SAINT JOSEPH COLLEGE OF SINDANGAN INCORPORATED

COLLEGE OF ACCOUNTANCY

NAME OF STUDENT: ________________________________________________________________________

PROFESSOR:___________________________________________TIME SCHEDULE:______________________

MODULE 4
I. CASH FLOW ANALYSIS
II. OPERATING AND FINANCIAL LEVERAGE

III. TOPIC DISCUSSION

 USEFULNESS OF THE STATEMENT OF CASH FLOWS
 To provide relevant information about a company’s cash
receipts and cash payments during an accounting period.
 PAS 7 states that the information in a statement of cash
flows, if used with information in the other financial
statements, should help users to assess and evaluate:
 a company’s ability to generate positive future net
cash flows,
 a company’s ability to meet its obligations and pay
dividends,
 a company’s need for external financing,
 the reasons for differences between a company’s net
income and associated cash receipts and payments,
and
 both the cash and noncash aspects of a company’s
financing and investing transactions during the
accounting period.
 Information that may also obtained from the cash flow
statement:
 the changes in net assets of an enterprise of an enterprise
and its ability to affect the amount and timing of cash

1
 flows in order to adopt to changing circumstances and
opportunities,
 the ability of the enterprise to generate cash and cash
equivalents and enables the users to develop models to
assess and compare the present value of the future cash
flows of different enterprises; and
 it enhances the comparability of the reporting of
operating performance by different enterprises because it
eliminates the effects of suing different accounting
treatments for the same transactions and events.

 Statement of Cash Flows provide the means of measuring a

business firm’s:
 Financial liquidity – which refers to the “measures to cash”
of assets and liabilities.

Formula:

Current cash debt coverage ratio Net cash provided by operating

= activities
Average Current Liabilities

 Financial flexibility-which refers to a company’s ability to

respond and adapt to financial adversity and unexpected
needs and opportunities.

Formula:
Net cash provided by operating
Cash debt coverage ratio = activities
Average Total Liabilities

 Free Cash Flow

 A more sophisticated way to examine a company’s
financial flexibility is to develop a free cash flow
analysis. Free cash flow is the amount of
2
 discretionary cash flow a company has. It can use this
cash flow to purchase additional investments, retire
its debt, purchase treasury shares, or simply add to
its liquidity.

Free cash flow computation:

Net cash provided by operating activities xx

Capital expenditures (xx)
Dividends (xx)
Free cash flow P xx

 If the fee cash flow is positive, the business firm

could have satisfactory financial flexibility.
Companies that have strong flexibility can:
 take advantage of profitable investment even in
tough terms, and
 be free from worry about survival in poor
economic terms.

 The basic approach to a cash flow statement

 The term cash broadly defined to include both cash
and cash equivalent.
 Cash equivalents consists of short-term, highly liquid
investments such as treasury bills, SEC registered
commercial papers and money market funds.

 Classification of Cash Flow Activities

 Operating Activities
 The amount of cash flows arising from operating
activities is a key indicator of the extent to
which the operations of the enterprise have
generated sufficient cash flows to repay loans,
3
 maintain the operating capability of the
enterprise, pay dividends and make new
investments without recourse to external
sources of financing.
 Investing Activities
 The separate disclosure of cash flows arising
from investing activities is important because
the cash flows represent the extent to which
expenditure have been made for resources
intended to generate future income and cash
flows.
 Financing Activities
 The separate disclosure of cash flows arising
from financing activities is important because it
is useful in predicting claims on future cash
flows by providers of capital to the enterprise.

 Content and form of the Statement of Cash Flows

 Net cash
 Provided or used by operating activities
 Provided or used by investing activities
 Provided or used by financing activities
 Net effect of those flows on cash and cash
equivalents during the period in a manner that
reconciles the beginning and ending cash and cash
equivalents.
 Noncash investing and financing activities affecting
the financial position shall be excluded from a cash
flow statements.

 Calculating Cash Flow From Operating Activities

 Direct Method

4
  Enterprises are encouraged to report major
classes of gross cash receipts and gross cash
payments and the net cash flow from operating
activities. At minimum, the following classes of
operating cash receipts and payments should be
separately reported:
1. Cash collected from customers, including
lessees, licensees and the like
2. Interest, fees, royalties and dividends
received
3. Other operating cash receipts, if any
4. Cash paid to employees and other
suppliers of goods or services
5. Interest paid
6. Income taxes paid
7. Other operating payments, if any
8. Contracts held for dealing or trading
purposes
 Indirect Method
 Enterprises that choose not to provide the
major classes of operating cash receipts and
payments by the direct method shall determine
and report the same amount of net cash flow
from operating activities indirectly by adjusting
net income to reconcile it to net cash flow from
operating activities.
 Adjustments to Convert Net Income to Net Cash
Flow from Operating Activities(INDIRECT
METHOD).

 Net Income after Taxes

-Plus-

5
 Decrease in current assets (except cash,
marketable securities and non-trade
accounts)
 Increases in current liabilities (except
financing or non-operating accounts, e.g.,
bank loan, current maturities of long-term
debt)
 Depreciation, depletion, and amortization
expense
 Amortization of discount on bonds payable
 Amortization of premium on investment in
bonds
 Increase in deferred income taxes
 Loss (net) on disposal of assets and
liabilities
 Subsidiary loss under the equity method
 Interest Expense
 Income Taxes
-Minus-
 Increases in current assets (except cash,
marketable securities, and non-trade
accounts)
 Decreases in current liabilities (except
financing or non-operating accounts, e.g,
bank loan, current maturities of long-term
debt)
 Amortization of premium on bonds payable
 Amortization of discount on investment in
bonds
 Decrease in deferred income taxes
 Gain (net) on disposal of assets or liabilities
 Subsidiary gain under the equity method
-Equals-
6
  Net Cash Flow From Operations

 Interest paid

 Income Taxes paid

 Net Cash from Operating Activities

 OPERATING AND FINANCIAL LEVERAGE

 Leverage represents the use of fixed costs items to magnify the
firm’s results. It is however, important to keep in mind that
leverage is a two-edged sword producing highly favorable
results when things go well, and quite the opposite under
negative conditions.

 Cost-volume-profit (CVP) analysis

 Is powerful tool and vital in many business decisions

because it helps managers understand the relationship
among cost, volume and profit.
 It focused on how profts are affected by the following
elements:
 Selling prices
 Sales volume
 Unit variable costs
 Total fixed costs
 Mix of products sold
 Critical questions to consider:
 What is company’s breakeven volume?
 What is its margin of safety?

7
  What is likely to happen if specific changes are made
in prices, costs and volume?

 Contribution Margin (CM) per unit or marginal income per

unit
 This is the excess of unit selling price over unit variable
costs and the amount each unit sold contributes toward
1. Covering fixed costs and
2. providing operating profits.

Formula:
CM per unit = Unit selling price – unit variable costs

 Contribution Margin Ratio

 This is the percentage of contribution margin to total sales.

Formula:
CM Ratio = Contribution Margin
Sales

 CVP Analysis for Breakeven Planning

 Breakeven point is the level of sales volume where total
revenues and total expenses are equal, that is, there is
neither profit or loss.

Formulas:

1. Breakeven point (units) = Total Fixed Costs

Contribution Margin per unit

Total Fixed Costs

2. Breakeven point (pesos) =
Variable Costs
1=
Sales

3.a. Break-even sales for multi-

products
3.b. Weighted Contribution
Firm (combined units) = (Unit CM x No. of units
Totalper Mix)Costs
Fixed +( Unit CM x
Margin per unit = No. of units perContribution
Mix) 8
Weighted Average
Total number of units per Sales Mix
Margin
 4.a. Break-even sales for multi-products firm (combined Total Fixed
pesos)= Costs
4.b. Weighted CM Ratio = Total Weighted CM (P) CM
Weighted
Total Weighted Sales ratio
(P)

 CVP Analysis for Revenue and Cost Planning

 Can be used to determine the level of sales needed to
achieve a desired level of profit. In revenue planning, CVP
analysis assists managers in determining the revenue
required to achieve a desired profit level.

Formula:

Sales (units) = Total Fixed Costs + Desired Profit

Contribution Margin Per Unit

or

Sales (P) = Total Fixed Costs + Desired Profit

Contribution Margin Ratio

 Sales Mix
 Refers to the relative proportions in which a company’s
products are sold.
 To achieve the combination, or mix that will yield the
greatest amount of profits.
 Profits will be greater if high-margin rather than low-
margin items make up a relatively large proportion of total
sales.

Illustration:

9
 Trump, Inc. produces only two products of A and B.
These account for 60% and 40% of the total sales pesos of
Trump’s respectively. Variable costs as a percentage of
sales pesos are 60% for A and 85% for B. Total fixed costs
are P 150,000. There are no other costs.

Required:

1. Compute the weighted contribution margin ratio.

2. Compute the break-even point in sales pesos.
3. Compute the sales pesos necessary to generate a net
income of P 9,000 if total fixed costs will increase by
30%.

Solutions:

A B
1. Sales mix ratio 60% 40%
Multiplied by: CM ratio 40% 15%
Wieghted CM ratio 24% + 6% = 30%

2. Fixed costs
BEP (P) = Weighted
CMR

150,000.00
30%

500,000.00

3. Desired net income 9,000.00

Add: Total Fixed Costs
(150,000 x 130%) 195,000.00
Contribution margin 204,000.00
Divided by : Weighted CMR 30%
Sales necessary to generate
desired net income 680,000.00

 Operating Leverage

10
  Is measure of how sensitive net operating income is to a
given percentage change in peso sales.
 Acts as a multiplier
 If operating leverage is high, a small percentage increase
in sales can produce a much larger percentage increase
in net operating income.

Formula:
Or
Degree of operating leverage = Contribution Margin
Net Operating Income
Degree of operating leverage = Percent change in operating income
The Percent change in unit volume
degree
of operating leverage is a measures, at a given level of sales, of how a
percentage change in sales volume will affect profits.

 Financial Leverage
 Reflects the amount of debt used in the capital
structure of the firm.
 It affects the liabilities and Owner’s Equity

Formula:
Or
Degree of financial leverage Percent change in Earnings Per Share
= (EPS)
Degree of financial leverage = Percent change InEBIT
Earnings before
IV. EBIT -1
interest and taxes(EBIT)

ACTIVITIES

A. PROBLEM SOLVING

Shown below are partial financial statements for Garcia’s Health

Care, Inc. Fill in the blanks on the three financial statements.

Garcia’s Health Care, Inc.

11
 Statement of Financial Position as of December 31, 2018 and 2019
(In millions of pesos)
2018 2019
ASSETS
Current Assets:

Cash and marketabke securities   421.00

Accounts receivable 1,020.00  
Inventory 1,581.00 1,760.00
Total   3,290.00

Fixed Assets:
Gross pland and equipment 4,743.00  
Leess: Depreciation 640.00 840.00

Net plant and equipment   4,972.00

Other long-term assets 790.00  
Total 4,893.00 5,864.00
Total Assets 7,889.00  

Liabilities and Equity

Current liabilities:
Accrued wages and taxes 242.00 316.00
Accounts payable 791.00 867.00
Notes payable 714.00  
Total 1,747.00 2,055.00

Long-term debt:   3,090.00

Stockholders' equity:
Preferred stock (25 milliong shares) 60.00 60.00
Common stock and paid-in surplus
(200 million shares)   637.00
Retained Earnings 2,440.00 3,312.00
Total 3,137.00 4,009.00

Total Liabilities and equity 7,889.00 9,154.00

Garcia’s Health Care, Inc.

Income Statement for Years Ending December 31, 2018 and 2019
(In millions of pesos)
2018 2019
Net sales   4,980.00
Less: Cost of goods sold 2,135.00  
Gross profits 2,213.00 2,609.00
Less: Depreciation 191.00 200.00
Earnings before interest and taxes (EBIT)   2,409.00
Less : Interest 285.00  
Earnings before taxes (EBT) 1,737.00 2,094.00
Less: Taxes    

12
Net Income 1,105.00 1,327.00

Garcia’s Health Care, Inc.

Statement of Cash Flows for Year 2019
(In millions of pesos)

2019
A. Cash flows from operating activities
Net income  
Additions (sources of cash)
Depreciation  
Increase accrued wages and taxes  
Increase in account payable  

Substractions (uses of cash)

Increase in accounts receivable  
Increase in other long-term assets  
Net cash flow form operating activities  

B. Cash flows from investing activities

Substractions:
Increase fixed assets  
Increase in other long-term assets  
Net cash flow from investing activities  

C. Cash flows from financing activities

Additions:
Increase in notes payable  
Increase in long-term debt  
Increase in common and preferred stock  
Substraction
Pay dividends 455.00
Net cash flow from financing activities  

D. Net change in cash and cash marketable securities (26.00 )

B. MULTIPLE CHOICES (Show your solutions). Encircle the letter of the

correct answer.

Use the following data to answer questions 1 to 4.

13
 Marcus Company manufactures and sell a single product,
Product E. The product sell for P 60 per unit has a C/M ratio of 40%.
The company’s monthly fixed expenses are P 28,800.

1. The variable cost per unit of PRODUCT E is

a. P 31.20
b. P 24
c. P36
d. P 28. 80
2. The break-even point for Product E is
a. P 48,000
b. P 72,000
c. 800 units
d. 1,000 units
3. If Marcus Company desires a monthly income equal to 10% of sales,
monthly sales will have to be (ignore taxes)
a. 1,500 units
b. 760 units
c. 2,000 units
d. 1,600 units
4. If the selling price were reduced by 5%, variable costs reduced by P
1.00, and fixed costs increased to a total of P 38,400, how many
units would need to be sold to earn an income of P 21,000 (ignore
taxes)?
a. 1,000 units
b. 2,700 units
c. 1,700 units
d. 2,950 units

Use the following information to answer questions 5 and 6:

14
 Redwood Furniture Company produces two kinds of chairs: an oak
model and a chestnut wood model. The oak model sell for P 60 and the
chestnut wood model sell for P100. The variable expenses are as follows:

Oak Chestnut
Variable production costs per unit P 30 P 35
Variable selling expenses per unit 6 5

Expected sales in units next year are : 5,000 oak chairs and 1,000
chestnut chairs. Fixed expenses are budgeted at P 135,000 per year.

5. The yearly break-even point in total sales for the sales mix expected
is
a. P 270,000
b. P 300,000
c. P 485,000
d. P 500,000
6. The company’s overall contribution margin ratio for the sales mix
expected is
a. 40%
b. 45%
c. 50%
d. 60%

Use the following information to answer questions 7 to 9.

Given the following income statement for OR Company for 20x4:

15
Sales (30,000 units) P 600,000
Less Operating Expenses: 390,000
Variable 140,000 530,000
Net income P 70,000
7. The break-even point for 20x4 is
a. 26,600 units
b. 17,500 units
c. P 460,000
d. P 400,000

8. The Company’s degree of operating leverage is

a. 3
b. 2
c. 4.28
d. 8.57

9. The Company’s margin of safety (rounded to the nearest whole

percent) is
a. 33%
b. 50%
c. 12%
d. 67%

The following information pertains to questions 10 to 12

Kristin is a distributor of brass picture frames. For 20x4, she plans to

purchase for P30 each and sell them for P45 each. Kristin’s fixed costs are
expected to be P240,000. Kristin’s only other costs will be variable costs
of P 60 per shipment for preparing the invoice and delivery documents,
organizing the delivery, and following up for collecting accounts
receivable. The P 60 cost will be incurred each time Kristin ships an order
of picture frames, regardless of the number of frames in the order.

16
 10. Suppose Kristin sell 400,000 pictures frames in 1,000 shipments
in 20x4, what is the Kristin’s operating income for 20x4?
a. P 300,000
b. P 420,000
c. P 240,000
d. P 450,000

11. Suppose Kristine sells 400,000 pictures frames in 800 shipments

in 20x4 what is the Kristin’s operating income for 20x4?
a. P246,000
b. P325,000
c. P 211,000
d. P 312,000
12. Suppose Kristin anticipates making 500 shipments in 20x4. How
many picture frames must Kristine sell to break even in 20x4?
a. 18,000
b. 12,000
c. 14,000
d. 16,000

The following information pertains to questions 13 to 15.

Sales (75,000) P 750,000
Variable costs 225,000
Contribution Margin P 525,000
Fixed Manufacturing Costs 187,500
Operating Income P337,500
Interest 75,000
Earnings before taxes P 262,500
Taxes (at 31%) 81,375
Net Income P 181,125
17
Shares Outstanding 15,000

13. The Degree of Operating Leverage is

a. 1.43x
b. 1.56x
c. 3.33x
d. 2.22
14. The Degree of Financial Leverage is
a. 1.29x
b. 4.50x
c. 3.50x
d. 1.32x
15. The Degree of Combined Leverage is
a. 2.1 x
b. 1.9x
c. 2.9x
d. 2.0x

-END-

18