Republic of the Philippines

AKLAN STATE UNIVERSITY

SCHOOL OF MANAGEMENT SCIENCES
ACCOUNTANCY DEPARTMENT
Banga, Aklan
Subject:
Subject Description:
Topic:
Reporters:

Finance 2
Financial Management
Evaluating Operating and Financial Performance
Canoy, Riz D.
Cardinales, Juji G.
Cariscal, Jessa S.

INTRODUCTION
This output paper contains discussion on the following broad topics:
a.
b.
c.
d.

Understanding Financial Statements

Analysis of Financial Statements
Cash Flow Analysis
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 enterprise
b. Benefits of disclosure
c. 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 enterprise
In general, the quantity and quality of accounting information that companies supply are
determined by the managers 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 managements
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 disclosure
The advantages of supplying accounting information extend to a companys capital,
labor, input, and output markets. Companies compete in these markets.
The companys 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.

Timeliness
If 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 cost

The 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 characteristics

The 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 presentation

Financial 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.
b.
c.
d.
e.

Definition of financial statement analysis

Limitations of financial statement analysis
Bases for comparison
Tools for analysis
DuPont Disaggregation Analysis

Sample problems are also included in this output paper.

a. Definition of financial statement analysis
Financial statement analysis is the process of extracting information from financial
statements to better understand a companys current and future performance and
financial condition.
Analyzing financial statements involves evaluating three characteristics: a companys
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 companys ability to survive over a long period of time. Longterm creditors consider such measures as the amount of debt in the companys 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 analysis

Although 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:
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.
i.

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 comparison
Comparison can be made on a number of bases. Three are illustrated in the following:
i. Intracompany basis
Comparisons within a company are often useful to detect changes in financial
relationships and significant trends.
ii. Industry averages
Comparisons with industry averages provide information about a companys
relative position within the industry.
iii. Intercompany basis
Comparisons with other companies provide insight into a companys 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) Analysis
Horizontal (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:

2009
Php 17, 556

J.C. Penney Company

Net Sales (in millions)
2008
Php 18, 486

2007
Php 19, 860

Change Since Base Period (consider 2007 as base period)

2007 to 2008
2007 to 2009

Php 18, 486 Php 19, 860

Php 19, 860
Php 17, 556 Php 19, 860
Php 19, 860

6.92% decrease
11.60% decrease

Current Results in relation to Base Period (consider 2007 as base period)

2007 & 2008
2007 & 2009

Php 18, 486

Php 19, 860
Php 17, 556
Php 19, 860

93.08%
88.40%

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 31
2009
Assets
Current assets
Plant assets (net)
Intangible assets
Total assets
Liabilities
Current liabilities
Long-term liabilities
Total liabilities
Stockholders Equity
Common stock, P1 par
Retained earnings
Total stockholders equity
Total liabilities and
stockholders equity

Increase (Decrease)
During 2009
Amount
Percent

2008

P 1,020,000
800,000
15,000
P 1,835,000

945,000
632,500
17,500
P 1,595,000

344,500
487,500
832,000

275,400
727,600
1,003,000
P 1,835,000

303,000
497,000
800,000

270,000
525,000
795,000
P 1,595,000

75,000
167,500
(2,500)
240,000

7.9%
26.5%
(14.3%)
15.0%

41,500
(9,500)
32,000

13.7%
(1.9%)
4.0%

5,400
202,600
208,000
240,000

2.0%
38.6%
26.2%
15.0%

The comparative balance sheets in the above illustration show that a number of
significant changes have occurred in the department stores 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) Analysis
Vertical (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

2008

Sales Revenue
Sales return and allowances
Net Sales
Cost of goods sold
Gross profit
Selling expenses
Administrative expenses
Total operating expenses
Income from operations
Other revenues and gains
Interest and dividends
Other expenses and losses
Interest expense
Income before income taxes
Income tax expense
Net income

Amount
P 2,195,000
98,000
2,097,000
1,281,000
816,000
253,000
104,000
357,000
459,000

Percent
104.7%
4.7%
100.0%
61.1%
38.9%
12.0%
5.0%
17.0%
21.9%

Amount
P 1,960,000
123,000
1,837,000
1,140,000
697,000
211,500
108,500
320,000
377,000

Percent
106.7%
6.7%
100.0%
62.1%
37.9%
11.5%
5.9%
17.4%
20.5%

9,000

0.4%

11,000

0.6%

36,000
432,000
168,200
263,800

1.7%
20.6%
8.0%
12.6%

40,500
347,500
139,000
208,500

2.2%
18.9%
7.5%
11.4%

The vertical analysis of the companys 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)

Net Sales
Cost of goods sold
Gross profit
Selling and administrative
expenses

Quality Department Store,

Inc.
Amount
Percent
P
2,097
100.0%
1,281
61.1%
816
38.9%
357

17.0%

J.C. Penney Company

Amount
P 7,556,000
10,646,000
6,910,000
6,247,000

Percent
100.0%
60.6%
39.4%
35.7%

Income from operations

Other expenses and revenues
(including income taxes)
Net income

459

21.9%

195
264

9.3%
12.6%

663,000

3.7%

412,000
251,000

2.3%
1.4%

An associated benefit of vertical analysis is that it enables comparison between

companies of different sizes. In the above sample, J.C. Penneys 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
Qualitys and J.C. Penneys 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
Qualitys selling and administrative expense percentage (17%) which is much
lower than J.C. Penneys (35.7%). Although J.C. Penney earned net income
more than 951 times larger than Qualitys, J.C. Penneys net income as a percent
of each sales peso (1.4%) is only 11% of Qualitys (12.6%).
iii. Ratio Analysis
Ratio 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 ratios
These ratios give an idea of the firms 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 ratios
These 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 ratios
These ratios which consider the stock price give an idea of what investors
think about the firm and its future prospects.
4. Debt management ratios
These ratios tell how the firm has financed its assets as well as the firms
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 ratios
These 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
Current ratio

Formula
Total Current Assets_
Total Current Liabilities

Significance
Primary test of solvency
to meet current
obligations from current
assets as a going
concern; measure of
adequacy of working
capital

Acid-test ratio or quick

ratio

Total Quick Assets*_

Total Current Liabilities

A more severe test of

immediate solvency; test
of ability to meet
demands from current
assets

* Cash + Marketable Securities

+ Accounts Receivable

Working capital to total

assets ratio

Working Capital
Total Assets

Indicates relative liquidity

of total assets and
distribution of resources
employed

Cash flow liquidity ratio

Cash + Marketable
Securities + Cash Flow
from Operating Activities
Current Liabilities

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
Trade receivable
turnover

Formula
Net Credit Sales*
Average Trade
Receivable (net)
* net sales if net credit sales
figure is not available

Average collection
period or number of
days sales uncollected

360 days_______
Receivable Turnover
or

Significance
Velocity of collection of
trade accounts and
notes; test of efficiency of
collection

Evaluates the liquidity of

accounts receivable and
the firms credit policies

Accounts Receivable
Net Sales / 360
Merchandise turnover

Finished goods
inventory turnover

Goods in process
turnover

Raw materials turnover

Days supply in
inventory

Working capital
turnover
Percent of each current

Cost of Goods Sold__

Average Merchandise
Inventory

Measures efficiency of
the firm in managing and
selling inventories

Cost of Goods Sold__

Average Finished Goods
Inventory

Measures efficiency of
the firm in managing and
selling inventories

Cost of Goods
Manufactured____
Average Goods-inProcess Inventory
Raw Materials Used__
Average Raw Materials
Inventory

Measures efficiency of
the firm in managing and
selling inventories
Number of times raw
materials inventory was
used and replenished
during the period

360 days______
Inventory Turnover

Measures average
number of days to sell or
consume the average
inventory

Net Sales_______
Average Working Capital

Indicates adequacy and

activity of working capital

Amount of each current

Indicates relative

asset to total current

assets
Current assets
turnover

asset item______
Total Current Assets
Cost of Sales +
Operating Expenses +
Income Taxes + Other
Expenses (net, excluding
depreciation and

investment in each
current asset
Measures movement and
utilization of current
resources to meet
operating requirements

amortization)_____
Average Current Assets
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 Balance

Cash 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

Net Sales_______
Average Fixed Assets
(net)

Tests roughly the

efficiency of
management in keeping
plant properties
employed

Sales to fixed assets

(plant assets turnover)

Capital intensity ratio

Total Assets
Net 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
Debt ratio

Equity ratio

Debt to equity ratio

Formula
Total Liabilities
Total Assets

Significance
Shows proportion of all
assets that are financed
with debt

Total Equity
Total Assets

Indicates proportion of
assets provided by
owners; reflects financial
strength and caution to
creditors

Total Liabilities
Total Equity

Measures debt relative to

amounts of resources
provided by owners

Fixed assets to longterm 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 owners 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 Shareholders
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

Interest and Taxes__
Annual Interest Charges

Measures how many

times interest expense is
covered by operating
profit

Times preferred
dividend requirement
earned

Net Income After Taxes

Preferred 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*)

Measures coverage
capability more broadly
than times interest
earned by including other
fixed charges.

* Sinking fund payment before

taxes = Sinking Fund payment
after taxes / (1 Tax Rate)

Ratios used to measure profitability and returns to investors

Name
Gross Profit Margin

Formula
Gross Profit
Net sales

Significance
Measures profit
generated after
consideration of cost of
product sold

Operating Profit Margin

Operating Profit
Net Sales

Net Profit Margin (Rate

of Return on Sales)

Net Profit
Net 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

Measures overall
efficiency of the firm in
managing assets and
generating profits

or

Measures profit
generated after
consideration of
operating costs

Asset Turnover
x
Net Profit Margin
* If there is interest bearing

Net Income + [Interest

A measure of productivity of

debt, ROA is computed as:

Rate of Return on
equity (ROE)

Expense (1-Tax Rate)]

Average Total Assets

_____Net Income______
Average Ordinary Equity
or

assets regardless of how the

assets are financed.

Measures rate of return

on resources provided by
owners.

Return on Assets x
Equity Multiplier*
* Equity multiplier = 1/Equity
Ratio

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 Share

Earnings 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/Declared
Ordinary 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

Rate of Return on
Average Current Assets
Current Assets Turnover

Shows profitability of
each turnover of current

Assets

assets

e. DuPont Disaggregation Analysis

DuPont 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:

Net
RO
Net x
E =Income
x
Average
Sale
= Inco
Stockholders
s__
me
SaleEquity
Aver
age
s
Total
Asse
ts

Average
Total
Assets
Average
Stockhol
ders
Equity

Financial Leverage

Profit margin is the

that the company earns from each peso of sales.

amount of profit

Asset turnover is a productivity measure that reflects the volume of sales that a company
generates from each peso invested in sales.
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 Liquidity
b. Financial Flexibility
c. Calculating Cash Flow from Operating Activities
Although net income provides a long-term measure of a companys 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 Liquidity
Readers 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.

Net Cash Provided by Operating

Activities
Average Current Liabilities
The higher the current cash debt coverage ratio, the less likely a company will have
liquidity problems.
b. Financial Flexibility
The cash debt coverage ratio provides information on financial flexibility. It indicates a
companys ability to repay its liabilities from net cash provided by operating activities,
without having to liquidate the assets employed in its operations.

Net Cash Provided by Operating

Activities
Average Total Liabilities
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.
Free cash flow, a more sophisticated way to examine a companys 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.

Net cash provided by operating

activities
xx
Capital expenditures
(xx)
Dividends
(xx)
Free Cash Flow
xx
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 Activities
There 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

Indirect Method

Operating and Financial Leverage

In this section, the following topics are discussed:
a.
b.
c.
d.
e.
f.

CVP Analysis
Sales Mix
Profit Planning
Operating Leverage
Financial Leverage
Combined Leverage

Leverage represents the use of fixed costs items to magnify the firms 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 Analysis
Cost-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.

CM per unit = Unit

selling price unit
variable costs
2. Contribution margin ratio
This 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 ratio =
Contribution
Margin per Unit
Unit
selling price

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:

BEP (pesos) =
Total Fixed
Cost________
Variable Cost
Sales

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
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:

Sales (pesos) = Total

Fixed Cost + Desired
Profit
Contribution Margin
Ratio
b. Sales Mix
Sales mix refers to the relative proportions in which a companys 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 Planning
Profit 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 Leverage
Operating 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.

Degree of Operating
Leverage =
Contribution Margin_
Net Operating
Income

Degree of
Operating
Leverage =
Percent
change in
Operating Income_
Percent
change in Volume
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 Leverage
Financial 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 Financial
Leverage =
Percent change in
EPS_
Percent change in
EBIT
Degree of Financial
Leverage =
__ EBIT__
EBIT
I
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 Leverage
Degree 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

References
Agamata, 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.