BA 141

CHAPTER 3

Prepared by: Ma. Rona Corda-Prado

Business Finance SY2017-2018
 Stockholders’ Report

Annual report that

publicly owned
corporations must
provide to
stockholders.

✓ It summarizes and documents the firm’s financial activities during the past year.

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LETTER TO STOCKHOLDERS
First element of the annual stockholders’ report

❖Primary communication from management

❖Describes the events that are considered to have
the greatest effect on the firm during the year
❖Discusses management philosophy, corporate
governance issues, strategies and actions, as
well as future plans
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 RATIO
ANALYSIS • Involves methods of calculating and
interpreting financial ratios to analyze
and monitor the firm’s performance
• Basic inputs are the firm’s statement
of comprehensive income and
statement of financial position
• Interpretation of the ratio value is
more important than the calculation

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INTERESTED PARTIES

1 Current and prospective shareholders are interested in the firm’s current

and future level of risk and return, which directly affect share price.

2 Creditors are interested in the short-term liquidity of the company and

its ability to make interest and principal payments.

3 Management is concerned with all aspects of the firm’s financial

situation, and it attempts to produce financial ratios that will be
considered favorable by both owners and creditors.
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TYPES OF RATIO COMPARISONS

Benchmarking

Cross-sectional analysis
Comparison of different firms’
Type of cross-sectional analysis in which the
financial ratios at the same point in
firm’s ratio values are compared to those of a
time; involves comparing the firm’s
key competitor or group of competitors that it
ratios to those of other firms in its
wishes to emulate. BA141 | Business Finance
industry or to industry averages 6
 COMPARISON TO
INDUSTRY
AVERAGES IS ALSO
POPULAR.

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• Evaluation of the firm’s financial performance
over time using financial ratio analysis
• Comparison of current to past performance,
using ratios, enables analysts to assess the
firm’s progress.
• Developing trends can be seen by using
multiyear comparisons.
• The most informative approach to ratio
analysis combines cross-sectional and time-
series analyses

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COMBINED ANALYSIS
 CAUTIONS ABOUT USING RATIO ANALYSIS
6 issues
A single ratio does not generally It is preferable to use Results can be
provide sufficient information audited financial distorted by inflation.
from which to judge the overall statements.
6
performance of the firm.
4
2

5
3 The financial data
1
Financial statements used for being compared should
Ratios with significant deviation ratio analysis should be have been developed
from the norm only indicate dated at the same point in in the same way.
the possibility of a problem. time during the year. BA141 | Business Finance 10
CAUTIONS ABOUT USING RATIO ANALYSIS

Technological changes
Analysts should look beyond
the ratios. Industry trends and consumer
taste

Changes within the company

There are other factors and
indicators that could make ratio
analysis and interpretation more Economic factors
meaningful and relevant.

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5 CATEGORIES OF FINANCIAL RATIOS

Liquidity Solvency of the firm’s overall financial position

Measure the speed with which various accounts are

Activity
converted into sales or cash – inflows or outflows

Measures the proportion of total assets financed by

Debt
the firm’s creditors

Profitability Measures return

Market Measures risk and return

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Liquidity
• Current ratio
• Quick (acid-test) ratio
✓ Measure the short-term ability of the company to
pay its maturing obligations and to meet
unexpected needs for cash.
✓ Can provide early signs of cash flow problems and
impending business failure
✓ Short-term creditors such as bankers and
suppliers are particularly interested in assessing
liquidity.
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 CURRENT RATIO
Measures a company’s short-term debt paying ability.

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 Pros Cons
Declining current ratio may be Declining current ratio may be
the result of eliminating a sign of deteriorating financial
obsolete inventories. condition.
A low current ratio may not be A very high ratio may indicate
too critical if the firm has easy surplus cash or marketable
access to short term funding. securities that could be
converted to long term
investments for higher returns.

CURRENT RATIO
A higher current ratio indicates a greater degree of liquidity. How much liquidity a firm needs depends on a
variety of factors, including the firm’s size, its access to short-term funding and the volatility of the business.
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 QUICK (ACID-TEST) RATIO
Measures liquidity by excluding inventory or prepaid expenses from current assets (only
consider quick assets) as they are the least liquid among the current assets.
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QUICK ASSETS
Why are inventories and prepayments excluded?

INVENTORY
PREPAYMENTS
• Could not easily be easily sold (i.e.
They are excluded because generally,
work in process, specialized inventory
the payment cannot be reversed and
items, etc)
therefore are not liquid like the other
• Typically sold on credit (A/R first
quick assets.
before it becomes cash)
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QUICK
RATIO • Only a better measure of liquidity
if inventory cannot be easily
converted to cash
• If inventory is liquid, then the
current ratio is preferred

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PRACTICE 19
SOLVING FOR LIQUIDITY RATIOS

1. Current assets is PHP2,000, current liabilities

is PHP3,500. What is current ratio? 1. Current ratio: 2,000/3,500 = 0.57
2. Inventory is PHP150. Accounts payable is 2. Current ratio: (800 + 150)/450 = 2.11
Quick ratio: 800/450 = 1.78
PHP450. Cash and accounts receivable total
3. Total receivables: 1.7=
PHP800. What is the current ratio? Quick
(X+20,000+7500)/
ratio? 30,000 = 23,500
3. If current ratio is 1.7, what is the total 4. Current ratio: 2.3 = (6,900 + 16,100)/
accounts receivable if cash is PHP20,000, 10,000
inventory is PHP7,500, and accounts payable Assuming an increase in
is PHP30,000. noncurrent
4. Cash is 30% of total current assets. If current assets of 50%
ratio is 2.3, what is the new current ratio if New current ratio:(6,900 + 24,150)/
total non-cash current assets grew by 50%? 10,000 = 3.105

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REFLECTION POINTS

1. What is a good current ratio? 1? 2? 0.5?

2. Can a current ratio be lower than the
quick ratio?
3. Is a high current ratio always good? Is a
low current ratio always bad?
4. What factors affect company’s decisions
in managing current ratio?
5. If company A has current ratio of 1.3
while company B has a current ratio of
2.3, which is a better company?

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Activity
• Accounts Receivable Turnover ✓Also known as efficiency ratios
• Average Collection Period
✓Measure how efficiently a firm operates
• Inventory Turnover
along a variety of dimensions such as
• Average Age of Inventory inventory management, disbursements and
• Accounts Payable Turnover collections.
• Average Payment Period
• Total Asset Turnover
• Fixed Asset Turnover
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ACCOUNTS RECEIVABLE TURNOVER
* If the problem is silent, assume that all sales are on credit.
** Sometimes, average accounts receivable is used. 23
 ACCOUNTS
RECEIVABLE
• Used to measure the liquidity of
TURNOVER the receivables (number of times,
on average, receivables are
RATIO collected during the period).
• The faster, the better.

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 AVERAGE COLLECTION PERIOD
Analysts frequently use the average collection period to assess the effectiveness of a
company’s credit and collection policies. The general rule is that the collection
period should not greatly exceed the credit term period. 25
 • A company’s average collection
AVERAGE period should be compared with the
credit terms it grants its customers.
COLLECTION • If the average collection period is
higher than the credit period, it may
PERIOD indicate a problem with the credit
department (granting credit to
noncreditworthy people or
companies) or with the collection
department (inefficient or lack of
means of collection) or both

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 AVERAGE
COLLECTION • Companies in the building
materials, grocery, and
PERIOD merchandise store industries
collect in just a few days, whereas
firms in the computer industry take
roughly two months to collect on
their sales.

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PRACTICE 28
 Accounts receivable
turnover: 44.4x
Average collection
period: 8.2 days

PRACTICE PRACTICE
 INVENTORY TURNOVER
Measures the number of times on average the inventory is sold during the period. Its purpose
is to measure the liquidity of the inventory.
* Sometimes, average inventory is used. 30
 • Generally, the faster the inventory
INVENTORY turnover, the less cash is tied up in
inventory and the less the chance
TURNOVER of inventory becoming obsolete.
• Of course, a downside of high
RATIO inventory turnover is that the
company can run out of inventory
when it is needed.
• More meaningful if compared with
other firms in the same industry or
the firm’s past inventory turnover

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 AVERAGE AGE OF INVENTORY
Also known as average days in inventory. May vary considerably among industries
and within a company, there may be significant differences among different types of
products. 32
PRACTICE
 Inventory turnover:
10x
Average age of
inventory: 36.5 days

PRACTICE PRACTICE
ACCOUNTS PAYABLE TURNOVER
* If purchases is not given, COGS could be used.
** Sometimes, average accounts payable is used.
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ACCOUNTS
• If the turnover ratio declines from one
PAYABLE period to the next, this indicates that
the company is paying its suppliers
TURNOVER more slowly, and may be an indicator
of worsening financial condition.
• If a company is paying its suppliers
very quickly, it may mean that the
suppliers are demanding fast payment
terms, or that the company is taking
advantage of early payment discounts.
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 AVERAGE PAYMENT PERIOD
Measures the average number of days it takes a business to pay its vendors for
purchases made on credit hence it is the average amount of time it takes a
company to pay off credit accounts payable. 37
AVERAGE • Average payment period makes sense
to be analyzed in relation to the credit
PAYMENT terms extended by a company’s
suppliers.
PERIOD • If a company manages to pay beyond
the credit period available (in finance,
this is called “stretching the payables”)
without damaging its credit rating, then
this indicates good payables
management by the company because
they are able to take advantage of
(almost) free financing.
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PRACTICE 39
 Accounts Payable
turnover: 18.57x
Average payment
period: 19.65 days

PRACTICE PRACTICE
 TOTAL ASSET TURNOVER
Measures the efficiency of a company's use of its assets in generating sales
revenue or sales income to the company.
41
 • Generally, the higher the ratio, the more
efficiently its assets have been used. A higher
ratio is a strong positive indicator of a firm’s
TOTAL operations.
• However, note that, due to depreciation of fixed
ASSET assets, older companies in an industry may
appear to be much more efficient in terms of
TURNOVER generating sales using its assets.
• A higher-than-average total assets turnover
might indicate that the company is already in
its mature stage (due to high sales amount
relative to assets), that its fixed assets are
getting too old, or that it may need to review
its depreciation policies (it may be depreciating
its fixed assets too quickly).
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 FIXED ASSET TURNOVER
Measures the efficiency of a company's use of its fixed assets in generating sales
revenue or sales income to the company. Very relevant for companies which
have invested heavily in PPE such as those in the utility industries. 43
PRACTICE 44
 Total Asset
turnover: 0.41
Fixed Asset
turnover: 0.44

PRACTICE PRACTICE
PRACTICE

Questions

1. Total asset is PHP750,000. Sales is

PHP1,500,000. What is the total asset
turnover?
2. Accounts receivable turnover is 4. What is
the average collection period assuming
annual data are used?

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PRACTICE

Question

Sales for the year amount to PHP100,000.

Accounts receivable amount to PHP12,000.
What is the average collection period
assuming annual data are used?

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PRACTICE

Question

The quick ratio is 1.7 while the current ratio is

2.5. The current liabilities amount to PHP5,000.
Cost of goods sold is PHP52,500. What is the
inventory turnover? Average age of inventory?

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PRACTICE

Question

Beginning inventory is PHP2,000 while ending

inventory is PHP5,000. Cost of goods sold is
double the ending inventory and accounts
payable is PHP4,000. What is accounts payable
turnover? Average payment period?

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PRACTICE

Question

Ending inventory is PHP13,000 while accounts

payable is PHP2,500. Purchases were half the
ending inventory. What is accounts payable
turnover? Average age of payables?

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PRACTICE

Question

Current assets amount to PHP30,000 while

noncurrent assets are PHP50,000. Sales
amount to PHP200,000. What is the total asset
turnover?

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Debt
• Debt ratio
• Debt-to-equity ratio
• Times Interest Earned Ratio
• Fixed-Payment Coverage Ratio
✓ Also known as leverage or solvency ratios
✓ Measure the ability of the enterprise to survive
over a long period of time.
✓ Long-term creditors and stockholders are
interested in a company's long-run solvency,
particularly its ability to pay interest as it comes
due and to repay the face value of the debt at
maturity.
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DEBT TO TOTAL ASSETS OR DEBT RATIO
Measures the percentage of the total assets provided by creditors.

53
 DEBT
RATIO • In general, the more debt a firm uses in relation
to its total assets, the greater its financial
leverage (risk and return through the use of
fixed cost financing such as debt and preferred
stock).
• Measures a company’s degree of indebtedness
(amount of debt relative to other items in the
balance sheet)

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 Pros Cons
The higher the percentage of
With increased debt comes
debt to total assets, the greater
greater return.
the risk that the company may
be unable to meet its maturing
The lower the ratio, the more
obligations.
equity “buffer” is available to
creditors if the company
becomes insolvent.

DEBT RATIO

55
DEBT VS NO-DEBT PLAN 56
DEBT TO EQUITY RATIO
Shows the proportion of debt to equity

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FACTORS THAT AFFECT CAPITAL STRUCTURE
Stage of Business Development
New businesses would
normally have lower
Industry Prospects debt.
Good industry prospects would
allow room for more risks.
Management style
Management and the
board of directors can
be aggressive or
conservative in terms of
taking on risk.
Taxes
Interest expense is tax
deductible.
Nature of Business
If the business is risky, expect a lower
Macroeconomic debt ratio.
conditions
If the overall economy is
good then management
can be more aggressive
on taking more risks.
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 TIMES INTEREST EARNED RATIO
Indicates the company’s ability to meet interest payments as they come due
(ability to service debts). Generally, the higher, the better (better margin of
safety). 59
 FIXED PAYMENT COVERAGE RATIO
Indicates the company’s ability to meet interest payments as they come due
(ability to service debts). Generally, the higher, the better (better margin of
safety). 60
PRACTICE 61
 Debt ratio =
57.65%
Interest coverage
ratio = 180.7143

Assume this is all interest expense.

PRACTICE PRACTICE
PRACTICE
1. Total assets is 100,000. Total debt is 50,000.
What is the debt-to-equity ratio?
1. 1 or 1:1
2. If the pro forma balance sheet shows that 2. C
total asset increase by PHP400,000 while
retaining a debt-equity ratio of .75 then:
A. debt must increase by PHP300,000.
B. equity must increase by the full
PHPH400,000.
C. debt must increase by PHP171,428.
D. equity must increase by PHP100,000.
© 2012 Pearson Prentice Hall. All rights reserved. 63
Profitability
• Gross Profit Margin
• Operating Profit Margin
• Net Profit Margin
• Earnings per Share (EPS)
• Return on Total Assets (ROA)
• Return on Common Equity
(ROE)
✓ Profitability refers to the company’s ability to
generate earnings.
✓ Ratios measure the income or operating success
of a company for a given period of time.
✓ Without profits, a firm could not attract outside
capital.
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COMMON-SIZE
FINANCIAL
STATEMENTS
A common-size financial statement is a
vertical analysis in which each financial
statement item is expressed as a
percentage.

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COMMON-SIZE STATEMENTS

Burger King McDonald's

(dollars in millions) Dollars Percentage Dollars Percentage
2008 Net income $ 190 7.70% $ 4,313 18.30%

Common-size financial statements are

particularly useful when comparing data
from different companies.
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COMMON-SIZE FINANCIAL STATEMENTS

Statement of Comprehensive Income

All items are usually expressed as
a percentage of sales.

Statement of Financial Position

All items are usually expressed as
a percentage of total assets.

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 GROSS PROFIT MARGIN
Indicates how much of each sales peso is left after deducting the cost of goods
sold to cover expenses and provide a profit.
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 OPERATING PROFIT MARGIN
Measures “pure profits” (measure only the profits earned on from its core or
main business(es).
69
 NET PROFIT MARGIN
Measures the percentage of each sales dollar remaining after all costs and
expenses including interest, taxes and preferred stock dividends are deducted.
The higher the firm’s net profit margin, the better. 70
 EARNINGS PER SHARE
Stockholders usually think in terms of the number of shares they own or plan to own.
Expressing net income earned on a per share basis provides a useful perspective for
determining profitability. 71
 RETURN ON TOTAL ASSETS (ROA)
Measures the overall profitability of assets in terms of the income earned on each dollar
invested in assets; also called return on investment (ROI)
72
 RETURN ON COMMON EQUITY (ROE)
This measure indicates how well the company used the owners’ investments to earn
income.
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 REVIEW

• ROE
• ROA
• Gross profit
margin
• Operating
profit margin
• Net profit
margin

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Market
• Price/Earnings (P/E) Ratio
• Market/Book (M/B) Ratio
✓ Relate the firm’s market value as measured by its
current share price to certain accounting values
✓ Gives insights into how investors in the
marketplace feel the firm is doing in terms of risk
and return
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 PRICE/EARNINGS RATIO
Oft-quoted statistic that measure the ratio of the market price of each share of common
stock to the EPS; reflection of investors’ assessments of a company’s future earnings.
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 BOOK VALUE PER SHARE
Measures the amount that would be distributed to holders of each share of
common stock if all assets were sold at their balance sheet carrying amounts
after all creditors were paid off. 77
 MARKET/BOOK (M/B) RATIO
Provides an assessment of how investors view the firm’s performance.

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DuPont
The DuPont system of analysis is used
to dissect the firm’s financial
statements and to assess its financial
condition.
✓ The DuPont system of analysis is used to dissect
the firm’s financial statements and to assess its
financial condition. It merges the income
statement and balance sheet into two summary
measures of profitability.
✓ The Modified DuPont Formula relates the firm’s
ROA to its ROE using the financial leverage
multiplier (FLM).
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 RETURN ON ASSETS (DU PONT)
Provides an assessment of how investors view the firm’s performance.

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 RETURN ON EQUITY (MODIFIED DU PONT)
Relates the firm’s return on total assets to its return on common equity. The latter is
calculated by multiplying the return on total assets (ROA) by the financial leverage
multiplier (FLM), which is the ratio of total assets to common stock equity 81
DU PONT
ANALYSIS • Allows the firm to dissect its ROE into a profit
on sales component (net profit margin), an
efficiency of asset use component (total asset
turnover) and the use of financial leverage
(FLM)

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HORIZONTAL ANALYSIS
▪ Allows the learners to see the trend for the different accounts in the
Financial Statements.
▪ Also known as trend analysis.
▪ To establish the trend, percentage changes of accounts from one
period to another have to be made
▪ To compute:
» Amount of change = Current year amount – Base (earlier) year
amount
» Percent of change = Amount of change/Base (earlier) year
amount

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HORIZONTAL ANALYSIS

2015 2014
 SEATWORK
• 3-25 (Annual principal payment is $100,000)
• 3-26

ASSIGNMENT
• 3-23
• 3-24
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