(Chapter 4) Advance (Chapter 5) Working Capital Chapter 1: Introduction To Financial Management

(Chapter 4) Advance
(Chapter 5) Working Capital

Chapter 1: Introduction to Financial Management
Purpose of the chapter:
 To define finance, its major areas and opportunities, and the legal forms of business
organization.
 To understand the managerial finance function and its relationship to economics and
accounting.
 To know the primary activities of the financial manager.
 To explain the goal of the firm, corporate governance, the role of ethics, and the
agency issue.
 To understand financial institutions and markets, and the role they play in managerial
finance.
Finance is a broad term that describes two related activities: the study of how money is
managed and the actual process of acquiring needed funds. It encompasses the oversight,
creation and study of money, banking, credit, investments, assets and liabilities that make up
financial systems. (investopedia.com)
Management is often included as a factor of production along with? machines, materials,

and money. According to the management guru Peter Drucker (1909-2005), the basic task of
management includes both marketing and innovation. Practice of modern management
originates from the 16th century study of low-efficiency and failures of certain enterprises,
conducted by the English statesman Sir Thomas More (1478-1535). Management consists of
the interlocking functions of creating corporate policy and organizing, planning, controlling,
and directing an organization's resources in order to achieve the objectives of that policy.
Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
(managementstudyguide.com)
Financial management has focuses on risk-return relationship and the maximization of

return for a given level of risk.
Financial managers attempt to achieve wealth maximization through daily activities such as
credit and inventory management and through longer-term decisions related to raising
funds.
Financial managers must carefully consider domestic and international business conditions
in carrying out their responsibilities.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control
of financial resources of a concern. Its objectives are:
1. To ensure regular and adequate supply of funds to the concern.

Instructional Manual in Financial Management 1 | P a g e
2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Primary Activities of a Financial Manager
1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected
costs and profits and future programmes and policies of a concern. Estimations have
to be made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and
period of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.
Use of Financial Management in our daily lives

Students can use the different techniques in financial management such as:
a. budgeting for predicting future expenses and allocating their current resources to
cover possible future expenditures.
b. reconciliation of the cash balance using the statement of cash flows
c. simple investment decisions
Exercise 1: In your own definition, what is financial management? Cite situation wherein a
student can apply financial management,

Chapter 2: Statement of Cash Flows
Purpose of the chapter:
 To understand tax depreciation procedures and the effect of depreciation on the firm’s
cash flows.
 To discuss the firm’s statement of cash flows, operating cash flow, and free cash flow.
 To understand the financial planning process, including long-term (strategic) financial
plans and short-term (operating) financial plans.
 To discuss the cash-planning process and the preparation, evaluation, and use of the
cash budget.
To prepare statement of cash flows using the direct and indirect method. Cash flow
is the movement of money being transferred into and out of a business. Cash inflow if there
is a collection or receipt of cash and Cash Outflow if cash is used for purchase, payment of
expenses, payment of liabilities and claims and etc.
The Statement of Cash flows is one of the complete set of financial statements. The other
financial statements are Income Statement, Statement of Financial Position, Statement of
Changes in Equity and Notes to Financial Statement.
The Statement of Cash flows emphasizes the sources and utilization of cash, its primary
purpose is to provide information about cash receipts and cash disbursement.
Statement of Cash flows is a financial statement that shows how changes in balance sheet
accounts and income affect cash and cash equivalents, and breaks the analysis down to
operating, investing and financing activities.
Three segments of the statement of Cash flows:
1. Cash flow from Operating Activities
2. Cash flow from Investing Activities
3. Cash flow from Financing Activities
1. Operating Activities
Cash from operating activities determine the cash inflows and outflows from a company's
main business activities. Example: Collection from Customers, Payment of Salaries, Payment
of Supplies and etc.
Cash flow from operating activities can be solve using two method: Direct method and
Indirect Method
The direct method of present in detail or itemized the major classes of gross cash
receipts and gross cash payments while the indirect method reconcile the net income to
cash flows from operating activities
Example: (Financial Accounting Vol. 3, Valix et. al., 2017)

a. Cash receipts from sale of goods and rendering services
b. Cash receipts from rental, fess, commissions and other revenues
c. Cash payments to suppliers fro goods and services
d. Cash payments for selling, administrative and other expenses
e. Cash receipts and cash payments of an insurance enterprise
f. Cash payments or refunds of income taxes
g. Cash receipts and payments for securities held for dealing or trading purposes
a. Direct Method – Operating Activities

Most items needed in the Operating Activities is found on the income statement
(because it is known as statement of operations) and in current assets and current
liabilities (because it is used for the current operation)
Formulas:
Cash Received from Customers =

Net Sales
+ Beginning Accounts Receivable (before allowance for doubtful accounts)
− Ending Accounts Receivable (before allowance for doubtful accounts)
Cash Payments to Suppliers =
Cost of Goods Sold
+ Ending Inventory
− Beginning Inventory
+ Beginning Accounts Payable
− Ending Accounts Payable
Cash Payments for Expenses =

Expenses (Accrual Basis)
+ Beginning Accrued Expense; Ending Prepaid Expense
− Ending Accrued Expense; Beginning Prepaid Expense
Cash Payment for Income Taxes =

Income Tax Expense
+ Beginning Income Tax Payable
- Ending Income Tax Payable
To get the cash flow from operating activities, All cash receipts are added and all cash
disbursement are deducted.
Illustration:
Presented below is the income statement of Foley, Inc.:
Sales P380,000
Cost of goods sold 225,000
Gross profit P155,000
Operating expenses 85,000
Income before income taxes 70,000
Income taxes 28,000
Net income P 42,000
In addition, the following information related to net changes in working capital is presented:
Debit Credit
Cash P12,000
Trade accounts receivable 15,000
Inventories 19,400
Salaries payable (operating expenses) 8,000
Trade accounts payable P12,000
Income tax payable 3,000
Present the Operating Activity portion of the statement of cash flows

Answer:
Cash flows from operating activities
Cash received from customers P365,000
Cash payment to suppliers P193,600
Cash Payment for expenses 93,000
Cash payment for income taxes 31,000 317,600
Net cash provided by operating activities P 47,400
Cash Received from Customer:

Sales 380,000
- Increase in Accounts Receivable 15,000
Cash Received from Customer 365,000
Cash Payment to Suppliers:

Cost of Goods Sold 225,000
-Increase in Inventory 19,400
-Increase in Trade Accounts 12,000
Payable
Cash Payment to Suppliers 193,600
Cash Payment for Expenses

Operating Expenses 85,000
+ Decrease in Salaries Payable 8,000
Cash Payment for Expenses 93,000
Cash payment for income taxes

Income Tax Expense 28,000
+Decrease in income tax expense 3,000
Cash payment for income taxes 31,000
b. Indirect Method – Operating Activities

Since most items used in Operating Activities are found in the income statement, the
indirect method of presenting starts for the net income/loss deduct the non cash items
that affected income; add the decrease in current assets (except cash); deduct the

increase in current assets (except cash); add the increase in current liabilities and;
deduct the decrease in current liabilities
Formula:
Net Income/Loss
+ Expenses or Losses that doesn’t have cash outflow (example depreciation, amortization)
- Revenue or Gain that doesn’t have cash inflow
+ decrease in current assets (gross for accounts receivable, allowance doens’t affect cash)
- increase in current assets
+ increase in current liabilities
- decrease in current liabilities
Illustration:
Refer to the previous illustration, prepare the indirect method.
Answer:
Net income P42,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Increase in trade accounts receivable P(15,000)
Decrease in inventories 19,400
Decrease in salaries payable (operating expenses) (8,000)
Increase in trade accounts payable 12,000
Decrease in income taxes payable (3,000) 5,400
Net cash provided by operating activities P47,400
Regardless of which method is used, the net cash provided for operating activities for
direct method is always equal to the net cash provided for operating activities for indirect
method.
Which is more preferred?

Direct method is preferred by layman because it is easier to understand and interpret,
while the indirect method is usually used for reconciliation or if it impossible to prepare
the direct method.
2. Investing Activities
Cash from investing activities determines the cash inflows and outflows from a company's
non-current assets.

a. Cash payments to acquire property, plant and equipment, intangibles and other long-term
assets.
b. Cash receipts from sales of property, plant and equipment and other long-term assets
c. Cash payments to acquire equity or debt instruments of other entities
d. Cash receipts from sale of equity or debt instruments of other entities
e. Cash advances and loans to other parties
f. Cash receipts from repayment of advances and loans made to other parties
g. Cash payments/receipts for future contract, forward contract and etc.
Illustration:
Lange Co. provided the following information on selected transactions during 2018:
Purchase of land by issuing bonds P250,000
Proceeds from issuing bonds 500,000
Purchases of inventory 950,000
Purchases of treasury stock 150,000
Loans made to affiliated corporations 350,000
Dividends paid to preferred stockholders 100,000
Proceeds from issuing preferred stock 400,000
Proceeds from sale of equipment 50,000
Present the Investing Activity portion of the statement of cash flows.

Answer:

Loans made to affiliated corporation (350,000)
Net cash provided(used) by Investing Activities (300,000)
The purchase of land from issuing bonds does not affect cash although it affects the non-
current assets
3. Financing Activities
Cash from financing activities determine on the cash inflows and outflows from transaction
between owners and creditors. Example: Payment of Long-term debt, Additional
Investment.
From the Previous Illustration, Present the Financing Activity portion of the statement of
cash flows:
a. Cash receipts from issuing shares or other equity instruments
b. Cash payments to owners to acquire or redeem the enterprise’s share
c. Cash receipts from issuing debentures, loans, notes, bonds, mortgages, and other short or
long term borrowings
d. Cash payments for amounts borrowed
e. Cash payments by a lessee for the reduction of the outstanding liability relating to a
finance lease.
Note that the borrows does not include obligations arising from trade and operations like
accounts payable, notes payable, income tax payable, accrued expenses and similar items.
Answer:
Purchases of treasury stock (150,000)
Dividends paid to preferred stockholders (100,000)
Proceeds from issuing preferred stock 400,000
Net cash provided (used) by Financing Activities 650,000
Treatment of dividend and interest
Dividend and Interest Revenue/Expense are generally presented in the Operating

Activities, because it is presented as part of the income statement. Alternatively,
Dividend and Interest Revenue can be presented in the Investing Activities, treated
as fruits of investment while Dividend and Interest Expense can be presented in the
Financing Activities, treated as costs of financing.
Noncash Transactions
Investment and financing transactions that do not require use of cash or cash
equivalents shall be excluded from the statement of cash flows
The statement of cash flows is “strictly” a cash concept, noncash transactions are
excluded from the statement of cash flows

a. Acquisition of asset by assuming a liability
b. Acquisition of asset by means of issuing share capital
c. Conversion of debt to equity
d. Conversion of preference share to ordinary share
e. Property and Share dividends
Comprehensive Example:
Donelly, Inc. has prepared the following comparative statement of financial position for 2017 and
2018:
2018 2017
Cash and Cash Equivalents P 297,000 P 153,000
Receivables 159,000 117,000
Inventory 150,000 180,000
Prepaid expenses 18,000 27,000
Property Plant and Equipment 1,260,000 1,050,000
Accumulated depreciation (450,000) (375,000)
Patent 153,000 174,000
P1,587,000 P1,326,000
Accounts payable P 153,000 P 168,000

Accrued liabilities 60,000 42,000
Mortgage payable — 450,000
Preference shares 525,000 —
Share Premium 120,000 —
Common shares 600,000 600,000
Retained earnings 129,000 66,000
P1,587,000 P1,326,000
1. The Accumulated Depreciation account has been credited only for the depreciation expense for
the period.
2. The Retained Earnings account has been charged for dividends of P138,000 and credited for the
net income for the year.
The income statement for 2018 is as follows:
Sales P1,980,000
Cost of sales 1,089,000
Gross profit 891,000
Net income P 201,000
Prepare the statement of cash flows using the direct method:

Answer:
Donelly, Inc.
Statement of Cash flows
For Y0ear Ended December 31, 2018

Cash received from customers (1) P1,938,000
Cash paid to suppliers (2) P1,074,000
Operating expenses paid (3) 567,000 1,641,000
Net cash provided by operating activities P 297,000

Cash used in investing activities
Purchase of plant assets (210,000)
Cash flows from financing activities

Payment of cash dividend (138,000)
Retirement of mortgage payable (450,000)
Sale of preferred stock 645,000
Net cash provided by financing activities 57,000
Net increase in cash 144,000

Cash, January 1, 2018 153,000
Cash, December 31, 2018 P297,000
(1) P1,980,000 – P42,000

(2) P1,089,000 – P30,000 + P15,000
(3) P690,000 – P75,000 – P21,000 – P9,000 – P18,000
The Ending balance of the statement of cash flows should be equal to the ending
balance of cash in the statement of financial position

Exercise 1: True or False
1. The primary purpose of the statement of cash flows is to provide cash-basis
information about the company’s operating, investing, and financing activities.
2. The statement of cash flows provides information to help investors and creditors
assess the cash and noncash investing and financing transactions during the period.
3. Companies classify some cash flows relating to investing or financing activities as
operating activities.
4. The first step in the preparation of the statement of cash flows is to determine the
net cash flow from operating activities.
5. The net increase (decrease) in cash reported on the statement of cash flows should
reconcile the beginning and ending cash balances reported in the comparative
balance sheets.
6. Under the accrual basis of accounting, net income is usually the same as net cash
flow from operating activities.
7. A company can convert net income to net cash flow from operating activities through
either the direct method or the indirect method.
8. The direct method, also called the reconciliation method, reports cash receipts and
cash disbursements from operating activities.
9. The indirect method adjusts net income for items that affected reported net income
but did not affect cash.
10. The FASB encourages the use of the indirect method over the direct method.
11. When accounts receivable decrease during a period, cash-basis revenues are higher
than revenues reported on an accrual basis.
12. When prepaid expenses decrease during a period, expenses on the accrual-basis are
lower than they are on a cash-basis.
13. Income from an investment in common stock using the equity method is added to
net income in computing net cash provided from operating activities.
14. Cash receipts from customers are computed by adding a decrease in accounts
receivable to revenue from sales.
15. Cash payments for operating expenses are computed by subtracting an increase in
prepaid expenses and a decrease in accrued expenses payable from operating
expenses.
16. A company should add back bond premium amortization to net income to arrive at
net cash flow from operating activities.
17. Companies report the cash flows from purchases and sales of trading securities as
cash flows from operating activities.
18. Noncash investing and financing activities are disclosed either in a separate schedule
or in a separate note to the financial statements.
19. When numerous adjustments are necessary, companies often use a cash flow
worksheet instead of preparing a statement of cash flows.
20. The issuance of stock dividends is entered on the cash flow worksheet, but is not
reported in the statement of cash flows.

Exercise 2: Classification
Classify each item as part of Operating (O), Investing (I) or Financial (F) Activities,
indicate if the Items is a Cash Inflow (+) or Cash Outflow (-). Write the word “none” if
the item is not required to be reported in the statement of cash flows
Example:
O- and I+ 1. An insurance policy was canceled at year end, and a cash settlement was
received by the firm. These proceeds were in excess of the book value of the policy.
Operating activity outflow because insurance premiums were paid for the year and
Investment activity inflow because the cash settlement was received to settle a long term
investment.
_____ 1. Sales discounts lapsed and not taken by customers. (Sales recorded at net
originally.)
_____ 2. Accrued estimated income taxes for the period. These taxes will be paid next
year.
_____ 3. Amortization of premium on bonds payable.
_____ 4. Premium amortized on investment in bonds.
_____ 5. The book value of trading securities was reduced to fair value.
_____ 6. Purchase of available-for-sale securities.
_____ 7. Declaration of stock dividends (not yet issued).
_____ 8. Issued preferred stock in exchange for equipment.
_____ 9. Bad debts (under allowance method) estimated and recorded for the period
(receivables classified as current).
_____ 10. Gain on disposal of old machinery.
_____ 11. Payment of cash dividends (previously declared in a prior period).
_____ 12. Trading securities are sold at a loss.
_____ 13. Two-year notes issued at discount for a patent.
_____ 14. Amortization of Discount on Notes Receivable (long-term).
_____ 15. Decrease in Retained Earnings Appropriated for Self-insurance.

Exercise 3: Multiple Choice
1. It is an objective of the statement of cash flows to
a. disclose changes during the period in all asset and all equity accounts.
b. disclose the change in working capital during the period.
c. provide information about the operating, investing, and financing activities of an
entity during a period.
d. none of these.
2. The primary purpose of the statement of cash flows is to provide information
a. about the operating, investing, and financing activities of an entity during a
period.
b. that is useful in assessing cash flow prospects.
c. about the cash receipts and cash payments of an entity during a period.
d. about the entity's ability to meet its obligations, its ability to pay dividends, and
its needs for external financing.
3. Of the following questions, which one would not be answered by the statement of
cash flows?
a. Where did the cash come from during the period?
b. What was the cash used for during the period?
c. Were all the cash expenditures of benefit to the company during the period?
d. What was the change in the cash balance during the period?
4. The first step in the preparation of the statement of cash flows requires the use of
information included in which comparative financial statements?
a. Statements of cash flows
b. Balance sheets
c. Income statements
d. Statements of retained earnings
5. A company borrows P10,000 and signs a 90-day nontrade note payable. In preparing
a statement of cash flows (indirect method), this event would be reflected as a(n)
a. addition adjustment to net income in the cash flows from operating activities
section.
b. cash outflow from investing activities.
c. cash inflow from investing activities.
d. cash inflow from financing activities.
6. To arrive at net cash provided by operating activities, it is necessary to report
revenues and expenses on a cash basis. This is done by
a. re-recording all income statement transactions that directly affect cash in a
separate cash flow journal.
b. estimating the percentage of income statement transactions that were originally
reported on a cash basis and projecting this amount to the entire array of income
statement transactions.
c. eliminating the effects of income statement transactions that did not result in a
corresponding increase or decrease in cash.

d. eliminating all transactions that have no current or future effect on cash, such as
depreciation, from the net income computation.
7. An increase in inventory balance would be reported in a statement of cash flows
using the indirect method (reconciliation method) as a(n)
a. addition to net income in arriving at net cash flow from operating activities.
b. deduction from net income in arriving at net cash flow from operating activities.
c. cash outflow from investing activities.
d. cash outflow from financing activities.
8. A statement of cash flows typically would not disclose the effects of
a. capital stock issued at an amount greater than par value.
b. stock dividends declared.
c. cash dividends paid.
d. a purchase and immediate retirement of treasury stock.
9. When preparing a statement of cash flows (indirect method), which of the following
is not an adjustment to reconcile net income to net cash provided by operating
activities?
a. A change in interest payable
b. A change in dividends payable
c. A change in income taxes payable
d. All of these are adjustments.
10. Declaration of a cash dividend on common stock affects cash flows from operating
activities under the direct and indirect methods as follows:
Direct Method Indirect Method
a. Outflow Inflow
b. Inflow Inflow
c. Outflow Outflow
d. No effect No effect
11. In a statement of cash flows, the cash flows from investing activities section should
report
a. the issuance of common stock in exchange for a factory building.
b. stock dividends received.
c. a major repair to machinery charged to accumulated depreciation.
d. the assignment of accounts receivable.
12. Xanthe Corporation had the following transactions occur in the current year:
1. Cash sale of merchandise inventory.
2. Sale of delivery truck at book value.
3. Sale of Xanthe common stock for cash.
4. Issuance of a note payable to a bank for cash.
5. Sale of a security held as an available-for-sale investment.
6. Collection of loan receivable.
How many of the above items will appear as a cash inflow from investing activities on
a statement of cash flows for the current year?
a. Five items
b. Four items
c. Three items
d. Two items

13. Which of the following would be classified as a financing activity on a statement of
cash flows?
a. Declaration and distribution of a stock dividend
b. Deposit to a bond sinking fund
c. Sale of a loan receivable
d. Payment of interest to a creditor
14. The amortization of bond premium on long-term debt should be presented in a

statement of cash flows (using the indirect method for operating activities) as a(n)
a. addition to net income.
b. deduction from net income.
c. investing activity.
d. financing activity.
15. Crabbe Company reported P80,000 of selling and administrative expenses on its
income statement for the past year. The company had depreciation expense and an
increase in prepaid expenses associated with the selling and administrative expenses
for the year. Assuming use of the direct method, how would these items be handled
in converting the accrual based selling and administrative expenses to the cash basis?
Increase in
Depreciation Prepaid Expenses
a. Deducted From Deducted From
b. Added To Added To
c. Deducted From Added To
d. Added To Deducted From
16. When preparing a statement of cash flows (indirect method), an increase in ending
inventory over beginning inventory will result in an adjustment to reported net
earnings because
a. cash was increased while cost of goods sold was decreased.
b. cost of goods sold on an accrual basis is lower than on a cash basis.
c. acquisition of inventory is an investment activity.
d. inventory purchased during the period was less than inventory sold resulting in a
net cash increase.
17. When preparing a statement of cash flows, a decrease in accounts receivable during
a period would cause which one of the following adjustments in determining cash
flow from operating activities?
Direct Method Indirect Method
a. Increase Decrease
b. Decrease Increase
c. Increase Increase
d. Decrease Decrease
18. In determining net cash flow from operating activities, a decrease in accounts
payable during a period
a. means that income on an accrual basis is less than income on a cash basis.
b. requires an addition adjustment to net income under the indirect method.
c. requires an increase adjustment to cost of goods sold under the direct method.
d. requires a decrease adjustment to cost of goods sold under the direct method.

19. When preparing a statement of cash flows, an increase in accounts payable during a
period would require which of the following adjustments in determining cash flows
from operating activities?
Indirect Method Direct Method
20. When preparing a statement of cash flows, a decrease in prepaid insurance during a
period would require which of the following adjustments in determining cash flows
from operating activities?
Indirect Method Direct Method
21. When preparing a statement of cash flows, the following are used for which method
in determining cash flows from operating activities?
Gross Accounts Receivable Net Accounts Receivable
a. Indirect Direct
b. Direct Indirect
c. Direct Direct
d. Neither Indirect
22. Which of the following statements is correct?
a. The indirect method starts with income before extraordinary items.
b. The direct method is known as the reconciliation method.
c. The direct method is more consistent with the primary purpose of the statement
of cash flows.
d. All of these.
23. Riley Company reports its income from investments under the equity method and
recognized income of P25,000 from its investment in Wood Co. during the current
year, even though no dividends were declared or paid by Wood during the year.
On Riley's statement of cash flows (indirect method), the P25,000 should
a. not be shown.
b. be shown as cash inflow from investing activities.
c. be shown as cash outflow from financing activities.
d. be shown as a deduction from net income in the cash flows from operating
activities section.

Exercise 4:
Donelly, Inc. has prepared the following comparative balance sheets for 2017 and 2018:
2018 2017
Cash P 297,000 P 153,000
Receivables 159,000 117,000
Inventory 150,000 180,000
Plant assets 1,260,000 1,050,000
Patent 153,000 174,000
P1,587,000 P1,326,000

Mortgage payable — 450,000
Preferred stock 525,000 —
Additional paid-in capital—preferred 120,000 —
Common stock 600,000 600,000
P1,587,000 P1,326,000
1. The Accumulated Depreciation account has been credited only for the depreciation
expense for the period.
2. The Retained Earnings account has been charged for dividends of P138,000 and credited
for the net income for the year.
The income statement for 2018 is as follows:
Sales P1,980,000
Cost of sales 1,089,000
Gross profit 891,000
Net income P 201,000
Instructions

From the information above, prepare a schedule of cash provided by operating
activities using the indirect method.
Exercise 5:
The following information is taken from Reyser Corporation's financial statements:
December 31
2018 2017
Cash P90,000 P 27,000
Accounts receivable 92,000 80,000
Allowance for doubtful accounts (4,500) (3,100)
Inventory 155,000 175,000
Land 90,000 60,000
Buildings 287,000 244,000
Patents 20,000 35,000
P705,000 P611,700

Bonds payable 125,000 60,000
Common stock 100,000 100,000
Retained earnings—appropriated 80,000 10,000
Retained earnings—unappropriated 271,000 302,700
Treasury stock, at cost (15,000) (8,000)
P705,000 P611,700
For 2018 Year

Net income P58,300
Depreciation expense 19,000
Amortization of patents 5,000
Cash dividends declared and paid 20,000
Gain or loss on sale of patents none
Instructions
Prepare a statement of cash flows for Reyser Corporation for the year 2018. (Use the indirect
method.)

Exercise 6: Short Problems
1. The following information on selected cash transactions for 2018 has been provided
by Simpson Company:
Proceeds from sale of land P160,000
Proceeds from long-term borrowings 400,000
Purchases of plant assets 144,000
Purchases of inventories 680,000
Proceeds from sale of Simpson common stock 240,000
What is the cash provided (used) by investing activities for the year ended December
31, 2018, as a result of the above information?
a. P16,000
b. P256,000.
c. P160,000.
d. P800,000.
2. Selected information from Adison Company's 2018 accounting records is as follows:

Proceeds from issuance of common stock P 400,000
Proceeds from issuance of bonds 1,200,000
Cash dividends on common stock paid 160,000
Cash dividends on preferred stock paid 60,000
Sale of stock to officers and employees not included above 100,000
Adison's statement of cash flows for the year ended December 31, 2018, would show
net cash provided (used) by financing activities of
a. P60,000.
b. P(220,000).
c. P160,000.
d. P1,360,000.
3. During 2018, Ogden Inc. had the following activities related to its financial
operations:
Carrying value of convertible preferred stock in Ogden,
converted into common shares of Ogden P 360,000
Payment in 2018 of cash dividend declared in 2017 to

preferred shareholders 186,000
Payment for the early retirement of long-term bonds payable
(carrying amount P2,220,000) 2,250,000
Proceeds from the sale of treasury stock (on books at cost of P258,000) 300,000
The amount of net cash used in financing activities to appear in Ogden's statement of
cash flows for 2018 should be
a. P1,590,000.
b. P1,776,000.
c. P2,136,000.
d. P2,148,000.
4. Tobin Company sold some of its plant assets during 2018. The original cost of the
plant assets was P750,000 and the accumulated depreciation at date of sale was
P700,000. The proceeds from the sale of the plant assets were P105,000. The
information concerning the sale of the plant assets should be shown on Tobin's
statement of cash flows (indirect method) for the year ended December 31, 2018, as
a(n)
a. subtraction from net income of P55,000 and a P50,000 increase in cash flows
from financing activities.
b. addition to net income of P55,000 and a P105,000 increase in cash flows from
investing activities.
c. subtraction from net income of P55,000 and a P105,000 increase in cash flows
from investing activities.
d. addition of P105,000 to net income.
5. An analysis of the machinery accounts of Doonan Company for 2018 is as follows:

Machinery, Net of
Accumulated Accumulated
Machinery Depreciation
Depreciation
Balance at January 1, 2018 P500,000 P125,000 P375,000
Purchases of new machinery in 2018
for cash 200,000 — 200,000
Depreciation in 2018 — 100,000 (100,000)
Balance at Dec. 31, 2018 P700,000 P225,000 P475,000
The information concerning Doonan's machinery accounts should be shown in

Doonan's statement of cash flows (indirect method) for the year ended December
31, 2018, as a(n)
a. subtraction from net income of P100,000 and a P200,000 decrease in cash flows
from financing activities.
b. addition to net income of P100,000 and a P200,000 decrease in cash flows from
investing activities.
c. P100,000 increase in cash flows from financing activities.
d. P200,000 decrease in cash flows from investing activities.
6. Equipment which cost P213,000 and had accumulated depreciation of P114,000 was
sold for P111,000. This transaction should be shown on the statement of cash flows
(indirect method) as a(n)
a. addition to net income of P12,000 and a P111,000 cash inflow from financing
activities.
b. deduction from net income of P12,000 and a P99,000 cash inflow from investing
activities.
c. deduction from net income of P12,000 and a P111,000 cash inflow from investing
activities.
d. addition to net income of P12,000 and a P99,000 cash inflow from financing
activities.
7. During 2018, equipment was sold for P156,000. The equipment cost P252,000 and
had a book value of P144,000. Accumulated Depreciation—Equipment was P687,000
at 12/31/17 and P735,000 at 12/31/18. Depreciation expense for 2018 was
a. P60,000.
b. P96,000.
c. P156,000.
d. P192,000.
Use the following information for questions 8 and 9.

Equipment that cost P300,000 and had a book value of P156,000 was sold for P180,000.
Data from the comparative balance sheets are:
12/31/18 12/31/17
Equipment P2,160,000 P1,950,000
Accumulated Depreciation 660,000 570,000
8. Depreciation expense for 2018 was

a. P258,000.
b. P234,000.
c. P54,000.
d. P36,000.
9. Equipment purchased during 2018 was

a. P510,000.
b. P300,000.
c. P210,000.
d. P90,000.
The balance in retained earnings at December 31, 2017 was P720,000 and at December 31,
2018 was P582,000. Net income for 2018 was P500,000. A stock dividend was declared and
distributed which increased common stock P200,000 and paid-in capital P110,000. A cash
dividend was declared and paid.

10. The amount of the cash dividend was
a. P248,000.
b. P328,000.
c. P442,000.
d. P638,000.
11. The stock dividend should be reported on the statement of cash flows (indirect
method) as
a. an outflow from financing activities of P200,000.
b. an outflow from financing activities of P310,000.
c. an outflow from investing activities of P310,000.
d. Stock dividends are not shown on a statement of cash flows.
12. The following information was taken from the 2018 financial statements of Sawyer
Corporation:
Bonds payable, January 1, 2018 P 500,000
Bonds payable, December 31, 2018 2,000,000
During 2018
 A P450,000 payment was made to retire bonds payable with a face amount of
P500,000.
 Bonds payable with a face amount of P200,000 were issued in exchange for
equipment.
In its statement of cash flows for the year ended December 31, 2018, what amount
should Sawyer report as proceeds from issuance of bonds payable?
a. P1,500,000
b. P1,750,000
c. P1,800,000
d. P2,200,000
13. Richman Corporation had net income for 2018 of P3,000,000. Additional information
is as follows:
Depreciation of plant assets P1,200,000
Amortization of intangibles 240,000
Increase in accounts receivable 420,000
Increase in accounts payable 540,000
Richman's net cash provided by operating activities for 2018 was
a. P4,560,000.
b. P4,440,000.
c. P4,320,000.
d. P1,680,000.
14. Net cash flow from operating activities for 2018 for Fordham Corporation was
P300,000. The following items are reported on the financial statements for 2018:
Cash dividends paid on common stock 20,000
Depreciation and amortization 12,000

Increase in accounts receivables 24,000
Based on the information above, Fordham’s net income for 2018 was
a. P312,000.
b. P296,000.
c. P264,000.
d. P256,000.
15. During 2018, Hogan Company earned net income of P384,000 which included
deprecia-tion expense of P78,000. In addition, the company experienced the
following changes in the account balances listed below:
Increases Decreases
Accounts payable P45,000 Accounts receivable P12,000
Inventory 36,000 Accrued liabilities 24,000
Prepaid insurance 33,000
Based upon this information what amount will be shown for net cash provided by
operating activities for 2018?
a. P492,000
b. P465,000
c. P285,000
d. P267,000
16. Robley Company reported net income of P340,000 for the year ended 12/31/08.
Included in the computation of net income were: depreciation expense, P60,000;
amortization of a patent, P32,000; income from an investment in common stock of
Brett Inc., accounted for under the equity method, P48,000; and amortization of a
bond discount, P12,000. Robley also paid an P80,000 dividend during the year. The
net cash provided by operating activities would be reported at:
a. P396,000.
b. P316,000.
c. P284,000.
d. P204,000.
Weimers Company provided the following information on selected transactions during 2018:
Dividends paid to preferred stockholders P 150,000
Loans made to affiliated corporations 750,000
Proceeds from issuing preferred stock 1,050,000
Purchases of inventories 1,200,000
Purchase of land by issuing bonds 300,000
17. The net cash provided (used) by investing activities during 2018 is
a. P(600,000).

b. P(300,000).
c. P150,000.
d. P450,000.
18. The net cash provided (used) by financing activities during 2018 is
a. P(1,650,000).
b. P450,000.
c. P750,000.
d. P1,200,000.
19. The net cash provided by operating activities in Otto Company's statement of cash
flows for 2018 was P115,000. For 2018, depreciation on plant assets was P45,000,
amortization of patent was P8,000, and cash dividends paid on common stock was P54,000.
Based only on the information given above, Otto’s net income for 2018 was
a. P115,000.
b. P62,000.
c. P8,000.
d. P116,000.
20. During 2018, Garber Corporation, which uses the allowance method of accounting
for doubtful accounts, recorded a provision for bad debt expense of P25,000 and in
addition it wrote off, as uncollectible, accounts receivable of P10,000. As a result of
these transactions, net cash flows from operating activities would be calculated
(indirect method) by adjusting net income with a
a. P25,000 increase.
b. P10,000 increase.
c. P15,000 increase.
d. P15,000 decrease.

A flood damaged a building and contents. Floods are unusual and infrequent in this area.
The receipts from insurance companies totaled P300,000, which was P90,000 less than the
book values. The tax rate is 30%.
21. On the statement of cash flows (indirect method), the receipts from insurance
companies should
a. be shown as an addition to net income of P210,000.
b. be shown as an inflow from investing activities of P210,000.
c. be shown as an inflow from investing activities of P300,000.
d. not be shown.
22. On the statement of cash flows (indirect method), the flood loss should
a. be shown as an addition to net income of P63,000.
b. be shown as an addition to net income of P90,000.
c. be shown as an inflow from investing activities of P63,000.

Chapter 3: Financial Statement Analysis
Purpose of the Chapter:
 To understand who uses financial ratios, and how.

 To use ratios to analyze a firm’s liquidity and activity.
 To discuss the relationship between debt and financial leverage and the ratios used to
analyze a firm’s debt.
 To use ratios to analyze a firm’s profitability and market value.
To use a summary of financial ratios and the DuPont system of analysis to perform a
complete ratio analysis.
There are four phases of the accounting process:

1. Recording phase
2. Classifying phase
3. Summarizing phase
4. Interpreting phase
The first 3 phases of accounting are discuss in the basic accounting, while the 4 th phase,
interpreting, is the focus of the chapter. The ending figure of the statements are not enough
to access the performance of an entity, example: which is more profitable, A company
earning P50 but have P1,000 capital or a company that earns P20 but have P100 capital.
Financial statement analysis are used to weigh and evaluate the operating performance of a
firm. It access the profitability of the business firm, the firm’s ability to meet its obligations,
safety of the investment in the business and effectiveness of management in running the
firm. Financial statement analysis are used to predict figures in the future or be used for the
future economic decisions.
There are different tools and techniques used in the financial statement analysis, its usage
will depend on the company/managers need. A company might find a method more useful
than the other in assessing the performance of an entity, and the company will also
determine their own acceptable ratios, a company might say that 12% return is enough
while others might say that 12% return is not acceptable
Tools and techniques in analysing financial statement.

1. Horizontal Analysis – involves comparing figures in two or more consecutive period.
The difference between the figures of the two periods is calculated and the
percentage of change from one period to the next, with the earliest period as the
base.
Example: 2017 2018 %change
Sales 10,000 15,000 50%

Increases are usually reflected with a positive % of change and decreases are usually
reflected with a negative () % of change.
The Horizontal Analysis analyses the changes in two or more periods to pinpoint the
significant changes in the figures which require additional research or investigation to
justify such significant change.
Example:
Analysis: Net Income Decreases by 42.29% as a result of decrease in sales of 5%,

though Cost of Goods Sold decreases by 1.49% it didn’t equal the decrease of 5% in
sales (possible scenarios are: The volume of sale decreases and cost to produce one
unit increases or Selling Price decreases as a result of decreasing the cost of goods
sold) and Total operating expenses decreases by 3.49%. The company would want to
investigate the decrease of 42.29% in the net income, because a decrease of a
significant percentage in profit might indicate a problem in the company
particularly on the increase of 39.76% in the repairs because the percentage is
significant and 9.09% decrease in the gross profit because the amount is significant.
a. Trend Analysis – a more advance form of Horizontal Analysis. Trend Analysis
needs at least 5 – 10 years of experience in order to determine the trend for a
particular account, unusual changes are not reflected in the trend. The firm will
then compare the financial statement for a given year, based on the trend with
that of the actual financial statement of the firm.
2. Vertical Analysis – involves identifying the composition of a specific balance to the
total. The base for income statement is the revenue/sales and the base for balance
sheet is the total assets/ total liabilities and equity. Vertical Analysis are effective
when comparing two or more companies.
A Company B Company

Analysis: for A company 6.67% of sales ended up as net income while for B Company
4.05% of sales ended up as net income. B Company might find the difference
significant and would want to investigate the reason why A company is performing
better than B company.
3. Ratio Analysis – different ratios are computed to access the performance of the firm.
Ratio Analysis are categorized into three (3).

a. Liquidity ratios – allows the firm to measure its ability to pay its current obligations.
b. Solvency ratios – allows the firm to measure its ability to pay long-term obligations. It
access the firm’s ability to exist in the long run (going concern).
c. Profitability ratios – allows the firm to measure its ability to earn an adequate return
on sales, total assets and invested capital. It allows the firm to access if its capital is
earning effectively through operations. Usually the firm’s rate of return is compared
to a highest risk-free rate of return of an investment that is available in the market
Liquidity Ratios:
1. Current ratio – also called the working capital ratio, measures the number of times
that the current liabilities can be paid with the available current liabilities. Working
Capital = Current Assets – Current Liabilities
Formula is:
Current Assets
Current Ratio =
Current Liabilities
Example: If Current Assets is 1,000,000 and Current Liabilities is 200,000. Then:
Current Ratio = 1,000,000= 5
200,000
Which means that the current liabilities can be paid 5 times until the current assets
are exhausted. Current Ratio roughly defines the short term debt-paying ability of the
firm. The company might set its own acceptable ratio but in no way that a company
can have a current ratio lower than 1 and considered to be liquid, when the current
ratio is less than 1, it means that the current assets are not enough to settle the
current liabilities.
2. Acid test/Quick ratio – also called the quick asset ratio, because not all asset can pay
current liabilities, like prepaid expenses, quick asset considers only the part of
current liabilities that are nearly converted into cash. The quick assets are: Cash and
cash equivalent, trading securities and receivables.
Formula is:
Cash & Cash Equivalent + Trading Securities + Receivables
Acid test ratio =
Current Liabilities
Example: If Cash is 150,000, Short term Investment is 200,000 and Accounts
Receivable is 400,000 and Current Liabilities is 200,000. Then:
Acid test ratio = 150,000 + 200,000 + 400,000 = 3.75
200,000
Acid test ratio is stricter than current ratio. Acid test ratio does not include inventory
and prepaid expense, because inventory needs to be sold then collected first
before it can be used to pay debts and prepaid expenses will never be converted to
cash while short term investments can be immediately sold through active market
and accounts receivable can be used to finance short term debt through pledging
and factoring.
The company might set its own acceptable ratio but in no way that a company can
have a acid ratio lower than 1 and considered to be liquid, when the current ratio is
less than 1, it means that the acid assets are not enough to settle the current
liabilities.
3. Working capital activity ratios – measures the turnover rate of working capital
a. Receivable turnover – measures how fast cash is collected from receivable, it is
presented in the unit (times), times meaning in a single year how many times
does receivable be converted to cash.
Formula is:
Net Credit Sales
Receivable Turnover =
Average Receivable
Average Receivable = Beginning Receivable + Ending Receivable
2
Example: If net credit sales is 500,000 and average receivable is 50,000. Then:
Receivable Turnover = 500,000 = 10 times
50,000
b. Average Age of Receivable – at an average how many days will it take for
accounts receivable before it is collected.
Formula is:
365 days
Average age of receivable =
Receivable Turnover
Example: In the previous example,
Average Age of Receivable = 365 = 36.5 days
10
Which means that at an average, receivables are collected after 36.5 days
c. Inventory turnover – measures how fast inventory is sold, meaning in a single
year how many times inventories are purchased and sold.
Formula is:
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Average Inventory = Beginning Inventory + Ending Inventory
2
Example: if Cost of Goods sold is 300,000 and average inventory is 60,000. Then:
Inventory Turnover = 300,000 = 5 times
60,000
d. Average Age of Inventory = at an average how many days will it take for the
inventory to be sold.
Formula is:
365 days
Average age of Inventory =
Inventory Turnover

Example: In the previous example,
Average Age of Inventory = 365 = 73 days
5
Which means that inventory are sold 73 days after purchase.
e. Accounts Payable turnover – measures how fast payables are paid.
Formula is:
Net Credit Purchases
Payables Turnover =
Average Trade Payables
Average Trade Payables = Beginning Payables + Ending Payables
2
Example: If Net Credit Purchase is 500,000 and Average Trade Payables is
200,000. Then:
Accounts Payable Turnover = 500,000 = 2.5 times
200,000
f. Average Age of Trade Payables = at an average how many days will it take for
payables to be paid.
Formula is:
365 days
Average age of Inventory =
Inventory Turnover
In the Previous Example,
Average age of Inventory = 365 = 146 days

2.5
At an average it takes 146 days for accounts payable to be paid.
g. Asset turnover = This ratio measures how efficiently a firm uses its
assets to generate sales, so a higher ratio is always more
favorable.
Gross Sales
Asset turnover =
Average total assets
Average Total Assets = Beginning total assets + Ending total assets
2
The company might set its own acceptable ratio, depending on the nature and
policy of the company.
Operating Cycle and Cash Conversion Cycle

Operating Cycle – The length of time raw materials are acquired, through production,
sale of finished goods, until the time when receivables are collected or converted
into cash which may in turn be used again to acquire raw materials.
Formula is:
Ave. Age of Receivable + Ave. Age of
Operating Cycle =
Inventory

Example: If Average Age of Receivable is 36.5 days and Average Age of Inventory is 73
days then:
Operating Cycle = 36.5 + 73 = 109.5 days
Which means that if inventory are sold on credit, it takes 109.5 days for purchased
inventory to be sold and ultimately collected
Cash Conversion Cycle – The length of time for cash used to purchase inventory to be
converted back to cash.
Cash Conversion Cycle = Ave. Age of Receivable + Ave. Age of Inventory – Ave Age of
Payable
The acceptable liquidity ratios depends on the accepted standard of the entity but in no
case should it be lower than one (1). A liquidity ratio of less than one indicates that the
entity is no longer liquid. A very high liquidity ratio may indicate that the entity might not
be utilizing its assets efficiently, To avoid underutilization of asset, the entity can either
choose to expand their business, establish a new project or purchase long-term assets, pay
liabilities or issue dividends.
Decision Making
When the company finds that they are no longer liquid, or fall short of the acceptable
liquidity ratios set by the manager, the company could:
1. Source out finances from long-term liabilities and equity
2. Refinance short-term liability to long-term liabilities
3. Sell long-term assets
Current assets have high risk, Cash are susceptible to theft, Past due accounts receivable are
subject to doubtful accounts expense, and inventories are at risk with shrinkage, theft,
breakage and spoilage. When the company finds that they have high liquidity ratio, it means
that the current assets are underutilized, The Company could:
1. Expand the business
2. Establish a new project
3. Purchase long-term assets
4. Issue dividends
5. Pay liabilities
Solvency Ratios:
1. Times Interest Earned – Determines the company’s ability to cover its interest
expense
Formula is:
Times Interest Earned = Income before interest and tax
Interest Expense
Example: Income before interest and taxes is 500,000 while interest expense is
250,000. Then:
Times Interest Earned = 500,000 = 2 times
250,000
Times Interest Earned shows if your earnings are beings used up to pay interest. If a
company has less than one (1) times interest earned, then the entities earnings are
actually not enough to cover the interest of loans. If a company has low times
interest earned (depends on the standard of the company) most operating income
are used to pay interest. High times interest earned is desired.
2. Debt-equity ratio – Comparing to the total equity, how high or how low is the
company’s liability.
Formula is:
Total Liabilities
Debt-equity ratio =
Total Equity
Example: If Total Liabilities is 300,000 and Total Equity is 100,000. Then:
Debt-Equity Ratio = 300,000 = 3
100,000
Debt-equity ratio compares the ownership of creditors to the total asset, a very high
debt-equity ratio shows that if the entity is liquidated, most of assets are actually
used to pay liabilities, while a minimal amount goes to the owner. A lower Debt-
Equity Ratio is more desirable
3. Debt Ratio – Indicates the percentage of total assets provided by creditors.
Formula is:
Total Liabilities
Debt ratio =
Total Assets
Example: If Total Liabilities is 300,000 and Total Assets is 400,000. Then:
Debt Ratio = 300,000 = 75%

400,000
Debt Ratio shows the percentage of ownership of creditors to the total asset, in the
example in shows that 75% of the total asset belongs to the creditors. A lower debt
ratio is desirable
4. Equity Ratio – Indicates the percentage of total assets provided by the owners or
stockholders.
Formula is:
Total Equity
Equity ratio =
Total Assets
Example: If Total Equity is 100,000 and Total Assets is 400,000. Then:
Equity Ratio = 100,000 = 75%
400,000
Equity Ratio shows the percentage of ownership of shareholders to the total asset, in
the example in shows that 25% of the total asset belongs to the shareholders. A
higher Equity ratio is desirable
Note:
Equity Ratio + Debt Ratio = 100%
Just like the Liquidity Ratio, the company would decide the ratios that are
acceptable to them.

Decision Making
When the company finds that they are no longer solvent, or fall short of the acceptable
solvency ratios set by the manager, the company could:
1. Pay long-term liabilities and reduce the interest expense
2. Invest additional funds
Though liabilities incur risk they also incur rewards like, funding profitable projects where
the current resources are not enough and help expand the business. When the company
finds that they have solvency ratio so above the acceptable level, it means that the company
have fear in for incurring liabilities, the company could:
1. Borrow a long-term liabilities, by expanding the business, but the company needs to
conduct first a feasibility study to make sure that the rewards are higher than the risk
and interests.
Profitability Ratio:
1. Rate of Return – also known as return on investment
Formula is:
Net Income
Rate of Return =
Investment
2. Return on Sales – measures the percentage of each peso revenue that results in net
income
Formula is:
Net Income
Return on Sales =
Net Sales
3. Operating Margin Ratio – measure the percentage of each peso revenue that results
in operating income, operating income is the net income before interest and taxes, as
interest and taxes are not controllable by the company, some liabilities are
mandatory to finance the projects and taxes are controlled by the government
Operating Margin (net income + interest + taxes)
Operating Margin Ratio =
Net Sales
4. Gross margin percentage – measures the percentage of gross margin to net sales
Gross Margin/Gross Profit
Gross margin/profit percentage =
Net Sales
5. Return on Asset – it measures how assets were efficiently used to produce the sales
or revenue
Formula is:
Net Income
Return on Asset =
Average Total Asset
6. Return on Owners’ Equity/Capital – measures the percentage of net income to
capital
Formula is:

Net Income
Return on Equity =
Average Equity
7. Return on Common Equity – measures the percentage of return to common equity
after deducting the dividends for preference stock.
Formula is:
Net Income – Preferred Dividends
Rate on Common Equity =
Average Common Stockholders’ Equity
8. Basic Earnings Power Ratio - ratio is a measure that calculates the earning power of
a business before the effect of the business' income taxes and its financial
leverage.
Formula is:
Net Income Before Interest and Taxes
Basic Earnings Power Ratio =
Average Common Stockholders’ Equity
9. Earnings per share
Formula is:
Net Income – Preferred Dividends
Earnings per share = Weighted Average Number of Common
Shares
Average vs Weighted Average
Common average averages the beginning and ending while weighted average gives
importance to the number of months or days the amount is outstanding
Common Average = Beginning + Ending
2
Weighted Average = Balance x Months Outstanding + Balance (if there are changes x MO)
12 12
Example: A company have the following number of shares throughout the year. Beginning
165,000; June 30 200,000; December 1 180,000.
Common Average = 165,000 + 180,000 = 172,500
2
Weighted Average = 165,000 x 6* + 200,000 x 5* + 180,000 x 1* = 180,833.33
12 12 12
* From January 1 to June 30 is 6 months; from June 30 to December 1 is 5 months; and from
December 1 to December 31 is 1 month.
10. Market Tests – relationship of price, dividends and earnings, market test shows if
shares of stocks are worth purchasing or not.
a. Price-earnings ratio – relationship price to earnings, it shows how many years
would it take for the shareholder to recover the price paid for the shares using
the earnings received from the same shares, low price-earnings ratio indicates
that the stocks are underpriced, while high price-earnings ratio indicates that
the shares are overpriced.
Formula is:

Price per share
Price-Earnings Ratio (P/E) =
Earnings Per Share
b. Dividend yield – relationship of dividends to the price per share, it shows the
percentage of the price that was recovered through dividends. High dividend
yield is desirable.
Formula is:
Dividend per share
Dividend Yield =
Price per Share
c. Dividend payout – percentage of earnings that is distributed as dividends.
Formula is:
Common Dividend Per Share
Dividend payout =
Earnings Per Share
The Company could set its acceptable ratios which would be used for decision making
When the company finds that they have low profitable ratio, or fall short of the acceptable
solvency ratios set by the manager, the company could:
1. Increase the profit by: allowing credit sales, increase the selling price, decrease the
selling price to increase the sales volume, reduction of cost and etc.
2. Find a new profitable product.
3. If there is no longer any solution to increase the profitability ratios, the company
could liquidate
Unlike in liquidity and solvency ratios wherein a very high ratios could are not that all
acceptable, high profitability ratios doesn’t carry any risk, in fact the higher the profitability
ratio the better.
Comprehensive Example:
Springfield Bank is evaluating Creek Enterprises, which has requested a P4,000,000 loan, to
access the firm’s financial leverage and financial risk. On the basis of the debt ratios for
Creek, along with the industry average and Creek’s recent financial statements, evaluate and
recommend appropriate action on the loan request.
Creek Enterprises
Income Statement
For the Year Ended December 31, 2018
Sales Revenue P 30,000,000.00
Less: Cost of Goods Sold 21,000,000.00
Gross Profit P 9,000,000.00
Less: Operating Expenses
Selling Expenses P 3,000,000.00
General and Administrative Expenses 1,800,000.00
Lease Expense 200,000.00
Depreciation Expense 1,000,000.00
Total Operating Expense 6,000,000.00
Operating Profit P 3,000,000.00
Less: Interest Expnse 1,000,000.00
Net profit before tax P 2,000,000.00
Less: Taxes 800,000.00
Net profits after tax P 1,200,000.00
Less: Preferred stock dividends 100,000.00
Earnings availalbe for common stockholders P 1,100,000.00
Creek Enterprises
Balance Sheet
December 31, 2018
Assets: Liabilities and Equity:
Current Assets: Current Liabilities:
Cash P 1,000,000.00 Accounts Payable P 8,000,000.00
Marketable Securities 3,000,000.00 Notes Payable 8,000,000.00
Accounts Receivable 12,000,000.00 Accruals 500,000.00
Inventories 7,500,000.00 Total Current Liabilities P16,500,000.00
Total Current Assets P 23,500,000.00 Long-term Liabilities 20,000,000.00
Noncurrent Assets: Total Liabilities 36,500,000.00
Property plant & Equipment P11,000,000.00 Shareholder’s Equity:
Machinery and Equipment 20,500,000.00 Preferred stock (25,000
Furnitures and Fixtures 8,000,000.00 Shares, P4 dividend) P2,500,000.00
Less: Accumulated Depre. (13,000,000.00) Common stock (1 million
Total Noncurrent Assets 26,500,000.00 Shares, P5 par) 5,000,000.00
Additional paid in capital 4,000,000.00
Retained Earnings 2,000,000.00
Total shareholder’s equity 13,500,000.00
Total Assets P 50,000,000.00 Total Liabilities & Equity P50,000,000.00
The firm has a 4-year financial lease requiring annual beginning-of-year payments of
P200,000. Three years of the lease have yet to run.
Required annual principal payments are P800,000.
Analyse the financial statement.
Vertical Analysis:
Creek Enterprises
Income Statement
Vertical Analysis (December 31, 2018)
Sales Revenue P 30,000,000.00 100.00%
Less: Cost of Goods Sold 21,000,000.00 70.00%
Gross Profit P 9,000,000.00 30.00%
Less: Operating Expenses
Selling Expenses P 3,000,000.00 10.00%
General and Administrative Expenses 1,800,000.00 6.00%
Lease Expense 200,000.00 0.67%
Depreciation Expense 1,000,000.00 3.33%
Total Operating Expense 6,000,000.00 20.00%
Operating Profit P 3,000,000.00 10.00%
Less: Interest Expense 1,000,000.00 3.33%
Net profit before tax P 2,000,000.00 6.67%
Less: Taxes 800,000.00 2.67%
Net profits after tax P 1,200,000.00 4.00%
Note: The cost of goods sold is 70% of sales, this is compared to a companies with the same nature with Creek
Enterprise. If for example, the cost of goods sold of another company is 60% of sales, Creek Enterprise will look
into the effect of reducing the cost or increasing the selling price to the total amount. Net profit is 4% of the
total sales revenue, it means that for every peso sale, 0.04 becomes net profit after tax.
Creek Enterprises
Balance Sheet
December 31, 2018
Assets:
Current Assets:
Cash P 1,000,000.00 2.00%
Marketable Securities 3,000,000.00 6.00%
Accounts Receivable 12,000,000.00 24.00%
Inventories 7,500,000.00 15.00%
Total Current Assets P 23,500,000.00 47.00%
oncurrent Assets:
Property plant & Equipment P11,000,000.00 22.00%
Machinery and Equipment 20,500,000.00 41.00%
Furnitures and Fixtures 8,000,000.00 16.00%
Less: Accumulated Depre. (13,000,000.00) (26.00%)
Total Noncurrent Assets 26,500,000.00 53.00%
Total Assets P 50,000,000.00 100.00%
Liabilities and Equity:
Current Liabilities:
Accounts Payable P 8,000,000.00 16.00%
Notes Payable 8,000,000.00 16.00%
Accruals 500,000.00 1.00%
Total Current Liabilities P16,500,000.00 33.00%
Long-term Liabilities 20,000,000.00 40.00%
Total Liabilities 36,500,000.00 73.00%
Shareholder’s Equity:
Preferred stock (25,000
Shares, P4 dividend) P2,500,000.00 5.00%
Common stock (1 million
Shares, P5 par) 5,000,000.00 10.00%
Additional paid in capital 4,000,000.00 8.00%
Retained Earnings 2,000,000.00 4.00%
Total shareholder’s equity 13,500,000.00 27.00%
Total Liabilities & Equity P50,000,000.00 100.00%
Horizontal and Vertical Analysis is usually compared either to another entity or years
Current Ratio = 23,500,000.00 = 1.42

16,500,000.00
A current ratio of 1.42 is just above 1, some entities might not accept this ratio because of low margin of safety
or room for uncontrollable circumstances
Quick Ratio = 17,000,000.00 = 1.03
16,500,000.00
A Quick Ratio of 1.03 is just above 1, some entities might not accept this ratio because of low margin of safety
or room for uncontrollable circumstances
Receivable Turnover = 30,000,000.00 = 2.5 times
12,000,000.00
Average Age of Receivables = 365 days = 146 days
2.5 Times
The 146 average age of receivables is compared to the credit period the entity offers, for example if the entity
offers n/30 as its credit period. Comparing the average age of receivable to the credit period, it is concluded
that the credit department are not doing well.
Inventory Turnover = 21,000,000.00 = 2.8 times
7,500,000.00
Average Age of Inventory = 365 days = 130 days
2.8 times
The 130 average age of inventory is compared to the type of product an entity sells, some product have high
inventory turnover like grocery items and some have low inventory turnover like cars. For example, if creek
entity is selling grocery items, the 130 days average age of inventory is unacceptable, grocery items are prone
to theft, spoilage, brokerage and etc. so much risk are associated with small products specially if it is normally
stored for 130 days. The entity could even conclude that there is oversupply of inventory.
Accounts Payable Turnover = 21,000,000.00 = 2.63 times
8,000,000.00
Average Age of Payables = 365 days = 139 days
2.63 times
You could use the Cost of Goods Sold as Substitute to the Net Credit Purchases if the latter is not given. The
Average Age of Payables of 139 days is compared to the credit period given to the company, if the average age
of payables is much higher than the credit period, the credit standing of the entity is low, and vice versa.
Operating Cycle = 146+130 = 276 days
Cash Conversion Cycle = 146+130-139 = 137 days
It takes 276 days to convert inventories to cash and 137 to recover the cash paid.
Times Interest Earned = 3,000,000.00 = 3 times
1,000,000.00
The entity is only earning 3 times the interest expense. Meaning 33.33% of operating income are paid just to
cover the interest expense for the period.
Debt-equity ratio = 36,500,000.00 = 2.70

13,500,000.00
The borrowings are higher than the capital by 2.70 times.
Debt Ratio = 36,500,000.00 = 73%
50,000,000.00
Equity Ratio = 13,500,000.00 = 27%
50,000,000.00
73% of the total assets comes from debt and 27% of the total assets comes from equity.

Exercise 1: True or False
1. The purpose of financial statement analysis is not only to understand the historical
results of financial statements but also to use that information to forecast the future.
2. Liquidity ratios measure a firm’s ability to repay its obligations.
3. One of the common credit ratios is the return on capital ratio.
4. The revenue growth rate is a ratio that measures the expansion or contraction of the
business.
5. A ratio is most meaningful when the numerator and denominator are related to each
other.
6. When the times interest earned ratio is computed, the lower the result, the better
the firm’s ability to make interest payments.
7. The Market test ratio is a popular metric used to determine the relationship between
the market price of a stock and its earnings power as measured by earnings per share.
8. The only ratio that measures return on investment is the return on common equity.
9. The benchmark used in vertical analysis is the prior performance of the firm currently
undergoing analysis.
10. A firm “cannibalizes” its revenue when it adds additional store locations into an area
in which the firm already has existing stores.
11. The benchmark used in trend analysis is a given firm’s performance over a period of
time.
12. When analyzing revenue growth in trend analysis, often the analyst will not only look
at overall revenue growth rates but also at revenue growth by business segment.
13. In horizontal analysis, we compare two or more companies using financial ratios, and
we may also compare the companies’ ratios to an industry average.
14. In doing ratio analysis, we must recognize that different firms provide different levels
of disclosure.

1. In financial analysis, ratios are used to help us learn about the firm’s:
a. profitability
b. growth and potential for growth
c. resource needs
d. All of the above answers are correct.
2. A ratio that is used to evaluate a firm’s operating margin percentage is classified as:
a. specialty ratio
b. investment ratio
c. credit ratio
d. operating margin ratio
3. The only ratio that uses the cost of sales in its numerator is the:
a. market-to-book ratio
b. quick ratio
c. inventory turnover ratio
d. days payables outstanding ratio
4. The inventory turnover ratio, varies greatly by industry. An example of a business with a
high inventory turnover ratio is a:
a. watch repair shop
b. grocery store
c. jewelry retailer
d. CPA firm
5. To help determine whether a business should extend credit to various other businesses,
an analyst will look at liquidity ratios. The ratio that measures the speed with which the
firm can pay its obligations with cash, cash equivalents, and short-term investments is
known as the:
a. days payables outstanding ratio

b. debt to capital ratio
c. current ratio
d. quick ratio
6. The denominator in the debt to equity ratio consists of:

a. debt, minority interest, and equity
b. the total obligations of the firm
c. the total equity of the firm
d. net income, common and preferred stock, and retained earnings
7. Investors and managers use the price-earnings and dividend-yield ratios to:
a. primarily measure business performance
b. primarily screen potential investments
c. measure business performance and screen potential investments
d. track the efficiency of leverage in capital spending in both foreign and domestic
markets
8. A ratio has little meaning until it is compared to a benchmark. Financial analysts use
several common benchmarks to help them better understand and interpret financial
ratios. The benchmark in which ratios from several different companies or an industry
segment are analyzed is known as a:
a. vertical analysis
b. trend analysis
c. horizontal analysis
d. cause-of-action analysis
9. A thorough financial analysis includes any adjustments to the financial statements that
are necessary to develop useful forecasts. Such forecasts are used in the analyst’s
valuation work. An example of an adjustment made to understand a business more
completely for purposes of valuation is to:
a. change financial statement items even though such adjustment may not be per GAAP
b. change financial statement items that may incorporate accounting policies different than
that of the firm
c. exclude a financial statement item such as partnership income
d. All of the answers above are correct.
10. An analyst can restate each item on an income statement as a percentage of revenues.
This will afford the analyst an opportunity to factor out size differences among
statements of various firms. What is this restatement known as and with which method
can it be used?
a. change of accounting principle restatement; cross-sectional analysis only
b. change of accounting principle restatement; trend or cross-sectional analysis
c. common-size income statement; trend or cross-sectional analysis
d. common-size income statement; trend analysis only
11. Identify the ratio that cannot be computed given the following information for a firm:
Current assets are P475,806; current liabilities are P257,814; cash is P89,774; earnings
before interest and taxes is P72,005; short-term investments, P145,850; equity,
P192,615; minority interest, P0; interest expense, P47,899.
a. current
b. quick
c. debt to equity
d. times interest earned
12. Identify the ratio that can be computed given the following information for a firm:
Current assets are P475,806; current liabilities are P257,814; cash is P89,774; earnings
before taxes is P72,005; short-term investments, P145,850; equity at end of period,
P192,615; minority interest, P0; income taxes, P11,211; interest expense, P47,899.
a. return on capital
b. effective income tax rate
c. gross margin percentage
d. inventory turnover
13. Identify the ratio that cannot be computed given the following information for a firm:
earnings per share, P3.57; market price of the firm’s stock, P47.75; average common
equity, P879,550; net income, P99,772; average total capital, P625,740; aftertax interest
expense, P14,885.
a. price-earnings
b. dividend pay-out ratio
c. return on common equity
d. return on capital
14. A firm has the following growth rates for the last four years: 2000, 39.8%; 2001, 34.2%;
2002, 28.4%; 2003, 29.1%. From a standpoint of trend analysis, what conclusion might
an analyst reach regarding the firm’s revenue growth?
a. The trend analysis indicates the firm has had flat revenue growth over time.
b. The trend analysis indicates the firm has had diminished revenue growth over time.
c. The trend analysis indicates the firm has had moderately increasing revenue growth over
time.
d. The trend analysis indicates the firm has had significant, but slowing, revenue growth
over time.
15. A firm has the following operating income rates for the last four years: 2000, 9.0%; 2001,
8.9%; 2002, 9.1%; 2003, 8.8%. From a standpoint of trend analysis, what conclusion
might an analyst reach regarding the firm’s revenue growth?
a. The trend analysis indicates the firm’s operating income has been flat over time.
b. The trend analysis indicates the firm’s operating income has materially declined over
time and is cause for investor concern.
c. The trend analysis indicates the firm’s operating income has been increasing at a fiscally
healthy rate over time.
d. The conclusion is indeterminable from the information given.
16. There are two key ratios that measure profitability. The numerator for the __________
ratio uses operating income while the __________ ratio uses revenues less cost of goods
sold in its computation.
a. gross margin percentage; operating margin percentage
b. operating margin percentage; gross margin percentage
c. quick; operating margin percentage
d. current; gross margin percentage
17. The analyst must exercise caution when using ratios as part of the analysis of a firm. The
fact that ratios often vary across industries is an example of what is called:
a. an accounting method discrepancy
b. an industry and business difference
c. a business environment change
d. an ambiguous ratio definition
18. Select the answer that best fits this statement, “Analysts define ratios differently.”
a. What some analysts call trend analysis others call cross-sectional analysis.
b. What some analysts call the current ratio is called the quick ratio by others.
c. The numerator used in the return on capital ratio may vary.
d. The income statement is restated in non-GAAP terms.
19. Ratios often aid analysts to project the future. Such projections require the adjustment
of certain items found on the financial statements. One such item that should be
adjusted in such a projection is:
a. removing an extraordinary item from the income statement
b. removing revenue from the income statement
c. the earnings-per-share calculation when there are no dilutive or anti-dilutive items
d. the reconciliation of cash on the balance sheet

Problems
1. Following are data about Blite Company
Average total assets P150,000
Average owner’s equity 60,000
Net income after interest but before tax 10,000
Bonds payable, 8% 50,000
Income tax rate 35%
Calculate the following ratios.
1. Times interest earned
2. Return on equity
3. Return on assets
4. Basic earnings power ratio
2. Below are data about Loi Merchandising Company:

Sales P500,000
Cost of goods sold 200,000
Average inventory 20,000
Average receivable 30,000
Compute the following:
a. Inventory turnover
b. Receivable turnover
c. Average age of accounts receivable
d. Average age of inventory
e. Operating cycle
3. Estrada Inc. is concerned about the level of its advertising and office salaries
expense.
Selected statement of comprehensive income data from 2016 – 2018 appear below:
2018 2017 2016
Sales P140,000 P60,000 P37,500
Gross Profit 89,600 37,200 22,500
Advertising Expense 7,000 3,300 2,250
Office Salaries 22,400 9,000 4,500
Profit 30,800 13,800 9,000
4. The following information was taken from the statement of financial position of
Blanche Corporation:
Cash P13,250
Accounts Receivable (net) 33,000
Merchandise Inventory 40,000
Prepaid Expenses 9,950
Accounts Payable 25,200
Accrued Payables 1,800
Notes Payable (due in 6 months) 10,000
Calculate the working capital, current ratio and quick ratio

5. The following data are available from Gumban’s annual report:
Beginning Merchandise Inventory P 245,000
Ending Merchandise Inventory 375,000
Beginning Accounts Receivable 250,000
Ending Accounts Receivable 297,000
Cost of Goods Sold 2,480,000
Cash Sales 1,000,000
Total Sales 5,100,000
Gumban’s Credit Terms Net 30 days
Required:
1. Calculate inventory turnover and accounts receivable turnover
2. In your opinion, is Gumban doing a good job in receivables? Explain.
Horizontal analysis
6. Kline Corporation had net income of P2 million in 2016. Using the 2016 financial
elements as the base data, net income decreased by 70 percent in 2017 and increased by
175 percent in 2018. The respective net income reported by Kline Corporation for 2017 and
2018 are:
A. P 600,000 and P5,500,000 C. P1,400,000 and P3,500,000
B. P5,500,000 and P 600,000 D. P1,400,000 and P5,500,000
7. Assume that Axle Inc. reported a net loss of P50,000 in 2016 and net income of P250,000
in 2017. The increase in net income of P300,000:
A. can be stated as 0% C. cannot be stated as a percentage
B. can be stated as 100% increase D. can be stated as 200% increase
Liquidity ratios
8. The following financial data have been taken from the records of Ratio Company:
Accounts receivable P200,000
Accounts payable 80,000
Bonds payable, due in 10 years 500,000
Cash 100,000
Interest payable, due in three months 25,000
Inventory 440,000
Land 800,000
Notes payable, due in six months 250,000
What will happen to the ratios below if Ratio Company uses cash to pay 50 percent of
its accounts payable?
A. B. C. D.
Current Increase Decrease Increase Decrease
ratio
Acid-test Increase Decrease Decrease Increase
ratio

Question Nos. 9 through 11 are based on the data taken from the balance sheet of Nomad
Company at the end of the current year:
Accounts payable P145,000
Accounts receivable 110,000
Accrued liabilities 4,000
Cash 80,000
Income tax payable 10,000
Inventory 140,000
Marketable securities 250,000
Notes payable, short-term 85,000
Prepaid expenses 15,000
9. The amount of working capital for the company is:

A. P351,000 C. P211,000
B. P361,000 D. P336,000
10. The company’s current ratio as of the balance sheet date is:
A. 2.67:1 C. 2.02:1
B. 2.44:1 D. 1.95:1
11. The company’s acid-test ratio as of the balance sheet date is:
A. 1.80:1 C. 2.02:1
B. 2.40:1 D. 1.76:1
Activity ratios
Receivables turnover
12. Pine Hardware Store had net credit sales of P6,500,000 and cost of goods sold of
P5,000,000 for the year. The Accounts Receivable balances at the beginning and end of the
year were P600,000 and P700,000, respectively. The receivables turnover was
A. 7.7 times. C. 9.3 times.
B. 10.8 times. D. 10.0 times.
13. Milward Corporation’s books disclosed the following information for the year ended
December 31, 2017:
Net credit sales P1,500,000
Net cash sales 240,000
Accounts receivable at beginning of year 200,000
Accounts receivable at end of year 400,000
Milward’s accounts receivable turnover is
A. 3.75 times C. 5.00 times
B. 4.35 times D. 5.80 times
Days receivable
14. Batik Clothing Store had a balance in the Accounts Receivable account of P390,000 at the
beginning of the year and a balance of P410,000 at the end of the year. The net credit sales
during the year amounted to P4,000,000. Using 360-day year, what is the average collection
period of the receivables?
A. 30 days C. 73 days
B. 65 days D. 36 days
Cash collection
15. Deity Company had sales of P30,000, increase in accounts payable of P5,000, decrease in
accounts receivable of P1,000, increase in inventories of P4,000, and depreciation expense
of P4,000. What was the cash collected from customers?
A. P31,000 C. P34,000
B. P35,000 D. P25,000
Inventory turnover
16. During 2017, Tarlac Company purchased P960,000 of inventory. The cost of goods sold
for 2017 was P900,000, and the ending inventory at December 31, 2017 was P180,000.
What was the inventory turnover for 2017?
A. 6.4 C. 5.3
B. 6.0 D. 5.0
17. Selected information from the accounting records of Petals Company is as follows:
Net sales for 2017 P900,000
Cost of goods sold for 2017 600,000
Inventory at December 31, 2016 180,000
Inventory at December 31, 2017 156,000
Petals’ inventory turnover for 2017 is
18. The Moss Company presents the following data for 2017.
Net Sales, 2017 P3,007,124
Net Sales, 2016 P 930,247
Cost of Goods Sold, 2017 P2,000,326
Cost of Goods Sold, 2017 P1,000,120
Inventory, beginning of 2017 P 341,169
Inventory, end of 2017 P 376,526
The merchandise inventory turnover for 2017 is:
A. 5.6 C. 7.5
B. 15.6 D. 7.7
19. Based on the following data for the current year, what is the inventory turnover?
Net sales on account during year P 500,000
Cost of merchandise sold during year 330,000
Accounts receivable, beginning of year 45,000
Accounts receivable, end of year 35,000
/16
Inventory, end of year 110,000
A. 3.3 C. 3.7
B. 8.3 D. 3.0
Days inventory
20. Selected information from the accounting records of Eternity Manufacturing Company
follows:
Net sales P3,600,000
Cost of goods sold 2,400,000
Inventories at January 1 672,000
Inventories at December 31 576,000
What is the number of days’ sales in average inventories for the year?
A. 102.2 C. 87.6
B. 94.9 D. 68.1
Turnover ratios
Asset turnover
Asset
21. Net sales are P6,000,000, beginning total assets are P2,800,000, and the asset turnover
is 3.0. What is the ending total asset balance?
A. P2,000,000. C. P2,800,000.
B. P1,200,000. D. P1,600,000.
Solvency ratios
Debt ratio
22. Jordan Manufacturing reports the following capital structure:
Current liabilities P100,000
Long-term debt 400,000
Deferred income taxes 10,000
Preferred stock 80,000
Common stock 100,000
Premium on common stock 180,000
Retained earnings 170,000
What is the debt ratio?
A. 0.48 C. 0.93
B. 0.49 D. 0.96
Times interest earned

23. House of Fashion Company had the following financial statistics for 2016:
Long-term debt (average rate of interest is 8%) P400,000
Interest expense 35,000
Net income 48,000
Income tax 46,000
Operating income 107,000
What is the times interest earned for 2016?
24. Brava Company reported the following on its income statement:

Income before taxes P400,000
Income tax expense 100,000
Net income P300,000
An analysis of the income statement revealed that interest expense was P100,000. Brava
Company’s times interest earned (TIE) was
A. 5 times C. 3.5 times
B. 4 times D. 3 times
25. The balance sheet and income statement data for Candle Factory indicate the following:
Bonds payable, 10% (issued 1998 due 2022) P1,000,000
Preferred 5% stock, P100 par (no change during year) 300,000
Common stock, P50 par (no change during year) 2,000,000
Income before income tax for year 350,000
Income tax for year 80,000
Common dividends paid 50,000
Preferred dividends paid 15,000
Based on the data presented above, what is the number of times bond interest charges
were earned (round to one decimal point)?
A. 3.7 C. 4.5
B. 4.4 D. 3.5
26. The following data were abstracted from the records of Johnson Corporation for the
year:
Sales P1,800,000
Bond interest expense 60,000
Income taxes 300,000
Net income 400,000
How many times was bond interest earned?
A. 7.67 C. 12.67
B. 11.67 D. 13.67
Net income
27. The times interest earned ratio of Mikoto Company is 4.5 times. The interest expense
for the year was P20,000, and the company’s tax rate is 40%. The company’s net income
is:
A. P22,000 C. P54,000
B. P42,000 D. P66,000

Profitability Ratios
Return on Common Equity
28. Selected information for Ivano Company as of December 31 is as follows:
2016 2017
Preferred stock, 8%, par P100, P250,000 P250,000
nonconvertible, noncumulative
Common stock 600,000 800,000
Dividends paid on preferred stock for the 20,000 20,000
year
Net income for the year 120,000 240,000
Ivano’s return on common stockholders’ equity, rounded to the nearest percentage
point, for 2017 is
A. 17% C. 21%
B. 19% D. 23%
Dividend yield
29. The following information is available for Duncan Co.:
2016
Dividends per share of common stock P 1.40
Market price per share of common stock 17.50
Which of the following statements is correct?
A. The dividend yield is 8.0%, which is of interest to investors seeking an increase in
market price of their stocks.
B. The dividend yield is 8.0%, which is of special interest to investors seeking current
returns on their investments.
C. The dividend yield is 12.5%, which is of interest to bondholders.
D. The dividend yield is 8.0 times the market price, which is important in solvency
analysis.
Market Test Ratios

Market/Book value ratio
Price per share
30. What is the market price of a share of stock for a firm with 100,000 shares outstanding, a
book value of equity of P3,000,000, and a market/book ratio of 3.5?
A. P8.57 C. P85.70
B. P30.00 D. P105.00
P/E ratio
31. Orchard Company’s capital stock at December 31 consisted of the following:
 Common stock, P2 par value; 100,000 shares authorized, issued, and
outstanding.
 10% noncumulative, nonconvertible preferred stock, P100 par value; 1,000
shares authorized, issued, and outstanding.
Orchard’s common stock, which is listed on a major stock exchange, was quoted at P4
per share on December 31. Orchard’s net income for the year ended December 31 was

P50,000. The yearly preferred dividend was declared. No capital stock transactions
occurred. What was the price earnings ratio on Orchard’s common stock at December
31?
A. 6 to 1 C. 10 to 1
B. 8 to 1 D. 16 to 1
32. On December 31, 2016 and 2017, Renegade Corporation had 100,000 shares of common
stock and 50,000 shares of noncumulative and nonconvertible preferred stock issued and
outstanding.
Additional information:
Stockholders’ equity at 12/31/07 P4,500,000
Net income year ended 12/31/07 1,200,000
Dividends on preferred stock year ended 12/31/07 300,000
Market price per share of common stock at 12/31/07 144
The price-earnings ratio on common stock at December 31, 2017, was
A. 10 to 1 C. 14 to 1
B. 12 to 1 D. 16 to 1
Payout ratio
33. Selected financial data of Alexander Corporation for the year ended December 31, 2017,
is presented below:
Operating income P900,000
Interest expense (100,000)
Income before income taxes 800,000
Income tax (320,000)
Net income 480,000
Preferred stock dividend (200,000)
Net income available to common stockholders 280,000
Common stock dividends were P120,000. The payout ratio is:
A. 42.9 percent C. 25.0 percent
B. 66.7 percent D. 71.4 percent
P/E ratio & Payout ratio

Use the following information for question Nos. 33 and 34:
Terry Corporation had net income of P200,000 and paid dividends to common
stockholders of P40,000 in 2017. The weighted-average number of shares outstanding in
2017 was 50,000 shares. Terry Corporation’s common stock is selling for P60 per share in
the local stock exchange.
34. Terry Corporation’s price-earnings ratio is

B. 15 times D. 6 times
35. Terry Corporation’s payout ratio for 2017 is

A. P4 per share C. 20.0 percent
Integrated ratios
Liquidity & activity ratios
Inventory
36. The current assets of Mayon Enterprise consists of cash, accounts receivable, and
inventory. The following information is available:
Credit sales 75% of total sales
Inventory turnover 5 times
Working capital P1,120,000
Current ratio 2.00 to 1
Quick ratio 1.25 to 1
Average Collection period 42 days
Working days 360
The estimated inventory amount is:
A. 840,000 C. 720,000
B. 600,000 D. 550,000
37. The following data were obtained from the records of Salacot Company:
Current ratio (at year end) 1.5 to 1
Inventory turnover based on sales and ending inventory 15 times
Inventory turnover based on cost of goods sold and ending inventory10.5 times
Gross margin for 2017 P360,000
What was Salacot Company’s December 31, 2017 balance in the Inventory account?
A. P120,000 C. P 80,000
B. P 54,000 D. P 95,000
Net sales
38. Selected data from Mildred Company’s year-end financial statements are presented
below. The difference between average and ending inventory is immaterial.
Current ratio 2.0
Quick ratio 1.5
Current liabilities P120,000
Inventory turnover (based on cost of sales) 8 times
Gross profit margin 40%
Mildred’s net sales for the year were
A. P 800,000 C. P 480,000
B. P 672,000 D. P1,200,000
Gross margin
39. Selected information from the accounting records of the Blackwood Co. is as follows:
Net A/R at December 31, 2016 P 900,000
Net A/R at December 31, 2017 P1,000,000
Accounts receivable turnover 5 to 1
Inventories at December 31, 2016 P1,100,000
Inventories at December 31, 2017 P1,200,000
Inventory turnover 4 to 1
What was the gross margin for 2017?
A. P150,000 C. P300,000
B. P200,000 D. P400,000
Market Test Ratio

Dividend yield
40. Recto Co. has a price earnings ratio of 10, earnings per share of P2.20, and a pay out
ratio of 75%. The dividend yield is
A. 25.0% C. 7.5%
B. 22.0% D. 10.0%
41. The following were reflected from the records of Salvacion Company:
Earnings before interest and taxes P1,250,000
Interest expense 250,000
Preferred dividends 200,000
Payout ratio 40 percent
Shares outstanding throughout 2016
Preferred 20,000
Common 25,000
Income tax rate 40 percent
Price earnings ratio 5 times
The dividend yield ratio is
A. 0.50 C. 0.40
B. 0.12 D. 0.08
Comprehensive
42. The balance sheets of Magdangal Company at the end of each of the first two years of
operations indicate the following:
2017 2016
Total current assets P600,000 P560,000
Total investments 60,000 40,000
Total property, plant, and equipment 900,000 700,000
Total current liabilities 150,000 80,000
Total long-term liabilities 350,000 250,000
Preferred 9% stock, P100 par 100,000 100,000
Common stock, P10 par 600,000 600,000
Paid-in capital in excess of par-common 60,000 60,000
stock
Net income is P115,000 and interest expense is P30,000 for 2017.
What is the rate earned on total assets for 2017 (round percent to one decimal point)?
43. What is the rate earned on stockholders' equity for 2017 (round percent to one decimal
point)?

44. What is the earnings per share on common stock for 2017, (round to two decimal
places)?
A. P1.92 C. P1.77
B. P1.89 D. P1.42
Chapter 4: Time Value of Money

 To discuss the role of time value in finance, the use of computational tools, and the
basic patterns of cash flow.
 To understand the concepts of future value and present value, their calculations for
single amounts, and the relationship between them.
 To be able to find the future value and the present value of both annuity and an annuity
due, and find the present value of a perpetuity.
 To be able to calculate both the future value and the present value of a mixed stream of
cash flows.
 To understand the effect that compounding interest more frequently than annually has
on future value and on the effective annual rate of interest.
 To describe the procedures involved in (1) determining deposits needed to accumulate
a future sum, (2) loan amortization, (3) finding interest or growth rate, and (4) finding
an unknown number of periods.
A single peso today may not equivalent to a single peso in the past or in the future, the
actual value of money changes from time to time. Your money could change its value either
through investments or inflation.
Time value of money (TVM) is the idea that money that is available at the present time is
worth more than the same amount in the future, due to its potential earning capacity. This
core principle of finance holds that provided money can earn interest, any amount of money
is worth more the sooner it is received. One of the most fundamental concepts in finance is
that money has a time value attached to it. In simpler terms, it would be safe to say that a
dollar was worth more yesterday than today and a dollar today is worth more than a dollar
tomorrow. (https://psu.instructure.com/courses/1806581/pages/introduction-what-is-time-
value-of-money)
Time Value of money involves two major concepts: future value and present value. Both
concept consider three factors (1) principal, (2) interest rate, and (3) time period.
Present value answers, if we want X how much should we invest today.

While future value answers, if we invest X today, how much will we have in the future.
General Note for the Chapter: All factors are rounded off to the 4 th decimal place, All interest is rounder off to the 2 nd
decimal place and all Amounts are rounded to the nearest whole number for uniformity, understandability and simplicity.
Simple Interest vs compounding.

Simple Interest means only the principal earns interest while compounding means that
interests also earn interest.
Using Simple interest, Interest = Principal x interest rate. While compounding interest,
Interest = Carrying Amount x interest rate. While both of them might be the same, the
principal never change but the Carrying Amount changes per interest is paid, Carrying
Amount = Principal + Interest – any payment
Example: ABC Corporation deposits P10,000 in a bank at 10 percent interest per annum,
how much will the investment be after 2 years, using a. simple interest and b. compound
interest
a. Simple interest b. Compound Interest
Year 1: Principal 10,000 Year 1: Principal 10,000
Interest (10,000 x 10%) 1,000 Interest (10,000 x 10%) 1,000
Carrying Amount 11,000 Carrying Amount 11,000
Year 2: Interest (10,000 x 10%) 1,000 Year 2: Interest (11,000 x 10%) 1,100
Periods of Compounding:
Interest maybe compounded monthly, quarterly, semi-annually or annually. Interest is not
equal for different compounding interest.
When an interest is compounded to another periods other annually, the period is multiplied
by the number of periods (2 for semi-annual, 4 for quarterly and 12 for monthly) while
interest is divided by the number of periods:
Using the same example: ABC Corporation deposits P10,000 in a bank at 10 percent interest
per annum, how much will the investment be after 2 years, using compound interest a.
compounded yearly and b. compounded semi-annually
a. Compound interest (annual) b. Compound Interest (semi-annual)

Period1: Principal 10,000 Period1: Principal 10,000
Interest (10,000 x 10%) 1,000 Interest (10,000 x 5%*) 500
Carrying Amount 10,500
Period2: Interest (10,500 x 5%) 525
Period2: Interest (11,000 x 10%) 1,100 Period3: Interest (11,025 x 5%) 551
Period4: Interest (11,576 x 5%) 579
Since it is semi-annual, Interest = 10%/2 = 5% and Period = 2 x 2 = 4 Periods.
Computation of Effective Interest:

The interest for the same rate compounded at different periods have different effective
interest rate, effective interest is the actual annual interest rate for a single year.
Formula:
Effective Interest = [(1+i)n]-1
Example: A company invest in a 12% interest rate compounded for 2 years, compute the :
a. Annually
b. Semi-Annually
c. Quarterly
d. Monthly
Annually: (1+.12)1-1 = .12 or 12%
2
Semi-Annually: (1+.06) -1 = .1236 or 12.36%
4
Quarterly: (1+.03) -1 = .1255 or 12.55%
12
Monthly: (1+.01) -1 = .1268 or 12.68%
n should only be equivalent to one year for effective interest, regardless of the given period.
Formulas in time value of money is divided into:

a. Future Value
b. Present Value
Future Value – used when determining the future value of cash.
Formula:
Single Payment:
FVf = (1+i)n
FV = FVf x PMT
Where:
FV = Future Value
FVf= Future Value Factor
i = Interest Rate
n = Number of Periods
PMT = Amount of money invested/borrowed
Using the same example: ABC Corporation deposits P10,000 in a bank at 10 percent interest
per annum, how much will the investment be after 2 years, interest is compounded semi-
annually
FVf = (1+0.05)4
= 1.2155
FV = 1.2155 x 10,000
FV = 12,155
Note on the previous example in the previous page, the carrying amount of the investment
after 2 years on semi-annual compounding is also 12,155. In the previous example, it
features the long method in solving for the future value while for this example, it features
the formula method.

Annuity: (Annuity means equal payments at fixed interval example 2,000 per year for the
next 5 years)
FVfa = [(1+i)n-1]
i
FV = FVfa x PMT
Where:
FV = Future Value
FVfa= Future Value Factor at an annuity
i = Interest Rate
Example: ABC Company will invest 2,000 per year for the next 5 years in an investment that
earns 10% per annum. How much would the investment be after 5 years?
FVfa = [(1+0.1)5-1]
0.1
= 6.1051
FV = 6.1051 x 2,000
FV = 12,210.20
Present Value – used when determining the today value of a future amount.
Formula:
Single Payment:
PVf = (1+i)-n
PV = PVf x PMT
Where:
PV = Present Value
PVf= Present Value Factor
i = Interest Rate
Example:
Using the same example as Present Value Single Payment:
ABC Corporation want to have 12,155 at the end of 2 years in a bank at 10 percent interest
per annum, how much should he invest today if the interest is compounded semi-annually.
(The answer should be 10,000 as the question in the Present Value Single Payment is only
reversed.)
PVf = (1+0.05)-4
= 0.8227
PV = 0.8227 x 12,155
= 9,999.92 or 10,000. (The difference of 0.08 is due to rounding off)

It should be noted that the Present Value and Future Value are interrelated with each other.
Hence you can use the PVf to solve for the Future Value and FVf to solve for the Present
Value.
Example:
Solving for the Future Value using the PVf:
FV = PMT
PVf
FV = 10,000
0.8227
FV = 12,155
Solving for the Present Value using the FVf:

PV = PMT
FVf
PV = 12,155
1.2155
= 10,000
Annuity: (Annuity means equal payments at fixed interval)
Present Value of an Annuity

PVfa = [1-(1+i)-n]
i
PVa = PVfa x PMT
Where:
PVa = Present Value of an Annuity
PVfa= Present Value Factor at an annuity
i = Interest Rate
Example: If you wish to receive 5,000 every year for the next 3 years, in an investment which
earns 12% interest compounded annually, how much should you invest today?
PVfa = [1-(1+0.12)-3]
0.12
= 2.4018
PV = 2.4018 x 5,000
=12,009
Checking if the answer is correct:

Using the Previous problem, the answer is you need to invest 12,009 to receive 5,000 in a
year for 3 years. To Check:
Balance of the Investment = 12,009
Interest(12,009 x 12%) 1,441
Receive 5,000 (5,000)
Interest (8,450 x 12%) 1,014
Receive 5,000 (5,000)
Interest (4464 x 12%) 536
Receive (5,000)
Carrying Amount 0
Future Value of an Annuity

FVfa = [(1+i)n-1]
i
FVa = FVfa x PMT
Where:
PVa = Future Value of an Annuity
FVfa= Future Value Factor at an annuity
i = Interest Rate
Example: If you wish to invest 5,000 every year for the next 3 years, in an investment which
earns 12% interest compounded annually, how much will you receive in the future?
FVfa = [(1+0.12)3-1]
0.12
= 3.3744
FVa = 3.3744 x 5,000
=16,872
Computation of the PVfa and FVfa using the PVf and FVf formula:
Using the Previous Problems.
ABC Company will invest 2,000 per year for the next 5 years in an investment that earns 10%
per annum. How much would the investment be after 5 years?
Using the formula FVfa = 6.1051
Another way to solve for FVfa:
1st Period = (1+0.1)4 =1.4641
2nd Period = (1+0.1)3 =1.331
3rd Period = (1+0.1)2 =1.21
4th Period = (1+0.1)1 =1.1
th
5 Period = (1+0.1)0 =1.0 _
6.1051

If you wish to receive 5,000 for the next 3 years, in an investment which earns 12% interest
compounded annually, how much should you invest today?
Using the Formula PVfa =2.4018

Another way to solve for PVfa:
1st Period = (1+0.12)-1 =0.8929
2nd Period = (1+0.12)-2 =0.7972
3rd Period = (1+0.12)-3 =0.7118
2.4019 or 2.4018 (due to rounding off)
Solving for a problem with a mix stream payment:

Mix steam = periodic payment but with different amount, example for the 1 st year 3,000 for
the 2nd year 5,000 and 3rd year 6,000.
Example: What is the present value of an investment that gives 3,000 in the 1 st year, 5,000 in
the 2nd year and 6,000 in the 3 rd year if the investment earns 12% per annum compounded
annually:
1st Period = (1+0.12)-1 =0.8929 x 3,000 = 2,679

2nd Period = (1+0.12)-2 =0.7972 x 5,000 = 3,986
3rd Period = (1+0.12)-3 =0.7118 x 6,000 = 4,271
10,936
Solving of the interest rate:
Using trial and error method is used to determine the interest rate of a problem, but what if
you are solving for the exact interest rate, including the decimal.
First, solve for the higher and lower interest rate using the trial and error
(LIRA – EA)
Interest rate = LIR +
(LIRA – HIRA)
Where: LIR = Lower Interest Rate

LIRA = Amount using the lower interest rate
EA = Exact Amount, the Amount Given
HIRA = Amount using the higher interest rate
Example: ABC Company invested 20,000 for 5 years, compounded annually, after 5 years the
amount grows to 29,048. What is the interest rate of the investment?
Using Trial and Error
LIR = 7%
HIR = 8%
Answer = 7-8%
Solve for the Exact,

(28,051– 29,048)
Interest rate = 7% +
(28,051 – 29,387)
(997)
Interest rate = 7% +
(1,336)
Interest Rate = 7% + 0.75% = 7.75%
LIRA = (1.07)5 x 20,000 = 28,051

HIRA = (1.08)5 x 20,000 = 29,387
EA = Given
Computation of period
Computation for period is just the same as the computation of interest rate.
First, solve for the higher and lower interest rate using the trial and error
(LPA – EA)
Period = LP +
(LPA – HPA)
Where: LP = Lower Period

LPA = Amount using the lower period
EA = Exact Amount, the Amount Given
HPA = Amount using the higher period
Example: ABC Company invest 20,000 in a 12% interest rate compounded annually, how
many years will it take for the investment to grow 28,950.
LP = 3 years
HP = 4 years
(28,098 – 28,950)
Period = 3 Years +
(28,098 – 31,469)
(852)
Period = 3 Years +
(3,371) Period = 3.25 Years or 3.2634 (due to adjustments)
Period = 3 Years + 0.25
Alternative Method:
Log (Future Amount/Present
Period = Amount)
Log (1+i)
Example: ABC Company invest 20,000 in a 12% interest rate compounded annually, how
many years will it take for the investment to grow 28,950.
Log (28,950/20,000)
Period =
Log (1+0.12)
Log (1.4475)
Period =
Log (1.12)
Period = 3.2634
True or False
1. The time value of money refers to the fact that a peso received today is worth less than
a peso promised at some time in the future. T
2. Interest is the excess cash received or repaid over and above the amount lent or
borrowed. T
3. Simple interest is computed on principal and on any interest earned that has not been
withdrawn. F
4. Compound interest, rather than simple interest, must be used to properly evaluate
long- term investment proposals. T
5. Compound interest uses the accumulated balance at each year end to compute
interest in the succeeding year. T
6. The future value of an ordinary annuity table is used when payments are invested at
the beginning of each period. F
7. The present value of an annuity due table is used when payments are made at the end
of each period. F
8. If the compounding period is less than one year, the annual interest rate must be
converted to the compounding period interest rate by dividing the annual rate by the
number of compounding periods per year. T
9. Present value is the value now of a future sum or sums discounted assuming
compound interest. T
10. The future value of a single sum is determined by multiplying the future value factor by
its present value. T
11. In determining present value, a company moves backward in time using a process of
accumulation. T
12. The unknown present value is always a larger amount than the known future value
because pesos received currently are worth more than pesos to be received in the
future. F
13. The rents that comprise an annuity due earn no interest during the period in which
they are originally deposited. F
14. If two annuities have the same number of rents with the same peso amount, but one is
an annuity due and one is an ordinary annuity, the future value of the annuity due will
be greater than the future value of the ordinary annuity. T
15. If two annuities have the same number of rents with the same peso amount, but one is
an annuity due and one is an ordinary annuity, the present value of the annuity due
will be greater than the present value of the ordinary annuity. T

16. The number of compounding periods will always be one less than the number of rents
when computing the future value of an ordinary annuity. F
17. The future value of an annuity due factor is found by multiplying the future value of an
ordinary annuity factor by 1 minus the interest rate. F
18. The present value of an ordinary annuity is the present value of a series of equal rents
withdrawn at equal intervals. T
19. The future value of a deferred annuity is less than the future value of an annuity not
deferred. T
20. At the date of issue, bond buyers determine the present value of the bonds’ cash flows
using the market interest rate.
Multiple Choice
21. Which of the following transactions would require the use of the present value of an
annuity due concept in order to calculate the present value of the asset obtained or
liability owed at the date of incurrence? A
a. A capital lease is entered into with the initial lease payment due upon the signing
of the lease agreement.
b. A capital lease is entered into with the initial lease payment due one month
subse-quent to the signing of the lease agreement.
c. A ten-year 8% bond is issued on January 2 with interest payable semiannually on
July 1 and January 1 yielding 7%.
d. A ten-year 8% bond is issued on January 2 with interest payable semiannually on
July 1 and January 1 yielding 9%.
22. Which of the following tables would show the smallest value for an interest rate of
5% for six periods? B
a. Future value of 1
b. Present value of 1
c. Future value of an ordinary annuity of 1
d. Present value of an ordinary annuity of 1
23. Which table would you use to determine how much you would need to have
deposited three years ago at 10% compounded annually in order to have P1,000
today? A
a. Future value of 1 or present value of 1
b. Future value of an annuity due of 1
24. Which table would you use to determine how much must be deposited now in order
to provide for 5 annual withdrawals at the beginning of each year, starting one year
hence? A
a. Future value of an ordinary annuity of 1
b. Future value of an annuity due of 1
c. Present value of an annuity due of 1
d. None of these
25. Which table has a factor of 1.00000 for 1 period at every interest rate? C
b. Present value of 1
26. Which table would show the largest factor for an interest rate of 8% for five periods?
C
b. Present value of an ordinary annuity of 1
c. Future value of an annuity due of 1
d. Present value of an annuity due of 1
27. Which of the following tables would show the smallest factor for an interest rate of
10% for six periods? B
b. Present value of an ordinary annuity of 1
c. Future value of an annuity due of 1
d. Present value of an annuity due of 1
28. The figure .94232 is taken from the column marked 2% and the row marked three
periods in a certain interest table. From what interest table is this figure taken? C
b. Future value of annuity of 1
c. Present value of 1
d. Present value of annuity of 1
29. Which of the following tables would show the largest value for an interest rate of
10% for 8 periods?
a. Future amount of 1 table.
b. Present value of 1 table.
c. Future amount of an ordinary annuity of 1 table.
d. Present value of an ordinary annuity of 1 table.
30. On June 1, 2006, Walsh Company sold some equipment to Fischer Company. The
two companies entered into an installment sales contract at a rate of 8%. The
contract required 8 equal annual payments with the first payment due on June 1,
2006. What type of compound interest table is appropriate for this situation? A
a. Present value of an annuity due of 1 table.
b. Present value of an ordinary annuity of 1 table.
c. Future amount of an ordinary annuity of 1 table.
d. Future amount of 1 table.
31. Which of the following transactions would best use the present value of an annuity
due of 1 table? A
a. Diamond Bar, Inc. rents a truck for 5 years with annual rental payments of
P20,000 to be made at the beginning of each year.
b. Michener Co. rents a warehouse for 7 years with annual rental payments of
P120,000 to be made at the end of each year.
c. Durant, Inc. borrows P20,000 and has agreed to pay back the principal plus
interest in three years.
d. Babbitt, Inc. wants to deposit a lump sum to accumulate P50,000 for the
construction of a new parking lot in 4 years.
32. A series of equal receipts at equal intervals of time when each receipt is received at
the beginning of each time period is called an
a. ordinary annuity.
b. annuity in arrears.
c. annuity due.

d. unearned receipt.
33. In the time diagram below, which concept is being depicted?
0 1 2 3 4
P1 P1 P1 P1
PV
a. Present value of an ordinary annuity

b. Present value of an annuity due
c. Future value of an ordinary annuity
d. Future value of an annuity due
34. On December 1, 2007, Michael Hess Company sold some machinery to Shawn Keling
Company. The two companies entered into an installment sales contract at a
predetermined interest rate. The contract required four equal annual payments with
the first payment due on December 1, 2007, the date of the sale. What present value
concept is appropriate for this situation?
a. Future amount of an annuity of 1 for four periods
b. Future amount of 1 for four periods
c. Present value of an ordinary annuity of 1 for four periods
d. Present value of an annuity due of 1 for four periods.
35. An amount is deposited for eight years at 8%. If compounding occurs quarterly, then
the table value is found at
a. 8% for eight periods.
b. 2% for eight periods.
c. 8% for 32 periods.
d. 2% for 32 periods.
36. If the number of periods is known, the interest rate is determined by
a. dividing the future value by the present value and looking for the quotient in the
future value of 1 table.
b. dividing the future value by the present value and looking for the quotient in the
present value of 1 table.
c. dividing the present value by the future value and looking for the quotient in the
future value of 1 table.
d. multiplying the present value by the future value and looking for the product in
the present value of 1 table.
37. Present value is
a. the value now of a future amount.
b. the amount that must be invested now to produce a known future value.
c. always smaller than the future value.
d. all of these.
38. Which of the following statements is true?
a. The higher the discount rate, the higher the present value.
b. The process of accumulating interest on interest is referred to as discounting.
c. If money is worth 10% compounded annually, P1,100 due one year from today is
equivalent to P1,000 today.

d. If a single sum is due on December 31, 2010, the present value of that sum
decreases as the date draws closer to December 31, 2010.
39 If the interest rate is 10%, the factor for the future value of annuity due of 1 for n = 5,
i = 10% is equal to the factor for the future value of an ordinary annuity of 1 for n = 5,
i = 10%
a. plus 1.10.
b. minus 1.10.
c. multiplied by 1.10.
d. divided by 1.10.
40. Which of the following is true?
a. Rents occur at the beginning of each period of an ordinary annuity.
b. Rents occur at the end of each period of an annuity due.
c. Rents occur at the beginning of each period of an annuity due.
d. None of these.
41. Which statement is false?
a. The factor for the future value of an annuity due is found by multiplying the
ordinary annuity table value by one plus the interest rate.
b. The factor for the present value of an annuity due is found by multiplying the
ordinary annuity table value by one minus the interest rate.
c. The factor for the future value of an annuity due is found by subtracting 1.00000
from the ordinary annuity table value for one more period.
d. The factor for the present value of an annuity due is found by adding 1.00000 to
the ordinary annuity table value for one less period.
42. Ed Sloan wants to withdraw P20,000 (including principal) from an investment fund at
the end of each year for five years. How should he compute his required initial
investment at the beginning of the first year if the fund earns 10% compounded
annually?
a. P20,000 times the future value of a 5-year, 10% ordinary annuity of 1.
b. P20,000 divided by the future value of a 5-year, 10% ordinary annuity of 1.
c. P20,000 times the present value of a 5-year, 10% ordinary annuity of 1.
d. P20,000 divided by the present value of a 5-year, 10% ordinary annuity of 1.
43. Ann Ruth wants to invest a certain sum of money at the end of each year for five
years. The investment will earn 6% compounded annually. At the end of five years,
she will need a total of P40,000 accumulated. How should she compute her required
annual invest-ment?
a. P40,000 times the future value of a 5-year, 6% ordinary annuity of 1.
b. P40,000 divided by the future value of a 5-year, 6% ordinary annuity of 1.
c. P40,000 times the present value of a 5-year, 6% ordinary annuity of 1.
d. P40,000 divided by the present value of a 5-year, 6% ordinary annuity of 1.
44. An accountant wishes to find the present value of an annuity of P1 payable at the
beginning of each period at 10% for eight periods. The accountant has only one
present value table which shows the present value of an annuity of P1 payable at the
end of each period. To compute the present value, the accountant would use the
present value factor in the 10% column for
a. seven periods.
b. eight periods and multiply by (1 + .10).
c. eight periods.
d. nine periods and multiply by (1 – .10).

45. If an annuity due and an ordinary annuity have the same number of equal payments
and the same interest rates, then
a. the present value of the annuity due is less than the present value of the ordinary
annuity.
b. the present value of the annuity due is greater than the present value of the
ordinary annuity.
c. the future value of the annuity due is equal to the future value of the ordinary
annuity.
d. the future value of the annuity due is less than the future value of the ordinary
annuity.
46. Which of the following is false?
a. The future value of a deferred annuity is the same as the future value of an
annuity not deferred.
b. A deferred annuity is an annuity in which the rents begin after a specified number of
periods.
c. To compute the present value of a deferred annuity, we compute the present
value of an ordinary annuity of 1 for the entire period and subtract the present
value of the rents which were not received during the deferral period.
d. If the first rent is received at the end of the sixth period, it means the ordinary
annuity is deferred for six periods.

MULTIPLE CHOICE—Computational
47. If a savings account pays interest at 4% compounded quarterly, then the amount of
P1 left on deposit for 8 years would be found in a table using
a. 8 periods at 4%.
b. 8 periods at 1%.
c. 32 periods at 4%.
d. 32 periods at 1%.
Items 48 through 51 apply to the appropriate use of interest tables. Given below are the
future value factors for 1 at 8% for one to five periods. Each of the items 48 to 51 is based on
8% interest compounded annually.
Periods Future Value of 1 at 8%
1 1.080
2 1.166
3 1.260
4 1.360
5 1.469
48. What amount should be deposited in a bank account today to grow to P10,000 three
years from today?
a. P10,000 × 1.260
b. P10,000 × 1.260 × 3
c. P10,000 ÷ 1.260
d. P10,000 ÷ 1.080 × 3
49. If P3,000 is put in a savings account today, what amount will be available three years
from today?
a. P3,000 ÷ 1.260
b. P3,000 × 1.260
c. P3,000 × 1.080 × 3
d. (P3,000 × 1.080) + (P3,000 × 1.166) + (P3,000 × 1.260)
50. What amount will be in a bank account three years from now if P6,000 is invested
each year for four years with the first investment to be made today?
a. (P6,000 × 1.260) + (P6,000 × 1.166) + (P6,000 × 1.080) + P6,000
b. P6,000 × 1.360 × 4
c. (P6,000 × 1.080) + (P6,000 × 1.166) + (P6,000 × 1.260) + (P6,000 × 1.360)
d. P6,000 × 1.080 × 4
51. If P4,000 is put in a savings account today, what amount will be available six years
from now?
a. P4,000 × 1.080 × 6
b. P4,000 × 1.080 × 1.469
c. P4,000 × 1.166 × 3
d. P4,000 × 1.260 × 2
Items 52 through 55 apply to the appropriate use of present value tables. Given below are
the present value factors for P1.00 discounted at 10% for one to five periods. Each of the
items 52 to 55 is based on 10% interest compounded annually.
Present Value of P1
Periods Discounted at 10% per Period
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
52. If an individual put P4,000 in a savings account today, what amount of cash would be
available two years from today?
a. P4,000 × 0.826
b. P4,000 × 0.826 × 2
c. P4,000 ÷ 0.826
d. P4,000 ÷ 0.909 × 2
53. What is the present value today of P6,000 to be received six years from today?
a. P6,000 × 0.909 × 6
b. P6,000 × 0.751 × 2
c. P6,000 × 0.621 × 0.909
d. P6,000 × 0.683 × 3
54. What amount should be deposited in a bank today to grow to P3,000 three years
from today?
a. P3,000 ÷ 0.751
b. P3,000 × 0.909 × 3
c. (P3,000 × 0.909) + (P3,000 × 0.826) + (P3,000 × 0.751)
d. P3,000 × 0.751
55. What amount should an individual have in a bank account today before withdrawal
of P5,000 is needed each year for four years with the first withdrawal to be made
today and each subsequent withdrawal at one-year intervals? (The balance in the
bank account should be zero after the fourth withdrawal.)
a. P5,000 + (P5,000 × 0.909) + (P5,000 × 0.826) + (P5,000 × 0.751)
b. P5,000 ÷ 0.683 × 4
c. (P5,000 × 0.909) + (P5,000 × 0.826) + (P5,000 × 0.751) + (P5,000 × 0.683)
d. P5,000 ÷ 0.909 × 4
56. At the end of two years, what will be the balance in a savings account paying 6%
annually if P5,000 is deposited today? The future value of one at 6% for one period
is 1.06.
a. P5,000
b. P5,300
c. P5,600
d. P5,618
57. Windsor Company will receive P100,000 in 7 years. If the appropriate interest rate is
10%, the present value of the P100,000 receipt is
a. P51,000.
b. P51,316.
c. P151,000.
d. P194,872.

58. Sheeley Company will receive P100,000 in a future year. If the future receipt is
discounted at an interest rate of 10%, its present value is P51,316. In how many years
is the P100,000 received?
a. 5 years
b. 6 years
c. 7 years
d. 8 years
59. Jensen Company will invest P200,000 today. The investment will earn 6% for 5 years,
with no funds withdrawn. In 5 years, the amount in the investment fund is
a. P200,000.
b. P260,000.
c. P267,646.
d. P268,058.
60. Finley Company will receive P500,000 in 7 years. If the appropriate interest rate is
10%, the present value of the P500,000 receipt is
a. P255,000.
b. P256,580.
c. P755,000.
d. P974,360.
61. Swanson Company will receive P100,000 in a future year. If the future receipt is
discounted at an interest rate of 8%, its present value is P63,017. In how many years
is the P100,000 received?
a. 5 years
b. 6 years
c. 7 years
d. 8 years
62. Jasper Company will invest P300,000 today. The investment will earn 6% for 5 years,
with no funds withdrawn. In 5 years, the amount in the investment fund is
a. P300,000.
b. P390,000.
c. P401,469.
d. P402,087.
63. Quincey Corporation makes an investment today (January 1, 2006). They will receive
P10,000 every December 31st for the next six years (2006 – 2011). If Quincey wants
to earn 12% on the investment, what is the most they should invest on January 1,
2006?
a. P41,114.
b. P46,048.
c. P81,152.
d. P90,890.
64. Craig Rusch Corporation will receive P10,000 today (January 1, 2006), and also on
each January 1st for the next five years (2007 – 2011). What is the present value of
the six P10,000 receipts, assuming a 12% interest rate?
a. P41,114.
b. P46,048.
c. P81,152.
d. P90,890.

65. Schmitt Corporation will invest P10,000 every December 31st for the next six years
(2006 – 2011). If Schmitt will earn 12% on the investment, what amount will be in the
investment fund on December 31, 2011?
a. P41,114.
b. P46,048.
c. P81,152.
d. P90,890.
66. Linton Corporation will invest P10,000 every January 1st for the next six years (2006 –
2011). If Linton will earn 12% on the investment, what amount will be in the
a. P41,114
b. P46,048.
c. P81,152.
d. P90,890.
67. Gorman Corporation makes an investment today (January 1, 2006). They will receive
P20,000 every December 31st for the next six years (2006 – 2011). If Gorman wants
to earn 12% on the investment, what is the most they should invest on January 1,
2006?
a. P82,228.
b. P92,096.
c. P162,304.
d. P181,780.
68. Renfro Corporation will receive P20,000 today (January 1, 2006), and also on each
January 1st for the next five years (2007 – 2011). What is the present value of the six
P20,000 receipts, assuming a 12% interest rate.?
a. P82,228.
b. P92,096.
c. P162,304.
d. P181,780.
69. Pedigo Corporation will invest P30,000 every December 31st for the next six years
(2006 – 2011). If Pedigo will earn 12% on the investment, what amount will be in the
a. P123,342
b. P138,144.
c. P243,456.
d. P272,670.
70. Wagner Corporation will invest P25,000 every January 1st for the next six years (2006
– 2011). If Wagner will earn 12% on the investment, what amount will be in the
a. P102,785.
b. P115,120.
c. P202,880.
d. P227,225.
71. On January 1, 2007, Carly Company decided to begin accumulating a fund for asset
replacement five years later. The company plans to make five annual deposits of
P50,000 at 9% each January 1 beginning in 2007. What will be the balance in the

fund, within P10, on January 1, 2012 (one year after the last deposit)? The following
9% interest factors may be used.
Present Value of Future Value of
Ordinary Annuity Ordinary Annuity
4 periods 3.2397 4.5731
5 periods 3.8897 5.9847
6 periods 4.4859 7.5233
a. P326,166
b. P299,235
c. P272,500
d. P250,000
Use the following 8% interest factors for questions 72 through 75.

Present Value of Future Value of
Ordinary Annuity Ordinary Annuity
7 periods 5.2064 8.92280
8 periods 5.7466 10.63663
9 periods 6.2469 12.48756
72. What will be the balance on September 1, 2013 in a fund which is accumulated by
making P8,000 annual deposits each September 1 beginning in 2006, with the last
deposit being made on September 1, 2013? The fund pays interest at 8%
compounded annually.
a. P85,093
b. P71,383
c. P60,480
d. P45,973
73. If P5,000 is deposited annually starting on January 1, 2007 and it earns 8%, what will
the balance be on December 31, 2014?
a. P44,614
b. P48,183
c. P53,183
d. P57,438
74. Henson Company wishes to accumulate P300,000 by May 1, 2015 by making 8 equal
annual deposits beginning May 1, 2007 to a fund paying 8% interest compounded
annually. What is the required amount of each deposit?
a. P52,205
b. P28,204
c. P26,115
d. P30,234
75. What amount should be recorded as the cost of a machine purchased December 31,
2006, which is to be financed by making 8 annual payments of P6,000 each beginning
December 31, 2007? The applicable interest rate is 8%.
a. P42,000
b. P37,481
c. P63,820
d. P34,480
76. How much must be deposited on January 1, 2007 in a savings account paying 6%
annually in order to make annual withdrawals of P20,000 at the end of the years
2007 and 2008? The present value of one at 6% for one period is .9434.
a. P36,668
b. P37,740
c. P40,000
d. P17,800
77. How much must be invested now to receive P10,000 for 15 years if the first P10,000
is received today and the rate is 9%?
Present Value of
Periods Ordinary Annuity at 9%
14 7.78615
15 8.06069
16 8.31256
a. P80,607
b. P87,862
c. P150,000
d. P73,125
78. Foley Company financed the purchase of a machine by making payments of P18,000
at the end of each of five years. The appropriate rate of interest was 8%. The future
value of one for five periods at 8% is 1.46933. The future value of an ordinary
annuity for five periods at 8% is 5.8666. The present value of an ordinary annuity for
five periods at 8% is 3.99271. What was the cost of the machine to Foley?
a. P26,448
b. P71,869
c. P90,000
d. P105,600
79. A machine is purchased by making payments of P5,000 at the beginning of each of
the next five years. The interest rate was 10%. The future value of an ordinary
annuity of 1 for five periods is 6.10510. The present value of an ordinary annuity of 1
for five periods is 3.79079. What was the cost of the machine?
a. P33,578
b. P30,526
c. P20,849
d. P18,954
80. Catt Co. has a machine that cost P200,000. It is to be leased for 20 years with rent
received at the beginning of each year. Catt wants a return of 10%. Calculate the
amount of the annual rent.
Present Value of
Period Ordinary Annuity
19 8.36492
20 8.51356
21 8.64869
a. P21,356
b. P23,909
c. P29,728
d. P23,492

81. Find the present value of an investment in plant and equipment if it is expected to
provide annual earnings of P21,000 for 15 years and to have a resale value of
P40,000 at the end of that period. Assume a 10% rate and earnings at year end. The
present value of 1 at 10% for 15 periods is .23939. The present value of an ordinary
annuity at 10% for 15 periods is 7.60608. The future value of 1 at 10% for 15 periods
is 4.17725.
a. P159,728
b. P169,303
c. P185,276
d. P324,576
82. On January 2, 2007, Yenn Corporation wishes to issue P2,000,000 (par value) of its
8%, 10-year bonds. The bonds pay interest annually on January 1. The current yield
rate on such bonds is 10%. Using the interest factors below, compute the amount
that Yenn will realize from the sale (issuance) of the bonds.
Present value of 1 at 8% for 10 periods 0.4632
Present value of 1 at 10% for 10 periods 0.3855
Present value of an ordinary annuity at 8% for 10 periods 6.7101
Present value of an ordinary annuity at 10% for 10 periods 6.1446
a. P2,000,000
b. P1,754,136
c. P2,000,012
d. P2,212,052
83. The market price of a P200,000, ten-year, 12% (pays interest semiannually) bond
issue sold to yield an effective rate of 10% is
a. P224,578.
b. P224,925.
c. P226,654.
d. P374,472.

Chapter 5: Working Capital and Current Asset Management
Purpose of the Chapter:
 To understand short-term financial management, net working capital, and the related
tradeoff between profitability and risk.
 To describe the cash conversion cycle, its funding requirements, and the key strategies for
managing it.
 To discuss inventory management: differing views, common techniques, and international
concerns.
 To explain the credit selection process and the quantitative procedures for evaluating
changes in credit standards.
 To review the procedures for quantitatively considering cash discount changes, other
aspects of credit terms, and credit monitoring.
 To understand the management of receipts and disbursements, including float, speeding
up collections, slowing down payments, cash concentration, zero-balance accounts, and
investing in marketable securities.
The basic current assets that an entity can control is:

1. Cash
2. Accounts Receivable
3. Inventory
Although Prepaid Expenses are one of the basic current asset, it cannot be controlled as
these expenses are already paid, are only waiting to be used or for time to exhaust the
prepaid expenses.
Cash Management
Cash Conversion Cycle = Average Age of Receivable + Average Age of Inventory – Average
Age of Payables
Funding Requirements of the Cash Conversion Cycle

The activity of an entity fluctuates over time base on the nature, trend and other aspects so
the cash requirement of an entity also fluctuate over the year.
Permanent versus Seasonal Funding Needs

Permanent Funding Requirement is the constant funding requirement of the company
throughout the year. Seasonal Funding Requirement is the funding requirement that
fluctuates over time.
Aggressive versus Conservative Seasonal Funding Strategies

Short-term funds are typically less expensive than long-term funds. (The yield curve is
typically upward-sloping.) However, long-term funds allow the firm to lock in its cost of
funds over a period of time and thus avoid the risk of increases in short-term interest rates.
Also, long-term funding ensures that the required funds are available to the firm when
needed. Short-term funding exposes the firm to the risk that it may not be able to obtain the
funds needed to cover its seasonal peaks. Under an aggressive funding strategy, the firm

funds its seasonal requirements with short-term debt and its permanent requirements with
long-term debt. Under a conservative funding strategy, the firm funds both its seasonal and
its permanent requirements with long-term debt.
Example: Semper Pump Company has a permanent funding requirement of P135,000 in
operating assets and seasonal funding requirement vary between P0 and P990,000 and
average P101,250. If Semper can borrow short-term funds at 6.25% and long-term funds at
8%, and if it can earn 5% on the investment of any surplus balances, then the annual cost of
an aggressive strategy for seasonal funding will be:
Aggressive strategy:
Cost of short-term financing (6.25% x 101,250) = P 6,328.13
+Cost of long-term financing (8% x 135,000) = 10,800.00
-Earning on surplus balances (5% x 0) = 0
Total cost of aggressive strategy P17,128.13
Conservative strategy:
Cost of short-term financing (6.25% x 0) = 0
+Cost of long-term financing (8% x 1,125,000) = P90,000.00
-Earning on surplus balances (5% x 888,750) = 44,437.50
Total cost of aggressive strategy 45,562.50
The aggressive strategy has lower cost but has high risk, for example at some point the
company actually needs 1,125,000 (the highest possible funding requirement, 135,000
+1,125,000) but the aggressive strategy only can finance up to 236,250 (101,250 +135,000).
The company would suffer loss of sales, freezing of operations and etc.
Conservative strategy removes the risk from lack of funds by borrowing the highest possible
amount, the company, at an average, would then incur excess of funds which they can invest
for a 5% return, in the problem the excess fund is 888,750 which is computed 1,125,000 –
101,250 – 135,000
Strategies for Managing the Cash Conversion Cycle
The goal of a company is to minimize the length of cash conversion cycle, which minimizes
negotiated liabilities. This goal can be realized through application of the following
strategies:
1. Turn over inventory as quickly as possible without stockouts that result in lost sales
2. Collect accounts receivable as quickly as possible without losing sales from high-
pressure collection techniques
3. Manage mail, processing, and clearing time to reduce them when collecting from
customers and to increase them when paying suppliers
4. Pay accounts payable as slowly as possible without damaging the firm’s credit rating

Managing Receivables
Receivable management involves decisions made by the management to net income:

1. Offer credit sales to customers or stop selling to customers on credit
2. Increase/decrease credit period, discount period or discount rate
3. Increase/decrease the number of collecting officer or salaries of the collecting officer
When deciding the net benefit of the decision is computed:

Increase in net sales XXX
+ cost savings from reduced investment in accounts receivable1 XXX
+ decrease in expenses due to the decision XXX
- opportunity cost of money tied up to accounts receivable1 XXX
- lost sales XXX
- increase in expenses due to the decision XXX
Net Benefit or loss XXX
1
Cost Savings/Opportunity cost = Increase/Decrease in Accounts Receivable x opportunity
cost/rate of return)
Cost Savings if the Accounts Receivable Increases while Opportunity cost if it increases
Example: Max Company has an average collection period of 40 days (turnover = 360/40 = 9).
In accordance with the firm’s credit terms of the net 30, this period is divided into 32 days
until the customers place their payments in the mail and 8 days to receive, process, and
collect payment once they are mailed. Max is considering initiating a cash discount by
changing its credit terms from net 30 to 2/10 net 30. The firm expects this change to reduce
the amount of time until the payment are placed in the maid, resulting in an average
collection period of 25 days (turnover = 360/25 = 14.4), Max normally sold 1,100 units but
the discount will result in an increase of sale by 50, the selling price is 3,000 while the
variable cost is 2,300. It is estimated that 80% of the customers with avail the discount. If the
opportunity cost is 14%. What is the net advantage/disadvantage of the decision
Additional profit on sales [50 x (3,000-2300)] P35,000
Cost of marginal investment in AR:
Average AR before the decision
(2,300 x 1,100)
9 P281,111
Average investment with proposed cash discount
(2,300 x 1,150)
14.4 183,681
Reduction in Accounts Receivable Investment P97,430
Cost saving (0.14 x 97,430) 13,640
Cost of Cash Discount (0.02 x 0.80 x 1,150 x 3,000) (55,200)
Net profit from initiation of proposed cash discount ( 6.640)
Note: 2,300 is the actual investment in AR, which is the variable costs.

Managing Receipts and Disbursements
Average collection period has two parts:

1. The time from sale until the customer mails the payment
2. The receipt, processing, and collection time
Average payment period also has two parts:
1. The time from purchase of goods on account until the firm mails its payment
2. The receipt, processing, and collection time required by the firm’s suppliers.
Float refers to funds that has been set by the payer but are not yet usable funds to the
payee. Float is important n the cash conversion cycle because its presence lengthens
both the firm’s average collection period and average payment period. However, the goal
of the firm should be to shorten its average collection period and lengthen its average
payment period. Both can be accomplished by managing float.
Float has three component parts:

1. Mail float is the time delay between when payment is placed in the main and when it
is received
2. Processing float is the time between receipt of the payment and its deposit into the
firm’s account
3. Clearing float is the time between deposit of the payment and when spendable funds
become available to the firm. The component of float is attributable to the time
required from a check to clear the banking system
Possible techniques are:

1. Speeding up collections
2. Slowing down payments
3. Cash Concentration
4. Zero-Balance Accounts
The net benefit/loss is computed:

Decrease in Collection period x Average daily collections XXX
+Increase in Payment period x Average daily payments XXX
Total XXX
x Opportunity Cost/Rate of Return XXX
Benefit XXX
- Additional Expenses XXX
Net Benefit/Loss XXX

Managing Inventory
Common techniques for Managing Inventory:

1. The ABC System
ABC Inventory System divides the inventory into three categories: A, B, and C. The
group A includes the item with the largest peso investment these are the most
expensive and most important inventory, The group B consist of items that are less
expensive and less important than B, and the group C consist of the least expensive
and least important inventories. The company would then implement controls based
on the category, example category A is tracked down using the perpetual inventory
system, has higher security and etc. Group B, is tracked down using the periodic
inventory and so on.
2. Just in Time (JIT) System
JIT is used to minimize inventory investment. JIT means that materials should arrive
at exactly the time they are needed for production, because ideally no inventory is
kept by the company it has the following advantage, No/Low storage/security cost,
No/Low spoilage/breakerage/shrinkage, No/Low money tied to inventory. The JIT
system requires at least two supplier close to the vicinity of the company and an
expert to strategically measures when to order inventories.
3. The Economic Order Quantity (EOQ) Model
One of the most common techniques for determining the optimal order size for
inventory items is the economic order quantity (EOQ) mode. The EOQ model
considers various costs of inventor and then determines what order size minimizes
total inventory cost.
EOQ assumes that the relevant costs of inventory can be divided into order costs and
carrying costs. (The model excludes the actual cost of the inventory item, because it
is uncontrollable) Each of them has certain key components and characteristics.
Order costs include the fixed clerical costs of placing and receiving orders: the cost of
writing a purchase order, of processing the resulting paperwork, and of receiving an
order and checking it against the invoice. Order costs are stated in pesos per order.
Carrying costs include storage costs, insurance costs, the costs of deterioration and
obsolescence, and the opportunity or financial cost of having funds invested in
inventory. These costs are stated in pesos per unit per period.
Order costs decreases as the size of the order increases. Carrying costs, however,
increase with increase in the order size. The EOQ model analyses the tradeoff
between order costs and carrying costs to determine the order quantity that
minimizes the total inventory costs.
Order Cost = Cost per order x (Total Quantity Needed/Order Size)

Carrying Amount = Carrying cost per unit x (Order Size/2)
Because the EOQ is defined as the order quantity that minimizes the total cost function, we
must solve the total cost function for the EOQ. The resulting equation is:

EOQ = 2 x N x O
C
Although the EOQ model has weaknesses, it is certainly better than subjective decision
making. Despite the fact that the use of the EOQ model is outside the control of the financial
manager, the financial manager must be aware of its utility and must provide certain inputs,
specifically with respect to inventory carrying costs.
Reorder Point
Once the firm has determine its economic order quantity, it must determine when to place
an order. The order point reflects the firm’s daily usage of the inventory item and the
number of days needed to place and receive an order. Assuming that inventory is used at a
constant rate, the formula for the reorder point is
Reorder point = Maximum lead time x Daily usage
Lead time is number of days until the ordered inventory is receive. Safety stock is sometimes
kept as an extra inventory.
Safety stock = (Maximum Lead time – Normal Lead time) x Daily usage
Example: MAX Company has an A group inventory item that is vital to the production
process. This item costs P1,500, and Max uses 1,200 units of the item per year. MAX wants
to determine its optima order strategy for the item. To calculate EOQ, we need the following
inputs:
Cost per order = P150
Carrying cost per unit = P100
EOQ = 2 x 1,200 x 150

100
EOQ = 60 units
Total Order Cost = 1,200/60 x 150 = 3,000

Total Carrying Cost = 60/2 x 100 = 3,000
At EOQ, Total Order Cost = Total Carrying Cost
The reorder point for MAX depends on the number of days MAX operates per year.
Assuming that MAX operates 250 per year and uses 1,200 units this item, its daily usage is
4.8/units (1200/250). If the normal lead time is 2 days and the maximum lead time is 4 days.
The reorder point is (4.8 x 4) = 19.2 units or 19 units. It means that orders are made when
the inventory falls 19 units. And the safety stocks is (4.8 x 2) = 9.6 units or 10 units.

1. Working capital management is mainly concerned with:
a. the placement of the firm's debt and equity issues
b. the financing and management of the firm's current assets
c. inventory management
d. management of the firm's capital assets
2. The key to current asset planning is:
a. ensuring that the firm remains current on its obligation
b. maintaining an inventory surplus to ensure liquidity
c. forecasting sales accurately and matching production with the forecast
d. maintaining the proper rate of asset growth
3. In most firms:
a. capital assets grow at a constant rate
b. the rate of growth for fixed and current assets remains constant
c. there is no relationship between the growth rates for fixed and current assets
d. capital assets grow slowly, while current assets fluctuate
4. Level production methods tend to:
a. use manpower and equipment efficiently at a lower cost
b. be more difficult to manage than those matching sales and productions
c. result in a more stable value for current assets
d. eliminate seasonal bulges or reductions in current assets
5. Most retail stores are mainly concerned with:
a. their buyers' forecasts for the coming season
b. matching sales and inventory levels
c. decreasing inventory turnover
d. their investment in capital assets
6. The cash conversion cycle equals:
a. inventory period + collection period - payables period
b. payables period - inventory period - collection period
c. payables period + inventory period - collection period
d. inventory period - collection period + payables period
7. Which of the following would not be important in examining the firm's build-up of
accounts receivable/cash/current assets:
a. sales forecast
b. cash receipts and cash payments schedules
c. income statement
d. a brief cash budget
8. The belief that current assets should always be financed by current liabilities:
a. is sound financial practice and should always be followed
b. doesn't necessarily hold true
c. is grounded in the belief that a permanent building of current assets occurs

1. Working capital management involves investment and financing decisions related to:
A. plant and equipment and current liabilities.
B. current assets and capital structure.
C. current assets and current liabilities.
D. sales and credit.
2. The goal of managing working capital, such as inventory, should be to minimize the:
A. costs of carrying inventory
B. opportunity cost of capital
C. aggregate of carrying and shortage costs
D. amount of spoilage or pilferage
3. Zap Company follows an aggressive financing policy in its working capital management
while Zing Corporation follows a conservative financing policy. Which one of the
following statements is correct?
A. Zap has low ratio of short-term debt to total debt while Zing has a high ratio of
short-term debt to total debt.
B. Zap has a low current ratio while Zing has a high current ratio.
C. Zap has less liquidity risk while Zing has more liquidity risk.
D. Zap finances short-term assets with long-term debt while Zing finances short-term
assets with short-term debt.
4. Which of the following would increase risk?

A. Raise the level of working capital.
B. Decrease the amount of inventory by formulating an effective inventory policy.
C. Increase the amount of short-term borrowing.
D. Increase the amount of equity financing.
5. As a company becomes more conservative with respect to working capital policy, it

would tend to have a(n)
A. Increase in the ratio of current liabilities to noncurrent liabilities.
B. Increase in the operating cycle.
C. Decrease in the operating cycle.
D. Increase in the ratio of current assets to current liabilities.
6. Short-term financing plans with high liquidity have:

A. high return and high risk
B. moderate return and moderate risk
C. low profit and low risk
D. none of the above
7. Temporary working capital supports

A. the cash needs of the company. C. acquisition of capital equipment.
B. payment of long term debt. D. seasonal peaks.
8. The transaction motive for holding cash is for:

A. a safety cushion C. compensating balance requirements

B. daily operating requirements D. none of the above
8. The difference between the cash balance on the firm's books and the balance shown on
the bank statement is called:
A, the compensating balance C. a safety cushion
B. float D. none of the above
9. The length of time between payment for inventory and the collection of cash is referred
to as:
A. payables deferral period C. operating cycle
B. receivables conversion period D. cash conversion cycle
10. As a firm's cash conversion cycle increases, the firm:

A. becomes less profitable
B. increases its investment in working capital
C. reduces its accounts payable period
D. incurs more shortage costs
11. The longer the firm's accounts payable period, the:

A. longer the firm's cash conversion cycle is.
B. shorter the firm's inventory period is.
C. more the delay in the accounts receivable period.
D. less the firm must invest in working capital.
12. The average length of time a peso is tied up in current asset is called the:
A. net working capital. C. receivables conversion period.
B. inventory conversion period. D. cash conversion period.
13. All of these factors are used in credit policy administration except:
A. credit standards C. peso amount of receivables
B. terms of trade D. collection policy
14. Which of the following statements is most correct? If a company lowers its DSO, but no
changes occur in sales or operating costs, then:
A. the company might well end up with a higher debt ratio.
B. the company might well end up with a lower debt ratio.
C. the company would probably end up with a higher ROE.
D. the company's total asset turnover ratio would probably decline.
15. All but which of the following is considered in determining credit policy?
A. Credit standards C. Accounts payable deferral period
B. Credit limits D. Collection efforts
16. The use of safety stock by a firm will:

A. reduce inventory costs C. have no effect on inventory costs
B. increase inventory costs D. none of the above

18. When a specified level of safety stock is carried for an item in inventory, the average
inventory level for that item
A. decreases by the amount of the safety stock.
B. is one-half the level of the safety stock.
C. Increases by one-half the amount of the safety stock.
D. Increases by the number of units of the safety stock.
19. Which of the following statements is correct for a firm that currently has total costs of
carrying and ordering inventory that are 50% higher than total carrying costs?
A. Current order size is greater than optimal
B. Current order size is less than optimal
C. Per unit carrying costs are too high
D. The optimal order size is currently being used
20. With credit terms of 3/8, n/30, what is the customer’s payment decision date?
A. Three days after the invoice is received.
B. The 8th day is the customer’s decision date.
C. Anytime during the period, 8th to the 30th.
D. The 30th day is the primary decision date.
PROBLEMS
21.Casie Company turns out 200 calculators a day at a cost of P250 per calculator for
materials and variable conversion cost. It takes the firm 18 days to convert raw materials
into calculator. Casie’s usual credit terms extended to its customers is 30 days, and the
firm generally pays its suppliers in 20 days.
If the foregoing cycles are constant, what amount of working capital must Casie
Company finance?
A. P1,400,000 C. P 900,000
B. P2,400,000 D. P1,800,000
Cash conversion cycle

22. Luke Company has an inventory conversion period of 60 days, a receivables conversion
period of 45 days, and a payments cycle of 30 days. What is the length of the firm’s cash
conversion cycle?
23. The Spades Company has an inventory conversion period of 75 days, a receivables
conversion period of 38 days, and a payable payment period of 30 days. What is the length
of the firm’s cash conversion cycle?
24. Samaritan Supplies, Inc. has P5 million in inventory and P2 million in accounts receivable.
Its average daily sales are P100,000. The company has P1.5 million in accounts payable. Its
average daily purchases are P50,000. What is the length of the company’s cash conversion
period?
Days inventory
25. What is the inventory period for a firm with an annual cost of goods sold of P8 million,
P1.5 million in average inventory, and a cash conversion cycle of 75 days?
A. 6.56 days C. 52.60 days
B. 18.75 days D. 67.50 days
26. Samaritan Supplies, Inc. has P5 million in inventory and P2 million in accounts receivable.
Its average daily sales are P100,000. The company has P1.5 million in accounts payable. Its
average daily purchases are P50,000. What is the length of the company’s inventory
conversion period?
Cash management
Economic conversion quantity (ECQ)
27. Simile Inc. has a total annual cash requirement of P9,075,000 which are to be paid
uniformly. Simile has the opportunity to invest the money at 24% per annum. The
company spends, on the average, P40 for every cash conversion to marketable securities.
What is the optimal cash conversion size?
A. P60,000 C. P45,000
B. P55,000 D. P72,500
Opportunity cost
28. Hyperbole Corporation estimates its total annual cash disbursements of P3,251,250
which are to be paid uniformly. Hyperbole has the opportunity to invest the money at 9%
per annum. The company spends, on the average, P25 for every cash conversion to
marketable securities and vice versa.
What is the opportunity cost of keeping cash in the bank account?
A. P3,825.00 C. P4,190.00
B. P1,912.50 D. P 188.55
Annual savings
29. What are the expected annual savings from a lock-box system that collects 150 checks
per day averaging P500 each, and reduces mailing and processing times by 2.5 and 1.5 days
respectively, if the annual interest rate is 7%?
A. P 5,250 C. P 21,000
B. P 13,125 D. P300,000
Receivables management
Carrying cost
30. The Camp Company has an inventory conversion period of 60 days, a receivable
conversion period of 30 days, and a payable payment period of 45 days. The Camp’s
variable cost ratio is 60 percent and annual fixed costs of P600,000. The current cost of
capital for Camp is 12%.
If Camp’s annual sales are P3,375,000 and all sales are on credit, what is the firm’s
carrying cost on accounts receivable, using 360 days year?
A. P281,250 C. P 20,250
B. P168,750 D. P 56,250
Average receivables
31. Caja Company sells on terms 3/10, net 30. Total sales for the year are P900,000. Forty
percent of the customers pay on the tenth day and take discounts; the other 60 percent
pay, on average, 45 days after their purchases.
What is the average amount of receivables?
A. P70,000 C. P77,200
B. P77,500 D. P67,500
32. Palm Company’s budgeted sales for the coming year are P40,500,000 of which 80% are
expected to be credit sales at terms of n/30. Palm estimates that a proposed relaxation of
credit standards will increase credit sales by 20% and increase the average collection
period from 30 days to 40 days. Based on a 360-day year, the proposed relaxation of credit
to standards will result in an expected increase in the average accounts receivable balance
of
A. P 540,000 C. P2,700,000
B. P 900,000 D. P1,620,000
Investment in receivables
33. Currently, La Carlota Company has annual sales of P2,500,000. Its average collection
period is 45 days, and bad debts are 3 percent of sales. The credit and collection manager
is considering instituting a stricter collection policy, whereby bad debts would be reduced
to 1.5 percent of total sales, and the average collection period would fall to 30 days.
However, sales would also fall by an estimated P300,000 annually. Variable costs are 75
percent of sales and the cost of carrying receivables is 10 percent. Assume a tax rate of 40
percent and 360 days per year.
What would be the decrease in investment in receivables if the change were made?
A. P 9,688 C. P 96,875
B. P 12,988 D. P129,975
Comprehensive
Question Nos. 34 through 36 are based on the following data:
Sonata Company is considering changing its credit terms from 2/15, net 30 to 3/10, net 30
in order to speed collections. At present, 40 percent of Sonata Company‘s customers take
the 2 percent discount. Under the new term, discount customers are expected to rise to
50 percent. Regardless of the credit terms, half of the customers who do not take the
discount are expected to pay on time, whereas the remainder will pay 10 days late. The
change does not involve a relaxation of credit standards; therefore bad debt losses are not
expected to rise above their present 2 percent level. However, the more generous cash

discount terms are expected to increase sales from P2 million to P2.6 million per year.
Sonata Company’s variable cost ratio is 75 percent, the interest rate on funds invested in
accounts receivable is 9 percent, and the firm’s income tax rate is 40 percent.
34. What are the days sales outstanding (DSO) before and after the change of credit
policy?
A. 27.0 days and 22.5 days, respectively C. 22.5 days and 21.5 days, respectively
B. 22.5 days and 27.0 days, respectively D. 21.5 days and 22.5 days respectively
35. The incremental carrying cost on receivable is

A. P 843.75 C. P 643.75
B. P8,889.00 D. P6,667.00
36. The incremental after tax profit from the change in credit terms is
A. P68,493 C. P60,615
B. P65,640 D. P57,615
Inventory management
EOQ
37. What is the economic order quantity for the following inventory policy: A firm sells
32,000 bags of premium sugar per year. The cost per order is P200 and the firm experiences
a carrying cost of P0.80 per bag.
A. 2,000 bags C. 8,000 bags
B. 4,000 bags D. 16,000 bags
Annual demand
38. Marsman Co. has determined the following for a given year:
Economic order quantity (standard order size) 5,000 units
Total cost to place purchase orders for the year P40,000
Cost to place one purchase order P 100
Cost to carry one unit for one year P 4
What is Marsman’s estimated annual usage in units?
A. 1,000,000 C. 500,000
B. 2,000,000 D. 1,500,000
Required annual return on investment

39. BIBO Company is a distributor of videotapes. Pirate Mart is a local retail outlet which
sells blank and recorded videos. Pirate Mart purchases tapes from BIBO Company at
P300.00 per tape; tapes are shipped in packages of 20. BIBO Company pays all incoming
freight, and Pirate Mart does not inspect the tapes due to BIBO Company's reputation for
high quality. Annual demand is 104,000 tapes at a rate of 4,000 tapes per week. Pirate
Mart earns 20% on its cash investments. The purchase-order lead time is two weeks.
The following cost data are available:
Relevant ordering costs per purchase order P80 P90.50
Carrying costs per package per year 3
Relevant insurance, materials handling, breakage, etc., per year 2 P 4.50

What is the required annual return on investment per package?
A. P6,000 C. P1,200
B. P 250 D. P 600
Order quantity
40. For Raw Material L12, a company maintains a safety stock of 5,000 pounds. Its average
inventory (taking into account the safety stock) is 12,000 pounds. What is the apparent
order quantity?
A. 18,000 lbs. C. 14,000 lbs.
B. 6,000 lbs. D. 24,000 lbs
Optimal safety stock level

41. Each stockout of a product sold by Arnis Co. costs P1,750 per occurrence. The
company’s carrying cost per unit of inventory is P5 per year, and the company orders 1,500
units of product 20 times a year at a cost of P100 per order. The probabilities of a stockout
at various levels of safety stock are:
Units of Safety Stock Probability of Stockout
0. 0.50
100. 0.30
200. 0.14
300. 0.05
400. 0.01
The optimal safety stock level for the company based on the units of safety stock level
above is
A. 200 units C. 100 units
B. 300 units D. 400 units
42. Paeng Company uses the EOQ model for inventory control. The company has an annual
demand of 50,000 units for part number 6702 and has computed an optimal lot size of 6,250
units. Per-unit carrying costs and stockout costs are P9 and P4, respectively. The following
data have been gathered in an attempt to determine an appropriate safety stock level:
Units Short Because of Excess Number of Times Short
Demand during the Lead Time in the last 40 Reorder Cycles
Period
100 8
200 10
300 14
400 8
What is the optimal safety stock level?
A. 100 units C. 200 units
B. 300 units D. 400 units
Annual inventory costs

43. Durable Furniture Company uses about 200,000 yards of a particular fabric each year.
The fabric costs P25 per yard. The current policy is to order the fabric four times a year.
Incremental ordering costs are about P200 per order, and incremental carrying costs are
about P0.75 per yard, much of which represents the opportunity cost of the funds tied up
in inventory.
How much total annual costs are associated with the current inventory policy?
A. P19,550 C. P38,300
B. P18,750 D. P62,500
Maximum interest rate

44. Narra Company is considering a switch to level production. Cost efficiencies will occur
under level production and after tax cost would decline by P70,000 but inventory would
increase from P1,000,000 to P1,800,000. Narra would have to finance the extra inventory
at a cost of 10.5 percent.
What is the maximum interest rate that makes level production feasible?
Opportunity cost
45. Diesel Fashion estimates that 90,000 zippers will be needed in the manufacture of high
selling products for the coming year. Its supplier quoted a price of P25 per zipper. Diesel
planned to purchase 7,500 units per month but its supplier could not guarantee this
delivery schedule. In order to ensure availability of these zippers, Diesel is considering the
purchase of all these 90,000 units on January 1. Assuming Diesel can invest cash at 12%,
the company’s opportunity cost of purchasing the 90,000 units at the beginning of the
year is
A. P127,500 C. P123,750
B. P135,000 D. P264,000
Trade credit
46. If a firm is given a trade credit terms of 2/10, net 30, then the cost to the firm failing to
take the discount is:
A. 2.0%. C. 36.7%
B. 30.0%. D. 10.0%.
47. The cost of discounts missed on credit terms of 2/10, n/60 is

Bank loans
Discount loan
48. You plan to borrow P10,000 from your bank, which offers to lend you the money at a 10
percent nominal, or stated, rate on a one-year loan. What is the effective interest rate if the
loan is a discount loan?
A. 10.00% C. 12.45%
B. 11.11% D. 14.56%
Discount loan with compensating balance

49. What is the effective rate of a 15% discounted loan for 90 days, P200,000, with 10%
compensating balance? Assume 360 days per year.

A. 20.0% C. 17.4%
B. 15.0% D. 22.2%
Compensating balance with interest

50. The Premiere Company obtained a short-term bank loan for P1,000,000 at an annual
interest rate 12%. As a condition of the loan, Premiere is required to maintain a
compensating balance of P300,000 in its checking account. The checking account earns
interest at an annual rate of 3%. Premiere would otherwise maintain only P100,000 in its
checking account for transactional purposes. Premiere’s effective interest costs of the loan
is
A. 12.00% C. 16.30%
B. 14.25% D. 15.86%
Add-on
51. Perlas Company borrowed from a bank an amount of P1,000,000. The bank charged a
12% stated rate in an add-on arrangement, payable in 12 equal monthly installments.
A. 22.15% C. 25.05%
B. 24.00% D. 12.70%
Financing alternative
52. A company has accounts payable of P5 million with terms of 2% discount within 15
days, net 30 days (2/15 net 30). It can borrow funds from a bank at an annual rate of 12%,
or it can wait until the 30th day when it will receive revenues to cover the payment. If it
borrows funds on the last day of the discount period in order to obtain the discount, its
total cost will be
A. P 51,000 less C. P 75,500 less
B. P100,000 less D. P 24,500 more
53. Every 15 days a company receives P10,000 worth of raw materials from its suppliers.
The credit terms for these purchases are 2/10, net 30, and payment is made on the 30th
day after each delivery. Thus, the company is considering a 1-year bank loan for P9,800
(98% of the invoice amount). If the effective annual interest rate on this loan is 12%, what
will be the net peso savings over the year by borrowing and then taking the discount on
the materials?
A. P3,624 C. P4,800
B. P1,176 D. P1,224
54. An invoice of a P100,000 purchase has credit terms of 1/10, n/40. A bank loan for 8
percent can be arranged at any time. When should the customer pay the invoice?
A. Pay on the 1st. C. Pay on the 40th
B. Pay on the 10th D. Pay on the 60th
55. The Peninsula Commercial Bank and Island Corporation agreed to the following loan

proposal:
 Stated interest rate of 10% on a one-year discounted loan; and
 15% of the loan as compensating balance on zero-interest current account to be
maintained by Island Corporation with Peninsula Commercial Bank.
The loan requires a net proceeds of P1.5 million. What is the principal amount of loan
applied for as part of the loan agreement?
A.P1,666,667 C. P1,764,706
B.P2,000,000 D. P1,125,000

References:
Intermediate Accounting Kieso, Weygandt, Warfield Testbank
Introduction to Managerial Finance Lawrence J. Gitman ©2006
Financial Accounting Vol 3, Conrado Valix © 2017
Management Advisory Services, Rodelio Roque © 2013
https://www.dummies.com/business/accounting/horizontal-and-vertical-analysis/
Prof. Bobadilla, Financial Management (2017)
https://www.investopedia.com

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(Chapter 4) Advance (Chapter 5) Working Capital Chapter 1: Introduction To Financial Management

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(Chapter 4) Advance

(Chapter 5) Working Capital

Management is often included as a factor of production along with? machines, materials,

Financial management has focuses on risk-return relationship and the maximization of

Objectives of Financial Management

1. To ensure regular and adequate supply of funds to the concern.

Primary Activities of a Financial Manager

1. Estimation of capital requirements: A finance manager has to make estimation with

Use of Financial Management in our daily lives

Instructional Manual in Financial Management 3 | P a g e

2. Cash flow from Investing Activities

3. Cash flow from Financing Activities

Instructional Manual in Financial Management 4 | P a g e

a. Direct Method – Operating Activities

Cash Received from Customers =

Cash Payments for Expenses =

Cash Payment for Income Taxes =

Present the Operating Activity portion of the statement of cash flows

Cash Received from Customer:

Cash Payment to Suppliers:

Cash Payment for Expenses

Cash payment for income taxes

b. Indirect Method – Operating Activities

Instructional Manual in Financial Management 6 | P a g e

Which is more preferred?

Example: (Financial Accounting Vol. 3, Valix et. al., 2017)

Present the Investing Activity portion of the statement of cash flows.

Proceeds from sale of equipment 50,000

Dividend and Interest Revenue/Expense are generally presented in the Operating

Example: (Financial Accounting Vol. 3, Valix et. al., 2017)

Accounts payable P 153,000 P 168,000

The income statement for 2018 is as follows:

Prepare the statement of cash flows using the direct method:

Cash flows from operating activities

Net cash provided by operating activities P 297,000

Cash flows from financing activities

Net cash provided by financing activities 57,000

Net increase in cash 144,000

(1) P1,980,000 – P42,000

Instructional Manual in Financial Management 10 | P a g e

Instructional Manual in Financial Management 11 | P a g e

Instructional Manual in Financial Management 12 | P a g e

Instructional Manual in Financial Management 13 | P a g e

Instructional Manual in Financial Management 14 | P a g e

14. The amortization of bond premium on long-term debt should be presented in a

Instructional Manual in Financial Management 15 | P a g e

Instructional Manual in Financial Management 16 | P a g e

Accounts payable P 153,000 P 168,000

The income statement for 2018 is as follows:

Instructional Manual in Financial Management 17 | P a g e

Accounts payable P 90,000 P 84,000

For 2018 Year

Instructional Manual in Financial Management 18 | P a g e

2. Selected information from Adison Company's 2018 accounting records is as follows:

Instructional Manual in Financial Management 19 | P a g e

5. An analysis of the machinery accounts of Doonan Company for 2018 is as follows:

The information concerning Doonan's machinery accounts should be shown in

Use the following information for questions 8 and 9.

8. Depreciation expense for 2018 was