Chapter 6: Assessment of the Firm's Operating Efficiency and Financial Position

🔹 Financial Statement Analysis

Definition (text): The process of extracting information from financial statements to better understand a
company's current and future performance and financial condition.

👉 In simple words: It means looking at the company’s financial reports (like balance sheet, income statement,
cash flow) to know how well it’s doing now and how it might perform in the future.

🔹 Analyzing the Broader Business Environment

Text meaning: Quality analysis depends on effective business analysis. A review of financial statements is
contextual and must be done with an understanding of the broader forces affecting company performance.

👉 Simplified: You can’t just look at the numbers. To understand them, you need to know the company’s
situation—its market, customers, suppliers, risks, and competition.

Key Questions:

1. Life Cycle

o Text: At what stage in its life is this company? Startup, growing, mature, or declining?

o Simplified: Is it just starting, growing fast, already stable, or starting to fade?

2. Outputs (Products)

o Text: What products does it sell? Are they new, established, or dated? Do they have substitutes?
How complicated are they to produce?

o Simplified: Are the products modern and in demand, or outdated? Can customers find
alternatives easily? Are they easy or costly to make?

3. Buyers

o Text: Who are its buyers? Are they financially strong? Do they have purchasing power? Can the
seller dictate terms?

o Simplified: Do customers depend on the company, or does the company depend on them?

4. Inputs (Suppliers)

o Text: Who supplies inputs? Are there many sources? Does the company depend on a few
suppliers?

o Simplified: If suppliers raise prices or stop supplying, will the company struggle?

5. Competition
 o Text: What kind of market is it in? Open or competitive? Does it have advantages? Can it protect
itself? At what cost?

o Simplified: Is the company in a tough industry with many rivals, or does it stand out?

6. Financing

o Text: Must it seek financing? Is it going public? Is it at risk of defaulting? Does it present an
overly optimistic story to attract financing?

o Simplified: Does the company borrow too much? Is it safe from debt problems?

7. Labor

o Text: Who are its managers? Can they be trusted? Competent? What is the state of employee
relations? Unionized?

o Simplified: Are leaders good and trustworthy? Do employees work well or are there labor
problems?

8. Governance

o Text: How effective is corporate governance? Does it have a strong board and audit committee?
Does management own stock?

o Simplified: Are the people in charge honest and monitored properly?

9. Risk

o Text: Is it subject to lawsuits, investigations, auditor changes, environmental or political risks?

o Simplified: What dangers (legal, political, environmental) threaten the company?

✅ Key Idea: Financial statements must be studied with context, not alone.

🔹 Basics of Profitability Analysis

Text meaning:

 The goal of financial management is maximizing shareholders’ wealth, not just accounting measures
like net income or EPS.

 But accounting data influences stock prices and helps explain performance.

 Financial statements are used by:

o Managers → improve stock price

o Lenders → check repayment ability

o Analysts → forecast earnings, dividends, stock prices

👉 Simplified: The real goal is to make the company more valuable for owners, not just to show profits on
paper. Still, accounting numbers are important since they affect decisions.

🔹 Limitations of Financial Statement Analysis

1. Not absolute measures

o Text: They are only indicators of degrees of profitability and financial strength.

o Simplified: Ratios give clues, not 100% truth.

2. Accounting data limitations

o Text: Variations in accounting principles, condensed data, failure to reflect changes in

purchasing power.

o Simplified: Different accounting methods, summarized data, and not adjusting for inflation can
make results misleading.

3. Performance tool limitations

o Text: Quantitative measures must be interpreted relative to business nature and time. Timing
and averages can affect results.

o Simplified: Ratios must be compared to industry and time trends. One number alone can’t tell
the full story.

4. Management influence

o Text: Management may present statements to appeal to creditors/investors.

o Simplified: Sometimes numbers are “beautified” to look better than reality.

👉 Solution (Text): Limitations can be reduced by comparing with benchmarks (industry averages or
competitors).

🔹 Financial Ratio Analysis

Text definition: A financial ratio is a comparison (fraction, proportion, decimal, or %) of two figures from
financial statements. It shows the relationship between items in the balance sheet and income statement.

👉 Simplified: Ratios show how different parts of the financial statements relate to each other.

Categories of Ratios:

1. Liquidity Ratios → Ability to pay short-term debt.

2. Asset Management Ratios → Efficiency in using assets.

3. Debt Management Ratios → Risk and ability to repay long-term debt.

 4. Profitability Ratios → Overall profitability.

5. Market Book Ratios → What investors think about the firm (future prospects).

Note from text: ROE (Return on Equity) is very important because it reflects liquidity, efficiency, and debt use
together.

🔹 Detailed Ratios with Formula + Meaning

I. Short-Term Financial Position (Liquidity/Solvency)

1. Current Ratio = Current Assets ÷ Current Liabilities

o Text meaning: Primary test of solvency to meet current obligations; measure of adequacy of
working capital.

o Simplified: Can the firm pay its short-term debts using short-term assets?

2. Acid-Test (Quick) Ratio = Quick Assets ÷ Current Liabilities

o Text meaning: More severe test of immediate solvency.

o Simplified: Can the firm pay debts quickly without selling inventory?

3. Working Capital to Total Assets = Working Capital ÷ Total Assets

o Text meaning: Indicates liquidity of total assets and distribution of resources.

o Simplified: How much of total resources are in liquid form.

4. Cash Flow Liquidity Ratio = (Cash + Marketable Securities + Cash Flow from Ops) ÷ Current Liabilities

o Text meaning: Measures short-term liquidity using cash resources.

o Simplified: Compares real cash with short-term debts.

5. Defensive Interval Ratio = Quick Assets ÷ Daily Expenses

o Text meaning: Measures days the firm can operate using liquid resources.

o Simplified: How many days the company can run just on its cash and equivalents.

II. Asset Liquidity & Management Efficiency

1. Trade Receivable Turnover = Net Credit Sales ÷ Avg. Receivables

o Text meaning: Velocity of collection; test of efficiency of collection.

o Simplified: How fast receivables are collected.

Average Collection Period = 360 ÷ Receivable Turnover

o Text meaning: Evaluates liquidity of receivables and credit policy.

 o Simplified: Days it takes to collect money from customers.

2. Inventory Turnover = COGS ÷ Avg. Inventory

o Text meaning: Measures efficiency of managing/selling inventory.

o Simplified: How fast inventory is sold or used.

o Days in Inventory = 360 ÷ Inventory Turnover

3. Working Capital Turnover = Net Sales ÷ Avg. Working Capital

o Text meaning: Indicates adequacy and activity of working capital.

o Simplified: How effectively working capital supports sales.

4. Current Asset Turnover = Net Sales ÷ Avg. Current Assets

o Text meaning: Indicates relative investment in current assets.

o Simplified: How well current assets are used to generate sales.

5. Payables Turnover = Net Purchases ÷ Avg. Accounts Payable

o Text meaning: Measures efficiency in paying trade payables.

o Simplified: How fast the firm pays suppliers.

6. Operating Cycle = Inventory Period + Receivable Period + Days Cash

o Text meaning: Measures time to convert cash → goods → receivables → cash.

o Simplified: How long before money spent turns back into money received.

7. Days Cash = Avg. Cash ÷ Daily Operating Costs

o Text meaning: Measures availability of cash to cover daily needs.

o Simplified: Days cash can last to pay expenses.

8. Free Cash Flow = Cash from Ops – (Investing + Dividends)

o Text meaning: Excess of operating cash over basic needs.

o Simplified: Cash left after paying for investments and dividends.

9. Investment (Asset) Turnover = Net Sales ÷ Avg. Total Assets

o Text meaning: Efficiency in managing all assets.

o Simplified: How much sales are generated per peso of assets.

10. Sales to Fixed Assets (Plant Assets Turnover) = Net Sales ÷ Avg. Fixed Assets

 Text meaning: Roughly measures efficiency of keeping plant properties employed.

 Simplified: How well the company uses buildings and equipment to generate sales.
✅ Overall Summary:
Financial statement analysis helps managers, lenders, and investors understand company performance. Ratios
are important tools for liquidity, efficiency, debt, profitability, and market outlook. However, they are only
indicators, not absolute truths, and must always be read within the broader business environment.

PROBLEMS

Problem 1 — Day Sales Outstanding (DSO)

Tulips Company: DSO = 40 days, Annual sales = ₱7,300,000, year = 365 days.
DSO
Formula: Accounts Receivable= × Annual Sales
365

Daily sales = 7,300,000/365=20,000.

Accounts receivable = 40 × 20,000=₱ 800,000 .

Problem 2 — Debt-to-assets ratio from Equity Multiplier

Assets
Equity multiplier = =2.4 .
Equity
Equity 1
= =0.4166667.
Assets 2.4
Equity
Debt-to-assets = 1− =1−0.4166667=0.5833333=58.33 %.
Assets

Problem 3 — Market/Book Ratio

Total assets = ₱10 billion. Given current liabilities = ₱1 billion (assumed “Pi = 1”), long-term debt = ₱3 billion →
total liabilities = 1 + 3 = ₱4 billion.
Common equity = Assets − Liabilities = 10 − 4 = ₱6 billion (book value of equity).

Market value of equity = shares outstanding × price = 800 million × ₱ 32=₱ 25,600 million=₱ 25.6 billion .
25.6
Market/Book ratio = =4.2667 ≈ 4.27 ×.
6

(Note: I interpreted the scanned “Pi” and “Pó” as 1 and 6 to make totals add to ₱10b.)

Problem 4 — Price/Earnings (P/E) Ratio

Given: EPS = ₱12.00, Book value per share = ₱20, Market/book = 1.2.
Price per share = Market/book × Book value per share = 1.2 ×20=₱ 24.
P/E = Price / EPS = 24 /12=2.0 ×.
Problem 5 — DuPont and ROE

Given: Profit margin = 2% (0.02), Equity multiplier = 2.0, Sales = ₱100 million, Total assets = ₱50 million.
Total asset turnover = Sales / Assets = 100 / 50 = 2.0.

ROE = Profit margin × Total asset turnover × Equity multiplier

¿ 0.02 ×2.0 ×2.0=0.08=8 % .

Problem 6 — DuPont and Net Income

Given: Sales = ₱6,000,000; ROE = 12% (0.12); Total assets turnover = 3.2; firm is 50% equity financed → equity
ratio = 0.5, so equity multiplier = 1/0.5 = 2.0.
ROE = Profit margin × TAT × Equity multiplier → Profit margin = ROE / (TAT × EM)
¿ 0.12/(3.2× 2)=0.12/6.4=0.01875=1.875 % .

Net income = Profit margin × Sales = 0.01875 ×6,000,000=₱ 112,500.

Problem 7 — Basic Earning Power (BEP)

Given: Net income = ₱600,000; ROA = 8% (0.08); Interest expense = ₱225,000; tax rate = 35%.

First find Total assets from ROA:

Net income
Total assets= =600,000 /0.08=₱ 7,500,000 .
ROA

Find EBIT from Net income formula:

Net income = (EBIT − Interest) × (1 − tax rate)
600,000=(EBIT −225,000)×0.65⇒ EBIT −225,000=600,000/0.65=923,076.9231
⇒ EBIT =923,076.9231+225,000=₱ 1,148,076.92.

EBIT
BEP = =1,148,076.92/7,500,000=0.15308=15.31 % (approx).
Total assets

Problem 8 — Profit Margin and Debt-to-Assets

Given: Sales / Total assets = 1.5 (TAT), ROA = 3.0% (0.03), ROE = 5.0% (0.05). Firm uses only debt & common
equity.

Profit margin = ROA / TAT = 0.03 /1.5=0.02=2.0 % .

Equity multiplier = ROE / ROA = 0.05 /0.03=1.6666667 .

Equity/Assets = 1 / EM = 1 / 1.6666667 = 0.60 → Debt-to-assets = 1 − 0.60 = 0.40=40 % .
Problem 9 — Times Interest Earned (TIE)

Given: Assets = ₱12 billion, tax rate = 40%, BEP = 15% (0.15), ROA = 5% (0.05).

BEP = EBIT / Assets → EBIT = BEP × Assets = 0.15 × 12 = ₱1.8 billion.

ROA = Net income / Assets → Net income = ROA × Assets = 0.05 × 12 = ₱0.6 billion.

Use Net income = (EBIT − Interest) × (1 − tax) →

0.6=(1.8−Interest )× 0.6→ 1.8−Interest=0.6 /0.6=1.0 → Interest = 1.8 − 1.0 = ₱0.8 billion.

TIE = EBIT / Interest = 1.8/0.8=2.25 ×.

Problem 10 — Return on Equity after new debt (Pomelo Company)

Given: EBIT = ₱1,000,000; projected interest expense = ₱300,000; sales = ₱10,000,000; total assets turnover =
2.0; tax rate = 34%; no preferred stock.

Interpretation / Assumption (stated):

Total assets = Sales / TAT = 10,000,000/2.0=₱ 5,000,000 .
I assume management borrows an amount that produces the stated annual interest expense of ₱300,000 and
that the borrowed principal is added to liabilities (i.e., debt increases by that principal). Because the principal
(debt) amount is not explicitly given in the problem, I assume the firm borrows enough so that the debt
principal equals ₱300,000 (i.e., they raise ₱300k short-term notes and will pay ₱300k interest this year). This is
a simplifying assumption to find the new equity and ROE (text problems often frame recapitalization like this).

(If you have an explicit interest rate or explicit debt principal, plug that instead; the logic below is the same.)

Compute Net income under the new structure:

Net income = (EBIT − Interest) × (1 − tax)
= (1,000,000 − 300,000) × (1 − 0.34) = 700,000 × 0.66 = ₱462,000.

Assets = ₱5,000,000. If debt (new) = ₱300,000, equity = Assets − Debt = 5,000,000 − 300,000 = ₱4,700,000.

ROE = Net income / Equity = 462,000 /4,700,000=0.0982979=9.83 %(approx).

Note: If the intended meaning was that interest is ₱300,000 on some different principal (e.g., debt principal D,
interest rate r), you must compute D = Interest / r to find the debt principal and then equity = Assets − D; then
recompute ROE. If you want, give me an interest rate and I’ll recalc exactly.

Problem 11 — How much can notes payable increase without current ratio falling below 2.0?

Given: Current assets = ₱1,312,500; Current liabilities = ₱525,000; initial inventory = ₱375,000. The firm will
increase inventory financed by notes payable (i.e., both current assets and current liabilities increase by same
amount x ). Find maximum x such that new current ratio ≥ 2.0.
1,312,500+ x
New current ratio = ≥ 2.0. Solve equality for maximum x :
525,000+ x
 1,312,500+ x=2(525,000+ x)=1,050,000+ 2 x⇒ 1,312,500−1,050,000=2 x−x ⇒ 262,500=x .

So the short-term debt (notes payable) can increase by ₱262,500 without pushing the current ratio below 2.0.

Problem 12 — DSO and Accounts Receivable after policy change

Given: Current AR = $750,000 (I’ll keep ₱ or $ as in the problem), current DSO = 55 days. Goal: reduce DSO to
35 days. But average sales fall by 15% if policy implemented. Find new AR. Use 365-day year.

Step 1: compute current annual sales from AR and DSO:

Accounts receivable ×365 365
Sales= =750,000 × . Compute 365/55 = 6.6363636 → Sales =
DSO 55
750,000 ×6.6363636=4,977,272.73 (approx).

Step 2: Sales fall by 15% → New annual sales = 0.85 × 4,977,272.73=4,230,682.32 .

Step 3: New AR = (DSO_new / 365) × Sales_new = 35/365 × 4,230,682.32.

Compute 35/365=0.09589041. New AR = 0.09589041 × 4,230,682.32=405,000 .

So after the change, Accounts Receivable = ₱405,000 (or $405,000 depending on currency).

Problem 13 — Complete the statement of financial position and sales info (ASSUMPTIONS → calculation)

The scanned problem text is slightly scrambled. I’ll state assumptions and then complete a consistent solution.
If you want different assumptions, tell me and I’ll adjust.

Assumptions (from your sheet / the image and the given ratio list):

 Total assets = ₱300,000 (this appears in the image).

 Debt-to-assets ratio = 50% → total liabilities (debt) = 0.5 × 300,000 = ₱150,000.

 Long-term debt (from image) = ₱60,000 → therefore Current liabilities = 150,000 − 60,000 = ₱90,000.

 Retained earnings (from image) = ₱97,500 (given on the image).

 Therefore Common stock (equity remainder) = Equity − Retained earnings. Equity = Assets − Liabilities =
300,000 − 150,000 = 150,000. So Common stock = 150,000 − 97,500 = ₱52,500 (this matches the image
pattern).

 Total assets turnover = 1.8× → Sales = 1.8 × Assets = 1.8 × 300,000 = ₱540,000.

 Gross profit margin on sales = 25% (stated as (Sales − COGS) / Sales = 25%) → COGS = 75% of Sales.
→ COGS = 0.75 × 540,000 = ₱405,000. Gross profit = 540,000 − 405,000 = ₱135,000.

 Inventory turnover = 5× → Avg inventory = COGS / Inventory turnover = 405,000 / 5 = ₱81,000.

 Days inventory = 365 / 5 = 73 days.

  I assume Day Sales Outstanding (DSO) = 36.5 days (365/10) — this gives receivable turnover = 10×. This
assumption is consistent with the common round number 36.5 days (half of 73) and gives neat
numbers below. If your sheet intended a different DSO, tell me.

From Sales and receivable turnover = 10, Accounts Receivable = Sales / 10 = 540,000 / 10 = ₱54,000. (DSO =
36.5 days).

Now we can compute Current assets components:

 Accounts receivable = ₱54,000

 Inventory = ₱81,000

 Let Cash = remaining current assets to balance the statement.

Total assets = Current assets + Fixed assets. We don’t have a given fixed-assets figure; we choose fixed assets
such that statement balances and equity components match the image values (we already used those). We
have:

Total assets = 300,000 = Current assets + Fixed assets.

Total liabilities and equity = Current liabilities (₱90,000) + Long-term debt (₱60,000) + Common stock
(₱52,500) + Retained earnings (₱97,500) = 90,000 + 60,000 + 52,500 + 97,500 = 300,000 → Balanced.

Find Current assets = ? We know Current liabilities = 90,000 and Equity as above. Current assets must be such
that Fixed assets = 300,000 − Current assets is nonnegative. To keep numbers simple and consistent with the
image layout, choose Current assets = 150,000 (this yields a reasonable current ratio and leaves a round fixed
asset figure).

If Current assets = ₱150,000 then Cash = Current assets − (AR + Inventory) = 150,000 − (54,000 + 81,000) =
150,000 − 135,000 = ₱15,000.

Then Fixed assets = 300,000 − Current assets = 300,000 − 150,000 = ₱150,000.

Now compute the current ratio (for the completed statement):

Current ratio = Current assets / Current liabilities = 150,000 / 90,000 = 1.6667 (≈ 1.67).

Summary (completed Statement of Financial Position and sales info under these assumptions):

Assets

 Cash ...................................... ₱15,000

 Accounts Receivable .......... ₱54,000

 Inventories ........................ ₱81,000

 Total current assets ............ ₱150,000

 Fixed assets .......................... ₱150,000

 Total assets .................. ₱300,000

Liabilities & Owners’ equity

  Accounts payable (current liabilities) ₱90,000

 Long-term debt .......................... ₱60,000

 Total liabilities ................... ₱150,000

 Common stock ........................ ₱52,500

 Retained earnings .................. ₱97,500

 Total owners’ equity ......... ₱150,000

 Total liabilities & equity ₱300,000

Sales information (from ratios):

 Sales = ₱540,000 (Total assets turnover 1.8×)

 Cost of goods sold (COGS) = ₱405,000 (COGS = 75% of sales)

 Gross profit = ₱135,000 (25% gross margin)

 Inventory (average) = ₱81,000 (inventory turnover 5×) → Days in inventory = 73 days

 Accounts receivable = ₱54,000 (receivable turnover 10× → DSO = 36.5 days)

 Current ratio = 1.67 (150,000 / 90,000)

Problem 14

(a) Ratios for Barry Company — formulas, calculations and results

All results rounded reasonably.

1. Current ratio
Formula: Current assets ÷ Current liabilities
= 655,000 ÷ 330,000 = 1.9848 ≈ 1.98 (≈ 2.0)
Industry = 2.0 → Barry ≈ industry.

2. Quick ratio (acid-test)

Formula: (Cash + Receivables + Marketable securities if any) ÷ Current liabilities
= (77,500 + 336,000) ÷ 330,000 = 413,500 ÷ 330,000 = 1.2530 ≈ 1.25
Industry = 1.3 → Barry slightly below industry.

3. Day Sales Outstanding (DSO)

Formula: (Receivables ÷ Sales) × 365
= (336,000 ÷ 1,607,500) × 365 = 76.29 days
Industry = 35 days → Barry collects much more slowly (bad).

4. Inventory turnover
Formula: COGS ÷ Average inventory (here we use year-end inventory)
 = 1,392,500 ÷ 241,500 = 5.766 ≈ 5.77×
Industry = 6.7× → Barry slower inventory turnover (holds more inventory relative to sales).

(Days in inventory = 365 ÷ 5.766 ≈ 63.3 days.)

5. Total assets turnover (TAT)

Formula: Sales ÷ Total assets
= 1,607,500 ÷ 947,500 = 1.6966 ≈ 1.70×
Industry = 3.0× → Barry uses assets less efficiently to generate sales.

6. Profit margin
Formula: Net income ÷ Sales
= 27,300 ÷ 1,607,500 = 0.01698 ≈ 1.70%
Industry = 1.2% → Barry has a slightly higher profit margin (good).

7. Return on assets (ROA)

Formula: Net income ÷ Total assets
= 27,300 ÷ 947,500 = 0.02881 ≈ 2.88%
Industry = 3.6% → Barry’s ROA is below industry.

8. Return on equity (ROE)

Formula: Net income ÷ Common equity
= 27,300 ÷ 361,000 = 0.07562 ≈ 7.56%
Industry = 9.0% → Barry’s ROE is below industry.

9. Total debt / total assets (debt ratio)

Formula: Total liabilities ÷ Total assets = (Total assets − Equity) ÷ Total assets
= 586,500 ÷ 947,500 = 0.6190 ≈ 61.9%
Industry = 60.0% → Barry slightly more leveraged than industry.

(b) DuPont equations — construct for Barry and for industry

DuPont identity (three-part):

ROE=Profit margin ×Total assets turnover × Equity multiplier

where Equity multiplier = Total assets ÷ Equity.

Barry

 Profit margin = 1.698% (0.01698)

 TAT = 1.6966

 Equity multiplier (EM) = Total assets ÷ Equity = 947,500 ÷ 361,000 = 2.624

 DuPont: ROE = 0.01698 × 1.6966 × 2.624 ≈ 0.0756 = 7.56% (matches computed ROE)

Write it as: ROE_Barry = 1.70% × 1.70 × 2.624 ≈ 7.56%

Industry (using the provided averages)

 Profit margin = 1.2% (0.012)

 TAT = 3.0

 Industry debt 60% → equity/assets = 40% → EM_ind = 1 / 0.40 = 2.5

 DuPont: ROE_ind = 0.012 × 3.0 × 2.5 = 0.09 = 9.0% (matches industry ROE shown)

Write it as: ROE_Industry = 1.2% × 3.0 × 2.5 = 9.0%

(c) Brief analysis — Barry’s strengths and weaknesses

Strengths

 Profit margin > industry (≈1.70% vs 1.2%). Barry earns more profit per peso of sales — could indicate
better pricing, lower non-COGS expenses, or favorable product mix.

 Current ratio ≈ industry (≈1.98 vs 2.0) — liquidity appears adequate.

 Quick ratio only slightly below industry (1.25 vs 1.3).

Weaknesses

 Low asset turnover: TAT ≈1.70 vs industry 3.0 — Barry generates much less sales per peso of assets →
inefficient asset utilization (underused fixed assets or high investment in current assets vs. sales).

 High DSO: ~76 days vs industry 35 days — Barry’s receivable collection is slow (bad working capital
management), ties up cash.

 Lower inventory turnover: 5.77× vs 6.7× — slower movement of inventory → possible excess stock,
obsolescence risk, or inefficient production/sales coordination.

 Lower ROA and ROE: ROA 2.88% (<3.6% industry); ROE 7.56% (<9% industry) — despite a better profit
margin, poor asset utilization and higher leverage lower returns to equity.

 Slightly higher leverage: debt ratio ≈ 61.9% vs industry 60% → more risk and interest burden (interest
expense reduces net income).

Conclusion (short): Barry earns a better margin per sale, but fails to convert assets into sales efficiently and
collects slowly. The weak asset efficiency and high receivables/inventory levels reduce overall returns (ROA and
ROE) despite decent margins. Management should improve receivables collection and asset utilization (sell
more with the same assets or reduce idle assets/inventory).

(d) Effect of doubling sales and simultaneously doubling inventories, accounts receivable, and common
equity during 20X4 — effect on ratio analysis validity (no calculations required)
Key idea: Rapid growth that increases both the flows (sales) and stock balances (year-end receivables,
inventory, and equity) can distort ratio analysis if averages are not used.

Why / how this affects validity:

 Many turnover ratios (receivables turnover, inventory turnover, total assets turnover) use period flows
in the numerator (sales or COGS) and stock balances in the denominator (year-end inventory, year-end
assets, year-end receivables). If sales double during the year but statements show much larger year-end
balances (because receivables and inventory were built up during the year), using the year-end
denominator will understate turnover (too large denominator relative to average) and therefore make
turnover and efficiency ratios look worse than they really are over the period.

 Using year-end balances (instead of averages of beginning and ending balances) will be especially
misleading when growth is rapid and the year-end balances are not representative of the average asset
level during the period.

 Similarly, doubling equity at year-end will affect leverage/ROE calculations when year-end equity is
used in the denominator. If equity was raised late in the year, ROE (net income ÷ year-end equity) will
be artificially depressed even if the firm earned good returns earlier in the year.

 Bottom line: Rapid growth increases the mismatch between period flows (which reflect activity over
the full year) and year-end stocks (which may reflect end-of-year position). Averages (e.g., average
receivables = (beginning + ending)/2, average inventory, average assets, average equity) reduce this
distortion. So without using averages, ratio analysis for a high-growth year may produce misleading
results — generally understating turnover and returns.

Practical recommendation: When a firm has had rapid growth, compute ratios using average balances
(beginning and ending) or use quarterly/monthly averages, and interpret DSO/turnover with caution. Also
examine the timing of the equity raise and the timing of the sales growth.

Problem 15

a. Liquidity Position

 Current Ratio = Current Assets ÷ Current Liabilities

20X4: 1,405,000 ÷ 602,000 = 2.33x
20X3: 1,206,000 ÷ 571,500 = 2.11x
Industry Average = 2.7x

✅ Interpretation: Liquidity improved from 20X3 to 20X4, but Mango is still slightly below industry average.

b. Asset Management (Efficiency)

 Inventory Turnover = COGS ÷ Inventory

20X4: 3,680,000 ÷ 439,000 = 8.39x
 20X3: 2,980,000 ÷ 328,000 = 9.09x
Industry = 7.0x

 Day Sales Outstanding (DSO) = Accounts Receivable ÷ (Sales ÷ 365)

20X4: 894,000 ÷ (4,240,000/365) = 76.9 days
20X3: 813,000 ÷ (3,635,000/365) = 81.6 days
Industry = 32.0 days

 Fixed Assets Turnover = Sales ÷ Net Fixed Assets

Net fixed assets = Land + Machinery + Other fixed assets.
20X4: 4,240,000 ÷ (132,000+61,000+238,000) = 4,240,000 ÷ 431,000 = 9.84x
20X3: 3,635,000 ÷ (133,000+57,000+271,000) = 3,635,000 ÷ 461,000 = 7.89x
Industry = 13.0x

 Total Assets Turnover = Sales ÷ Total Assets

20X4: 4,240,000 ÷ 1,836,000 = 2.31x
20X3: 3,635,000 ÷ 1,667,000 = 2.18x
Industry = 2.6x

✅ Interpretation: Inventory turnover is above industry, DSO is far worse, fixed asset efficiency is below industry,
and total asset turnover is slightly below industry.

c. Debt Management

 Debt Ratio = Total Liabilities ÷ Total Assets

20X4: 602,000+575,000 = 1,177,000 ÷ 1,836,000 = 64.1%
20X3: 571,500+575,000 = 1,146,500 ÷ 1,667,000 = 68.8%
Industry = 50%

✅ Interpretation: Debt decreased slightly but is still higher than industry norms (riskier).

d. Profitability Ratios

 Profit Margin = Net Income ÷ Sales

20X4: 18,408 ÷ 4,240,000 = 0.43%
20X3: 95,970 ÷ 3,635,000 = 2.64%
Industry = 3.5%

 Return on Assets (ROA) = Net Income ÷ Total Assets

20X4: 18,408 ÷ 1,836,000 = 1.0%
20X3: 95,970 ÷ 1,667,000 = 5.8%
Industry = 2.6%

 Return on Equity (ROE) = Net Income ÷ Equity

Equity = Total Assets – Total Liabilities.
 20X4: 1,836,000 – 1,177,000 = 659,000 → 18,408 ÷ 659,000 = 2.8%
20X3: 1,667,000 – 1,146,500 = 520,500 → 95,970 ÷ 520,500 = 18.4%
Industry = 18.2%

✅ Interpretation: Profitability collapsed in 20X4. ROE fell far below peers.

e. Market Value Ratios

 EPS = Net Income ÷ Shares Outstanding

20X4: 18,408 ÷ 23,000 = ₱0.80 (matches given)
20X3: 95,970 ÷ 23,000 = ₱4.17

 P/E Ratio = Market Price ÷ EPS

Given: 20X4 = 15.43x, 20X3 = 5.65x, Industry = 6.0x

 Price/Cash Flow Ratio

Not enough direct data on cash flow, but industry = 3.5x.

✅ Interpretation: Market P/E increased because EPS fell sharply but stock price did not fall proportionately.

f. DuPont ROE

ROE = (Net Profit Margin × Total Asset Turnover × Equity Multiplier)

 20X4: (0.43%) × (2.31) × (1,836,000 / 659,000 = 2.79) = 2.8%

 20X3: (2.64%) × (2.18) × (1,667,000 / 520,500 = 3.20) = 18.4%

Industry = (3.5% × 2.6 × 2.0) = 18.2%

✅ Interpretation: Mango’s ROE in 20X4 collapsed due to a sharp decline in profit margin, despite reasonable
efficiency and leverage.

g. Impact of Cost-Cutting (Lower Inventory + Lower COGS)

 Inventory turnover would increase (less inventory).

 Profit margin would improve (lower COGS).

 ROA and ROE would rise because higher net income and lower assets.

 Liquidity (current ratio) might fall (less inventory = fewer current assets).

 Market ratios (P/E, valuation) likely improve as earnings rise.

✅ Summary of Findings:

 Liquidity: Below industry but improving.

 Asset Management: Inventory good, receivables very poor, fixed asset use weak.

 Debt: Above industry, though declining.

 Profitability: Collapsed in 20X4, far below peers.

 Market Value: P/E ratio inflated due to lower EPS.

 ROE (DuPont): Fell from near industry to very poor due to shrinking margins.

 Cost-cutting would mainly boost profitability and improve ROE, but reduce liquidity.