12

FUNDAMENTALS OF
ACCOUNTANCY, BUSINESS &
MANAGEMENT 2

1
 GRADE

FUNDAMENTALS OF
ACCOUNTANCY, BUSINESS
& MANAGEMENT 2
Quarter 1 Module 6 Week 6
Analysis and Interpretation
of Financial Statements
Lesson Define the measurement levels, namely, liquidity, solvency,
stability, and profitability.
6.2
Compute and interpret financial ratios such as current ratio,
working capital, gross profit ratio, net profit ratio, receivable
turnover, inventory turnover, debt-to-equity ratio, and the
like

What I Know?
TRUE or FALSE. Read each sentence carefully and determine whether the
statement is TRUE or FALSE. Write your answers in the space provided before the number.

_______ 1. Financial statement analysis uses computational and analytical techniques to

Evaluate the company’s risks, performance, financial health and future prospects
With the objective of making economic decisions.
_______ 2. Return on asset is an operational efficiency ratio.
_______ 3. Profitability ratios measure the ability of the company’s assets to generate sales.
_______ 4. Gross Profit Margin provides an indication of the company’s average pricing policy.
_______ 5. Accounts receivable turnover measures the number of days in the company’s
Average collections period.
_______ 6. Debt to equity ratio measures the percentage of assets financed by equity.
_______ 7. Current ratio is generally higher than quick ratio.

2
 GRADE

Introduction

In this lesson, we continue our discussion of financial statement analysis. It is

already clear from the previous lesson that reading the financial statement is not
enough to make economic decisions. In previous lesson, we learned how to use
horizontal and vertical analysis techniques to analyze financial statement information. In
this lesson we will use financial ratios to gain better understanding of the company’s
PROFITABILITY, OPERATING EFFICIENCY, LIQUIDITY and SOLVENCY.

What is it?

Financial statement (FS) analysis is the process of evaluating risks,

performance, financial health, and future prospects of a business by subjecting financial
statement data to computational and analytical techniques with the objective of making
economic decisions (White et.al 1998).There are three kinds of FS analysis techniques:
 Horizontal analysis
 Vertical analysis
 Financial ratios

(Note: This lesson will focus on FINANCIAL RATIOS.)

Financial Ratio is composed of a numerator and a denominator. It expresses the

relationship between specific financial statement data. The resulting ratio may be interpreted
as a percentage, a rate or a proportion. Take for example a company with sales of P1,000,000
and net income of P100,000. If we take the ratio of net income divided by sales, the result is
10%. We can understand this as “Net Income is 10% of Sales”. We can also look at it as a rate
or proportion. For every P1.00 of sales that the company generate, it earns P0.10 of net
income. Our understanding of this company’s operations has already improved significantly.
Previously, we only know the monetary value of sales and net income. Now, we know how
much income the company gets for every peso of sales. This ratio is called Net Profit Margin.

Profitability Ratios measure the ability of the company to generate income from
the use of its assets and invested capital. The company’s ability to control its cost is also
inferred from profitability ratios. Refer to Table 1for a list of ratios classified as profitability
measures.

3
 GRADE

Name of Ratio Formula

Gross Profit
Gross Profit Margin Net Sales

Net Sales-Cost of Goods Sold

Gross Profit Rate Net Sales

Operating Income Margin Operating Income

Net Sales

Net Profit Margin Net Income

Net Sales

Return on Assets Net Income

Average Assets

Return on Equity Net Income

Average Equity

Gross Profit Margin expresses gross profit as a percentage of Sales. It can be

interpreted as the peso value of the gross profit earned for every peso of sales. We can infer
the average pricing policy from the gross profit margin.

For example, if the gross profit margin is 60%, then cost of goods sold is 40% of sales.
This means that the company establishes its selling price by adding a mark-up of 150%
(60%/40%) of cost. If the company bought the inventory at P100 per unit, the mark-up is P150
(100 X 150%) and the selling price is P250. Check the gross profit rate in this example. Gross
profit is P150 (P250-P100) and the rate is P150/P250=60%.

We can also measure the company’s ability to control its cost from gross profit margin.
A company that operates in a highly competitive environment cannot dictate the selling price
for its product. Recall that gross profit is sales less cost of goods sold. If the company cannot
control sales, its only alternative in order to improve gross profit is to decrease cost of goods
sold. Therefore, between two companies in the same competitive industry, the one with a
better gross profit margin is the one who has better control of its cost.

Operating Income Margin expresses operating income as a percentage of sales. It is

the peso value of the operating income earned for every peso of sales. Operating Income is
computed as gross profit less operating expenses. Therefore, between two companies with the
same gross profit margin, the company with the better operating income margin has leaner
operations. In business, leaner operations means lower operating expenses as a percentage
of sales.

4
 GRADE

Net Profit Margin expresses net income as a percentage of sales. It can be interpreted
as the peso value of the net income earned for every peso of sales. A company with a higher
Net Profit Margin is considered more profitable. Recall from Chapter 2 that the difference
between operating and net income are other income and other expenses. Therefore, between
two companies with the same level of operating profit margin, the company with the higher net
profit margin may have lower interest expense (other expense) or higher other income (as a
percentage of sales).

Return on Assets also known as ROA, return on asset is computed as net income
divided by average total assets. ROA can also be computed using the ending balance of total
assets instead of average total assets. It is popular measure of the profitability of the
company’s assets. It also measures the company’s efficiency to generate income by employing
its assets. In comparing companies, the company with a higher ROA is judged to be more
profitable.

Return on Equity is computed as net income divided by average total equity. Like
return on assets, ROE can also be computed using the ending balance of equity. It measures
the return (net income) generated by the capital invested by the owner in the business. Like
ROA, the company with a higher ROE is judged to be more profitable.

Activity 1.

JC Trading Company
Statement of Financial Position
As of December 31

2014 2013
Cash and Cash Equivalents 470,310 519,860
Accounts Receivable (Net) 660,110 565,170
Inventory 653,060 555,480
Prepaid Expenses 173,740 228,810
Total Current Assets 1,957,220 1,869,320
Property, Plant & Equipment 5,910,530 5,501,660
Intangible Assets 745,200 721,910
Total Assets 8,612,950 8,092,890

Current Liabilities 1,273,050 1,123,700

Long-Term Liabilities 577,580 541,540
Total Liabilities 1,850,630 1,665,240
JC, Capital 6,762,320 6,427,650
Total Liabilities and Owner’s Equity 8,612,950 8,092,890

5
 GRADE

JC Trading Company
Statement of Comprehensive Income
For the year Ended

2014 2013
Sales Revenue 5,385,860 4,921,850
Cost of Goods Sold 1,374,790 1,254,860
Gross Profit 4,011,070 3,666,990
Selling and Administrative Exp. 3,406,460 3,127,150
Operating Income 604,610 539,840
Interest Expense 11,820 23,040
Net Income 592,790 516,800

Required: Compute for the profitability ratios discussed above.

Name of the Ratio Formula 2014 JC Trading Ratio

Gross Profit Margin Gross Profit 4,011,070
Net Sales 5,385,960
= 74.47%
Gross Profit Rate Net Sales-COGS
Net Sales
604,610
Operating Income
5,385,860
Operating Income Margin Net Sales
= 11.23%
592,790
Net Income
5,385,860
Net Profit Margin Net Sales
=11.00%
592,790
Net Income
8,352,920
Return on Assets Average Assets
=7.10%
572,790
Net Income
6,594,990
Return on Equity Average Equity
=8.69%

Asset Beginning + Asset Ending

*Average Assets = 2

Owner’s Capital Beginning + Owner’s Capital Ending

*Average Equity = 2

Operational Efficiency measures the ability of the company to utilize its assets.
Assets are generally acquired for the purpose of generating sales. Operational Efficiency is
measured based on the company’s ability to generate sales from the utilization of its assets, as
a whole or individually. The turnover ratios are primarily used to measure operational
efficiency. List of ratios for measuring operational efficiency are listed in Table 2.

6
 GRADE

Ratio Formula

Asset Turnover Net Sales

Average Asset

Fixed Asset Turnover Net Sales

Average Fixed Asset

Inventory Turnover Cost of Goods Sold

Average Inventory

Days in Inventory 365

Inventory Turnover

Accounts Receivable Turnover Net Sales

Average Accounts Receivable

Days in Accounts Receivable 365

Average Collection Period Accounts Receivable Turnover

Asset Turnover ratio is an indicator of the efficiency with which the company is utilizing
all of its assets. It measures the peso value of sales generated for every peso of the
company’s assets. The higher the turnover rate, the more efficient the company is in using its
assets.

Fixed Asset Turnover this ratio is similar to asset turnover, except that it is focused on
fixed assets only. Fixed asset is composed of property, plant and equipment. It is an indicator
of the efficiency of fixed assets in generating sales.

Inventory Turnover is measured based on cost of goods sold and not sales. This is
because inventory, upon sale, is transferred to cost of goods sold. It makes both the numerator
and denominator measured at cost. Thus ratio is an indicator of how fast the company can sell
its inventory. Assume that a company will restock merchandise only when all inventory in the
warehouse are sold. This means inventory is zeroed out before purchasing a new batch.
Inventory turnover measures the number of times the company restock inventory. Company A,
with an inventory of 3X (read as three times) means that it made three purchases during the
year. The company with 7X (read as seven times) inventory turnover outperformed Company
A.

Days in Inventory is much easier to appreciate the concept of number of days in

inventory. This ratio computes the average number of days that inventories are held until sold.
Days in inventory can be easily derived from inventory turnover by multiplying 365 days by
1/Inventory Turnover. We can also compute days in inventory as follows:

7
 GRADE

Average Inventory
Average Daily Cost of Goods Sold

Where:

Inventory Beginning + Inventory End

Average Inventory= 2

Cost of Goods Sold

Average Daily Cost of Goods Sold= 365

Accounts Receivable Turnover/Days in Receivable

Accounts receivable turnover measures the number of times the company can convert
accounts receivable to cash during the year. Basically, the ratio asks how many times the
company was able to collect on its average accounts receivable during the year.

Another measure of the company’s collection effectiveness is days in receivables. It can

be computed from the turnover ratio or computed on its own. Days in receivables is a more
visual indicator as compared to accounts receivable turnover. It computes for the average
number of days from date of sale to date of collection.

365
Days in Accounts Receivable = Accounts Receivable Turnover

Average Accounts Receivable

Days in Accounts Receivable = Average Daily Sale

Where:
A/R beginning. + A/R End
Average Accounts Receivable = 2

Sales
Average Daily Sales = 365

Required: Using the JC Trading Company financial statements above, compute for the 2014
operating efficiency ratios.

2104 JC Trading
Name of the Ratio Formula
Ratio
5,385,860
Net Sales
Asset Turnover 8,352,920
Average Asset
=0.65
5,385,860
Net Sales
Fixed Asset Turnover 5,706,100
Average Fixed Asset
=0.94
1,374,790
Cost of Goods Sold
Inventory Turnover 604,270
Average Inventory
=2.28
Days in Inventory 365 365
Inventory Turnover 2.28
=160.43

8
 GRADE

5,385,860
Accounts Receivable Net Sales
612,640
Turnover Average Accounts Receivable
=8.79
365
365
Days in Receivable 8.79
Accounts Receivable Turnover
=41.52

Financial Health
To evaluate the financial health of the business, we will look into the company’s
solvency and liquidity ratios. Solvency refers to the company’s capacity to pay their long-term
liabilities. On the other hand, Liquidity ratio intends to measure the company’s ability to pay
debts that are coming due (Current Liabilities). Liquidity is a more urgent issue as compared to
solvency. Creditors look both solvency and liquidity ratios to evaluate the company’s ability to
pay back their debts as well as pay interests. We will use the ratios at Table 3 as indicators of
a company’s financial health.

Table 3: Solvency and Liquidity Ratios

Ratio Formula
Solvency Measures

Total Debt
Debt to Equity Ratio
Equity

Total Debt
Debt Ratio
Total Assets

Operating Income
Interest Coverage Ratio
Interest Expense

Liquidity

Current Assets
Current Ratio
Current Liabilities

Quick Assets
Quick Ratio or Acid Test Ratio
Current Liabilities

Debt to Equity Ratio indicates the company’s reliance to debt or liability as a source of
financing relative to equity. A ratio suggests a high level of debt that may result in high interest
expense. A debt to equity ratio of greater than 1 implies that the company’s debt exceeds its
capital.

9
 GRADE

Debt Ratio is similar to debt equity ratio. It indicates the percentage of the company’s
assets that are financed by debt. A high debt to asset ratio implies a high level of debt.

Interest Coverage Ratio measures the company’s ability to cover the interest expense
on its liability with its operating income. A ratio greater than 1 means the company’s operating
income can meet its interest expense. But 1 is a very low ratio. Creditors prefer a high
coverage ratio to give them protection that interest can be repaid from income.

Current Ratio is used to evaluate the company’s liquidity. Basically, we want to know
whether there are sufficient current assets to pay for current liabilities. A ratio of 1 means
current assets can fully cover current liabilities. However, creditors want a margin of safety.
Some creditors require a current ratio of 2.

An alternative measure of liquidity is the net working capital. This refers to current
assets less current liabilities. A positive net working capital means that not only is current
liabilities fully covered by current assets, there are excess current assets that the company can
use for other purposes. On the other hand, a negative net working capital means that current
assets are not sufficient to pay liabilities that are coming due.

Quick Ratio is stricter than current ratio. It suggests that not all current assets can be
easily liquidated to pay for short-term liabilities. Current assets such as inventory will take a
longer time to liquidate. There are also items like prepaid expenses that are not convertible to
cash. By definition, quick assets include only current assets that can be quickly turned into
cash such as cash and cash equivalents, accounts receivable and marketable securities.

Like current ratio, we want to know whether there are sufficient quick assets to pay for
current liabilities. A quick ratio of 1 is acceptable.

Required: Using the JC Trading Company financial statements above, compute for the 2014
financial health ratios:

Name of the Ratio Formula 2104 JC Trading Ratio

Solvency Ratios
1,850,630
Total Debt
Debt to Equity Ratio 6,762,320
Equity
=27.37%
1,850,630
Total Debt
Debt Ratio 8,612,950
Total Assets
=21.49
604,610
Operating Income
Interest Coverage Ratio 11,820
Interest Expense
=51.15
Liquidity Ratios
1,957,229
Current Assets
Current Ratio 1,273,050
Current Liabilities
=1.54
1,130,420
Quick Assets
Quick ratio 1,273,050
Current Liabilities
=0.89

1
 GRADE

Uses and Limitations of Financial Statement Analysis

Financial ratios can also be used for forecasting. Assuming the company expects to
maintain the relationships between accounts, ratios computed based on historical numbers can
be used to prepare forecasted financial statements. Financial ratios can also be used to check
the reasonableness of targets.

Financial ratios are widely used by potential creditors and investors. Potential creditors
want to know the company’s ability to pay its debts when they are due. Investors want to know
whether the company can bring an acceptable return on their investments. Even employees
perform financial statement analysis to determine whether the company can afford to pay
wages and benefits. However, users should be aware of the limitations of financial statement
analysis.

Financial statement analysis is used to support business decisions that will have an
effect on future time period. For creditors, can the company repay principal and interest in the
future? For investors, will the company’s future operations bring about an acceptable rate of
return on an investment to be made today? Remember that horizontal analysis, common size
financial statements and financial ratios are based on historical financial statements. Historical
performance may provide an indication but will not ensure future performance.

Another limitation on financial statement analysis is the financial statement itself. A good
financial analysis will be worthless if the financial statements are erroneous or fraudulent. As
they say, garbage I and garbage out. Therefore, the first step to financial statement analysis
should be to determine the credibility of the financial statements. It should be free from material
errors and biases.

Activity 1. Modified Matching Type: Form the financial ratios listed in the box, group the
financial ratios as to Profitability, Operational Efficiency, and Financial Health Ratios.

Return on Assets Gross Profit Margin Debt Ratio

Current Ratio Debt to Equity Ratio Accounts Receivable Turnover
Quick Ratio Days in Inventory Interest Coverage ratio
Return on Equity Net Profit Margin
Asset Turnover Fixed Asset Turnover

Profitability Ratios

1
 GRADE

Operational Efficiency Ratios

Financial Helath Ratios

What’s more?
Activity 2. Problem Solving

Walang Forever Trading Company

Statement of Financial Position
As of December 31

2014 2015
Cash and Cash Equivalents 350,000 310,000
Accounts Receivable (Net) 540,000 345,000
Inventory 560,000 455,000
Prepaid Expenses 155,000 205,000
Total Current Assets 1,604,000 1,313,000
Property, Plant & Equipment 5,250,000 4,100,000
Intangible Assets 645,000 650,000
Total Assets 7,500,000 6,065,000

Current Liabilities 1,170,000 1,200,000

Long-Term Liabilities 485,000 540,000
Total Liabilities 1,655,000 1,740,000
JC, Capital 5,845,000 4,325,000
Total Liabilities and Owner’s Equity 7,500,000 6,065,000

1
 GRADE

Move on Trading Company

Statement of Comprehensive Income
For the year Ended

2014 2015
Sales Revenue 4,540,000 3,850,000
Cost of Goods Sold 1,350,000 1,250,000
Gross Profit 3,190,000 2,600,000
Selling and Administrative Exp. 2,520,000 1,840,000
Operating Income 670,000 760,000
Interest Expense 21,000 40,000
Net Income 649,000 730,000

Required: 1. Compute for the Profitability Ratios.

2. Compute for the Operational Efficiency Ratios.
3. Compute for the Financial Health Ratios.

Assessment
Multiple Choice: Read each sentence carefully and choose the letter of the
correct answer. Write the letter in the space provided before the number.

____ 1. Which of the following cannot be used to analyze financial statements?

a. Liquidity ratios b. Solvency Ratios c. Profitability ratios d. None of the Above
____ 2. This is the availability of resources to meet short term cash requirements.
a. Liquidity b. Solvency c. Profitability d. None of the above
____ 3. This is the excess of current assets over current liabilities.
a. Working Capital b. Current Ratio c. Acid Test Ratio d. Quick Ratio
____ 4. If Current assets amounted to P600,000 and Current liabilities amounted to P200,000,
How much is the working capital of the entity?
a. P800,000 b. P400,000 c. 3 d. 1/3
____ 5. If current assets amounted to P600,000 and current liabilities amounted to P200,000,
What is the current ratio of the entity?
a. P800,000 b. P400,000 c. 3 d. 1/3
____ 6. Which of the following is not considered as a quick asset?
a. Cash b. Inventory c. Accounts Receivable d. None of the above

1
 GRADE

____ 7. Which of the following is considered as a quick asset?

a. Prepaid asset b. Trading securities c. Both A & B d. None of the above
____ 8. If quick assets of the company amounted to P90,000, and the quick ratio is 9, how
Much is the current liabilities?
a. P810,000 b. P89,997 c. P90,000 d. P10,000
____ 9. This measures the frequency of accounts receivable converted into cash?
a. A/R turnover ratio b. Average collection period c. Both A & B d. None of the above
____10. If net sales is P200,000 and the average accounts receivable is P50,000, what is
A/R turnover ratio?
a. 4 b. ¼ c. P150,000 d. P250,000

Answer Key

What I know?
1. T
2. F
3. F
4. T
5. F
6. T
7. F

Assessment
1. D
2. A
3. A
4. B
5. C
6. D
7. C
8. D
9. C
10. A

1
 GRADE