STRATEGIC BUSINESS ANALYSIS (SBA)

SBA 03: Financial Statement Analysis

Ratio Analysis & Financial Forecasting
Prepared by: R. Pascual

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 statements)
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)

TESTS OF PROFITABILITY

Profitability can be measured in absolute peso terms, like net income, or in terms of ratios. When we express profit as ratio,
we actually relate profit (or income or return) to the amount of investment acquired or used in generating such return. Relate
to the company’s performance in the current period. It shows the company’s ability to generate income.

MARGINS - measure operating efficiency of the entity

Ratio Formula Description

Gross Profit Measures profit generated after

Gross Profit Margin Net Sales consideration of cost of products sold.

Operating Profit Margin Operating Profit Measures profit generated after

Net Sales consideration of operating costs

Net Profit Margin or Return on Net Income Measures profit generated after
Sales (ROS) Net Sales consideration of all expenses and
revenues.

ILLUSTRATION 1: MARGINS

AGGLC Corporation issued the following income statement for the year 2030

Sales revenue 3,000,000

Cost of sales 1,000,000
Gross profit 2,000,000
Operating expenses 400,000
Operating income 1,600,000
Interest expense 600,000
Net income before tax 1,000,000
Income tax (30%) 300,000
Net income after tax 700,000

Required: Compute GP Margin, Operating Profit Margin, Net profit

ILLUSTRATION 2: Profit Margin

The financial statements for DJ Company for the current year are as follows:

Balance Sheet Statement of Income and RE

Cash 100 Sale 3,000
A/R 200 COGS 1,600
Inventory 50 Gross Profit 1,400
Net Fixed Assets 600 Operating expenses 970
Total Assets 950 Operating Income 430
Interest Expense 30
Income before tax 400
A/P 140 Income tax 200
Long Term Debt 300 Net Income 200
Capital Stock 260 Add: Jan. 1, RE 150
Retained Earnings 250 Less: Dividends 100
Total Liab. & Equity 950 Dec. 31 RE 250

Required: What is DJ Company’s profit margin?

ILLUSTRATION 3: Gross Profit Margin

Alpha Corporation
Selected Financial Data

Year Ended December 31

Accounts 2027 2028
Cash P 10,000 P 80,000
Marketable Securities 30,000 10,000
Accounts Receivable, net 50,000 150,000
Inventories 90,000 150,000
Land And Building, Net 340,000 360,000
Notes Payable, Trade 70,000 110,000
Accounts Payable, Trade 20,000 40,000
Mortgage Payable 270,000 280,000

Year Ended December 31

2027 2028
Cash Sales P 1,800,000 P 1,600,000
Credit Sales 500,000 800,000
Cost Of Sales 1,000,000 1,400,000

Required: What is Alpha’s gross profit margin in 2027 & 2028?

RETURNS – measure the investment’s profitability

Ratio Formula Description

Net Income or Operating Income (1 − TR)

Average Total Assets Measures overall efficiency of the firm
Return on Assets (ROA) in managing assets and generating
or profits. A measure of productivity of
assets regardless of how the assets
Net Income + (Interest Expense)(1 − 𝑇𝑅) are financed.
Average Total Assets
It compares the amount of net income
to average stockholders’ equity. It
reports the net amount earned during
the period as a percentage of each
Return on Equity (ROE) Net Income peso contributed by stockholders and
Average Shareholders′ 𝑒𝑞𝑢𝑖𝑡𝑦 retained in the business. The return on
equity (ROE) measures the amount
or earned on the owners’ investment. It is
an important indication of firm’s
ROE = ROA x Equity Multiplier profitability because it determines how
Equity Multiplier = 1 / Equity Ratio well the company is performing with
the investment contributed by its
owners

Return on Common Equity Net Income − Preferred Dividends Measures rate of return on resources
(ROCE) Average Common stockholders′ equity provided by owners.

ILLUSTRATION 4: RETURNS

Lulu Co. presented the following in the balance sheet:

2030 2029
Debt 60,000 100,000
Preferred Stock 40,000 40,000
Common Stock 20,000 20,000
Retained Earnings 140,000 60,000
Total Assets 260,000 220,000

Excerpts from income statement:

Operating income 45,000

Interest expense 5,000
Net income before tax 40,000
Income tax (20%) 8,000
Net Income after tax 32,000

*Preferred dividends declared in the year totaled P3,200

Required: Compute ROA, ROE, ROCE

ILLUSTRATION 5: ROA

The financial statements for DJ Company for the current year are as follows:

Balance Sheet Statement of Income and RE

Cash 100 Sale 3,000
A/R 200 COGS 1,600
Inventory 50 Gross Profit 1,400
Net Fixed Assets 600 Operating expenses 970
Total Assets 950 Operating Income 430
Interest Expense 30
Income before tax 400
A/P 140 Income tax (50%) 200
Long Term Debt 300 Net Income 200
Capital Stock 260 Add: Jan. 1, RE 150
Retained Earnings 250 Less: Dividends 100
Total Liab. & Equity 950 Dec. 31 RE 250

Required: What is DJ Company’s return on assets?

ILLUSTRATION 6: ROA

The president of ABS-CBN Company is establishing performance goals for each of the company’s manufacturing plants.
The data below represent prior-year results for one of the plants:

Revenues 400,000
Variable Costs 100,000
Fixed Costs 200,000
Average Assets 1,000,000
Average Liabilities 200,000

The plant’s return on assets is

ILLUSTRATION 7: RETURN ON EQUITY (ROE)

Kath Company had P15 million in sales, while total fixed costs were held to P6 million. The firm’s total assets averaged P20
million and the debt-to-equity ratio was calculated at 0.60. If the firm’s EBIT is P3 million, the interest on all debt 9%, and
the tax rate is 40%, what is the firm’s return on equity?

ILLUSTRATION 8: DuPont model

Selected financial data for Kathniel Company for the year is shown below:

Beg. Of Year End of Year

Assets 9,600,000 10,000,000
Liabilities 6,200,000 6,800,000
Shares Outstanding 1,400,000 1,500,000
Market Price per share P2.40 P2.50
Sales 22,000,000
EBIT 1,700,000
Interest Expense 500,000
Tax rate 40%

Required: Using the above data, the firm’s return on equity using the DuPont Model is?

Ratio Formula Description

It indicates the amount of sales
Net Sales revenue generated for each peso
Asset Turnover Average Total Assets invested in assets during the period.

It indicates how much revenue the

Net Sales company generates for each peso
Fixed Asset Turnover Average net fixed assets invested in fixed assets.

ILLUSTRATION 9: Asset Turnover

The selected data pertain to a company on December 31

Quick Assets 208,000

Acid Test Ratio 2.6 to 1
Current Ratio 3.5 to 1
Net sales for the year 1,800,000
Cost of sales for the year 990,000
Average total assets for the year 1,200,000
Required: What is the company’s asset turnover ratio for the year?

ILLUSTRATION 10: Fixed Asset Turnover

On its year-end financial statements, Lily Corporation showed sales of P3,000,000, net fixed assets of P1,300,000 and
total assets of P2,000,000.

Required: What is the company’s fixed asset turnover?

Ratio Formula Description

It indicates the amount of earnings
generated for each share of
Net Income − Preferred dividends (if any) outstanding common stock. Earnings
Earnings Per Share (EPS) Weighted average number of common shares per share is computed for common
shares only. No such computation is
done for preferred stockholders
because they are entitled for a fixed
amount of earnings per share, i.e.,
their dividend rate.

MARKET TESTS

Stockholders and investors are usually interested in the market price of a corporation’s common stock and the ratios that
indicate the stock’s performance or attractiveness in the market.

Ratio Formula Description

It indicates the number of pesos
required to buy P1.00 of earnings. The
Price Per Share or Stock Market Price price earnings ratio (also called times
Price-Earnings Ratio (P/E) Earnings Per Share (EPS) earnings ratio) is the ratio of the
current price per share to the earnings
per share of stocks.
It measures the rate of return in the
Dividend Per Share investor’s common stock investments.
Dividend Yield Price Per Share One of the reasons why investors buy
common stocks is to earn dividend
income.
It indicates the proportion of earnings
Dividend Per Share distributed as dividends. The payout
= ratio or dividend payout is the ratio of
Earnings Per Share (EPS)
Dividend Payout ratio dividends per share to earnings per
Or share.

Ordinary share dividends

=
Net income (O/S)

ILLUSTRATION 11: Earnings Per Share (EPS) & Price Earnings Ratio

CAT Corporation's excerpt from the balance sheet shows the ff. figures:

2030
Preferred Stock (10% Cumulative) 20,000
Common Stock (1,000 Shares Outstanding) 10,000
Retained Earnings 90,000
Total SHE 120,000

Profit for the year is P20,000. Dividends in arrears total P4,000. The stock price is currently at P144.

Required: Compute EPS & P/E Ratio

ILLUSTRATION 12: Dividend Yield

Mouse Company paid a regular quarterly dividend of P0.20 per share and had earnings of P3.20 per share. The market
price of Mouse stock at the end of the period was P40.00 per share.

Required: What was Mouse’ dividend yield?

ILLUSTRATION 13: Dividend pay-out

Gary Company paid out one-half of last year’s earnings in dividends. Gary’s earnings increased by 20% and the amount
of its dividends increase by 15% in the current year.

Required: What was Gary Company’s dividend pay-out ratio?

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. 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:
➢ Turnover ratios: Sales and purchases are made on credit.
➢ 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, 300 working days or any appropriate number of
days.
OTHER MEANINGFUL RATIOS

• RATIOS USED TO EVALUATE LONG-TERM FINANCIAL POSITION OR STABILITY

Fixed Assets to Total Equity Fixed Assets Measures the proportion of owners' equity to fixed
Total Equity assets. Indicative of over or under investment by
owners and weakness, in trading on the equity*

Indicates possible over-expansion. of plant and

Fixed Assets to Total Equity Fixed Assets (Net) equipment
Total Assets

Sales to Fixed Assets Net Sales

Tests roughly the efficiency of
Fixed Assets (Net) management in keeping plant properties employed.

Book value per share - Common

stock Common Stockholders' equity Measures recoverable amount by
common stockholders in the event of liquidation of
Common Shares Outstanding
assets are realized at their book values.

Times preferred dividends

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.

Income before taxes and fixed

Times Fixed Charges Earned charges
Measures the ability to meet fixed
Fixed Charges + Sinking fund
payment** Charges.

*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.

TESTS OF OVER-ALL SHORT-TERM SOLVENCY OR SHORT-TERM FINANCIAL POSITION

Net Sales Indicates adequacy of working capital to support

Working Capital Turnover
Average Working Capital operation (sales)

Defensive Interval Ratio Current Liabilities

Measures coverage of current liabilities
Cash & Cash Equivalent

Net Purchases Measures efficiency of the company in

Payable Turnover meeting the accounts payable
Average Accounts Payable
Reflects extent of the utilization of
Fixed Assets to Long-term Fixed Assets
resources from long-term debt. Indicative
Liabilities Long term Liabilities of sources of additional funds.

*RATIOS INDICATIVE OF INCOME POSITION

Rate of Return on Average Measures the profitability of current assets invested.

Income
Current Asset
Average Current Assets
Measures profit generated after consideration of
Operating Profit
Operating Profit Margin operating costs.
Net Sales
Measures the ability of the firm to translate sales to
Operating Cash Flow
Cash Flow Margin cash
Net Sales
- END -