UNIVERSITY OF BAGUIO

SBAA CPA Review

MANAGEMENT ADVISORY SERVICES

Financial Statement Analysis

Financial statement analysis involves the assessment and evaluation of the firm's past performance, its
present condition, and future business potentials. The analysis serves to provide information about the
following:
1. Profitability of the business firm;
2. The firm's ability to meet its obligations;
3. Safety of the investment in the business;
4. Effectiveness of management in running the firm; and
5. Over-all company marketability

ANALYTICAL TOOLS AND TECHNIQUES:

1. Analysis of variation in gross profit and net income
2. Cash flow statement
3. Vertical analysis (common size statements)
4. Horizontal analysis (trend ratios and percentages)
5. Financial ratios (ratio analysis

HORIZONTAL ANALYSIS- involves comparing figures shown in the financial statements of two or
more consecutive periods.

Formula:
Percentage Most recent value - Base period value
Change = -------------------------------------
Base period value

VERTICAL ANALYSIS- the process of comparing figures in the financial statements of a single period.
It involves converting the figures in the statements to a common base i.e. ratios, percentages.
Converted financial statements are called Common Size Financial Statements.

RATIO ANALYSIS- involves the development of mathematical relationships between accounts in the
financial statements.

DIFFERENT RATIOS FOR DIFFERENT USERS:

A. TESTS OF LIQUIDITY (Liquidity refers to the company's ability to pay its short-term current
liabilities as they fall due).

1. Current Ratio = Current Assets / Current Liabilities

- (Or banker's ratio or working capital ratio) measures the number of times that the current
liabilities could be paid with the available current assets.

2. Acid Test Ratio = Quick Assets* / Current Liabilities

- (Or quick ratio) measures the number of times that the current liabilities could be paid with the
available cash and near cash assets. *Cash + marketable securities + receivables.

3. Cash Ratio = Cash + MES / Current Liabilities

- measures available cash to settle maturing short-term obligations

4. Working capital activity ratios (turnovers):

a. Receivable Turnover= Net Credit Sales* / Ave. Receivables
- The time required to complete one collection cycle-from the time receivables are recorded,
then collected, to the time new receivables are recorded again.

Average age of receivables = No. of working days in yr. / Receivables turnover

- (Or days’ sales in receivables or average collection period) indicates the average number of
days during which the company must wait before receivables are collected.

b. Inventory Turnover:
Merchandising Firms
 Inventory Turnover = Cost of goods sold / Ave. Mdse. Inventory
- Measures the number of times that inventory is replaced during the period.

Average Age of Inventory = Number of Working Days / Inventory Turnover

- Indicates the average number of days during which the company must wait before
inventories are sold.

c. Operating Cycle = Ave. Age of Rec. + Ave. Age of Invent.

d. Trade Payables Turnover = Net Credit Purchases / Ave. Trade Payables

Ave. age of trade payables = No. Of working days / Payables Turnover

- Indicates the length of time during which payables remain unpaid

e. Cash flow cycle = Operating cycle - Ave. age of trade payables

f. Current Assets Turnover = Cost of Sales + Operating Expenses (excluding depreciation and
amortization) / Average Current Assets
o Measures the movement and utilization of current assets to meet operating
requirements.

4. Working Capital to total assets = Working Capital / Total Assets

- Indicates relative liquidity of total assets and distribution of resources employed.

5. Working Capital Turnover = Net Sales / Average Working Capital

- Indicates adequacy and activity of working capital.

B. TESTS OF SOLVENCY (solvency refers to the company's ability to pay all its debts, whether such
liabilities are current or non-current)

1. Times Interest Earned =Income before tax + Interest expense / Interest Expense
- Determines the extent to which operations cover interest expense

2. Debt-Equity Ratio = Total Liabilities / Total Owners' or Stockholders' equity

- Proportion of assets provided by creditors compared to that provided by owners.
Equity Multiplier = Total Owner’s Equity / Total Liabilities
-measures utilization of borrowed funds against owner’s contribution

3. Debt Ratio = Total Liabilities / Total Assets

- Proportion of total assets provided by creditors.

4. Equity Ratio = Total Owner's or Stockholders' Equity / Total Assets

- Proportion of total assets provided by owners.

5. Fixed Assets to Long-term Liabilities = Fixed Assets / Long-term liabilities

- Reflects extent of the utilization of resources from long-term debt. Indicative of sources
of additional funds.

6. Fixed assets to Total Equity = Fixed Assets / Total Equity

- Measures the proportion of owners' equity to fixed assets. Indicative of over or under
investment by owners; also weakness in "trading on the equity".

7. Fixed assets to Total Assets = Fixed Assets (Net) / Total Assets

- Indicates possible over expansion of plant and equipment.

8. Sales to fixed assets (plant turnover) = Net Sales / Fixed Assets (Net)
- Test roughly the efficiency of management in keeping plant properties employed.

9. Book value per share on common stock = Common stock equity / # of outstanding common
stock
- Measures recoverable amount in the event of liquidation if assets are realized at their book
values.
10. Times Preferred Dividend requirements = Net income After Taxes / Preferred Dividend
Requirements
- Indicates ability to provide dividends to preferred stockholders.

11. Times Fixed Charges Earned

= Net income before taxes and fixed charges /
Fixed charges (rent + interest + Sinking fund payment before taxes)
- Measures ability to meet fixed charges.

12. Sinking fund payments bef. Tax = Sinking fund payment after taxes / 1 - Tax Rate

C. TESTS OF PROFITABILITY

1. Return on Sales = Income after tax/ Net Sales

- Determines the amount of income earned on each peso sales.

Gross Profit Ratio = Gross Profit / Net Sales

2. Return of Total Assets (ROA) = Earnings before Interest after tax / Average total assets
- Efficiency with which managers use total assets to operate the business.

3. Return on Owners' equity = Earnings after tax / Ave. Owners' Equity

- Measures the amount earned on the owners' or stockholders' investment.

4. Earnings Per Share = Net Income - Preferred Dividends (in any) /

Weighted Ave. Number of Common Shares
- Measures the amount of net income earned buy each common share.

5. Rate of Return on Current Assets = Net Income / Average Current Assets

- Measures the profitability of current assets invested.

6. Rate of Return Per turnover of current Assets

= Rate of Return on Ave. Current Assets / Current Assets Turnover
- Shows profitability of each turnover of current assets.

D. MARKET TESTS:

1. Price/Earnings Ratio (P/E) = Price Per Share / Earnings Per Share

- Indicates the number of pesos required to buy P1 of earnings

2. Dividend Yield = Ordinary Dividend Per Share / Price Per Share

- Measures the rate of return in the investor's common stock investments.

3. Dividend Pay-out = Ordinary Dividend Per Share / Earnings Per Share

- Indicates the proportion of earnings distributed as dividends.

4. Plow-back ratio= 1-Dividend Pay-out

-measures internal financing for capital investment projects

5. Earnings Yield = Earnings Per Share / Price Per Share

- determines earnings generated for every peso invested
 REVIEW QUESTIONS

1. The gross margin percentage is equal to:

A) (Net operating income + Operating expenses)/Sales
B) Net operating income/Sales
A C) Cost of goods sold/Sales
D) Cost of goods sold/Net income

2. Earnings per share of common stock is computed by:

A) dividing net income by the average number of common and preferred
shares outstanding.
B) dividing net income by the average number of common shares
outstanding.
D C) dividing net income minus preferred dividends by the average number
of common and preferred shares outstanding.
D) dividing net income minus preferred dividends by the average number
of common shares outstanding.

3. Which of the following is true regarding the calculation of return on

total assets?
A) The numerator of the ratio consists only of net income.
B) The denominator of the ratio consists of the balance of total
assets at the end of the period under consideration.
D C) The numerator of the ratio consists of net income plus interest
expense times the tax rate.
D) The numerator of the ratio consists of net income plus interest
expense times one minus the tax rate.

4. Which of the following is not a source of financial leverage?

A) Bonds payable.
B) Accounts payable.
D
C) Interest payable.
D) Prepaid rent.

5. The book value per share of common is usually significantly different

from the market value of the common stock because of:
A) the omission of total assets from the numerator in the calculation
of the book value per share.
B) the use of the matching principle in preparing financial
D statements.
C) the omission of the number of preferred shares outstanding in the
calculation of the book value per share.
D) the use of historical costs in preparing financial statements

6. Sale of a piece of equipment at book value for cash will:

A) increase working capital.
B) decrease the acid-test ratio.
A C) decrease the debt-to-equity ratio.
D) increase net income.

7. A company's current ratio is greater than 1. Purchasing raw materials

on credit would:
A) increase the current ratio.
B) decrease the current ratio.
B C) increase net working capital.
D) decrease net working capital.

8. Zack Company has a current ratio of 2.5. What will be the effect of a
purchase of inventory with cash on the acid-test ratio and on working
capital?

Acid-test ratio Working Capital

B
A) decrease decrease
B) decrease no effect
C) no effect decrease
D) no effect no effect
 9. Solomon Company has a current ratio greater than 1 and an acid-test
ratio less than 1. How would cash payments to suppliers to reduce
accounts payable affect these ratios?
Current ratio Quick ratio
C
A) Decreased Decreased
B) Decreased Increased
C) Increased Decreased
D) Increased Increased

10. Norton Inc. could improve its current ratio of 2 by:

A) paying a previously declared stock dividend.
B) writing off an uncollectible receivable.
C C) selling merchandise on credit at a profit.
D) purchasing inventory on credit.

11. How is the average inventory used in the calculation of each of the
following?
Acid-test Inventory
(quick) ratio turnover rate
A) Numerator Numerator
C B) Numerator Denominator
C) Not used Denominator
D) Not used Numerator

12. Bernadette Company has an acid-test (quick) ratio of 2.0. This ratio
would decrease if:
A) previously declared common stock dividends were paid.
B) the company collected an account receivable.
C) the company sold merchandise on open account that earned a normal
D gross margin.
D) the company purchased inventory on open account.

13. Sand Company has an acid-test ratio of 0.8. Which of the following
actions would improve the acid-test ratio?
A) Collect some accounts receivable.
B) Acquire some inventory on account.
C) Sell some equipment for cash.
C
D) Use cash to pay off some accounts payable.

14. Assuming stable business conditions, a decrease in the accounts

receivable turnover ratio could be explained by:
A) an easing of policies with respect to the granting of credit to
customers.
A B) stricter policies with respect to the granting of credit to
customers.
C) a speedup in collection of accounts from customers.
D) none of these.

15. Accounts receivable turnover will normally decrease as a result of:

A) the write-off of an uncollectible account against the allowance for
bad debts.
B) a significant sales volume decrease near the end of the accounting
period.
D C) an increase in cash sales in proportion to credit sales.
D) a change in credit policy to lengthen the period for cash
discounts.

16. Stern Company has 100,000 shares of common stock and 20,000 shares of
preferred stock outstanding. There was no change in the number of
common or preferred shares outstanding during the year. Preferred
stockholders received dividends totaling P140,000 during the year.
D Common stockholders received dividends totaling P210,000. If the
dividend payout ratio was 70%, then the net income was:
A) P200,000 B) P300,000 C) P500,000 D) P440,000
 17. The market price per share of Farren Co. stock at the beginning of the
year was P60.00 and at the end of the year was P72.00. Net income for
the year was P48,000. Dividends to the preferred stockholders for the
D year totaled P12,000, and dividends of P2.50 per share were paid on
the 6,000 shares of common stock outstanding during the year. The
price-earnings ratio at year end was:
A) 10 B) 6 C) 11 D) 12

18. Fackrell Company has provided the following data:

Common stock:
Shares outstanding ........... 20,000
Market value, December 31 .... P150,000
Book value, December 31 ...... P80,000
Dividends paid ............... P40,000
B Preferred stock, 8%, 100 par .. P100,000
Net income .................... P100,000
Interest on long-term debt .... P10,000

The price-earnings ratio is closest to:

A) 1.50 B) 1.63 C) 2.50 D) 2.88

19. Farrell Company has provided the following data:

Common stock:
Shares outstanding ........... 30,000
Market value, December 31 .... P165,000
Book value, December 31 ...... P90,000
Dividends paid ............... P50,000
B Preferred stock, 10%, P100 par P100,000
Net income .................... P150,000
Interest on long-term debt .... P15,000

The price-earnings ratio is closest to:

A) 1.10 B) 1.18 C) 1.65 D) 1.83

20. Cammer Company has 40,000 shares of common stock outstanding. The
following data pertain to these shares for the most recent year:
Price originally issued .. P25 per share
Book value, December 31 .. P40 per share
Market value, January 1 .. P50 per share
Market value, December 31 P60 per share

The total dividend on common stock was P480,000. Cammer Company's

dividend yield ratio for the year was:
A) 24% B) 20% C) 48% D) 30%

21. Cameron Company has 40,000 shares of common stock outstanding that it
originally issued for P30 per share. The following data pertains to
these shares for the most recent year:
Book value, December 31 .. P60 per share
Market value, January 1 .. P75 per share
Market value, December 31 P80 per share

The total dividend on common stock was P360,000. The dividend yield
ratio for the year was:
A) 11.25% B) 12.00% C) 15.00% D) 30.00%

22. Tribble Company has provided the following data:

Sales ......................... P5,000,000
Interest expense .............. P30,000
Total assets, beginning of
year ......................... P185,000
Total assets, end of year ..... P215,000
Tax rate ...................... 30%
Return on total assets ........ 15.5%
Tribble Company's net income was:
A) P1,000 B) P10,000 C) P22,000 D) P31,000
23. Jense Company's return on common stockholders' equity is 16%. Midtown
Bank has offered a P100,000 loan at an annual interest rate of 14%.
Jense currently has 50,000 shares of common stock and 10,000 shares of
8% preferred stock outstanding. The financial leverage of the loan
would be:
A) positive.
B) negative.
C) neither positive nor negative.
D) cannot be determined with the data given.

24. If a company can borrow at an interest rate of 8%, the tax rate is
30%, and the company's assets are generating an after-tax return of
7%, then financial leverage is:
A) positive.
B) negative.
C) neither positive nor negative.
D) impossible to determine without knowing the return on common
stockholders' equity.

25. The following account balances have been provided for the end of the
most recent year:

Total assets .................. P1,000,000

Total liabilities ............. P400,000
Total stockholders’ equity .... P600,000
Common stock (40,000 shares) .. P300,000
Preferred stock (10,000
shares) ...................... P100,000

The common stock's book value per share is:

A) P22.50 B) P12.50 C) P20.00 D) P12.00

26. Nybo Company's current liabilities are P60,000, its long-term

liabilities are P180,000, and its working capital is P90,000. If Nybo
Company's debt to equity ratio is 0.4, its total long-term assets must
equal:
A) P490,000 B) P840,000 C) P600,000 D) P690,000

27. Nelson Company's current liabilities are P50,000, its long-term

liabilities are P150,000, and its working capital is P80,000. If
Nelson Company's debt-to-equity ratio is 0.32, its total long-term
assets must equal:
A) P625,000 B) P745,000 C) P825,000 D) P695,000

28. Selected data from Perry Corporation's financial statements follow:

Current ratio ........................... 2.0

Acid-test ratio ......................... 1.5
Current liabilities ..................... P120,000
Inventory turnover ...................... 8
Gross profit margin as a percentage of
sales .................................. 40%

The company has no prepaid expenses and there were no changes in

inventories during the year. Perry Corporation's net sales for the
year were:
A) P800,000 B) P480,000 C) P1,200,000 D) P240,000

29. Mattick Company has provided the following data:

Inventory and prepaid expenses P36,000
Current ratio ................. 2.4
Acid-test ratio ............... 1.6

Mattick Company's current liabilities are:

A) P60,000 B) P30,000 C) P45,000 D) P48,000
30. The Seabury Company has a current ratio of 3.5 and an acid-test ratio
of 2.8. Inventory equals P49,000 and there are no prepaid expenses.
Seabury Company's current liabilities must be:
A) P70,000 B) P100,000 C) P49,000 D) P125,000

31. Matlock Company has provided the following data:

Inventory and prepaid expenses P35,000
Current ratio ................. 2.2
Acid-test Ratio ............... 1.5

Matlock Company's current liabilities were:

A) P40,000 B) P50,000 C) P63,000 D) P44,100

32. A company's current ratio is 2. According to the fine print in its

bond agreements, the company cannot allow its current ratio to fall
below 1.5 without defaulting on the debt and going into bankruptcy. If
current liabilities are P200,000, what is the maximum amount of
additional new short-term debt the company can take on without
defaulting if the new debt is used to finance new current assets?
A) P200,000 B) P66,667 C) P266,667 D) P150,000

33. Windham Company has current assets of P400,000 and current liabilities
of P500,000. Windham Company's current ratio would be increased by:
A) the purchase of P100,000 of inventory on account.
B) the payment of P100,000 of accounts payable.
C) the collection of P100,000 of accounts receivable.
D) refinancing a P100,000 long-term loan with short-term debt.

34. The Carney, Inc. has sales of P5 million per year (all credit) and an
average collection period of 35 days. What is its average amount of
accounts receivable outstanding?
A) P479,452 B) P142,857 C) P150,000 D) P500,000

35. Peavey Company's accounts receivable were P430,000 at the beginning of

the year and P480,000 at the end of the year. Cash sales were P175,000
for the year. The accounts receivable turnover was 5. Peavey Company's
total sales for the year were:
A) P3,150,000 B) P2,450,000 C) P2,275,000 D) P2,575,000

36. The accounts receivable for Note Company was P240,000 at the beginning
of the year and P260,000 at the end of the year. If the accounts
receivable turnover for the year was 8 and 20% of the total sales were
cash sales, the total sales for the year were:
A) P2,600,000 B) P2,000,000 C) P2,400,000 D) P2,500,000

37. The accounts receivable for Allegro Company was P140,000 at the
beginning of the year and P180,000 at the end of the year. The
accounts receivable turnover for the year was 8.5 and 15% of total
sales were cash sales. The total sales for the year were:
A) P1,400,000 B) P1,360,000 C) P1,600,000 D) P1,800,000

38. Last year Chatham Company purchased P500,000 of inventory. The cost of
goods sold was P550,000 and the ending inventory was P100,000. The
inventory turnover for the year was:
A) 4.0 B) 4.4 C) 5.5 D) 11.0

39. Last year Truro Company purchased P800,000 of inventory. The cost of
goods sold was P750,000 and the ending inventory was P125,000. The
inventory turnover for the year was:
A) 6.0 B) 7.5 C) 6.4 D) 8.0

40. Last year Jungo Company purchased P550,000 of inventory. The inventory
balance at the beginning of the year was P200,000 and the cost of
goods sold was P650,000. The inventory turnover was closest to:
A) 6.50 B) 4.33 C) 3.67 D) 3.25
41. The following information is available for Weston Company:
Year 2 Year 1
Sales ................... P1,800,000 P1,400,000
Inventory, year-end ..... P210,000 P190,000
Bad debt expense ........ P10,000 P12,000
Cost of goods sold ...... P920,000 P840,000

The inventory turnover for Year 2 is:

A) 4.4 B) 4.6 C) 9.0 D) 8.0

42. Selected information from the accounting records of Kay Company for
the most recent year follow:

Net sales ............... P1,800,000

Cost of goods sold ...... P1,200,000
Inventory, beginning .... P360,000
Inventory, ending ....... P312,000

Kay's inventory turnover for the year is closest to:

A) 3.57 B) 3.85 C) 5.36 D) 5.77

43. Last year James Company purchased P400,000 of inventory. The inventory
balance at the beginning of the year was P150,000 and the cost of
goods sold for the year was P425,000. The inventory turnover for the
year was:
A) 2.83 B) 2.91 C) 3.09 D) 3.40

44. Spotech Co.'s budgeted sales and budgeted cost of sales for the coming
year are P212,000,000 and P132,500,000 respectively. Short-term
interest rates are expected to be 5%. Assume that all inventory must
be financed with short-term debt. If Spotech could increase inventory
turnover from its current 8 times per year to 10 times per year, its
expected interest cost savings in the current year would be:
A) P165,625 B) P0 C) P331,250 D) P81,812

45. Neelty Corporation has interest expense of P16,000, sales of P600,000,

a tax rate of 30%, and after-tax net income of P56,000. What is the
firm's times interest earned ratio?
A) 6.0 B) 5.0 C) 4.5 D) 3.5

46. K.T. Company has sales of P400,000, interest expense of P12,000, a tax
rate of 40%, and after-tax net income of P50,400. K.T. Company's times
interest earned ratio is closest to:
A) 4.2 B) 11.5 C) 5.2 D) 8.0

47. Whitney Company has a times interest earned ratio of 3.0. The
company's tax rate is 40% and its interest expense is P21,000. The
company's after-tax net income is closest to:
A) P63,000 B) P25,200 C) P21,000 D) P42,000

48. KMT Company has sales of P200,000, interest expense of P6,000, a tax
rate of 40%, and after-tax net income of P30,000. KMT Company's times
interest earned ratio is closest to:
A) 5.0 B) 6.0 C) 9.3 D) 13.5

49. Houston Company has a times interest earned ratio of 2.5. The
company's tax rate is 40% and its interest expense is P20,000. The
company's after-tax net income is:
A) P50,000 B) P20,000 C) P30,000 D) P18,000

50. Falmouth Company's debt to equity ratio is 0.6. Current liabilities

are P120,000, long term liabilities are P360,000, and working capital
is P140,000. Total assets of the company must be:
A) P600,000 B) P1,200,000 C) P800,000 D) P1,280,000
 The CSC Company for the prior year that has maintained the following
relationships among the data on its financial statements.
Accounts receivable turnover 8 times
Inventory turnover 6 times
Gross margin on sales 40%
Net income to net sales 10%
Current ratio 3 to 1
Quick ratio 2 to 1
Quick assets: Cash – 8%; Marketable securities – 32%; Accounts receivable –
60%
Asset turnover 2 times
Ratio of total assets to intangible assets 20 to 1
Ratio of accumulated depreciation to cost of fixed assets 1 to 2
Net income for the year P240,000
Accounts were reconstructed based on the above information.

51. What is the balance of the cash account?

a. P50,000 b. P40,000 c. P70,000 d. P60,000

52. What is the inventory account balance?

a. P300,000 b. P250,000 c. P200,000 d. P240,000

53. What is the total cost of property and equipment?

a. P390,000 b. P585,000 c. P350,000 d. P500,000

The December 31, 20x9 balance sheet of EARTH INC. is presented below.
This are the only accounts in EARTH's balance sheet. Amounts indicated by a
question mark (?) can be calculated from the additional information given
ASSETS:
Cash P25,000
Accounts receivable (net) ?
Inventory ?
Property, plant and equipment net 294,000
432,000
LIABILITIES & STOCKHOLDERS'
EQUITY:
Accounts payable P ?
Income taxes payable (current) 25,000
Long-term debts ?
Common stock 300,000
Retained earnings P ?
P ?
ADDITIONAL INFORMATION:
Current ratio at year end 1.5 to 1
Total liabilities divided by total stock holders' equity 0.8
Inventory turnover based on sales & ending inventory 15 times
Inventory turnover based on CGS and ending inventory 10.5 times
Gross margin for 20x9 P315,000

54. What was EARTH's Dec. 31, 20x9, balance in trade accounts payable?
a. P67,000 b. P92,000 c. P 182,000 d. P207,000

55. What was EARTH's Dec. 31, 20x9 balance of retained earnings?
a. (P60,000) b. P60,000 c. (P132,000) d. P132,000

56. What was EARTH's Dec. 31, 20x9 balance in inventory accounts?
a. P21,000 b. P30,000 c. P70,000 d. P135,000