Ratio Analysis: Define The Measurement Levels, Namely, Liquidity, Solvency, Stability, and Profitability

RATIO
ANALYSIS
Define the measurement

levels,
namely, liquidity, solvency,
stability,
and profitability
WHAT IS RATIO ANALYSIS?
Ratio analysis is a quantitative method of gaining insight into a

company's liquidity, operational efficiency, solvency, and profitability
by studying its financial statements such as the balance sheet and
income statement. INVESTOPEDIA
TYPES OF FINANCIAL RATIO ANALYSIS
1. Liquidity Ratios – measure the ability of an entity to pay currently

maturing obligations and meet unexpected cash needs.
2. Solvency Ratios – measure the ability of an entity to survive over a long
period of time.
3. Profitability Ratios – measure the ability of an entity to earn income over a
period of time.
4. Operational Efficiency Ratios - measures the ability of the company to
utilize its assets.
LIQUIDITY
RATIOS
LR – CURRENT RATIO
Current ratio is the relationship of available current assets to meet payments of current
liabilities. Also called working capital ratio. It is an important measure of financial
health since creditors can measure a company's ability to pay off its debts within a
year.
CURRENT RATIO = CURRENT ASSETS
CURRENT LIABILITIES
Dec. 31, 20X4 Dec. 31, 20X3
Total Current Assets P420,000 P460,000
Divided by Current Liabilities P160,000 P150,000
Equals the Current Ratio 2.63 3.07
INTERPRETATION
In 20X4, it indicates that Craft Company has available current assets of P2.63 for
every P1.00 of current liability. 2.63:1
In 20X3, there is P3.07 of current assets available to pay every P1.00 of current
liability. 3.07:1
• THERE IS A DECREASE IN CURRENT RATIO – CONSIDERED UNFAVORABLE
(CREDITORS)
• *HOWEVER, IF THE BUSINESS IS STILL ABLE TO PAY W/O FINANCIAL DIFFICULTY,
A DECREASE SHOULD NOT CAUSE ALARM.
LR – ACID TEST RATIO/QUICK
RATIO
Acid test ratio is similar to Current ratio. However, it is stricter in its application because
it does not include inventories and prepaid items.
ACID TEST RATIO = QUICK ASSETS(Cash, Temp. Investments and Short term A/R)
TOTAL CURRENT LIABILITIES
Cable Co. Field Co.
Total QAssets P280,000 P600,000
Total Current LiabP300,000 P400,000
Acid-test Ratio .93:1 1.5:1
INTERPRETATION
Cable Co. has available P.93 of quick assets to pay for every P1.00 of current
liabilities, whereas, Field Co. has 1.50 of quick assets for every P1.00 of current
liabilities.
*FIELD CO. IS IN A BETTER POSITION TO PAY ITS DEBTS ON THE DUE
DATE.
Note: There is no standard acceptable ratio. The acceptable ratio is determined by

the creditor or management or whoever is using the quick ratio as a tool for analysis.
SOLVENCY
RATIOS
SR – Debt to Equity Ratio
Debt to equity ratio indicates the company’s reliance to Formula

debt or liability as a source of financing relative to equity.
INTERPRETATION:
The debt to equity ratio of .27 : 1 means that for every P1
peso invested by the owner to the business, the creditors
provide 27 centavos. A high debt to equity ratio is not
favorable to the business.
SR – Debt to Total Assets Ratio
Debt Ratio basically measures the Formula
percentage or proportion of funds/assets that

is provided by the creditor.
INTERPRETATION:
It means that P.21 or 21 centavos has been
provided by the creditor for every P1 of the
business. .21 : 1
PROPRIETARY
RATIO
Equity Ratio
Equity Ratio is the ratio of the total owner’s equity to the

total assets.
Formula
Equity Ratio = Total Owner’s Equity
Total Assets
Illustration:
Cosio Co. records show the following:

Current Assets P 1,000,000
PPE 4,000,000
Total Assets 5,000,000
Current Liabilities P 2,000,000
Owner’s Equity 3,000,000
Total Liabilities and Owner’s Equity P 5,000,000
Interpretation
.60:1
This means that for every P1.00 Total Assets, the owner’s share is
P.60. This shows long-term solvency of the business
PROFITABILITY
RATIOS
PR – Gross Profit Ratio
It is the relationship between gross profit and net sales. Gross Profit = Net Sales –
This ratio measures how profitable a company sells its
inventory or merchandise. In other words, the gross profit Cost of Goods Sold
ratio is essentially the percentage markup on merchandise
from its cost.
* Net Sales = Sales minus
FORMULA: Sales Discounts and Sales
Gross Profit Ratio = Gross Profit returns and allowances
Net Sales
Example: King Co. for 20X4 (page 64)
Gross Profit Ratio = 418,000 / 1,230,000 = .34 : 1
INTERPRETATION:
This means that for every P1.00 of net sales, the gross margin of the
business is P.34 or 34 centavos.
*For every 1.00 sales that King Co. made in 20X4, the company gets to
keep 34 centavos worth of profit.
High Profit Margin
FAVORABLE
Exercise:
Assume James’ Clothing Store spent 100,000 on

inventory for the year. James was able to sell this
inventory for 500,000. Unfortunately, 50,000 of
the sales were returned by customers and
refunded.
PR – Net Profit Ratio
The net profit margin measures the overall operating

performance of the business. Also known as Return
on Sales.
* Net Sales = Sales

FORMULA:
minus Sales Discounts
Net Profit Ratio = Net Income and Sales returns and
Net Sales allowances
Example: King Co. for 20X4 (page 64)
Net Profit Ratio = 79,000 / 1,230,000 = .064 : 1
INTERPRETATION:
*For every 1.00 sales that King Co. made in 20X4, the net income is
around P.06.
High Ratio Higher profitability in
every peso of sales
PR – Return on Equity
It is the relationship of net income to owner’s

equity. It shows the rate of return on the
investment of the owners
*Average Equity =
Beginning Equity +
Ending Equity / 2
FORMULA:
Return on Equity = Net Income Or
Average Equity Ending Period Equity
Example: The Net Income of Lian Co. for 20X4 is P
262,500. The owner’s equity section is as follows:
20X4 20X3
Owner’s Equity P 850,000 P 900,000
Return on Equity = 262,500

875,000
Average Equity = 850,000 plus 900,000 divided by 2

INTERPRETATION
Return on Equity = 262,500

875,000
= .30 : 1
The owner earned a return of P.30 or 30 centavos for every
P1.00 on his investment
PR – Return on Assets
It measures the profitability of a business in relation to its

total assets.
ROA gives a manager, investor, or analyst an idea as to how
*Average Assets=
efficient a company's management is at using its assets to Beginning assets + Ending
generate earnings Assets / 2
FORMULA:
Return on Assets = Net Income Or
Average Assets Ending Period Assets
Example:
Total Assets of King Co. is P2, 000,000 and the net income is P79,000
Return on Assets ROA = 79,000
2,000,000
= .04 : 1
It means that for every peso that the owners of King Co. invested in assets during the year
produced P.04 of net income
Exercise: Calculate for ROA
Joe’s Construction Company is a growing construction

business that has a few contracts to build storefronts in NCR.
Joe’s balance sheet shows beginning assets of 1,000,000 and an
ending balance of 2,000,000 of assets. During the current year,
Joe’s company had net income of 20,000,000.
OPERATIONAL
EFFICIENCY
OER– Inventory Turnover
Inventory turnover is measured based on the cost of

goods sold and not sales. This ratio is an indicator of
how fast the company can sell its inventory and the
number of times the company restock inventory. *Average Inventory=
Beginning Inventory +
FORMULA: Ending Inventory / 2
Inventory Turnover = Cost of Goods Sold Or
Average Inventory Ending Period Inventory
Example
OER– Days in Inventory
This ratio computes the number of days

that inventories are held until sold.
FORMULA:
Days in Inventory = 360 days
Inventory Turnover
OER– Accounts Receivable Turnover
This ratio measures the number of times the company

can convert accounts receivable to cash during the
year. Basically, the ratio asks how many times the *Average A/R=
company was able to collect during the year. Beginning A/R +
Ending A/R / 2
FORMULA:
A/R Turnover = Net Sales Or
Average Receivable Ending Period A/R
Example
OER– Days in Receivable
FORMULA:
Days in Receivable = 360 days
A/R Turnover
Days in Receivable
365
Days in receivable =
A/R Turnover
365
Days in Inventory =
8.79
41.52
This means that JC Trading normally collects its receivable

every 41 days.

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RATIO

Define the measurement

Ratio analysis is a quantitative method of gaining insight into a

1. Liquidity Ratios – measure the ability of an entity to pay currently

Note: There is no standard acceptable ratio. The acceptable ratio is determined by

Debt to equity ratio indicates the company’s reliance to Formula

Debt Ratio basically measures the Formula

percentage or proportion of funds/assets that

Equity Ratio is the ratio of the total owner’s equity to the

Cosio Co. records show the following:

Assume James’ Clothing Store spent 100,000 on

The net profit margin measures the overall operating

* Net Sales = Sales

It is the relationship of net income to owner’s

Owner’s Equity P 850,000 P 900,000

Return on Equity = 262,500

Average Equity = 850,000 plus 900,000 divided by 2

Return on Equity = 262,500

It measures the profitability of a business in relation to its

Joe’s Construction Company is a growing construction

Inventory turnover is measured based on the cost of

This ratio computes the number of days

This ratio measures the number of times the company

This means that JC Trading normally collects its receivable

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