Business Finance

Financial Ratios

Topic: Financial Ratios

4.1 Define the financial ratios namely, liquidity, profitability, efficiency, and leverage.

Financial Ratio
 Financial Ratio expresses the relationship between specific financial statement data. The resulting ratio
may be interpreted as a percentage, a rate or proportion. Financial ratios make use of the relationship
of accounts though ratios and percentages.
1. Liquidity - is a company’s ability to convert its assets to cash in order to pay its liabilities when they are
due.
Types of Liquidity

Current Ratio - Tests the ability of the company to pay for its current obligation.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Formula: Current Ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Acid Ratio or Quick Ratio - A stricter test of the company’s ability to pay current obligation.
𝑇𝑜𝑡𝑎𝑙 𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
Formula: Quick Ratio =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Note: To compute Quick Assets removed inventory and prepaid assets from the total value of current assets.
2. Profitability - refers to the company’s ability to generate earnings. It is one of the most important goals of
businesses. There are different levels of measuring profit: gross profit, operating profit and net profit or net
income.
Components of Profitability

Return on equity - measures the amount of net income earned in relation to stockholders’ equity.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Formula: ROE =
𝑆𝑡𝑜𝑐𝑘𝑠ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦

Return on assets - measures the ability of a company to generate income out of its resources/assets.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Formula: ROA =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Gross profit margin - shows how many pesos of gross profit is earned for every peso of sale. It provides
information regarding the ability of a company to cover its manufacturing cost from its sales.
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
Formula: Gross profit margin =
𝑆𝑎𝑙𝑒𝑠
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Financial Ratios
Operating profit margin - shows how many pesos of operating profit is earned for every peso of sale. It
measures the amount of income generated from the core business of a company.
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
Formula: Operating profit margin =
𝑆𝑎𝑙𝑒𝑠

Net profit margin measures - how much net profit a company generates for every peso of sales or revenues
that it generates.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Formula: Net profit margin =
𝑆𝑎𝑙𝑒𝑠

3. Efficiency - refers to a company’s ability to be efficient in its operations. Specifically, it refers to the speed
with which various current accounts are converted into sales, and ultimately, cash.
Components of Efficiency
𝑆𝑎𝑙𝑒𝑠
Accounts receivable turnover =
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
365
Average collection period =
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

Inventory turnover =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

365
Average age of inventory or days’ inventory =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
Accounts payable turnover =
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

Note: In computing Purchases: Ending Inventory + Cost of Goods Sold - Beginning Inventory
365
Average payment period =
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝑆𝑎𝑙𝑒𝑠
Total asset turnover =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Operating cycle = Average Collection Period + Average Age of Inventory

Cash conversion cycle = Operating Cycle - Average payment period

4. Leverage - refers to the company’s use of debt. It defines the company’s capital structure which indicates
how much of the total assets are financed by debt and equity.
Types of Leverage

Debt ratio - measures the proportion of total assets finance by total liabilities or money provided by creditors.
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Formula: Debt ratio =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
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Financial Ratios
Debt-to-equity ratio - a variation of debt ratio, shows the proportion of debt to equity.
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Formula: Debt-to-equity ratio =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Interest coverage ratio - shows the company’s ability to pay its fixed interest charges in relation to its
operating income or earnings before interest and taxes. Another name of interest coverage ratio is Times
Interest Earned.
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑒𝑠 (𝐸𝐵𝐼𝑇)
Formula: Interest coverage ratio =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

4.2 Compute, analyze, and interpret Financial Ratios

Example of computing Financial Ratios using the financial statement below. Provide that the beginning
inventory is P 247,000.
ABC Company Statement of Financial Position as of December 31, 2020

ASSETS LIABILITIES AND SHAREHOLDER'S EQUITY

Cash P 120,000 Accounts payable P 70,000
Marketable Securities 35,000 Short-term payable 55,000
Accounts Receivable 45,000 Current liabilities 125,000
Inventories 130,000 Long-term debt 2,700,000
Current Assets 330,000 Total Liabilities 2,825,000
Equipment 2,970,000 Common stock 500,000
Buildings 1,600,000 Retained Earnings 1,575,000
Non-Current Assets 4,570,000 Stockholders' equity 2,075,000
Total Assets 4,900,000 Total Liabilities and equity 4,900,000

ABC Company Statement of Financial Performance as of December 31, 2020

Sales Revenue P 2,000,000

Additional note: “Other
Cost of Sales (P 1,300,000)
expenses” in the Statement of
Gross Margin 700,000 Financial Performance is
Operating Expense (P 199,000) composed solely of interest
Operating Profit 501,000 expense. Hence, interest
expense for the period ended
Other Income 5,000
December 31, 2014 is Php
Other Expense (P 2,800) 2,800.
Net Income before Tax 503,200
Income Tax (P 150,960)
Net Income after Tax 352,240
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Financial Ratios
Computation for Liquidity
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

= 330,000 / 125,000 = 2.64

𝑇𝑜𝑡𝑎𝑙 𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
Quick Ratio = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

= 200,000 / 125,000 = 1.6

Computation for Profitability

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
ROE = 𝑆𝑡𝑜𝑐𝑘𝑠ℎ𝑜𝑙𝑑𝑒𝑟 ′𝑠 𝑒𝑞𝑢𝑖𝑡𝑦

= 352,240 / 2,075,000
= 0.16975 x 100 = 16.98 %
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
ROA = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

= 352,240 / 4,900,000

= 0.0718 x 100 = 7.19 %

𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
GPM = 𝑆𝑎𝑙𝑒𝑠

= 700,000 / 2,000,000
= 0.35 x 100 = 35%
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
OPM = 𝑆𝑎𝑙𝑒𝑠

= 501,000 / 2,000,000
= 0.2505 x 100 = 25.05%
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
NPM = 𝑆𝑎𝑙𝑒𝑠

= 352,240 / 2,000,000

= 0.1761 x 100 = 17.61%

Computation for efficiency

𝑆𝑎𝑙𝑒𝑠
Accounts receivable turnover = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

= 2,000,000 / 45,000 = 44.44

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365
Average collection period = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

= 365 / 44.44 = 8.2 days

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
Inventory turnover = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

= 1,300,000 / 130,000 = 10
365
Average age of inventory or days’ inventory = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

= 365 / 10 = 36.5 days

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
Accounts payable turnover = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

= 1,183,000 / 70,000 = 16.9

365
Average payment period = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

= 365 / 16.9 = 21.60 days

𝑆𝑎𝑙𝑒𝑠
Total asset turnover = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

= 2,000,000 / 4,900,000 = 0.41

Operating cycle = Average Collection Period + Average Age of Inventory
= 8.2 days + 36.5 days = 44.7 days

Cash conversion cycle = Operating Cycle - Average payment period

= 44.7 days – 21.60 days = 23.1 days

Computation for leverage

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Debt ratio = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

= 2,825,000 / 4,900,000

= 0.5765 x 100 = 57.65 %

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Debt-to-equity ratio =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

= 2,825,000 / 2,075,000.00 = 1.3614

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𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑒𝑠 (𝐸𝐵𝐼𝑇)
Interest coverage ratio = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

= 501,000 + 5,000 / 2,800 = 180.7143

Factors influence capital structure. The following are just some of the factors that can influence
management’s decision in setting its capital structure.
Nature of Business – If the business is risk then it has to be financed conservatively hence, lower debt ratio.

State of Business Development – A newly formed business may have difficulty borrowing from banks.
Banks usually look for the historical financial performance of borrowers.

Macroeconomic conditions – If the overall economy is good then management can be more aggressive on
taking in risk through increased debt financing.
Prospects of the industry – A growing industry makes business more confident to take on more financial
risk.
Taxes - Interest expenses are tax deductible while cash dividends are not. By having more debt than equity,
businesses save on taxes as interest expense (multiplied by the tax rate) decreases income tax due.

Management style –Management and the board of directors can be aggressive or conservative in terms of
taking on risk.