AEC 6 – Financial Management

Activity#2

Chapter 2 – Evaluating Operating & Financial Performance of Business Entity

(100 points)

Name: RHEA MAY G. BALUTE Date:

_____________

Activity 2A - Discussion Questions: (5 points each)

1. What four financial statements are contained in most corporate annual reports? Explain its
significance in making sound management decision.
- An annual report for a corporation normally includes four types of financial
statement: a balance sheet, income statement, cash flow statement; and statement of equity.
Balance Sheet- A balance sheet is a summary of an organization’s financial position.
Balance sheet is useful for evaluating an organization’s ability to meet its long-term financial
commitments. A balance sheet lists all the assets that an organization owns, together with its
liabilities, and the equity owned by various stakeholders.
Income Statement- An income statement summarizes the amount of money an
organization earned and the amount it spent during the accounting year. Earnings derive
from the revenue an organization achieves from the sale of products or services, plus any
capital gains. Expenditure refers to the money an organization spends to create revenue,
such as materials, running costs and cost of sales. Deducting expenditure from revenue
provides a figure of net income.
Cash flow Statement-The statement of cash flows, or the cash flow statement, is a financial
statement that summarizes the amount of cash and cash equivalents entering and leaving a
company. The cash flow statement measures how well a company manages its cash position,
meaning how well the company generates cash to pay its debt obligations and fund its
operating expenses.
Statement of Equity- The statement of owner’s equity reports the changes in company
equity. The changes that are generally reflected in the equity statement include the earned
profits, dividends, inflow of equity, withdrawal of equity, net loss, and so on.

2. How is the income statement related to the statement of Financial Position? If you are a
consultant of a company to acquire another entity, what you are going to examine more, the
Statement of Financial Position or Statement of Performance? Explain your answer.
- When an accountant records a sale or expense entry using double-entry accounting,
he or she sees the interconnections between the income statement and balance sheet. A sale
increases an asset or decreases a liability, and an expense decreases an asset or increases a
liability.Therefore, one side of every sales and expense entry is in the income statement, and
the other side is in the balance sheet. You can’t record a sale or an expense without affecting
the balance sheet.
 For me Both because Statement of Financial Position and Statement of Performance has a big
role in a business.

3. Discuss why inflation may restrict the usefulness of the statement of financial position as
normally presented.
- All assets and liabilities are recorded in the balance sheet at their historical cost. For
example, the cost to the firm at the time that they were acquired. For assets that depreciate it
is possible to make a regular adjustment using the depreciation accounts mentioned above.
But for other assets it is difficult (given the general requirement for prudence and the
tendency for conservatism) to revalue assets at current market values. This requires some
kind of offset and may affect the Income statement which is a little scary from a truth point
of view.
4. Explain in general terms the concept of return on investment. Why is this concept important
in the analysis of financial performance?
-Return on Investment (ROI) is a performance measure used to evaluate the
efficiency of an investment or compare the efficiency of a number of different investments.
ROI tries to directly measure the amount of return on a particular investment, relative to the
investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the
cost of the investment. The result is expressed as a percentage or a ratio.
Return on Investment is one of the profitability ratios. It is one of the simplest measures for
investors to understand the profitability of their return. Thus, the analysis helps investors and
management in comparing various investment opportunities. One can also use ROI analysis
to calculate and compare the return of the current and previous periods for better
understanding of the portfolio performance. Fund managers carry ROI analysis on the
portfolios to understand the competitiveness in the market.
5. Explain the concept of liquidity, why it is crucial to company survival.
- Liquidity means cash availability. It refers to how much cash a company has and
how much it can raise on short notice. The liquidity of a company means the liquid assets
held by it that can be easily converted into cash. It consists of money in the company's safe
and balances in banks and financial institutions. Cash is crucial because the company pay
their debt and different expenses by cash.
6. What is the difference between net cash flow from operating activities, net cash flow from
investing activities and net cash flow from financing activities?
- Cash flows from operating activities arise from the activities a business uses to produce
net income. For example, operating cash flows include cash sources from sales and cash used
to purchase inventory and to pay for operating expenses such as salaries and utilities. While
Cash flows from investing activities are cash business transactions related to a business’
investments in long-term assets. They can usually be identified from changes in the Fixed
Assets section of the long-term assets section of the balance sheet. While Cash flows from
financing activities are cash transactions related to the business raising money from debt or
stock, or repaying that debt. They can be identified from changes in long-term liabilities and
equity.
7. What are the free cash flows for a firm? What does it mean when a firm’s free cash flow is
negative?
 - Free cash flow to the firm (FCFF) represents the amount of cash flow from operations
available for distribution after accounting for depreciation expenses, taxes, working capital,
and investments. A company with negative cash flow doesn’t signify that it is bad because
new companies usually spend a lot of cash. They do investments getting high rate of return
due to which they run out of cash at hand. Since the availability of cash does not appear so
attractive to investor, high rate of return and investment is therefore given much more
importance. It is also considered a good sign of financial position.

8. What is meant by the terms; Operating Leverage, Financial Leverage, Break-even Point, and
Margin of safety. Present a sample computation using the formula of each analysis.
Operating Leverage- is a cost-accounting formula that measures the degree to which
a firm or project can increase operating income by increasing revenue. A business that
generates sales with a high gross margin and low variable costs has high operating leverage.
For example, Company A sells 500,000 products for a unit price of $6 each. The company’s
fixed costs are $800,000. It costs $0.05 in variable costs per unit to make each product.
Calculate company A’s degree of operating leverage as follows:

500,000∗($6.00−$0.05).
500,000∗($6.00−$0.05)−$800,000
= $2,175,000
$2,975,000
=1.37 or 137%.

Financial Laverage- is the use of borrowed money (debt) to finance the purchase of assets
with the expectation that the income or capital gain from the new asset will exceed the cost
of borrowing.
Example 1
Bob and Jim are both looking to purchase the same house that costs $500,000. Bob plans to
make a 10% down payment and take a $450,000 mortgage for the rest of the payment
(mortgage cost is 5% annually). Jim wants to purchase the house for $500,000 cash today.
Who will realize a higher return on investment if they sell the house for $550,000 a year
from today?
Although Jim makes a higher profit, Bob sees a much higher return on investment because he
made $27,500 profit with an investment of only $50,000 (while Jim made $50,000 profit with a
$500,000 investment).

Break-even-analysis Break Even Analysis in economics, business, and cost accounting refers to
the point in which total cost and total revenue are equal. A break even point analysis is used to
determine the number of units or dollars of revenue needed to cover total costs (fixed and
variable costs).
Example: Colin is the managerial accountant in charge of Company A, which sells water
bottles. He previously determined that the fixed costs of Company A consist of property
taxes, a lease, and executive salaries, which add up to $100,000. The variable cost
associated with producing one water bottle is $2 per unit. The water bottle is sold at a
premium price of $12. To determine the break even point of Company A’s premium water
bottle:

Break even quantity = $100,000 / ($12 – $2) = 10,000

Margin of safety- The margin of safety is the difference between the amount of expected
profitability and the break-even point. The margin of safety formula is equal to current sales
minus the breakeven point, divided by current sales.
Example: Ford company purchased a new piece of machinery to expand the production
output of its top of the line car model. The machine’s costs will increase the operating
expenses to $1,000,000 per year, and the sales output will likewise augment. After the
machine was purchased, the company achieved a sales revenue of $4.2M, with a breakeven
point of $3.95M, giving a margin of safety of 5.8%.

9. What is meant by the term sales mix? What assumption is usually made concerning sales mix
in CVP analysis?
- The sales mix is the relative proportions in which a company’s products are sold.The usual
assumption is cost-volume-profit analysis is that the sales mix will notchange.

10. Explain how the break-even point and operating leverage are affected by the choice of
manufacturing facilities (labor intensive vs capital intensive).
- A labor-intensive company will have low fixed costs and a correspondingly low
break-even point. However, the impact of operating leverage on the firm is small and there will
be little magnification of profits as volume increases. A capital-intensive firm, on the other hand,
will have a higher break-even point and enjoy the positive influences of operating leverage as
volume increases.
Activity 2B - Problems:

1. Refer to Problem 7 of Chapter 5, page 74. (10 points)

a. Prepare an Income Statement for Year 20x5.
b. Prepare a Statement of Retained Earnings for Year 20x5.
c. Prepare a Statement of Financial Position as of December 31, 20x5.

2. Refer to Problem 8 of Chapter 5, page 76. (10 points)

a. Prepare Statement of Cash Flows.
b. Describe the general relationship between Net Income and Net Cash Flows from
Operating Activities.

3. Refer to Problem 14 of Chapter 6, page 119. Calculate the following ratios. (7 points)
a. Current ratio
b. Quick (Acid-test) ratio
c. Days sales outstanding
d. Inventory turnover
e. Total assets turnover
f. ROA
g. ROE

4. Refer to Problem 26 of Chapter 6, page 127. (4 points)

a. Calculate the accounts receivable
b. Calculate the marketable securities
c. Calculate the fixed assets
 d. Calculate the long-term debt.

5. Refer to Problem 7 of Chapter 7, page 150 to 153. (15 points)

a. Fill in the blanks on the four financial statements. Present properly each report.

6. Refer to Problem 10 of Chapter 8, page 182. Compute the following. (4 points)

a. Degree of Operating Leverage.
b. Degree of Financial Leverage
c. Degree of Combine Leverage
d. Break-even point in units