CPALE Syllabus Covered

2.0 Financial Management

2.2 Financial Management Concepts and Techniques for Planning, Control & Decision
Making

2.2.1 Financial Statement Analysis

2.2.1.1 Vertical analysis (common-size financial statement)

2.2.1.2 Horizontal analysis (trend percentages and index analysis)

2.2.1.3 Cash flow analysis (interpretation of cash flows including free cash flow
concept)

2.2.1.4 Gross profit variance analysis (price, cost, and volume factors)

2.2.1.5 Financial ratios (liquidity, solvency, activity, profitability, growth, and other
ratios; DU Pont model)

2.2.1.6 Financial forecasting using additional funds needed (AFN)

2.2.1 Financial Statement Analysis

Financial statement analysis involves the assessment and evaluation of the firm’s past
performance, its present condition, and future business potential. The analysis serves to provide
information about the following:

1. Profitability of the business firm

2. The firm’s ability to meet its obligations
3. Safety of the investment in the business
4. Effectiveness of management in running the firm
5. Over-all company marketability

2.2.1.1 Vertical analysis (common-size financial statements)

Vertical analysis is a financial statement analysis technique in which line item is listed
as a percentage of a base figure in the statement. Vertical analysis makes comparing financial
statements from one company to another an across industries much easier.

Converted financial statements are called Common Size Financial Statements. It

allows the analyst to:

1. Comprehend or visualize the changes in individual items

2. Compare statements of two or more companies

Illustration:

Sales 5,000,000
Cost of goods sold 1,000,000

Gross profit 4,000,000

General and Administrative Expenses 2,000,000

Operating income 2,000,000

Taxes (%25) 500,000

Net income 1,500,000

Prepare a common size Statement of Profit and Loss

2.2.1.2 Horizontal analysis (trend percentages an index analysis)

Horizontal enables investors and analysts to see what has been driving the
company’s financial performance over time, as well as identify trends and growth patterns. The
statements for two or more periods are used in horizontal analysis. The study of percentage
changes in comparative statements ai called horizontal analysis. It is computed as

% Change = Most recent value – Base period value / Base period value

2.2.1.3 Cash flow analysis (interpretation of cash flows including free cash flow concept)

The cash flow statement (CFS), also known as the statement of cash flows, is a
financial statement that summarizes the amount of cash and cash equivalents entering and
leaving a company.

The main components of the cash flow statement are:

1. Cash from operating activities

2. Cash from investing activities
3. Cash from financing activities
4. Disclosure of noncash activities

FREE CASH FLOW

The cash a company generates after accounting for cash outflows to support
operations and maintain capital assets is referred to as free cash flow (FCF). Unlike earnings or
net income, free cash flow is a measure of profitability that excludes non-cash expenses from
the income statement and includes spending on equipment and assets as well as balance-
sheet changes in working capital.

Free cash flow can be computed as follows:

If the starting point is Cash Flow from Operating Activities

+ Cash Flow from Operating Activities

+ Interest Expense

- Tax Shield on Interest Expense

- Capital Expenditures (CAPEX)

= Free Cash Flow

If the starting point is EBIT

+ EBIT x (1 – Tax Rate)

+ Non-cash Expenses (Depreciation, Amortization, etc.)

- Change in (Current Assets – Current Liabilities)

- Capital Expenditures (CAPEX)

= Free Cash Flow

If the starting point is Net Income

+ Net Income

+ Interest Expense

- Tax Shield on Interest Expense

+ Non-cash Expenses (Depreciation, Amortization, etc.)

- Change in (Current Assets – Current Liabilities)

- Capital Expenditures

= Free Cash Flow

Interpreting Free Cash Flow

Growing free cash flows are frequently a prelude to increased earnings. Companies
that experience surging FCF-due to revenue growth, efficiency improvements, cost reductions,
share buybacks, dividend distributions, or debt elimination- can reward investors tomorrow.

2.2.1.4 Gross profit variance analysis (price, cost and volume factors)

Gross profit analysis is used to determine the reasons why the gross profit margin
changes from period to period, so that management can take steps to bring the gross margin
in line with expectations. The two primary factors that result to revenue variances are the price
and the physical/quantity factors. The following equations are used to compute the variances.
Sales price variance (SPV)/ Sales Factor

= (Selling price per unit this year – Selling price per unit last year) x Sales units this year

= Total sales this year – Sales this year at last year’s price

Cost price variance (CPV)/ Cost Factor

= (Unit cost this year – Unit cost last year) x Sales units this year

= Cost of sales this year – Cost of sales this year at last year’s price

The physical or the quantity variance can be divided into two, the Sales Quantity Variance,
and Cost Quality Variance. The combined effect of the two quantity variances is the Sales
Volume Variance or Quantity Factor. The quantity variances are computed as follows:

Sales Quantity Variance (SQV)

= (Sales Qty this year – Sales Qty last year) x Selling price las year

Cost Quantity Variance (CQV)

= (Sales Qty this year – Sales Qty last year) x Unit cost last year

Sales Volume Variance/ Quantity Factor

= (Sales Qty this year – Sales Qty last year) x Gross Profit per unit last year

If a company sells more than one product, the Sales Volume Variance can be further
subdivided into the Sales Mix Variance and Sales Yield Variance/ Sales Quantity Variance.
Moreover, the Sales Quantity Variance can be analyzed further to consider external factors
affecting the sales units. External factors will give rise to the Market Share Variance and Market
Size Variance.

2.2.1.5 Financial ratios (liquidity, solvency, activity, profitability, growth and other ratios: Du Pont
model)

Ratio analysis is a quantitative method for gaining insight into a company’s liquidity,
operational efficiency, and profitability by examining financial statements such as the balance
sheet and income statement. Ratio analysis is a fundamental component of fundamental
equity analysis.

TESTS OF LIQUIDITY

Liquidity ratios measure a company’s ability to pay off its short-term debits as they
become due.

● Current Ratio = Current Assets / Current Liabilities

 ▪ (or Banker’s Ratio or Working Capital Ratio) measures the number of times that the
current liabilities could be paid with the available current assets.
o Working Capital = Current Assets – Current Liabilities
● Acid Test Ratio = Quick Assets* / Current Liabilities

▪ (Or quick ratio) measures the number of times that the current liabilities could be paid
with the available cash and near cash assets.
*Cash = marketable securities + receivables
● Cash Ratio = Cash and Marketable Securities / Current Liabilities

● Working Capital Activity Ratios (turnovers):

▪ Receivable Turnover = Net Credit Sales* / Average Receivables

o The time required to complete one collection cycle-from the time receivables
are recorded, then collected, to the time new receivables are recorded again.
▪ Average age of receivables = No. of working days in years / Receivable turnover =
Average Receivables / Average daily credit sales
o (or day’s sales in receivables or average collection period) indicates the
average number of days during which the company must wait before
receivables are collected.
▪ Inventory turnover:
Merchandising Firms:
o Inventory turnover = Cost of goods sold / Average Merchandising Inventory
- Measures the number of times that inventory is replaced during the period
o Average age of inventory = number of working days / Inventory Turnover
- Indicates the average number of days during which the company must
wait before inventories are sold
o Operating cycle = average age of receivables + average age of inventory
▪ Trade payables turnover = Net credit purchases / Average trade payables
o Average age of trade payables = Number of working days / Payables Turnover =
Average accounts payable / Average daily credit purchase
- Indicates the length of time during which payable remain unpaid
▪ Cash flow cycle = Operating cycle – Average age of trade payables

▪ Current assets turnover = Cost of Sales + Operating expenses (excluding depreciation

and amortization / Average current assets
o Measures the movement and utilization of current assets to meet operating
requirements
● Working Capital to Total Assets = Working Capital / Total Assets

▪ Indicates relative liquidity of total assets and distribution of resources employed

● Working Capital Turnover = Net Sales / Average Working Capital

▪ Indicates adequacy and activity of working capital

TESTS OF SOLVENCY
Also called financial leverage ratios, solvency ratios compare a company’s debt levels with its
assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the
long haul, by paying off its long-term debt as well as the interest on its debt.
● Times interest earned = income before tax + interest expense / interest expense

▪ Determines the extent to which operations cover interest expense

● Debt-equity ratio = total liabilities / total owners’ or stockholders’ equity

▪ Proportion of assets provided by creditors compared to that provided by owners

o Equity multiplier = total assets / total owners’ equity
● Debt ratio = total liabilities / total assets

▪ Proportion of total assets provided by creditors

● Equity ratio = total owners’ or stockholders’ equity / total assets

▪ Proportion of total assets provided by owners

● Fixed assets to long-term liabilities = fixed assets / long-term liabilities

▪ Reflects extent of the utilization of resources from long-term debt. Indicative of

sources of additional funds
● Fixed assets to total equity = fixed assets / total equity

▪ Measures the proportion of owners’ equity to fixed assets. Indicative of over or under
investment by owners; also weakness in “trading on the equity”
● Fixed assets to total assets = fixed assets (net) / total assets

▪ Indicates possible over expansion of plant and equipment

● Sales to fixed assets (plant turnover) = net sales / fixed assets (net)

▪ Test roughly the efficiency of management in keeping plant properties employed

● Book value per share on common stock = common stock equity / no. of outstanding
common stock
▪ Measures recoverable amount in the event of liquidation if assets are realized at their
book values
● Times preferred dividend requirements = net income before after taxes / preferred
dividend requirements
▪ Indicates ability to provide dividends to preferred stockholders

● Times fixed charges earned = net income before taxes and fixed charges / fixed charges
(rent + interest + sinking fund payment before taxes)
▪ Measures ability to meet fixed charges

● Sinking fund payments before tax = sinking fund payment after taxes / 1 – Tax Rate

TESTS OF PROFITABILITY
These ratios convey how well a company can generate profits from its operations.
● Return on sales = earnings after tax / net sales
 ▪ Determines the amount of income earned on each peso sales
o Gross profit/Margin Ratio = Gross Profit / Net Sales
● Return of total assets (ROA) = income before interest but after taxes / average total assets

▪ Efficiency with which managers use total assets to operate the business

● Return on owners’ equity = earnings after tax / average owners’ equity

▪ Measures the amount earned on the owners’ or stockholders’ investment

● Earnings per share = earnings after tax – preferred dividends (in any) / weighted average
number of common shares
▪ Measures the amount of net income earned by each common share

● Rate of return on current assets = earnings after tax / average current assets

▪ Measures the profitability of current assets invested

● Rate of return per turnover of current assets = rate of return on average current assets /
current assets turnover
▪ Shows profitability of each turnover of current assets

MARKET TESTS
These are the most used ratios in fundamental analysis. Marketability refers to how financial
instruments can be quickly converted into cash at a reasonable price.
● Price/Earnings Ratio (P/E) = price per share / earing per share

▪ Indicates the number of pesos required to buy P1 of earnings

● Dividend yield = ordinary dividend per share / price per share

▪ Measures the rate of return in the investor’s common stock investments

● Dividend pay-out = ordinary dividend per share / earnings per share

▪ Indicates the proportion of earnings distributed as dividends

● Plow-back ratio = 1 – Payout Ratio

▪ Determines the portion of earnings used for internal financing

● Earning yield = earning per share / price per share

▪ Determines how much will be earned for every P1 invested

DU PONT EQUATION
Du Pont analysis is a useful technique used to decompose the different drivers of return on
equity (ROE). The decomposition of ROE allows investors to focus on the key metrics of financial
performance individually to identify strengths and weaknesses. Du Pont is compute as:
Du Pont = Net profit margin X Asset turnover X Equity multiplier

Operating income Total sales Total assets

Total sales Total assets Shareholders’ equity

2.2.1.6 Financial forecasting using additional funds needed (AFN)
It is a way of calculating how much new funding will be required, so that the firm can
realistically look at whether they will be able to generate the additional funding and therefore
be able to achieve a higher sales level. The simplified formula is:

AFN = Projected increase in assets – spontaneous increase in liabilities – any increase in retained
earnings

The more formal equation for AFN is:

AFN = (A*/S0) ∆S – (L*/S0) ∆S – MS1(RR)

A = assets tied directly to sales

L = spontaneous liabilities that are affected by sales
S0 = the previous year’s sales
S1 = total projected sales for next year
∆S = the change in sales between S0 and S1
M = profit margin
MS1 = projected net income
RR = the retention ratio from net income (equal to 1 minus the dividend payout ratio; disregard
if dividends are not declared)