Republic of the Philippines AKLAN STATE UNIVERSITY SCHOOL OF MANAGEMENT SCIENCES ACCOUNTANCY DEPARTMENT Banga, Aklan Subject: Finance 2 Subject Description: Financial Management Topic: Evaluating Operating and Financial Performance Reporters: Canoy, Riz D. Cardinales, Juji G. Cariscal, Jessa S. INTRODUCTION This output paper contains discussion on the following broad topics: a. Understanding Financial Statements b. Analysis of Financial Statements c. Cash Flow Analysis d. Operating and Financial Leverage Why is it important that we learn what we could on these topics? What could it give us? What is its implication in our daily lives? Being students who study accounting, we look forward to being a Certified Public Accountant someday. However, the profession does not stop at simply being an accountant. We may become managers someday, or analysts who can influence decisions of businessmen. Understanding the aforementioned topics would take us farther than what we could reach by knowing only the processes of accounting. Financial statements are the end product of our profession, but it is our belief that when we take one step farther by learning how to understand the financial statements that we have prepared, and by knowing how to extract information from all the reports we have made, we become individuals who are capable of something beyond what is expected from us. Thus, we could give more to our employers and elevate our professional level to its maximum.
Transcript
Republic of the PhilippinesAKLAN STATE UNIVERSITY
SCHOOL OF MANAGEMENT SCIENCESACCOUNTANCY DEPARTMENT
Banga, Aklan
Subject: Finance 2Subject Description: Financial ManagementTopic: Evaluating Operating and Financial PerformanceReporters: Canoy, Riz D.
Cardinales, Juji G.Cariscal, Jessa S.
INTRODUCTION
This output paper contains discussion on the following broad topics:
a. Understanding Financial Statementsb. Analysis of Financial Statementsc. Cash Flow Analysisd. Operating and Financial Leverage
Why is it important that we learn what we could on these topics? What could it give us? What is its implication in our daily lives?
Being students who study accounting, we look forward to being a Certified Public Accountant someday. However, the profession does not stop at simply being an accountant. We may become managers someday, or analysts who can influence decisions of businessmen. Understanding the aforementioned topics would take us farther than what we could reach by knowing only the processes of accounting. Financial statements are the end product of our profession, but it is our belief that when we take one step farther by learning how to understand the financial statements that we have prepared, and by knowing how to extract information from all the reports we have made, we become individuals who are capable of something beyond what is expected from us. Thus, we could give more to our employers and elevate our professional level to its maximum.
The basic financial reports are a wealth of reports intended to inform all interested parties about the financial activities of a business organization. The reports reflect the basic business functions with respect to financing, investing, and operating activities. By analyzing the financial statements, one will come to know the financial health, effectiveness ad dynamism of an organization. Put it simply, behind the numbers presented in the financial statements are interesting stories of strategies and performances.
We shall now embark on our journey towards learning new things and discovering the implications of the numbers reported on the financial statements that we will be preparing in the exercise of our chosen path. However, put into mind that this output paper is made for
accountancy students. Thus, readers are expected to have the know-how on some topics that were chosen not to be included in this report since it would be too redundant to do such.
DISCUSSION
Understanding Financial Statements
In this section, we will only discuss the following topics:
a. Sources of information about a business enterpriseb. Benefits of disclosurec. Constraints on relevant and reliable information
Topics such as general objectives of financial statements, users of financial information, and the contents of financial statements are excluded in this report since readers are assumed to have mastered details of such in their previous accounting subjects.
a. Sources of information about a business enterpriseIn general, the quantity and quality of accounting information that companies supply are determined by the manager’s assessment of the benefits and costs of disclosure. In the Philippines, publicly listed companies must file financial accounting information with the Securities and Exchange Commission (SEC). These are:
i. Audited financial report that includes the four financial statements (Statement of Financial Position, Statement of Comprehensive Income, Statement of Stockholders’ Equity, and Statement of Cash Flows) with explanatory notes and the management’s discussion and analysis of financial results;
ii. Unaudited quarterly or interim reports that include summary version of the four financial statements and limited additional disclosure.
All other registered corporations and partnerships are likewise required to file annually audited financial statements with accompanying explanatory notes with the SEC.
b. Benefits of disclosureThe advantages of supplying accounting information extend to a company’s capital, labor, input, and output markets. Companies compete in these markets.
The company’s ability to disclose reliable (audited) accounting information about its product, processes and other business activities enable them to better compete in capital, labor, input, and output markets.
c. Constraints on relevant and reliable information
i. TimelinessIf there is undue delay in the reporting of information, it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information.
ii. Balance between benefit and costThe benefits derived from information should exceed the cost of providing it. The evaluation of benefits and costs is, however, substantially a judgmental process.
iii. Balance between qualitative characteristicsThe aim is to achieve an appropriate balance among the qualitative characteristics in order to meet the objective of financial statements. The relative importance of the characteristics in different cases is a matter of professional judgment.
iv. True fair view or fair presentationFinancial statements are frequently described as showing a true and fair view of the financial position, performance, and changes in financial position of an enterprise. The applications of the principal qualitative characteristics and appropriate accounting standards normally results in financial statements that convey what is generally understood as a true ad fair view of such information.
Analysis of Financial Statements
In this section, the following topics are discussed:
a. Definition of financial statement analysisb. Limitations of financial statement analysisc. Bases for comparisond. Tools for analysise. DuPont Disaggregation Analysis
Sample problems are also included in this output paper.
a. Definition of financial statement analysisFinancial statement analysis is the process of extracting information from financial statements to better understand a company’s current and future performance and financial condition.
Analyzing financial statements involves evaluating three characteristics: a company’s liquidity, profitability, and solvency.A short-term creditor, such as a bank, is primarily interested in liquidity – the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important in evaluating the safety of a loan.
A long-term creditor, such as bondholders, looks to the profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments.
Similarly, stockholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of the stock.
b. Limitations of financial statement analysisAlthough financial statement analysis is a useful tool, the analyst should consider its limitations. The limitations involve the comparability of financial data between companies and the need to look beyond ratios.
The limitations are as follows:i. Information derived by the analysis are not absolute measures of performance in
any and all of areas of business operations. They are only indicators of degrees of profitability and financial strength of the firm.
ii. Limitations inherent in the accounting data the analyst works with. These are brought about by among others: (a) variation and lack of consistency in the application of accounting principles, policies, and procedures, (b) too-condensed presentation of data, and (c) failure to reflect change in purchasing power.
iii. Limitations of the performance measures or tools and techniques used in the analysis. Quantitative measurements are not absolute measures but should be interpreted relative to the nature of the business and in the light of past, current, and future operations. Timing of transactions and the use of averages can also affect the results obtained in applying the techniques in financial analysis.
iv. Analysts should be alert to the potential for management to influence the outcome of financial statements in order to appeal to creditors, investors, and others.
Limitations of analysis may be overcome to some extent by finding appropriate benchmarks used by most analysts such as the performance of comparable components and the average performance of several companies in the same industry.
c. Bases for comparisonComparison can be made on a number of bases. Three are illustrated in the following:
i. Intracompany basisComparisons within a company are often useful to detect changes in financial relationships and significant trends.
ii. Industry averagesComparisons with industry averages provide information about a company’s relative position within the industry.
iii. Intercompany basisComparisons with other companies provide insight into a company’s competitive position.
d. Tools for analysis
There are various tools to evaluate the significance of financial statement data. Three commonly used tools are:
i. Horizontal (Trend) AnalysisHorizontal (trend) analysis evaluates a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. This change may be expressed as either an amount or percentage.
This analysis is primarily used in intracompany comparisons. Two features in published financial statements facilitate this type of comparison: (1) each of the basic financial statements presents comparative financial data for a minimum of two years, and (2) a summary of selected financial data is presented for a series of five to ten years or more.
Formula:
Change since Base Period =
Current Year Amount – Base Year Amount Base Year Amount
Current Results in relation to Base Period =
Current Year Amount Base Year Amount
Sample Problem:
J.C. Penney CompanyNet Sales (in millions)
2009 2008 2007Php 17, 556 Php 18, 486 Php 19, 860
Change Since Base Period (consider 2007 as base period)
Current Results in relation to Base Period (consider 2007 as base period)
2007 & 2008 Php 18, 486 Php 19, 860
93.08%
2007 & 2009 Php 17, 556 88.40%
Php 19, 860
Using the percentage computed, management can now make an assessment if such decrease in net sales is material or alarming.
Balance Sheet (Horizontal Analysis)
Quality Department Store, Inc.Condensed Balance Sheets
December 31Increase (Decrease)
During 20092009 2008 Amount Percent
AssetsCurrent assets P 1,020,000 P 945,000 P 75,000 7.9%Plant assets (net) 800,000 632,500 167,500 26.5%Intangible assets 15,000 17,500 (2,500) (14.3%) Total assets P 1,835,000 P 1,595,000 P 240,000 15.0%
LiabilitiesCurrent liabilities P 344,500 P 303,000 P 41,500 13.7%Long-term liabilities 487,500 497,000 (9,500) (1.9%) Total liabilities 832,000 800,000 32,000 4.0%
Stockholders’ EquityCommon stock, P1 par 275,400 270,000 5,400 2.0%Retained earnings 727,600 525,000 202,600 38.6% Total stockholders’ equity 1,003,000 795,000 208,000 26.2% Total liabilities and
stockholders’ equityP 1,835,000 P 1,595,000 P 240,000 15.0%
The comparative balance sheets in the above illustration show that a number of significant changes have occurred in the department store’s financial structure from 2008 to 2009:
i. In the assets section, plant assets (net) increased P 167,500 or 26.5%.ii. In the liabilities section, current liabilities increased P 41,500 or 13.7%.iii. In the stockholders’ equity section, retained earnings increased P
202,600 or 38.6%.
These changes suggest that the company expanded its asset base during 2009 and financed this expansion primarily by retaining income rather than assuming additional long-term debt.
ii. Vertical (Common-size) AnalysisVertical (common-size) analysis evaluates financial statement data by expressing each item in a financial statement as a percent of base amount.
It is used both in intra- and intercompany comparisons.
Sample Problem:
Income Statement (Intracompany Vertical Analysis)
Quality Department Store, Inc.Condensed Income Statement
For the Years Ended December 31
2009 2008Amount Percent Amount Percent
Sales Revenue P 2,195,000 104.7% P 1,960,000 106.7%Sales return and allowances 98,000 4.7% 123,000 6.7%Net Sales 2,097,000 100.0% 1,837,000 100.0%Cost of goods sold 1,281,000 61.1% 1,140,000 62.1%Gross profit 816,000 38.9% 697,000 37.9%Selling expenses 253,000 12.0% 211,500 11.5%Administrative expenses 104,000 5.0% 108,500 5.9%Total operating expenses 357,000 17.0% 320,000 17.4%Income from operations 459,000 21.9% 377,000 20.5%Other revenues and gains Interest and dividends 9,000 0.4% 11,000 0.6%Other expenses and losses Interest expense 36,000 1.7% 40,500 2.2%Income before income taxes 432,000 20.6% 347,500 18.9%Income tax expense 168,200 8.0% 139,000 7.5%Net income P 263,800 12.6% P 208,500 11.4%
The vertical analysis of the company’s income statements show that cost of goods sold as a percentage of net sales declined, and total operating expenses declined. As a result, net income increased as a percent of net sales. The company appears to be a profitable business that is becoming even more successful.
Income Statement (Intercompany Vertical Analysis)
Condensed Income Statements(in thousands)
Quality Department Store, Inc.
J.C. Penney Company
Amount Percent Amount PercentNet Sales P 2,097 100.0% P 7,556,000 100.0%Cost of goods sold 1,281 61.1% 10,646,000 60.6%Gross profit 816 38.9% 6,910,000 39.4%Selling and administrative
expenses 357 17.0% 6,247,000 35.7%Income from operations 459 21.9% 663,000 3.7%Other expenses and revenues
(including income taxes) 195 9.3% 412,000 2.3%Net income P 264 12.6% P 251,000 1.4%
An associated benefit of vertical analysis is that it enables comparison between companies of different sizes. In the above sample, J.C. Penney’s net sales are 8,372 times greater than the net sales of relatively tiny Quality Department Store. But vertical analysis eliminates this difference in size. The percentages show that Quality’s and J.C. Penney’s gross profit rates were comparable at 38.9% and 39.4%. However, the percentages related to income from operations were significantly different at 21.9% and 3.7%. This disparity can be attributed to Quality’s selling and administrative expense percentage (17%) which is much lower than J.C. Penney’s (35.7%). Although J.C. Penney earned net income more than 951 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales peso (1.4%) is only 11% of Quality’s (12.6%).
iii. Ratio AnalysisRatio analysis expresses the relationship among selected items of financial statement data. This analysis is used in all three types of comparisons.
In this analysis, we evaluate financial statements using financial ratios. Financial ratio is a comparison in fraction, proportion, decimal or percentage of two significant figures taken from financial statements. It expresses the direct relationship between two or more quantities in the statement of financial position and statement of comprehensive income of a business firm.The ratio can be categorized as follows:
1. Liquidity ratiosThese ratios give an idea of the firm’s ability to pay off debts that are maturing within a year or within the next operating cycle. Satisfactorily, liquidity ratios are necessary if the firm is to continue operating.
2. Asset management ratiosThese ratios give an idea of how efficiently the firm is using its assets. Good asset management ratios are necessary for the firm to keep its costs low and thus, net income high.
3. Market book ratiosThese ratios which consider the stock price give an idea of what investors think about the firm and its future prospects.
4. Debt management ratiosThese ratios tell how the firm has financed its assets as well as the firm’s ability to repay its long-term debt. Debt management ratios indicate how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders.
5. Profitability ratiosThese ratios give an idea of how profitably the firm is operating and utilizing its assets. Profitability ratios combine asset and debt management categories and show their effects on return on equity.
A summary of the ratios, their formula and significance is presented below.
Ratios used to evaluate short-term financial position (Short-term Solvency and Liquidity)
Name Formula SignificanceCurrent ratio Total Current Assets_
Total Current LiabilitiesPrimary test of solvency to meet current obligations from current assets as a going concern; measure of adequacy of working capital
Measures short-term liquidity by considering as cash resources (numerator) cash plus cash equivalents plus cash flow from operating activities
Defensive interval ratio ___Quick Assets_____Projected Daily
Operational Expenses
Measures length of time in days the firm can operate on its present liquid resources
Ratios used to evaluate asset liquidity and management efficiency
Name Formula SignificanceTrade receivable turnover
Net Credit Sales*Average Trade
Receivable (net)
* net sales if net credit sales figure is not available
Velocity of collection of trade accounts and notes; test of efficiency of collection
Average collection period or number of days sales uncollected
360 days_______Receivable Turnover
or
Accounts ReceivableNet Sales / 360
Evaluates the liquidity of accounts receivable and the firm’s credit policies
Merchandise turnover Cost of Goods Sold__Average Merchandise
Inventory
Measures efficiency of the firm in managing and selling inventories
Finished goods inventory turnover
Cost of Goods Sold__Average Finished Goods
Inventory
Measures efficiency of the firm in managing and selling inventories
Goods in process turnover
Cost of Goods Manufactured____
Average Goods-in-Process Inventory
Measures efficiency of the firm in managing and selling inventories
Raw materials turnover Raw Materials Used__Average Raw Materials
Inventory
Number of times raw materials inventory was used and replenished
during the period
Days supply in inventory
360 days______Inventory Turnover
Measures average number of days to sell or consume the average inventory
Working capital turnover
Net Sales_______Average Working Capital
Indicates adequacy and activity of working capital
Percent of each current asset to total current assets
Amount of each current asset item______
Total Current Assets
Indicates relative investment in each current asset
Current assets turnover Cost of Sales + Operating Expenses + Income Taxes + Other
Expenses (net, excluding depreciation and
amortization)_____Average Current Assets
Measures movement and utilization of current resources to meet operating requirements
Payable turnover Net Purchases____Average Accounts
Payable
Measure efficiency of the company in meeting trade payable
Operating cycle Average Conversion Period of Inventories +
Average Collection Period of Receivable +
Days Cash
Measures the length of time required to convert cash to finished goods; then to receivable and then back to cash
Days cash Average Cash BalanceCash Operating Costs /
360 days
Measures availability of cash to meet average daily cash requirement
Free cash flow Net Cash from Operating Activities – Cash Used for Investing Activities
and Dividends
Excess of operating cash flow over basic needs
Investment or assets turnover
Net Sales______Average Total
Investment or Total Assets
Measures efficiency of the firm in managing all assets
Sales to fixed assets (plant assets turnover)
Net Sales_______Average Fixed Assets
Tests roughly the efficiency of
(net) management in keeping plant properties employed
Capital intensity ratio Total AssetsNet Sales
Measures efficiency of the firm to generate sales through employment of its resources
Ratios used to evaluate long-term financial position or stability/leverage
Name Formula SignificanceDebt ratio Total Liabilities
Total AssetsShows proportion of all assets that are financed with debt
Equity ratio Total EquityTotal Assets
Indicates proportion of assets provided by owners; reflects financial strength and caution to creditors
Debt to equity ratio Total LiabilitiesTotal Equity
Measures debt relative to amounts of resources provided by owners
Fixed assets to long-term liabilities
Fixed Assets (net)Total Long-term
Liabilities
Reflects extent of investment in long-term assets financed from long-term debt
Fixed assets to total equity
Fixed Assets (net)Total Equity
Measures the proportion of owner’s capital invested in fixed assets
Fixed assets to total assets
Fixed Assets (net)Total Assets
Measures investment in long-term capital assets
Book value per share of ordinary shares
Ordinary Shareholder’s Equity_______
No. of Outstanding Ordinary Shares
Measures recoverable amount in the event of liquidation if assets are realized at their book values
Times interest earned Net Income Before Measures how many
Interest and Taxes__Annual Interest Charges
times interest expense is covered by operating profit
Times preferred dividend requirement earned
Net Income After TaxesPreferred Dividends
Requirement
Indicates ability to provide dividends for preference shareholders
Times fixed charges earned
Net Income Before Taxes and Fixed Charges__
Fixed Charges (Rent + Interest + Sinking Fund payment before taxes*)
* Sinking fund payment before taxes = Sinking Fund payment after taxes / (1 – Tax Rate)
Measures coverage capability more broadly than times interest earned by including other fixed charges.
Ratios used to measure profitability and returns to investors
Name Formula SignificanceGross Profit Margin Gross Profit
Net salesMeasures profit generated after consideration of cost of product sold
Operating Profit Margin Operating ProfitNet Sales
Measures profit generated after consideration of operating costs
Net Profit Margin (Rate of Return on Sales)
Net ProfitNet Sales
Measures profit generated after consideration of all expenses and revenues
Cash Flow Margin Cash Flow for Operating_______Activities______
Net Sales
Measures ability of the firm to translate sales to cash
Rate of Return on Assets (ROA)*
______Net Profit______Average Total Assets
or
Asset Turnoverx
Net Profit Margin
Measures overall efficiency of the firm in managing assets and generating profits
* If there is interest bearing debt, ROA is computed as:
Net Income + [Interest Expense (1-Tax Rate)]Average Total Assets
A measure of productivity of assets regardless of how the assets are financed.
Rate of Return on equity (ROE)
_____Net Income______Average Ordinary Equity
or
Return on Assets x Equity Multiplier*
* Equity multiplier = 1/Equity Ratio
Measures rate of return on resources provided by owners.
Earnings per share Net Income less Preference Dividends
____Requirement_____Average Ordinary Shares
Outstanding
Peso return on each ordinary share. Indicative of ability to pay dividends.
Price/earnings ratio Market Value per share__of Ordinary Shares___
Earnings per share of Ordinary Shares
Measures relationship between the price of ordinary shares in the open market and profit earned on a per share basis.
Dividend Payout Dividends per ShareEarnings per Share
Shows percentage of earnings paid to shareholders.
Dividend Yield Annual Dividends per_______Share________Market Value per share
of Ordinary Shares
Shows the rate earned by shareholders from dividends relative to current price of stock.
Dividends per Share Dividends Paid/DeclaredOrdinary Shares
Outstanding
Shows portion of income distributed to shareholders on a per share basis.
Rate of Return on Average Current Assets
_____Net Income______Average Current Assets
Measures the profitability of current assets invested
Rate of Return per Turnover of Current Assets
Rate of Return onAverage Current AssetsCurrent Assets Turnover
Shows profitability of each turnover of current assets
e. DuPont Disaggregation AnalysisDuPont equation is the formula that shows that the rate of return on equity can be found as the product of profit margin, total assets turnover and the equity multiplier. It shows the relationships among asset management, financial leverage management, and profitability ratios.
Disaggregation of return on equity was initially introduced by E.I. DuPont de Nemours and Company to help its managers in performance evaluation.
The basic DuPont model disaggregates ROE as follows:
Profit margin is the amount of profit that the company earns from each peso of sales.
Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each peso invested in sales.
ROE =
Net Income
Average Stockholder’s
Equity
= Net Incom
eSales
Sales__Avera
ge Total Asset
s
Average Total
AssetsAverage
Stockholder’s Equity
x x
Profit
Margin
Asset
Turnover
Financial Leverage
Financial leverage measures the degree to which the company finances its assets with debt rather than equity.
Cash Flow Analysis
In this section, the following topics are discussed:
a. Financial Liquidityb. Financial Flexibilityc. Calculating Cash Flow from Operating Activities
Although net income provides a long-term measure of a company’s success or failure, cash is its lifeblood. Without cash, a company will not survive. For small and newly developing companies, cash flow is the single most important element for survival. Even medium and large companies must control cash flow.
a. Financial LiquidityReaders of financial statements often assess liquidity by using the current cash debt coverage ratio. It indicates whether the company can pay off its current liabilities from its operations in a given year.
The higher the current cash debt coverage ratio, the less likely a company will have liquidity problems.
b. Financial FlexibilityThe cash debt coverage ratio provides information on financial flexibility. It indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations.
The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.
Current CashDebt
Coverage Ratio
= Net Cash Provided by Operating Activities
Average Current Liabilities
Cash DebtCoverage
Ratio
= Net Cash Provided by Operating Activities
Average Total Liabilities
Free cash flow, a more sophisticated way to examine a company’s financial flexibility, is the amount of discretionary cash flow a company has. It can use this cash flow to purchase additional investments, retire its debt, purchase treasury shares, or simply add to its liquidity.
If the free cash flow is positive, the business firm could have satisfactory financial flexibility. Companies that have strong financial flexibility can take advantage of profitable investment even in tough terms, and be free from worry about survival in poor economic terms.
c. Calculating Cash Flow from Operating ActivitiesThere are two methods which can be used in calculating cash flow from operating activities: the direct and indirect method.
The two methods are presented in the tables in the next page.
Direct Method
Net cash provided by operating activities xx
Capital expenditures(xx)
Dividends (xx)Free Cash Flow xx
Indirect Method
Operating and Financial Leverage
In this section, the following topics are discussed:
Leverage represents the use of fixed costs items to magnify the firm’s results. It is important to keep in mind that leverage is a two-edged sword – producing highly favorable results when things go well, and the opposite when under negative conditions.
a. CVP AnalysisCost-volume-profit analysis is a powerful tool and vital in many business decisions because it helps managers understand the relationships among cost, volume, and profit. This analysis is focused on how profits are affected by selling prices, sales volume, unit variable costs, total fixed costs, and mix of products sold.
The following assumptions underlie each CVP analysis:- The behavior of both costs and revenue is linear throughout the relevant
range of the activity index.- Costs can be classified accurately as either variable or fixed.- Changes in activity are the only factors that affect costs..- All units produced are sold.- When more than one type of product is sold, the sales mix will remain
constant.When these assumptions are not valid, the analysis may be inaccurate.
If costs are known, the following relationships may be established:1. Contribution margin per unit or marginal income per unit
This is the excess of unit selling price over unit variable costs and the amount each unit sold contributes toward covering fixed costs and providing operating profits.
2. Contribution margin ratioThis is the percentage of contribution margin to total sales. This is very useful because this shows how the contribution margin will be affected by a given peso change in total sales.
CM per unit = Unit selling price – unit variable costs
The starting point in many business plans is to determine the break-even point.
Break-even point is the level of sales volume where total revenues and total expenses are equal, that is, there is neither profit nor loss. This point can be determined by using CVP analysis. Computation is as follows:
CM ratio = Contribution Margin
Sales
CM ratio = Contribution Margin per Unit
Unit selling price
BEP (units) = Total Fixed Cost________
Contribution Margin per unit
BEP (pesos) = Total Fixed Cost________
1 – Variable Cost
Sales
BES for multi-products firm (combined units) =
Total Fixed Cost________
Weighted Average Contribution Margin
Weighted Contribution Margin per unit =
Unit CM x No. of Units +Unit CM x No. of Units
per mix_____ ______per mix____
Total Number of Units per Sales Mix
BES for multi-products firm (combined pesos) =
Total Fixed Cost________
Weighted CM Ratio
Weighted CM Ratio=
_ Total Weighted CM (P)_
Total Weighted Sales (P)
CVP analysis can be used to determine the level of sales needed to achieve a desired level of profit. The equations that may be used to compute for target sales are:
b. Sales MixSales mix refers to the relative proportions in which a company’s products are sold. The idea is to achieve the combination or mix that will yield the greatest amount of profits.
Profits will be greater if high-margin rather than low-margin items make up a relatively large proportion of total sales.
c. Profit PlanningProfit planning is anticipating the effects of variables affecting profit to measure its outcome. This directly relates to the normal operating activities and is short-term in nature.
In profit planning, the formulas for breakeven sales and the income statement can be very helpful in determining values.
d. Operating LeverageOperating leverage is a measure of how sensitive net operating income is to a given percentage change in peso sales. This acts as a multiplier.
If operating leverage is high, a small percentage change in sales can produce a much larger percentage increase in net operating income.
Sales (units) = Total Fixed Cost + Desired Profit
Contribution Margin per unit
Sales (pesos) = Total Fixed Cost + Desired Profit
Contribution Margin Ratio
Using this value, however, has its limitation. In an analysis using operating leverage, it is assumed that a constant or linear function exists for revenues and costs as volume changes.
Operating leverage influences the mix of plant and equipment.
e. Financial LeverageFinancial leverage reflects the amount of debt used in the capital structure of the firm.
It determines how the operation is to be financed. It is possible for two firms to have equal operating capabilities and yet show widely different results because of the use of financial leverage.
Financial leverage indicates the percentage change in Earnings per Share (EPS) that occurs as a result of percentage change in Earnings before Interest and Taxes (EBIT).
Degree of Operating Leverage = Contribution Margin_
Net Operating Income
Degree of Operating Leverage =
Percent change in Operating Income_
Percent change in Volume
The use of financial leverage in analysis, however, also has its limitation. Debt financing and financial leverage offer unique advantages but only up to a point that debt financing may be detrimental to the firm.
f. Combined LeverageDegree of combined leverage uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings per share.
Degree of Combined Leverage = Percent change in EPS_____ Percent change in Sales (or Volume)
Degree of Combined Leverage = Q (P – VC)_____ Q (P – VC) – FC – I
ReferencesAgamata, F. T. (2012 Edition). Management Advisory Services (A Comprehensive Guide).
Cabrera, M. E. (2012-2013 Edition). Financial Management Principles and Applications Comprehensive Volume. Manila, Philippines: GIC Enterprises & Co., Inc.
Weygandt, J., Kimmel, P., & Kieso, D. (10th Edition). Accounting Principles (International Student Version). Asia: John Wiley & Sons, Inc.
Degree of Financial Leverage = Percent change in EPS_
