Chapter 1: Introduction to Financial Management

Purpose of the chapter:

 To define finance, its major areas and opportunities, and the legal forms of business
organization.
 To understand the managerial finance function and its relationship to economics and
accounting.
 To know the primary activities of the financial manager.
 To explain the goal of the firm, corporate governance, the role of ethics, and the
agency issue.
 To understand financial institutions and markets, and the role they play in managerial
finance.

Finance is a broad term that describes how money is acquired and how money is managed.
It encompasses the oversight, creation, and study of money, banking, credit, investments,
assets, and liabilities that make up financial systems.

Major Areas of Finance

Management is the process of taking care of something. Management is often associated

with business practices as businesses are often fragile, especially during early operations.
The practice of modern management originates from the 16 th-century study of low
efficiency and failures of certain enterprises, conducted by the English statesman Sir Thomas
More (1478-1535). Management consists of the interlocking functions of creating corporate
policy and organizing, planning, controlling, and directing an organization's resources to
achieve the objectives of the business organization.

Areas of Management

Financial Management means planning, organizing, directing, and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to the financial resources of the enterprise.

Financial management focused on the risk-return relationship and the maximization of

return for a given level of risk.

Financial managers attempt to achieve wealth maximization through daily activities such as
credit and inventory management and through longer-term decisions related to raising
funds.
Financial managers must carefully consider domestic and international business conditions
in carrying out their responsibilities.

Objectives of Financial Management

Financial management is generally concerned with the procurement, allocation, and control
of financial resources of a concern. Its objectives are:

1. To ensure a regular and adequate supply of funds to the concern.

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 2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, the market price of the share, and expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in the maximum possible way at the least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures to
achieve an adequate rate of return.
5. To plan a sound capital structure, there should be a sound and fair composition of
capital to maintain a balance between debt and equity capital.

Primary Activities of a Financial Manager

1. Estimation of capital requirements: A finance manager has to estimate with regard

to the capital requirements of the company. This will depend upon expected costs
and profits and future programs and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of the enterprise.
2. Determination of capital composition: Once the estimation has been made, the
capital structure has to be decided. This involves short-term and long-term debt-
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn in form of bonds.

The choice of factor will depend on the relative merits and demerits of each source
and period of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns are
possible.
5. Disposal of surplus: The net profits decision has to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like a bonus.
b. Retained profits - The volume has to be decided which will depend upon the
expansion, innovational, and diversification plans of the company.
6. Management of cash: The finance manager has to make decisions with regard to
cash management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

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The decision function of financial management can be broken down into three
major areas:
1. Investment Decision
2. Financing Decision
3. Asset Management Decision

Investment Decision
Determine the total amount of assets needed to be held by the firm.
Answer the questions:
 What is the optimal firm size?
 What specific assets should be acquired
 What asset (if any) should be reduced or eliminated

Financing Decision
Determine how the assets will be financed.
Answer the questions:
 What is the best type of financing?
 What is the best financing mix?
 What is the best dividend policy?

Asset Management Decision

Determine how the assets will be handled.
Answer the questions:
 What techniques should be employed to effectively and efficiently use asset?

Use of Financial Management in our daily lives

Students can use different techniques in financial management such as:
a. budgeting for predicting future expenses and allocating their current resources to
cover possible future expenditures.
b. reconciliation of the cash balance using the statement of cash flows
c. simple investment decisions

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Exercise 1: Relate each daily activities with the primary activities of financial managers.
Write the following letters in the space provided to coincide with the primary activity of
financial managers.
A. Estimation of Capital Requirement
B. Determination of Capital Composition
C. Choice of Sources of Funds
D. Investment of Funds
E. Disposal of Surplus
F. Management of Cash
G. Financial Controls
Example:
F 1. Budgeting the allowance of P200 for daily expenses such as meals, transportation,
and daily school supplies.
1. The student decides to save P100 daily to invest in a 10% time deposit until P35,000
is accumulated for the purchase of a new phone.
2. Accounting books for the semester cost a total of P1,500. B determine the following
sources for the P1,500; (a) B will break his/her piggy bank; (b) ask his/her ate or
kuya; (c) ask his/her parents.
3. At the end of the semester, A adds all his/her allowance and deducts all the
expenses accumulated for the semester. A then compares the surplus with his cash
on hand.
4. D decides to no longer drink soft drinks and instead will bring his/her own water, this
will help D save P10 per day which he/she plans to spend on Regional Midyear
Convention which cost P4,800.
5. At the end of the year, Z saves P5,000 from allowances and receives an additional
P1,000 from relatives on Christmas. He/She then decides to purchase new shoes.
6. The most frequently asked question during the testimonial of new CPAs is how much
they spent during the review.
7. G compares his/her cash expenditure in the first semester and second semester
8. X determines that in order to finance his/her review for the licensure examination,
he/she needs to (a) accumulate 20,000 from allowances (b) earn 35,000 from part-
time jobs (c) ask his/her parents 25,00, and (e) apply for a scholarship to receive
30,000 allowances.
9. H determines that he/she needs P50,000 for this semester which includes tuition
fees, books, school supplies, and living expenses.
10. S decides to invest the P5,000 he receives from his/her relative during Christmas.
Exercise 2:
Group up with classmates to create a fictitious firm. Determine the Investment
Decision, Financing Decision, and Asset Management Decision that the management needs
to decide.

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Chapter 2: Financial Statement Analysis
Purpose of the Chapter:

 How analysts use historical financial statements in financial statement analysis.

 Calculate and interpret operating, credit, and investment ratios.
 Prepare a trend analysis of a company’s financial ratios.
 How analysts use financial statement analysis to help prepare a valuation forecast.
 The cautions analysts must consider when using financial statement analysis.

Having an income does not constitute that the firm has a positive performance, the
determination of the performance of the firm digs deeper than just having a positive profit
in the income statement. One of the techniques shown in the shareholders’ report of the
firm is the comparative financial statement, which shows a side-by-side comparison of the
performance of the firm with that of its previous performance. Showing the firm’s past
performance gives a more reliable view of the firm’s performance because it shows if there
are increases or decreases as compared to last year.
Comparative presentation of the financial statements is also known as Horizontal Analysis
in financial statement analysis.
Financial statement analysis is an evaluation technique used to weigh the operating
performance of a firm. It assesses the profitability of the firm, its ability to meet its
obligation, the safety of investment in the business, and the effectiveness of management in
running the firm.

Users of financial statement analysis

Financial Statement Analysis are used by internal users of the firm which include
management, current and potential investors, and employees.
1. Management is interested in financial statement analysis to assess the effect of their
decision on the financial statement of the firm. This will help them determine the
effectiveness of their decision and if revisions are needed.
2. Investors are interested in the financial statement analysis to determine the
profitability of their investment and whether to buy or sell their shares of stocks.
3. Employees are interested in financial statement analysis to determine their job
performance.

Tools and techniques in analyzing financial statements.

1. Horizontal Analysis – involves comparing figures in two or more consecutive periods.
The difference between the figures of the two periods is calculated and the
percentage of change from one period to the next, with the earliest period as the
base.
Example

2017 2018 % Change 2019 % Change

Sales 10,000 15,000 50% 20,000 100%

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Increases are usually reflected with a positive % of change and decreases are usually
reflected with a negative () % of change.
Account 2022 2023 % Change
Sales 500,000 475,000 -5.00%
Cost of Goods sold 269,000 265,000 -1.49%
Gross Profit 231,000 210,000 -9.09%

Wages 163,000 154,000 -5.52%

Repairs 4,150 5,800 39.76%
Rent 12,000 13,000 8.33%
Taxes 17,930 16,940 -5.52%
Office Expenses 587 1.023 74.27%
Total Expenses 197,667 190,763 -3.49%
Net Income 33,333 19,237 -42.29%

The percentage of change in sales of -5.00% is computed by subtracting the

difference between 2023 and 2022 sales which is 475,000 – 500,000 = -25,000 and
dividing the difference to the 2022 sales, -25,000/500,000 = -5.00%.
Formula is:
Current year amount – Previous year amount
% of Change =
Previous year amount

Analysing the example: Net Income Decreased by 42.29% as a result of the decrease
in sales of 5%, though the Cost of Goods Sold decreased by 1.49% it didn’t equal the
decrease of 5% in sales (possible scenarios are: The volume of sales decreases and
cost to produce one unit increases or Selling Price decreases as a result of decreasing
the cost of goods sold) and Total operating expenses decreased by 3.49%.
Additionally, the company should try to investigate the repair, and office expenses
as the percentage of increase in Repairs and Office Expenses which is 39.76% and
74.27% respectively is material.
a. Trend Analysis – a more advanced form of Horizontal Analysis. Trend Analysis
needs at least 5 – 10 years of experience to determine the trend for a particular
account, unusual changes are not reflected in the trend. The firm will then
compare the financial statement for a given year, based on the trend with that of
the actual financial statement of the firm.

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 Trend Analysis
450000
400000
350000
300000
250000
200000
150000
100000
50000
0
Year 1 Year 2 Year 3 Year 4 Year 5

Sales Cost of Goods Sold Income

2. Vertical Analysis – involves comparing figures in financial statements of a single

period. The base for the income statement is the revenue/sales and the base for the
balance sheet is the total assets/ total liabilities and equity. Vertical Analysis are
effective when comparing two or more companies.
Example: A firm’s salaries expense is 60% of revenue while another firm’s salaries
expense is 70% of revenue.
Account 2022 % 2023 %
Sales 500,000 100.00% 475,000 100.00%
Cost of Goods sold 269,000 53.80% 265,000 55.79%
Gross Profit 231,000 46.20% 210,000 44.21%

Wages 163,000 32.60% 154,000 32.42%

Reparis 4,150 0.83% 5,800 1.22%
Rent 12,000 2.40% 13,000 2.74%
Taxes 17,930 3.59% 16,940 3.57%
Office Expenses 587 0.12% 1.023 0.22%
Total Expenses 197,667 39.53% 190,763 40.16%
Net Income 33,333 6.67% 19,237 4.05%
In vertical analysis our basis is always the sales in income statement and total assets
or liabilities and owner’s equity for statement of financial position
The percentage is computed by dividing the amount to the basis amount, example
the % of cost of goods sold in 2022 is computed 269,000/500,000 = 53.80%.
Amount
% =
Basis amount (Sales/Total Assets/Total Liabilities or Owners Equity)

At the bottom of the analysis, note that net income, as a percentage of sales,
declined by 2.62 percentage points (6.67 percent to 4.05 percent). As a dollar
amount, net income declined by 14,096 (33,333 to 19,237). Management should
consider both the percentage change and the dollar amount change.

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 3. Ratio Analysis – different ratios are computed to access the performance of the firm.
Financial statement ratios are categorized into four (3).
a. Liquidity ratios – allows the firm to measure its ability to pay its current obligations.
b. Solvency ratios – allows the firm to measure its ability to pay long-term obligations.
It accesses the firm’s ability to exist in the long run (going concern).
c. Profitability ratios – allows the firm to measure its ability to earn an adequate return
on sales, total assets, and invested capital. It allows the firm to access if its capital is
earning effectively through operations. Usually, the firm’s rate of return is compared
to the highest risk-free rate of return on an investment that is available in the market
Liquidity Ratios:
1. Current ratio – also called the working capital ratio, measures the number of times
that the current liabilities can be paid with the available current assets. Working
Capital = Current Assets – Current Liabilities
Formula is:
Current Assets
Current Ratio =
Current Liabilities
Example: If Current Assets is 1,000,000 and Current Liabilities is 200,000. Then:
Current Ratio = 1,000,000= 5
200,000
This means that the current liabilities can be paid 5 times until the current assets are
exhausted. The current ratio roughly defines the short-term debt-paying ability of
the firm

2. Acid test ratio – also called the quick asset ratio, the acid test ratio only considers
highly liquid assets because not all assets can pay current liabilities, like prepaid
expenses, quick asset considers only the part of the current assets that is nearly
converted into cash. The quick assets are: Cash and cash equivalent, trading
securities, and receivables.
Formula is:
Cash & Cash Equivalent + Trading Securities + Receivables
Acid test ratio =
Current Liabilities
Example: If Cash is 150,000, Short term Investment is 200,000 Accounts Receivable is
400,000, and Current Liabilities are 200,000. Then:
Acid test ratio = 150,000 + 200,000 + 400,000 = 3.75
200,000
The acid test ratio is stricter than the current ratio. The acid test ratio does not
include inventory and prepaid expense, because inventory needs to be sold and then
collected first before it can be used to pay debts and prepaid expenses will never be
converted to cash while short-term investments can be immediately sold through
active market and account receivable can be used to finance short term debt
through pledging and factoring.

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3. Working capital activity ratios – measures the turnover rate of working capital
a. Receivable turnover – measures how fast cash is collected from receivables, it is
presented in the unit (times), times meaning in a single year how many times
does receivables be converted to cash.
Formula is:
Net Credit Sales
Receivable Turnover =
Average Receivable
Average Receivable = Beginning Receivable + Ending Receivable
2
Example: If net credit sales is 500,000 and average receivable is 50,000. Then:
Receivable Turnover = 500,000 = 10 times
50,000
This means that in a single year, receivables of 50,000 is collected 10 times.

b. Average Age of Receivable –on average how many days will it take for accounts
receivable before it is collected.
Formula is:
365 days
Average age of receivable =
Receivable Turnover
Example: In the previous example,
Average Age of Receivable = 365 = 36.5 days
10
This means that on average, receivables are collected after 36.5 days. For
average age of receivalble, average age of inventory and average age of payables
always use 365 days unless the problem states that 360 days will be use.

c. Inventory turnover – measures how fast inventory is sold, meaning in a single

year how many times inventories are purchased and sold.
Formula is:
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Average Inventory = Beginning Inventory + Ending Inventory
2
Example: if the Cost of Goods sold is 300,000 and the average inventory is
60,000. Then:
Inventory Turnover = 300,000 = 5 times
60,000
This means that in a single year, inventory of 60,000 are sold 5 times.

d. Average Age of Inventory = at an average of how many days will it take for the
inventory to be sold.
Formula is:

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 365 days
Average age of Inventory =
Inventory Turnover

Example: In the previous example,

Average Age of Inventory = 365 = 73 days
5
This means that inventory is sold 73 days after purchase.

Operating Cycle – The length of time raw materials are acquired, through the
production, and sale of finished goods, until the time when receivables are
collected or converted into cash which may in turn be used again to acquire raw
materials. Operating cycle assumes that all customer will purchase on credit.
Formula is:
Ave. Age of Receivable + Ave. Age of Inventory
Operating Cycle =
Example: If the Average Age of Receivable is 36.5 days and the Average Age of
Inventory is 73 days then:
Operating Cycle = 36.5 + 73 = 109.5 days
This means that if inventory is sold on credit, it takes 109.5 days for purchased
inventory to be sold and ultimately collected

e. Accounts Payable turnover – measures how fast payables are paid.

Formula is:
Net Credit Purchases
Payables Turnover =
Average Trade Payables
Average Trade Payables = Beginning Payables + Ending Payables
2
Example: If Net Credit Purchase is 500,000 and Average Trade Payables is
200,000. Then:
Accounts Payable Turnover = 500,000 = 2.5 times
200,000

f. Average Age of Trade Payables = at an average how many days will it take for
payables to be paid.
Formula is:
365 days
Average age of Payables =
Payable Turnover
In the Previous Example,
Average age of Payables = 365 = 146 days
2.5
On average, it takes 146 days for accounts payable to be paid.

Cash Conversion Cycle – The length of time for cash used to purchase inventory to be
converted back to cash.
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 Cash Conversion Cycle = Ave. Age of Receivable + Ave. Age of Inventory – Ave Age of
Payable
The acceptable liquidity ratios depend on the accepted standard of the entity but in no case
should it be lower than one (1). A liquidity ratio of less than one indicates that the entity is
no longer liquid. A very high liquidity ratio may indicate that the entity might not be utilizing
its assets efficiently, To avoid underutilization of assets, the entity can either choose to
expand its business, establish a new project or purchase long-term assets.
Solvency Ratios:
1. Times Interest Earned – Determines the company’s ability to cover its interest
expense
Formula is:
Times Interest Earned = Income before interest and tax
Interest Expense
Example: Income before interest and taxes is 500,000 while interest expense is
250,000. Then:
Times Interest Earned = 500,000 = 2 times
250,000
Times Interest Earned shows if your earnings are beings used up to pay interest. If a
company has less than one (1) times the interest earned, then the entity’s earnings
are actually not enough to cover the interest on loans. If a company has low times
interest earned (depending on the standard of the company) most operating income
is used to pay interest. High times interest earnings are desired.

2. Debt-equity ratio – Ratio of Debt to Equity

Formula is:
Total Liabilities
Debt-equity ratio =
Total Equity
Example: If Total Liabilities is 300,000 and Total Equity is 100,000. Then:
Debt-Equity Ratio = 300,000 = 3
100,000
The debt-equity ratio compares the ownership of creditors to the total asset, a very
high debt-equity ratio shows that if the entity is liquidated, most of the assets are
actually used to pay liabilities, while a minimal amount goes to the owner.
3. Debt Ratio – Indicates the percentage of total assets provided by creditors.
Formula is:
Total Liabilities
Debt ratio =
Total Assets

Example: If Total Liabilities is 300,000 and Total Assets is 400,000. Then:

Debt Ratio = 300,000 = 75%
400,000
Debt Ratio shows the percentage of ownership of creditors to the total asset, in the
example shows that 75% of the total asset belongs to the creditors.

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 4. Equity Ratio – Indicates the percentage of total assets provided by the owners or
stockholders.
Formula is:
Total Equity
Equity ratio =
Total Assets
Example: If Total Equity is 100,000 and Total Assets is 400,000. Then:
Equity Ratio = 100,000 = 25%
400,000
The equity Ratio shows the percentage of ownership of shareholders to the total
asset, the example shows that 25% of the total asset belongs to the shareholders.
Equity Ratio + Debt Ratio = 100%
Profitability Ratio:
1. Rate of Return – also known as return on investment
Formula is:
Net Income
Rate of Return =
Investment
2. Return on Sales – measures the percentage of each peso revenue that results in net
income
Formula is:
Net Income
Return on Sales =
Net Sales
3. Return on Asset – it measures how assets were efficiently used to produce the sales
or revenue
Formula is:
Net Income
Return on Asset =
Average Total Asset
4. Return on Owners’ Equity – measures the percentage of net income to capital
Formula is:
Net Income
Return on Equity =
Average Equity
5. Return on Common Equity – measures the percentage of return to common equity
after deducting the dividends for preference stock.
Formula is:
Net Income – Preferred Dividends
Rate on Common Equity =
Average Common Stockholders’ Equity
6. Basic Earnings Power Ratio - ratio is a measure that calculates the earning power of a
business before the effect of the business' income taxes and its financial leverage.
Formula is:
Net Income Before Interest and Taxes
Basic Earnings Power Ratio =
Total Assets
7. Earnings per share
Formula is:

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 Net Income – Preferred Dividends
Earnings per share = Weighted Average Number of Common
Shares
January – 10,000 shares x 5/12 = 4,166.67
June – 20,000 shares x 7/12 = 11,666.67 = 15,833.33 – Weighted Average number of
Common shares

8. Market Tests – the relationship of price, dividends, and earnings, market test shows
if shares of stocks are worth purchasing or not.
a. Price-earnings ratio – relationship price to earnings, it shows how many years
would it take for the shareholder to recover the price paid for the shares using
the earnings received from the same shares, lower price-earnings ratio is
desirable, while a high price-earnings ratio indicates that the shares are
overpriced.
Formula is:
Price per share
Price-Earnings Ratio (P/E) =
Earnings Per Share
b. Dividend yield – the relationship of dividends to the price per share, it shows the
percentage of the price that was recovered through dividends. A high dividend
yield is desirable.
Formula is:
Dividend per share
Dividend Yield =
Price per Share
c. Dividend payout – the percentage of earnings that are distributed as dividends.
Formula is:
Common Dividend Per Share
Dividend payout =
Earnings Per Share

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Exercise 1: True or False
1. The purpose of financial statement analysis is not only to understand the historical
results of financial statements but also to use that information to forecast the future.
2. Operating ratios measure a firm’s ability to repay its obligations.
3. One of the common credit ratios is the return on capital ratio.
4. The revenue growth rate is a ratio that measures the expansion or contraction of the
business.
5. A ratio is most meaningful when the numerator and denominator are related to each
other.
6. When a times interest earned is computed, the lower the result, the better the firm’s
ability to make interest payments.
7. The price-earnings ratio is a popular metric used to determine the relationship between
the market price of a stock and its earnings power as measured by earnings per share.
8. The only ratio that measures the return on investment is the return on common equity.
9. The benchmark used in horizontal analysis is the prior performance of the firm currently
undergoing analysis.
10. A firm “cannibalizes” its revenue when it adds additional store locations into an area in
which the firm already has existing stores.
11. The benchmark used in trend analysis is a given firm’s performance over a period of
time.
12. When analyzing revenue growth in trend analysis, often the analyst will not only look at
overall revenue growth rates but also at revenue growth by business segment.
13. Horizontal analysis is a special kind of evaluation in which the reasons for a change in a
specific item over some period are identified.
14. In Vertical analysis, we compare two or more companies using financial ratios, and we
may also compare the companies’ ratios to an industry average.
15. In doing ratio analysis, we must recognize that different firms provide different levels of
disclosure.

Exercise 2: Multiple Choice

16. In financial analysis, ratios are used to help us learn about the firm’s:
a. profitability
b. growth and potential for growth
c. resource needs
d. All of the above answers are correct.

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17. A ratio that is used to evaluate a firm’s operating margin percentage is classified as:
a. a specialty ratio
b. an investment ratio
c. a credit ratio
d. an operating ratio

18. A ratio that measures income taxes to revenues is:

a. relatively meaningless since it tells us little about the income tax rate or the profitability
of the firm
b. an excellent metric since it compares the effective rate of income tax to the profitability
of the firm
c. classified as a common investment ratio
d. complimentary to the return on common equity ratio

19. The only operating ratio that uses the cost of sales in its numerator is the:
a. market-to-book ratio
b. quick ratio
c. inventory turnover ratio
d. days payables outstanding ratio

20. An operating ratio, such as the inventory turnover ratio, varies greatly by industry. An
example of a business with a high inventory turnover ratio is a:
a. watch repair shop
b. grocery store
c. jewelry retailer
d. CPA firm

21. To help determine whether a business should extend credit to various other businesses,
an analyst will look at credit ratios. The ratio that measures the speed with which the
firm can pay its obligations with cash, cash equivalents, and short-term investments is
known as the:
a. days payables outstanding ratio
b. debt to capital ratio
c. current ratio
d. quick ratio

22. The denominator in the debt to capital ratio consists of:

a. debt, minority interest, and equity
b. the total obligations of the firm
c. the total equity of the firm
d. net income, common and preferred stock, and retained earnings

23. Investors and managers use the price-to-earnings and market-to-book ratios to:
a. primarily measure business performance

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b. primarily screen potential investments
c. measure business performance and screen potential investments
d. track the efficiency of leverage in capital spending in both foreign and domestic markets

24. The __________ ratio uses net income in its numerator while the __________ ratio uses
diluted earnings per share in its denominator.
a. return on common equity; market-to-book
b. return on common equity; price-to earnings
c. return on capital; market-to-book
d. return on capital; price-to-earnings

25. A ratio has little meaning until it is compared to a benchmark. Financial analysts use
several common benchmarks to help them better understand and interpret financial
ratios. The benchmark in which ratios from several different companies or an industry
segment are analyzed is known as a:
a. cross-sectional analysis
b. trend analysis
c. cause-of-change analysis
d. cause-of-action analysis

26. A thorough financial analysis includes any adjustments to the financial statements that
are necessary to develop useful forecasts. Such forecasts are used in the analyst’s
valuation work. An example of an adjustment made to understand a business more
completely for purposes of valuation is to:
a. change financial statement items even though such adjustment may not be per GAAP
b. change financial statement items that may incorporate accounting policies different
than that of the firm
c. exclude a financial statement item such as joint venture income
d. All of the answers above are correct.

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27. An analyst can restate each item on an income statement as a percentage of revenues.
This will afford the analyst an opportunity to factor out size differences among
statements of various firms. What is this restatement known as and with which method
can it be used?
a. change of accounting principle restatement; cross-sectional analysis only
b. change of accounting principle restatement; trend or cross-sectional analysis
c. common-size income statement; trend or cross-sectional analysis
d. common-size income statement; trend analysis only

28. Identify the ratio that cannot be computed given the following information for a firm:
Current assets are P475,806; current liabilities are P257,814; cash is P89,774; earnings
before interest and taxes is P72,005; short-term investments, P145,850; equity,
P192,615; minority interest, P0; interest expense, P47,899.
a. current
b. quick
c. debt to capital
d. interest coverage

29. Identify the ratio that can be computed given the following information for a firm:
Current assets are P475,806; current liabilities are P257,814; cash is P89,774; earnings
before taxes is P72,005; short-term investments, P145,850; equity at end of period,
P192,615; minority interest, P0; income taxes, P11,211; interest expense, P47,899.
a. return on capital
b. effective income tax rate
c. gross margin percentage
d. inventory turnover

30. Identify the ratio that cannot be computed given the following information for a firm:
Diluted earnings per share, P3.57; market price of the firm’s stock, P47.75; average
common equity, P879,550; net income, P99,772; average total capital, P625,740;
aftertax interest expense, P14,885.
a. price-earnings
b. market-to-book
c. return on common equity
d. return on capital

31. A firm has the following growth rates for the last four years: 2000, 39.8%; 2001, 34.2%;
2002, 28.4%; 2003, 29.1%. From a standpoint of trend analysis, what conclusion might
an analyst reach regarding the firm’s revenue growth?
a. The trend analysis indicates the firm has had flat revenue growth over time.
b. The trend analysis indicates the firm has had diminished revenue growth over time.
c. The trend analysis indicates the firm has had moderately increasing revenue growth
over time.
d. The trend analysis indicates the firm has had significant, but slowing, revenue growth
over time.

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32. A firm has the following operating income rates for the last four years: 2000, 9.0%; 2001,
8.9%; 2002, 9.1%; 2003, 8.8%. From a standpoint of trend analysis, what conclusion
might an analyst reach regarding the firm’s revenue growth?
a. The trend analysis indicates the firm’s operating income has been flat over time.
b. The trend analysis indicates the firm’s operating income has materially declined over
time and is cause for investor concern.
c. The trend analysis indicates the firm’s operating income has been increasing at a fiscally
healthy rate over time.
d. The conclusion is indeterminable from the information given.

33. There are two key ratios that measure operating profitability. The numerator for the
__________ ratio uses income while the __________ ratio uses revenues less cost of
goods sold in its computation.
a. gross margin percentage; operating margin percentage
b. operating margin percentage; gross margin percentage
c. quick; operating margin percentage
d. current; gross margin percentage

34. The analyst must exercise caution when using ratios as part of the analysis of a firm. The
fact that ratios often vary across industries is an example of what is called:
a. an accounting method discrepancy
b. an industry and business difference
c. a business environment change
d. an ambiguous ratio definition

35. Select the answer that best fits this statement, “Analysts define ratios differently.”
a. What some analysts call trend analysis others call cross-sectional analysis.
b. What some analysts call the current ratio is called the quick ratio by others.
c. The numerator used in the return on capital ratio may vary.
d. The income statement is restated in non-GAAP terms.

36. Ratios often aid analysts to project the future. Such projections require the adjustment
of certain items found on the financial statements. One such item that should be
adjusted in such a projection is:
a. removing an extraordinary item from the income statement
b. removing revenue from the income statement
c. the earnings-per-share calculation when there are no dilutive or anti-dilutive items
d. the reconciliation of cash on the balance sheet

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Problems
1. Following are data about Blite Company
Average total assets P150,000
Average owner’s equity 60,000
Net income after interest but before tax 10,000
Bonds payable, 8% 50,000
Income tax rate 35%
Calculate the following ratios.
1. Times interest earned
2. Return on equity
3. Return on assets
4. Basic earnings power ratio

2. Below are data about Loi Merchandising Company:

Sales P500,000
Cost of goods sold 200,000
Average inventory 20,000
Average receivable 30,000
Compute the following:
a. Inventory turnover
b. Receivable turnover
c. Collection period of accounts receivable
d. Average age of inventory
e. Operating cycle

3. Estrada Inc. is concerned about the level of its advertising and office salaries
expense.
Selected statement of comprehensive income data from 2016 – 2018 appear below:
2018 2017 2016
Sales P140,000 P60,000 P37,500
Gross Profit 89,600 37,200 22,500
Advertising Expense 7,000 3,300 2,250
Office Salaries 22,400 9,000 4,500
Profit 30,800 13,800 9,000

4. The following information was taken from the statement of financial position of
Blanche Corporation:
Cash P13,250
Accounts Receivable (net) 33,000
Merchandise Inventory 40,000
Prepaid Expenses 9,950
Accounts Payable 25,200
Accrued Payables 1,800
Notes Payable (due in 6 months) 10,000
Calculate the working capital, current ratio and quick ratio

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 5. The following data are available from Gumban’s annual report:
Beginning Merchandise Inventory P 245,000
Ending Merchandise Inventory 375,000
Beginning Accounts Receivable 250,000
Ending Accounts Receivable 297,000
Cost of Goods Sold 2,480,000
Cash Sales 1,000,000
Total Sales 5,100,000
Gumban’s Credit Terms Net 30 days

Required:
1. Calculate inventory turnover and accounts receivable turnover
2. In your opinion, is Gumban doing a good job in receivables? Explain.

Horizontal analysis
6. Kline Corporation had net income of P2 million in 2016. Using the 2016 financial
elements as the base data, net income decreased by 70 percent in 2017 and increased by
175 percent in 2018. The respective net income reported by Kline Corporation for 2017 and
2018 are:
A. P 600,000 and P5,500,000 C. P1,400,000 and P3,500,000
B. P5,500,000 and P 600,000 D. P1,400,000 and P5,500,000

7. Assume that Axle Inc. reported a net loss of P50,000 in 2016 and net income of P250,000
in 2017. The increase in net income of P300,000:
A. can be stated as 0% C. cannot be stated as a percentage
B. can be stated as 100% increase D. can be stated as 200% increase

Liquidity ratios

8. The following financial data have been taken from the records of Ratio Company:
Accounts receivable P200,000
Accounts payable 80,000
Bonds payable, due in 10 years 500,000
Cash 100,000
Interest payable, due in three months 25,000
Inventory 440,000
Land 800,000
Notes payable, due in six months 250,000
What will happen to the ratios below if Ratio Company uses cash to pay 50 percent of
its accounts payable?
A. B. C. D.
Current Increase Decrease Increase Decrease
ratio
Acid-test Increase Decrease Decrease Increase
ratio

Question Nos. 9 through 11 are based on the data taken from the balance sheet of Nomad

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Company at the end of the current year:
Accounts payable P145,000
Accounts receivable 110,000
Accrued liabilities 4,000
Cash 80,000
Income tax payable 10,000
Inventory 140,000
Marketable securities 250,000
Notes payable, short-term 85,000
Prepaid expenses 15,000

9. The amount of working capital for the company is:

A. P351,000 C. P211,000
B. P361,000 D. P336,000

10. The company’s current ratio as of the balance sheet date is:
A. 2.67:1 C. 2.02:1
B. 2.44:1 D. 1.95:1

11. The company’s acid-test ratio as of the balance sheet date is:
A. 1.80:1 C. 2.02:1
B. 2.40:1 D. 1.76:1

Activity ratios
Receivables turnover
12. Pine Hardware Store had net credit sales of P6,500,000 and cost of goods sold of
P5,000,000 for the year. The Accounts Receivable balances at the beginning and end of
the year were P600,000 and P700,000, respectively. The receivables turnover was
A. 7.7 times. C. 9.3 times.
B. 10.8 times. D. 10.0 times.

13. Milward Corporation’s books disclosed the following information for the year ended
December 31, 2017:
Net credit sales P1,500,000
Net cash sales 240,000
Accounts receivable at beginning of year 200,000
Accounts receivable at end of year 400,000
Milward’s accounts receivable turnover is
A. 3.75 times C. 5.00 times
B. 4.35 times D. 5.80 times

Days receivable
14. Batik Clothing Store had a balance in the Accounts Receivable account of P390,000 at
the beginning of the year and a balance of P410,000 at the end of the year. The net credit
sales during the year amounted to P4,000,000. Using 360-day year, what is the average
collection period of the receivables?
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 A. 30 days C. 73 days
B. 65 days D. 36 days

Cash collection
15. Deity Company had sales of P30,000, increase in accounts payable of P5,000, decrease in
accounts receivable of P1,000, increase in inventories of P4,000, and depreciation expense
of P4,000. What was the cash collected from customers?
A. P31,000 C. P34,000
B. P35,000 D. P25,000

Inventory turnover
16. During 2017, Tarlac Company purchased P960,000 of inventory. The cost of goods sold
for 2017 was P900,000, and the ending inventory at December 31, 2017 was P180,000.
What was the inventory turnover for 2017?
A. 6.4 C. 5.3
B. 6.0 D. 5.0

17. Selected information from the accounting records of Petals Company is as follows:
Net sales for 2017 P900,000
Cost of goods sold for 2017 600,000
Inventory at December 31, 2016 180,000
Inventory at December 31, 2017 156,000
Petals’ inventory turnover for 2017 is
A. 5.77 times C. 3.67 times
B. 3.85 times D. 3.57 times

18. The Moss Company presents the following data for 2017.
Net Sales, 2017 P3,007,124
Net Sales, 2016 P 930,247
Cost of Goods Sold, 2017 P2,000,326
Cost of Goods Sold, 2017 P1,000,120
Inventory, beginning of 2017 P 341,169
Inventory, end of 2017 P 376,526
The merchandise inventory turnover for 2017 is:
A. 5.6 C. 7.5
B. 15.6 D. 7.7

19. Based on the following data for the current year, what is the inventory turnover?
Net sales on account during year P 500,000
Cost of merchandise sold during year 330,000
Accounts receivable, beginning of year 45,000
Accounts receivable, end of year 35,000
/16
Inventory, end of year 110,000
A. 3.3 C. 3.7
B. 8.3 D. 3.0
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Days inventory
20. Selected information from the accounting records of Eternity Manufacturing Company
follows:
Net sales P3,600,000
Cost of goods sold 2,400,000
Inventories at January 1 672,000
Inventories at December 31 576,000
What is the number of days’ sales in average inventories for the year?
A. 102.2 C. 87.6
B. 94.9 D. 68.1

Turnover ratios
Asset turnover
Asset
21. Net sales are P6,000,000, beginning total assets are P2,800,000, and the asset turnover
is 3.0. What is the ending total asset balance?
A. P2,000,000. C. P2,800,000.
B. P1,200,000. D. P1,600,000.

Solvency ratios
Debt ratio
22. Jordan Manufacturing reports the following capital structure:
Current liabilities P100,000
Long-term debt 400,000
Deferred income taxes of 10,000
Preferred stock 80,000
Common stock 100,000
Premium on common stock 180,000
Retained earnings 170,000
What is the debt ratio?
A. 0.48 C. 0.93
B. 0.49 D. 0.96

Times interest earned

23. House of Fashion Company had the following financial statistics for 2016:
Long-term debt (average rate of interest is 8%) P400,000
Interest expense 35,000
Net income 48,000
Income tax 46,000
Operating income 107,000
What is the times interest earned for 2016?
A. 11.4 times C. 3.1 times
B. 3.3 times D. 3.7 times

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24. Brava Company reported the following on its income statement:
Income before taxes P400,000
Income tax expense 100,000
Net income P300,000
An analysis of the income statement revealed that interest expense was P100,000.
Brava Company’s times interest earned (TIE) was
A. 5 times C. 3.5 times
B. 4 times D. 3 times

25. The balance sheet and income statement data for Candle Factory indicate the following:
Bonds payable, 10% (issued 1998 due 2022) P1,000,000
Preferred 5% stock, P100 par (no change during year) 300,000
Common stock, P50 par (no change during year) 2,000,000
Income before income tax for year 350,000
Income tax for year 80,000
Common dividends paid 50,000
Preferred dividends paid 15,000
Based on the data presented above, what is the number of times bond interest charges
were earned (round to one decimal point)?
A. 3.7 C. 4.5
B. 4.4 D. 3.5

26. The following data were abstracted from the records of Johnson Corporation for the
year:
Sales P1,800,000
Bond interest expense 60,000
Income taxes 300,000
Net income 400,000
How many times was bond interest earned?
A. 7.67 C. 12.67
B. 11.67 D. 13.67

Net income

27. The times interest earned ratio of Mikoto Company is 4.5 times. The interest expense
for the year was P20,000, and the company’s tax rate is 40%. The company’s net income
is:
A. P22,000 C. P54,000
B. P42,000 D. P66,000

Profitability Ratios
Return on Common Equity
28. Selected information for Ivano Company as of December 31 is as follows:
2016 2017
Preferred stock, 8%, par P100, P250,000 P250,000

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 nonconvertible, noncumulative
Common stock 600,000 800,000
Retained earnings 150,000 370,000
Dividends paid on preferred stock for the 20,000 20,000
year
Net income for the year 120,000 240,000
Ivano’s return on common stockholders’ equity, rounded to the nearest percentage
point, for 2017 is
A. 17% C. 21%
B. 19% D. 23%

Dividend yield
29. The following information is available for Duncan Co.:
2016
Dividends per share of common stock P 1.40
Market price per share of common stock 17.50
Which of the following statements is correct?
A. The dividend yield is 8.0%, which is of interest to investors seeking an increase in the
market price of their stocks.
B. The dividend yield is 8.0%, which is of special interest to investors seeking current
returns on their investments.
C. The dividend yield is 12.5%, which is of interest to bondholders.
D. The dividend yield is 8.0 times the market price, which is important in solvency
analysis.

Market Test Ratios

Market/Book value ratio
Price per share
30. What is the market price of a share of stock for a firm with 100,000 shares outstanding,
a book value of equity of P3,000,000, and a market/book ratio of 3.5?
A. P8.57 C. P85.70
B. P30.00 D. P105.00

P/E ratio
31. Orchard Company’s capital stonk at December 31 consisted of the following:
 Common stock, P2 par value; 100,000 shares authorized, issued, and outstanding.
 10% noncumulative, nonconvertible preferred stock, P100 par value; 1,000 shares
authorized, issued, and outstanding.
Orchard’s common stock, which is listed on a major stock exchange, was quoted at P4
per share on December 31. Orchard’s net income for the year ended December 31 was
P50,000. The yearly preferred dividend was declared. No capital stock transactions
occurred. What was the price-earnings ratio on Orchard’s common stock on December
31?

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 A. 6 to 1 C. 10 to 1
B. 8 to 1 D. 16 to 1

32. On December 31, 2016, and 2017, Renegade Corporation had 100,000 shares of
common stock and 50,000 shares of noncumulative and nonconvertible preferred stock
issued and outstanding.
Additional information:
Stockholders’ equity at 12/31/07 P4,500,000
Net income year ended 12/31/07 1,200,000
Dividends on the preferred stock year ended 12/31/07 300,000
Market price per share of common stock on 12/31/07 144
The price-earnings ratio on commonontock at December 31, 2017, was
A. 10 to 1 C. 14 to 1
B. 12 to 1 D. 16 to 1

Payout ratio
33. Selected financial data of Alexander Corporation for the year ended December 31, 2017,
is presented below:
Operating income P900,000
Interest expense (100,000)
Income before income taxes 800,000
Income tax (320,000)
Net income 480,000
Preferred stock dividend (200,000)
Net income available to common stockholders 280,000
Common stock dividends were P120,000. The payout ratio is:
A. 42.9 percent C. 25.0 percent
B. 66.7 percent D. 71.4 percent

P/E ratio & Payout ratio

Use the following information for question Nos. 33 and 34:
Terry Corporation had net income of P200,000 and paid dividends to common
stockholders of P40,000 in 2017. The weighted-average number of shares outstanding in
2017 was 50,000 shares. Terry Corporation’s common stock is selling for P60 per share in
the local stock exchange.

34. Terry Corporation’s price-earnings ratio is

A. 3.8 times C. 18.8 times
B. 15 times D. 6 times

35. Terry Corporation’s payout ratio for 2017 is

A. P4 per share C. 20.0 percent
B. 12.5 percent D. 25.0 percent

Integrated ratios
Liquidity & activity ratios
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Inventory
36. The current assets of Mayon Enterprise consists of cash, accounts receivable, and
inventory. The following information is available:
Credit sales 75% of total sales
Inventory turnover 5 times
Working capital P1,120,000
Current ratio 2.00 to 1
Quick ratio 1.25 to 1
Average Collection period 42 days
Working days 360
The estimated inventory amount is:
A. 840,000 C. 720,000
B. 600,000 D. 550,000

37. The following data were obtained from the records of Salacot Company:
Current ratio (at year end) 1.5 to 1
Inventory turnover based on sales and ending inventory 15 times
Inventory turnover based on cost of goods sold and ending inventory 10.5 times
Gross margin for 2017 P360,000
What was Salacot Company’s December 31, 2017 balance in the Inventory account?
A. P120,000 C. P 80,000
B. P 54,000 D. P 95,000

Net sales
38. Selected data from Mildred Company’s year-end financial statements are presented
below. The difference between average and ending inventory is immaterial.
Current ratio 2.0
Quick ratio 1.5
Current liabilities P120,000
Inventory turnover (based on cost of sales) 8 times
Gross profit margin 40%
Mildred’s net sales for the year were
A. P 800,000 C. P 480,000
B. P 672,000 D. P1,200,000

Gross margin
39. Selected information from the accounting records of the Blackwood Co. is as follows:
Net A/R at December 31, 2016 P 900,000
Net A/R at December 31, 2017 P1,000,000
Accounts receivable turnover 5 to 1
Inventories on December 31, 2016, P1,100,000
Inventories on December 31, 2017, P1,200,000
Inventory turnover 4 to 1
What was the gross margin for 2017?
A. P150,000 C. P300,000
B. P200,000 D. P400,000
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Market Test Ratio
Dividend yield
40. Recto [Link]-earnings ratio of 10, earnings per share of P2.20, and a payout ratio of
75%. The dividend yield is
A. 25.0% C. 7.5%
B. 22.0% D. 10.0%

41. The following were reflected in the records of Salvacion Company:

Earnings before interest and taxes P1,250,000
Interest expense 250,000
Preferred dividends 200,000
Payout ratio 40 percent
Shares outstanding Throughout 2016
Preferred 20,000
Common 25,000
Income tax rate 40 percent
Price earnings ratio 5 times
The dividend yield ratio is
A. 0.50 C. 0.40
B. 0.12 D. 0.08

Comprehensive
42. The balance sheets of Magdangal Company at the end of each of the first two years of
operations indicate the following:
2017 2016
Total current assets P600,000 P560,000
Total investments 60,000 40,000
Total property, plant, and equipment 900,000 700,000
Total current liabilities 150,000 80,000
Total long-term liabilities 350,000 250,000
Preferred 9% stock, P100 par 100,000 100,000
Common stock, P10 par 600,000 600,000
Paid-in capital over par-common stock 60,000 60,000
Retained earnings 300,000 210,000
Net income is P115,000 and interest expense is P30,000 for 2017.
What is the rate earned on total assets for 2017 (round percent to one decimal point)?
A. 9.3 percent C. 8.9 percent
B. 10.1 percent D. 7.4 percent

43. What is the rate earned on stockholders' equity for 2017 (round percent to one decimal
point)?
A. 10.6 percent C. 12.4 percent
B. 11.2 percent D. 15.6 percent

44. What are the earnings per share on common stock for 2017, (round to two decimal
28 | P a g e
places)?
A. P1.92 C. P1.77
B. P1.89 D. P1.42

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