POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Sta. Mesa, Manila

BUSINESS MANAGEMENT ACCOUNTING

MODULE 2
Financial Statements Analysis

DISCUSSION QUESTIONS

1. What is financial statement report?

2. What are the primary financial statement reports? Discuss each kind of report.

3. Discuss the objectives of financial statement analysis.

4. What are the two basic financial statement analysis techniques? Discuss each kind of
technique.

5. Define horizontal analysis of analyzing financial statements.

6. Define vertical analysis of analyzing financial statements.

7. What is a trend analysis?

8. What is a ratio analysis?

9. What is the so-called “notes to financial statement analysis”? Discuss its importance to
financial statement analysis.

10. Why do you think the use of borrowed funds is usually practiced by businessmen?

11. Enumerate the two reasons why financial leverage improves the rate of returns to
stockholders or owners.

12. Discuss some limitations in financial statement analysis.

13. What is a working capital?

14. What is a financial leverage?

15. Outline the formula of the following ratios and discuss each terms:
a. Current asset and current asset ratio
b. Quick assets and quick asset ratio
c. Accounts Receivable turnover
d. Inventory turnover
e. Debt to total asset ratio
f. Debt to equity ratio
g. Profit margin ratio
h. Total asset turnover
i. Return on Total Asset
j. Return on sales
k. Return on equity
l. Earnings per share
m. Dividend per share
n. Dividend payout ratio
o. DuPont Formula in determining Return on Asset (ROA)
TRUE OR FALSE: Write “True” if the statement is true. Write “False” if the statement is false.

1. Attention directing is one of the many basic objectives of financial statement analysis.

2. In trend analysis, percentage figures art usually computed by using the most recent year
as a base.

3. Common-size statements are statements of companies of similar size and operations.

4. Trend percentages in financial statements would be an example of vertical analysis.

5. A common-size statement is one the shows the separate items appearing on it in

percentage form, with each item stated as a percentage of some total of which that item
is a part.

6. The inventory turnover is computed by dividing sales by average inventory.

7. Comparisons within a company are often useful to detect changes in financial

relationships and significant trends.

8. In horizontal analysis, if an item has a negative amount in the base year, and a positive
amount in the following year, no percentage change for that item can be computed.

9. The average age of inventory is viewed as the average length of time inventory is held
by the firm or as the average number of days’ sales in inventory.

10. Total asset turnover commonly measures the liquidity of a firm’s total asset.

11. The emphasis on risk and return trade-off is introduced through the use of fixed-cost
financing such as debt and preferred stock is called financial leverage.

12. The less fixed-cost debt (financial leverage) a firm uses, the greater will be its risk and
return.

13. Vertical analysis is a technique for evaluating a series of financial statement data over a
period of time to determine the increase (decrease) that has taken place.

14. Notes to financial statements are integral part of financial statement.

15. The firm’s creditors are primarily interested in the short-term liquidity of the company
and its ability to make interest and principal payments.

16. Ratio analysis merely directs the analyst to potential areas of concern; it does not
provide conclusive evidence as to existence of a problem.

17. In a cross-sectional comparison of firms operating in several lines of business, the

industry average ratios of any of the firm’s product lines may be used to analyze the
multiproduct firm’s financial performance.

18. If an analysis is concerned only with certain specific aspects of a firm’s financial
position, one or two ratios may provide sufficient information from which to make a
reasonable judgment.

19. The liquidity of a business firm refers to the insolvency of the firm’s financial position.

20. The liquidity of a business firm is measured by its ability to satisfy its long-term
obligations as they come due.

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 21. In ratio analysis, the financial statements being used for comparison should be dated at
the same point in time during the year. If not, the effect of seasonality may produce
erroneous conclusions and decisions.

22. Both present and prospective shareholders are interested in the firm’s current and future
level of risk and return. These two dimensions directly affect share price.

23. The use of differing accounting treatments – especially relative to inventory and
depreciation – can distort the results of ratio analysis, regardless of whether cross-
sectional or time-series analysis is used.

24. Comparisons with industry averages provide information about a company’s relative
position within the industry.

25. Horizontal analysis is a technique for evaluating financial statement data that expresses
each item in a financial statement as a percent of a base amount.

26. Earnings per share represent the peso amount earned and distributed to shareholders.

27. Present and prospective shareholders and lenders pay close attention to the firm’s
degree of indebtedness and ability to repay the debt. Shareholders are concerned since
the claims of creditors must be satisfied prior to the distribution of earnings to them.

28. Lenders are concerned since the more indebted the firm, the higher the probability that
the firm will be unable to satisfy the claims of all its creditors.

29. The liquidity of a business refers to the solvency of the firm’s overall financial position.

30. The liquidity of a business firm is measured by its ability to satisfy its long-term
obligations as they come due.

31. The current ratio provides a better measure of overall liquidity only when a firm’s
inventory cannot easily be converted into cash. If inventory is liquid, the quick ratio is a
preferred measure of overall liquidity.

32. Since the differences in the composition of a firm’s current assets and liabilities can
significantly affect the firm’s “true” liquidity, it is important to look beyond measures of
overall liquidity to assess the activity (liquidity) of specific current accounts.

33. The higher the value of the times interest earned ratio, the higher the proportion of the
firm’s interest earnings compared to its contractual interest payments.

34. In general, the more debt (other people’s money) a firm uses in relation to its assets, the
smaller its financial leverage.

35. The higher the debt ratio, the more financial leverage a firm has and, thus, the greater
will be its risk and return.

36. Return on total assets (ROA) measures the overall effectiveness of management in
generating profits with the owners’ investment in the firm.

37. The price/earnings (P/E) ratio represents the degree of confidence that investors have in
the firm’s future performance.

38. The DuPont formula allows the firm to break down its return into the net profit margin,
which measure the firm’s profitability on sales, and its total asset turnover, which
indicates how efficiently the firm has used its assets to generate sales.

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 39. The DuPont system allows the firm top break its return on equity into a profit-on-sales
component, an efficiency-of-asset-use component, and a use-of-leverage component.

40. The average age of inventory can be calculated as inventory divided by 365 days.

41. The average age of inventory can be calculated as inventory turnover divided by 365
days.

42. The average age of inventory can be calculated as 365 days by inventory turnover.

43. Ratio analysis merely directs the analyst to potential areas of concern; it does not
provide conclusive evidence as to the existence of a problem.

44. The average age of inventory is viewed as the average length of time inventory is held
by the firm or as the average number of days’ sales in inventory.

45. The higher the debt ratio, the more financial leverage a firm has and, thus, the greater
will be its risk and return.

MULTIPLE CHOICE QUESTIONS

Encircle the letter that corresponds to the best answer of the following statements.

1. The percentage change in total assets between two balance sheet dates is an example of:
a. vertical analysis c. capital analysis
b. horizontal analysis d. profitability analysis

2. The tools and techniques used to analyze financial statements are divided into broad
categories including all of the above except:
a. capital analysis c. horizontal analysis
b. vertical analysis d. ratio analysis

3. The percentage change in any individual item shown on comparative financial

statements is calculated by dividing the peso amount of the change from the base-period
to the current period by:
a. the amount shown for the current period
b. the sum of the current period amount and the base-period amount
c. the average of the amounts shown for the base period and the current period
d. the base-period amount

4. Horizontal analysis involves the study of:

a. percentage changes in the balances shown in comparative financial statements
b. the percentage amount of various financial statement amounts compared to a total
amount on the financial statement
c. the change in key financial statement ratios over a certain time frame or horizon
d. the interrelationship between the income statement and the balance sheet

5. Profit margin equals

a. income divided by sales
b. incomes divided by average inventory
c. income divided by average assets
d. income divided by average stockholders’ equity

6. The DuPont model measures

a. residual income c. throughput
b. return on investment d. profit

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 7. If sales and expenses both rise by P100,000, profit margin will
a. decrease and asset turnover will decrease
b. increase and asset turnover will decrease
c. decrease and asset turnover will increase
d. increase and asset turnover will increase

8. Asset turnover equals

a. income divided by average c. sales divided by average assets
assets d. assets divided by sale
b. sales divided by assets

9. In the DuPont model, profit margin is a ratio of

a. income to sales c. sales to income
b. income to assets d. sales to assets

10. In preparing a horizontal analysis of financial statements, subtract the:

a. later year amount from the earlier amount and divide by the later year amount
b. earlier year amount from the later amount and divide by the later year amount
c. earlier year amount from the later amount and divide by the earlier year amount
d. later year amount from the earlier amount and multiply by the earlier year amount

11. A company reported P18,000 of net income for 2012, P24,000 for 2013, and P26,000 for
2014. The percentage change in net income from 2013 to 2014 was:
a. 20.00% b. 30.00% c. 10.00% d. 8.33%

12. If year one equals P700, year two equals P742, and year three equals P770, the
percentage change to be assigned for year three in a trend analysis, assuming that year
one is the base year, is
a. 110% b. 106% c. 91% d. 100%

13. Assume the following sales data for a company:

2013 P1,000,000
2012 900,000
2011 750,000
2010 600,000
If 2010 is the base year, what is the percentage increase in sales from 2010-2011?
a. 125% b. 167% c. 25% d. 20%

14. Ratios are most useful in identifying

a. trends c. causes
b. differences d. relationships

15. Horizontal analysis of comparative financial statements includes

a. development of common size statements
b. calculation of liquidity ratios
c. calculation of peso amount changes and percentage changes from the previous to
the current year
d. evaluation of financial statement data that expresses each item in a financial
statement as a percentage of a base amount

16. The receivable turnover and inventory turnover ratios are used to analyze
a. long term solvency c. liquidity
b. profitability d. leverage

17. company had a balance in the Accounts Receivable account of P780,000 at the beginning
of the year and a balance of P820,000 at the end of the year. Net credit sales during the
year amounted to P5,840,000. The receivable turnover ratio was

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 a. 7.1 times c. 7.5 times
b. 7.3 times d. 7 times

18. A company has a receivables turnover ratio of 10. The average net receivables during the
period are P400,000. What is the amount of net credit sales for the period?
a. P40,000 c. P480,000
b. P4,000,000 d. P520,000
e.

19. A company has an average inventory on hand of P60,000 and its average days in
inventory is 29.2 days. What is the cost of goods sold?
a. P750,000 c. P1,680,000
b. P1,752,000 d. P876,000

20. A company had a balance in the Accounts Receivable account of P780,000 at the
beginning of the year and a balance of P820,000 at the end of the year. Net credit sales
during the year amounted to P5,840,000. The average collection period of the receivables
in terms of days was
a. 30 days c. 100 days
b. 365 days d. 50 days

PROBLEMS

Problem 1

Comparative information taken from the Calla Company financial statements is shown
below:

Year 2 Year 1
a. Accounts receivable P175,000 P140,000
b. Retained earnings 30,000 (40,000)
c. Sales 855,000 750,000
d. Operating expenses 170,000 200,000
e. Income taxes payable 22,000 20,000

Instructions:

1. Calculate the peso change for each item and indicate whether the change is increase or
decrease.

2. Calculate the percentage change from Year 1 to Year 2 with Year 1 as the base year.

Problem 2

The following items were taken from the financial statements of Dally Inc., over a three-
year period:

Item Year 3 Year 2 Year 1

Net Sales P226,000 P212,000 P200,000
Cost of Goods Sold 150,000 140,000 136,000
Gross Profit P76,000 P72,000 P64,000

Instructions:

Using horizontal analysis and Year 1 as the base year, compute the trend percentages for
net sales, cost of goods sold, and gross profit. Explain whether the trends are favorable or
unfavorable for each item.
Problem 3

The following selected information from the comparative financial statements of Elly
Company for the year ended December 31:

Year 2 Year 1
Accounts Receivable (net) P175,000 P200,000
Inventory 130,000 150,000
Total Assets 1,100,000 800,000
Current Liabilities 140,000 110,000
Long-term debt 410,000 300,000
Net credit sales 800,000 700,000
Cost of goods sold 600,000 530,000
Interest expense 40,000 25,000
Income tax expense 60,000 29,000
Net Income 150,000 85,000

Instructions: Answer the following questions relating to the year ended December 31, year 2.
Show computations.

1. The inventory turnover ratio for Year 2 is _________________.

2. The number of times interest earned ratio in Year 2 is ________________.

3. The receivables turnover ratio for Year 2 is ______________.

4. The return on assets ratio for Year 2 is _______________.

Problem 4

Jany Corporation has issued common stock only. The company has been successful and
has a gross profit rate of 20%. The information shown below was taken from the company’s
financial statements.
Beginning
inventory P482,000
Purchases 4,416,000
Ending
inventory ?
Average accounts
receivable 700,000
Average common stockholder's equity 3,500,000
Sales (all on
credit) 5,200,000
Net income 420,000

Instructions: Compute the following:

1. Receivables turnover

2. Average number of days required to collect the accounts receivable

3. Inventory turnover

4. Average days in inventory

5. Return on common stockholders’ equity

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Problem 5

The following information pertains to Greenwich Company. Assume that all balance
sheet amounts represent both average and ending balance figures. Assume that all sales were
on credit.

Balance Sheet
Assets
Cash and short-term investments P40,000
Accounts receivable, net 25,000
Inventory 20,000
Property, plant, and equipment 210,000
Total Assets P295,000

Liabilities and Stockholders’ Equity

Current Liabilities P60,000
Long-term liabilities 85,000
Stockholders' equity -- common 150,000
Total Liabilities and Stockholders' Equity P295,000

Income Statement
Sales P85,000
Cost of goods sold 45,000
Gross profit P40,000
Operating expenses 20,000
Net income P20,000

Number of shares of common stock 6,000

Market price of common stock P20
Dividends per share P0.90

Requirements:

1. What is the current ratio for this company?

2. What is the receivable turnover for this company?

3. What is the inventory turnover for this company?

4. What is the Debt/Equity ratio?

5. What is the return on sales?

6. What is the Earnings per share (EPS)?

7. What is the dividend pay-out ratio?

8. What is the net income or net profit ratio?

9. What is the gross profit ratio?

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