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Lesson 5

The Operating Cycle,

Classifications of Assets & Liabilities
and Interpreting the Financial Statements
Lesson Objectives:

At the end of the lesson, the students are expected to:

a. Prepare properly classified financial statements.

b. Interpret financial statements using ratios, trends and percentages.
c. Explain when the business is considered profitable, solvent and stable.

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DISCUSSION OF CONTENT

Operating Cycle

The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce
goods, sell the goods, and receive cash from customers in exchange for the goods. In simple terms, it is the length of time
it takes for cash to be converted back into cash, depending on the type of business operations, as shown in theillustrations
below. When the operating cycle cannot be clearly identified, its duration is assumed to be twelve months or one year.
This information is relevant in classifying assets and liabilities of an entity and is used in the planning by management.

CLASSIFICATION OF ASSETS AND LIABILITIES

Generally, assets and liabilities are classified into current and non-current when presented in the financial
statements as these will be essential in the analysis of the company’s overall financial condition in the perspective of the
stakeholders especially the internal users for the decision-making.

 Current Assets – include cash and cash equivalents which are not restricted in use, as well as other assets
expected to be realized as into cash, or sold or consumed within the normal operating cycle of the business or one
year, whichever is longer. These include Cash (on hand or in bank), Marketable Securities, Accounts Receivables,
Notes Receivables, Inventories (for Merchandisers and Manufacturers), and Prepaid Expenses (supplies,
insurance and rent).

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 Non-Current Assets–are long-term investments where the full value will not be realized within the normal
operating cycle or simply assets that are not considered current. These includes Land, Property, Plant and
Equipment, Trademarks, Long-term Investments and Goodwill.
 Current Liabilities – are those debts or obligations reasonably expected to be liquidated in the normal course of
the business’ operating cycle or paid within one year using the current assets or the creation of other current
liabilities. Examples are Accounts Payable, Notes Payable, Salaries Payable, Utilities Payable and Taxes Payable.
 Non-Current Liabilities – are long term liabilities or obligations which are payable or expected to be liquidated
longer than one year such as Mortgage Payable and Bonds Payable.

FINANCIAL STATEMENTS ANALYSIS

Just looking at the financial statements will not give you a complete picture of the company’s financial position
and operating performance. You need to convert the absolute amounts into ratios, turnover, and percentages after which
these are compared against the figures of the previous year (intra-comparability) or against the figures of a competitor
(inter-comparability or benchmarking). Although it is important to study the raw figures in the financial statements, it also
becomes more meaningful when the figures are “standardized” or reduced into a common size by using ratios and
percentages, especially when comparing two companies which have different scales of operation.
The financial data contained in the financial statements are evaluated primarily for two reasons:

1. Evaluate operating performance of the business bases on profitability.

2. Assess strength in financial position based on liquidity and solvency.

To illustrate the financial analyses that will be further discussed, we will use the financial statements below:

MGR PRINT SHOP

INCOME STATEMENT
For the year ended December 31, 2019

Revenue:
Service Income P 275,000
Other Income 15,450
Total P 290,450
Expense:
Salaries Expense 45,000
Depreciation Expense 9,750
Other Operating Expenses 125,800 (180,550)
Interest Expense ( 1,000)
Profit for the year P 108,900

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MGR PRINT SHOP

STATEMENT OF FINANCIAL POSITION
As of December 31, 2019

ASSETS
Current Assets:
Cash P 70,000
Trade and Other Receivables 74,550
Prepaid Expenses 5,200
Total P 149,750
Non-Current Assets:
Property & Equipment 165,250
Total Assets P 315,000

LIABILITIES AND OWNER’S EQUITY

Current Liabilities:
Trade and Other Payables P 78,250
Owner’s Equity:
Mark, Capital 236,750
Total Liabilities and Owner’s Equity P315,000

PROFITABILITY

Itis the ability of the entity to obtain adequate profit for the investors. The relevant data are:

1. the revenues earned

2. the net income obtained
3. the assets used in the operation
4. the investment made by the owner

The owners or investors will be interested in the following ratios: Profits Margin, Return on Assets, and Return on
Equity.

1. Profit Margin: Net Income / Revenues (108,900/290,450) = 37%

- This shows the adequacy of the revenue to earn profit, basically interpreted as for every peso of revenue,
37% or 37 cents went to profit. The higher the ratio, the more profitable the business is.

2. Return on Total Assets: Net Income / Average Total Assets (108,900/315,000) = 35%
- If the total assets of the previous period is given, get the average by adding the total assets of the start and
end of the year and dividing it by 2. You can consider the initial investment of the owner as the beginning
balances if this is the first year of operations.

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- The rate of return shows the income earned by the business based on assets invested. It is interpreted as
for every peso of asset invested, 35% or 35 cents was earned. A higher rate means the assets are being
used profitably by the business.

3. Return on Equity:Net Income / Average Owner’s Equity (108,900/236,750) = 46%

- This means that the owner earned 46% or 46 cents for every peso of investment.

Based on the above three ratios, the business is profitable venture for the owner. For investors, they can compare
the figures with the business’ competitors for a reliable benchmarking.

LIQUIDITY

It is the ability of the business to pay for its short-term obligations. Short-term creditors such as suppliers and
lenders (bank) are interested in this information. The relevant data are:

1. Current assets
2. Current liabilities

The ratios used are Working Capital, Current Ratio and Quick Ratio.

1. Working Capital: Current Assets – Current Liabilities (149,750-78,250) = 71,500

- This means that the business is financially stable to cover its short-term debts and expenses and has
potential to invest and grow.

2. Current Ratio: Current Assets / Current Liabilities (149,750/78,250) = 1.91:1

- This means that the business has P1.91 current assets to pay for a peso of current liability. This kind of
current ratio or higher makes a good impression to the investors.

3. Quick Ratio or Acid-Test Ratio: Quick Assets / Current Liabilities (144,550/78,250) = 1.85:1
- This is a stricter measurement of liquidity since only the quick assets (Cash, Accounts Receivables and
Marketable Securities) are in reality used to pay for the business’ obligations. The ratio above shows that
the business has P1.88 quick assets to pay for a peso of current liability. There are two ways of assessing
this ratio which shows the business is highly liquid considering the ideal rule of thumb which is 1:1.
a. If the company is going to use this for growth and expansion, then it is wise to build up current
assets or working capital.
b. If there is no plan for expansion, then it seems that the firm is keeping idle funds. These funds
must be moved and used profitably, else, return on equity will be adversely affected.

SOLVENCY

It is the long-term liquidity and is measured based on the ability of the business to pay for long term obligations
when they fall due. This is determined by computing for the debt ratio and equity ratio.

1. Debt Ratio: Total Liabilities / Total Assets (78,250/315,000) = 25%

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- It shows the proportion of the assets provided by the creditors. The ratio above means that for every peso
of asset, only 25% or 25 cents is funded by debt. This may also indicate that the business has lower
financial risk.

2. Equity Ratio: Total Owner’s Equity / Total Assets (236,750/315,000) = 75%

- It shows the proportion of the assets invested by the owner. The ratio above means that for every peso of
asset, 75% or 75 cents is contributed by the owner. This indicate that the business is very solvent but very
conservative at the same time.

SUMMARY OF THE LESSON

 Operating cycle is the amount of time it takes for a business to convert cash invested back into cash.
 Current assets pertain to assets that are easily convertible to cash within the normal operating cycle or 1 year
while Non-Current Assets are long-term assets expected to be realized longer than 1 year.
 Current Liabilities are obligations that are expected to be liquidated within the normal operating cycle or 1 year
while Non-Current Liabilities are long-term obligations expected to be extinguished longer than 1 year.
 In interpreting the financial status of a business using the Financial Statements, 3 factors are considered with the
financial ratios being used:
1. Profitability –Profit Margin, Return on Assets and Return on Equity
2. Liquidity – Working Capital, Current Ratio and Quick Ratio
3. Solvency – Debt Ratio and Equity Ratio

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