specific base and
whether it is good or not depends on its effect on the financial position or
performance of the business. For example, if over a period of time the sizes
of the expenses have grown against the size of the revenue , this will
adversely affect net income. It means that the company is spending much
for expenses but is not generating more revenues than it should be.
Vertical analysis is computed by dividing the amount of each item to the
specific base. For example: income in 2012 was (695,800/6,522,500 x 100).
Another example: cash in 2015 was 16.28% (675,000/4,147,000 x 100) of
total asset while in 2016 it increased to 19.37% (850,000/4,387,500) of total
assets. This confirms the upward change of current assets in the horizontal
analysis which builds up working capital.

It is the process of comparing figures in the financial statements of a

single period. It involves converting of figures in the statements to a
common base. This is accomplished by expressing all the figures in the
statements as percentages of an important item such as total assets (in the
balance sheet) or total or net sales (in the income statement). The converted
statements are called common-size statements or percentage composition
statements.

Figure 9.1. Jerome Shoes Incorporated, Comparative Statement of

Financial Position, Vertical Analysis

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 JEROME SHOES INCORPORATED
COMPARATIVE STATEMENT OF FINANCIAL
POSITION

ASSETS
Percentage
Current Assets: 2016 s 2015 Percentages
Cash 850,000 19.37% 675,000 16.28%
Accounts Receivable 250,000 5.70% 130,000 3.13%
Mechandise Inventory 707,500 16.13% 600,000 14.47%
Supplies 45,000 1.03% 17,000 0.41%
Total Current Assets 1,852,500 42.22% 1,422,000 34.29%

Property Plant and

Equipment:
Trucks, net of accumulated
depreciation 1,900,000 43.30% 2,200,000 53.05%
Equipment, net of accumulated
depreciation 415,000 9.46% 290,000 6.99%
Furniture and Fixtures, net of
accumulated depreciation 220,000 5.01% 235,000 5.67%
Total Property, Plant and
Equipment 2,535,000 57.78% 2,725,000 65.71%
TOTAL ASSETS 4,387,500 100.00% 4,147,000 100.00%

LIABILITIES AND SHAREHOLDERS' EQUITY

Current Liabilities
Accounts Payable 110,000 2.51% 150,000 3.62%
Rent Payable 100,000 2.28%
Taxes Payable 298,200 6.80% 271,800 6.55%
Utilities Payable 75,000 1.71% 55,000 1.33%
Total Current Liabilities 583,200 13.29% 476,800 11.50%
Long-term Liability
Loans Payable 1,250,000 28.49% 1,500,000 36.17%
Total Liabilities 1,833,200 41.78% 1,976,800 47.67%
Shareholder's Equity:
Share Capital 1,750,000 39.89% 1,536,000 37.04%
Retained Earnings 804,300 18.33% 634,200 15.29%
Total 2,554,300 58.22% 2,170,200 52.33%
TOTAL LIABILITIES AND
OWNER'S EQUITY 4,387,500 100.00% 4,147,000 100.00%

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Interpretation:

There is a shift of proportion in the assets, current assets increased

from 34.29% to 42.23% while property and equipment decreased from
65.71% to 57.77%. All the current assets increased in size, confirming the
build up of working capital. Plant, property and equipment decreased in
size primarily because of the provision for depreciation. Total liabilities
likewise decreased in size from 47.67% to 41.78% primarily because of the
payment of loans and decrease in accounts payable. Shareholder’s equity
increased in size from 52.33% to 58.21%. This means that more resources
are coming from the shareholders which is good for the creditors as this
serves as a security for them. The attractiveness of the investments will be
tested by computing for the return on equity and efficiency in using
borrowed funds to enhance net income when preparing the financial ratio
analysis.

Figure 9.2. Jerome Shoes Incorporated, Comparative Statement of

Income, Vertical Analysis

JEROME SHOES INCORPORATED

COMPARATIVE STATEMENT OF INCOME
Percentage Percentage
2016 s 2015 s
Sales 6,522,500 100.00% 5,642,000 100.00%
Cost of Goods Sold 2,275,000 34.88% 1,886,000 33.43%
Gross Profit 4,247,500 65.12% 3,756,000 66.57%
Less Operating Expenses:
Rent Expenses 1,087,500 16.67% 945,000 16.75%
Salary Expenses 900,000 13.80% 760,000 13.47%
Gas & Oil Expense 465,200 7.13% 355,000 6.29%
Depreciation Expense 340,000 5.21% 325,000 5.76%

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 Utilities Expense 190,000 2.91% 155,000 2.75%
Repair Expense 115,000 1.76% 100,000 1.77%
Supplies Expense 43,300 0.66% 75,000 1.33%
Total 3,141,000 48.16% 2,715,000 48.12%
Operating Profit 1,106,500 16.96% 1,041,000 18.45%
Less Interest Expense 112,500 1.72% 135,000 2.39%
Net Income Before Tax 994,000 15.24% 906,000 16.06%
Less Tax Provision of 30% 298,200 4.57% 271,800 4.82%
NET INCOME P 695,800 10.67% P 634,200 11.24%

Interpretation:

The income statement shows favorable proportions in 2015 compared

to 2016. Cost of sales has increased in size from 33.43% in 2015 to 34.88% in
2016 thus decreasing the share of the gross profit from 66.57% to 65.12%.
There was efficient control of expenses as it has maintained its size at an
average of 48% for operating expenses and decrease in size of interest
expense from 2.39% to 1.72%. Although the operating expenses did not
practically change in proportion, the effect of the increase in size of the cost
of sales lowered the size of operating income to 16.96% from 18.45%.
Again, it signals decrease in efficiency and requires a review of pricing and
costing policy of the company. Profitability has gone slightly lower from
11.24% to 10.67%.

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SAMPLE PROBLEM

Problem 9-1

Sales P3,280
Cost of Sales 2,120
Selling Expense 350
Administrative Expense 420
Interest Expense 30
Income tax 30%

Using vertical analysis, compute the following:

1. The amount in percentage of the net income.

2. The amount in percentage of the income before tax.
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 3. The amount in percentage of the income tax.

Problem 9-2

Here are the comparative statement of financial position of Ogie Alcasid

Corporation:

Ogie Alcasid Corporation

Statement of Financial Position at December 31, 2014 and 2013
2014 2013
ASSETS
Current Assets
Cash PHP 2,030.50 PHP 1,191.00
Marketable Securities 2,636.00 4,002.00
Accounts Receivable 4,704.00 4,383.50
Allowance for Doubtful Accounts (224.00) (208.50)
Inventories 23,520.50 18,384.50
Prepaid Expenses 256.00 379.00
Total Current Assets PHP 32,923.00 PHP 28,131.50

Property, Plant and Equipment

Land 405.50 405.50
Buildings and Leasehold improvements 9,136.50 5,964.00
Equipment 10,761.50 6,884.00
20,303.50 13,253.50
Less: Accumulated depreciation and
amortization (5,764.00) (3,765.00)
Net property, plant and equipment 14,539.50 9,488.50

Other Assets 186.50 334.00

Total Assets PHP 47,649.00 PHP 37,954.00

LIABILITIES AND
EQUITY
Current Liabilities
Accounts Payable PHP 7,147.00 PHP 3,795.50
Notes Payable - banks 2,807.00 3,006.00

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 Current maturities of long term debt 942.00 758.00
Accrued Liabilities 2,834.50 2,656.50
Total Current Liabilities PHP 13,730.50 PHP 10,216.00
Deferred Income Taxes 421.50 317.50

Long-Term Debt 10,529.50 8,487.50

Total Liabilities PHP 24,681.50 PHP 19,021.00

Equity
Ordinary shares 2,401.50 2,297.00
Additional paid-in capital 478.50 455.00
Retained Earnings 20,087.50 16,181.50
Total Equity 22,967.50 18,933.50

Total Liabilities and Equity PHP 47,649.00 PHP 37,954.50

Using vertical analysis, compute the following:

1. The amount in percentage of the total current assets in 2013.

2. The amount in percentage of the total current liability in 2014.
3. The amount in percentage of the total equity in 2014.

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ANSWER:

PROBLEM 9-1

Answer:

1. 7.68%
2. 10.98%
3. 3.29%

2,017 Percent
Sales 3,280 100.00
%
Less: Cost of Sales 2,120 64.63%
Gross Income 1,160 35.37%
Less: Operating Expenses
Selling Expense 350 10.67%
Administrative Expense 420 770 12.80% 23.48%
Income From Operations 390 11.89%

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 Less: Interest Expense 30 0.91%
Income before tax 360 10.98%
Income tax 30% 108 3.29%
Net Income 252 7.68%

PROBLEM 9-2

Answer:

1. 74.12%
2. 28.82%
3. 48.20%

Ogie Alcasid Corporation

Statement of Financial Position at December 31, 2014 and 2013
2014 2013
ASSETS
Current Assets

Cash 2,030.50 4.26% 1,191.00 3.14%

Marketable Securities 2,636.00 5.53% 4,002.00 10.54%

Accounts Receivable 4,704.00 9.87% 4,383.50 11.55%

Allowance for Doubtful Accounts (224.00) -0.47% (208.50) -0.55%

Inventories 23,520.50 49.36% 18,384.50 48.44%

Prepaid Expenses 256.00 0.54% 379.00 1.00%

Total Current Assets 32,923.00 69.09% 28,131.50 74.12%

Property, Plant and Equipment

Land 405.50 0.85% 405.50 1.07%

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 Buildings and Leasehold improvements 9,136.50 19.17% 5,964.00 15.71%

Equipment 10,761.50 22.58% 6,884.00 18.14%

20,303.50 13,253.50
Less: Accumulated depreciation and
amortization (5,764.00) -12.10% (3,765.00) -9.92%

Net property, plant and equipment 14,539.50 30.51% 9,488.50 25.00%

Other Assets 186.50 0.39% 334.00 0.88%

100.00 100.00
Total Assets 47,649.00 % 37,954.00 %

LIABILITIES AND
EQUITY
Current Liabilities

Accounts Payable 7,147.00 15.00% 3,795.50 10.00%

Notes Payable - banks 2,807.00 5.89% 3,006.00 7.92%

Current maturities of long term debt 942.00 1.98% 758.00 2.00%

Accrued Liabilities 2,834.50 5.95% 2,656.50 7.00%

Total Current Liabilities 13,730.50 28.82% 10,216.00 26.92%

Deferred Income Taxes 421.50 0.88% 317.50 0.84%

Long-Term Debt 10,529.50 22.10% 8,487.50 22.36%

Total Liabilities 24,681.50 51.80% 19,021.00 23.20%

Equity

Ordinary shares 2,401.50 5.04% 2,297.00 6.05%

Additional paid-in capital 478.50 1.00% 455.00 1.20%

Retained Earnings 20,087.50 42.16% 16,181.50 42.63%

Total Equity 22,967.50 48.20% 18,933.50 49.88%

Total Liabilities and Equity 100.00 37,954.50 100.00

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 47,649.00 % %

CHAPTER X

COMPARATIVE FINANCIAL STATEMENTS – FINANCIAL

RATIOS (LIQUIDITY)

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.

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 This is a widely used tool in financial statement analysis as they
provide means of measuring and evaluating company performance and
financial position. One must know how to use the formulas to draw out
ratios and percentages and identify relevant relationships among financial
data. And then again, to be able to arrive at informed judgment, one must
be intercomparability or intracomparability.

Ratios are calculated from the financial statements to provide users of

such statements with relevant information about the firm’s liquidity, use of
leverage, asset management, cost control, profitability, growth, and
valuation.

LIQUIDITY

Liquidity is the ability of the business to efficiently manage working

capital and ensure that there is adequate assets to cover for its current
obligations as they fall due. Liquidity is arrived at by comparing the
current assets and the current liabilities and computing for: working
capital, current ratio and acid test ratio. Working capital is the difference
between the current assets and current liabilities. Current ratio is
determined by dividing the current assets by the current liabilities, the
ideal ratio of which is 2:1. A stricter measurement of liquidity is the acid
test ratio. It is similar to current ratio except that only quick assets like cash
and cash equivalents, receivables and marketable securities are used
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instead of all the current assets. The ideal ratio is 1:1. The liquidity of the
firm is used by a creditor in evaluating the safety of a loan.

Liquidity ratios provide information about the firm’s ability to pay its
current obligations and continue operations. It gives an idea of the firm’s
ability to pay off debts that are maturing within a year or within the next
operating cycle. Satisfactorily, liquidity ratios are necessary if the firm is to
continue operating.

To illustrate using Jerome Sandals Incorporated:

Working Capital: Current Assets – Current Liabilities

2016 2015
P1,852,500 – P583,200 = P1,269,300 P1,422,000 – P476,800 = P945,200

Current Ratio: Current Assets/Current Liabilities

2016 2015
P1,852,500/P583,200 = 3.18:1 P1,422,000/P476,800 = 2.98:1

Interpretation:

The business has P3.18 of current assets to pay for a peso of current liability
in 2015 while only P2.98 current assets was available to pay for a peso of
current liability in 2015. The rule of thumb is 2:1. Both periods show that
the company is very liquid. Note that having so much current assets is not
good for the company unless it is building up resources in preparation for
growth and expansion. Non-productive or idle assets will not contribute to

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the company’s profitability. This will be proven when we go to the quality
use of assets.

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 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.

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 at discounted price.
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Quick Ratio or Acid Test Ratio: Quick Assets/Current Liabilities

2016 2015
P1,100,000/P583,200 = 1.89:1 P805,000/P476,800 = 1.69:1

Interpretation:

The business has P1.89 quick assets in 2016 to pay for a peso of current
liability, whereas in 2015 was P1.69 for a peso of current liability. As the
rule of thumb is a 1:1 ratio, based on its quick assets the company is very
liquid.

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 P1 of quick assets.

Turnover Rates

Complementing the liquidity ratios are the turnover rates. It signifies

efficiency in using the resources. Turnover gives you the number of times
resources are used to generate revenue. Inefficient use of assets can
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adversely affect liquidity. The receivable turnover is a measure of efficiency
in collection which would greatly affect the liquidity position of the
company. The inventory turnover (for merchandising concern) is a
measure of efficiency in using the merchandise which would also greatly
affect liquidity and profitability. The asset turnover is a measure of
efficiency in using all the company resources in generating revenue. The
more turnovers, the more quickly cash is collected which in turn is used to
buy more merchandise. The more times merchandise is bought and sold,
the more times revenue is generated. With more revenues generated, if
costs and expenses are managed efficiently, the greater profit is obtained,
and the higher is the return on owner’s equity. Business becomes more
profitable.

Receivable Turnover: Credit Revenue/Average Receivables

2016 2015
Average Receivable: (250,000 + 130,000)/2 = Average Receivable:
P190,000 P130,000

2016 2015
Turnover:1,630,625/190,000 = 8.58 Turnover: 1,410,500/130,000 = 10.85
times times

Receivable is only related to credit revenue (revenue on account).

Author assumed that 25% of sales was on credit in both years. Thus,

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P6,522,500 x 25% = P1,630,625 and P5,642,000 x 25% = P1,410,500. Average
receivable is computed by adding receivable beginning to receivable end
and dividing the sum by two. If 2015 is the start of operation then there is
no beginning balance. The number of days that it takes for receivable to be
collected may be computed by dividing 365 by the turnover.

The accounts receivable turnover roughly measures how many times a

company’s accounts receivable have been turned into cash during the year.
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.

Days collection (Average Age of Receivables or Number of Days of

Receivable or Collection Period):

2016 2015
365/8.58 = 42.54 days 365/10.85 = 33.64 days

Based on the turnover rate and days collection period, the company
was more efficient in collecting receivables in 2015 because the turnover is
more at 10.85 times and the number of days accounts are collected is only
an average of 34 days. It is best that this be compared against the credit
term of the firm. If the credit term is 30 days, then a collection period of
42.5 days for 2016 is quite lax. It is also significant to note that the company

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is having a problem in managing an increasing volume of accounts
receivable.

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 explanation such as temporary
problem caused by a depressed economy.

Inventory Turnover

The inventory informs us of the number of times inventory is

replaced (or is being sold). The more times is replaced, the more times
profit cycle is repeated and the more profitable the business is. Expensive
items like jewelry normally has a low turnover period. Necessity goods
and perishable goods like food and grocery items normally as a high
turnover. To illustrate, using Jerome Shoes Incorporated:

2016 2015
Average Inventory: (707,500 + 600,000)/2 = Average Inventory: 600,000
653,750

Turnover: Cost of Sales/Average Inventory

2016 2015
2,275,000/653,750 = 3.48 times 1,886,000/600,000 = 3.14 times

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Holding Period or Average Sale Period (Average Age of Inventories or
Number of Days Inventory): 365 days divide by the turnover

2016 2015
365/3.48 = 104.88 days 365/3.14 = 116.24 days

It shows that the company is unable to move out the stock speedily,
as it took 104.88 days or 3.5 months to sell the stock in 2016, more so in
2015 when it took them 116 days or 3.88 months. Apparently, they bought
and held more stock than what was required for the sales volume of the
company. Holding goods for a long period ties down investment
unproductively. This will affect liquidity and profitability.

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 net sales as the numerator and the average level
of inventory as the denominator. 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.

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

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 fever funds are tied up in inventory and more profits are generated.

Asset Turnover: Revenue/Average Total Assets

2016 2015
Average Total Asset: (4,387,500 + 4,147,000)/2 = 4,267,250 4,147,000

Turnover:

2016 2015
6,522,500/4,267,250 = 1.53 times 5,642,000/4,147,000 = 1.36 times

Interpretation:

Based on the turnover rates, the company was more efficient in 2016
than in 2015 when assets were used 1.53 times to generate revenue in 2016
compared to 1.36 times in 2015. It would be better if one benchmarks this
against a competitor or determine the industry’s average turnover rate. If

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industry’s turnover rate is 1.5, then the company is less efficient in using
assets to generate revenue in 2012.

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. There may however be justification for the low turnover.
For example, the firm may have undertaken an extensive plant
modernization or placed in assets is service at year-end which will generate
positive results in the long-term.

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.

SUMMARY:

RATIO FORMULA SIGNIFICANCE

Net Working Capital Current Assets less Indicates relative
Current liabilities liquidity of total assets
and distribution of
resources employed
Current Ratio or Total Current Test of short-term debt
Working Capital Ratio Assets/Total Current paying ability; Primary

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or Bankers’ Ratio Liabilities test or solvency to meet
current obligations
from current assets as a
going concern; measure
of adequacy of working
capital
Acid Test or Quick Quick Assets/Current Measures the firm’s
Ratio Liabilities ability to pay its short-
term debts from its
Quick Assets = Cash + most liquid assets
Cash Equivalents + Net without having to rely
Receivables + on inventory; a more
Marketable Securities severe test of
immediate solvency;
test of ability to meet
demands from current
assets.
 Cash Ratio Cash + Cash A more conservative
Equivalents + variation in Quick
Marketable Securities / Ratio. It tests short-
Current Liabilities term liquidity without
having to rely on
receivables and
inventory.
 Cash to Current Cash + Cash Measures the liquidity
Asset Ratio Equivalents + of current assets.

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 Marketable Securities /
Current Liabilities /
Current Assets
 Cash Flow Ratio Operating Cash Shows the significance
Flow/Current of cash flow for setting
Liabilities current obligations as
they become due.
Receivable Turnover Net Credit Measures the average
Ratio Sales/Average number of days to
Accounts Receivable collect a receivable;
velocity of collection of
Note: If net credit sales trade accounts and
figure is not available, notes; test of efficiency
net sales could be used. of collection
Average Age of Number of Days in a Measures the average
Receivables or Number Year/Receivables number of days to
of Days of Receivable Turnover Ratio collect a receivable;
or Collection Period evaluates the liquidity
Or of accounts receivable
and the firm’s credit
Average Accounts policies
Receivable/Average
Daily Sales

Or

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 Accounts
Receivable/(Net
Sales/365)
Finished Goods or Cost of Sales/Average Indicates if a firm holds
Merchandise Inventory Inventory excessive stocks of
Turnover inventories that are
unproductive and the
lessen the company’s
profitability; measures
efficiency of the firm in
managing and selling
inventories
Average Age of Number of Days in a Measures the average
Inventories or Number Year/Inventory number of days that
of Days Inventory or Turnover Ratio inventory is held before
Days supply in sale; measure average
inventory or Average Or number of days to sell
Sale Period or consume the average
Average inventory
Inventory/Average
Daily Cost of Sales
Operating Cycle or Average Age of Measures the average
Conversion Period Inventories + Average number of days to
Age of Receivables convert inventories to
cash; measures the
length of time required

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 to convert cash to
finished goods; then to
receivable and then
back to cash
Total Assets Turnover Net Sales/Average Measures the level of
Ratio Total Assets capital investment
relative to sales
volume; measures
efficiency of the firm in
managing all assets
Fixed Assets Turnover Net Sales/Average Net Measures the level of
Ratio or Plant assets Fixed Assets use of property, plant
turnover ratio and equipment; tests
roughly the efficiency
of management in
keeping plant
properties employed

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SAMPLE PROBLEM

Problem 10-1

The following are taken from the balance sheet of Joy Fee Company as of
December 31, 2017:
Current assets:
Cash on hand and in banks P341,600
Accounts receivable 200,000
Merchandise Inventory 308,400 P850,000

Liabilities:
Current Liabilities:
Notes payable P280,800
Accounts payable 781,700 P1,062,500
Long-term liabilities 3,000,000

What are the company’s current ratio and quick (acid test) ratio?
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Problem 10-2

The following data were taken from the comparative balance sheets of Gem
Lloyd Trucking Company
December 31, 2017 December 31, 2016
Cash P35,000 P33,125
Marketable securities 16,375 15,125
Notes and Accounts receivable, net 49,375 48,000
Inventories 71,250 69,375
Prepaid expenses 2,375 5,000
Notes and accounts payable (short-term) 31,250 35,625
Accrued Liabilities 7,500 10,500
Bonds payable, due 2018 100,000 100,000
What is the company’s working capital increase from 2016 to 2017?

Problem 10-3

Following are selected financial and operating data taken from the financial
statements of Jose Louis Trust Corporation
December 31, 2017 December 31, 2016
Cash P80,000 P640,000
Notes and Accounts receivable, net 400,000 1,200,000
Merchandise Inventory 720,000 1,200,000
Marketable securities – short term 240,000 80,000
Land and Building (net) 2,720,000 2,880,000
Bonds payable – long term 2,160,000 2,240,000
Accounts payable – trade 560,000 880,000
Notes payable – short-term 160,000 320,000

December 31, 2017 December 31, 2016

Sales (20% cash, 80% credit sales) P18,400,000 P19,200,000
Cost of goods sold 8,000,000 11,200,000

Compute the following:

1. Current ratio as of December 31, 2017

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 2. Quick (acid test) ratio as of December 31, 2017
3. Accounts receivable turnover for 2017
4. Merchandise Inventory turnover for 2017
5. The average age of accounts receivable for 2017 (use 365 days)

Problem 10-4

The following information pertains to Kimberly Company for 2017:

Inventory at December 31, 2017 P16,000
Purchase of merchandise, all on credit 72,000
Cost of goods sold 80,000
How much is the company’s merchandise inventory turnover for 2017?

Problem 10-5

The following information pertains to Dyna Company for 2017:

Accounts receivable, January 1, 2017 P8,000
Accounts receivable, December 31, 2017 9,600
Net cash sales 3,200
Accounts receivable turnover for 2017 5 times

How much is the company’s net sales?

Problem 10-6

If a company has current assets of P200,000, including inventory of P80,000

and a quick ratio of 2:1, what is the value of the company’s current
liabilities?

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Problem 10-7

Consider the following data about a company:

Current ratio 3:5 to 1
Acid-test ratio 3:0 to 1
Current liabilities at year-end P150,000
Inventory, beginning of the year P125,000
Inventory turnover 8 times

1. What is the value of the company’s inventory at the end of the year?
2. How much is the company’s cost of goods sold during the year?

Problem 10-8

Presented below are the comparative Statements of Financial Position of SJ

Madalips Company for the calendar years 2017 and 2016:
In thousands
2017 2016
ASSETS
Current assets:
Cash P240 P200
Marketable securities 160 120
Accounts receivable (net) 360 240
Inventories 480 400
Other current assets 120 160
Total current assets P1,360 P1,120

Non-current assets:
Investment in securities P200 P160
Property, plant and equipment, net 2,000 2,120
Other non-current assets, net 440 240
Total non-current assets P2,640 P2,520
Total assets P4,000 P3,640

LIABILITIES AND EQUITY

Liabilities:

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 Current liabilities P680 P440
Non-current liabilities 200 200
Total liabilities P880 P640

Equity:
5% Cumulative, non-participating Preferred stock,
P10 par value 8,000 shares issued and outstanding P800 P800
Common stock, P10 par
160,000 shares authorized
120,000 shares issued and outstanding 1,200 1,200
APIC – Common 600 600
Total Equity P3,120 P3,000
Total liabilities and equity P4,000 P3,640
1. Based on the given statements of financial position, compute the
current ratios for both years.
2. Based on the given statements of financial position, compute the
quick (acid-test) ratios for both years
3. Assume that for 2017, net credit sales was P2,400,000 and the gross
profit was 26.67%. What was the company’s accounts receivable
turnover for the year?

Problem 10-9

The following data show actual figures for selected accounts of Jerahly
Corporation for the calendar year 2016 and selected budget figures for
2017. The company’s accounting manager is in the process of reviewing the
2017 budget and calculating some ratios which he thinks are relevant in the
review:
Budgeted Actual
December 31, 2017 December 31, 2016`
Current assets:
Cash P16,000 P8,000
Accounts receivable 80,000 56,000
Inventory 56,000 64,000
Other current assets 16,000 16,000
Total current assets P168,000 144,000
Non-current assets 220,000 204,000

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Total assets P388,000 P348,000

Current liabilities P62,400 P68,000

Long-term liabilities 60,000 24,000
Total liabilities P122,400 P92,000
Common stock (P24 par value) P240,000 P240,000
Retained earnings 25,600 16,000
Total equity P265,600 P256,000
Total liabilities and equity P388,000 P348,000

BUDGETED INCOME STATEMENT

For the Year Ended December 31, 2017
Sales (all on credit) P280,000
Cost of goods sold 128,000
Gross income 152,000
Administrative expenses 53,600
Operating income 98,400
Interest expense 2,400
Income before tax 96,000
Income tax (40%) 38,400
Net Income P57,600

Compute the following, for the year 2017:

1. The expected Accounts Receivable Turnover
2. The expected Inventory Turnover
3. The expected Total Assets Turnover
4. The expected collection period
5. The expected average age of inventory

Problem 10-10

Last year’s asset turnover of Noa Company was 3.0. this year, the
company’s sales increased by 25% and average total assets decreased by
5%. What is this year’s asset turnover?
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ANSWER:
PROBLEM 10-1

Answer: 0.80 and 0.51

Current Ratio = Current Assets/Current Liabilities

Current Ratio = P850,000/P1,062,500

Current Ratio = 0.80

Quick Ratio = Quick Assets/Current Liabilities

Quick Ratio = (P341,600 + P200,000)/P1,062,500

Quick Ratio = 0.51

PROBLEM 10-2

Answer: P11,125

December 31, 2017 December 31, 2016

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Current Assets:
Cash P35,000 P33,125
Marketable securities 16,375 15,125
Notes and Accounts receivable, net 49,375 48,000
Inventories 71,250 69,375
Prepaid expenses 2,375 5,000
Total Current Assets P174,375 P170,625
Less current liabilities
Notes and accounts payable (short-term) 31,250 35,625
Accrued Liabilities 7,500 10,500
Total Current liabilities P38,750 P46,125
Working Capital P135,625 P124,500

Increase in working capital (P135,625 – P124,500) = P11,125

PROBLEM 10-3

Answers:

1. 2
2. 1
3. 18.4
4. 8.33
5. 19.84%

1. Current Ratio = Current Assets/Current Liabilities

Current Assets:
Cash P80,000
Notes and Accounts receivable, net 400,000
Inventories 720,000
Marketable securities 240,000 P1,440,00
0
Divide by current liabilities:
Accounts payable – trade P560,00
0
Notes payable – short-term 160,000 720,000

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 Current ratio 2

2. Quick Ratio = Quick Assets/Current Liabilities

Quick Assets:
Cash P80,000
Notes and Accounts receivable, net 400,000
Marketable securities 240,000 P720,000
Divide by current liabilities:
Accounts payable – trade P560,00
0
Notes payable – short-term 160,000 720,000
Quick ratio 1

3. Accounts Receivable Turnover = Net Credit Sales/Average Accounts

Receivable
Accounts Receivable Turnover = (P18,400,000 x 80%)/(P400,000 +
P1,200,000)/2
Accounts Receivable Turnover = P14,720,000/P800,000
Accounts Receivable Turnover = 18.4 times

4. Merchandise Inventory Turnover = Cost of Goods Sold/Average

Merchandise Inventory
Merchandise Inventory Turnover = P8,000,000/(P720,000+P1,200,000)/2
Merchandise Inventory Turnover = P8,000,000/P960,000
Merchandise Inventory Turnover = 8.33 times

5. Average Age of Accounts Receivable = Number of Days in a Year/Accounts

Receivable Turnover
Average Age of Accounts Receivable = 365/18.40times
Average Age of Accounts Receivable = 19.84%

PROBLEM 10-4

Answer: 4.0 times

Merchandise Inventory Turnover = Cost of Goods Sold/(Beginning + Ending

Inventories)/2

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Merchandise Inventory Turnover = P80,000/(P24,000*+P16,000)/2
Merchandise Inventory Turnover = 4.0 times

*Computation of beginning inventory:

Cost of Goods sold P80,000
Add inventory, December 31, 2017 16,000
Total P96,000
Less purchases 72,000
Merchandise Inventory, January 31, 2017 P24,000

PROBLEM 10-5

Answer: P47,200

Accounts Receivable Turnover = Net Credit Sales/(Accounts Receivable

Beginning + Accounts Receivable Ending)/2

5 = Net Credit Sales/(P8,000+P9,600)/2

5 = Net Credit Sales/P8,800

Net credit sales P44,000

+Add net cash 3,200
sales
Total net sales P47.200

PROBLEM 10-6

Answer: P60,000

Quick Ratio = Quick Assets/Current Liabilities

2 = (P200,000 – P80,000)/Current liabilities
Current Liabilities = P120,000/2
Current Liabilities = P60,000

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PROBLEM 10-7

Answer:

1. P75,000
2. P800,000

Current Ratio = Current Assets/Current Liabilities

3.5 = Current Assets/P150,000
Current Assets = P150,000 x 3.5 = P525,000
Quick Ratio = Quick Assets/Current Liabilities
3 = Quick Assets/150,000
Quick Assets = P150,000 x 3 = P450,000

Current Assets P525,000

Less quick assets 450,000
Inventory at year-end P75,000

Inventory Turnover = Cost of Goods Sold/Average Inventory

8 = Cost of goods sold/(P125,000+P75,000)/2
Cost of goods sold = P100,000 x 8 = P800,000

PROBLEM 10-8

Answer:

1. 2.00 and 2.54

2. 1.12 and 1.27
3. 8 times

2017 2016
Current assets P1,360 P1,120
Divide by current liabilities 680 440
Current ratio 2.00 2.54

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Quick assets:
Cash P240 P200
Marketable securities 160 120
Accounts receivable 360 240
Total quick assets 760 560
Divide by current liabilities 680 440
Quick (acid test) Ratio 1.12 1.27

Accounts Receivable Turnover = Net Credit Sales/Average Accounts

Receivable

Accounts Receivable Turnover = P2,400/(P240 + P360)/2

Accounts Receivable Turnover = P2,400/P300 = 8 times

PROBLEM 10-9

Answer:

1. 4.12 times
2. 2.13 times
3. 0.76 times
4. 88.59 days
5. 171.36days

Accounts Receivable Turnover = Net Credit/Average Accounts Receivable

Accounts Receivable Turnover = P280,000/(P56,000+P80,000)/2
Accounts Receivable Turnover = 4.12 times

Inventory Turnover = Cost of Goods Sold/Average Inventory

Inventory Turnover =P128,000/(P64,000+P56,000)/2
Inventory Turnover = 2.13 times

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Total Assets Turnover = Sales/Average Total Assets
Total Assets Turnover = P280,000/(P348,000+388,000)/2
Total Assets Turnover = 0.76 times

Average Age of Receivables = 365/Accounts Receivable Turnover

Average Age of Receivables = 365/4.12 times = 88.59 days

Average Age of Inventory = 365/Inventory Turnover

Average Age of Inventory = 365/2.13 times = 171.36 days

PROBLEM 10-10

Answer: 3.9
Asset Turnover last year = Sales/Average Total Assets =3.0
Asset Turnover this year = 3 x 1.25 / 1 x 0.95 = 3.75/0.95 = 3.9

CHAPTER XI

COMPARATIVE FINANCIAL STATEMENTS – FINANCIAL

RATIOS (PROFITABILITY)

Profitability is the ability of the business to earn a satisfactory return

on owner’s capital. The rate of return on owner’s equity or ROE (net
income divided by average owner’s equity) must at least be equal to or
greater than the bank’s prime interest rate if the investor’s money is placed
in some other profitable venture such as the bank’s time deposit.
Profitability is also determined by computing for the profit margin ratio or
the return on sales ratio (ROS) which is computed by dividing net income
by the revenues earned. Operating margin ratio (operating income divided
by sales) measures efficiency in operating the business while return on
total assets or ROA (net income divided by average total assets) is a

133 | P a g e
measure of profitability like ROE. The higher the ratios, the more profitable
the firm is. Aside from the owner and potential investor, a long-term
lender is interested in the profitability of the firm. The manager’s ability to
successfully direct operation through its profitable performance is also
evaluated using the operating margin ratio.

These ratios give an idea of how profitability of the firm is

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

To illustrate, using Jerome Shoes Incorporated:

Return on Sales (Profit Margin on Sales or Net Profit Percentage): Net

Income/Revenues

2016 2015
695,800/6,522,500 x 100 = 10.67% 634,200/5,642,000 x 100 = 11.24%

Interpretation:

It measures the proportion of revenue going to profit. 10.67% of sales

earned went to profit in 2016 while in 2015 it was slightly higher at 11.24%.
Or for a P1 of sales, the business earned P0.1067 profit in 2016 and P0.1124
profit in 2015. The higher the ratio, the more profitable the business is.

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

The Net Profit Margin measure profitability after considering all

revenue and expenses, including interest, taxes and nonoperating items
such as extraordinary items cumulative effect of accounting change. Etc.

Operating Ratio (Net Operating Income to Sales): Operating

Income/Sales

2016 2015
1,106,500/6,522,500 = 16.96% 1,041,000/5,642,000 = 18.45%
Interpretation:

It measures the efficiency of the company to control cost and

expenses. In 2016, 16.96% of the sales earned went to profit after cost and
expenses while in 2015 it was higher at 18.45%. The higher the ratio the
more profitable the business and it also shows efficiency of management to
control its cost and expenses.

The operating profit margin measure of overall operating efficiency and

incorporates all of the expenses associated with ordinary or normal
business activities.

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Return on Total Assets (Return on Investment): Net Income/Average
Total Assets

2016 2015
Average Total Asset: (4,387,500 + 4,147,000)/2 = 4,147,000
4,267,250

2016 2015
695,800/4,267,250 x 100 = 16.31% 634,200/4,147,000 x 100 = 15.29%

Interpretation:

It shows the rate of return the business earned for a peso of

investment. A high rate means the assets are being used profitably by the
business. In 2016, the rate of return on assets or net income earned by using
the assets was higher at 16.31% compared to 15.29% in 2015.

Rate of Return on Equity: Net Income/Average Owner’s Equity

Average Shareholder’s Equity

2016 2015
695,800/2,362,250 x 100 = 29.45% 634,200/2,170,200 x 100 = 29.22%

Interpretation:

It means that the firm in 2016 earned 29.45% on invested capital

compared to 29.22% in 2015.

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 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 to the level of investment in total assets and investment of
common shareholders.

Based on the above four computations, the business was more profitable in
2016.

SUMMARY:

RATIO FORMULA SIGNIFICANCE

Profit Margin on Sales Net Income/Net Sales Measures the
or Net Profit percentage of net
Percentage or Net income to sales;
Profit Margin Measures profit
generated after
consideration of all
expenses and revenues
Net Operating Income Operating Profit/Net Measures the
to Sales or Operating Sales percentage of operating
Profit Margin income to sales;
Or measures profit
generated after
EBIT/Net Sales consideration of

137 | P a g e
 operating costs
Return on Investment Net Income/Average Indicates whether
or Return on Total Total Assets management is using
Assets or Return on funds wisely; measures
Invested Capital Or overall efficiency of the
firm on managing
Asset Turnover x Net assets and generating
Profit Margin profits
Rate of Return on Net Income/Average Measures the return on
Equity Total Equity resources provided by
owners

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SAMPLE PROBLEM

Problem 11-1

The following ratios were computed Shaira Jane Company’s financial

statements for 2017:
Return on asset 24%
Asset turnover 1.6 times
What was the company’s profit margin ratio?

Problem 11-2

Following are selected financial and operating data taken from the financial
statements of Jose Louis Trust Corporation
December 31, 2017 December 31, 2016
Cash P80,000 P640,000
Notes and Accounts receivable, net 400,000 1,200,000
Merchandise Inventory 720,000 1,200,000
Marketable securities – short term 240,000 80,000
Land and Building (net) 2,720,000 2,880,000
Bonds payable – long term 2,160,000 2,240,000
Accounts payable – trade 560,000 880,000
Notes payable – short-term 160,000 320,000

December 31, 2017 December 31, 2016

Sales (20% cash, 80% credit sales) P18,400,000 P19,200,000
Cost of goods sold 8,000,000 11,200,000

Compute the gross margin rate for 2016

Problem 11-3

Net sales, P1.8M; Cost of goods sold, P1.08M; Operating expenses,

P315,000; Earnings before interest and tax, P405,000; Net income, P195,000;

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Total stockholder’s equity P0.75M; Total assets; P1M; Cash flow from
operating activities, P25,000. Compute the return on investment.

Problem 11-4
The following data show actual figures for selected accounts of Jerahly
Corporation for the calendar year 2016 and selected budget figures for
2017. The company’s accounting manager is in the process of reviewing the
2017 budget and calculating some ratios which he thinks are relevant in the
review:
Budgeted Actual
December 31, 2017 December 31, 2016`
Current assets:
Cash P16,000 P8,000
Accounts receivable 80,000 56,000
Inventory 56,000 64,000
Other current assets 16,000 16,000
Total current assets P168,000 144,000
Non-current assets 220,000 204,000
Total assets P388,000 P348,000

Current liabilities P62,400 P68,000

Long-term liabilities 60,000 24,000
Total liabilities P122,400 P92,000
Common stock (P24 par value) P240,000 P240,000
Retained earnings 25,600 16,000
Total equity P265,600 P256,000
Total liabilities and equity P388,000 P348,000

BUDGETED INCOME STATEMENT

For the Year Ended December 31, 2017
Sales (all on credit) P280,000
Cost of goods sold 128,000
Gross income 152,000
Administrative expenses 53,600
Operating income 98,400

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Interest expense 2,400
Income before tax 96,000
Income tax (40%) 38,400
Net Income P57,600

What is the expected return on assets in 2017?

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ANSWERS:
PROBLEM 11-1

Answer: 15%

The profit margin ratio is the return on sales, which is equal to income divided by
sales. Given the return on asset (income/assets) and asset turnover (Sales/assets),
the return on sales may be obtained using the Du Pont Formula:

Return on Sales x Asset Turnover = Return on Assets

Income/Sales x Sales/Assets = Income/Assets
Return on sales x 1.6 = 24%
Return on Sales or Profit Margin Ratio = 24%/1.6 = 15%

PROBLEM 11-2

Answer: 41.67%
Gross Margin Rate = Gross Profit/Sales
Gross Margin Rate =P19,200,000 – P11,200,000 / P19,200,000
Gross Margin Rate = 41.67%

PROBLEM 11-3

Answer: 19.5%
Return on Investment = Net Income/Total Assets
Return on Investment = P195,000/P1,000,000
Return on Investment = 19.5%

PROBLEM 11-4
Answer: 15.65%
Return on Assets = Net Income/Average Assets
Return on Assets =P57,600/( P348,000+388,000)/2
Return on Assets = 15.65%

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 CHAPTER XII
COMPARATIVE FINANCIAL STATEMENTS – FINANCIAL
RATIOS (SOLVENCY)

Stabillity or long-term solvency is the ability of the business to stand

pressure and operate indefinitely or for a long period of time. The assets
must be sufficient to meet long-term obligations (principal plus interest).
This is determined by computing for the debt ratio (the long term debts
divided by total assets). Alternatively, the equity ratio may be computed
by dividing the owner’s equity by the total assets. The debt ratio shows the
proportion of the assets provided by the creditor whereas the equity ratio
shows the proportion of the assets invested by the owner. A balanced
financial structure shows an equal proportion of debt and equity shares
over the assets. A conservative position is marked by a high equity ratio
than the debt ratio and this is favored by the creditors because the owner’s
or investor’s contribution serves as a protection for them. The lower the
ratio, the lower is the risk of non-payment or bankruptcy of the business. A
high debt ratio is favored by the owner/investor as it means more returns
(for the owner/investor) on borrowed funds used. Another computation
used is the times interest earned which is determined by dividing net
income before interest and taxes by the interest expense. This shows the
ability of the company’s operating income to meet interest payments and is
measure by the number of times interest is being earned by the business.

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The higher the frequency the more stable is the business. Long-term
creditors, owners and potential investors are interested in these ratios.

Debt Ratio: Total Liabilities/Total Assets

2016 2015
1,833,200/4,387,500 x100 = 41.78% 1,976,800/4,147,000 x 100 = 47.66%

Equity Ratio: Owner’s Equity/Total Assets

2016 2015
2,554,300/4,387,500 x100 = 58.21% 2,170,200/4,147,000 x 100 = 52.34%

Interpretation:

The ratios indicate a more balanced financial structure in 2015, as

47.66% of the assets were provided by the creditors and 52.34% were
provided by the investors. In 2016, the financial structure learned more
towards a more conservative policy as 52.81% of the assets were provided
by the investors while only 41.78% were provided by the creditors.

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.

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 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 will ultimately result in bankruptcy.

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 the
creditors (debt) and investors (equity).

Times Interest Earned:

(Net Income before tax + Interest Expense net of tax)/Interest Expense net
of tax

2016 2015
(994,000 + 78,750)/78/750 = 13.62 times (906,000 + 94,500)/94,500 = 10.59 times

Interpretation:

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 It means that the profit of the company has earned the interest
expense 13.62 times in 2016, and 10.59 times in 2015. Stated another way, in
2016 the firm was able to generate profit 13.62 times more than the interest
expense the firm is obliged to pay which is an improvement from the 2012
ratio which was only 10.59 times. Based on the three ratios, the company
was more solvent in 2016.

Times 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.

SUMMARY:

RATIO FORMULA SIGNIFICANCE

Total Debt Ratio Total Liabilities/Total Measures the
Assets percentage of funds
provided by creditors;
shows proportion of all
assets that are financed
with debt
Total Equity Ratio Total Equity/Total Measures the
Assets proportion of the total
assets that are financed
by stockholders, as

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 opposed to creditors;
indicates proportion of
assets provided by
owners; reflects
financial strength and
caution to creditors
Debt to Equity Ratio Total liabilities/Total Compares resources
Equity provided by creditors
with resources
provided by
shareholders; measures
debt relative to
amounts of resources
provided by owners
Times Interest-Earned EBIT/Interest Expense Indicates the margin of
Ratio or Interest safety for payment of
Coverage Ratio Or fixed interest charges;
measures how many
Net Income before times interest expense
interest and is covered by operating
taxes/Annual Interest profit
Charges

Some things to remember at this point:

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 1. Use average figure for the balance sheet accounts when the formula
makes use of a balance sheet and an income statement account such
as ROE and ROA.
2. No percentage can be computed (for horizontal analysis) when there
is no amount in the preceding year (used as a base year) such as Rent
Payable from zero to P100,000.
3. The ratios, trends and figures are only indicators. These are not
absolute measures of performance hence care must be exercised in
passing conclusion and recommendations.

Problem 12-1

The following data show actual figures for selected accounts of Jerahly
Corporation for the calendar year 2016 and selected budget figures for
2017. The company’s accounting manager is in the process of reviewing the
2017 budget and calculating some ratios which he thinks are relevant in the
review:
Budgeted Actual
December 31, 2017 December 31, 2016`
Current assets:
Cash P16,000 P8,000
Accounts receivable 80,000 56,000
Inventory 56,000 64,000
Other current assets 16,000 16,000
Total current assets P168,000 144,000
Non-current assets 220,000 204,000
Total assets P388,000 P348,000

Current liabilities P62,400 P68,000

Long-term liabilities 60,000 24,000
Total liabilities P122,400 P92,000

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Common stock (P24 par value) P240,000 P240,000
Retained earnings 25,600 16,000
Total equity P265,600 P256,000
Total liabilities and equity P388,000 P348,000

BUDGETED INCOME STATEMENT

For the Year Ended December 31, 2017
Sales (all on credit) P280,000
Cost of goods sold 128,000
Gross income 152,000
Administrative expenses 53,600
Operating income 98,400
Interest expense 2,400
Income before tax 96,000
Income tax (40%) 38,400
Net Income P57,600

1. What is the expected Debt to total asset Ratio?

2. What is the expected number of times the company can earn interest
expense?

Problem 12-2

The following selected data were taken from Nicolas Company’s income
statement for the calendar year 2018:
Net sales P334,000
Gross income 103,600
Interest expense 4,000
Income tax 9,600
Net Income 30,000
Gain on sale of a business segment, net of tax 16,800
What is the number of times interest earned in 2018?

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ANSWERS:

PROBLEM 12-1

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Answer: 31.55%

Debt to total Asset Ratio = Total Debt/Total Assets = P122,400/P388,000 =

31.55%

Answer: 41 times

Times Interest Earned = Operating Income/Interest expense

Times Interest Earned = P98,400/P2,400
Times Interest Earned = 41 times

PROBLEM 12-2

Answer: 6.9 times

Times Interest Earned = Earnings before Interest and Tax/Interest Expense

Net income P30,800

Less: gain on sale of business segment 16,800
Net income from operations P14,000
Add: Income tax P9,600
Interest expense 4,000 13,600
Earnings before interest and tax P27,600
Divide by interest expense 4,000
Times interest earned 6.9 times

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