STRATEGIC COST MANAGEMENT 2

FINANCIAL ANALYSIS

FS Analysis – involves the evaluation of the firm’s past performance, present condition and business potentials. The analysis provides
information about the following, among others:
Profitability of the business firm Safety of investment in the business
Ability to meet company obligations Effectiveness of management in running the firm

FS Analysis Tools and Techniques

Horizontal analysis (trend or index analysis) Gross profit variation analysis
Vertical analysis Cash flow analysis
 Financial ratios

Horizontal Analysis – involves comparison of figures shown in the financial statements of two or more consecutive periods. The difference of
the amount between two periods is calculated, and the percentage change from one period to the next is computed using the earlier period
as the base.
Percentage Change = (Most Recent Value – Base Period Value) / Base Period Value

Comparisons can be made between an actual amount compared against a budgeted amount, with the ‘budget’ serving as the base or pattern
of performance.

LIMITATION: If a negative or a zero amount appears in the base year, percentage change cannot be computed.

INCOME STATEMENT:

2019 2020 INCREASE/DECREASE

AMOUNT %
SALES 10M 11M 1M INC. 10% INC.
COGS 6M 7.2M 1.2 M INC. 20% INC.

STATEMENT OF FP:

CASH 200K 210K 1OK INC. 5% INC.

PREP RENT 0 20K 20K INC. -

Vertical Analysis – is the process of comparing figures in the financial statements of a single period. It involves conversion of figures in the
statements to a common base. This is accomplished by expressing all figures in the statements as percentages of an important item such as
total assets (in the balance sheet) or net sales (in the income statement). These converted statements are called common-size statements or
percentage composition statements.

Percentage composition statements are used for comparing:

1. Multiple years of data from the same firm.
2. Companies that are different in size.
3. Company to industry averages.

INCOME STATEMENT FOR 2020:

SALES 100M 100%

COGS 70M 70%
GP 30M 30%
OP EXP 20M 20%
P/L 10M 10%

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Ratio Analysis–involves development of mathematical relationships among accounts in the financial statements. Ratios calculated from
these statements provide users and analysts with relevant information about the firm’s liquidity, solvency and profitability.

Basic rules on ratio calculations:

• When calculating a ratio using balance sheet numbers only, the numerator and denominator should be from the same balance
sheet date only. The same is true for ratios using only income statement numbers. Exception: calculation of growth ratios.
• If an income statement account and a balance sheet account are both used to calculate a ratio, the balance sheet account should be
expressed as an average for the time period represented by the income statement account.
• If the beginning balance of a balance sheet account is not available, the ending balance is normally used to represent the average
balance of the account.
• If sales and/or purchases are given without making distinction as to whether made in cash or on credit, assumptions are made
depending on the ratio being calculated:
o Turnover ratios: Sales and purchases are made on credit.
o Cash flow ratios: Sales and purchases are made in cash.
• Generally, the number of days in a month or year is not critical to the analysis: a year may have 360 days, 52 weeks, and 12 months;
alternatively, a year may be comprised of 365 calendar days, 360 working days or any appropriate number of days.

CURRENT RATIO = CURRENT ASSETS-2020/ CURRENT LIABILITIES-2020 (LIQUIDITY RATIO)

TOTAL ASSETS 100M

CA 5M
NCA 95M
TOTAL LIAB 40M
CL 10M
NCL 30M

RETURN ON SALES = PROFIT AFTER TAX-2019 / NET SALES-2019 (PROFITABILITY RATIO)

INCOME STATEMENT

GROSS SALES 22M

SR&A 1.5M CREDIT ????
SD 0.5M 20M
CASH ???

A/R TURNOVER = NET CREDIT SALES / AVE. AR

NET CS – 2020 P 20M (1/1/20 – 12/31/20)

AR, 1/1/20 1.9M
AR, 12/31/20 2.1M

ARTO = 20M / 2M
= 10 X

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Financial Ratios

A. Liquidity Ratios

Liquidity refers to the company’s ability to pay its current liabilities as they fall due.
Current ratio It is a measure of adequacy of working capital. It is the primary
(Banker’s ratio) Current assets test of solvency to meet current obligations from current assets.
(Working capital ratio) Current liabilities
Quick ratio It measures the number of times that the current liabilities
(Acid-Test ratio) Quick assets could be paid with the available cash and near-cash assets (i.e.,
Current liabilities cash, current receivables and marketable securities.

Working Capital Activity Ratios (Efficiency Ratios)

Turnover Income statement account Average age No. of days in a year
Average balance sheet account Turnover

It is the time required to complete one collection cycle

Receivables turnover Net (Credit) sales from the time receivables are recorded, then collected,
Average receivables to the time new receivables are recorded again.
Average age of receivables 360 days It indicates the average number of days during which the
(Average collection period) Receivables turnover company must wait before receivables are collected.
(Days’ sales in receivables)
Cost of goods sold It measures the number of times that the inventory is
Inventory turnover Ave. merchandise inventory replaced during the period.
Average age on inventory * It indicates the average number of days during which the
(Inventory conversion period) 360 days company must wait before the inventories are sold.
(Days’ sales in inventory) Inventory turnover

* In some accounting and finance texts, average inventory age is also called as the average sales period.

Raw materials turnover Raw materials used

Ave. raw materials inventory
Work in process turnover Cost of goods manufactured
Ave. WIP inventory
Finished goods turnover Cost of goods sold
Ave. FG inventory
Normal operating cycle Ave. age of inventory + Ave. age of receivables
Trade payables turnover Net credit purchases
Ave. trade payables

Ave. age of trade payables 360 days It indicates the length of time during which
(Payable deferral period) Payables turnover payables remain unpaid.
(Days’ purchases in payables)
Cost of sales + Operating expenses** It measures the movement and utilization of current
Current assets turnover Ave. current assets assets to meet operating requirements.

** These exclude depreciation, amortization and other expenses related to long-term assets.

B. Solvency Ratios

Solvency refers to the ability of company to pay its debts.

These ratios involve leverage ratios. “Leverage” refers to how much of company’s resources are financed by debt and/or
preferred equity, both of which require fixed payment of interests and dividends.

Times interest earned EBIT It determines the extent to which operations cover
Interest expense interest expense.
Debt-equity ratio Total liabilities Proportion of assets provided by creditors
Total shareholders’ equity compared to that provided by owners.
Debt ratio Total liabilities Proportion of total assets provided by creditors
Total assets
Equity ratio Total shareholders’ equity Proportion of total assets provided by owners
Total assets

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C. Profitability Ratios

Return on sales Income Determines the portion of sales that went into
Net sales company’s earnings
Return on assets Income Efficiency with which assets are used to operate the
Ave. assets business

What INCOME figure should be used?

If the intention is to measure operational performance, income is expressed as before interest and tax; alternatively, income before
‘after-tax’ interest may be used to exclude the effect of capital structure.
If the intention is to evaluate total managerial effort, income is expressed after interest and tax.
The practice of expressing income after interest but before tax is now being discouraged.
Income should include dividends and interest earned if the said investments are included in asset base.
If used in the DuPont technique, income must be after interests, taxes and preferred stock dividends.

Return on equity = Return on sales x Assets turnover x Equity multiplier

Return on equity Income Measures the amount earned on the owners’ or

Ave. equity stockholders’ investment
Earnings per share Net income – Preferred dividends Measures the amount of net income earned by each
Weighted average CS outstanding common share

D. Market Tests

Price-earnings ratio Price per share It indicates the number of pesos required to buy P1
EPS of earnings
Dividend yield Dividend per share Measures the rate of return in the investor’s
Price per share common stock investments
Dividend pay-out Dividend per share It indicates the proportion of earnings distributed
EPS as dividends

E. Stability Ratios
Ratios used to evaluate long-term financial position

Fixed assets Measures the proportion of owners’ equity to fixed

Fixed assets to Total equity Total equity assets. Indicative of over or under investment by
owners and weakness in trading in the equity*
Fixed assets to Total assets Fixed assets (net) Indicates possible over-expansion of plant and
Total assets equipment
Sales to Fixed assets Net sales Tests roughly the efficiency of management in
(Plant turnover) Fixed assets (net) keeping plant properties employed
Book value per share – CS Common SHE Measures recoverable amount by common
Common shares outstanding stockholders in the event of liquidation if assets are
realized at their book values
Times preferred dividend earned Net income after taxes It indicates ability to provide dividends to preferred
Preferred dividends stockholders
Capital intensity ratio Total assets Measures efficiency of the firm to generate sales
Net sales through employment of its resources
Times fixed charged earned Net income before taxes & fixed charges Measures ability to meet fixed charges
Fixed charges + sinking fund payment**

* ‘Trading on the equity’ is another name for leverage.

** Fixed charges shall include rent, interests and other relevant fixed expenses; sinking fund payment must be expressed before tax.

F. Tests of Over-all Short-term Solvency or Short-term Financial Position

Working capital turnover Net sales Indicates adequacy of working capital to support
Ave. Working capital operation (sales)
Defensive interval ratio Current liabilities Measures coverage of current liabilities
Cash & Cash equivalent

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 Payable turnover Net purchases Measures efficiency of the company in meeting the
Ave. Accounts payable accounts payable
Fixed assets to Long-term Fixed assets Reflects extent of the utilization of resources from
liabilities Long-term liabilities long-term debt. Indicative of sources of additional
funds

G. Ratios Indicative of Income Position

Rate of return on Average Income Measures the profitability of current assets invested
current asset Ave. Current assets
Operating profit margin Operating profit Measures the profit generated after consideration of
Net sales operating costs
Cash flow margin Operating cash flow Measures the ability of the firm to translate sales to
Net sales cash

Illustration: Horizontal Analysis , Vertical Analysis and Financial Ratios

RED Merchandising has 1,000,000 common shares outstanding. The price of the stock is P8. RED declared dividends per share of P0.10. The
financial statements for RED Merchandising are as follows:

RED Merchandising
Income Statement
For the year ended December 31, 2018
(In thousands)
Net sales
Cash P 300
Credit 4,400 P 4,700
Cost of goods sold:
Inventory, beg. P 400
Net purchases:
Cash P 520
Credit 1,800 2,320
Goods available for sale P 2,720
Inventory, end 420 2,300
Gross profit P 2,400
Operating expenses:
Depreciation P 320
Other 1,230 1,550
Income before interest and taxes P 850
Interest expense 150
Income before taxes P 700
Income taxes 280
Net income P 420

RED Merchandising
Comparative Statement of Financial Position
December 31, 2017 and 2018
(In thousands)

ASSETS LIABILITIES & EQUITY

2017 2018 2017 2018
Cash P 210 P 230 Accounts payable P 200 P 180
Accounts receivable 430 450 Accrued expenses 190 170
Inventory 400 420 Total current liabilities P 390 P 350
Total current assets P 1,040 P 1,100 Long-term debt P 1,910 P 1,690
Plant and equipment P 5,500 P 5,700 Common stock 1,810 1,810
Accumulated depreciation (2,000) (2,200) Retained earnings 430 750
Total assets P 4,540 P 4,600 Total liabilities and equity P 4,540 P 4,600

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Required: (Round-off answers to two decimal places)
1. Prepare horizontal analysis for the statement of financial position of RED Merchandising for 2017 and 2018.

1)
RED Merchandising
Comparative Statement of Financial Position
December 31, 2017 and 2018
(In thousands)

ASSETS LIABILITIES & EQUITY

2017 2018 INC/DEC 2017 2018 INC/DEC
AMT %
Cash P 210 P 230 20 9.52 Accounts payable P 200 P 180
Accounts receivable 430 450 20 4.65 Accrued expenses 190 170
Inventory 400 420 20 5.00 Total current liabilities P 390 P 350
Total current assets P 1,040 P 1,100 Long-term debt P 1,910 P 1,690
Plant and equipment P 5,500 P 5,700 (200) 3.64 Common stock 1,810 1,810
Accumulated depreciation (2,000) (2,200) Retained earnings 430 750
Total assets P 4,540 P 4,600 Total liabilities and equity P 4,540 P 4,600

2. Prepare common-size income statement and statement of financial position for the year 2018.

RED Merchandising
Income Statement
For the year ended December 31, 2018
(In thousands)
Net sales
Cash P 300 (6.38%)
Credit 4,400 (93.62%) P 4,700 (100%)
Cost of goods sold:
Inventory, beg. P 400
Net purchases:
Cash P 520
Credit 1,800 2,320
Goods available for sale P 2,720
Inventory, end 420 2,300
Gross profit P 2,400
Operating expenses:
Depreciation P 320
Other 1,230 1,550
Income before interest and taxes P 850
Interest expense 150
Income before taxes P 700
Income taxes 280
Net income P 420 (8.94%)

3. Prepare ratio analysis for 2018 and determine the following:

LIQUIDITY: PROFITABILITY:
a) Current ratio = CA ÷ CL m) Gross profit margin
= 1,100 ÷ 350 = GP ÷ NET SALES
= 3.14 = 2,400 ÷ 4,700
= 51.06%

b) Acid-test ratio = Quick Assets ÷ CL n) Operating profit margin

= 680 ÷ 350 = OP INC ÷ NET SALES
= 1.94 = 850 ÷ 4,700
= 18.09%
QA = Cash + Marketable Securities + AR
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c) Accounts receivable turnover o) Return on sales
= Net CS ÷ Ave. AR = NIAT ÷ NET SALES
= 4,400 ÷ 440 = 420 ÷ 4,700
= 10 = 8.94%

d) Collection period* p) ROA – operational performance

= 360 days ÷ ARTO = OP INC ÷ AVE. ASSETS
= 360 days ÷ 10 = 850 ÷ 4,570
= 36 days = 18.6%

*also known as Days’ sales outstanding and Age of AR

e) Inventory turnover q) ROA – total management effort

= COGS ÷ Ave. Inventory = NIAT ÷ AVE. ASSETS
= 2,300 ÷ 410 = 420 ÷ 4,570
= 5.61 = 9.19%

f) Inventory conversion period* r) Return on equity

= 360 days ÷ ITO = NIAT ÷ AVE. SHE
= 360 ÷ 5.61 = 420 ÷ 2,400
= 64.17 days = 17.5%
*Age of Inventory

NORMAL OPERATING CYCLE = ICP + CP

= 64.17 DAYS + 36 DAYS
= 100.17 DAYS

------------------------NORMAL OPERATING CYCLE---------------------------→

INV CONV PERIOD COLLECTION PERIOD

X -----------------------X--------------------- X ------------------------------------------- X
PURCHASE PAYMENT SALE COLLECTION
INV COGS
AP INV
AR CASH
SALES AR
AP
CASH
PAYMENT PERIOD

----------------------CASH CONVERSION CYCLE--------→

CCC = NOC – PAYMENT PERIOD

= 100.17 DAYS – 38.01 DAYS
= 62.16 DAYS

g) Accounts payable turnover s) Total asset turnover

= NET CREDIT PURCH. ÷ AVE. A/P = NET SALES ÷ AVE. ASSETS
= 1,800 ÷ 190 = 4,700 ÷ 4,570
= 9.47 = 1.03

h) Payment period t) Capital Intensity Ratio (amount of capital needed to generate P1 revenue)
= 360 days ÷ APTO = AVE. ASSETS ÷ NET SALES
= 360 ÷ 9.47 = 4,570 ÷ 4,700
= 38.01 days = 0.97

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 u) Earnings per share
= NI available to OS ÷ Outstanding OS
= (NIAT – Pref Div.) ÷ O/S OS
= (420k – 0) ÷ 1M
= P0.42

SOLVENCY: MARKET-TESTS:
i) Times interest earned v) Price-earnings ratio
= EBIT ÷ INT EXP = PPS ÷ EPS
= 850 ÷ 150 = P8 ÷ P0.42
= 5.67 = 19.05

j) Debt ratio w) Dividend yield

= TL ÷ TA = DPS ÷ PPS
= 2,040 ÷ 4,600 = P0.10 ÷ P8
= 0.44 = 1.25%

k) Debt-equity ratio x) Payout ratio

= TL ÷ SHE = DPS ÷ EPS
= 2,040 ÷ 2,560 = P0.10 ÷ P0.42
= 0.80 = 23.81%

l) Equity Ratio y) Retention or plowback ratio (1 – POR)

= SHE ÷ TA = 1 - POR
= 2,560 ÷ 4,600 = 1 – 23.81%
= 0.56 = 76.19%

z) Sustainable growth rate (ROE x RR)

= 17.5% x 76.99%
= 13.47%