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BM1915 INTRODUCTION TO MANAGERIAL ACCOUNTING Definition and Objectives of Managerial Accounting Managerial accounting, also known as management accounting, is the p...

BM1915 INTRODUCTION TO MANAGERIAL ACCOUNTING Definition and Objectives of Managerial Accounting Managerial accounting, also known as management accounting, is the process of identifying, measuring, analyzing, interpreting, and communicating information in pursuit of an organization’s goals. It is a field of accounting that provides financial information for managers and other internal users to make sound economic decisions. Managers make decisions during the day-to-day operations of the business, and managerial accounting provides information used for these decisions. To achieve the organization’s goals, it acquires resources (e.g., funds, equipment, buildings), hires people, and then engages in an organized set of activities. The day-to-day work of the management includes the following activities (Hilton & Platt, 2017): 1. Decision making 2. Planning 3. Directing operational activities 4. Controlling In this regard, managerial accounting is considered an integral part of the management process because knowing managerial accounting is not only for managerial accountants but also for managers, as they are all part of the management team. With the use of the tools of managerial accounting, the organization can achieve its goals effectively and efficiently. Objectives of Management Accounting Managers need information about the managerial activities enumerated above. That information comes from a variety of sources like economists, financial experts, marketing and production personnel, accountants, and the organization’s managerial accounting system. Managerial accounting systems supply all kinds of information to management in support of management’s role in directing the organization’s activities. Some examples of managerial accounting information which will be discussed are as follows: Classifying manufacturing and other costs and reporting them in the financial statements (cost concepts) Analyzing and interpreting financial statements with the use of different analytical techniques (financial statement analysis) Evaluating the impact of cost allocation on pricing products and services and allocating product costs using activity-based costing (activity-based costing) Estimating the behavior of costs for various levels of activity and assessing cost-volume-profit relationships (cost-volume-profit analysis) Evaluating performance using cost behavior relationships (product costing / variable costing) Evaluating special decision-making situations by comparing differential revenues and costs (differential cost analysis / relevant costing) Evaluating manufacturing costs by comparing actual with expected results (standard costing) Planning for the future by preparing budgets (short-term budgeting) Evaluating decentralized operations by comparing actual and budgeted costs as well as computing various measures of profitability (responsibility accounting, transfer pricing, pricing decisions) Evaluating alternative proposals for long term investments in fixed assets (capital budgeting). These sets of tools and perspectives add value to an organization by supporting the following major objectives of managerial accounting: 1. To provide information for decision making and planning 01 Handout 1 *Property of STI  [email protected] Page 1 of 11  BM1915 2. To assist managers in directing and controlling operational activities 3. To motivate managers and other employees toward the organization’s goals 4. To measure the performance of activities, subunits, managers, and other employees within the organization. 5. To assess the organization’s competitive position and work with other managers to ensure the organization’s long-run competitiveness in its industry. Management Accounting vs. Financial Accounting Accounting information should address three (3) different functions: 1. Estimating the cost of products or services (cost accounting) 2. Providing financial information to external users (financial accounting) 3. Providing information to management for decision-making (management accounting). Given the objectives of managerial accounting, it can be perceived that the focus in each of these objectives is on managers. Thus, managerial accounting focuses on the needs of the managers within the organization rather than the interested parties outside the organization (Hilton & Platt, 2017). On the other hand, financial accounting is a field of accounting that uses accounting information for reporting to parties outside the organization. There are many similarities between managerial accounting information and financial accounting information because they both draw upon data from an organization’s accounting system (a system of procedures, personnel, and computers used to accumulate and store financial data in the organization). One part of the overall accounting system is the cost accounting system that accumulates data about the costs of producing goods and services (Hilton & Platt, 2017). Cost accounting creates an overlap between financial accounting and managerial accounting. It integrates with financial accounting by providing product costing information for financial statements. Production cost data are also used in helping managers evaluate the pricing of different products and services (see Figure 1). Accounting System (one part of the organization’s management information system) Accumulates data for use in financial and managerial accounting Cost Accounting System (one part of the organization’s overall accounting system) Accumulates cost information Managerial Accounting Financial Accounting Information for decision making, Published financial statements and directing, planning, and controlling other financial reports an organization’s operations. Internal users of information External users of information Figure 1. Managerial accounting, cost accounting, and financial accounting Source: Managerial Accounting, 2017. p. 12 01 Handout 1 *Property of STI  [email protected] Page 2 of 11  BM1915 Managerial Accounting Financial Accounting Users of reports Managers and other internal users Shareholders, creditors, regulators and (within the organization) other external users (outside the organization) Purpose To provide internal users with To provide external users with information that may be used by information about the organization’s managers in carrying out the functions financial position and financial of planning, controlling, decision- performance making, and performance evaluation Focus of reports Reports often focus on sub-units or Financial reports focus on the business segments within the organization as a whole Types of reports Management reports (budgets, Financial statements financial projections, cost analyses, etc.) Regulation/Standards Optional and unregulated since it is Required and must conform to the of presentation only intended for management use generally accepted accounting Management can set its own rules in principles (GAAP), PFRS (Philippine producing information that is most Financial Reporting Standards), and relevant to its needs PAS (Philippine Accounting Standards) Period covered Reports may cover any period as Reports usually cover a year, quarter, required by the management or month Table 1. Comparison of managerial accounting and financial accounting Standard of Ethical Conduct for Management Accountants Management accountants are responsible for complying with and upholding the standards of competence, confidentiality, integrity, and credibility. Failure to comply may result in disciplinary action (Institute of Management Accountants, 2017). 1. Competence a. Maintain an appropriate level of professional leadership and expertise by enhancing knowledge and skills. b. Perform professional duties in accordance with relevant laws, regulations, and technical standards. c. Provide decision-support information and recommendations that are accurate, clear, concise, and timely. 2. Confidentiality a. Keep information confidential except when disclosure is authorized or legally required. b. Inform all relevant parties regarding the appropriate use of confidential information. Monitor to ensure compliance. c. Refrain from using confidential information for unethical or illegal advantage. 3. Integrity a. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts of interest. b. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. c. Abstain from engaging in or supporting any activity that might discredit the profession. d. Contribute to a positive ethical culture and place integrity of the profession above personal interests. 4. Credibility a. Communicate information fairly and objectively. 01 Handout 1 *Property of STI  [email protected] Page 3 of 11  BM1915 b. Provide all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations. c. Report any delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. d. Communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. Cost Concepts, Classification, and Segregation When notified by a term that defines the purpose, cost becomes operational (e.g., selling cost, variable cost, etc.). The point is that different cost concepts and classification are used for different purposes. There are many types of costs because these costs are classified differently based on the needs of the management. Definition of Terms Cost – It refers to a measurement, in monetary terms, of the amount of resources used for some purpose. Cost pool – It is an account in which a variety of similar costs are accumulated prior to allocation to cost objects. It is a group of costs associated with an activity (e.g., overhead account). Cost object – It is the intermediate and final disposition of cost pools (e.g., product, job, process). Cost driver – It is a factor that causes a change in the cost pool for a particular activity. It is used as a basis for cost allocation (any factor or activity that has a direct cause-effect relationship). Cost behavior – It describes how a cost behaves or changes as the amount of cost driver changes. Cost function – It is the formula to which the total cost of the firm will be computed. It is an algebraic equation used by managers to describe the relationship between a cost and its cost driver. Activity – It refers to any event, action, transaction, or work sequence that incurs costs when producing a product or providing a service. Relevant range – It is a range of activity that reflects the company’s normal operating range. Within the relevant range, the cost behavior is valid. Classification of Costs 1. As to traceability (assigning costs to cost objects) Direct cost – It is a cost that can be traced to a particular plant or department. Indirect cost – It is a cost that is not directly traceable to a particular department or sub-unit. 2. As to controllability Controllable cost – It is a cost that the manager can significantly or heavily influence its incurrence. For example, from the perspective of a department manager, controllable costs include salaries of supervisors, supplies, electricity, and other similar costs that are controllable by the said department manager. Uncontrollable cost – It is a cost that the manager cannot significantly or heavily influence its incurrence. Examples include allocated costs that are received from other segments or departments. 3. As to functional areas in the organization to which the costs relate Manufacturing cost – This is the cost incurred in the production of the product or service (converting raw materials into finished goods) and is composed of three (3) elements: o Direct materials – raw materials that become an integral part of, and is directly traceable to, the finished product o Direct labor – consists of labor costs that can be easily traced to individual units of product. o Manufacturing overhead – consists of manufacturing costs other than direct materials and direct labor 01 Handout 1 *Property of STI  [email protected] Page 4 of 11  BM1915 Prime cost = Direct materials + Direct labor Conversion cost = Direct labor + Manufacturing overhead Nonmanufacturing cost – This cost is incurred in administering the operations of the business and commercializing the product. It is commonly called operating expenses, which are charged to revenues for the period. o Selling costs – include all costs incurred to secure customer orders and get the finished product to the customer o Administrative costs – include all costs associated with the general management of an organization rather than with manufacturing or selling. 4. As to timing of charges to revenue in an accounting period (in preparing financial statements) Product cost – Also known as inventoriable cost, it is a cost assigned to goods or services until sold. Product costs “attach” to a unit as it is purchased or manufactured, and they stay attached to each unit of product as long as it remains in inventory awaiting sale. When goods are sold, it will be released from inventory as expenses (called cost of goods sold) matched against sales revenue. Period cost – This cost is matched against revenue in the time in which it is incurred. 5. As to relevance in decision making Differential cost – Also known as incremental costs, it is the amount by which the cost differs under two (2) alternative actions. Relevant cost – It is the cost incurred in one (1) alternative but will not be incurred in another alternative. As costs are incurred in both alternatives, such costs would be irrelevant in decision- making. Standard cost – It refers to the predetermined cost based on some reasonable basis such as past experiences, budgeted amounts, and industry standards. It is estimated based on actual capacity. Opportunity cost – It refers to the benefit forgone or given up when an alternative is chosen over the other/s. For instance, if a business decides to use its building for production rather than renting out to its tenants, the opportunity cost will be the rental income that would be earned had the business decide to rent out the building. Sunk costs – It refers to the historical costs that will not make any difference in making a decision. Examples include the acquisition cost of office equipment and the manufacturing costs of finished goods on hand. Out of pocket cost – It is a cost that requires the payment of cash or other assets in the future as a result of their incurrence. 6. As to cost behavior Variable cost – Within the relevant range and time period under consideration, it is a cost that changes, in total, directly proportional to changes in the level of activity (or cost driver). For example, if the level of activity increases by 15%, total variable costs will increase by 15%. If the level of activity decreases by 20%, total variable costs will also decrease by 20%. It may also be defined as a cost that remains constant per unit in every level of activity. 01 Handout 1 *Property of STI  [email protected] Page 5 of 11  BM1915 Total Variable Cost Line 150 Total cost (Pesos) 100 50 0 1 2 3 4 5 6 Volume of Production (Units) Figure 2. Total variable cost line ILLUSTRATION: ABC Expeditions is a small company that provides a daylong whitewater rafting excursion on the rivers of Palawan. The company provides all the necessary equipment and experienced tour guides and serves gourmet meals to its guests. The meals are purchased from a caterer for PHP 500 for a daylong excursion. The behavior of this variable cost is shown below: Number of guests Cost of meals per guest Total cost of meals 200 PHP 500 100,000 400 PHP 500 200,000 600 PHP 500 300,000 800 PHP 500 400,000 Variable cost 400,000 Total costs of meals (in pesos) 300,000 200,000 100,000 - 200 400 600 800 Number of guests Figure 3.Variable cost behavior Fixed cost – Within the relevant range and time period under consideration, the total amount is constant, but the per-unit amount varies inversely or indirectly as the level of activity (or cost driver) changes. o Committed fixed costs – It refers to the costs resulting from an organization’s structure or the use of its facilities. Examples include property taxes, salaries of management personnel, and cost of renting facilities. o Discretionary fixed costs – It refers to the costs resulting from a management decision to spend a particular amount of money for a specific purpose. Examples include the amount of money to spend on research and development, contributions to charitable institutions, and advertising. 01 Handout 1 *Property of STI  [email protected] Page 6 of 11  BM1915 Fixed Cost Line 15 Total cost (Pesos) 10 5 0 1 2 3 4 5 6 Volume of Production (Units) Figure 4. Fixed cost line ILLUSTRATION: To continue the ABC Expeditions example, assume the company rents a building for PHP 25,000 per month to store its equipment. The total amount of rent paid is the same regardless of the number of guests the company takes on its expeditions during any given month. The concept of fixed cost is shown graphically below. Fixed Cost Monthly rental cost (in 30,000.00 25,000.00 20,000.00 pesos) 15,000.00 10,000.00 5,000.00 - 200 400 600 800 Number of guests Figure 5. Fixed cost behavior Mixed Cost – This cost has both fixed and variable components. Examples include electricity, inter- department services, water and sewage, maintenance and repairs, and employer contributions to government agencies. Chart Title 30.00 20.00 10.00 - 1 2 3 4 5 Variable cost Fixed cost Figure 6. Mixed cost 01 Handout 1 *Property of STI  [email protected] Page 7 of 11  BM1915 Within the relevant range, the aforementioned cost behavior is valid. See the information below: Total amount Per cost driver Varies proportionately Variable cost Constant with the cost driver Varies inversely with the Fixed Cost Constant cost driver Here is a summary of the classification of costs: Purpose Cost Classification Examples Assigning costs to cost Direct (can be easily traced) Direct materials, direct labor objects Indirect (cannot be easily traced) Manufacturing overhead, indirect materials, indirect labor As to controllability Controllable cost The controllability of a cost is Uncontrollable cost dependent on the authority assigned to a specific manager. Accounting for costs in Manufacturing costs Direct materials, direct labor, manufacturing manufacturing/factory overhead companies Nonmanufacturing costs Selling costs, administrative costs, research and development As to timing of charges Product costs (inventoriable) Direct materials, direct labor, variable overhead, fixed overhead Period costs (expensed) Administrative expenses, selling expenses, distribution expenses Making decisions Differential cost (differs between Variable production costs (i.e., direct alternatives) materials, direct labor, variable overhead) and variable expenses Relevant cost In a decision to rent or construct an office building, the rent expense is a relevant cost from both alternatives Standard cost Assuming the planned or budgeted capacity is 5,000 units, the standard unit cost is PHP20, and the actual capacity is 6,000 units. The standard costs would be P120,000 (i.e., 6,000 x PHP20). Opportunity cost (benefit A company is evaluating whether to foregone) sell product A and earn PHP20,000 or sell product B and earn PHP25,000. If the company decides to sell product A, its opportunity cost is PHP25,000 because it is the potential income foregone for not selling product B. Sunk cost (should be ignored) Depreciation expense Out-of-pocket cost Salaries, rent, electricity, insurance 01 Handout 1 *Property of STI  [email protected] Page 8 of 11  BM1915 Purpose Cost Classification Examples Variable costs (proportional to Direct materials, direct labor, variable activity) manufacturing overhead (e.g., indirect materials, indirect labor, repairs, and supplies), variable selling expenses (e.g., sales commissions, and delivery expenses), and variable administrative expenses (e.g., general supplies, overtime costs, and Predicting cost behavior communications expenses) in response to changes in Fixed costs (constant in total) Committed fixed cost: rent, insurance, activity real property taxes Discretionary fixed cost: advertising expense, research and development expense Mixed costs (has variable and Electricity, inter-department services, fixed elements) water and sewage, maintenance and repairs, and employer contributions to government agencies. Table 2. Summary of cost classifications Analysis of Mixed Costs Classifying costs as to variable or fixed is very useful in planning and budgeting. The manager must be able to anticipate what will happen to these costs in case of changes in activity; if a cost is expected to change, the manager must know how much or up to what extent. Mixed cost is composed of the total variable costs and total fixed costs. However, the variable cost is measured on a per-unit basis and the total cost will vary depending on the level of activity. In this case, the firm must develop a cost function. 𝑌𝑌 = 𝑎𝑎 + 𝑏𝑏𝑏𝑏 Where: Y = total costs a = total fixed costs b = variable cost per unit x = level of activity or cost driver or the number of units produced ILLUSTRATION: Assuming for the month of January, ABC Expeditions had 500 guests who availed of the meals during the daylong excursions. The total cost could be determined at this level as: 𝑌𝑌 = 𝑎𝑎 + 𝑏𝑏𝑏𝑏 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑃𝑃25,000 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑙𝑙𝑙𝑙 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑃𝑃500(500 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔) = 𝑃𝑃25,000 + 𝑃𝑃250,000 = 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷, 𝟎𝟎𝟎𝟎𝟎𝟎 High-Low Method This is a cost segregation technique that is based on the premise that a change in costs is attributed to the change in variable cost—fixed cost being assumed to be constant. The high-low method involves taking the highest level of activity and the lowest level of activity and comparing the total costs at each level. 01 Handout 1 *Property of STI  [email protected] Page 9 of 11  BM1915 ILLUSTRATION: ABC Expeditions is preparing a flexible budget for next year and requires a breakdown of the maintenance cost into the fixed and variable components. The maintenance costs and machine hours are as follows: Maintenance costs Machine hours January P15,450 1,800 February 10,720 1,166 March 15,000 1,770 April 15,840 2,190 May 14,900 1,702 June 10,620 1,300 Using the high-low method of analysis, compute for the variable and fixed component. Step 1. Find the highest and lowest activities. Machine Hours and Maintenance Costs 20,000 2,500 15,000 2,000 1,500 10,000 1,000 5,000 500 0 0 January February March April May June Maintenance costs Machine hours Figure 7. Machine hours and maintenance costs Highest activity level April 2,190 machine hours Lowest activity level February 1,166 machine hours Note: It is the highest and lowest activity levels that need to be identified first rather than the highest/lowest cost. The number of hours (1,166) does not correspond to the lowest cost (P10,620). In this case, the cost driver or activity level prevails. Step 2. Calculate variable cost per unit. 𝐻𝐻𝐻𝐻𝐻𝐻ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 = 𝐻𝐻𝐻𝐻𝐻𝐻ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 − 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑃𝑃15,840 − 𝑃𝑃10,720 Variable cost per unit = 2190 − 1166 𝑃𝑃5,120 Variable cost per unit = 1,024 Variable cost per unit = 𝑷𝑷𝑷𝑷. 𝟎𝟎𝟎𝟎 01 Handout 1 *Property of STI  [email protected] Page 10 of 11  BM1915 Step 3. Calculate fixed cost. After computing for the variable cost per unit, calculate the fixed cost by subtracting the total variable cost at a specific activity level from the total cost at that activity level. 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝐻𝐻𝐻𝐻𝐻𝐻ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 (𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙) or 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 (𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑙𝑙𝑙𝑙𝑙𝑙𝑒𝑒𝑙𝑙) High Low Total cost P15,840 P 10,720 Less: Total variable cost P5 x 2,190 hours 10,950 P5 x 1,166 hours 5,830 Monthly fixed cost P4,890 P4,890 To check using the cost function: 𝑌𝑌 = 𝑎𝑎 + 𝑏𝑏𝑏𝑏 𝑃𝑃15,840 = 𝑃𝑃4,890 + 𝑃𝑃5(2190) 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟖𝟖𝟖𝟖𝟖𝟖 = 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟖𝟖𝟖𝟖𝟖𝟖 or 𝑃𝑃10,720 = 𝑃𝑃4,890 + 𝑃𝑃5(1,166) 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟕𝟕𝟕𝟕𝟕𝟕 = 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟕𝟕𝟕𝟕𝟕𝟕 Step 4. Calculate the total variable cost for new activity. Multiply the variable cost per unit (Step 2) by the activity level to compute for the total variable cost for that month. Assuming the company will be consuming 1,500 machine hours for July, the computation will be as follows: 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑏𝑏(𝑥𝑥) = 𝑃𝑃5(1,500) = 𝑷𝑷𝑷𝑷, 𝟓𝟓𝟓𝟓𝟓𝟓 Step 5. Calculate the total cost. Add the computed total variable cost (Step 4) to the total fixed cost (Step 3). Using the cost function, the total cost at 1,500 level is: 𝑌𝑌 = 𝑃𝑃4,890 + 𝑃𝑃5(1,500) = 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟑𝟑𝟑𝟑𝟑𝟑 References: Hilton, R. W., & Platt, D. E. (2017). Managerial accounting: Creating value in a dynamic business environment (11th Ed.). 2 Penn Plaza, New York, NY: McGraw Hill Education. Institute of Management Accountants. (2017). IMA Statement of Ethical Professional Practice. Retrieved, November 14, 2019, from https://www.imanet.org/-/media/b6fbeeb74d964e6c9fe654c48456e61f.ashx Weygandt, Ph.D., CPA, J. J., Kimmel, Ph.D., CPA, P. D., Kieso, Ph.D., CPA, D. E., & Aly, Ph.D., I. M. (2018). Managerial accounting: Tools for business decision-making. Canada: John Wiley & Sons, Inc. 01 Handout 1 *Property of STI  [email protected] Page 11 of 11  BM1915 FINANCIAL STATEMENT ANALYSIS Overview of Financial Statements Financial statements provide the basic source of information to managers and other interested parties outside the organization. A financial statement is referred to as the means in which financial information is accumulated and processed. It is a structured representation of the entity’s financial position and operating performance and is periodically communicated to different users (Robles & Empleo, 2016). Financial statements are primarily prepared for external users, but managers find it equally useful for decision-making. Objective of Financial Statements (IAS 1) The objective of a financial statement is to provide information about the financial position, financial performance, and cash flows of an entity that are useful to a wide range of users in making economic decisions. Financial statements also show the results of the management’s stewardship of the resources entrusted to it. Elements of Financial Statements (IAS 1) 1. Assets – These are resources controlled by the enterprise as a result of past transactions and events and from which future economic benefits are expected to flow from the enterprise. 2. Liabilities – These are present obligations of an enterprise arising from past transactions or events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. 3. Capital – It represents the equity or claim of the owner on the assets of the business. 4. Revenue – It is the gross inflow of economic benefits during the period in the form of inflows or enhancements on assets or decrease in liabilities that increase in equity. 5. Expenses – It represents the gross outflow of economic benefits during the period in the ordinary course of business when these outflows result in a decrease in equity other than those relating to distribution to owners. Components of Financial Statements (Robles & Empleo, 2016) A complete set of financial statement comprises the following: Statement of financial position at the end of the period; Statement of profit or loss and other comprehensive income for the period; Statement of changes in owner’s equity for the period; Statement of cash flows for the period; and Notes comprising significant accounting policies and other explanatory information. Note: Since the financial statement analysis is intended for managerial decisions, the heading or caption of the financial statements may not necessarily be in accordance with the generally accepted accounting principles (GAAP). For example, for the financial reporting of income statement, the heading is: ABC Company (Company name) Statement of Comprehensive Income (Name of financial statement) For Year Ended December 31, 201A (Period covered) For management purposes, it can be presented without complying with the prescribed heading as long as the financial statement presented can be identified and the year/s it covers is indicated. 02 Handout 1 *Property of STI  [email protected] Page 1 of 16  BM1915 1. Statement of Financial Position (Balance Sheet) Current assets – An entity shall classify an asset as current when: It expects to realize the asset, or intends to sell or consume it, in its normal operating cycle; It holds the asset primarily for trading; It expects to realize the asset within 12 months after the reporting period; or The asset is cash or cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting period (International Accounting Standards [IAS] 1). Non-current assets – These are assets that do not meet the definition of current assets. Examples of this type of assets are machinery, land, equipment, and building. Current liabilities – An entity shall classify a liability as current when: It expects to settle the liability in its normal operating cycle; It holds the liability primarily for trading; The liability is due to be settled within 12 months after the reporting period; or It does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period (IAS 1). Non-current liabilities – These are assets that do not meet the definition of current liabilities. Examples of this type of liabilities are bonds payable and mortgage payable. Assets Liabilities Current Assets Current Liabilities Cash xxx Accounts Payable xxx Accounts Receivable xxx Accrued Expense xxx Prepaid Rent xxx Unearned Revenue xxx Inventory xxx Total Current Liabilities xxx Long-Term Liabilities xxx Total Current Assets xxx Total Liabilities xxx Stockholders’ Equity Long-Term Assets Ordinary Share Capital Machinery xxx Preference Share Capital xxx Accumulated Depreciation (xxx) xxx Retained Earnings xxx Total Long-Term Assets xxx Total Stockholders’ Equity xxx Total Assets xxx Total Liabilities and Stockholders’ Equity xxx Table 1. Statement of financial position 2. Statement of Comprehensive Income (Income Statement) It reports the results of the operation of the business and shows the revenues and expenses of a particular period. Table 2 is an example of an income statement. Sales xxx Less: Sales Returns and Allowances xxx Net Sales xxx Less: Cost of goods sold xxx Gross Profit xxx Less: Operating Expenses xxx Income from operations xxx Less: Interest expense xxx Income before income tax xxx Less: Income Tax (30%) xxx Net Income/Net Loss xxx Table 2. Income statement 02 Handout 1 *Property of STI  [email protected] Page 2 of 16  BM1915 Manufacturing companies must consider inventory in various stages of production in order to compute for the cost of goods sold, which will be charged against the sales revenue to get the net income for the period. Raw Materials Inventory Work-in-process Inventory Finished Goods Inventory Raw materials, beginning xxx Raw materials used xxx Finished goods, beginning xxx Add: Raw materials purchased xxx Direct labor xxx Add: Cost of goods manufactured xxx Less: Raw materials, end xxx Manufacturing overhead xxx Total cost of goods available for sale xxx Raw materials used xxx Total manufacturing cost xxx Less: Finished goods, end xxx Add: WIP, beginning xxx Cost of goods sold xxx Less: WIP, end xxx Cost of goods manufactured xxx Table 3. Cost of goods sold by a manufacturing company 3. Statement of Changes in Equity This financial statement shows the link between the income statement and the statement of financial position. It portrays changes in the capital balance of a business over a reporting period due to additional investment or contributions, withdrawals, and net income/net loss. 4. Statement of Cash Flows This provides users with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilize those cash flows. This type of financial statement is presented using the cash basis of accounting. 5. Notes to the Financial Statements This is a document accompanying the numerical data listed on the financial statements. The notes shall provide information that is not presented elsewhere in the financial statements but is relevant to an understanding of any of them. Working Capital Management Surveys indicate that the largest portion of most financial managers’ time is devoted to day-to-day operations. A company requires financing, whether from creditors (debt) or owners (equity), to acquire assets and generate revenues. Working capital management refers to the administration and control of current assets and current liabilities to minimize the firm’s value by achieving a balance between profitability and risk (Payongayong, 2016). For financial analysts, working capital equals current assets, while for accountants, it equals current assets minus current liabilities. Example (Payongayong, 2016): Mr. Tan, President of EDGE, Inc., was shocked to learn that one of the company’s financial suppliers had just informed the company that it would no longer supply the firm with parts needed in their products. The reason is the company’s inability to pay its obligation in due time for quite some time now, including other suppliers. It was also found out that the reason for slow payments was the shortage of cash. Mr. Tan cannot believe and understand how that happened, when, in fact, the company’s sales were great and the profits break its records in the past. “How can that happen? How can the company possibly not have enough cash to pay our bills on time?” The financial officer’s response was short and simple: “There’s a big difference between profits and cash. We’re making profits, yes, but because of the amazing growth we are experiencing, we had to acquire more 02 Handout 1 *Property of STI  [email protected] Page 3 of 16  BM1915 new assets than we could finance with retained earnings. We have lots of inventory, receivables, and fixed assets, but no cash. We really have to change our operating policies, or else we will go bankrupt.” The above situation is typical among firms and happens all the time. With this, two (2) questions can be asked from the situation above: 1. How much should be invested in current assets (cash, accounts receivable, inventory, or temporary investments)? 2. How should the investment be financed? An effective working capital will improve the overall return on investment performance of the firm. In this regard, the goal of the company is not to maximize, but to minimize the net working capital. Here are some of the ways to minimize the working capital requirement: Manage cash and raw materials effectively. Be efficient in making collections and in the manufacturing operations. Implement effective credit and collection policies. Reduce the time lag between completion and delivery of finished goods. Seek favorable terms from suppliers and other creditors. Comparative Analysis Financial statement (FS) analysis involves careful selection of data from financial statements in order to assess and evaluate the firm’s past performance, present condition, and future business potentials. Objectives of Financial Statement Analysis (Garrison, Noreen, & Brewer, 2018) The primary purpose of FS analysis is to evaluate and forecast the company’s financial condition. Interested parties, such as managers, investors, and creditors, can identify the company’s financial strengths and weaknesses and know about the following: Profitability of the firm Solvency of the firm Safety of the investment in the business Effectiveness of management in running the firm. Limitations of Financial Statement Analysis (Garrison, Noreen, & Brewer, 2018) This topic discusses two (2) limitations of FS analysis that managers should always keep in mind: 1. Comparison of financial data across companies Comparisons of one company with another can provide information about the financial health of an organization. However, the following factors make it difficult to compare their financial data: Differences in accounting methods and estimates Valuation problem – Financial statements are based on historical costs and, therefore, do not reflect the current market value of the firm’s assets. Moreover, the effects of price level changes must be considered. The timing of transactions and the use of averages in applying the various techniques in FS analysis affect the results obtained. 2. The need to look beyond ratios These refer to the financial ratios. The ratios are designed to show relationships between financial statement accounts. For example, Company A might have a debt of P2 million and interest charges of P150,000, while Company B might have a debt of P20 million and interest charges of P1.5 million. Which company is stronger? It depends. The burden of these debts and the company’s ability to repay 02 Handout 1 *Property of STI  [email protected] Page 4 of 16  BM1915 them can be ascertained by comparing each firm’s debt to its assets or by comparing the interest to the income available for the payment of interest. However, financial ratios should not be viewed as an end, but rather as a starting point. Ratios are not sufficient in themselves as a basis for judgment about the future. Other factors must be considered, such as the following: Internal factors Employee learning and growth Business process performance Customer satisfaction External factors Industry trends Technological changes Changes in consumer tastes Changes in broad economic indicators An item on a balance sheet or income statement has a little meaning by itself. Suppose a company’s sales for a year were P2,500,000. In isolation, that is not particularly useful information. How is that item compared to last year’s sales? How do the sales relate to the cost of goods sold? In making these comparisons, three (3) analytical techniques are widely used: 1. Horizontal analysis 2. Vertical analysis 3. Ratio analysis. Horizontal analysis Also known as trend analysis, this involves analyzing data over time, such as computing year-to-year peso and percentage changes within a set of financial statements. Each item on the most recent statement is compared with the same item on one (1) or more earlier statements, in which the earlier statement is normally used as the base year for computing increases and decreases (Garrison, Noreen, & Brewer, 2018). 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 − 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 − 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 A comprehensive illustration of the horizontal and vertical analyses in the comparative financial statements of Mighty Warrior Corporation is shown on the next page. Note that the amounts are in pesos. 02 Handout 1 *Property of STI  [email protected] Page 5 of 16  BM1915 Mighty Warrior Corporation Comparative Statement of Financial Position December 31, 201B and 201A Increase (Decrease) 201B 201A Peso change % change Assets Current Assets Cash 100,000 127,000 (27,000) (21.3%) Marketable Securities 40,000 40,000 0 0.0% Accounts Receivable, Net 80,000 100,000 (20,000) (20.0%) Inventory 200,000 140,000 60,000 42.9% Prepaid Expenses 30,000 20,000 10,000 50.0% Total Current Assets 450,000 427,000 23,000 5.4% Long-Term Investments 180,000 162,500 17,500 10.8% Property, Plant, and Equipment 510,400 603,000 (92,600) (15.4%) Intangible Assets 90,000 120,000 (30,000) (25.0%) Total Assets 1,230,400 1,312,500 (82,100) (6.3%) Liabilities Current Liabilities 140,000 162,000 (22,000) (13.6%) Long-Term Liabilities 130,000 220,000 (90,000) (40.9%) Total Liabilities 270,000 382,000 (112,000) (29.3%) Stockholders' Equity Preferred Stock, 6%, P100 par 150,000 150,000 0 0.00% Common Stock, P30 par 480,000 480,000 0 0.00% Retained Earnings 330,400 300,500 29,900 10.0% Total Stockholders' Equity 960,400 930,500 52,900 5.7% Total Liabilities and Stockholders' Equity 1,253,400 1,312,500 (82,100) (6.3%) Table 4. Horizontal analysis – Comparative statement of financial position Mighty Warrior Corporation Comparative Income Statement December 31, 201B and 201A Increase (Decrease) 201B 201A Peso change % change Sales 455,000 390,000 65,000 16.7% Less: Sales Returns and Allowances 5,000 3,000 2,000 66.7% Net Sales 450,000 387,000 63,000 16.3% Less: Cost of goods sold 297,000 288,750 8,250 2.9% Gross Profit 153,000 98,250 54,750 55.7% Less: Operating Expenses 52,000 22,000 30,000 136.4% Income from operations 101,000 76,250 24,750 32.5% Less: Interest expense 18,250 21,000 (2,750) (13.1%) Income before income tax 82,750 55,250 27,500 49.8% Less: Income Tax (30%) 24,825 16,575 8,250 49.8% Net Income 57,925 38,675 19,250 49.8% Table 5. Horizontal analysis – Comparative income statement 02 Handout 1 *Property of STI  [email protected] Page 6 of 16  BM1915 An extended horizontal analysis can be developed, and it is called trend analysis. For example, assume the sales and net income items for the past seven (7) years are as follows: 201A 201B 201C 201D 201E 201F 201G Sales 313,425 341,805 352,830 341,175 361,125 421,590 411,615 100% 109% 113% 109% 115% 135% 131% Net Income 53,160 35,925 64,695 68,265 74,190 83,790 71,370 100% 68% 122% 128% 140% 158% 134% Table 6. Trend analysis In the data above, it can be seen that sales increased every year except for years 201D and 201G and the net income increased every year except 201B and 201G. In the table, both the sales and net income have been restated as percentages of the 201A sales and net income. Note that the earliest year should be the base period unless otherwise stated. For example, the sales during 201E of P361,125 is 115% of the sales during 201A of P313,425. This trend analysis is plotted in Figure 1. TREND ANALYSIS Sales Net income 200% 158% 140% 134% 150% 122% 128% 100% 109% 135% 131% 100% 115% 113% 109% 50% 68% 0% 201A 201B 201C 201D 201E 201F 201G Figure 1. Trend analysis Vertical Analysis Vertical analysis focuses on the relations among financial statements at a given point in time (Garrison, Noreen, & Brewer, 2018). A common-size financial statement is a vertical analysis in which each account is expressed as percentage. In the statement of financial position, all items are expressed as a percentage of total assets and total liabilities and equity, while in income statements, all items are expressed as a percentage of net sales. A common size balance sheet and income statement are shown on the next page. 02 Handout 1 *Property of STI  [email protected] Page 7 of 16  BM1915 Mighty Warrior Corporation Common-Size Statement of Financial Position December 31, 201B and 201A 201B 201A Assets Current Assets Cash 100,000 8.13% 127,000 9.68% Marketable Securities 40,000 3.25% 40,000 3.05% Accounts Receivable, net 80,000 6.50% 100,000 7.62% Inventory 200,000 16.25% 140,000 10.67% Prepaid Expenses 30,000 2.44% 20,000 1.52% Total Current Assets 450,000 36.57% 427,000 32.53% Long-Term Investments 180,000 14.63% 162,500 12.38% Property, Plant, and Equipment 510,400 41.48% 603,000 45.94% Intangible Assets 90,000 7.31% 120,000 9.14% Total Assets 1,230,400 100% 1,312,500 100% Liabilities Current Liabilities 140,000 11.38% 162,000 12.34% Long-Term Liabilities 130,000 10.57% 220,000 16.76% Total Liabilities 270,000 21.94% 382,000 29.10% Stockholders' Equity Preferred Stock, 6%, P100 par 150,000 12.19% 150,000 11.43% Common Stock, P30 par 480,000 39.01% 480,000 36.57% Retained Earnings 330,400 26.85% 300,500 22.90% Total Stockholders' Equity 960,400 78.06% 930,500 70.90% Total Liabilities and Stockholders' Equity 1,230,400 100% 1,312,500 100% Table 7. Vertical analysis – Common-size statement of financial position Mighty Warrior Corporation Common-Size Income Statement December 31, 201B and 201A (in pesos) 201B 201A Sales 455,000 101.11% 390,000 100.8% Less: Sales Returns and Allowances 5,000 1.11% 3,000 0.8% Net Sales 450,000 100.00% 387,000 100.0% Less: Cost of goods sold 297,000 66.00% 288,750 74.6% Gross Profit 153,000 34.00% 98,250 25.4% Less: Operating Expenses 52,000 11.56% 22,000 5.7% Income from operations 101,000 22.44% 76,250 19.7% Less: Interest expense 18,250 4.06% 21,000 5.4% Income before income tax 82,750 18.39% 55,250 14.3% Less: Income Tax (30%) 24,825 5.52% 16,575 4.3% Net Income 57,925 12.87% 38,675 10.0% Table 8. Vertical analysis – Common-size income statement 02 Handout 1 *Property of STI  [email protected] Page 8 of 16  BM1915 Ratio Analysis Financial statements are fundamentally related. Data contained in one statement is also related to that information found in another. In the financial ratio analysis, the account used from the financial statements shall be as follows: Financial Statements Basis Examples Income Statement Net amount Net sales, net income, net purchases (Beginning balance + Ending Balance) Balance Sheet Average 2 The following are the most common ratios used by financial analysts (Garrison, Noreen, & Brewer, 2018): I. STATEMENT OF FINANCIAL POSITION Liquidity Ratios Liquidity refers to how quickly an asset can be converted into cash. Companies need to continuously monitor the amount of liquid assets (current assets) relative to the amount that they owe to short-term creditors (current liabilities), such as suppliers. If a company’s liquid assets are not enough to support timely payments to creditors, this presents an important management problem that, if not remedied, can lead to bankruptcy. RATIO FORMULA SIGNIFICANCE 1 Net working 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝐶𝐶𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 If a company has enough working capital capital, it assures that the company can pay its creditors in full and on time. However, it must be financed with long-term debt and equity—both of which are expensive. Furthermore, a large and growing working capital may indicate troubles, such as excessive growth in inventories. 2 Current ratio 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 It is the basic test of liquidity of the 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 firm. This will determine the adequacy of working capital to meet current obligations. It measures a rough estimate in the ability of the business to meet its currently maturing obligations; this ratio varies in great disparity from one industry to another. The higher the current ratio, the better, as it would mean more current assets are available for paying its current obligations. 3 Quick ratio 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 It is a more severe test of immediate (Acid-test ratio) 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 liquidity to meet currently maturing obligations. OR 02 Handout 1 *Property of STI  [email protected] Page 9 of 16  BM1915 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 − 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 Quick assets include cash, marketable 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 securities, and receivables. The higher the quick ratio, the better liquidity position of the firm. Asset Management Ratios It measures how the firm uses its assets to generate revenue and income. It is a set of ratios that measures how effectively a firm is managing its assets. These ratios are called utilization ratios, and these measure how effectively the firm utilized its assets to earn profits. Normally, companies borrow or obtain capital from other sources to acquire assets. If a company has too many assets acquired through borrowings, the interest expenses will be too high, hence a lower profit. On the other hand, if assets are too low, profitable sales may be lost. Managing assets, most especially current assets, will help the firm avoid borrowing funds to finance operations. RATIO FORMULA SIGNIFICANCE 1 Accounts receivable 𝑁𝑁𝑁𝑁𝑁𝑁 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 It measures the efficiency of turnover 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 collections. The higher the turnover, the better, as it would mean a greater number of times receivable is reinvested for more profit. 2 Number of days in 365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 It measures the average number of accounts receivable 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 days to collect a receivable. The shorter, the better. 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 Average collection period 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 3 Inventory turnover 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 It determines how fast the inventories 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 are converted to sales. It indicates if a firm holds excessive inventories that are unproductive, which lessens the company’s productivity. For a manufacturing company, the number of days and turnover is determined for each item in the inventory. Raw materials turnover Work in process turnover Finished goods turnover 4 Number of days in 365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 It measures the average number of inventory 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 days that inventory is held before sale. 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 02 Handout 1 *Property of STI  [email protected] Page 10 of 16  BM1915 5 Fixed assets turnover 𝑁𝑁𝑁𝑁𝑁𝑁 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 It measures the level of use of fixed 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑛𝑛𝑛𝑛𝑛𝑛 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 assets such as property, plant, and equipment. 6 Total assets turnover 𝑁𝑁𝑁𝑁𝑁𝑁 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 It measures the effectiveness of asset 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 utilization and determines the number of times investments in assets are used to generate sales. The more the number of times it turns over, the higher profit the company utilized its assets. Solvency Ratios or Financial Leverage It measures the ability of the business to use debt in maximizing the shareholder’s value. These measure the extent to which the firm uses its debt financing or financial leverage. Some important implications can be raised: 1. By raising funds through debt, owners can maintain control of the firm with limited investment. 2. Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, that is, if the owners have provided only a small proportion of the total financing, the risks of the enterprise are borne mainly by its creditors. However, financial leverage raises the expected rate of return to stockholders for two (2) reasons: 1. Since interest is deductible, the use of debt financing lowers the tax and leaves more of the firm’s operating income available to its shareholders. 2. If the rate of return on assets (net income/total assets) exceeds the interest rate on debt, as it generally does, then the company can use debts to finance assets, pay the interest on the debt, and have something left over for its stockholders. Normally, firms with high debt ratios are exposed to more risks of losses but also have higher expected returns. Conversely, firms with low debt ratios are less risky, but they also forego the opportunity to leverage up on their return on equity. Ratio Formula Significance 1 Debt-to-equity It measures the use of debt to 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 ratio finance operations and provides a 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑠𝑠 ′ 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 measure of relative amount of resources contributed by the creditors and owners. 2 Debt ratio or 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 It measures the relative share of Debt-to-assets 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 creditors over the total resources of ratio the firm. 1 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 3 Equity ratio 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑠𝑠 ′ 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 It measures the amount of resources 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 provided by the owners of the firm. 1 − 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 4 Times-interest- 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 (𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸) EBIT is the income from operations earned 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 before deducting interest and taxes. 02 Handout 1 *Property of STI  [email protected] Page 11 of 16  BM1915 This is the ability of the firm to meet its annual interest payments. II. INCOME STATEMENT Profitability Ratios Profitability is a measure of operating effectiveness. It measures the ability of the business to recover long- term investments from money generated by its normal operating activities. It also measures earnings in relation to some base such as assets, sales, or capital. Ratio Formula Significance 1 Profit margin on sales / 𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 It measures profit percentage Return on sales (ROS) 𝑁𝑁𝑁𝑁𝑁𝑁 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 per peso sales. 2 Gross Profit ratio It measures the gross profit 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 percentage on sales to recover 𝑁𝑁𝑁𝑁𝑁𝑁 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 operating expenses. 3 Cost ratio 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 It measures the proportion of 𝑁𝑁𝑁𝑁𝑁𝑁 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 the cost of good