Senior High School

Fundamentals of
Accountancy
Business and
Management 2
Quarter 1 –Module 5.2
Tools for Analysis and
Interpretation of Financial
Statements
(Financial Ratios)

T-II BACOLOR HIGH SCHOOL

Editors:
JANE P. VALENCIA, ED. D., EPS –
 What I Need to Know

This module was designed and written with you in mind. It is here to help you master
the subject Fundamentals of Accountancy, Business and Management II – G12
particularly the Analysis and Interpretation of Financial Statements. The scope of this
module permits it to be used in many different learning situations. The language used
recognizes the diverse vocabulary level of students. The lessons are arranged to follow
the standard sequence of the course. But the order in which you read them can be
changed to correspond with the textbook you are now using.

This module will cover financial statement analysis, namely:

Lesson 1 – Tools for Analysis and Interpretation of Financial Statements
(Financial Ratios) namely liquidity, solvency, stability and profitability

After going through this module, you are expected to:

1. Determine the different financial ratios.
2. Calculate and interpret financial ratios including profitability, liquidity,
solvency, efficiency (Turnover Ratios)

What I Know

PRE-ASSESSMENT. Choose the letter of the best answer. Write the chosen letter on a
separate sheet of paper.
1. In which line of business would you expect the Inventory Turnover ratio to be
higher?
a. Supermarket c. Appliances
b. Construction supplies d. Clothes and Accessories

2. What consequence will you expect if the inventory days are reduced
from 78 to 64?
i. profitability of the business will improve
ii. Liquidity of the business will improve
iii. Operational efficiency of the business will improve
a. i b. i, ii c. i, ii, iii d. no consequence
3. Sales in the year ending 31st March 2012 were P43,200. Identify the
gross profit ratio, as a percentage, if gross profit for the year was
P5,400
a. 7% b. 12.5% c. 20% d. 25.7%

4. Which formula is defined by Current assets DIVIDED BY current liabilities?

a. Current Ratio c. Net Worth Ratio
b. Debt Ratio d. Working Capital

5. Which inventory turnover ratio is favorable to a company?

a. 2.4 b. 2.75 c. 3.24 d. 3.79

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 6. It narrates the connection between the numbers presented in the
financial statement.
a. Financial Ratio Analysis c. Trend Analysis
b. Horizontal analysis d. Vertical Analysis

7. Which is a Profitability Ratio?

a. Inventory Turnover c. Average Sales Period
b. Debt to Equity Ratio d. Return on Assets

8. Which is a Liquidity Ratio?

a. Inventory Turnover c. Profit Margin
b. Debt to Equity Ratio d. Return on Assets

9. Looking at the items below:

Amount
Cash P410,000
Accounts Receivables 120,000
Merchandise Inventory 235,000
Property, Plant and Equipment 455,000
Accounts Payables 265,000

* Compute the Current Ratio

a. 1.5 c. 9.4
b. 2 d. 2.9

10.Which of the following is unfavorable to the company’s Debt ratio?

a. 64% b. 53% c. 24% d. 15%

Notes to the Teacher

Before starting this module, the teacher should review

the learner on the components of the four major financial
statements, as well as his/her Business Math computation
skill in ratios and percentages. Remind the learner that
analysis of a financial statement goes beyond computation, it
also involves interpretation. Be prepared to roll out their
analytic minds.

Lesson Analysis and Interpretation of

3 Financial Statement: Financial Ratios

In the last module, we looked into the evaluation of the company’s health
condition by putting some numbers and analysis into it, through the horizontal and
vertical analysis. These analyses allowed intra-comparability (compare company’s
performance with itself), inter-comparability (compare company’s performance with a
competitor), and comparison with the industry standard (compare company’s
performance with the industry’s standard average). For this module, we will continue
our discussion on financial statement analysis focusing on financial ratios to dig deeper
into the company’s profitability, liquidity, solvency and efficiency.

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 What’s New

Let’s look back at the data from Faithful John’s Merchandising from our previous
module:

Sales Gross Net Gross Net Profit

Profit Profit Profit Margin
Faithful John’s MerchandisingMargin
Statement of Comprehensive Income
Gross Profit Net Income
For the year ended December 31 Net Sales Net Sales

Bituin Hardware P240,000 P60,000 2017 P30,0002016 INC/DEC %

Net Sales P350,000 P275,000 P75,000 27.3
Cost of Goods Sold (225,000) (200,000) (25,000) 12.5
Gross Profit
Tala Hardware P300,000 P125,000
P75,000 P30,000 P75,000 P50,000 66.7
Operating Expenses (105,000) (55,000) (50,000) 90.9
Net Income P20,000 P20,000 0 0

While the horizontal analysis was able to make a comparison between the
company’s performance in both years, more essential information can still be drawn on
issues like:
1. If a business makes sales, does it mean that it is also making profit?
2. How fast can they sell their inventory?
3. How many days does it take to collect receivables from customers?
4. How much revenue is generated for each peso of asset invested in the
business?
Answers to these questions may be taken from financial statements and drawn
further through financial ratios.

What’s In

Can you tell which of the two businesses has

performed Better?

In the case of Bituin and Tala, both had the same amount of net income of
P______________ but differ in their Net Profit Margin (Bituin: _____%, Tala: ____%).
Although Tala showed higher amount of sales at P_______________, its NPM was _____%
lower. This may indicate a weakness of control in operating costs and expenses.

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 What is It

Financial ratio analysis compares relationships between financial statement

accounts to identify the strengths and weaknesses of a company.

• They may be interpreted as decimal, percentage or a

proportion.
• They are composed of a numerator and denominator. One
number divided by another number.
•They allow comparison between different companies in the
industry.
•They are used by management and creditors as well.

Let us assume that you are an owner of a business, as an owner, you will surely
be interested to know the performance of your company from different aspects like your
company’s ability to pay debt, how much of asset is utilized to generate income and its
operating efficiency. Your business may make a sale, but it does not guarantee that it
is also generating profit for company, this is where financial ratios can help. To make
you get a clearer picture of your firm’s performance. Consider the following questions:

How much of my investment is being used to produce

income?

How much of my every peso sale goes to net profit?

How fast can my company sell its inventory?

How much time does it take to collect receivables from
my customers?

To have an organized idea, financial ratios are often grouped in categories based
on what they measure. Each of these will be discussed in the following sections.

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 Remember, in analyzing financial ratios we need to the apply the two phases
discussed from our previous module. Do you still remember them?

You have to start with the (computation, interpretation) phase to determine the
differences, ratios and percentages followed by the (computation, interpretation) phase
to figure the results and communicate their meaning to its users.
If you want to check whether a company is effective in making sales while
controlling costs and expenses, you might consider doing profitability ratios.

PROFITABILITY RATIOS- show how well companies use their existing

assets to generate profit by comparing income statement accounts and
categories.

To illustrate, using the available data of Milly’s Pet Shop on

December 31,2015, Milly’s books showed an average total asset of P300,000 and a
Statement of Comprehensive Income.

Net Sales P250,000

COGS (120,000)
Gross Profit P130,000
Operating Expenses (60,000)
Operating Income P70,000
Interest Expense (3,000)
Net Income P67,000

PRACTICE ACTIVITY 1. PROFITABILITY. Let’s try to find answers to the following

questions below and look at the appropriate tool used to compute for the ratios under
profitability:
TOOLS FORMULAS
1. How much of sales is gross profit?
Gross Profit Margin- it
measures gross profit as
percentage of sales.
2.How much of sales is operating income?
 Operating Profit Margin-it
expresses income as percentage of
sales after deducting the COGS and
operating expenses.
3.How much of sales is net income?
Net Profit Margin-it reflects net
income as a percentage of sales. It
shows how much will go to the
owner for every peso of sale made.
4.How much of assets were utilized to
generate income?
 Return On Assets- it measures
income generated by utilizing
company assets *Average total asset= asset beginning + asset end/2

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Note that, the higher the profitability ratios, the more stable a company is
considered, as it indicates that the company is making more from each sale.

The finances of a business must be properly managed to make it successful.

As the business grows bigger, operations become more complex and thus business
may enter into debt. A well-managed business is capable of meeting obligations
and reduce the risk for the company.

Although debts may help bring extra cash needed for the growth and
expansion of the business, too much debt can bring the company out of business.
Owners must ensure the balance between making debt and having the ability to
pay them back. This is measured by checking the firm’s solvency and liquidity.

SOLVENCY RATIOS
You will know if the company is solvent if it has greater assets than liabilities.
Solvency talks about the company’s ability to meet its long-term debt while still
sustaining itself. Let’s take a look at the appropriate tools to compute for solvency.

1.To tell how much of the company’s 2.To tell how much of the company’s
assets are financed by debt, the assets are financed by capital, the Equity
company’s Debt Ratio is measured. Ratio is measured.
This is done by applying the formula: This is done by applying the formula:

 A high debt ratio implies a high level A high equity to asset ratio implies a
of debt that would mean low solvency high level of capital which means the
for the company. It is desirable to keep company is solvent.
it lower.
3.To tell how much of the company 4.To tell the company’s ability to pay
depends on debt, the Debt-to Equity interest from its operating income, the
Ratio is measured. Times Interest Earned is measured.
This is done by applying the formula: This is done by applying the formula:

A high debt to equity ratio reflects A high ratio gives the creditors safety
high level of debts, resulting to high that the interest due them can be paid.
interest expense. Solvent companies Solvent companies desire to keep it
desire to keep it lower. higher.

In general, a higher solvency ratio reflects the company’s ability to meet its
long-term liabilities/financial obligations.
LIQUIDITY RATIOS
How easy can a company meet its short-term debt? This question can be
answered by assessing if the company is liquid. We say that a liquid company has

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 a lot of cash or cash equivalent on hand. This is measured by the company’s
Current and Quick Ratios.

1.To measure whether the company 2. Another stricter tool to measure

has sufficient current assets to pay for company’s liquidity is the Quick Ratio.
current liabilities the Current Ratio is This tool does not include all the current
computed using the following formula: assets, instead, only those that are easier
to liquidate such as cash and accounts
receivables. These assets are referred to
as quick assets. A Quick Ratio is
computed using the following formula:
A high current ratio implies a high
level of liquidity for the company.

 In general, a high liquidity ratio shows that a business has cash available and
can safely meet its current liabilities.

Practice Activity 2. SOLVENCY & LIQUIDITY. The following are taken from the
books of Nature’s Merchandise for the year ended December 31, 2016. Write the formula
and compute the following ratios. The first item is done for you.

Cash P510,000
Accounts Receivable 320,000
Merchandise Inventory 435,000
Property, Plant and Equipment 650,000
Accounts Payable 260,000
Total Liabilities 760,000
Total Equity 1,155,000
Interest Expense 9,000
Net Sales 420,000
Gross Profit 154,000

RATIO FORMULA SOLUTION

1. Debt Ratio

2. Equity Ratio

3. Debt-to-Equity Ratio

4. Times Interest Earned

5. Current Ratio

6. Quick Ratio

ACTIVITY 3. INTERPRETING RATIOS. So far, we have already discussed the three

tools. Before moving on to the third, let’s practice interpreting results based on what
has been discussed.
Assume that you are the manager of Pinya Trading. At the end of the year,
financial ratios for your company and your competitor Pilak Trading were presented to
you. Based on how you interpret the data given, tell whether your company is winning,
losing or setting an equal foot with your competitor. Write: WIN, LOSE, or EQUAL
between the ratios. Three items are done to illustrate.

PINYA WIN/LOSE/EQUAL PILAK

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 Profitability
1.Gross Profit Ratio 25% Win 20%
2.Net Profit Ratio 15% 15%
Solvency
3.Debt Ratio 30% Win 40%
4.Equity Ratio 70% 60%
Liquidity
5.Current Ratio 9:1 4:1
6.Quick Ratio 1:1 Lose 4:1

Another tool to determine the success of a business is by

measuring its operating efficiency. As a business does its
operations, transactions also grow and become more complex.
For the business to earn, it has to offer goods or services,
purchase equipment for faster services and pay various expenses
needed for it to operate. To put numbers in assessing the
company’s operating efficiency, turnover ratios are utilized to
show the company’s behavior in terms of sales, receivable, inventory and collection.

It shows how fast the company can INVENTORY TURNOVER

sell and replace its inventory.
Ex. Joe Trading spends P5,000 for a
given period, during which it has an average Inventory Turnover = Cost of Goods Sold
of P1000 worth of inventory on hand, has an Average Inventory
inventory turnover ratio of 5 during that
period. *Ave. Inventory.= Beginning inv. + Ending Inv/2

The higher the ratio, the more quickly your business is cycling through the
investments it makes, moving product into customers' hands rather than storing it unsold.

It indicates the average time inventory

AVERAGE SALES PERIOD is sold and replaced during the year.
Ex. Joe’s Average Sales Period
Average Sales Period = 360 days_____ 360 days_____ = 360 days_____= 72 days
Inventory Turnover Inventory Turnover 5

A decrease in average sales period indicates overstocking or slow movement of

inventory, which is not favorable for the business.

It measures the efficiency of the

company to collect the amount due from RECEIVABLE TURNOVER
credit customers. Net Credit Sales_
Receivable Turnover =
Ex. Net Credit Sales P150,000 Average Accounts Receivable

Beginning Receivable 15,600 P150,000_= 9.06

Ending Receivable 17,500 P16,550
*Ave Receivable= Beginning + Ending/ 2

Generally, a high receivable turnover is considered favorable for the company as it

shows aggressive collection efforts.
It is the approximate number of days
AVERAGE COLLECTION
it takes a firm to collect credit sales.
PERIOD Ex. Joe had the following data from
There are two possible formulas his books.
to compute the ACP: Receivable Turnover 9.06
Average Receivable P59,610
Annual Sales P540,000
1.Average Collection Period 360 days_____
ACP= 360 days__=39.74 days
=
9.06

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 Receivable Turnover ACP= P59,610__=39.74 days
Average Receivable_ P1,500
2.Average Collection Period
= Average Daily Sales
*Ave Daily Sales = Annual Sales/360days

The favorableness of the average collection period depends on the term extended by the
company. If a company has a 30 days term of credit, an average collection period of 37 days
will not be favorable.

Activity 4. Turnover Ratios. Let’s try if you can identify the ratio that can be
computed using the components in the boxes below. Compute and write you answers
on the space provided. The first one is done for you.
RATIOS ANSWERS

Net credit sales P700,000

Average Accounts Receivable P300,000
Ratio: Receivable Turnover r 1.Inventory Turnover
_________________________
Receivable Turnover 2.25 2. Average Collection
360 days Period
Ratio: ________________________________
_________________________

Cost of goods sold P400,000 3. Receivable Turnover

Average Inventory P53,500 2.33 3
Ratio: ________________________________
4. Average Sale Period
_________________________
Inventory Turnover 1.6
360 days
Ratio: ________________________________

What’s More

Answer the following activities on a separate sheet of paper.

INDEPENDENT ACTIVITY 1. Types of Ratios. Identify the type of ratio listed below
based on what it measures. Write the letter of the correct answer on the blank.

a. Profitability b. Solvency c. Liquidity d. Turnover

_____ 1. Debt- to Equity Ratio _____ 6. Average Sale Period

_____ 2. Times Interest Earned _____ 7. Quick Ratio

_____ 3. Average Collection Period _____ 8. Gross Profit Ratio

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_____ 4. Current Ratio _____ 9. Operating Profit Margin

_____ 5. Equity Ratio _____ 10. Return on Assets

INDEPENDENT ASSESSMENT 1. Ratio Formulas. Match the following ratios with their
correct formulas.

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 _____1. Debt Ratio a. CURRENT ASSETS
CURRENT LIABILITES
_____2. Operating Profit Margin b. QUICK ASSETS
CURRENT LIABILITIES
_____3. Current Ratio c. TOTAL LIABILITIES
TOAL EQUITY
_____4. Receivable Turnover d. OPERATING INCOME
NET SALES
_____5. Return on Asset e. GROSS PROFIT
NET SALES
_____6. Quick Ratio f. TOTAL LIABILITES
TOTAL ASSETS
_____7. Net Profit Margin g. NET CREDIT SALES
AVERAGE ACCOUNTS RECEIVABLES

_____8. Debt to Equity Ratio h. NET INCOME

AVERAGE TOTAL ASSET
_____9. Gross Profit Ratio i. TOTAL EQUITY
TOTAL ASSETS
_____10. Equity Ratio j. NET INCOME
NET SALES

INDEPENDENT ACTIVITY 2. INTERPRETING RATIOS.

Assume that you are the manager of Dukit Trading. At the end of the year,
financial ratios for your company and your competitor Habi Trading were presented
to you. Based on how you interpret the data given, tell whether your company is
winning, losing or setting an equal foot with your competitor. Write: WIN, LOSE, or
EQUAL between the ratios. Three items are done to illustrate.

DUKIT WIN/LOSE/EQUAL HABI

Profitability
1.Gross Profit Ratio 35% WIN 25%
2.Net Profit Ratio 25% EQUAL 25%
Solvency
3.Debt Ratio 40% EQUAL 40%
4.Equity Ratio 60% LOSE 70%
Liquidity
5.Current Ratio 7:1 WIN 5:1
6.Quick Ratio 2:1 LOSE 4:1
Efficiency
7.Inventory 9 LOSE 15
Turnover
8.Average Collection 15 WIN 30
Period

What I Have Learned

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KEYWORDS. Fill in the blanks with the correct answers based on our discussion on
Financial Ratios.
Financial statements can be analyzed in terms of ratios based on what they measure:

I.______________ measures the efficiency of the company in utilizing assets to generate

income.
•It measures the peso sales earned after deducting the cost of goods
sold______.
•It measures the rate of income after deducting operating expenses
from gross profit _________.
•It reflects net income as percentage of sales ___________.
•It measures the assets utilized to generate income_________.
II. ___________ measures the company’s ability to pay its creditors as they fall due.
•It tells how much of assets are financed by debts_________.
•It tells how much of assets are financed by equity_________.
•It tells how much of the company depends on debts _________.
•The company’s ability to pay interest from operating income _______.

III. __________ measures company’s performance to pay short term obligations.

•The company’s ability to pay short term debts ________.
•The company’s ability to pay current/immediate debts ________.

IV. _______________ reflects the company’s performance in term of operating efficiency

•It measures how many times a company can sell and replace it inventory____.
•The average time to convert inventory into sales _______.
•The company’s ability to collect from credit customers ______.
•The number of days it takes a business to collect its receivables _______.

What I Can Do

APPLICATION I. COMPUTATION. Using the following data available from the

books of Timm’s Fruits Trading. Compute the following ratios for December 31, 2015.

Timm’s Fruits Trading

Statement of Financial Position 1. Current Ratio
As of December 31, 2015
ASSETS
Current Assets
2. Quick Ratio
Cash P108,000
Accounts Receivables 225,000
Merchandise Inventory 250,000
3. Equity Ratio
Prepaid Expenses 13,000
Total Current Assets P596,000
Property, Plant and Equipment 1,310,000
4. Debt to Equity Ratio
Total Assets P1,906,000
Liabilities and Owner’s Equity
Accounts Payables P380,000

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 Non-current Liabilities 5. Inventory Turnover
Loans Payable 458,000
Total Liabilities P838,000 6. Average Sales Period
Owner’s Equity 1,068,000
Total Liabilities and Owner’s Equity P1,906,000
7. Gross Profit Ratio
Timm’s Fruits Trading
Statement of Comprehensive Income
For the year ended December 31, 2015
Net Sales P2,780,000
Cost of Goods Sold (1,056,000) 8. Return on Assets
Gross Profit P1,724,000
Operating Expenses (688,000)
Operating Income P1,036,000 9. Net Profit Margin
Interest Expense (35,000)
Income Before Tax P1,001,000
Income Tax Expense (26,000) 10.Times Interest Earned
Net Income P975,000

Note: All sales are credit sales

Inventory Beginning P280,000
Accounts Receivable Beginning P275,000

APPLICATION 2. INTERPRETATION. From your computed ratios for Timm’s Fruit

Trading. Indicate whether the ratios are FAVORABLE OR NOT FAVORABLE to the
company.

COMPUTED RATIO FAVORABLE /

UNFAVORABLE
1. Current Ratio
2. Quick Ratio
3. Equity Ratio
4. Debt to Equity Ratio
5. Inventory Turnover
6. Average Sales Period
7. Gross Profit Ratio
8. Return on Assets
9. Net Profit Margin
10.Times Interest Earned

Assessment

Choose the letter of the best answer. Write the chosen letter on a separate sheet of
paper.

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1. Which formula is defined by annual sales DIVIDED BY 360 days?
a. Average collection period c. Current Ratio
b. Average sales period d. Average daily sales
2. Which business would possibly have a higher Inventory Turnover ratio?
a. Supermarket c. Appliances
b. Construction supplies d. Clothes and Accessories
3. Which is NOT a Solvency Ratio?
a. Current Ratio c. Gross Profit Ratio
b. Debt Ratio d. Debt to Equity Ratio

4. Sales in the year ending 31st March 2012 were P43,200. Compute
for the gross profit, if the gross profit ratio is 12.5%?
a. P3,200 b. P5,400 c. 7,800 d. P12,300

5. Current Ratio is computed by dividing Current assets by which account?

a. Cost of goods sold c. Current liabilities
b. Quick Assets d. Net income

6. Which inventory turnover ratio is unfavorable to a company?

a. 2.1 b. 2.47 c. 3.24 d. 3.79
7. The debt-to equity ratio of a company is 28% in 2014, and went up
to 42% in 2015.
a. This is good for the company
b. This is bad for the company
c. This has no effect to the company
d. None of the above
8. If the Net Income after tax of a company is P900,000, with a
starting asset balance of P250,000 and ending asset balance of
P480,000, what is the return on asset?
a. 2.1 b. 2.47 c. 3.24 d. 3.79
9. If the company’s Inventory turnover is 4 and uses a 360day/year,
what is the average sales period?
a. 1440 days c. 180 days
b. 960 days d. 90days
10. If total asset is P1,000,000 and the total equity is P350,000, how much is the
debt ratio?
a. .35 b. .65 c. .724 d. .793

Additional Activities

WHICH BUSINESS TO INVEST IN?

You want to invest your savings of P200,000 in a business, which of the

two businesses will you invest in? Calculate the following ratios to determine
the financial health of each business.

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 Ken’s Milk Tea Nila’s Pizza
Burger House Parlor
Cash P400,000 P320,000
Accounts Receivable 20,000 25,000
Property, Plant and 650,000 P540,000
Equipment
Accounts Payable 60,000 150,000
Total Liabilities 245,000 270,000
Total Equity 825,000 615,000
Interest Expense 9,000 12,000
Net Sales 420,000 640,000
Gross Profit 154,000 170,000
Net Profit 52,600 56,000
Average inventory 435,000 300,000

I. Compute the following ratios to determine the financial health and condition of each
business.

Ken’s Milk Tea Nila’s Pizza

Burger House Parlor
1. Current Ratio
2. Inventory Turnover
3. Debt Ratio
4. Gross Profit Ratio
5. Net Profit Ratio

II. Tell which of the two business is your choice and why?

a. By comparing profitability margins, I can tell that ______________________

_____________________________________________________________________________________
______________________________________________________________________________.

b. By comparing solvency ratios, I can tell that ___________________________

_____________________________________________________________________________________
______________________________________________________________________________.

c. By looking into the turnover ratio, I can tell that _______________________

_____________________________________________________________________________________
______________________________________________________________________________.

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