Finance 2
Financial Management
Evaluating Operating and Financial Performance
Canoy, Riz D.
Cardinales, Juji G.
Cariscal, Jessa S.
INTRODUCTION
This output paper contains discussion on the following broad topics:
a.
b.
c.
d.
Why is it important that we learn what we could on these topics? What could it give us? What is
its implication in our daily lives?
Being students who study accounting, we look forward to being a Certified Public Accountant
someday. However, the profession does not stop at simply being an accountant. We may
become managers someday, or analysts who can influence decisions of businessmen.
Understanding the aforementioned topics would take us farther than what we could reach by
knowing only the processes of accounting. Financial statements are the end product of our
profession, but it is our belief that when we take one step farther by learning how to understand
the financial statements that we have prepared, and by knowing how to extract information from
all the reports we have made, we become individuals who are capable of something beyond
what is expected from us. Thus, we could give more to our employers and elevate our
professional level to its maximum.
The basic financial reports are a wealth of reports intended to inform all interested parties about
the financial activities of a business organization. The reports reflect the basic business
functions with respect to financing, investing, and operating activities. By analyzing the financial
statements, one will come to know the financial health, effectiveness ad dynamism of an
organization. Put it simply, behind the numbers presented in the financial statements are
interesting stories of strategies and performances.
We shall now embark on our journey towards learning new things and discovering the
implications of the numbers reported on the financial statements that we will be preparing in the
exercise of our chosen path. However, put into mind that this output paper is made for
accountancy students. Thus, readers are expected to have the know-how on some topics that
were chosen not to be included in this report since it would be too redundant to do such.
DISCUSSION
Understanding Financial Statements
In this section, we will only discuss the following topics:
a. Sources of information about a business enterprise
b. Benefits of disclosure
c. Constraints on relevant and reliable information
Topics such as general objectives of financial statements, users of financial information, and the
contents of financial statements are excluded in this report since readers are assumed to have
mastered details of such in their previous accounting subjects.
a. Sources of information about a business enterprise
In general, the quantity and quality of accounting information that companies supply are
determined by the managers assessment of the benefits and costs of disclosure. In the
Philippines, publicly listed companies must file financial accounting information with the
Securities and Exchange Commission (SEC). These are:
i. Audited financial report that includes the four financial statements (Statement of
Financial Position, Statement of Comprehensive Income, Statement of Stockholders
Equity, and Statement of Cash Flows) with explanatory notes and the managements
discussion and analysis of financial results;
ii. Unaudited quarterly or interim reports that include summary version of the four financial
statements and limited additional disclosure.
All other registered corporations and partnerships are likewise required to file annually
audited financial statements with accompanying explanatory notes with the SEC.
b. Benefits of disclosure
The advantages of supplying accounting information extend to a companys capital,
labor, input, and output markets. Companies compete in these markets.
The companys ability to disclose reliable (audited) accounting information about its
product, processes and other business activities enable them to better compete in
capital, labor, input, and output markets.
c. Constraints on relevant and reliable information
i.
Timeliness
If there is undue delay in the reporting of information, it may lose its relevance.
Management may need to balance the relative merits of timely reporting and the
provision of reliable information.
ii.
The benefits derived from information should exceed the cost of providing it. The
evaluation of benefits and costs is, however, substantially a judgmental process.
iii.
iv.
Although financial statement analysis is a 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.
The limitations are as follows:
Information derived by the analysis are not absolute measures of performance in any
and all of areas of business operations. They are only indicators of degrees of
profitability and financial strength of the firm.
ii. Limitations inherent in the accounting data the analyst works with. These are brought
about by among others: (a) variation and lack of consistency in the application of
accounting principles, policies, and procedures, (b) too-condensed presentation of data,
and (c) failure to reflect change in purchasing power.
iii. Limitations of the performance measures or tools and techniques used in the analysis.
Quantitative measurements are not absolute measures but should be interpreted relative
to the nature of the business and in the light of past, current, and future operations.
Timing of transactions and the use of averages can also affect the results obtained in
applying the techniques in financial analysis.
iv. Analysts should be alert to the potential for management to influence the outcome of
financial statements in order to appeal to creditors, investors, and others.
i.
Sample Problem:
2009
Php 17, 556
2007
Php 19, 860
6.92% decrease
11.60% decrease
93.08%
88.40%
Increase (Decrease)
During 2009
Amount
Percent
2008
P 1,020,000
800,000
15,000
P 1,835,000
945,000
632,500
17,500
P 1,595,000
344,500
487,500
832,000
275,400
727,600
1,003,000
P 1,835,000
303,000
497,000
800,000
270,000
525,000
795,000
P 1,595,000
75,000
167,500
(2,500)
240,000
7.9%
26.5%
(14.3%)
15.0%
41,500
(9,500)
32,000
13.7%
(1.9%)
4.0%
5,400
202,600
208,000
240,000
2.0%
38.6%
26.2%
15.0%
The comparative balance sheets in the above illustration show that a number of
significant changes have occurred in the department stores financial structure
from 2008 to 2009:
i. In the assets section, plant assets (net) increased P 167,500 or 26.5%.
ii. In the liabilities section, current liabilities increased P 41,500 or 13.7%.
iii. In the stockholders equity section, retained earnings increased P 202,600 or 38.6%.
These changes suggest that the company expanded its asset base during 2009
and financed this expansion primarily by retaining income rather than assuming
additional long-term debt.
ii. Vertical (Common-size) Analysis
Vertical (common-size) analysis evaluates financial statement data by expressing
each item in a financial statement as a percent of base amount.
It is used both in intra- and intercompany comparisons.
Sample Problem:
Income Statement (Intracompany Vertical Analysis)
Quality Department Store, Inc.
Condensed Income Statement
For the Years Ended December 31
2009
2008
Sales Revenue
Sales return and allowances
Net Sales
Cost of goods sold
Gross profit
Selling expenses
Administrative expenses
Total operating expenses
Income from operations
Other revenues and gains
Interest and dividends
Other expenses and losses
Interest expense
Income before income taxes
Income tax expense
Net income
Amount
P 2,195,000
98,000
2,097,000
1,281,000
816,000
253,000
104,000
357,000
459,000
Percent
104.7%
4.7%
100.0%
61.1%
38.9%
12.0%
5.0%
17.0%
21.9%
Amount
P 1,960,000
123,000
1,837,000
1,140,000
697,000
211,500
108,500
320,000
377,000
Percent
106.7%
6.7%
100.0%
62.1%
37.9%
11.5%
5.9%
17.4%
20.5%
9,000
0.4%
11,000
0.6%
36,000
432,000
168,200
263,800
1.7%
20.6%
8.0%
12.6%
40,500
347,500
139,000
208,500
2.2%
18.9%
7.5%
11.4%
The vertical analysis of the companys income statements show that cost of
goods sold as a percentage of net sales declined, and total operating expenses
declined. As a result, net income increased as a percent of net sales. The
company appears to be a profitable business that is becoming even more
successful.
Net Sales
Cost of goods sold
Gross profit
Selling and administrative
expenses
17.0%
Percent
100.0%
60.6%
39.4%
35.7%
459
21.9%
195
264
9.3%
12.6%
663,000
3.7%
412,000
251,000
2.3%
1.4%
5. Profitability ratios
These ratios give an idea of how profitably the firm is operating and
utilizing its assets. Profitability ratios combine asset and debt
management categories and show their effects on return on equity.
Formula
Total Current Assets_
Total Current Liabilities
Significance
Primary test of solvency
to meet current
obligations from current
assets as a going
concern; measure of
adequacy of working
capital
Working Capital
Total Assets
Cash + Marketable
Securities + Cash Flow
from Operating Activities
Current Liabilities
Measures short-term
liquidity by considering
as cash resources
(numerator) cash plus
cash equivalents plus
cash flow from operating
activities
___Quick Assets_____
Projected Daily
Operational Expenses
Formula
Net Credit Sales*
Average Trade
Receivable (net)
* net sales if net credit sales
figure is not available
Average collection
period or number of
days sales uncollected
360 days_______
Receivable Turnover
or
Significance
Velocity of collection of
trade accounts and
notes; test of efficiency of
collection
Accounts Receivable
Net Sales / 360
Merchandise turnover
Finished goods
inventory turnover
Goods in process
turnover
Days supply in
inventory
Working capital
turnover
Percent of each current
Measures efficiency of
the firm in managing and
selling inventories
Measures efficiency of
the firm in managing and
selling inventories
Cost of Goods
Manufactured____
Average Goods-inProcess Inventory
Raw Materials Used__
Average Raw Materials
Inventory
Measures efficiency of
the firm in managing and
selling inventories
Number of times raw
materials inventory was
used and replenished
during the period
360 days______
Inventory Turnover
Measures average
number of days to sell or
consume the average
inventory
Net Sales_______
Average Working Capital
Indicates relative
asset item______
Total Current Assets
Cost of Sales +
Operating Expenses +
Income Taxes + Other
Expenses (net, excluding
depreciation and
investment in each
current asset
Measures movement and
utilization of current
resources to meet
operating requirements
amortization)_____
Average Current Assets
Payable turnover
Net Purchases____
Average Accounts
Payable
Operating cycle
Average Conversion
Period of Inventories +
Average Collection
Period of Receivable +
Days Cash
Days cash
Measures availability of
cash to meet average
daily cash requirement
Investment or assets
turnover
Net Sales______
Average Total Investment
or Total Assets
Measures efficiency of
the firm in managing all
assets
Net Sales_______
Average Fixed Assets
(net)
Total Assets
Net Sales
Measures efficiency of
the firm to generate sales
through employment of
its resources
Equity ratio
Formula
Total Liabilities
Total Assets
Significance
Shows proportion of all
assets that are financed
with debt
Total Equity
Total Assets
Indicates proportion of
assets provided by
owners; reflects financial
strength and caution to
creditors
Total Liabilities
Total Equity
Reflects extent of
investment in long-term
assets financed from
long-term debt
Measures investment in
long-term capital assets
Ordinary Shareholders
Equity_______
No. of Outstanding
Ordinary Shares
Measures recoverable
amount in the event of
liquidation if assets are
realized at their book
values
Times preferred
dividend requirement
earned
Indicates ability to
provide dividends for
preference shareholders
Measures coverage
capability more broadly
than times interest
earned by including other
fixed charges.
Formula
Gross Profit
Net sales
Significance
Measures profit
generated after
consideration of cost of
product sold
Operating Profit
Net Sales
Net Profit
Net Sales
Measures profit
generated after
consideration of all
expenses and revenues
Rate of Return on
Assets (ROA)*
______Net Profit______
Average Total Assets
Measures overall
efficiency of the firm in
managing assets and
generating profits
or
Measures profit
generated after
consideration of
operating costs
Asset Turnover
x
Net Profit Margin
* If there is interest bearing
A measure of productivity of
Rate of Return on
equity (ROE)
_____Net Income______
Average Ordinary Equity
or
Return on Assets x
Equity Multiplier*
* Equity multiplier = 1/Equity
Ratio
Price/earnings ratio
Measures relationship
between the price of
ordinary shares in the
open market and profit
earned on a per share
basis.
Dividend Payout
Shows percentage of
earnings paid to
shareholders.
Dividend Yield
Dividends Paid/Declared
Ordinary Shares
Outstanding
Rate of Return on
Average Current
Assets
_____Net Income______
Average Current Assets
Rate of Return on
Average Current Assets
Current Assets Turnover
Shows profitability of
each turnover of current
Assets
assets
Net
RO
Net x
E =Income
x
Average
Sale
= Inco
Stockholders
s__
me
SaleEquity
Aver
age
s
Total
Asse
ts
Average
Total
Assets
Average
Stockhol
ders
Equity
Financial Leverage
amount of profit
Asset turnover is a productivity measure that reflects the volume of sales that a company
generates from each peso invested in sales.
Financial leverage measures the degree to which the company finances its assets with
debt rather than equity.
Direct Method
Indirect Method
CVP Analysis
Sales Mix
Profit Planning
Operating Leverage
Financial Leverage
Combined Leverage
Leverage represents the use of fixed costs items to magnify the firms results. It is important to
keep in mind that leverage is a two-edged sword producing highly favorable results when
things go well, and the opposite when under negative conditions.
a. CVP Analysis
Cost-volume-profit analysis is a powerful tool and vital in many business decisions
because it helps managers understand the relationships among cost, volume, and profit.
This analysis is focused on how profits are affected by selling prices, sales volume, unit
variable costs, total fixed costs, and mix of products sold.
The following assumptions underlie each CVP analysis:
- The behavior of both costs and revenue is linear throughout the relevant
range of the activity index.
- Costs can be classified accurately as either variable or fixed.
- Changes in activity are the only factors that affect costs..
- All units produced are sold.
- When more than one type of product is sold, the sales mix will remain
constant.
When these assumptions are not valid, the analysis may be inaccurate.
If costs are known, the following relationships may be established:
1. Contribution margin per unit or marginal income per unit
This is the excess of unit selling price over unit variable costs and the amount each
unit sold contributes toward covering fixed costs and providing operating profits.
CM ratio =
Contribution
Margin per Unit
Unit
selling price
The starting point in many business plans is to determine the break-even point.
Break-even point is the level of sales volume where total revenues and total expenses
are equal, that is, there is neither profit nor loss. This point can be determined by using
CVP analysis. Computation is as follows:
BEP (pesos) =
Total Fixed
Cost________
Variable Cost
Sales
Weighted
Contribution Margin
per unit =
Unit CM x No. of
Units + Unit CM x
No. of Units
per mix_____
______per
mix____
Total Number of
Units per Sales Mix
Weighted CM Ratio=
_ Total
Weighted CM (P)_
Total Weighted
Sales (P)
CVP analysis can be used to determine the level of sales needed to achieve a desired
level of profit. The equations that may be used to compute for target sales are:
Degree of Operating
Leverage =
Contribution Margin_
Net Operating
Income
Degree of
Operating
Leverage =
Percent
change in
Operating Income_
Percent
change in Volume
Using this value, however, has its limitation. In an analysis using operating leverage, it is
assumed that a constant or linear function exists for revenues and costs as volume
changes.
Operating leverage influences the mix of plant and equipment.
e. Financial Leverage
Financial leverage reflects the amount of debt used in the capital structure of the firm.
It determines how the operation is to be financed. It is possible for two firms to have
equal operating capabilities and yet show widely different results because of the use of
financial leverage.
Financial leverage indicates the percentage change in Earnings per Share (EPS) that
occurs as a result of percentage change in Earnings before Interest and Taxes (EBIT).
Degree of Financial
Leverage =
Percent change in
EPS_
Percent change in
EBIT
Degree of Financial
Leverage =
__ EBIT__
EBIT
I
The use of financial leverage in analysis, however, also has its limitation. Debt financing
and financial leverage offer unique advantages but only up to a point that debt financing
may be detrimental to the firm.
f.
Combined Leverage
Degree of combined leverage uses the entire income statement and shows the impact of
a change in sales or volume on bottom-line earnings per share.
Degree of Combined Leverage =
Percent change in EPS_____
Percent change in Sales (or Volume)
Degree of Combined Leverage =
Q (P VC)_____
Q (P VC) FC I
References
Agamata, F. T. (2012 Edition). Management Advisory Services (A Comprehensive Guide).
Cabrera, M. E. (2012-2013 Edition). Financial Management Principles and Applications
Comprehensive Volume. Manila, Philippines: GIC Enterprises & Co., Inc.
Weygandt, J., Kimmel, P., & Kieso, D. (10th Edition). Accounting Principles (International
Student Version). Asia: John Wiley & Sons, Inc.