Chapter 1

ANALYSIS AND INTERPRETATION OF

FINANCIAL STATEMENTS
LEARNING OBJECTIVES:

Upon completion of this chapter, you should be able to:

 Identify the qualitative characteristics of accounting information
 Identify the basic components of financial statements
 Identify the objectives, general approach, and limitations of financial statement analysis
 Analyze business performance and financial position using different methods

Financial statements are the end product or main output of the financial accounting process. It is a
document containing a wealth of useful information regarding the financial position of a company, the success
of its operations, the policies and strategies of the management, and insight into future performances.

Chart 1. Summary of Qualitative Characteristics

In order for accounting information from financial statements to be useful, qualitative characteristics
must be present. Qualitative characteristics are the qualities or attributes that make financial accounting
information useful to the users in making economic decisions. As summarized in Chart 1, it is classified into
two: fundamental qualitative characteristics and enhancing qualitative characteristics.

Fundamental qualitative characteristics relate to the content or substance of financial information. The
fundamental qualitative characteristics are relevance and faithful representation. Relevance is the capacity of
the information to influence a decision. Faithful representation means that the actual effects of the transactions
shall be properly accounted for and reported in the financial statements. To be faithfully represented, it must
have these three characteristics namely completeness, neutrality and free from error. Completeness requires
that relevant information should be presented in a way that facilitates understanding and avoids erroneous
implications. It is the result of the adequate disclosure standard or the principle of full disclosure. Neutrality
means that the financial statements should not be prepared as to favor one party to the detriment of another
party. In simpler words, financial statements must be free from bias. It must also be free from error. Information
must be both relevant and faithfully represented to be useful.

Enhancing qualitative characteristics relate to the presentation or form of financial information. The
enhancing qualitative characteristics are intended to increase the usefulness of accounting information that is
relevant and faithfully represented. The enhancing qualitative characteristics are verifiability, comparability,

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understandability, and timeliness. Verifiability is attained when the figures in the financial statement is
supported by evidence that an accountant that would look into the same evidence would arrive at the same
decision or conclusion. Comparability means the ability to bring together for the purpose of noting points of
likeliness and differences. There are two types of comparability – intracomparability and intercomparability.
Intracomparability refers to comparability within an entity. Intercomparability refers to comparability across
entities. Understandability requires the financial statements to be comprehensible or intelligible to be useful.
Timeliness means having information available to decision makers in time to influence their decisions

There are four basic components of financial statements. The following are: (1) balance sheet or
statement of financial position which shows the financial position – assets, liabilities and owner’s equity of the
firm on a particular date such as the end of a quarter or a year; (2) income statement or earnings statement
which represents the results of operations – revenues, expenses, net profits or loss, for the accounting period;
(3) statement of changes in equity which summarizes the changes in a company’s equity for a period of time
(generally one year); and cash flow statement which provides information about the cash inflows and outflows
from operating, financing and investing activities during an accounting period.

Financial statements analysis involves careful selection of data from financial statements for the
primary purpose of forecasting the financial health of the company. This is accomplished by examining trends
in key financial data, comparing financial data across companies, and analyzing key financial ratios.

One of the things that need to be considered is the objective. The major objective of financial statement
analysis is to provide decision makers information about a business enterprise for use in decision-making.
Users of financial statement information are the decision makers concerned with evaluating the economic
situation of the firm and predicting its future course.

The decision makers are futuristic and are always concerned with the future. Financial statements
which contain information on past performances are analyzed and interpreted as a basis for forecasting future
rates of return and for assessing risk. The following are common objectives of financial statement analysis:

1. Assessment of Past Performance. Past performance is a good indicator of future performance.

Investors or creditors are interested in the trend of past sales, cost of goods sold, operating expenses, net
income, cash flows and return on investment. These trends offer a means for judging management's past
performance and are possible indicators of future performance.

2. Assessment of Current Position. The analysis of current position indicates where the business
stands today. For instance, the current position analysis will show the types of assets owned by a business
enterprise and the different liabilities due against the enterprise. It will tell what the cash position is, how much
debt the company has in relation to equity and how reasonable the inventories and receivables are.

3. Prediction of Profitability and Growth Prospects. Financial statement analysis helps in assessing and
predicting the earning prospects and growth rates in earning which are used by investors while comparing
investment alternatives and other users in judging earning potential of business enterprise. Investors also
consider the risk or uncertainty associated with the expected return.

4. Prediction of Bankruptcy and Failure. Financial statement analysis is a significant tool in predicting
the bankruptcy and failure probability of business enterprises. After being aware about probable failure, both
managers and investors can take preventive measures to avoid/minimize losses.
Corporate managements can effect changes in operating policy, reorganize financial structure or even
go for voluntary liquidation to shorten the length of time losses. In accounting and finance area, empirical
studies conducted have suggested a set of financial ratios which can give early signal of corporate failure.
Such a prediction model based on financial statement analysis is useful to managers, investors and creditors.
Managers may use the ratios prediction model to assess the solvency position of their firms and thus
can take appropriate corrective actions. Investors and shareholder can use the model to make the optimum
portfolio selection and to bring changes in the investment strategy in accordance with their investment goals.
Similarly, creditors can apply the prediction model while evaluating the creditworthiness of business
enterprises.

5. Assessment of the Operational Efficiency. Financial statement analysis helps to assess the
operational efficiency of the management of a company. The actual performance of the firm which is revealed
in the financial statements can be compared with some standards set earlier and the deviation of any between
standards and actual performance can be used as the indicator of efficiency of the management.

6. Loan Decision by Financial Institutions and Banks. Financial statement analysis is used by financial
institutions, loaning agencies, banks and others to make sound loan or credit decision. In this way, they can
make proper allocation of credit among the different borrowers. Financial statement analysis helps in
determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date etc.

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General Approach to Financial Statement Analysis

A general approach to financial statements analysis will cover the broad areas given below. In addition,
each analytical situation should be tailored to meet specific user objectives.

1. Background study and evaluation of firm industry, economy, and outlook. Since economic
developments and the actions of competitors affect the ability of any business enterprise to perform
successfully, it is necessary to start the analysis of a firm’s financial statements with an evaluation of the
environment in which the firm conducts business.

2. Short – term solvency analysis. This refers to the analysis of the company’s Ability to meet near
term demand for cash and normal operating requirements. Some of the indications that a company enjoys a
satisfactory short term solvency position are:
• Favorable credit position
• Satisfactory proportion of cash to the requirements of the current volume
• Ability to pay currents in the regular course of business
• Ability to extend more credit to customers
• Ability to replenish inventory promptly

3. Capital structure and long – term solvency analysis. This pertains to the evaluation of the amount
and proportion of debt in a firm’s capital structure to assess its ability to service debt. This will also cover the
analysis of the use of financial leverage to maximize the returns to owners. A company is generally considered
enjoying satisfactory long-term financial position if it is able to:
• Maintain a well- balanced relationship between borrowed funds and equity
• Effectively employ borrowed funds and equity.
• Declare satisfactory amounts of dividends to shareholders.
• Withstand adverse business conditions.
• Engage in research and development to provide new products or improve old processes.
• Meet their commitment to borrowers and owners.

4. Evaluation of operating efficiency and profitability analysis. This involves the evaluation of how well
assets have been employed by the management in terms of generating revenues and maximizing returns on
such resources. Some indicators are:
• Ability to earn a satisfactory return on its investment of borrowed funds and equity.
• Ability to control operating costs with reasonable limits.
• Optimum level of investment in assets.

Limitations of Financial Statement Analysis

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

1. Information derived by the analysis is not absolute measures of performance in any and all of the areas
of business operations. They are only indicators of degrees of profitability and financial strength of the firm.

2. Limitation inherent in the accounting data the analyst work with. These are brought about by among
others:
 Variation and lack of consistency in the application of accounting principles, policies and procedures.
 Too-condensed presentation of data.
 Failure to reflect change in purchasing power.

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

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

Steps in Financial Statement Analysis

In analyzing financial statements, the following steps may be followed:

1. Establish objectives. Establish the objectives of the analysis to be conducted by defining the purpose
and context of financial statements analysis.

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 2. Collect data. Collect the necessary data and study the industry where the firm belongs. Acquire also
the company’s financial statements for several years, depending on the objectives established in step 1. As a
minimum, obtain the following statements, for at least 3 to 5 years: Balance Sheets, Income Statements,
Shareholders Equity Statements, and Cash flow Statements.

3. Process the data. Process the data gathered in the second phase which may range from simple
sorting and adjustments to preparing common-size financial statements and graphical representation of ratios
and trends. This is where you study the firm’s background and the quality of its management.

4. Conduct analysis. Analyze the processed data and interpret the results. Evaluate the firm’s financial
statements using the evaluation techniques available. (e.g. Horizontal Analysis, Vertical Analysis, Ratio
Analysis etc.)

5. Summarize results. Summarize the results of the studies and evaluation conducted.

6. Develop conclusions relevant to the established objectives. Develop conclusions in the light of
inferences drawn from analysis conducted and report/communicate them to relevant personnel. This phase is
the most critical of all from different perspectives. As it involves many responsibilities on part of the analysts
that he is required to fulfill regarding the recommendations and communication of those recommendations.

Analysis of Financial Statement

In order to analyze the accounting information from the financial statement, several methods are used
such as horizontal analysis, trend percentage, vertical analysis, ratio analysis, cash flow analysis and gross
profit-variation analysis.

1. Horizontal Analysis

It is the comparison of figures shown in the financial statement of two or more consecutive period. 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. The difference could either be an increase or a
decrease both in amount and in percentage.

Absolute Change (change in the Amount) = Most Recent Value – Base Period Value

Percentage Change = Most Recent Value – Base Period value

Base Period Value
Note: Percentage change is not computed if the base (Base Period Value) is zero or negative.

Exhibit 1.1
Valdez Corporation
Income Statements
For Years Ended December 31
(in thousands of pesos)

Increase
(Decrease)
2016 2015 Amount Percent
Sales ₱ 3,280 ₱ 2,950 ₱ 330 11%
Less: Cost of Sales 2,120 1,917 203 11
Gross Income ₱ 1,160 ₱ 1,033 ₱ 127 12%
Less: Operating Expenses
Selling 350 100 250 250
Administrative 420 480 (60) (13)
Total Operating Expenses ₱770 ₱580 ₱190 33%
Income from Operations 390 453 (63) (14)
Less: Interest expense 30 25 5 20
Income before tax ₱360 ₱428 (₱68) (16%)
Less: Income Tax 126 149.8 (23.8) (16)
Net Income ₱234 ₱278.2 (₱44.2) (16%)
Earnings per common share 2.34 2.78 (0.44) (16%)

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 With the use of horizontal analysis, the 2016 net income of P234, 000 represents a decrease of
P44, 200 or 16% as compared with net income in the previous year.

Exhibit 1.2
Valdez Corporation
Statement of Retained Earnings
For Years Ended December 31
(in thousands pesos)

Increase (Decrease)
2016 2015 Amount Percent
Retained earnings, Jan. 1 ₱ 274 145.8 128.2 88%
Add: Net Income 234 278 (44.2) (16)
Total ₱508 ₱424 ₱84 20%
Less: Dividends 150 150 ------ -----
Retained Earnings, Dec. 31 ₱358 ₱274 ₱84 31%

With the use of horizontal analysis, the 2016 retained earnings of P358,000 represents
an increase of P84,000 or 31% as compared with net income in the previous year.

Exhibit 1.3
Valdez Corporation
Balance Sheets
31-Dec
(in thousands pesos)

Increase
(Decrease)
2016 2015 Amount Percent
ASSETS
Current Assets:
Cash ₱120 ₱150 (₱30) (20%)
Marketable Securities 45 15 30 200
Accounts Receivable (net) 210 180 30 17
Merchandise Inventory 150 112 38 34
Other Current Assets 80 62 18 29
Total Current Assets ₱605 ₱519 ₱86 17%
Fixed Assets:
Land 210 120 90 75
Building 1, 129 1 129 0 0
Furniture & Fixtures 120 98 22 22
Store and Office Equipment 96 84 12 14
Total 1,555 1,431 124 9
Less: Accumulated Depreciation 360 300 60 20
Total Fixed Assets ₱1,195 ₱1,131 ₱64 6%
TOTAL ASSETS ₱1,800 ₱1,650 ₱150 9%

LIABILITIES & STOCKHOLDERS EQUITY

LIABILITIES
Current Liabilities:
Notes and Accounts payable 125 169 (44) (26)
Taxes payable 85 107 (22) (21)
Other Current Liabilities 82 0 82 0
Total Current Liabilities ₱292 ₱276 ₱16 6%
Long Term liabilities ₱650 ₱600 ₱50 8%
Total Liabilities ₱942 ₱876 ₱66 8%

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 STOCKHOLDERS EQUITY
Capital stock, P5 par value, 100,000 shares
issued and outstanding 500 500 0 0
Retained earnings 358 274 84 31
Total Stockholders’ Equity ₱858 ₱774 ₱84 11%
TOTAL LIABILITIES & STOCHOLDERS
EQUITY ₱1,800 ₱1,650 ₱150 9%

With the use of horizontal analysis, the 2016 total liabilities and stockholders’ equity of
P1, 800,000 represents an increase of P150, 000 or 9% as compared with net income in the
previous year.

Illustration 1.1:
2016 2015
ASSETS
Cash and Cash Equivalents ₱ 3,000 ₱ 5,000
Trade and other Receivables 40,000 25,000
Inventory 27,000 30,000
Investment Property 15,000 0
Property, plant and equipment (net) 100,000 75,000
Intangibles 10,000 10,000
Other noncurrent assets 5,000 20,000
Total Assets 200,000 165,000

LIABILITIES
Current liabilities P30,000 P47,000
Long-term liabilities 88,000 74,000
Total Liabilities 118,000 121,000

STOCKHOLDERS EQUITY
8% Preference equity 10,000 9,000
Ordinary equity 54,000 42,000
Share Premium 5,000 5,000
Retained earnings 13,000 (12,000)
Total Stockholders’ Equity 82,000 44,000
TOTAL LIABILITIES & STOCHOLDERS EQUITY 200,000 165,000

Required:
a. Prepare a horizontal analysis (comparative) statement of financial position showing
peso and percentage changes for 2016 as compared with 2015.

Illustration 1.2:
2016 2015
₱
Sales ₱ 440,000 480,000
Cost of Goods Sold (242,000) (360,000)
Selling and general expenses (118,800) (96,000)
Interest expense (30,800) (33,600)
Profit(loss) before income tax 48,400 (9600)
Income Tax (19,360) 3,840
Profit(loss) P29,040 (P3,760)

Required:
a. Prepare a horizontal analysis (comparative) statement of profit or loss showing peso
and percentage changes for 2016 as compared with 2015.

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2. Trend Percentages

It is used to analyze 3 or more sets if comparative data. It used indexes and ratios to simplify the visible
complications of numbers contained in the financial reports.
Indexes are expressed in hundreds while ratios are expressed in normal decimal places. In computing
the trend index or ration, the base year (100%) is normally the earliest year. The choice of the base year is,
however, purely judgmental.

Trend percentage = Current figure

Base

Illustration 1:
2016 2015 2014 2013 2012
₱ ₱
Sales ₱ 10,800 ₱9,600 ₱ 9,200 8,640 8,000
Current Assets 2,626 2,181 2,220 2,267 2,225
Current Liabilities 475 450 350 325 250

Required: Express all the sales, current assets and current liabilities on trend index.
Round your answer up to 2 decimal places. Use 2012 as the base year.

Trend Analysis: (Express the Sales, Current Assets, Current Liabilities on trend index)
Base Year = Year 2016
2016 2015 2014 2013 2012
Sales 1.00 0.89 0.85 0.8 0.74

Current Assets 1.00 0.83 0.85 0.86 0.85

Current Liabilities 1.00 0.95 0.74 0.68 0.53

Illustration 2:
2016 2015 2014 2013 2012
₱ ₱ ₱ ₱
Sales ₱ 12,000 11,700 10,780 9,850 9,000
Current Assets 3,000 2,108 2,220 2,800 2,435
Current Liabilities 500 450 395 340 270

Required: Express all the sales, current assets and current liabilities on trend index.
Round your answer up to 2 decimal places. Use 2012 as the base year.

Trend Analysis: (Express the Sales, Current Assets, Current Liabilities on trend index)

Base Year = Year 2012

2016 2015 2014 2013 2012
Sales 1.33 1.30 1.20 1.09 1.00

Current Assets 1.23 0.87 0.91 1.15 1.00

Current Liabilities 1.85 1.67 1.46 1.26 1.00

3. Vertical Analysis

It is the process of comparing figures in the financial statement of a single period.

It involves converting the figures in the statements to a common base. It is accomplished by expressing
all the figures in the statements as a percentage of an important item, such as total assets (in the balance
sheet) and total or net sales (in the income statement). These converted statements are called common-size
statements or percentage composition statements.
With vertical analysis, comparisons become more meaningful particularly when we are analyzing
financial statements of different companies. For instance, assume that we want to compare a company with
total assets of P25 million with a company having total assets of only P2 million. If the absolute figures are
used in comparison, the company with bigger total assets seems to be better. However, it is obvious that it is

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unfair and inappropriate to compare the two based on peso figures, To overcome this problem, the said
companies common size statements should be compared, where all the items are reduced to a common unit.

Conversion Procedures
1. Balance Sheet—total assets represent 100%. Other items on the balanced sheet are expressed as
percentages of total assets by dividing each item by total assets.

Percentage = Each item

Total Assets

Example: Assume a company that a company has total assets of P1, 800,000 and a cash balance of
P120, 000.
Percentage = Each item
Total Assets
= 120,000
1800,000 = 6.67%
Cash therefore, represents 6.67% of total assets.

Exhibit 3.1

Valdez Corporation
Balance Sheets
31-Dec
(in thousands pesos)

2016 2015
Amount Percent Amount Percent
ASSETS
Current Assets:
Cash ₱120 6.70% ₱150 9%
Marketable Securities 45 2.5 15 0.9
Accounts Receivable (net) 210 11.7 180 10.9
Merchandise Inventory 150 8.3 112 6.8
Other Current Assets 80 4.4 62 3.8
Total Current Assets ₱605 33.60% ₱519 31.5%
Fixed Assets:
Land 210 11.70% 120 7.30%
Building 1, 129 62.7 1 129 68.4
Furniture & Fixtures 120 6.70% 98 5.9
Store and Office Equipment 96 5.3 84 5.1
Total 1,555 86.40% 1,431 86.7
Less: Accumulated Depreciation 360 20 300 18.2
Total Fixed Assets ₱1,195 66.40% ₱1,131 68.5%
TOTAL ASSETS ₱1,800 100.00% ₱1,650 100.00%

LIABILITIES & STOCKHOLDERS EQUITY

LIABILITIES
Current Liabilities:
Notes and Accounts payable 125 6.90% 169 10.20%
Taxes payable 85 4.7 107 6.5
Other Current Liabilities 82 4.6 ----- -----
Total Current Liabilities ₱292 16.2 ₱276 16.7
Long Term liabilities ₱650 36.1 ₱600 36.4
Total Liabilities ₱942 52.3 ₱876 53.1

STOCKHOLDERS EQUITY
Capital stock, P5 par value, 100,000 shares 500 27.8 500 30.3

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 issued
And outstanding
Retained earnings 358 19.9 274 16.6
Total Stockholders’ Equity ₱858 47.7% ₱774 46.9%
TOTALLIABILITIES & STOCHOLDERS
EQUITY ₱1,800 100.00% ₱1,650 100.00%

As regards the company’s common size balance sheets, it may be noted that the current
assets in 2016 are 33.6% of total assets, higher than 31.5% in 2015. Current liabilities, on the
other hand, decreased from 36.4% to 36.1%. This is an indication of an improving working
capital position.

2. Income Statement—the net sales figure or net operating revenue is set at 100%. Each item in the income
statement is divided by net sales (or net operating revenue) to express such items as percentages of net
sales.
Percentage = Each Item
Net Sales

Example: Assume a company earned net sales of P3, 280,000 and incurred cost of sales of P2, 120,000
during a year.
Percentage = Each item
Net Sales
= 2,120,000
3,280,000
= 64.63%
Cost of sales therefore, represents 64.63% of net sales.
Exhibit 3.2
Valdez Corporation
Income Statements
For Years Ended December 31
(in thousands pesos)
2016 Percent 2015 Percent
Sales ₱ 3,280 100.00% ₱ 2,950 100%
Less: Cost of Sales 2,120 64.6 1,917 65
Gross Income ₱ 1,160 35.4 ₱ 1,033 35
Less: Operating Expenses
Selling 350 10.7 100 3.4
Administrative 420 12.8 480 16.3
Total Operating Expenses ₱ 770 23.5 ₱580 19.7
Income from Operations 390 11.9 453 15.3
Less: Interest expense 30 1 25 0.8
Income before tax ₱360 10.9 ₱428 14.5
Less: Income Tax 126 3.8 149.8 5.1
Net Income ₱234 7.1% ₱278.2 9.4%

Valdez Corporation’s common size income statements reveals that its costs of sales for the two years
2016 and 2015 were maintained at about 65%, and the gross income figures at 35%. This means that no
change in mark up on the goods sold was made during the two-year period. The increase in gross income was
due mainly to the increase in sales volume (units), not to a change in the company’s pricing policy.

Despite the increase in sales and gross income, the company’s net income dropped to 7.1% in 2016
from 9.4% in 2015. This is due to the increase in operating expenses (from 19.7% to 23.5%) and interest
expense (from 0.8% to 1.0%)

Apparently, further study of the company’s selling expenses should be made since this item caused
much increase in the total operating expenses during the two-year period under review.

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Comparison with other firm’s statements

A company may choose to compare its own financial statements with those other firms in the industry,
i.e., firms engaged in the same line of business, so it can evaluate its own performance to its competitors.
Presumably, the leading firms are the best managed, most profitable, and have attained a desirable balance in
their asset investment and equity structure.

Illustration 3.1:
2016 2015
ASSETS
Cash and Cash Equivalents ₱ 3,000 ₱ 5,000
Trade and other Receivables 40,000 25,000
Inventory 27,000 30,000
Investment Property 15,000 0
Property, plant and equipment (net) 100,000 75,000
Intangibles 10,000 10,000
Other noncurrent assets 5,000 20,000
Total Assets 200,000 165,000

LIABILITIES
Current liabilities P30,000 P47,000
Long-term liabilities 88,000 74,000
Total Liabilities 118,000 121,000

STOCKHOLDERS EQUITY
8% Preference equity 10,000 9,000
Ordinary equity 54,000 42,000
Share Premium 5,000 5,000
Retained earnings 13,000 (12,000)
Total Stockholders’ Equity 82,000 44,000
TOTAL LIABILITIES & STOCHOLDERS EQUITY 200,000 165,000

Required:
a. Prepare a vertical analysis (common-size) statement of financial position as of
December 31, 2015 and 2016.

Illustration 3.2:
2016 2015
₱
Sales ₱ 440,000 480,000
Cost of Goods Sold (242,000) (360,000)
Selling and general expenses (118,800) (96,000)
Interest expense (30,800) (33,600)
Profit(loss) before income tax 48,400 (9600)
Income Tax (19,360) 3,840
Profit(loss) P29,040 (P3,760)

Required:
a. Prepare a vertical analysis (common-size) statement of profit or loss as of
December 31, 2015 and 2016.

4. Ratio Analysis

It is a quantitative analysis of information contained in a company’s financial statements. Ratio analysis

is based on line items in financial statements like the balance sheet, income statement and cash flow
statement; the ratios of one item – or a combination of items - to another item or combination are then
calculated. Ratio analysis is used to evaluate various aspects of a company’s operating and financial
performance such as its efficiency, liquidity, profitability and solvency. The trend of these ratios over time is
studied to check whether they are improving or deteriorating. Ratio analysis is a cornerstone of fundamental
analysis.

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Different Ratios for Different Users

Different ratios are useful for different users. For instance, long-term creditors are interested in ratios
indicating solvency of the corporation, while short-term creditors are more interested in ratios indicating the
liquidity of the firm. In either case, these two types of creditors are concerned with the firm’s ability to pay its
liabilities when they mature. Potential investors and stockholders are interested in ratios indicative the
company’s profitability and the behavior of its share of stock in the market. Managers on the other hand, are
concerned with the ratios reflecting all such aforementioned aspects of probability, liquidity, solvency and
attractiveness of the stocks to ensure that the financial statements may be viewed favorable by all the other
interested parties- the creditor, stockholder and the potential investors.

TEST OF LIQUIDITY

Liquidity refers to the company’s ability to pay its short term current liabilities as they fall due. Though
the analysis of liquidity is most important to short term creditors, it is also of concern to long-term creditors and
stockholders. This is so because even if a firm has a very good long term prospect, its realization is impossible
if it could not pay even its short-term obligations. No firm could get to the long term if it could not even get
through the short term.

1. Current Ratio. This is also called working capital ratio or banker’s ratio. This ratio is calculated by dividing
current assets by current liabilities. It indicates the extent to which current liabilities are covered by those
assets expected to be converted to cash in the near future.

CURRENT RATIO =

Example:
The following details are extracted from the balance sheet of ABC Ltd. For the year ended December
31, 2016. Calculate the current ratio.

Current assets
Cash and bank balance 146.51
Sundry debtors 101.54
Bills Receivables 40.00
Advances (short term) 24.17
Stock:
Raw materials 2.07
Semi-finished goods 20.59
Finished goods 53.55
General stores and spares 13.66
Current Liabilities
Sundry creditors 17.17
Bills payables 10.00
Outstanding expenses 20.86
Other Current Liabilities 60.01

Solution:
CURRENT RATIO =

= 3.72
The current ratio indicates that the firm has enough current assets to pay its current liabilities thrice.
Rule of thumb – 3:1, there must be 3 current assets for every current liability.

2. Acid Test Ratio. It is a liquidity ratio that measures the ability of a company to pay its current liabilities when
they come due with only quick assets. Quick assets are current assets that can be converted to cash within
90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and
current accounts receivable are considered quick assets.

QUICK RATIO =

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Example:
The following details are extracted from the balance sheet of ABC Ltd. For the year ended December
31, 2016. Calculate the current ratio.

Current assets
Cash and bank balance 146.51
Sundry debtors 141.54
Short term investments 27.00
Inventory 73.00
Prepaid expenses 12.00
Current Liabilities
Sundry creditors 17.17
Bills payables 10.00
Outstanding expenses 20.86
Bank overdraft 60.01

Solution:
QUICK RATIO =

=2.95
The quick ratio indicates that the company has enough liquid assets to pay its current liabilities. Rule of thumb
– 2:1, there must be 2 quick assets for every current liability. Note: To some analyst, acid test ratio of at least 1
indicates an adequate ability to pay its current obligations. But the rule does not always apply to all companies
and situations.

3. Turnovers. This category answers the questions that the current and quick ratio fail to provide. This
answers the questions:
 How long the firm expects to realize cash from its receivables and inventories?
 When should the firm pay its various current liabilities?

3.1. RECEIVABLES TURNOVER. This is the time required to complete one collection cycle- from the time
receivables are recorded, then collected, to the time new receivables are recorded again The faster the cycle is
completed, the more quickly receivables are converted into cash.
Average Age of receivables indicates the number of days during which the company must wait before
receivables are collected.

RECEIVABLES TURNOVER =

AVERAGE RECEIVABLES =

AVERAGE AGE OF RECEIVABLES =

Example:
Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to all of his main
customers. At the end of the year, Bill's balance sheet shows P20,000 in accounts receivable, P75,000 of
gross credit sales, and P25,000 of returns. Last year's balance sheet showed P10, 000 of accounts receivable.

Solution:
RECEIVABLES TURNOVER =
=
=
=3.33
AVERAGE RECEIVABLES =
=15000

12
Bill's turnover is 3.33. This means that Bill collects his receivables about 3.3 times a year or once every 110
days. In other words, when Bill makes a credit sale, it will take him 110 days to collect the cash from that sale.

Example:
Assuming that Bill’s ski Shop has 120 working days in a year and has a credit term of 40 days, the
average age of its receivables is?

Solution:
AVERAGE AGE OF RECEIVABLES =
=
=36.04 days
The performance of the collection department is satisfactory for the average age of receivables is
lesser than that of the credit terms.

3.2. INVENTORY TURNOVER. This measures the number of times the inventory is replaced during the period.
Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to
have a high turn. This shows the company does not overspend by buying too much inventory and wastes
resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it
buys

a. MERCHANDISING FIRM

INVENTORY TURNOVER =

AVERAGE MERCHANDISE INVENTORY =

Example:
Donny's Furniture Company sells industrial furniture for office buildings. During the current year, Donny
reported cost of goods sold on its income statement of P1, 000,000. Donny's beginning inventory was P3,
000,000 and its ending inventory was P4, 000,000. Donny's turnover is?

Solution:
INVENTORY TURNOVER =
=0.29

AVERAGE MERCHANDISE INVENTORY =

= 3500000

Donny's turnover is .29. This means that Donny only sold roughly a third of its inventory during the year. It also
implies that it would take Donny approximately 3 years to sell his entire inventory or complete one turn. In other
words, Danny does not have very good inventory control.

b. MANUFACTURING FIRM

RAW MATERIALS TURNOVER=

GOODS IN PROCESS TURNOVER =

FINISHED GOODS TURNOVER =

3.3. TRADE PAYABLES TURNOVER. This is a short-term liquidity measure used to quantify the rate at
which a company pays off its suppliers. Average trade payables indicate the length of time or the
number of days during which trade payables remain unpaid.

PAYABLES TURNOVER =

AVERAGE AGE OF TRADE AYABLES =

13
Example:
Bob's Building Suppliers buys constructions equipment and materials from wholesalers and resells this
inventory to the general public in its retail store. During the current year Bob purchased P1, 000,000 worth of
construction materials from his vendors. According to Bob's balance sheet, his beginning accounts payable
was P55, 000 and his ending accounts payable was P958, 000.

Solution:
PAYABLES TURNOVER =
=
= 1.97
Based on this formula Bob's turnover ratio is 1.97. This means that Bob pays his vendors back on average
once every six months of twice a year. This is not a high turnover ratio.

3.4. CURRENT ASSETS TURNOVER. This measure the movement and utilization of current assets to meet
operating requirements. Depreciation and amortization are excluded because these expenses do not require
utilization of current assets.

CURRENT ASSETS TURNOVER=

TEST OF SOLVENCY

Solvency refers to the company’s ability to pay all its debts whether such liabilities are current or non-
current. Both long term creditors and stockholders are interested in a company’s solvency. The long term
creditor is interested there in because of his concern about receiving interest payments as well as the principal
of the loan granted to the company. Stockholders are concerned about it because they cannot be assured of
regular dividend payments and high market prices of stock if the firm could not survive because of insolvency.

1. Time Interest Earned. The times interest earned ratio, sometimes called the interest coverage ratio, is a
coverage ratio that measures the proportionate amount of income that can be used to cover interest expenses
in the future.
TIME INTEREST EARNED =
Example:
Tim's Tile Service is a construction company that is currently applying for a new loan to buy equipment. The
bank asks Tim for his financial statements before they will consider his loan. Tim's income statement shows
that he made P500, 000 of income before interest expense and income taxes. Tim's overall interest expense
for the year was only P50, 000.

Solution:
TIME INTEREST EARNED =
=
=10

Tim has a ratio of ten. This means that Tim's income is 10 times greater than his annual interest expense. In
other words, Tim can afford to pay additional interest expenses. In this respect, Tim's business is less risky
and the bank shouldn't have a problem accepting his loan.

2. Debt-equity ratio. This determines the amount provided by the creditors relative to that provided by the
owner. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor
financing (shareholders).A lower debt to equity ratio usually implies a more financially stable business.
Companies with a higher debt to equity ratio are considered more risky to creditors and investors than
companies with a lower ratio. A debt to equity ratio of 1 would mean that investors and creditors have an equal
stake in the business assets.

DEBT-EQUITY RATIO =

Example:
Assume a company has 100,000 of bank lines of credit and a 500,000 mortgage on its property. The
shareholders of the company have invested 1,200,000.

Solution:
DEBT-EQUITY RATIO = = 0.5

14
3. Debt ratio. It indicates the percentage of total assets provided by the creditors. Debt ratio is a solvency ratio
that measures a firm's total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a
company's ability to pay off its liabilities with its assets. In other words, this shows how many assets the
company must sell in order to pay off all of its liabilities. A lower debt ratio usually implies a more stable
business with the potential of longevity because a company with lower ratio also has lower overall debt.

DEBT RATIO =

A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many assets
as liabilities. Or said a different way, this company's liabilities are only 50 percent of its total assets. Essentially,
only its creditors own half of the company's assets and the shareholders own the remainder of the assets.

A ratio of 1 means that total liabilities equals total assets. In other words, the company would have to sell off all
of its assets in order to pay off its liabilities. Obviously, this is a highly leverage firm. Once its assets are sold
off, the business no longer can operate.

Example:
Dave's Guitar Shop is thinking about building an addition onto the back of its existing building for more storage.
Dave consults with his banker about applying for a new loan. The bank asks for Dave's balance to examine his
overall debt levels. The banker discovers that Dave has total assets of P100, 000 and total liabilities of P25,
000.

Solution:
DEBT RATIO =
=
= .25

Dave only has a debt ratio of .25. In other words, Dave has 4 times as many assets as he has liabilities. This is
a relatively low ratio and implies that Dave will be able to pay back his loan. Dave shouldn't have a problem
getting approved for his loan.

4. Equity ratio. It indicates the percentage of total assets provided by the owners or stockholders. The equity
ratio highlights two important financial concepts of a solvent and sustainable business:
 Shows how much of the total company assets are owned outright by the investors
 Shows how leveraged the company is with debt

Higher equity ratios are typically favorable for companies. Higher investment levels by shareholders shows
potential shareholders that the company is worth investing in since so many investors are willing to finance the
company. A higher ratio also shows potential creditors that the company is more sustainable and less risky to
lend future loans. Companies with higher equity ratios should have less financing and debt service costs than
companies with lower ratios.

EQUITY RATIO =

Example:
Tim's Tech Company is a new startup with a number of different investors. Tim is looking for additional
financing to help grow the company, so he talks to his business partners about financing options. Tim's total
assets are reported at P150, 000 and his total liabilities are P50, 000. Based on the accounting equation, we
can assume the total equity is P100, 000.

Solution:
EQUITY RATIO =
=
= 0.67

Tim's ratio is .67. This means that investors rather than debt are currently funding more assets. 67 percent of
the company's assets are owned by shareholders and not creditors. Depending on the industry, this is a
healthy ratio.

TEST OF PROFITABILITY

1. Return on sales. It measures the amount of income provided by the average peso sales. Return on sales,
often called the operating profit margin, is a financial ratio that calculates how efficiently a company is at

15
generating profits from its revenue. In other words, it measures a company’s performance by analyzing what
percentage of total company revenues are actually converted into company profits. Investors and creditors are
interested in this efficiency ratio because it shows the percentage of money that the company actually makes
on its revenues during a period. They can use this calculation to compare company performance from one
period to the next or compare two different sized companies’ performance for a given period.

RETURN ON SALES =

Gross profit ratio

GROSS PROFIT RATIO =

Net profit ratio

NET PROFIT RATIO =

Example:
Assume Jim’s Bowling Alley generates P500, 000 of business each year and shows operating profit of P100,
000 before any taxes or interest expenses are accounted for.

Solution:
RETURN ON SALES =
=
= .2

Jim converts 20 percent of his sales into profits. In other words, Jim spends 80 percent of the money he
collects from customers to run the business. If Jim wants to increase his net operating income, he can either
focus on reducing expenses or increasing revenues.

2. Return on total assets. The return on assets ratio, often called the return on total assets, is a profitability
ratio that measures the net income produced by total assets during a period by comparing net income to the
average total assets. In other words, the return on assets ratio or ROA measures how efficiently a company
can manage its assets to produce profits during a period.

RETURN ON TOTAL ASSETS =

or
=

Example:
Charlie's Construction Company is a growing construction business that has a few contracts to build
storefronts in downtown Chicago. Charlie's balance sheet shows beginning assets of P1, 000,000 and an
ending balance of P2, 000,000 of assets. During the current year, Charlie's company had net income of P20,
000, 000.

Solution:
RETURN ON TOTAL ASSETS =
= 13.33

Charlie's ratio is 1,333.3 percent. In other words, every peso that Charlie invested in assets during the year
produced P13.3 of net income. Depending on the economy, this can be a healthy return rate no matter what
the investment is.

3. Return on owner’s equity. The return on equity ratio or ROE is a profitability ratio that measures the ability
of a firm to generate profits from its shareholders investments in the company. In other words, the return on
equity ratio shows how much profit each pesos of common stockholders' equity generates. ROE is also an
indicator of how effective management is at using equity financing to fund operations and grow the company.

RETURN ON OWNERS EQUITY =

For corporations with only one class of shares of stocks, the ROE is computed as follows:

RETURN ON STOCKHOLDERS EQUITY =

16
If the corporation has preferred shares of stocks aside from the common shares, the formula for ROE is:

RETURN ON COMMON EQUITY =

Example:
Tammy's Tool Company is a retail store that sells tools to construction companies across the country. Tammy
reported net income of P100, 000 and issued preferred dividends of P10, 000 during the year. Tammy also had
10,000, P5 par common shares outstanding during the year.

Solution:
RETURN ON OWNERS EQUITY =
= 1.8
After preferred dividends are removed from net income Tammy's ROE is 1.8. This means that every peso of
common shareholder's equity earned about P1.80 this year. In other words, shareholders saw a 180 percent
return on their investment. Tammy's ratio is most likely considered high for her industry. This could indicate
that Tammy's is a growing company.

4. Earnings per share. Earnings per share, also called net income per share, is a market prospect ratio that
measures the amount of net income earned per share of stock outstanding. In other words, this is the amount
of money each share of stock would receive if all of the profits were distributed to the outstanding shares at the
end of the year.

EARNINGS PER SHARE =

Example:
Quality Co. has net income during the year of P50, 000. Since it is a small company, there are no preferred
shares outstanding. Quality Co. had 5,000 weighted average shares outstanding during the year.

Solution:
EARNINGS PER SHARE =
=10
Quality's EPS for the year is P10. This means that if Quality distributed every peso of income to its
shareholders, each share would receive 10 pesos.

MARKET TEST

1. Price-earnings ratio. The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a
market prospect ratio that calculates the market value of a stock relative to its earnings by comparing the
market price per share by the earnings per share. In other words, the price earnings ratio shows what the
market is willing to pay for a stock based on its current earnings. Investors often use this ratio to evaluate what
a stock's fair market value should be by predicting future earnings per share. Companies with higher future
earnings are usually expected to issue higher dividends or have appreciating stock in the future. A company
with a lower ratio, on the other hand, is usually an indication of poor current and future performance. This could
prove to be a poor investment. In general a higher ratio means that investors anticipate higher performance
and growth in the future. It also means that companies with losses have poor PE ratios.

PRICE EARNINGS RATIO =

Example:
The Island Corporation stock is currently trading at P50 a share and its earnings per share for the year are 5
pesos.

Solution:
PRICE EARNINGS RATIO =
=10

The Island's ratio is 10 times. This means that investors are willing to pay 10 pesos for every peso of earnings.
In other words, this stock is trading at a multiple of ten.

2. Dividend yield. The dividend yield is a financial ratio that measures the amount of cash dividends
distributed to common shareholders relative to the market value per share. The dividend yield is used by
investors to show how their investment in stock is generating either cash flows in the form of dividends or
increases in asset value by stock appreciation. Investors use the dividend yield formula to compute the cash

17
flow they are getting from their investment in stocks. In other words, investors want to know how much
dividends they are getting for every pesos that the stock is worth. A company with a high dividend yield pays its
investors a large dividend compared to the fair market value of the stock. This means the investors are getting
highly compensated for their investments compared with lower dividend yielding stocks.

DIVIDEND YIELD =

Example:
Stacy's Bakery is an upscale bakery that sells cupcakes and baked goods in Beverly Hills. Stacy's is listed on a
smaller stock exchange and the current market price per share is P15. As of last year, Stacy paid P15, 000 in
dividends with 1,000 shares outstanding.

Solution:
DIVIDEND YIELD =
=
=1

Stacy's yield is one peso. This means that Stacy's investors receive 1 peso in dividends for every peso they
have invested in the company. In other words, the investors are getting a 100 percent return on their
investment every year Stacy maintains this dividend level.

3. Dividend Pay-out. The dividend payout ratio measures the percentage of net income that is distributed to
shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the
company decides to keep funding operations and the portion of profits that is given to its shareholders.
Investors are particularly interested in the dividend payout ratio because they want to know if companies are
paying out a reasonable portion of net income to investors.

DIVIDEND PAY-OUT =
Example:
Joe's Kitchen is a restaurant change that has several shareholders. Joe reported P10, 000 of net income on
his income statement for the year. Joe's issued P3, 000 of dividends to its shareholders during the year.

Solution:
DIVIDEND PAY-OUT =
=
=.3
Joe is paying out 30 percent of his net income to his shareholders. Depending on Joe's debt levels and
operating expenses, this could be a sustainable rate since the earnings appear to support a 30 percent ratio.

5. Cash Flow Analysis

The statement of cash flows is a valuable analytical tool for managers as well as for investors and
creditors, although managers tend to be more concerned with forecasted statement of cash flows that are
prepared as part of the budgeting process. It summarizes all of a company’s cash inflows and outflows during
a period, thereby explaining the change in cash balance. The statement of cash flows can be used to answer
crucial questions such as:
 Is the company generating sufficient positive cash flows from its ongoing operations to
remain viable?
 Will the company be able to repay its debts?
 Will the company be able to pay its usual dividends?
 Why do net income and net cash flow differ?
 To what extent will the company have to borrow money in order to make needed
investments?
The statement of cash flows is based on the following fundamental balance sheet and income
statement equations:
Change in cash + Changes in noncash assets = Changes in liabilities + Changes in stockholders’ equity
Net cash flow = Change in cash
Changes in stockholders’ equity = Net income – Dividends + Change in capital stock

These three equations can be used to derive the following equation:

Net cash flow = Net income – Changes in noncash assets + Changes in liabilities – Dividends + Changes
in capital stock

18
Two basic equations that apply to all assets, contra-asset, liability, and stockholders’ equity accounts are as
follows:

Basic Equation for Asset Accounts

Beginning balance + Debits – Credits = Ending balance

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity

Accounts
Beginning balance – Debits + Credits = Ending balance

These equations will be used to compute various cash inflows and outflows that are reported in the statement
of cash flows.

In organizing the statement of cash flows, there are three sections that report cash flows which
include operating activities, investing activities, and financing activities. Operating activities generate cash
inflows and outflows related to revenue and expense transactions that affect net income. Investing activities
generate cash inflows and outflows related to acquiring or disposing of noncurrent assets such as property,
plant, and equipment, long-term investments, and loans to another entity. Financing activities generate cash
inflows and outflows related to borrowing from and repaying principal to creditors and completing transactions
with the company’s owners, such as selling or repurchasing shares of common stock and paying dividends.

Exhibit 1. Cash Inflows and Outflows Resulting from Operating, Investing, and Financing
Activities
Cash Cash
Inflow Outflow
Operating Activities
Collecting cash from customers…………………………………………………… √
Paying suppliers for inventory purchases………………………………………… √
Paying bills to insurers, utility providers, etc……………………………………... √
Paying wages and salaries to employees………………………………………... √
Paying taxes to governmental bodies…………………………………………….. √
Paying interest to lenders………………………………………………………….. √
Investing Activities
Buying property, plant, and equipment…………………………………………… √
Selling property, plant, and equipment…………………………………………… √
Buying stocks and bonds as long-term investment……………………………... √
Selling stocks and bonds held for long-term investment……………………….. √
Lending money to another entity………………………………………………….. √
Collecting the principal on a loan to another entity……………………………… √
Financing Activities
Borrowing money from a creditor…………………………………………………. √
Repaying the principal amount of a debt…………………………………………. √
Collecting cash from the sale of common stock…………………………………. √
Paying cash to repurchase your own common stock…………………………… √
Paying a dividend to stockholders………………………………………………… √

Operating Activities: Direct Method or Indirect Method?

The computation of the net amount of cash inflows and outflows resulting from operating activities is
known formally as the net cash provided by operating activities, using either the direct or indirect method.

Under the direct method, the income statement is reconstructed on a cash basis from top to bottom.
For example, cash collected from customers is listed instead of revenue, and payment to suppliers is listed
instead of cost of goods sold. In essence, cash receipts are counted as revenues and cash disbursements
pertaining to operating activities are counted as expense. The difference between the cash receipts and cash
disbursements is the net cash provided by operating activities.

Under the indirect method, net income is adjusted to a cash basis. That is, rather than directly
computing cash sales, cash expenses and so forth, these amounts are derived indirectly by removing from net
income any items that do not affect cash flows. The indirect method has an advantage over the direct method
because it shows the reasons for any differences between net income and net cash provided by operating
activities.

19
The Direct Method

Operating Activities
Cash receipts from customers……………………………………. P xx
Cash payments to suppliers………………………………………. (xx)
Cash payments for operating expenses…………………………. (xx)
Cash payments for interest expense…………………………….. (xx)
Cash payments for income tax expense………………………… (xx)
Net cash provided by operating activities……………………….. P xx

Adjustment Rules for the Direct Method

Income Statement Item Adjustment Rule

Sales revenue Deduct increases in accounts receivable or

Add decreases in accounts receivable

Cost of goods sold Add increases in inventory or

Deduct decreases in inventory
and
Deduct increases in accounts payable or
Add decreases in accounts payable

Operating expenses Add increases in prepaid expenses or

Deduct decreases in prepaid expenses
and
Deduct increases in accrued liabilities or
Add decreases in accrued liabilities

Depreciation expense Do not include in operating activities because item

is a noncash expense

Interest expense Deduct increases in interest payable or

Add decreases in interest payable

Gain or loss on sale of equipment Do not include in operating activities because item
is included in investing activities

Income tax expense Deduct increases in income tax payable or

Add decreases in income tax payable

The Indirect Method: A Three-Step Process

The indirect method adjusts net income to net cash provided by operating activities using the three-step
process.

Step 1. The first step is to add depreciation charges to net income. Depreciation charges are the credits to the
Accumulated Depreciation account during the period – the sum total of the entries that have increased
Accumulated Depreciation.

To compute the credits to the Accumulated Depreciation account the equation for contra-assets will be used:

Basic Equation for Contra-Asset Accounts

Beginning balance + Debits – Credits = Ending balance

For example, assume the Accumulated Depreciation account had beginning and ending balances of P 300,000
and P500, 000, respectively. Also, assume that the company sold (debit) equipment with accumulated
depreciation of P 70,000 during the period.

Beginning balance – Debits + Credits = Ending balance

300,000 – 70,000 + Credits = 500,000
Credits = 500,000 – 300,000 + 70,000
Credits = 270,000

Step 2. The second step is to analyze the net changes in noncash balance sheet accounts that impact the net
income. Each account shown in the exhibit is referred to the balance sheet and is used in the computation of
the change in the account balance from the beginning to the end of the period. If an asset account balance
increases during the period, then the amount of the increase is subtracted from the net income. If an asset
account balance decreases during the period, the amount of the decrease is added to the net income. The
current liability accounts are handled in the opposite fashion. If a liability account balance increases, then the
amount of the increase is added to net income. If a liability account balance decreases, then the amount of the
decrease is subtracted from net income.

20
 Exhibit 2. General Guidelines for Analyzing How Changes in Noncash Balance Sheet Accounts
Affect Net Income on the Statement of Cash Flows
Increase in Decrease in
Account Balance Account Balance
Current Assets
Accounts Subtract Add
receivable…………………………… Subtract Add
Inventory………………………………………… Subtract Add
Prepaid expenses………………………………
Current Liabilities
Accounts Add Subtract
payable……………………………… Add Subtract
Accrued Add Subtract
liabilities……………………………….
Income taxes
payable………………………….

When the accounts receivable balance increases it means that the amount of credit sales exceeds the
amount of cash collected from customers. In this case, the change in accounts receivable balance is
subtracted from net income because it reflects the amount by which credit sales exceeds cash collections from
customers. When the accounts receivable balance decreases it means that cash collected from customers
exceeds credit sales. In this case, the change in accounts receivable balance is added to net income because
it reflects the amount by which cash collections from customers exceeds credit sales.
The other accounts shown in Exhibit 2 have similar underlying logic. The inventory and accounts
payable adjustments translate cost of goods sold to cash paid for inventory purchases. The prepaid expenses
and accrued liabilities adjustments help translate selling and administrative expenses to a cash basis as well
as the income taxes payable account.

Step 3. The third step in computing the net cash provided by operating activities is to adjust for gains/losses
included in the income statement. The gains and losses pertaining to the sale of noncurrent assets must be
removed from the net income as reported in the operating activities section of the statement of cash flows. To
make this adjustment, subtract gains from net income and add losses to net income in operating activities
section.

Investing and Financing Activities: Gross Cash Flows

The gross method of reporting cash flows is not used in the operating activities section of the statement
of cash flows, where debits and credits are netted against each other. To compute gross cash flows for the
investing and financing activities sections of the statement of cash flows, the changes in the balance of each
applicable balance sheet account is calculated. As with the current assets, when noncurrent asset account
balance (including Property, Plant, and Equipment; Long-Term Investments; and Loans to Other Entities)
increases, it signals the need to subtract cash outflows in the investing activities section of the statement of
cash flows. If the balance in a noncurrent asset account decreases during the period, then it signals the need
to add cash inflows. The liability and equity account (Bonds Payable and Common Stock) are handled in the
opposite fashion. If a liability or equity account balance increases, then it signals a need to add cash inflows to
the financing activities section of the statement of cash flows. If liability or equity account balance decreases,
then it signals a need to subtract cash outflows.

Exhibit 3. General Guidelines for Analyzing How Changes in Noncash Balance Sheet Accounts Affect the
Investing and Financing Sections of the Statement of Cash Flows
Increase in Decrease in Account
Account Balance
Balance
Noncurrent Assets (Investing Activities)
Property, plant, and Equipment…………………….. Subtract Add
Long-term Investments……………..…… Subtract Add
Loans to other entities……………………………... Subtract Add
Liabilities and Stockholders’ Equity (Financing
activities) Add Subtract
Bond payable………….………………………………………. Add Subtract
Common stock……..…………………………………………. * *
Retained earnings…….……………………………………….
*Requires further analysis to quantify cash dividends
paid

21
Property, Plant, and Equipment. When a company purchases property, plant and equipment it debits the
Property, Plant and Equipment account for the amount of the purchase. When it sells or disposes of these
kinds of assets, it credits the Property, Plant, and Equipment account for the original cost of the asset. To
compute the cash outflows related to Property, Plant, and Equipment we use the basic equation for assets
mentioned earlier:

Basic Equation for Asset Accounts

Beginning balance + Debits – Credits = Ending balance

For example, assume that a company’s beginning and ending balances in its Property, Plant, and Equipment
account are P 10,000 and P 18,000, respectively. In addition, during the period the company sold a piece of
equipment for P 400 cash that originally costs 1,000 and had accumulated depreciation of 700. The company
recorded a gain on the sale of 100 which had been included in the net income.
Because the company did sell equipment, we must use the basic equation of asset accounts to compute the
cash outflows as follows:

Beginning balance + Debits – Credits = Ending balance

10,000 + Debits – 1,000 = 18,000
Debits = 18,000 – 10,000 + 1,000
Debits = 9000
Summarizing the cash outflows using T-account..

Property, Plant, and Equipment

Beg. Bal. 10,000

Additions Sale of equipment

9,000 1,000
End. Bal.
18,000

So, instead of reporting an 8000 cash outflow pertaining to Property, Plant and Equipment in the investing
activities section of the statement of cash flows, the proper accounting requires subtracting the 100 gain on the
sale of equipment from net income in the operating activities section of the statement. It also requires
disclosing a 400 cash inflow from the sale of equipment and a 9,000 cash outflow for additions to PPE in the
investing activities section of the statement.

Retained Earnings. When a company earns net income it credits the Retained Earnings account and when it
pays a dividend it debits the Retained Earnings account. To compute the amount of cash dividend payment we
use the basic equation for stockholders’ equity accounts mentioned earlier:

Basic Equation for Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance

For example, assume that a company’s beginning and ending balance balances in its Retained Earnings
account are 2,000 and 3,000, respectively. In addition, the company reported net income of 1,200 and paid a
cash dividend.

Beginning balance – Debits + Credits = Ending balance

2,000 – Debits + 1,200 = 3,000
Debits = 200

Summarizing the cash outflows using T-account..

Retained Earnings
Beg. Bal.
2,000
Dividends Net income
200 1,200
End. Bal.
3,000

So, instead of erroneously reporting a 1,000 cash flow pertaining to the overall change in Retained
Earnings, the proper accounting requires disclosing net income of 1,200 within the operating activities section
of the statement of cash flows and a 200 cash dividend in the financing activities section of the statement.

22
Summary of Key Concepts

Key Concept #1 Key Concept #2

The statement of cash flows is divided into three sections: Two methods for preparing the operating activities section of
the statement of cash flows:
Operating Activities
Net cash provided by (used in) operating activities P xx Direct Method
Cash receipts from customers P xx
Investing Activities Cash paid for inventory purchases xx
Net cash provided by (used in) investing activities xx Cash paid for selling and administrative expenses xx
Cash paid for income taxes xx
Financing Activities Net cash provided by (used in) operating activities P xx
Net cash provided by (used in) financing activities xx
Indirect Method
Net increase/decrease in cash and cash equivalents xx Net income P xx
Cash and cash equivalents, beginning balance xx Various Adjustments (+/-) xx
Cash and cash equivalents, ending balance P xx Net cash provided by (used in) operating activities P xx
Key Concept #3 Key Concept #4

Computing the net cash provided by operating activities using The investing and financing sections of the statement of cash
the indirect method in a three-step process: flows must report gross cash flows:
Operating Activities Net cash provided by (used in) operating activities
Net income
Adjustment to convert net income to Investing Activities
a cash basis: Purchase of property, plant, and equipment P (xx)
Sale of property, plant, and equipment xx
Step 1 Add: Depreciation P xx Purchase of long-term investments (xx)
Sale of long-term investments xx
Analyze net changes in noncash balance Net cash provided by (used in) investing activities P xx
sheet accounts:
Step 2 Increase in current asset accounts (xx) Financing Activities
Decrease in current asset accounts xx Issuance of bonds payable P xx
Increase in current liability accounts xx Repaying principal on bonds payable (xx)
Decrease in current liability accounts (xx) Issuance of common stock xx
Purchase own shares of common stock (xx)
Adjust for gains/losses: Paying a dividend (xx)
Step 3 Gain on sale (xx) Net cash provided by (used in) financing activities xx
Loss on sale xx Net increase/decrease in cash and cash equivalents xx
Cash and cash equivalents, beginning balance xx
Net cash provided by (used in) operating P xx Cash and cash equivalents, ending balance P xx
activities

Sample Problem:

Apparel, Inc.
Income Statement
(in millions)
Sales………………………………………………………………………. P 3,638
Cost of goods sold……………………………………………………….. 2, 469
Gross margin……………………………………………………………… 1,169
Selling and administrative expenses…………………………………… 941
Net operating income……………………………………………………. 228
Non-operating items: Gain on sale of store……………………………. 3
Income before taxes……………………………………………………... 231
Income taxes…………………………………………………………….. 91
Net income……………………………………………………………….. P 140

Apparel, Inc.
Comparative Balance Sheet
(in millions)
Ending Beginning
Balance Balance
Assets
Current assets:
Cash and cash equivalents………………………………. P 91 P 29
Accounts receivable………………………………………. 637 654
Inventory……………………………………………………. 586 537
Total current assets………………………………………….. 1,314 1,220
Property, plant, and equipment…………………………….. 1,517 1,394
Less accumulated depreciation…………………………. 654 561
Net property, plant, and equipment………………………… 863 833
Total assets…………………………………………………… P2,177 P 2,053
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable………………………………………. P 264 P 220
Accrued liabilities……………………………………….. 193 190
Income taxes payable………………………………….. 75 71
Total current liabilities……………………………………… 532 481
Bonds payable……………………………………………… 479 520

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 Total liabilities……………………………………………….. 1,011 1,001
Stockholders’ equity:
Common stock…………………………………………… 157 155
Retained earnings……………………………………….. 1,009 897
Total stockholders’ equity…………………………………. 1,166 1,052
Total liabilities and stockholders’ equity…………………. P 2,177 P 2,053

Assuming the following facts with respect to Apparel, Inc.:

1. The company sold a store that had an original cost of P 15 million and accumulated
depreciation of P 10 million. The cash proceeds from the sale were P 8 million. The
gain on sale was P 3 million.
2. The company did not issue any new bonds during the year.
3. The company did not repurchase any of its own common stock during the year.
4. The company paid a cash dividend during the year.

Solution to the Sample Problem

Apparel Inc.
Statement of Cash Flows- Indirect Method
(in millions)
Operating Activities
Net income…………………………………………………………….. P 140
Adjustments to convert net income to a cash basis:
Depreciation………………………………………………………… 103
Decrease in accounts receivable………………………………… 17
Increase in inventory………………………………………………. (49)
Increase in accounts payable…………………………………….. 44
Increase in accrued liabilities…………………………………….. 3
Increase in income taxes payable………..……………………… 4
Gain on sale of store………………………………………………. (3) 119
Net cash provided by operating activities………………………….. 259
Investing Activities
Additions to property, plant, and equipment……………………….. (138)
Proceeds from sale of store…………………………………………. 8
Net cash used in investing activities………………………………… (130)
Financing Activities
Retirement of bonds payable………………………………………… (41)
Issuance of common stock………………………………………….. 2
Cash dividends paid………………………………………………….. (28)
Net cash used in financing activities………………………………... (67)
Net increase in cash………………………………………………….. 62
Cash balance, beginning…………………………………………….. 29
Cash balance, ending………………………………………………… P 91

6. Gross Profit Variation Analysis

Gross profit is the difference between sales and cost of goods sold. It is a very important figure in the
income statement because it is one of the factors that determine the final result of operations.
To conduct a meaningful analysis of the variation in gross profit, the actual gross profit during a given
period may be compared with any of the following:
a. The immediately preceding period’s figures or any given period’s figures selected as the
base for comparison
b. The same period’s budgeted or standard figures
Changes in gross profit may be attributed to the change in any, or a combination of any of the following
factors:
1. Selling price of the products
2. Volume quantity or products sold which, in turn, may be due to change in:
a. Number of physical units sold (when the company sells only one product line)
b. Product mix or sales mix which refers to the composition of the products sold ( this is
applicable to companies selling more than one product line)
3. Cost of the product sold:
a. For merchandising firms, cost refers to the net purchase cost of the product

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 b. For manufacturing firms, cost includes the three manufacturing cost elements,
namely, materials, labor and factory overhead.
PROCEDURES FOR ANALYZING GROSS PROFIT VARIATION

For the following analysis let;

A – as actual data and;
B – as budgeted, standard, previous year, or base year data
4 – Way analysis:
Sales variances:
Sales price factor:
A – Sales xx
Less: A – Sales @ B – sales price xx xx
Sales volume factor:
A – Sales @ B – sales price xx
Less: B – sales xx xx xx

Cost variances:
Cost price factor:
A - Cost of sales xx
Less: A – cost of sales @ B – cost price xx xx
Cost volume factor:
A – cost of sales @ B – cost price xx
Less: B cost of sales xx xx xx

Net change in gross profit xx

or
Sales variance:
Price factor = difference in selling prices x A units
Volume/ Quantity factor = difference in units x B price
Cost variance:
Price factor = difference in cost prices x A units
Volume/Quantity factor = difference in units x B price

6 – Way analysis:
Sales variance:
Price factor = difference in selling prices x B units
Volume/Quantity factor = difference in units x B selling price
Price - Volume factor = difference in selling price x difference in units
Cost variance:
Price factor = difference in cost prices x B units
Volume factor = difference in units x B cost price
Price – Volume factor = difference in cost prices x difference in units

The price factor refers to the change in selling or cost prices assuming that there has been
no change in units sold.
The quantity or volume factor refers to the change in the number of units sold assuming
that there has been no change in the selling or cost prices.
The price – volume factor refers to the sales or cost of sales variances due to the
combined effects of the differences in prices and units sold.

3 – Way analysis:
Quantity or Volume factor = difference in units x B gross profit per unit
Price factor = difference in selling prices x A units
Cost factor = difference in cost prices x A units

The quantity factor refers to the change in gross profit due to the difference in units sold.
The price factor refers to the change in gross profit due to the difference in selling prices.
The cost factor refers to the change in gross profit due to the difference in cost prices.

Note: the variances or differences between the figures are described as either favorable or unfavorable.
Naturally, a decrease in sales in unfavorable and a decrease in cost is favorable. A decrease in gross
profit must be described as unfavorable.

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Illustrative example:
Jam Corporation

2017 2016
Sales volume in units 5000 8000
Selling price per unit P 10 P8
Cost per unit 7
6
Solution: 4- Way Analysis

Sales
Units Selling price Total
2017 5000 P 10 P50 000
2016 8000 8 64 000
Differences 3000 U P2F P14 000 U

Cost of Sales
2017 5000 P7 P 35 000
2016 8000 6 48 000
Differences 3000 F P1U P 13 000 F
Net Change in Gross Profit P 1 000 U
or

Sales variance:
Price factor = Differences in selling prices x A units
= P 2 F x 5000 = P 10 000 F
Volume/ Quantity factor = differences in units x B price
= 3000 U x P8 = P 24 000 U P 14 000 U
Cost variance:
Price factor = Difference in cost prices x A units
= P1 U x 5000 = P 5000 U
Volume/Quantity factor = differences in units x B price
= 3000 F 6x P6
– Way Analysis = 18 000 F P 13 000 F
Net Gross Profit Variance P 1 000 U

6- Way Analysis

Sales variance:
Price factor = difference in selling prices x B units
= P2 F x 8 000 = P16 000 F
Volume/Quantity factor = difference in units x B selling price
= 3000 U x P8 = 24 000 U
Price - Volume factor = difference in selling price x difference in units
= 3000 U x P2 F = 6 000 U P14 000 U

Cost variance:
Price factor = difference in cost prices x B units
= P1 U x 8000 = P8 000 U
Volume factor = difference in units x B cost price
= 3000 F x P6 = 18 000 F
Price – Volume factor = difference in cost prices x difference in units
= 3000 F x3P1 U
– Way Analysis = 3 000 F P 13 000 F
Net Gross Profit Variance P 1 000 U

3- Way Analysis

Quantity or Volume factor = difference in units x B gross profit per unit

= 3000 x (P8-P6) = P6 000 U
Price factor = difference in selling prices x A units
= P2 F x 5000 = P10 000 F
Cost factor = difference in cost prices x A units
= P1 U x 5000 = P5 000 U
Net Gross Profit Variance P 1 000 U

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Exercise:

Buboy Enterprises

2017 2016
Sales volume in units 12 000 10 000
Selling price per unit P 10 P 9.50
Cost per unit 7.50 7. 25

Required:
Compute and analyze the variation in gross profits using:
 4 - Way Analysis
 6 - Way Analysis
 3 - Way Analysis

Agoot, Gazelem Zeryne

Andres, Stephen

Balagat, Diana Joy

Buduan, Keith Ann

Cruz, PJ Placido

Inda, Rolen

Suniga, Yvonne Carmel

Ulep, Liam Marc

Bachelor of Science in Accountancy III

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