Introduction

Unit I
 I. Introduction

1.4 Basic Principles 1.5 Overview of

1.1 What is 1.2 Stock Prices 1.3 Legal Forms of
of Financial the Financial
Finance? and Shareholder Business
Management Market
Value Organization
Environment
1.4.1 Money has a Time
Value
1.4.2 There is Risk-
Return Trade-off
1.4.3 Cash Flows are the
Source of Value
1.4.4 Market Prices
Reflect Information
1.4.5 Individuals
Respond to Incentives
 1.1 What is Finance?

Watch: History of Money (https://youtu.be/YCN2aTlocOw)

is the art and science of managing money

is the system that includes the circulation of money, granting of

credit, the making of investments , and the provision of banking
facilities

3 types of Finance: public/ government; private / personal and

corporate/managerial finance
How the Finance Area Fits into a Corporation
Corporate Finance
Basic Recording and Manages assets and
Definition reporting past liabilities of firm to
financial plan for future
transactions growth
Importance Shows financial Assists in deciding
health of the future projects and
business managing assets
Key Reporting financial Maximize wealth
objective information
Why study finance
• It helps you understand the
difference of value and price
as well as its impact on
business decisions
• It improves your financial
literacy so you can make
sound financial decisions
• It allows you to see the big
picture of where company
obtain funds and how they
use it to create profit and
value
Primary financial goal:
• Maximize shareholder’s
wealth
• wealth- true, long-run value
of the firm (or its stock if
listed)
• Intrinsic value- an estimate of
the stock’s “true, long-run”
value based on accurate risk
and return data
• Stock price/ Market price-
perceived value based on
possibly incorrect information
as seen by the marginal
investor
How is stock price • stock’s price is a
determined? function of the
supply of shares
available and the
demand among
investors for the
shares

• Watch video
• https://www.you
tube.com/watch?v
=p7HKvqRI_Bo
 Determinants of Intrinsic Values and
Stock Prices

Managerial Actions, the Economic Environment,

Taxes, and the Political Climate

“True” Investor “Perceived” Investor “Perceived”

“True” Risk
Cash Flows Cash Flows Risk

Stock’s Stock’s
Intrinsic Value Market Price

Market Equilibrium:
Intrinsic Value = Stock Price
 Stock Prices and
Intrinsic Value
• In equilibrium, a stock’s price
should equal its “true” or
intrinsic value.
• To the extent that investor
perceptions are incorrect, a
stock’s price in the short run
may deviate from its intrinsic
value.
• Ideally, managers should avoid
actions that reduce intrinsic
value, even if those decisions
increase the stock price in the
short run.
March 26, 2020
Trading in Zoom Technologies Inc. (ticker: ZOOM) was
suspended by the U.S. Securities and Exchange
Commission Thursday through April 8 after the stock
climbed in recent weeks amid confusion with Zoom
Video Communications Inc. (ticker: ZM), the popular
virtual-meeting company.
Source: bloomberg news
 January 27, 2021
GameStop is a troubled video game
retailer that was once a fixture in
suburban malls. Retails investors
following Reddit page called Wall
Street Bets have band together to
pile trades, buying shares and stock
options, on GameStop and other companies to push their stock
prices into stratospheric levels. This aimed at hurting hedge
funds and other professionals who shorted on these stocks.
GameStop’s market value increased to over $24 billion from $2
billion in a matter of days. Its shares have risen over 1,700
percent since December.

Source: New York times

 Balancing Shareholder Interests
and Society Interests

• The primary financial goal of management is

shareholder wealth maximization, which
translates to maximizing stock price.
– Most significant decisions are evaluated in
terms of their financial consequences.

• Managers recognize that being socially

responsible is not inconsistent with maximizing
shareholder value.
 1.3 Forms of Business Organization

Business
Forms

Proprietorships Partnerships
Corporations
 PRINCIPLE
• A peso today is worth more than a peso
1:Money Has a tomorrow
Time Value

PRINCIPLE 2:
• The higher the risk, the higher the
There is a Risk- expected return
Return Trade-off

PRINCIPLE 3: Cash • Value of any asset today is the present

Flows Are the value of relevant cash flow stream to
Source of Value owners
PRINCIPLE 4:
Market • Stock prices change over time as conditions
Prices change and as investors respond to new
Reflect information about a company’s prospects
Information

• Managers are naturally inclined to act in their

PRINCIPLE 5: own best interests (which are not always the
Individuals same as the interest of stockholders). Aligning
Respond to incentives (like performance plan) with
Incentives stockholders’ interest can influence
management to act accordingly.
 • A market is a venue where
goods and services are
1.5 Overview exchanged.
of the • A financial market is a
Financial structure/ arena through which
Market funds flow. It is a place where
Environment user of funds are brought
together with supplier of funds.

• Watch video:
https://www.youtube.com/wat
ch?v=s58-mrPom7Q
 The Capital Allocation
Process
• In a well-functioning economy, capital flows efficiently
from those who supply capital to those who demand
it.
• Suppliers of capital: individuals and institutions with
“excess funds.” These groups are saving money and
looking for a rate of return on their investment.
• Demanders or users of capital: individuals and
institutions who need to raise funds to finance their
investment opportunities. These groups are willing to
pay a rate of return on the capital they borrow.
Well-functioning financial markets facilitate the flow of
capital from investors to the users of capital.
• Markets provide savers with returns on their money saved/invested,
which provide them money in the future.
• Markets provide users of capital with the necessary funds to finance
their investment projects.

Well-functioning markets promote economic growth.

Economies with well-developed markets perform better

than economies with poorly-functioning markets.
Types of Financial markets

Primary Money
VS VS

Secondary Capital
 Primary markets
• markets in which users of funds (e.g.,
corporations and governments) raise
funds through new issues of security
(e.g., stocks and bonds)
Primary
Secondary markets
vs.
Secondary • A market that trades financial
instruments once they are issued (e.g.,
Market PSE)
• Secondary markets add liquidity for
risky investments and encourage
investment in primary markets.
Secondary markets also aid in price
discovery, providing up to date signals of
the ongoing value of firms. These
signals also provide benchmarks for
corporate performance
• Money markets
– markets that trade debt securities with
maturities of one year or less (e.g., Certificates
of deposits and Treasury bills)
– little or no risk of capital loss, but low return
• Capital markets
– markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year
– substantial risk of capital loss, but higher
promised return
1.1 What is 1.2 Stock Prices 1.3 Legal Forms of 1.4 Basic 1.5 Overview of
Finance? and Shareholder Business Principles of the Financial
Value Organization Financial Market
Management Environment
1.4.1 Money has a Time
Value
1.4.2 There is Risk-
Return Trade-off
1.4.3 Cash Flows are the
Source of Value
1.4.4 Market Prices
Reflect Information
1.4.5 Individuals
Respond to Incentives
Questions?

What were your key

insights or learnings?
 2.1 Common-size financial
statements (vertical analysis)
2.2 Trend analysis (horizontal
analysis)
2.3 Cash Flow Analysis
Content 2.3.1 Free Cash Flow
2.3.2 Free Cash Flow to the
Firm
2.3.3 Free Cash Flow to the
Equity
• is a collection of formal reports that convey the business
activities and financial performance of a company
• Four key financial statements
1. Income Statement – shows the firm’s financial
performance during a reporting period
2. Balance Sheet – shows the firm’s financial position at
a specific point in time
3. Statement of Cash flows- report that shows how items
or activities affect the firm’s cash flows
4. Statement of Stockholders’ Equity- statement that
shows by how much a firm’s equity changed during
the reporting period and why this change occurred
 Income Statement
For the <period> ended <Month Day, Year>

Sales P xxx,xxx
Less: Cost of Goods Sold (xx,xxx)
Gross Profit or Gross margin P xxx,xxx
Less: Operating expenses
Selling expense P xx,xxx
General and administrative expense xx,xxx

Depreciation and amortization expense xx,xxx (xxx,xxx)

Net Operating income P xx,xxx
Other Income xxx
Earning before interest and taxes (EBIT) P xx,xxx
Less: Interest expense (x,xxx)
Earnings before taxes P xx,xxx
Less: Income tax expense (x,xxx)
Net Income P xx,xxx
 Balance Sheet
As of <Month Day, Year>

Liabilities
Assets
Accounts Payable P xxx
Cash P xxx Notes Payable xxx
Accounts Receivable xxx Accrued expenses xxx
Inventories xxx Total current liabilities P x,xxx
Other current assets xxx Long-term debt x,xxx
Total current assets P x,xxx Total Liabilities P x,xxx

Property, plant and equipment P xxx Stockholders’ Equity

Less: Accumulated Depreciation (xxx)
Common Stock xxx
Property, plant and equipment, xxx
net Additional Paid-in xxx

Other non-current assets xxx Retained Earnings xxx

Total non-current assets P x,xxx Treasury Stock (xxx)

Total Stockholders’ Equity P x,xxx
Total Assets P xx,xxx
Total Liabilities and SHE P xx,xxx
 Statement of Cash Flows
For the <period> ended <Month Day, Year>
Cash flow from Operating Activities
Net Income P xx,xxx
Depreciation expense xx,xxx
Loss (gain) on sale of fixed asset x,xxx
Decrease (increase) in accounts receivable (x,xxx)
Decrease (increase) in inventories x,xxx
Decrease (increase) in accruals (x,xxx)
Cash provided (used) in operating activities P xxx
Cash flow from Investing Activities
Purchases of fixed asset P ( xxx,xxx)
Proceeds from sale of fixed asset xx,xxx
Cash provided (used) in investing activities P (xxx,xxx)
Cash flow from Financing Activities
Increase (decrease) in short-term debt P xx,xxx
Borrowings (repayment) of long-term debt xxx,xxx
Cash dividends (xx,xxx)
Cash provided (used) in investing activities P xxx,xxx
Net increase (decrease) in cash P xxx
Cash at the beginning of the year xxx
Cash at the end of the year P xxx
 Statement of Stockholders’ Equity
For the <period> ended <Month Day, Year>

Common Additional Retained Treasury Total

Stock Paid-In earnings stock Stockholders’
Equity
Beginning balance P xxx P xxx P xxx P (xxx) P x,xxx
Net income xx,xxx xx,xxx
Cash dividends (xx,xxx) (xx,xxx)
Ending balances P xxx P xxx P xxx P (xxx) P xx,xxx
• Is the process of understanding a company’s financial
situation by reviewing its financial statements

• Purpose of Financial Statement Analysis

– Internal purpose: (1) evaluate firm’s/
division’s/employees’ performance; (2) prepare
financial projections
– External purpose: investment decision, loan approval
decision, extending credit decision, determining firm’s
credit rating
Common-size FS or vertical analysis

Trend or horizontal analysis

Cash flows analysis

Ratio analysis
• Common size FS (or vertical analysis) is a FS
analysis technique that expresses each item in
a financial statement as a percentage of a base
amount for the same time period
• Helps compare FS of firms that have different
sizes
• Common-size % = (item amount/ base amount)
x 100%
– Balance sheet: use Total Assets as base
amount
– Income statement: use Net Sales as base
amount
 Income Statement
For the year ended December 31, 20xx
(in thousands)
Sales ₱ 75,000 100.0%
45,000/ 75,000
Less: Cost of Goods Sold (45,000) -60.0% = 60%
Gross Profit or Gross margin ₱ 30,000 40.0%
Less: Operating expenses
Selling expense ₱ 3,750 5.0%
General and administrative expense 6,000 8.0%
Depreciation and amortization expense 2,250 3.0%
Total operating expense -₱ 12,000 -16.0%
Net Operating income ₱ 18,000 24.0%
Other Income 1,500 2.0%
Earning before interest and taxes (EBIT) ₱ 19,500 26.0%
Less: Interest expense (4,500) -6.0%
Earnings before taxes ₱ 15,000 20.0%
Less: Income tax expense (25%) (3,750) -5.0%
Net Income ₱ 11,250 15.0%
 Income Statement
For the year ended December 31, 20xx Cost of Goods
(in thousands) Sold is 60% of
sales for the
Sales ₱ 75,000 100.0% year
Less: Cost of Goods Sold (45,000) -60.0%
Gross Profit or Gross margin ₱ 30,000 40.0%
Less: Operating expenses
Selling expense ₱ 3,750 5.0%
General and administrative expense 6,000 8.0%
Depreciation and amortization expense 2,250 3.0%
Total operating expense -₱ 12,000 -16.0%
Net Operating income ₱ 18,000 24.0%
Other Income 1,500 2.0%
Earning before interest and taxes (EBIT) ₱ 19,500 26.0%
Less: Interest expense (4,500) -6.0%
Earnings before taxes ₱ 15,000 20.0%
Less: Income tax expense (25%) (3,750) -5.0% 15% of sales
exceeds total
Net Income ₱ 11,250 15.0% expenses for the
period
 Balance Sheet
As of December 31, 20xx
(in thousands)
4,000/ 80,000 Liabilities
Assets = 5%
Accounts Payable ₱ 12,000 15.0%
Cash ₱ 4,000 5.0% Notes Payable 4,000 5.0%
Accounts Receivable 8,000 10.0% Accrued expenses 4,000 5.0%
Inventories 16,000 20.0% Total current liabilities ₱ 20,000 25.0%
Other current assets 4,000 5.0% Long-term debt 20,000 25.0%
Total current assets Total Liabilities ₱ 40,000 50.0%
₱ 32,000 40.0%
Property, plant and equipment ₱ 53,200 66.5% Stockholders’ Equity
Less: Accumulated
Depreciation (11,200) -14.0% Common Stock ₱ 12,000 15.0%
Property, plant and Additional Paid-in 8,000 10.0%
equipment, net ₱ 42,000 52.5% Retained Earnings 28,000 35.0%
Other non-current assets 6,000 7.5% Treasury Stock
Total non-current assets (8,000) -10.0%
₱ 48,000 60.0% Total Stockholders’ Equity ₱ 40,000 50.0%
Total Assets
₱ 80,000 100.0% Total Liabilities and SHE ₱ 80,000 100.0%
 Balance Sheet LT debt
As of December 31, 20xx represents 25%
(in thousands) of Total liabilities
52.5% of total
and SHE
assets is Liabilities
PPE,net
Assets Accounts Payable ₱ 12,000 15.0%
Cash ₱ 4,000 5.0% Notes Payable 4,000 5.0%
Accounts Receivable 8,000 10.0% Accrued expenses 4,000 5.0%
Inventories 16,000 20.0% Total current liabilities ₱ 20,000 25.0%
Other current assets 4,000 5.0% Long-term debt 20,000 25.0%
Total current assets Total Liabilities ₱ 40,000 50.0%
₱ 32,000 40.0%
Property, plant and equipment ₱ 53,200 66.5% Stockholders’ Equity
Less: Accumulated
Depreciation (11,200) -14.0% Common Stock ₱ 12,000 15.0%
Property, plant and equipment, Additional Paid-in 8,000 10.0%
net ₱ 42,000 52.5% Retained Earnings 28,000 35.0%
Other non-current assets 6,000 7.5% Treasury Stock
Total non-current assets (8,000) -10.0%
₱ 48,000 60.0% Total Stockholders’ Equity ₱ 40,000 50.0%
Total Assets
₱ 80,000 100.0% Total Liabilities and SHE ₱ 80,000 100.0%
Trend (or horizontal) analysis is a FS
analysis technique that shows
changes of financial statement items
over a period of time
– The changes are generally
expressed in amount and
percentage
– FS of two or more periods
are used
– Change in amount= Item
amount in comparison year
less Item amount in base
year
– Percentage change= Change
in amount divide by
Item amount in base year
 2.2 Trend analysis
• Two methods of trend analysis
– Simple base-year- the
earliest period is used as
the base period
– Progressive base-year- the
base period changes every
period; it uses the period
immediately before the
period under review
• Example: 3-year trend analysis
covering 2018, 2019 and 2020
– Simple base-year: 2018
– Progressive base-year: 2019
uses 2018 as base year
while 2020 uses 2019 as
base year
 Illustrative: Two methods of Trend analysis
2018 2019 2020
Net sales P 300,000 P 450,000 P 425,000
Cost and expenses (192,000) (213,000) (209,500)
Net income P 108,000 P 237,000 P 215,500

Cash P 20,000 P 10,000 P 10,000

Receivables 60,000 70,000 80,000
Inventory 40,000 60,000 90,000
Total current assets P 120,000 P 140,000 P 180,000
Fixed assets 40,000 40,000 40,000
Total Assets P 160,000 P 180,000 P 220,000

Accounts Payable and accruals 40,000 50,000 90,000

Long-term debt 20,000 20,000 40,000
Total liabilities P 60,000 P 70,000 P 130,000
Stockholders’ Equity 100,000 110,000 90,000
Total liabilities and stockholders’ equity P 160,000 P 180,000 P 220,000

17
 Illustrative: Two methods
of Trend analysis for 2020

2020 Simple base-year 2020 Progressive base-year

Amount % Amount %
Net sales 125,000 41.67% -25,000 -5.56%
Net income 107,500 99.54% -21,500 -9.07%
Inventory 50,000 125% 30,000 50%
Current assets 160,000 50% 40,000 28.57%
Fixed assets 0 0% 0 0%
Total Assets 60,000 37.5% 40,000 22.22%
Stockholders’ Equity -10,000 -10% -20,000 -18.18%

18
 Income Statement
For the year ended December 31, 20xy and 20xx 78.6K – 75K
(in thousands) = 3,600 Inc (Dec)
20xy 20xx peso %
3600/ 75K
Sales ₱ 78,600 ₱ 75,000 ₱3,600 4.8% = 4.8%
Less: Cost of Goods Sold (46,900) (45,000) 1,900 4.2%
Gross Profit or Gross margin ₱ 31,700 ₱ 30,000 ₱1,700 5.7%
Less: Operating expenses
Selling expense
₱ 3,930 ₱ 3,750 ₱ 180 4.8%
General and administrative expense 5,120 6,000 (880) -14.7%
Depreciation and amortization expense 2,500 2,250 250 11.1%
Total operating expense -₱ 11,550 -₱ 12,000 ₱ 450 -3.8%
Net Operating income ₱ 20,150 ₱ 18,000 ₱2,150 11.9%
Other Income 800 1,500 (700) -46.7%
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500 ₱1,450 7.4%
Less: Interest expense (4,950) (4,500) 450 10.0%
Earnings before taxes ₱ 16,000 ₱ 15,000 ₱1,000 6.7%
Less: Income tax expense (25%) (4,000) (3,750) 250 6.7%
Net Income ₱ 12,000 ₱ 11,250 ₱ 750 6.7%
 Income Statement
For the year ended December 31, 20xy and 20xx
(in thousands) Inc (Dec)
20xy 20xx peso %
Sales ₱ 78,600 ₱ 75,000 ₱3,600 4.8%
Less: Cost of Goods Sold (46,900) (45,000) 1,900 4.2% General and
Gross Profit or Gross margin admin
₱ 31,700 ₱ 30,000 ₱1,700 5.7%
expense
Less: Operating expenses decreases
by 14.7%
Selling expense
₱ 3,930 ₱ 3,750 ₱ 180 4.8%
General and administrative expense 5,120 6,000 (880) -14.7%
Depreciation and amortization expense 2,500 2,250 250 11.1%
Total operating expense -₱ 11,550 -₱ 12,000 ₱ 450 -3.8% Depreciation
and
Net Operating income ₱ 20,150 ₱ 18,000 ₱2,150 11.9% amortization
increases by
Other Income 800 1,500 (700) -46.7% 11.1%
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500 ₱1,450 7.4%
Less: Interest expense (4,950) (4,500) 450 10.0%
Earnings before taxes ₱ 16,000 ₱ 15,000 ₱1,000 6.7%
Less: Income tax expense (25%) (4,000) (3,750) 250 6.7%
Net Income ₱ 12,000 ₱ 11,250 ₱ 750 6.7%
 Balance Sheet
As of December 31, 20xy and 20xx
(in thousands)

Assets 4,250-4,000
= 250
Inc (Dec)
20xy 20xx peso %
250/4,000
Cash ₱ 4,250 ₱ 4,000 ₱ 250 6.3% = 6.3%
Accounts Receivable 9,500 8,000 1,500 18.8%
Inventories 13,750 16,000 (2,250) -14.1%
Other current assets 5,000 4,000 1,000 25.0%
Total current assets
₱ 32,500 ₱ 32,000 ₱ 500 1.6%
Property, plant and equipment ₱ 58,400 ₱ 53,200 ₱ 5,200 9.8%
Less: Accumulated Depreciation
(13,700) (11,200) 2,500 22.3%
Property, plant and equipment, net ₱ 44,700 ₱ 42,000 ₱ 2,700 6.4%
Other non-current assets 5,300 6,000 (700) -11.7%
Total non-current assets ₱ 50,000 ₱ 48,000 ₱ 2,000 4.2%
Total Assets ₱ 82,500 ₱ 80,000 ₱ 2,500 3.1%
 Balance Sheet
As of December 31, 20xy and 20xx
(in thousands)
10K – 12K
Liabilities = (2,000)
Inc (Dec)
20xy 20xx peso % (2K)/12K
Accounts Payable ₱ 10,000 ₱ 12,000 -₱ 2,000 -16.7% = -16.7%
Notes Payable 2,500 4,000 (1,500) -37.5%
Accrued expenses 4,800 4,000 800 20.0%
Total current liabilities ₱ 17,300 ₱ 20,000 -₱ 2,700 -13.5%
Long-term debt 22,000 20,000 2,000 10.0%
Total Liabilities ₱ 39,300 ₱ 40,000 -₱ 700 -1.8%

Stockholders’ Equity
Common Stock
₱ 12,000 ₱ 12,000 ₱ - 0.0%
Additional Paid-in 8,000 8,000 - 0.0%
Retained Earnings 31,200 28,000 3,200 11.4%
Treasury Stock
(8,000) (8,000) - 0.0%
Total Stockholders’ Equity ₱ 43,200 ₱ 40,000 ₱ 3,200 8.0%
Total Liabilities and SHE ₱ 82,500 ₱ 80,000 ₱ 2,500 3.1%
 Balance Sheet
As of December 31, 20xy and 20xx
(in thousands)

Assets
Inc (Dec)
20xy 20xx peso %
Cash ₱ 4,250 ₱ 4,000 ₱ 250 6.3% Other current
assets increases
Accounts Receivable 9,500 8,000 1,500 18.8% by 25%, the
Inventories 13,750 16,000 (2,250) -14.1% highest increase
Other current assets of all assets
5,000 4,000 1,000 25.0%
Total current assets
₱ 32,500 ₱ 32,000 ₱ 500 1.6%
Property, plant and equipment ₱ 58,400 ₱ 53,200 ₱ 5,200 9.8%
Less: Accumulated Depreciation
(13,700) (11,200) 2,500 22.3%
Property, plant and equipment, net ₱ 44,700 ₱ 42,000 ₱ 2,700 6.4%
Other non-current assets 5,300 6,000 (700) -11.7%
Total non-current assets ₱ 50,000 ₱ 48,000 ₱ 2,000 4.2%
Total Assets ₱ 82,500 ₱ 80,000 ₱ 2,500 3.1%
 Balance Sheet
As of December 31, 20xy and 20xx
(in thousands)

Liabilities
Inc (Dec)
20xy 20xx peso % Notes payables
Accounts Payable decreases the
₱ 10,000 ₱ 12,000 -₱ 2,000 -16.7%
most (37.5%) of
Notes Payable 2,500 4,000 (1,500) -37.5% all liabilities
Accrued expenses 4,800 4,000 800 20.0%
Total current liabilities ₱ 17,300 ₱ 20,000 -₱ 2,700 -13.5%
Long-term debt 22,000 20,000 2,000 10.0%
Total Liabilities ₱ 39,300 ₱ 40,000 -₱ 700 -1.8%

Stockholders’ Equity
Common Stock
₱ 12,000 ₱ 12,000 ₱ - 0.0%
Additional Paid-in 8,000 8,000 - 0.0%
Retained Earnings 31,200 28,000 3,200 11.4%
Treasury Stock
(8,000) (8,000) - 0.0%
Total Stockholders’ Equity ₱ 43,200 ₱ 40,000 ₱ 3,200 8.0%
Total Liabilities and SHE ₱ 82,500 ₱ 80,000 ₱ 2,500 3.1%
Palette Company’s reported net income was 17% of its
net sales. It was able to generate an EBIT of P0.42 for
every peso of its sales. Tax rate is 25%. What is the
interest expense if Palette’s sales increased by 28% from
last year’s sales of P920,000.
OMI Industries has the following balance sheet totals for the past 5
years: 2017 2018 2019 2020 2021
Assets 754,000 810,500 880,000 854,000 820,750
Liabilities 414,700 536,800 440,000 432,100 415,500
SHE 339,300 273,700 440,000 421,900 405,250

a. What is the common size % of total liabilities of 2021?

b. What is the common size % of total SHE of 2021?
c. What would be the % increase/ decrease of total assets for 2021
using a simple base-year trend?
d. What would be the % increase/ decrease of total assets for 2021
using a progressive base-year trend?
27
• Is an evaluation of company’s cash inflows and
outflows
• typically uses Statement of Cash Flows and other
reports to determine overall value a firm based on
free cash flow (FCF)* the firm generates over time
• *Principle 3: Cash Flows are
the Source of Value
• In finance, FCF is regarded
as the single most important
number developed from FS
• Aka Cash flow from Assets
• is the amount of cash that could be
withdrawn without harming a firm’s ability
to operate and to produce future cash
flows
• cash flow that is free and available to be
distributed to the firm’s investors (both
debt and equity investors)
Calculated as follows:

NOPAT
Net fixed asset Net current
investment asset investment
OCF (NFAI) (NCAI)

where: EBIT- Earnings before Interest and taxes

T – applicable tax rate
NOWC- Net Operating Working Capital
NOPAT- Net Operating Profit after Tax
OCF- Operating Cash flow
Since the primary focus is on cash flow; there’s a need modify accrual-based financial
statements; here’s a modified income statement to compute NOPAT and OCF
Sales P xxx,xxx
Cost of sales (xx,xxx)
Gross profit P xxx,xxx
Cash operating expenses (xx,xxx)
Other income xxx
Earnings before interest, tax, depreciation and P xx,xxx
amortization (EBITDA)
Depreciation and amortization expense (xx,xxx)
Earning before interest and taxes (EBIT) P xx,xxx
Taxes (EBIT x tax rate) (x,xxx)
OCF is different
Net operating profit after tax (NOPAT) or [EBIT (1-T)] P xx,xxx
from “cash flows
Add: Depreciation and amortization expense xx,xxx from operating
Operating cash flows (OCF) P xx,xxx activities”
• aka Net Fixed Assets Investment (NFAI)
• Is the amount the company is investing in its fixed assets
• Can be calculated as follows:
CAPEX = [Property, plant and equipment (PPE), end] – [PPE, beg.]
CAPEX = [Increase in PPE, net] + [Depreciation expense]
• Can also be found in the Statement of Cash Flows
Cash flow from Operating Activities
Net Income P xx,xxx
Depreciation expense xx,xxx
Loss (gain) on sale of fixed asset x,xxx
Cash flow from Investing Activities
Purchases of fixed asset P ( xxx,xxx)
Proceeds from sale of property xx,xxx
Cash provided (used) in investing activities P (xxx,xxx)
 Balance Sheet
As of December 31, 20xy and 20xx

Assets
CAPEX= 58,400 –
20xy 20xx 53,200 = 5,200
Cash ₱ 4,250 ₱ 4,000
Accounts Receivable 9,500 8,000
OR
Inventories 13,750 16,000
CAPEX (44,700 –
Other current assets 5,000 4,000
42,000) + 2,500 =
Total current assets
₱ 32,500 ₱ 32,000 5,200
Property, plant and equipment ₱ 58,400 ₱ 53,200
Less: Accumulated Depreciation
(13,700) (11,200)
Property, plant and equipment, net ₱ 44,700 ₱ 42,000
Other non-current assets 5,300 6,000
Total non-current assets ₱ 50,000 ₱ 48,000
Total Assets ₱ 82,500 ₱ 80,000
• aka Net Current Asset Investment (NCAI)
• Current assets minus non-interest bearing/”free” liabilities
• different from Net working capital as shown below:
Net working capital= [current assets] - [current liabilities]
Net operating working capital= [current assets] -
[current liabilities- notes payable]

• FCF formula needs the change in NOWC calculated

as:
ΔNOWC = [NOWC, end] – [NOWC, beg]
 Cash outflows
• Increase in current
assets
• Decrease in
current liabilities

Cash inflows
• Decrease in
current assets
• Increase in current
liabilities
 Balance Sheet
As of December 31, 20xy and 20xx
(in thousands)

Assets
20xy 20xx
Cash ₱ 4,250 ₱ 4,000
Accounts Receivable 9,500 8,000 ΔNOWC = [32,500 –
Inventories 13,750 16,000 (17,300 – 2,500)] –
Other current assets 5,000 4,000
[32,000 – (20,000 –
Total current assets
4,000)]
₱ 32,500 ₱ 32,000
= 17,700 – 16,000
Liabilities
20xy 20xx =1,700
Accounts Payable ₱ 10,000 ₱ 12,000
Notes Payable 2,500 4,000
Accrued expenses 4,800 4,000
Total current liabilities ₱ 17,300 ₱ 20,000
Long-term debt 22,000 20,000
Total Liabilities ₱ 39,300 ₱ 40,000
Calculated as follows:

Alternatively, can be calculated as follows:

FCF = Cash flow from operating activities* + [Int exp (1-T)] + Cash flow
from investing activities
*assuming no change in (operating) cash balance
 Income Statement
For the year ended December 31, 20xy
(in thousands)

20xy
Sales ₱ 78,600
Less: Cost of Goods Sold (46,900)
Gross Profit or Gross margin ₱ 31,700
Less: Operating expenses
Selling expense
₱ 3,930
General and administrative expense 5,120
Depreciation and amortization expense 2,500
Total operating expense -₱ 11,550
Net Operating income ₱ 20,150
Other Income 800 Starting point of
Earning before interest and taxes (EBIT) ₱ 20,950 computing FCF
Less: Interest expense (4,950)
Earnings before taxes ₱ 16,000
Less: Income tax expense (25%) (4,000)
Net Income ₱ 12,000
FCF of ACYFMG Inc. for year 20xy is calculated as
follows:

FCF = [20,950 (1-25%) + 2,500 ] – [5,200 + 1,700]

FCF = 18,212.50 – 6,900
FCF = P11,312.50
• Positive FCF means the company generated adequate cash
flow to cover its operations and investments. The
company had excess cash flow to pay investors (interest,
dividends).
– Positive FCF is not always good; it may be a sign that the
company is not investing properly for company growth
• Negative FCF means the company is unable to generate
sufficient cash flow to support its operations and
investments. The company would have to finance its
operations/ investment with additional debt and/or
equity.
– Negative FCF is not always bad; it is a good when the
investments/CAPEX will create more cash flows in the future
• To interpret correctly, analyze using the trend of FCF
 FCF to Firm (FCFF) FCF to Equity (FCFE)
• aka unlevered cash flow or cash
flow from Assets • aka levered cash flow or Cash
• cash flow available for flow to Stockholders
discretionary distribution to all • discretionary cash flow available
investors of a company, both only to equity holders of a
equity and debt, after paying for company
cash operating expenses and • the residual cash flow left over
capital expenditure after meeting all financial
• Is the FCF discussed previously obligations and capital
• Used to calculate firm value requirements
• Used to calculate equity value
Watch:https://www.investopedia.com/ask/answers/033015/what-formula-
calculating-free-cash-
flow.asp#:~:text=Free%20cash%20flow%20is%20the,expenditures%2C%20also%20
known%20as%20CAPEX.
Calculated as follows:

where: Net Debt Repayment (borrowings) = Principal debt repayment less

new debt; OR = (Notes payable, beg + LT debt, beg) – (Notes payable, end
+ LT debt, end)

Can also be found in the Statement of Cash Flows

Cash provided (used) in investing activities P (xxx,xxx)
Cash flow from Financing Activities
Increase (decrease) in short-term debt P xx,xxx
Borrowings (repayment) of long-term debt xxx,xxx
Cash dividends (xx,xxx)
Cash provided (used) in investing activities P xxx,xxx
 Alternatively, can be calculated as follows:

Note: [Int Exp (1-T) + Net Debt Repayment] is aka as Cash flow to Creditors

FCFE = Cash flow from operating activities*+ Cash flow from investing
activities + [Cash flow from financing activities - common stock cash
dividends paid**]
*assuming no change in (operating) cash balance
**assuming dividends is the only equity (non-debt) related cash flow from financing activities
If the company has preferred stock (PS), the PS dividends and
redemption net of new issuance would have to be deducted to
arrive at FCFE. The formula will be revised as follows:

Alternatively, can be calculated as follows:

 Balance Sheet
As of December 31, 20xy and 20xx
(in thousands)

Liabilities
20xy 20xx
Accounts Payable Net debt repayment: (
₱ 10,000 ₱ 12,000
Notes Payable
4,000 -2,500) + (20,000
2,500 4,000
– 22,000)
Accrued expenses 4,800 4,000
Total current liabilities ₱ 17,300 ₱ 20,000 = 1,500 + -2,000
Long-term debt 22,000 20,000
Total Liabilities ₱ 39,300 ₱ 40,000 =-500

Stockholders’ Equity 20xx: 4,000 + 20,000 =

Common Stock 24,000
₱ 12,000 ₱ 12,000
Additional Paid-in 8,000 8,000
20xy: 2,500 + 22,000 =
Retained Earnings 31,200 28,000 24,500
Treasury Stock
(8,000) (8,000)
Total Stockholders’ Equity ₱ 43,200 ₱ 40,000
Total Liabilities and SHE ₱ 82,500 ₱ 80,000
• FCFE of ACYFMG Inc. for year 20xy is calculated as
follows:

FCFE = 11,312.50 – [(4,950 x 75%) + -500]

= 11,312.50 – (3,712.50 + -500)
= P8,100
 2021 2020
Depreciation expense P 1,800
EBIT 23,500
Interest expense 3,100
Tax rate 25%
Preferred stock dividends 3,500
Cash 4,000 P 4,250
Accounts Receivable 11,400 9,500
Inventories 15,000 13,500
PPE, net 45,600 44,700
Accounts payable 10,100 10,000
Notes payable 4,000 4,500
Accruals 4,200 4,800
Long-term debt 21,500 22,000
Preferred stock issued 5,700
Given the financial data for Newton Electronics World, Inc. (NEW), compute
for: (a) capital expenditures; (b) ΔNOWC, (c) FCFF, (d) net debt repayment
and (e) FCFE for the year ended 2021
Consider Minnie Company’s excerpt of statement of cash flows
shown below:
Net income P 110,600
Depreciation and amortization 37,500
Loss on sale of fixed asset 2,500
Inc. in accounts receivable (15,000)
Dec. in inventory 22,000
Inc. in accounts payable 18,000
Dec. in accruals (9,000)
Cash flow from operating activities 166,600
Purchase of fixed asset (150,000)
Proceeds from sale of fixed asset 38,100
Cash flow from investing activities (111,900)
Additional notes payable 20,000
Repayment of long-term debt (40,200)
Cash dividends (34,500)
Cash flow from financing activities (54,700)
Increase in cash balance 0
Cash balance, beginning 28,000
Cash balance, ending 28,000

Interest expense amounted P12,400 and income tax rate is 25%.

a.) How much is free cash flow to the firm?
b.) Compute for free cash flow to equity
• 2.1 Common-size financial statements (vertical
analysis)
• 2.2 Trend analysis (horizontal analysis)
• 2.3 Cash Flow Analysis
• 2.3.1 Free Cash Flow
• 2.3.2 Free Cash Flow to the Firm
• 2.3.3 Free Cash Flow to the Equity
Questions?
What were your key insights or learnings?
KNOWLEDGE
CHECK
1. Free cash flow (FCF) is the cash flow a firm generates from its
normal operations.
2. Incurrence and repayment of debt affects the level of FCF to
Equity but not the level of FCF to Firm.
3. An decrease in accounts receivable represents an increase in
net cash provided by operating activities because receivables
will produce cash when they are collected.
4. A corporate treasurer's focus tends to be more external, while
the controller's focus is more internal.
5. Finance is the system of verifying, analyzing, and recording
business transactions.
6. Primary and secondary markets are markets for short-term and
long-term securities, respectively.
7. There may be a substantial difference between a firm's
reported profits and its actual cash flow for the same period.
8. An increase in notes payable would result to an increase in net
operating working capital and decrease in free cash flow.
9. A horizontal FS analysis can be expressed in amount or
percentage.
10. Assets other than cash are expected to produce cash over
time, and the amounts of cash they eventually produce should
be exactly the same as the amounts at which the assets are
carried on the books.
11. Stock’s market price is determined based on accurate risk and
return data.
12. If a manager wants to know what percentage of its asset is
attributed to inventories, he/she can request for a financial
statement trend analysis.
13. Under the horizontal analysis of financial statements, the base
amount of balance sheet items would be Total Asset.
14. A firm without any interest-bearing liabilities and preferred stock
will have the same FCFF and FCFE.
15. For a stock to be in equilibrium, its market price should be equal
to its intrinsic value.
16. Which of the following is a forum in which suppliers and
demanders of funds can transact business directly?

A. financial market
B. financial institutions
C. commodities market
D. commercial institutions
17. One ___ of forming a ____ is that it is more difficult for investors
to transfer their ownership interests.
A. advantage; partnership
B. advantage; corporation
C. drawback; partnership
D. drawback; corporation
18. _____ is used to calculate firm value while ______ is used to
calculate equity value.

A. Free cash flow to firm, unlevered cash flow

B. Free cash flow to equity, Free cash flow to firm
C. Levered cash flow, unlevered cash flow
D. Unlevered cash flow, Free cash flow to equity
19. The money market is a market ________.
A. where foreign currencies are traded
B. where smaller, unlisted securities are traded
C. which brings together suppliers and demanders of short-term
funds
D. that enables suppliers and demanders of long-term funds to
make transactions
20. Managerial finance
A. involves tasks such as budgeting, financial forecasting, cash
management, and funds procurement
B. involves the design and delivery of advice and financial
products.
C. recognizes funds on an accrual basis.
D. devotes the majority of its attention to the collection and
presentation of financial data.
21. The financial manager is responsible for:
A. processing purchase orders and invoices.
B. ensuring accounts payable are paid on time.
C. preparing the monthly income statement.
D. analyzing the mix of current to fixed assets.
22. A portion of the common-size FS analysis is shown below.

Which of the following interpretations is correct?

A. Net fixed assets represent 64.3% of cash

B. 3.6% of total assets is made up of cash
C. The majority portion of total asset pertains to accounts receivable
D. Inventory is 17.9% of Net fixed assets
23. What is meant by the term “double taxation” as applied to the
corporate form of business organization?
A. Corporate income as taxed at twice the rate of partnership
income
B. Corporate income is taxed, and then corporate dividends
are taxed as well.
C. Corporations pay both income tax and commuity tax on
their earnings.
D. Corporations pay both income tax and sales taxes on their
goods.
24. What is the primary financial goal of a firm?
A. Maximize profit
B. Maximize shareholders’ wealth
C. Minimize liability
D. Minimize expenses
25. Analysts who follow Howe Industries recently noted that, relative
to the previous year, the company's cash provided from operations
increased, yet cash as reported on the balance sheet decreased.
Which of the following factors could explain this situation?
A. The company cut its dividend
B. The company issued new long-term debt
C. The company issued new common stock
D. The company made large investments in fixed assets
26. Other things held constant, which of the following actions would
increase the company's free cash flow to equity but not free cash
flow to firm?
A. The company issues new common stock.
B. The company issues new preferred stock.
C. The company repays 10-year bond.
D. All of the above
27. Which is a duty of a financial manager or treasurer?

A. Preparing budgets
B. Analyzing investment opportunities
C. Raising capital
D. All of the above
28. Which of the following is the best measure to ensure that
management decisions are in the best interest of the stockholders?
A. fire managers who are inefficient
B. remove management's perquisites
C. tie management compensation to the level of dividend per
share
D. tie management compensation to the performance of the
company's common stock price
29. Which of the following analysis would shows changes in financial
statement items over a period of time?
A. Horizontal analysis
B. Vertical analysis
C. Common-size FS analysis
D. Free cash flow calculation
30. Kyle and Theo have decided to start a travel business called
Excellent Adventures. Based on the nature of their business, their
clients may be harmed during the travels and claim damages.
Consequently, Kyle and Theo would like a business form that will
shield their personal wealth from any legal claims that the firm might
be subject to should there be any travel mishaps. If Kyle and Theo are
the only investors in this firm, which legal form of organization would
be best for Excellent Adventures to protect both of them?

A. Sole Proprietorship
B. Partnership
C. Limited Partnership
D. Corporation
31. Calculate a firm's free cash flow if it has net operating profit
after taxes of P60,000, depreciation expense of P10,000, net
fixed asset investment requirement of P40,000, a net current
asset requirement of P30,000 and a tax rate of 20%.

32. Prezas Company's balance sheet showed total current assets

of P42,500, all of which were required in operations. Its
current liabilities consisted of P9,550 of accounts payable,
P6,000 of 6% short-term notes payable to the bank, and
P2,800 of accrued wages and taxes. What was its net
operating working capital?
33. Portion of an FS vertical analysis is shown below:
Current Assets 122,100 30%
Current liabilities 85,470 21%
Total stockholders’ equity 195,360 ?
Last year’s Total stockholders’ equity amounted to P188,000.

a. Given the information above, calculate the percentage to be

assigned to total stockholders’ equity using vertical analysis.

b. Given the information above, calculate the percentage to be

assigned to total stockholders’ equity using horizontal analysis.
34. Shrives Publishing recently reported P10,750 of sales, P5,500
of operating costs other than depreciation, and P1,250 of
depreciation. The company had P3,500 of bonds that carry a
7.2% interest rate, and its income tax rate was 20%. During
the year, the firm had expenditures on fixed assets and net
operating working capital that totaled P1,550. These
expenditures were necessary for it to sustain operations and
generate future sales and cash flows. What was its free cash
flow?
35. Assume that Besley Golf Equipment commenced operations on
January 1, 2019. The company planned to depreciate its fixed
assets over 15 years, but in December 2019 management
realized that the assets would last for only 10 years.
Depreciation expense using 15 and 10 years will amount to
P20,000 and P30,000, respectively. If Free Cash Flow (FCF)
amount using the P20,000 depreciation expense is P12,500.
How much would be the revised FCF using 10 years
depreciable life if tax rate is 25%.
36. Houston Pumps recently reported P185,250 of sales, P140,500 of
operating costs other than depreciation, and P9,250 of depreciation.
The company had P35,250 of outstanding bonds maturing 5 years
from now that carry a 6.5% interest rate. In order to sustain its
operations and thus generate future sales and cash flows, the firm
was required to spend P15,250 to buy new fixed assets and to
invest P6,850 in net operating working capital. Its income tax rate is
25%. a. What was the firm's free cash flow? b. What was the firm's
free cash flow to equity?

37. CGPA Inc.’s total assets increased by 14% from last year’s total of
P745,000. If net fixed asset for the year totaled P470,000.
Compute for the common-size percentage of net fixed asset.
Financial Ratio
Analysis
Contents
• 2.4 Financial ratio analysis
• 2.4.1 Liquidity Ratios
• 2.4.2 Activity Ratios
• 2.4.3 Debt Management Ratios
• 2.4.4 Profitability Ratios
• 2.4.5 Market Ratios
• 2.5 DuPont and Modified DuPont systems of analysis
• 2.6 Uses and Limitations of Ratios
Financial ratio analysis
• Involves methods of calculating and interpreting
financial ratios to analyze and monitor firm’s
performance

• Importance and use

• Ratios standardize numbers and facilitate comparisons
• Ratios are used to highlight weaknesses and strengths
RATIO ANALYSIS: Interested parties

Investors Creditors Management

interested in the firm’s interested in the short-term concerned with all aspects of
current and future level of liquidity of the company and the firm’s financial situation,
risk and return, which its ability to make interest and it attempts to produce
directly affect share price and principal payments financial ratios that will be
considered favorable by both
Use ratios to assess Analyze ratios to help judge a owners and creditors
company’s efficiency, risk company’s ability to repay its
and growth prospects debts Use ratio to help analyze,
control and improve firm’s
performance
TYPES of FINANCIAL RATIOS

measures the firms ability

measures how efficiently LIQUIDITY ratios to pay off debts that are
a firm operates to ACTIVITY ratios maturing within a year
generate revenues

measures how the firm

DEBT ratios
has financed its assets as
Measures the firm’s well as the firm’s ability to
PROFITABILITY
ability to generate profit ratios repay its long-term debt
from its operations

measures what investors

MARKET ratios think about the firm and
its future prospects
Liquidity Ratios
Can we make required payments?

Quick (Acid Test)

Current Ratio
Ratio
Indicates the extent to which
Measures firm’s ability to pay off
current liabilities are covered by
short-term obligations without
liquid assets (convertible to cash
relying on the sale of inventories
within a year)

the higher the better: 1.0 means the higher the better: 1.0 means that
that for every peso of current every peso of current liabilities, there is
liabilities, there is one peso of one peso of current assets excluding
current assets inventories

Note: the last row is only a general interpretation for the purpose of understanding the ratio
Liquidity Ratios
Can we make required payments?

Net Working
Cash Ratio
Capital
Measures firm’s (immediate) ability to
pay off short-term obligations without Measures the firm’s liquidity level
relying on the sale of inventories and in absolute amounts
collection of receivables

-
the higher the better: 1.0 means the higher the better: P1,000 means
that for every peso of current that there is P1,000 left to continue
liabilities, there is one peso of cash operations after all current liabilities are
and marketable securities settled

Note: the last row is only a general interpretation for the purpose of understanding the ratio
 Comparing
Liquidity Ratios

Current
Ratio > Quick
Ratio

Quick
Ratio > Cash
Ratio

Assumption: for the same company and same FS period, there is inventory and accounts receivable
balances
 ACYFMG Inc.
Income Statement
For the year ended December 31, 20xy and 20xx
In thousands
20xy 20xx Additional info for 20xy (in
Sales ₱ 78,600 ₱ 75,000 thousands except for %
and per share values):
Less: Cost of Goods Sold (46,900) (45,000)
•Principal repayments on
Gross Profit or Gross margin ₱ 31,700 ₱ 30,000 debt- P1,750
Less: Operating expenses •Lease payments- 800
Selling expense • No. of shares
₱ 3,930 ₱ 3,750
outstanding -10,000
General and administrative expense 5,120 6,000 (same with 20xx)
Depreciation and amortization expense 2,500 2,250 • Dividends per share-
P0.84
Total operating expense -₱ 11,550 -₱ 12,000
• Market price per share-
Net Operating income ₱ 20,150 ₱ 18,000 P16
Other Income 800 1,500
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500
Less: Interest expense (4,950) (4,500)
Earnings before taxes ₱ 16,000 ₱ 15,000
Less: Income tax expense (25%) (4,000) (3,750)
Net Income ₱ 12,000 ₱ 11,250
 ACYFMG Inc.
Balance Sheet
As of December 31, 20xy and 20xx
in thousands

Assets Liabilities
20xy 20xx Accounts Payable ₱ 10,000 ₱ 12,000
Cash ₱ 4,250 ₱ 4,000 Notes Payable 2,500 4,000
Accounts Receivable 9,500 8,000 Accrued expenses 4,800 4,000
Inventories 13,750 16,000 Total current liabilities ₱ 17,300 ₱ 20,000
Other current assets 5,000 4,000 Long-term debt 22,000 20,000
Total current assets Total Liabilities ₱ 39,300 ₱ 40,000
₱ 32,500 ₱ 32,000

Property, plant and equipment ₱ 58,400 ₱ 53,200 Stockholders’ Equity

Less: Accumulated Depreciation (11,200)
(13,700) Common Stock ₱ 12,000 ₱ 12,000
Property, plant and equipment, Additional Paid-in 8,000 8,000
₱ 44,700 ₱ 42,000
net
Retained Earnings 31,200 28,000
Other non-current assets 5,300 6,000
Treasury Stock (8,000) (8,000)
Total non-current assets ₱ 50,000 ₱ 48,000 Total Stockholders’
₱ 43,200 ₱ 40,000
Total Assets Equity
₱ 82,500 ₱ 80,000
Total Liabilities and SHE ₱ 82,500 ₱ 80,000
Computing Liquidity for 20xy
• Current ratio= 32,500/ 17,300= 1.8786
• Quick ratio= (4,250+9,500)/ 17,300= 0.7948
• Cash ratio= 4,250/ 17,300= 0.2457
• Net working capital= 32,500 –17,300= P15,200
Activity (Efficiency or Asset Quality/ Utilization) Ratios
How fast can we convert our assets to sales or cash?

Days Sales Outstanding

Accounts Receivable
(Ave. Collection period or
Turnover Ratio
Ave. age of receivables)
Measures the speed of debt collection Measures the average number of
or the number of times a company’s days taken to collect an account
accounts receivable have been turned receivable
into cash during the year.

where Average AR = (Beg AR + End AR)/2

the lower the better: 10 days means that it took

the higher the better: 10x means that an average of 10 days for accounts receivable
accounts receivables were collected to be collected (equal or lower than credit
ten times during the year terms means the company is collecting AR on
time)
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Activity (Efficiency or Asset Quality/ Utilization) Ratios
How fast can we convert our assets to sales or cash?

Days Inventory Outstanding

Inventory (Days sales in inventory, Inventory
Turnover Ratio conversion period or Ave. age of
inventory)
Measures the number of times
Measure the average number of
inventory has been sold during the
days taken to sell the inventory one
year. It is a good indicator of
time
inventory quality.

where Average Inv = (Beg Inv + End Inv)/2

the lower the better: 10 days

the higher the better: 10x means
means that it took an average of 10
that the company’s inventory were
days for inventories on hand to be
sold ten times during the year
sold
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Activity (Efficiency or Asset Quality/ Utilization)
Ratios
How fast can we convert our assets to sales or cash?

Fixed Asset Total Asset

turnover Ratio turnover Ratio
Measures how effectively the firm Measures the efficiency of using
uses its plant and equipment assets to generate sales

Ave. net PPE = (Beg net PPE + End net PPE)/2 where Ave. TA = (Beg TA + End TA)/2

the higher the better: 2x means the higher the better: 2x means
that the company’s net PPE was that the company’s total assets was
converted to sales two times converted to sales two times
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Activity (Efficiency or Asset Quality/ Utilization) Ratios
How fast can we convert our assets to sales or cash?

Days Payables Outstanding

Accounts Payable turnover Ratio (AP deferral period, Ave. payment
period or Ave. age of payables)
Measures the number of times the Measure the average number of
company pays its accounts payable days taken to pay accounts payable.
during the year.

where Average AP = (Beg AP + End AP)/2

the lower the better: 10 days means
the higher the better: 10x means that it took an average of 10 days for
that the accounts payable were payables to be paid (equal or lower than
credit terms means the company is
paid ten times during the year paying AP on time)
Note: the last row is only a general interpretation for the purpose of understanding the ratio
 ACYFMG Inc.
Income Statement
For the year ended December 31, 20xy and 20xx
In thousands
20xy 20xx Additional info for 20xy (in
Sales ₱ 78,600 ₱ 75,000 thousands except for %
and per share values):
Less: Cost of Goods Sold (46,900) (45,000)
•Principal repayments on
Gross Profit or Gross margin ₱ 31,700 ₱ 30,000 debt- P1,750
Less: Operating expenses •Lease payments- 800
Selling expense • No. of shares
₱ 3,930 ₱ 3,750
outstanding -10,000
General and administrative expense 5,120 6,000 (same with 20xx)
Depreciation and amortization expense 2,500 2,250 • Dividends per share-
P0.84
Total operating expense -₱ 11,550 -₱ 12,000
• Market price per share-
Net Operating income ₱ 20,150 ₱ 18,000 P16
Other Income 800 1,500
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500
Less: Interest expense (4,950) (4,500)
Earnings before taxes ₱ 16,000 ₱ 15,000
Less: Income tax expense (25%) (4,000) (3,750)
Net Income ₱ 12,000 ₱ 11,250
 ACYFMG Inc.
Balance Sheet
As of December 31, 20xy and 20xx
in thousands

Assets Liabilities
20xy 20xx Accounts Payable ₱ 10,000 ₱ 12,000
Cash ₱ 4,250 ₱ 4,000 Notes Payable 2,500 4,000
Accounts Receivable 9,500 8,000 Accrued expenses 4,800 4,000
Inventories 13,750 16,000 Total current liabilities ₱ 17,300 ₱ 20,000
Other current assets 5,000 4,000 Long-term debt 22,000 20,000
Total current assets Total Liabilities ₱ 39,300 ₱ 40,000
₱ 32,500 ₱ 32,000

Property, plant and equipment ₱ 58,400 ₱ 53,200 Stockholders’ Equity

Less: Accumulated Depreciation (11,200)
(13,700) Common Stock ₱ 12,000 ₱ 12,000
Property, plant and equipment, Additional Paid-in 8,000 8,000
₱ 44,700 ₱ 42,000
net
Retained Earnings 31,200 28,000
Other non-current assets 5,300 6,000
Treasury Stock (8,000) (8,000)
Total non-current assets ₱ 50,000 ₱ 48,000 Total Stockholders’
₱ 43,200 ₱ 40,000
Total Assets Equity
₱ 82,500 ₱ 80,000
Total Liabilities and SHE ₱ 82,500 ₱ 80,000
Computing Activity ratios
for 20xy
• AR turnover= 78,600/[(8,000+9,500)/2]= 8.9829x
• Days sales outstanding= 360/8.9829 = 40.0763 days
• Inventory turnover= 46,900/[(16,000+13,750)/2]= 3.1529x
• Days inventory outstanding= 360/3.1529 = 114.1791 days
• Fixed asset turnover= 78,600/[(42,000+44,700)/2]= 1.8131x
• Total asset turnover= 78,600/[(80,000+82,500)/2]= 0.9674x
• AP turnover= (13,750 + 46,900 – 16,000)/[(12,000+10,000)/2]=
4.0591x
• Days payable outstanding= 360/ 4.0591 = 88.6898 days
Debt Management/ Utilization (Solvency or
Leverage) Ratios
Do we have the right mix of debt and equity?

Debt Ratio Equity Ratio

Measures the amount of assets Measures the amount of assets
being provided by creditors being provided by stockholders

the higher the better: 0.3 or 30%

the lower the better: 0.3 or 30%
means that the 30% of the
means that the 30% of the
company’s asset is funded by
company’s asset is funded by debt
equity
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Debt Management/ Utilization (Solvency or
Leverage) Ratios
Do we have the right mix of debt and equity?
Debt-to-Equity Debt-to-Capital
Ratio Ratio
Measures the amount provided by Measures the percentage of the
creditor for each peso being firm’s capital provided by
provided by stockholders debtholders

Total debt = All interest bearing liabilities (ST & LT)

Total capital = Total debt + Total SHE

the lower the better: 0.3 or 30% the lower the better: 0.3 or 30%
means that the company has P0.30 means that the 30% of the
of debt for every peso of equity company’s capital is funded by debt
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Debt Management/ Utilization (Solvency or
Leverage) Ratios
Do we have the right mix of debt and equity?
Times-interest-earned
Equity Multiplier (Financial
(TIE) or interest coverage
Leverage)
Ratio
captures the effect of the firm’s use of debt Measures the company’s ability to meet
financing on its return on equity. The equity annual interest payments or the extent to
multiplier increases in value as the firm uses which EBIT can decline before being unable
more debt. to pay interest

1
𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜

the higher the better: 2x means the the use the higher the better: 10x means the
of debt was able to double the assets company could pay its interest charges 10
provided by equity times over

Note: the last row is only a general interpretation for the purpose of understanding the ratio
Debt Management/ Utilization (Solvency or
Leverage) Ratios
Do we have the right mix of debt and equity?

Fixed-payment or Fixed-
EBITDA coverage Ratio
charge coverage Ratio
Measures the company’s ability to meet
Measures the company’s ability to meet its all fixed payment obligations like
lease and debt payments interest, loan principal, lease payments
and preferred stock dividends

the higher the better: 2x means the the higher the better: 2x means the
company could pay its interest expense,
loan principal and lease expense 2 times
company could pay its fixed
over charges 2 times over
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Deriving one ratio to/from another ratio

Debt ratio and D/E ratio

• Debt ratio = D/E ratio/ (1+ D/E)
• D/E = Debt ratio/ (1 – Debt ratio)

Equity multiplier and equity ratio

• EM = 1/ equity ratio
• Equity ratio= 1/ EM
 ACYFMG Inc.
Income Statement
For the year ended December 31, 20xy and 20xx
In thousands
20xy 20xx Additional info for 20xy (in
Sales ₱ 78,600 ₱ 75,000 thousands except for %
and per share values):
Less: Cost of Goods Sold (46,900) (45,000)
•Principal repayments on
Gross Profit or Gross margin ₱ 31,700 ₱ 30,000 debt- P1,750
Less: Operating expenses •Lease payments- 800
Selling expense • No. of shares
₱ 3,930 ₱ 3,750
outstanding -10,000 (same
General and administrative expense 5,120 6,000 with 20xx)
Depreciation and amortization expense 2,500 2,250 • Dividends per share-
P0.84
Total operating expense -₱ 11,550 -₱ 12,000
• Market price per share-
Net Operating income ₱ 20,150 ₱ 18,000 P16
Other Income 800 1,500
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500
Less: Interest expense (4,950) (4,500)
Earnings before taxes ₱ 16,000 ₱ 15,000
Less: Income tax expense (25%) (4,000) (3,750)
Net Income ₱ 12,000 ₱ 11,250
 ACYFMG Inc.
Balance Sheet
As of December 31, 20xy and 20xx
in thousands

Assets Liabilities
20xy 20xx Accounts Payable ₱ 10,000 ₱ 12,000
Cash ₱ 4,250 ₱ 4,000 Notes Payable 2,500 4,000
Accounts Receivable 9,500 8,000 Accrued expenses 4,800 4,000
Inventories 13,750 16,000 Total current liabilities ₱ 17,300 ₱ 20,000
Other current assets 5,000 4,000 Long-term debt 22,000 20,000
Total current assets Total Liabilities ₱ 39,300 ₱ 40,000
₱ 32,500 ₱ 32,000

Property, plant and equipment ₱ 58,400 ₱ 53,200 Stockholders’ Equity

Less: Accumulated Depreciation (11,200)
(13,700) Common Stock ₱ 12,000 ₱ 12,000
Property, plant and equipment, Additional Paid-in 8,000 8,000
₱ 44,700 ₱ 42,000
net
Retained Earnings 31,200 28,000
Other non-current assets 5,300 6,000
Treasury Stock (8,000) (8,000)
Total non-current assets ₱ 50,000 ₱ 48,000 Total Stockholders’
₱ 43,200 ₱ 40,000
Total Assets Equity
₱ 82,500 ₱ 80,000
Total Liabilities and SHE ₱ 82,500 ₱ 80,000
 Computing Debt ratios for 20xy
• Debt ratio= 39,300/82,500 or 90.97%/ (1+ 90.97%) = 0.4764 or 47.64%
• Equity ratio = 43,200/82,500 or 1/1.91= 0.5236 or 52.36%
• Debt-to-equity ratio= 39,300/43,200 or 47.64%/ (1 – 47.64%) = 0.9097
or 90.97%
• Debt to capital= (2,500 + 22,000)/ (2,500 + 22,000 + 43,200)=0.3619 or
36.19%
• Equity multiplier= 82,500/ 43,200 or 1/52.36% = 1.9097
• Times-interest-earned= 20,950/4,950= 4.2323
• EBITDA coverage= (20,950 + 2,500 +800)/ (4,950 + 800 + (1,750/75%))=
2.9988
• Fixed payment= (20,950 + 800)/ (4,950 + 800 + (1,750/75%)) = 2.6907
Profitability Ratios
How good is our business in generating profit? Did we earn
enough profit?

Gross Profit Operating Profit

Margin Margin
Measures percentage of each sales
Measures “pure profits” earned on
peso remaining after the firm has
each sales peso
paid for its goods

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝐸𝐵𝐼𝑇

𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠
the higher the better: 0.40 or 40%
the higher the better: 0.25 or 25%
means that the company earns on
means that the company earns on
average 40% of the sales price as
average 25% of its sales as EBIT
gross profit
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Profitability Ratios
How good is our business in generating profit? Did we earn
enough profit?
Return on Assets (ROA) or
Net Profit Margin (Return
Return on Investment
on Sales)
(ROI)
Measures net income per peso of measures the effectiveness of
management in generating net income
sales with its available assets

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑆𝑎𝑙𝑒𝑠 where Ave TA = (Beg TA + End TA)/2

the higher the better: 0.10 or 10%

means that company’s earns on the higher the better: 0.20 or 20%
means that every peso of asset
average 10% of its sales as net company’s earns 0.20 or 20%
income
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Profitability Ratios
How good is our business in generating profit? Did we earn
enough profit?

Return on Equity Return on Invested

(ROE) Capital (ROIC)
Measures the total return that the
Measures return earned on company has provided for its
common stockholders’ investment investors

NOPAT = EBIT (1- tax rate)

where Ave SHE = (Beg SHE + End SHE)/2 Ave Invested capital= Ave debt + Ave SHE

the higher the better: 0.40 or 40%

means that every peso of common the higher the better: 0.20 or 20%
stockholders’ equity generates 0.40 means that every peso of invested
of net income capital earned 0.20
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Profitability Ratios
How good is our business in generating profit? Did we earn
enough profit?

Earnings per Book Value per

Share (EPS) Share (BVPS)
Indicates the book value of a firm
Pertains to portion of a company's
on a per share basis and represents
profit that is allocated to each
outstanding share of common stock
the minimum value of a company’s
stock

* aka Earnings available to Common stockholders

the higher the better: P100 means that

the higher the better: P8 means that stockholders will receive P100 per share if all
P8 profit per share of stock was assets were liquidated at their carrying value
earned during the year and all liabilities and preferred stock were paid
off
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Profitability Ratios
How good is our business in generating profit? Did we earn
enough profit?

Dividend Payout Retention (Plowback)

Ratio Ratio
Pertains to the portion of the firm’s Pertains to the portion of the firm’s
earnings that was paid out as dividends; earnings that was reinvested in the firm;
Indicates how much money the Indicates how much money the
company is returning to the shareholder company is retaining for operations

the higher the better: 0.40 or 40% the lower the better: 0.40 or 40% means
means that 40% of the company’s that 40% of the company’s earnings was
earnings was paid out as dividends retained

Note: the last row is only a general interpretation for the purpose of understanding the ratio
Profitability Ratios
How good is our business in generating profit? Did we earn
enough profit?

Basic Earning
Power Ratio
Indicates the raw earning power
of firm’s assets

the higher the better: 0.15 or 15%

means that the firm’s assets was able
to generate 15% operating income

Note: the last row is only a general interpretation for the purpose of understanding the ratio
 ACYFMG Inc.
Income Statement
For the year ended December 31, 20xy and 20xx
In thousands
20xy 20xx Additional info for 20xy (in
Sales ₱ 78,600 ₱ 75,000 thousands except for %
and per share values):
Less: Cost of Goods Sold (46,900) (45,000)
•Principal repayments on
Gross Profit or Gross margin ₱ 31,700 ₱ 30,000 debt- P1,750
Less: Operating expenses •Lease payments- 800
Selling expense • No. of shares
₱ 3,930 ₱ 3,750
outstanding -10,000
General and administrative expense 5,120 6,000 (same with 20xx)
Depreciation and amortization expense 2,500 2,250 • Dividends per share-
P0.84
Total operating expense -₱ 11,550 -₱ 12,000
• Market price per share-
Net Operating income ₱ 20,150 ₱ 18,000 P16
Other Income 800 1,500
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500
Less: Interest expense (4,950) (4,500)
Earnings before taxes ₱ 16,000 ₱ 15,000
Less: Income tax expense (25%) (4,000) (3,750)
Net Income ₱ 12,000 ₱ 11,250
 ACYFMG Inc.
Balance Sheet
As of December 31, 20xy and 20xx
in thousands

Assets Liabilities
20xy 20xx Accounts Payable ₱ 10,000 ₱ 12,000
Cash ₱ 4,250 ₱ 4,000 Notes Payable 2,500 4,000
Accounts Receivable 9,500 8,000 Accrued expenses 4,800 4,000
Inventories 13,750 16,000 Total current liabilities ₱ 17,300 ₱ 20,000
Other current assets 5,000 4,000 Long-term debt 22,000 20,000
Total current assets Total Liabilities ₱ 39,300 ₱ 40,000
₱ 32,500 ₱ 32,000

Property, plant and equipment ₱ 58,400 ₱ 53,200 Stockholders’ Equity

Less: Accumulated Depreciation (11,200)
(13,700) Common Stock ₱ 12,000 ₱ 12,000
Property, plant and equipment, Additional Paid-in 8,000 8,000
₱ 44,700 ₱ 42,000
net
Retained Earnings 31,200 28,000
Other non-current assets 5,300 6,000
Treasury Stock (8,000) (8,000)
Total non-current assets ₱ 50,000 ₱ 48,000 Total Stockholders’
₱ 43,200 ₱ 40,000
Total Assets Equity
₱ 82,500 ₱ 80,000
Total Liabilities and SHE ₱ 82,500 ₱ 80,000
Computing Profitability ratios for 20xy
• Gross Profit margin= 31,700/ 78,600= 40.33% or 0.4033
• Operating profit margin= 20,950/ 78,600= 26.65% or 0.2665
• Net profit margin= 12,000/78,600 = 15.27% or 0.1527
• ROA= 12,000/ ((80,000+82,500)/2)= 14.77% or 0.1477
• ROE= 12,000/ ((40,000+43,200)/2)= 28.85% or 0.2885
• ROIC= (20,950 x 75%)/ (24,250 + 41,600) = 23.86% or 0.2386
• EPS= 12,000/ [(10,000+ 10,000)/2] = P1.2000/ share
• BVPS= 43,200/10,000= P4.3200/ share
• Dividend payout= 0.84/1.20 = 70% or 0.7000
• Retention= 1-70% = 30% or 0.3000
• Basic earning power= 20,950/ ((80,000+82,500)/2)= 25.78% or 0.2578
Market Ratios
What do investors think of our operating results and expect
from our future performance?
Market-to-book
Price Earnings
(M/B) or
(P/E) Ratio
Price-to-book (P/B) Ratio
Shows how much investors are willing to Provides an assessment of how
pay per peso of earnings; Indicates degree
of confidence that investor’s have in firm’s
investors view the firm’s
future performance performance

the higher the better: 10x means the higher the better: 10x means
investors are currently paying P10 for
investors were paying P10 for every every peso of book value of company’s
P1 of earnings stock
Note: the last row is only a general interpretation for the purpose of understanding the ratio
Market Ratios
What do investors think of our operating results and expect
from our future performance?

Dividend Yield
Ratio
Shows how much the company
pays out as dividends each year
relative to its stock price

the higher the better: 0.20 means

that P0.20 dividends were paid
out for every peso of stock price
Note: the last row is only a general interpretation for the purpose of understanding the ratio
 ACYFMG Inc.
Income Statement
For the year ended December 31, 20xy and 20xx
In thousands
20xy 20xx Additional info for 20xy (in
Sales ₱ 78,600 ₱ 75,000 thousands except for %
and per share values):
Less: Cost of Goods Sold (46,900) (45,000)
•Principal repayments on
Gross Profit or Gross margin ₱ 31,700 ₱ 30,000 debt- P1,750
Less: Operating expenses •Lease payments- 800
Selling expense • No. of shares
₱ 3,930 ₱ 3,750
outstanding -10,000
General and administrative expense 5,120 6,000 (same with 20xx)
Depreciation and amortization expense 2,500 2,250 • Dividends per share-
P0.84
Total operating expense -₱ 11,550 -₱ 12,000
• Market price per share-
Net Operating income ₱ 20,150 ₱ 18,000 P16
Other Income 800 1,500
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500
Less: Interest expense (4,950) (4,500)
Earnings before taxes ₱ 16,000 ₱ 15,000
Less: Income tax expense (25%) (4,000) (3,750)
Net Income ₱ 12,000 ₱ 11,250
 ACYFMG Inc.
Balance Sheet
As of December 31, 20xy and 20xx
in thousands

Assets Liabilities
20xy 20xx Accounts Payable ₱ 10,000 ₱ 12,000
Cash ₱ 4,250 ₱ 4,000 Notes Payable 2,500 4,000
Accounts Receivable 9,500 8,000 Accrued expenses 4,800 4,000
Inventories 13,750 16,000 Total current liabilities ₱ 17,300 ₱ 20,000
Other current assets 5,000 4,000 Long-term debt 22,000 20,000
Total current assets Total Liabilities ₱ 39,300 ₱ 40,000
₱ 32,500 ₱ 32,000

Property, plant and equipment ₱ 58,400 ₱ 53,200 Stockholders’ Equity

Less: Accumulated Depreciation (11,200)
(13,700) Common Stock ₱ 12,000 ₱ 12,000
Property, plant and equipment, Additional Paid-in 8,000 8,000
₱ 44,700 ₱ 42,000
net
Retained Earnings 31,200 28,000
Other non-current assets 5,300 6,000
Treasury Stock (8,000) (8,000)
Total non-current assets ₱ 50,000 ₱ 48,000 Total Stockholders’
₱ 43,200 ₱ 40,000
Total Assets Equity
₱ 82,500 ₱ 80,000
Total Liabilities and SHE ₱ 82,500 ₱ 80,000
Computing Market ratios for 20xy
• P/E ratio= 16/1.20 = 13.3333
• M/B ratio= 16/4.32= 3.7037
• Dividend yield= 0.84/16 = 0.0525
Illustrative: Financial ratios
Myers Electronics reports the following data for the past year:
EBIT P 2,207,000 # of common shares 400,000
Net income 1,435,500 Total dividends paid P1,120,000
Tax rate 25% Stock price 20

a. What is the current P/E ratio for the Myers?

b. Myers is applying for a new line of credit from their banking
partner. To issue the credit, the bank requires a TIE ratio of at
least 4.25. What is Myers TIE ratio?
Illustrative: Financial ratios

Fairy’s Herbal Shop has total current liabilities of P181,000 and

an inventory of P76,050. If its current ratio is 2.33, then what
is its quick ratio?

Wanderland Co. has an average age of inventory equal to 90

days. If its average inventory level is P44,500, then what is the
cost of goods sold during the year?
Interpreting Financial Ratios
• The general interpretation discussed was on a per ratio basis
only

• As with all things, maintaining balance is key, too much of something is

also not good (e.g. While a very high current ratio indicates a strong
liquidity position, it may also indicate that the firm has old inventories or
receivables)

• Depending on nature of operations and specific situation, certain industry

or firm might actually prefer the other way around (e.g. it is normal for
banks to have more debt than equity; hence very high debt-to-equity
ratio)
Using Financial ratios to assess
performance
• To properly assess performance of a company, we need put the
ratios in its proper perspective and look at the overall situation

• Tying the ratios together: DuPont and Modified DuPont systems of

analysis

• Ratio comparisons should be made through time and with

competitors.
• Cross-sectional (Industry) analysis
• Benchmark (peer) analysis
• Trend analysis
DuPont systems of analysis
• System used to dissect the firm’s financial statements and to assess
its financial condition
• Merges income statement and balance sheet into two summary
measures of profitability ROA and ROE

• Two formula / equation

• DuPont formula
• Modified (or expanded) DuPont formula
DuPont formula
• Analyzes ROA by decomposing it into two basic determinants:
profitability (expense control) and asset management efficiency
(asset utilization)

Net Total
ROA Profit assets
margin turnover

ROA = Net income/Sales x Sales/Total assets

*where: TATO= Sales/ TA,end ; ROA = NI/ TA,end

 Modified DuPont formula
• Relates ROA to Return on Equity (ROE)
• Analyzes ROE by decomposing it into three basic determinants:
profitability (expense control), asset management efficiency (asset
utilization) and equity multiplier (debt utilization) as follows:

Total
Net Profit Equity
ROE margin
assets
multiplier
turnover

ROE = Net income/Sales x Sales/Total assets x Total assets/SHE

= ROA x Equity multiplier
where: TATO= Sales/ TA, end; ROA= NI/ TA, end ; ROE = NI/ SHE,end
Using DuPont as diagnostic tool:
Begin with the rightmost value (ROE),
then move to the left, dissecting and
analyzing the inputs to the formula to
isolate probable cause of resulting
above-(below-)average value
 ACYFMG Inc.
Income Statement
For the year ended December 31, 20xy and 20xx
In thousands
20xy 20xx Additional info for 20xy (in
Sales ₱ 78,600 ₱ 75,000 thousands except for %
and per share values):
Less: Cost of Goods Sold (46,900) (45,000)
•Principal repayments on
Gross Profit or Gross margin ₱ 31,700 ₱ 30,000 debt- P1,750
Less: Operating expenses •Lease payments- 800
Selling expense • No. of shares
₱ 3,930 ₱ 3,750
outstanding -10,000 (same
General and administrative expense 5,120 6,000 with 20xx)
Depreciation and amortization expense 2,500 2,250 • Dividends per share-
P0.84
Total operating expense -₱ 11,550 -₱ 12,000
• Market price per share-
Net Operating income ₱ 20,150 ₱ 18,000 P16
Other Income 800 1,500
Earning before interest and taxes (EBIT) ₱ 20,950 ₱ 19,500
Less: Interest expense (4,950) (4,500)
Earnings before taxes ₱ 16,000 ₱ 15,000
Less: Income tax expense (25%) (4,000) (3,750)
Net Income ₱ 12,000 ₱ 11,250
 ACYFMG Inc.
Balance Sheet
As of December 31, 20xy and 20xx
in thousands

Assets Liabilities
20xy 20xx Accounts Payable ₱ 10,000 ₱ 12,000
Cash ₱ 4,250 ₱ 4,000 Notes Payable 2,500 4,000
Accounts Receivable 9,500 8,000 Accrued expenses 4,800 4,000
Inventories 13,750 16,000 Total current liabilities ₱ 17,300 ₱ 20,000
Other current assets 5,000 4,000 Long-term debt 22,000 20,000
Total current assets Total Liabilities ₱ 39,300 ₱ 40,000
₱ 32,500 ₱ 32,000

Property, plant and equipment ₱ 58,400 ₱ 53,200 Stockholders’ Equity

Less: Accumulated Depreciation (11,200)
(13,700) Common Stock ₱ 12,000 ₱ 12,000
Property, plant and equipment, Additional Paid-in 8,000 8,000
₱ 44,700 ₱ 42,000
net
Retained Earnings 31,200 28,000
Other non-current assets 5,300 6,000
Treasury Stock (8,000) (8,000)
Total non-current assets ₱ 50,000 ₱ 48,000 Total Stockholders’
₱ 43,200 ₱ 40,000
Total Assets Equity
₱ 82,500 ₱ 80,000
Total Liabilities and SHE ₱ 82,500 ₱ 80,000
DuPont analysis for ACYFMG:
ROA= (NI/Sales) x (Sales/ TA)
=15.2672% x 0.9527
=14.55% (previously computed ROA is 14.77%)

ROE= (NI/Sales) x (Sales/TA) x (TA/Equity)

= 15.2672% x 0.9527 x 1.9097
= 27.78% (previously computed ROE 28.85%)
OR
=ROA x (TA/Equity)
=14.55% x 1.9097
Effects of Debt on ROA and ROE
• Holding assets constant, if debt increases:
• Equity declines.
• Interest expense increases – which leads to a reduction in net income.
• ROA declines (due to the reduction in net income).
• ROE may increase or decrease (since both net income and equity
decline).
Problems with ROE
• ROE and shareholder wealth are correlated, but problems can arise
when ROE is the sole measure of performance.
• ROE does not consider risk.
• ROE does not consider the amount of capital invested.
• Given these problems, reliance on ROE may encourage managers
to make investments that do not benefit shareholders. As a result,
analysts have looked to develop other performance measures.
Illustrative: DuPont
Your firm has sales of P524,000 and total assets of P816,000.
The debt-equity ratio is 0.6 and the profit margin is 4.5%. What
are the values of the three parts of the Modified DuPont
formula? What is the ROE?

Third National, Inc. has a net profit margin of 11%, an equity

multiplier of 1.8, sales of P1,225,000 and a ROE of 15.4%. What
is Third National’s average total asset?
Ratio comparisons
• Cross-sectional (Industry) analysis- comparison of firm’s financial
ratios (at the same point in time) with those of other firms in its
industry or with industry averages
• Benchmark (peer) analysis- type of cross-sectional analysis in
which the firm’s ratio values are compared with those of a key
competitor or with a group of competitors that is wishes to
emulate
• Trend (time-series) analysis- evaluation of firm’s performance
over time using financial ratio analysis
• Combined analysis- combines cross-sectional and trend analyses
to assess trend of ratio in relation to industry trend
Benchmarking template
Combined analysis
Combined analysis
Combined analysis
Empirical evidence
A study of 30 Philippine publicly-listed service companies show that
taken together, liquidity, profitability, and leverage, when controlled
by firm size, significantly predicted firm value of. As a standalone,
except for liquidity which did not exhibit any significance, all other
variables showed significant effect on firm value.(Ang & Rabo, 2020)

A comparative analysis of two concrete ready-mix companies in

Cavite found out although Company 2 has better solvency ratios and
outperforms company 1 in respect to most profitability ratios;
Company 1 has better liquidity ratios and performed better than
company 2 based on 3 aspects of performance. (Esguerra et al,
2020)
Limitations of Ratio Analysis
1. A single ratio does not generally provide sufficient information
from which to judge the overall performance of the firm.
2. Difficult to tell whether a company is, on balance, in a strong or
weak position.
3. Picking an industry benchmark can sometimes be difficult.
4. An industry average is not necessarily a desirable target or norm.
5. Published peer-group or industry averages are not always
representative of the firm being analyzed.
6. Ratios that reveal large deviations from the norm merely indicate
the possibility of a problem.
Limitations of Ratio Analysis
7. Seasonal factors can distort ratios
8. Results can be distorted by inflation
9. Different accounting and operating practices among firms can
distort comparisons.
10. The results of financial analysis are dependent on the quality of
the financial statements; hence, “Window dressing” techniques can
make statements and ratios look better.
 Firm’s competitive
85%
environment

Legal and regulatory

75%
environment

Looking beyond the Are the firm’s revenues tied to one

numbers 50% key customer, product, or supplier?

a sound financial analysis consider

certain qualitative factors
What percentage of the firm’s
45% business is generated overseas?
Contents
• 2.4 Financial ratio analysis
• 2.4.1 Liquidity Ratios
• 2.4.2 Activity Ratios
• 2.4.3 Debt Management Ratios
• 2.4.4 Profitability Ratios
• 2.4.5 Market Ratios
• 2.5 DuPont and Modified DuPont systems of analysis
• 2.6 Uses and Limitations of Ratios
 End of 2.4-2.6

Questions?
Prepare for Quiz #1 (1.1-2.6)
Knowledge Check
KC: True or False
1. If a firm increases its sales while holding its inventories constant, then,
other things held constant, its inventory turnover ratio will decrease.
2.There is no such thing as a liquidity ratio being too high.
3. If a company wants to know how it is performing against its competitors
over time, it should perform a benchmarking analysis.
4. Creditors analyze ratios to help judge a company’s ability to repay its
debts
5. When the present financial ratios of a firm are compared with the
average ratios of its industry, it is called cross-sectional analysis.
 KC: True or False
6. Current assets consist of cash, accounts receivable, inventory, and net
plant, property, and equipment.
7. The operating profit margin measures operating income per peso of
sales.
8. The return on invested capital measures the total return that a company
has provided for its investors.
9. If a bank loan officer were considering a company's loan request, the
higher the company's TIE ratio, other things held constant, the higher the
interest rate the bank would charge.
10. In general, if investors regard a company as being relatively risky and/or
having relatively poor growth prospects, then it will have relatively high P/E
and M/B ratios.
KC: Multiple Choice
11. Which of the following financial ratios is the best measure of the operating
effectiveness of a firm's management?

A Current ratio
B Gross profit margin
C Quick ratio
D Return on investment
KC: Multiple Choice
12. The quick ratio is a better measure of liquidity than the current ratio if the
firm has current assets composed primarily of:

A Cash.
B Inventory.
C Marketable Securities.
D Accruals.
KC: Multiple Choice
13. If you only knew a company’s total assets and total debt, which item could
you easily calculate?

A Equity multiplier
B Return on assets
C Return on equity
D Profit margin
KC: Multiple Choice
14. A firm is conducting an analysis of trends over time and discovers that its
inventory turnover has declined. This may be due to:

A an increase in sales.
B an increase in cost of goods sold.
C an increase in inventory purchases.
D a decrease in inventory purchases.
KC: Multiple Choice
15. A decrease in the return on equity ratio could be caused by an increase in:

A Tax rate.
B Net Sales.
C Treasury stock
D All of the above
KC: Multiple Choice
16. An increase in _________will decrease the dividend yield ratio.

A Stock price
B Dividend per share
C Net income
D Sales
KC: Multiple Choice
17. When is the return on assets equal to the return on equity?

A When the current ratio of the firm equals 1.

B When the firm only issues equity to finance its borrowing.
C When the firm issues no dividends for a given time period.
D When the firm issues equal amounts of long term debt and common
stock.
KC: Multiple Choice
18. Companies HD and LD are both profitable, and they have the same total
assets (TA), total invested capital, sales (S), return on assets (ROA), and net
profit margin (NPM). Both firms finance using only debt and common equity.
Which conclusion is correct?

A Company HD has a lower total assets turnover than Company LD.

B Company HD has a higher fixed assets turnover than Company LD.
C Both companies have the same net income.
D Both companies have the same debt ratio.
KC: Multiple Choice
19. Which of the following parties would be interested in an analysis of the
firm's financial statements?

A Investors
B Creditors
C Firm’s managers
D All of the above
KC: Multiple Choice
20. The DuPont method decomposes return on equity into:

A return on assets and the debt ratio.

B return on assets and the equity multiplier.
C operating income and inventory turnover.
D net profit margin and fixed asset turnover.
KC: Problem Solving
21. Kingsbury Associates has current assets as follows:

Cash 38,000
Accounts receivable 40,500
Inventories 83,000

If Kingsbury has a current ratio of 2.5, what is its quick ratio?

22. In 2019, Short and stout (S & S), Inc. had a gross profit of P207,000 on
sales of P1,100,000. S & S's operating expenses for were P130,000, and its net
profit margin was .0585. S & S had no interest expense in 2019. Using this
information, what was S & S's operating profit margin for 2019?
KC: Problem Solving
23. If Challenge Corporation has sales of P1.8 million per year (80% on credit)
and an average collection period of 45 days, what is its average amount of
accounts receivable?

24. Straw Corp has an operating profit of P202,000 produced from P980,000
in sales. If Straw has no interest expense and currently pays 30% of its
operating profits in taxes and P37,000 per year in preferred dividends, then
what is Straw’s earnings per share if outstanding common stock is 112,000?
KC: Problem Solving
Bright Idea Inc.’s financial ratio analysis shows the following:
Book value per share 35
Basic earning power ratio 0.18
Market to book value ratio 4.5
Price earnings ratio 12.5
Equity multiplier 3.2
Common stock outstanding 50,000

25. What is the firm’s market price per share?

26. Compute for the firm’s earnings per share.
27. What is the firm debt ratio?
28. Compute for ROA.
29. How much is the EBIT for the year?
KC: Problem Solving
30. Benilli Corp has P720,000 of assets, and it uses no debt—it is
financed only with common equity. Current liabilities amounted to
P33,000. The new CFO wants to employ enough debt to raise the total
debt to total capital ratio to 35%, using the proceeds from borrowing to
buy back common stock at its book value. How much must the firm
borrow to achieve the target debt ratio?