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ABM 4 WEEKS 1-2

FINANCIAL RATIOS
Pages 91-110.
Financial ratios can be used to compare a company's current financial position and performance with those of
past years and identify strengths and weaknesses. It also allows comparison of different companies in different
industries. Their use is not only limited to management but to stockholders and creditors as well. Some creditors
or financial institutions require the presentation of certain ratios before they extend credit. This is to ascertain the
return of their money together with the interest.

In the process of using financial ratios to evaluate a company, ratios are often divided into four categories as
follows:

a. Liquidity is the ability of the company to settle its current obligations as they fall due.

b. Solvency - is the ability of the company to settle its non-current or long-term obligations and the interest
related to these obligations.

c. Profitability - measures the company's operating performance as a return on its investment. It gauges
management's efficiency in using company resources in order to generate revenue.

d. Market Value or Valuation - measures the company's potential for future earnings, dividend payments and
stock price growth.

For purposes of this course, market value or valuation will not be discussed in this book as lessons on dividends
and stocks have not yet been introduced to the students.

Illustration:
Liquidity Ratios
The liquidity ratio calculates the company's current or quick assets against its outstanding liabilities. Generally,
a high ratio indicates that the company has low risk of defaulting payment.

Common Types of Liquidity Ratios:

1. Current Ratio

Current ratio measures the ability of the business to pay its short-term obligations as they fall due. Generally, a
current ratio of 1 or 1.5 is considered satisfactory to serve as a company's cushion to its current liabilities although
the industry average has to be taken into consideration. However, some banks and financial institutions require
a current ratio of 2 or 3 before extending credit in order to assure collection of the principal with interest.
Nevertheless, this does not mean that the higher the current ratio the better. Although a low current ratio may
mean that the company may not be able to pay its short-term debt as they mature, a very high current ratio may
mean that the company is holding too much cash or liquid assets when in fact, a part of these could be put in
long-term investment which will yield higher income. The component of the current assets should also be
determined because a significant part of it might be inventory and prepaid expenses.

2016 2017

Current Assets P 665.4 P 725.8

Current Ratio = 1.07 = 1.32
Current Liabilities P 620.6 P 551.9

Analysis:

a. Current ratio for 2016 is 1.07 to 1 while that of 2017 is 1.32 to 1. This means that for 2016, the company has
P1.07 of current assets that can be converted to cash to pay every peso of current liability while for 2017, the
company has P1.32 of current assets to cover every peso of current liability that will fall due.

b. Current ratio for 2017 increased signifying more liquidity for the company although the company is satisfactorily
liquid in 2016.

c. Analyzing the components of currents assets for 2017, inventory and prepaid expenses form only 30% of the
current assets. Hence, the 70% is cash and receivable which can readily be used to pay short-term liabilities:
2. Quick Ratio

Quick ratio, otherwise known as the acid test ratio, measures immediate liquidity with the ability to pay current
liabilities with the most liquid assets. The quick ratio is a more conservative measure of liquidity since it only
considers current assets that can be converted to cash easily or quickly.

Current assets are composed of cash, short-term investments, receivables, merchandise inventory and
prepaid expenses. From these, we can notice that merchandise inventory is not easily convertible to cash as it
has to be sold first which does not guarantee instant cash because sometimes, it is sold on credit. Furthermore,
some inventory items are slow moving Due to obsolescence, these items may not even be sold in the long run.
On the other hand, prepaid expenses will never be converted to cash since they are not sold but used in the
normal operating cycle of the business. It is because of these reasons that these two accounts are not considered
when computing for the quick ratio. To illustrate, the quick ratio of Fidas Merchandising is computed as follows:

Cash + Short Term Investments + Trade Receivables

Quick Ratio =
Current Liabilities

2016 2017

P 330.2 + P172.1 P 222.9 + P282.5

Quick Ratio = 0.81 = 0.92
P 620.6 P 551.9

Quick ratio for 2016 is 0.81:1 and 0.92:1 for 2017.

Note: Since there are no short-term investments, only cash and trade receivables are added.

The quick ratio of Fidas Merchandising is 0.81 to 1 for 2016 and 0.92 to 1 for 2017. This means that for 2016,
the company has P0.81 of quick assets for every P1 of current liability and P0.92 for 2017. Being less than 1,
we cannot immediately jump into the conclusion that the ratio is unfavorable. A look into the company's ratio in
the past years may help as well as comparing it with other companies in the same line of business.

3. Receivable Turnover

Trade receivable turnover measures the efficiency to collect the amount due from credit customers. Generally,
a high trade receivable turnover is considered favorable since it may indicate a company's strict credit policies
combined with aggressive collection efforts while a low trade receivable turnover may indicate loose credit
policies combined with inadequate collection effort. However, imposing a very strict credit and collection policy
may lead to lesser sales as some customers may opt to buy from other companies with more lenient credit terms.

Net Credit Sales

Receivable Turnover =
Average Trade Receivable

Beginning Trade Receivable + Ending Trade Receivable

Average Trade Receivable =
2

Example: 2016 2017

P1,738.7 P2,213.3
Receivable Turnover = = 10.6 times = 9.74 times
P 164.05 P227.3

P156 + P172.1 P172.1 + P282.5

Average Receivable = = 164.05 = 227.3
2 2

Receivable turnover for Fidas Merchandising are 10.6 times and 9.74 times for 2016 and 2017, respectively.
This means that the company was able to collect its average receivables 10.6 times in 2016 and 9.74 times in
2017.
4. Average Collection Period

Average collection period, otherwise called day's sales outstanding, is the approximate number of days it
takes a business to collect its receivables from credit or account sales. In assessing whether the average
collection period is favorable or unfavorable, the credit terms extended by the company to its customers should
be considered. Average collection period has two formulas as follows:

360 days
Average Collection Period =
Trade Receivable Turnover

Example 2016 2017

360 days 360 days

Average Collection Period = 34 days = 37 days
10.6 9.74

Average Receivables
Average Collection Period =
Average Daily Sales

Annual Sales
Average Daily Sales =
360 days

Example 2016 2017

P164.05 P227.3
Average Collection Period = 34 days = 37 days
4.8 6.1

P1,738.7 P2,213.3
Average Daily Sales = 4.8 = 6.1
360 days 360 days

The average collection period for 2016 and 2017 are 34 days and 37 days respectively. The determination
whether 34 days and 37 days are favorable depends on the credit terms extended by Fidas Merchandising to its
account customers. If the company's terms of credit is 30 days, then the average collection period for both years
is not favorable since it exceeds the 30-day credit term.

More effort should be exerted by the company in collecting its receivables. However, if the credit term extended
by the company to its customers is 45 days, the resulting average collection period we computed for both years
2016 and 2017 is favorable since it is way below the credit term of 45 days.

5. Inventory Turnover

Inventory turnover measures the number of times a company's inventory is sold and replaced during the year.
Since the company generates income from sales, the faster the movement of inventory, the higher the company's
net income. Low inventory turnover may indicate overstocking of inventory or the presence of obsolete items.
This is not favorable as inventory items tend to deteriorate, spoil or be obsolete when stocked in the warehouse
for some time unless it is planned stocking in anticipation of product shortage or price increases, High inventory
turnover may indicate strong sales. However, it may also indicate inefficient purchasing where purchases are
made often in small quantities resulting to insufficient stock of goods or inadequate inventory levels. This may
result to losses in terms of sales as customer demand is not served when the product is out of stock. This may
also result to higher purchase price of goods as the company cannot avail of the maximum trade discount
available due to purchases made in small volumes.

Cost of Goods Sold Average Inventory

Inventory Turnover =
Average Inventory
 Beginning Inventory + Ending Inventory
Average Inventory =
2

Example 2016 2017

P831.8 P1,032.1
Inventory Turnover = 9 times = 8.6 times
P91.85 P119.55

P90.9 + P92.8 P92.8 + P 1463

Average Inventory = P91.85 = P119.55
2 2

Inventory turnover is 9 times and 8.6 times respectively for 2016 and 2017. As a general rule, the higher the
inventory turnover, the more profitable it is for the company. This may mean a high demand for the company's
products. On the other hand a low inventory turnover may signify a low demand on the products prompting the
company to make certain moves such as embarking on advertising programs.

6. Average Sales Period

Average sales period, otherwise known as the inventory conversion period, is the average time to convert
inventory to sales. Generally, the lower the average sales period, the more favorable it is for the company since
it signifies a shorter period to sell inventory.

360 days
Average Sales Period =
Inventory Turnover

Example 2016 2017

360 days 360 days

Average Sales Period = 40 days = 41.9 days
9 8.6

Average Sales Period for Fidas Merchandising increased from 40 days in 2016 to 41.9 days in 2017. This is
evident as the company's inventory turnover decreased from 9 times in 2016 to 8.6 times in 2017. This indicates
that the company might be overstocking some inventory items or the presence of slow moving items in its
inventory.

7. Working Capital

Working capital measures the short term liquidity of a company. The formula for working capital is

Working Capital = Current Assets - Current Liabilities

Example

Below is the working capital of Fidas Merchandising:

2016 P665.40 - P620.60 = P44.8

2017 P725.80 - P551.90 = P173.9

The working capital of Fidas Merchandising is P44.8 million in 2016 and P173.9 million in 2017. This means that
for 2017, the company is more liquid in meeting its short-term obligations especially since its cash and
receivables occupy a big percentage of the current assets.
SOLVENCY RATIOS
Solvency ratios, otherwise called leverage ratios, measure a company's ability to pay its maturing long-term
debts while sustaining operations indefinitely.

Common Types of Solvency Ratios:

1. Debt Ratio

Debt ratio, otherwise known as the debt to assets ratio, measures business liabilities as a percentage of total
assets. It measures the extent of total assets financed by liabilities. Generally, a lower ratio is favorable since it
means that more funds are provided by the owner. In discussing a company's sources of funds, we go back to
the fundamental accounting equation Assets = Liabilities + Owner's Equity. The accounting equation very well
shows that business funds come from two sources, namely, liabilities from creditors and owner's equity from
the owner. Generally, a 50-50 ratio where liabilities and owner's equity have the same proportion is considered
fair as this is determined to be the optimal debt ratio. However, a slightly higher debt ratio is also acceptable
although we have to take into account the industry and the payment history of the company.

Total Liabilities
Debt Ratio =
Total Assets

Example 2017 2016 2015

P2,374.3 P 997.2 980.7

Debt Ratio = 91.6 = 81.6 = 80.2
P2,592.2 P1,221.6 P1,223.1

Since 2015, Fidas Merchandising was heavily financed by creditors. In 2015, 80.2% of the assets was already
financed by creditors. This went slightly higher in 2016 as debt ratio was 81.6%. In 2017, debt ratio was even
higher at 91.6%. This is not a good sign as the company heavily sourced its financing from creditors. The
company is considered highly leveraged and this is risky for the company because most of its assets are
owned by the creditors. In simple words, the company will have to sell most of its assets to pay its creditors.

2. Equity Ratio

Equity ratio measures the percentage of total assets financed by the owner's investment. It measures the
extent of total assets owned by the owner. This is his/her stake in the company. Generally, the higher the
equity ratio, the more favorable it is for the company. This is also an advantage if the company is to apply for a
loan as potential creditors will find the company less risky.

Total Equity
Equity Ratio =
Total Assets

Example 2017 2016 2015

P217.9 224.4 242.4

Equity Ratio = 8.4 = 18.4 =19.8
P2,592.2 P1,221.6 P1,223.1

Fidas Merchandising's equity ratio is 19.8% for 2015. This slightly went down to 18.4% in 2016 then went down
further to 8.4% in 2017. These rates are critically low for the company as these indicate dependence on
creditors for sources of funds. For 2017, the owner only owns 8.4% of company assets while the creditors own
91.6 %. For 2016 and 2015, the owner owns 18.4% and 19.8% respectively while the creditors own 81.6% and
80.2% respectively. This is way below the optimal fair ratio.

3. Debt to Equity Ratio

Debt to equity ratio, otherwise known as financial leverage ratio, measures the financing provided by the
creditors against those provided by the owner. This measures the extent of the borrowed funds as compared to
the investment by the owner. The optimal fair ratio is 1 or 100%. This means that liabilities are equal to owner's
equity. The higher the ratio, the higher the risk as interest payments on liabilities are onerous. Hence, a lower
ratio is favorable.

Total Liabilities
Debt to Equity Ratio =
Total Equity

Example 2017 2016 2015

P 2,374.3 P 997.2 P 980.7

Debt to Equity Ratio = 10.9 = 4.4 = 4.0
P 217.9 P 224.4 P 242.4

The debt to equity ratio is increasing through the years. In 2015, debt equity ratio was 4:1 which meant that for
every P1 financed by the owner in the assets of the business, P4 was financed by the creditors. The following
year showed a slightly higher ratio that for every P1 financed by the owner, P4.40 was financed by the
creditors. During 2017, the creditors heavily funded the assets of the company that for every P1 funded by the
owner, the creditors funded P10.90. This is very unfavorable since the company will definitely pay huge
interest for the use of creditor funds in the business. This is evident as the interest expense surged in 2017
which can be seen in the income statement.

4. Times Interest Earned

Times interest earned measures the company's ability to pay the interest charged to the company for its
outstanding liabilities. It measures the number of times operating income can cover interest expense. The
higher the number of times the operating income can cover interest expense, the more favorable it is for the
creditors because it means the company is not struggling to pay its interests from loans.

Income before Interest and Taxes

Times Interest Earned =
Interest Expense

Example 2017 2016 2015

P292.0 P247.4 P287.6

Times Interest Earned= = 3.2 = 8.1 = 11.5
P 90.9 P 30.5 P 25.0

Fidas Merchandising's interest is 11.5 times of its income before interest and taxes in 2015, 8.1 times in 2016,
and 3.2 times in 2017. The decrease in number of times may be due to increasing interest payments from
large amounts of loans.

PROFITABILITY RATIOS
Profitability ratios measure a company's overall efficiency and performance based on its ability to generate
profit from operations relative to its available assets and resources.

Common Types of Profitability Ratio

1. Gross Profit Ratio

Gross Profit Ratio, otherwise called Gross Margin Ratio, measures the percentage of peso sales earned
after deducting cost of goods sold fence, this is the percentage of mark up a company adds to the cost of its
inventory which will later absorb the operating expenses related to the sale of the goods. A high gross profit
ratio is favorable as there will be greater operating income after all operating expenses have been paid.

Gross Profit
Gross Profit Ratio =
Net Sales
Fidas Merchandising's gross profit ratio was 54.6% is 2015. This was slightly lower in 2016 at 52.2%.
However, it went slightly higher in 2017 at 53.4%. The gross profit margin for three years was not bad as the
mark-up was more than 50% which will be used to absorb the operating expenses.

Example 2017 2016 2015

P1,181.2 P 906.9 P 843.1

Gross Profit Ratio = 53.4% = 52.2% = 54.6%

P2,213.3 P 1,738.7 P 1,543.2

2. Operating Profit Margin

Operating Profit Margin measures the percentage of income earned after deducting the cost of sales and the
operating expenses. In short, it is the income earned per peso of net sales after the cost of inventory and the
related operating expenses are deducted. This is an indication of how the company is effectively and efficiently
managing its expenses at its sales level. Hence, a higher ratio is favorable since it indicates efficiency in
managing expenses.

Operating Income
Operating Profit Margin =
Net Sales

Example 2017 2016 2015

P 292.0 P247.4 P 287.6

Operating Profit Margin = 13.2% = 14.2% = 18.6%
P2.213.3 P1,738.7 P1,543.2

Operating margin has a downward trend. From 18.6% in 2015, it went down to 14.2% in 2016 then to13.2% in
2017. This indicates that the company is not efficiently managing its expenses. A closer look at the company's
income statement reveals that selling and administrative expenses show an increasing trend. If this upward
trend in operating expenses will continue, it follows that operating margin will continue its downward trend. If
this will be the case, the company will end up incurring losses.

3. Net Profit Margin

Net Profit Margin, otherwise known as Return on Sales, measures the percentage of net income earned
from net sales after all other income has been added and all operating expenses and other expenses including
income taxes have been paid. A high net profit margin is favorable to the company.

Net Income
Net Profit Margin =
Net Sales

Example 2017 2016 2015

P 140.8 P151.9 P185.2

Net Profit Margin = 6.4% = 8.7% = 12%
P2,213.3 P1,738.7 P1,543.2

The net profit margin continued to decrease every year from 2015 to 2017. From 12% in 2015, it went down to
8.7% in 2016 then to 6,4% in 2017. Management should exert effort to Increase sales and cut on expenses if
they want to improve net income for future operations.
4. Return on Assets

Return on Assets, otherwise called Return on Investment, measures the company's efficiency in using its
level of investment in assets in order to generate income. Generally, a high ratio is favorable. Since capital
assets are one of the company's investments, the return on assets measures the income derived from these
asset acquisitions.

Net Income
Return on Assets =
Average Total Assets

Assets at Beginning of the Year + Assets at Ending of the Year

Average Total Assets =
2

Example 2017 2016

P140.8 P151.9
Return on Assets = 7.4% = 12.4%
(P2,592.2+1,221.6)/2 (P1,221.6+1,223.1)/2

The return on assets was 12.4% in 2016. This decreased to 7.4% in 2017 despite heavy acquisitions of
property plant and equipment in 2017. This means that company assets were not fully utilized to generate
income.

Qualitative Factors in Financial Statement Analysis

After discussing the quantitative factors which consist of mathematical formulas and numbers, it must be noted
that there are other factors that are equally important in analyzing financial statements. In the process of
analysis, not only are the quantitative factors significant. The qualitative factors are likewise significant as
follows:

1. Customers

Some companies have multitude of customers as source of income which is healthy as the loss of one or two
customers will not have an impact on company sales. However, there are some companies who have only few
customers whose sales rely heavily on one, two, or three customers. This is very dangerous as the loss of one
of these major customers can have a big impact on company sales.

2. Competitors

The company's competitors may dictate the price of the product in the industry. Thus, in pricing its products,
not only are the cost of producing the product considered but the prices of the competitors' products.

3. Market Share

The market share can determine the leaders in the industry. Most of the time, the industry leaders have the
advantage over small companies as they dictate the trend and the price while small companies tend to just
follow.

4. Industry Growth

This is one important factor to consider because a growing industry means more customers. Trends and new
innovations in the industry will also have to be considered. A company manufacturing beta max and VHS tapes
noticed a decline in sales when compact discs were introduced. On the other hand, the manufacturers of the
compact disc experienced the same decline in sales due to the introduction of the DVD. In like manner, the
same was experienced by the manufacturer of the DVD because of the introduction of the blu ray disc This
cycle will continue because the industry is continuously growing and evolving.
5. Supplier

The presence of many suppliers will cause the prices to drop as there are many competitors. However, the
presence of few suppliers may cause these suppliers to dictate the prices especially during times of shortage
of supplies.

Activity 2:

Activity 3:

Refer to On the Dot Trading in Activity 2 then compute the following solvency ratios:

1. Debt Ratio
2. Equity Ratio
3. Debt to Equity Ratio
4. Times Interest Earned
Activity 4:

Refer to On the Dot Trading in Activity 2, compute the following profitability ratios:

1. Gross Profit Ratio

2. Operating Profit Margin
3. Net Profit Margin
4. Return on Assets

Activity 5:

Identification of whether the ratios are favorable or unfavorable.

2017 2016

1. Current Ratio 1.5 1.3

2. Quick Ratio .86 1.1
3. Receivable Turnover 12 11
4. Average Collection Period 32 28
5. Inventory Turnover 10 8
6. Average Sales Period 38 45
7. Debt Ratio 45% 48%
8. Equity Ratio 55% 60%
9. Debt to Equity Ratio 3 4
10. Times Interest Earned 6 8
11. Gross Profit Ratio 35% 42%
12. Operating Profit Margin 25% 20%
13. Net Profit Margin 12% 15%
14. Return on Assets 21.8% 19.6%

Activity 6:
Required: Compute the following ratios for 2017.

1. Current Ratio
2. Quick Ratio
3. Receivable Turnover
4. Average Collection Period
5. Inventory Turnover
6. Average Sales Period
7. Working Capital
8. Debt Ratio
9. Equity Ratio
10. Debt to Equity Ratio
11. Times Interest Earned
12. Gross Profit Ratio
13. Operating Profit Margin
14. Net Profit Margin
15. Return on Assets

Source: Ong, F. & Gomendoza, J. (2017). Fundamentals of Accountancy, Business, and

Management 2. C & E Publishing Inc. Quezon City