LESSON 3

FINANCIAL STATEMENTS AND RATIOS, THEIR ANALYSIS AND IMPLICATIONS TO

MANAGEMENT

TOPICS
1. Kinds of Financial Statements;
2. Objectives and Limitations of Financial Statement Analysis;
3. Tools in Comparative Financial Statements Analysis; and
4. Financial Ratio Analyses and Its Effects in Decision Making

LEARNING OUTCOMES
At the end of the lesson, you should be able to create financial
statements and analyze it using methods and ratios.

Financial Statements represent a formal record of the financial activities of an entity. These are
written reports that quantify the financial strength, performance and liquidity of a company.
Financial Statements reflect the financial effects of business transactions and events on the
entity.

TOPIC 1: KINDS OF FINANCIAL STATEMENTS

There are four main kinds of financial statements, these are:

1. Statement of Financial Position

Statement of Financial Position, also known

as the Balance Sheet, presents the financial
position of an entity at a given date. It is
comprised of the following three elements:

▪ Assets: Something a business owns

or controls (e.g. cash, inventory, plant and
machinery, etc)

▪ Liabilities: Something a business

owes to someone (e.g. creditors, bank
loans, etc)

▪ Equity: What the business owes to its

owners. This represents the amount of
capital that remains in the business after its
assets are used to pay off its outstanding
liabilities. Equity therefore represents the
difference between the assets and
liabilities.

1
2. Income Statement

Income Statement, also known as the Profit and Loss Statement, reports the company's financial
performance in terms of net profit or loss over a specified period. Income Statement is composed
of the following two elements:

▪ Income: What the business has earned over a period (e.g. sales revenue, dividend income,
etc)

▪ Expense: The cost incurred by the business over a period (e.g. salaries and
wages, depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period. The
movement in cash flows is classified into the following segments:

▪ Operating Activities: Represents the cash flow from primary activities of a business.

▪ Investing Activities: Represents cash flow from the purchase and sale of assets other than
inventories (e.g. purchase of a factory plant)

▪ Financing Activities: Represents cash flow generated or spent on raising and repaying
share capital and debt together with the payments of interest and dividends.

4. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the
movement in owners' equity over a period. The movement in owners' equity is derived from the
following components:

▪ Net Profit or loss during the period as reported in the income statement

▪ Share capital issued or repaid during the period

▪ Dividend payments

▪ Gains or losses recognized directly in equity (e.g. revaluation surpluses)

▪ Effects of a change in accounting policy or correction of accounting error

TOPIC 2: OBJECTIVES AND LIMITATIONS OF FINANCIAL STATEMENTS ANALYSES

Fundamentally, analyses of financial statements are set to answer a wide-range of questions of

users. These users have diverse concerns, and objectives. Hence, they have different priorities.
However, all these users have common requirements where the very objective of financial
statements analyses originate. The analyses done aims to probe the company’s: Profitability,
Liquidity and Stability, Asset utilization or Activity, and Debt-utilization or Leverage.
The primary purpose of financial statement analysis is to examine the present, as well as past,
financial position (SPF) and results of operations (Income Statement) of the firm in order to
determine the best suitable estimate and predict the future state and performance of the
company. With this in mind, it would be fair to state that interpretations of financial ratios are
not ultimately conclusive. Results from the analysis are refutable. In addition to this, the main
object (the financial statement) used for the analysis is also subject to limitations. These
limitations, if not carefully considered, can ultimately bring about wrong decisions. The inherent
limitations of the financial statements among other things may stem from:

2
 1. Its failure to consider changes in the purchasing power, inconsistencies as well as
dissimilarities in the accounting principles, policies and procedures used by the firms
in the industry.
2. Its failure to consider changes in the purchasing power of currencies.
3. The age of the financial statements is a limitation. The older it gets, the less reliable it
becomes thus, considered as the risk management tool.
4. Failure to read and understand the information in the Notes to the financial
statements may obscure managers in evaluating the degree of risk.
5. Financial statements that have not undergone external auditing procedures may or
may not conform with the Generally Accepted Accounting Principles (GAAP) and
standards thus, usage of these statements may lead to erroneous analysis, and
ultimately erroneous decisions.
6. Financial statements that have not undergone external auditing procedures may
prove to be inaccurate or worse, fraudulent hence, do not fairly present the
company’s financial condition. Financial measurements from the analysis of these
companies are dependable and not conclusive.
7. Audited statements do not guarantee accuracy.

Lastly, the reality that a firm is trading in the stock exchange and that its financial statements are
readily available does not guarantee that the company in question is financially stable and credit-
worthy.

TOPIC 3: TOOLS IN COMPARATIVE FINANCIAL STATEMENT ANALYSIS

Financial statements are prepared to have complete information regarding assets, liabilities, equity,
reserves, expenses and profit and loss of an enterprise. To analyze & interpret the financial
statements, commonly used tools are comparative statements, common size statements etc. Let us
take a look.

Comparative Statements. Also known as ‘horizontal analysis, are financial statements showing
financial position & profitability at different periods of time. These statements give an idea of
the enterprise financial position of two or more periods. Comparison of financial statements is
possible only when same accounting principles are used in preparing these statements.

Comparative Balance Sheet. The progress of the company can be seen by observing the
different assets and liabilities of the firm on different dates to make the comparison of balances
from one date to another. To understand the comparative balance sheet, it must have two columns
for the data of original balance sheets. A third column is used to show increases/decrease in figures.
The fourth column gives percentages of increases or decreases.
By comparing the balance sheets of different dates, one can observe the following aspects
• Current financial position and Liquidity position
• Long-term financial position
• Profitability of the concern

Comparative Income Statement. Traditionally known as trading and profit and loss A/c. Net sales,
cost of goods sold, selling expenses, office expenses etc are important components of an income
statement. To compare the profitability, particulars of profit & loss are compared with the
corresponding figures of previous years individually. To analyze the profitability of the business, the
changes in money value and percentage is determined.

3
By comparing the profits of different dates, one can observe the following aspects:
• The increase/decrease in gross profit.
• The study of operational profits.
• The increase or decrease in net profit
• Study of the overall profitability of the business.

Common Size Statements. Also known as ‘Vertical analysis’. Financial statements, when read with
absolute figures, can be misleading. Therefore, a vertical analysis of financial information is done
by considering the percentage form. The balance sheet items are compared:
• to the total assets in terms of percentage by taking the total assets as 100.
• to the total liabilities in terms of percentage by taking the total liabilities as 100.
Therefore, the whole Balance Sheet is converted into percentage form. And such converted Balance
Sheet is known as Common-Size Balance Sheet. Similarly profit & loss items are compared:
• to the total incomes in terms of percentage by taking the total incomes as 100.
• to the total expenses in terms of percentage by taking the total expenses as 100.
Therefore, the whole Profit & loss account is converted into percentage form. And such converted
profit & loss account is known as Common-Size Profit & Loss account. As the numbers are brought
to a common base, the percentage can be easily compared with the results of corresponding
percentages of the previous year or of some other firms.

Trend Analysis. Also known as the Pyramid Method. Studying the operational results and financial
position over a series of years is trend analysis. Calculations of ratios of different items for various
periods is done & then compared under this analysis. Whether the enterprise is trending upward or
backward, the analysis of the ratios over a period of years is done. By observing this analysis, the
sign of good or poor management is detected.

Ratio Analysis. Quantitative analysis of information contained in a company’s financial statements

is ratio analysis. It describes the significant relationship which exists between various items of a
balance sheet and a statement of profit and loss of a firm. To assess the profitability, solvency, and
efficiency of a business, management can go through the technique of ratio analysis. It is an attempt
at developing a meaningful relationship between individual items (or group of items) in the balance
sheet or profit and loss account.

Cash Flow Analysis. The actual movement of cash into and out of a business is cash flow analysis.
The flow of cash into the business is called the cash inflow. Similarly, the flow of cash out of the firm
is called cash outflow. The difference between the inflow and outflow of cash is the net cash flow.
Cash flow statement is prepared to project the manner in which the cash has been received and has
been utilized during an accounting year. It is an important analytical tool. Analysis of cash flow
explains the reason for a change in cash. It helps in assessing the liquidity of the enterprise and in
evaluating the operating, investment & financing decisions.

4
 TOPIC 4: FINANCIAL RATIO ANALYSIS AND ITS EFFECTS IN DECISION MAKING

Ratios present relationships between two variables. Financial ratios, therefore, refer to the
relationships between financial statement items or accounts expressed in mathematical fashion.

In using these ratios, your task is to interpret them as favorable or unfavorable. To do so, you
should follow some standards that would determine the favorableness or unfavorableness of the
outcome. Some of the standard ratios used are based on:

1. Company budget for the same period;

2. Those used by the industry to which the firm belongs;
3. Those used by the firm’s successful competitors;
4. Those used by the firm using prior periods; and
5. Those used by the analyst in the past.

Industry ratios are averages developed by a group of experts involved in research. These
empirically-based ratios are used as standards in financial statement analysis. Industries have
their own peculiarities hence, experts developed ratios that are suitable for that industry. Since
this task is too tedious, analyst resort to using ratios of competitors, which are readily available.

There should be consistency in the computation as well as usage of ratios to ensure comparability
between results and prevent their misinterpretations. Just like any financial analysis technique,
financial ratios are subject to limitations. Results from financial ratio analysis are indicators of a
firm’s weakness or strength but are not in themselves, good or bad. This is understandable since
the ratios spring forth from financial statements, which as we have mentioned, are subject to
limitations.

Results derived from the computation of ratios could be presented as a percentage (%), a fraction
(1/4), a Peso amount (P25.50), or a relative ratio (2:1).

Illustrative Example:
Assume further that Riel Corporation is a leading department store of fashionable clothes and
apparels, with 5 strategic branches located in the metro.
In this example, the authors provided the computation of the ratios for the current year.

You are tasked to compute the ratio for the previous year.

Riel Corporation
Comparative Statements of Financial Position
Decembers 31, 2015 and 2014

2015 2014
Assets
Current Assets
Cash & Cash Equivalent 106,789 102,375
Trade & Other Receivables 327,611 277,467
Inventory 334,863 297,654
Prepaid Expenses 101,565 114,813
Total Current Assets 870,828 792,309

Non-Current Asset 135,754 166,481

Property, Plant & Equipment 7,500 7,500
Intangibles 143,254 173,981
Total Noncurrent Asset 143,254 173,981
TOTAL ASSETS 1,014,082 966,290

Liabilities and Shareholders’ Equity

5
 Current Liabilities
Trade & Other Payables 238,000 208,703
Unearned Revenues 107,508 82,456
Notes Payable - current 45,000 45,000
Total current liabilities 390,508 336,159
Non-Current Liabilities
Notes Payable – non-current 208,422 253,500
Total Liabilities 598,930 589,659

Shareholders’ Equity
Preference Shares,
P100 par 105,000 105,000
Ordinary Shares, P1 par 15,000 15,000
Premium on Ordinary Shares 135,000 135,000
Total paid-in-capital 255,000 255,000

Retained Earnings 160,152 121,631

Total Shareholders’ Equity 415,152 376,631
TOTAL LIABILITIES & SHAREHOLDERS’ 1,014,082 966,290
EQUITY

Riel Corporation
Comparative Income Statements
For the period ending December 31, 2015 and 2014

2015 2014
Sales 3,007,887 2,732,712
Less: Cost of good sold 2,208,520 1,964,865
Gross Profit 799,367 767,847
Less: Selling Expenses 372,000 345,000
Administrative Expenses 207,000 213,000
Total Operating Expenses 579,000 558,000
Operating Income 220,367 209,847
Less: Interest Expense 41,860 43,905
Net Income before taxes 178,507 165,942
Less: Income Tax 62,477 58,080
Net Income after taxes 116,030 107,862

In doing the analysis we shall cover the company status in terms of:

1. Liquidity – pertains to the firm’s ability to pay any immediate and incoming cash
disbursements (payment of payables, and operating costs and expenses).
2. Asset Utilization – measures how often is the turnover of accounts receivable, inventory
and long-term assets. Stated differently, we measure the liquidity of assets namely
accounts receivable, inventory and long-term assets. Along with this, we also measure how
efficient management uses these assets.
3. Debt-Utilization (Leverage) – estimates the overall debt status of the firm in light of its
asset base and earning power. We measure the degree of company financing in terms of
borrowings and investment or equity. We also measure the company’s ability to pay
interest and other fixed charges such as rent and payment of the investment funds like
sinking funds, redemptions, pensions, etc.
4. Profitability – this measures the firm’s capacity to earn sufficient return on sales, total
assets and owners’ investment.

6
Solution:
Liquidity/Short-term Solvency
1. Current ratio

(2015) = Current assets of P870,828 = 2.23:1 or 223%

Current liabilities of P390,508

(2014) =

Current ratio of 2.23:1 can be interpreted to mean that for every P1.0 of current liability, the
company has P2.23 current assets to pay it. This result may at times be considered as favorable
and satisfactory. It indicates the Riel is able to pay their current maturing debts, with P1.23 to
spare for every P1 of liability they have.

It is important to remember that no one current ratio is applicable or appropriate for all business.
Others may consider a ratio of 1:1 as satisfactory. A high current ratio does not necessarily mean
that the company is able to meet current maturing debts because the firm’s current asset is
composed mainly of inventories. Inventory is considered as a slow-moving asset in terms of its
convertibility into cash.

Another asset that some analysts do not use in the computation of current ratio is prepaid
expense. The reason is because they are not sources of cash. It represents the consumption or
use of future benefits like prepaid rent or prepaid advertisement. Consumption of these does not
entail cash inflow but recognition of expense for the company. So, a current ratio with significant
amount of prepaid expenses may not necessarily mean that the firm is capable of paying current
maturing obligations.

On the other hand, a company with a low current ratio may be able to pay current maturing
debts, because the composition of its current asset is easily convertible to cash like having
collectible receivables and highly saleable trading securities.

It is recommended to see whether the said ratio is favorable or not by comparing it with the
firm’s competitors or with the firm’s trend of liquidity over a period of 5 years.

Upward and Downward Movement of Current Ratio

Movements in current ratio components give rise to the changes in the current ratio.
Ponder on the following statements and experiment using the figures of Riel Corporation:
a. Increase in current assets or decrease in current liabilities increases the current ratio.

Previous current
Components Increase (decrease) New current ratio
ratio
Total current assets P 50,000 P 10,000 P 60,000
Total current
P 25,000 P 25,000
liabilities
Current ratio = 2:1 2.4:1 increase

Previous current
Components Increase (decrease) New current ratio
ratio
Total current assets P 50,000 P 50,000
Total current
P 25,000 P (10,000) P 15,000
liabilities
Current ratio = 2:1 3.3:1 increase

7
 b. If the previous current ratio is 1:1 and there is an increase or decrease of the same
amount on both the total current assets and total current liabilities, it shall have no
effect on the new current ratio or the new ratio will be the same as the previous. To
prove this, see the example below.

Previous current Increase of equal

Components New current ratio
ratio amounts
Total current assets P 50,000 P 10,000 P 60,000
Total current
P 50,000 P 10,000 P 60,000
liabilities
Current ratio = 1:1 no effect/ same
1:1
ratio

c. If the previous ratio is positive (current assets > current liabilities), and there is an
increase by the same amount in both total current assets and total current liabilities,
the ratio shall decrease and vice-versa. The opposite will occur if the previous current
ratio is negative (current liabilities > current assets).

Previous current Increase of equal

Components New current ratio
ratio amounts
Total current assets P 50,000 P 10,000 P 60,000
Total current
P 25,000 P 10,000 P 35,000
liabilities
Current ratio = 2:1 positive 1.71:1 decrease

Components Previous current Increase of equal New current ratio

ratio amounts
Total current assets P 25,000 P 10,000 P 35,000
Total current
P 50,000 P 10,000 P 60,000
liabilities
Current ratio = 0.5:1 negative 0.53:1 increase

2. Acid Test Ratio/quick ratio/liquidity ratio

Quick assets or (Cash + Trading Securities + Receivables)

of P106,789 + 327,611
(2015) = ____________________________________________________
Current liabilities of P390,508

= 1.11:1 or 1.11%

(2014) =

The quick ratio is a stricter test of liquidity. This could be interpreted that for every P1.0 liability,
the firm has P1.11 of current assets to pay it. As you can see, Riel is not as liquid as we pictured
it to be when the current ratio was used. As a general rule, the higher the quick ratio, the more
liquid the firm is and thus, can pay its current maturing debts.

Note that the inventories are ignored because of its nature being uncertain as to their salability.
Another reason for their exclusion from the formula is its uncertainty as to when the inventory
will be raw materials to work in process to finished goods, eventually and converted to
receivables and eventually collected and converted into cash.

8
Asset Utilization Liquidity Analysis

1. For Accounts Receivable

Accounts Receivable Turnover

Net Sales of P3,007,887

(2015) = _____________________________ = 9.94 times
Average Accounts Receivable of
277,467 + 327,611
_____________________________
2

(2014) =

Note: For the 2014 receivable turnover you may use the ending inventory of 2014 as the
average inventory.

Day’s Sales in Average Receivables or Average Collection Period

365 days
(2015) = ___________________________________________ = 36.7 days
Receivable turnover of 9.94 times

(2014) =

This ratio is used to measure the liquidity of the firm’s receivable. The result of 9.94 times could
be interpreted to mean that the firm is able to collect all their receivables 9.94 times in a year. A
high turnover rate means that receivables are collected in a short period of time. In Riel
Corporation’s case, it is able to collect the average receivables every 37 days or approximately
every month. This has great bearing on management, since a high receivable turnover, speeds
ups its conversion to cash and thus, management can use it further to enhance company
operations and ultimately, increase company profits.

High receivable turnover rate does not automatically mean good or efficient collection of the
company. The high turnover rate could be caused by any of the following:
a. Price level changes
b. Changes in sales terms
c. Special sales promotions
d. Strikes and plant shutdown during the previous period
e. Higher cash sales
f. The turnover was computed was when most receivables are collected

2. For Inventory
Inventory Turnover Ratio
The inventory turnover rate pertains to the number of times the average inventory is sold
(finished goods & merchandise), or used (raw materials), or processed (work in process).
The following formulas are adapted depending on the nature of the inventory being
assessed:

Raw Materials Raw Materials Used

Inventory Turnover = _____________________________
Average Raw Materials Inventory

Work in Process Cost of Goods Manufactured

Inventory Turnover = _____________________________
Average Work in Process Inventory

9
 Finished Goods Cost of Goods Sold
Inventory Turnover = _____________________________
Average Finished Goods Inventory

Merchandise Cost of Goods Sold

Inventory Turnover = _____________________________
Average Merchandise Inventory

Beginning Inventory + Ending Inventory

Average inventory = _____________________________
2

In our example we used Merchandise Inventory, hence the turnover rate is computed as:

Cost of Goods Sold of P2,208,520

(2015) = _________________________________ = 6.98 times
Average inventory of P297,654+P334,863

2
(2014) =

Note: Use ending inventory of 2014 to compute 2014 inventory turnover.

The inventory turnover indicates the company’s efficiency in managing and disposing inventory.
As a general rule, the higher the turnover-rate, the better. However, this is not always the case,
because a high turnover rate may also indicate that the firm is under-investing in their inventory
or suffering lost orders. It may also mean inventory shortages. On the other hand, a low inventory
turn-over rate may indicate that the firm is has too much inventory in their warehouse or is
harboring too much obsolete inventory. Low inventory turnover may also mean that the
company has slow-moving, or worse, inferior inventory stock. Lastly, it may simply indicate slow
and low sales of the firm for the period. As the analyst, you must account for the result of the
turnover when reporting it to management.
Again, it is important to mention that financial ratios, including inventory turnover rates vary,
depending on the industry the firm belongs. Firms that are involved in highly perishable products
like vegetables, fresh meat, and other agricultural produce do have a relatively high inventory
turnover. While firms selling wines, jewelry, or automobile have relatively low inventory turnover
rates but higher profit yields.

For purposes of providing an interpretation for Riel Corporation, the result has a relatively slight
unfavorable inventory turnover. A dress store like Riel should be able to dispose of their inventory
quicker, since fashion is highly dynamic and the turnover of new clothes are high, a higher
turnover for Riel would be more appropriate. Persons in management should recommend and
come up with strategies on improving the inventory turnover ratio.
Number of Days in Inventory or Average Sale Period

365 days
(2015) = _____________________________ = 52.30 days
Inventory Turnover of 6.98 times

(2014) =

The number of days in inventory indicates the number of the days the entire inventory is sold. As
a general rule, the higher the result, the better. This indicates that since inventories are sold out

10
quickly, funds used for the inventories are quickly converted to cash and ultimately translated to
more earnings. Riel’s days in inventory of 52.30 days can still be improved. It would be better if
management can dispose of their inventory in shorter number of days.

3. Property, Plant and Equipment (PPE) or Fixed Asset Turnover

Net Sales of P3,007,887

(2015) = ________________________________ = 19.90:1
Average net PPE of P135,754 + P166,481
2

(2014) =

This turnover indicated the firm’s efficiency in using their PPE in generating revenue. The
computed ratio of 19.90:1 can be interpreted that for every P1.0 PPE acquired and used by the
company, P19.90 sales revenue is generated. We could infer that Riel is efficient in using their
PPE.

4. Total Asset Turnover

Net Sales of P3,007,887

(2015) = ________________________________ = 3.04:1 or 304%
Average Total Assets of P1,014,082 + 966,290
2
(2014) =

This ratio presents the company’s efficiency in utilizing their total assets to generate revenue.
Low turnover rate means that there is slow or low sales generation or that there is too high
investment in assets. Looking at Riel’s asset turnover rate (3.04:1), we can interpret this to mean
that for every P1.0 asset of the company, P3.04 of sales revenue is generated. Based on this, we
can infer that management utilizes its assets efficiently. It can, however, be recommended that
the company instill more asset utilization policies that would further enhance asset usage
efficiency.

Debt-Utilization (Leverage) Ratios

The leverage ratios allow the analyst to ascertain how efficient the company manages its financial
obligations. Under this, you need to compare the liabilities and owners’ equity vis-à-vis total
assets or total liabilities & owners’ equity.

As previously mentioned in Chapter 3, the owners’ equity is considered as the margin of safety
by the creditors. This is because the owners’ equity is the amount that can absorb any decline in
asset. In other words, in case the assets of the company decline, the owners’ equity is the amount
that can be used to pay the creditors. In Riel Corporation, the total assets may decline by
P415,152 (amount of stockholders’ equity) or P598,930 and the company will still be able to pay
its creditors.

The following ratios may be used in the analyses:

1. Debt to Equity Ratio

Total Liabilities of P598,930

(2015) = ___________________________________ = 1.44:1 or 144%
Total Stockholders’ Equity of P415,152

(2014) =

11
The use of borrowed funds in carrying out the firm’s operation is called trade on equity. This
means that the firm is willing to borrow money and pay fixed interest charges from the loan. The
borrowed money will be used to increase volume of operation and ultimately earn more profit.
This is an example of financial leverage.

When a firm borrows fund to be used in the business, the total assets (cash) and total liabilities
(bank loan) of the company increase, however the owners’ equity remains the same. If profits
increase, the trading on equity (use of borrowed money) would increase the debt/equity ratio of
return on owners’ equity.

The debt/equity ratio presents the firm’s capital structure and its inherent risk. The liabilities of
the company present a risk, and blessings or benefit on the part of the owners. It is a risk
because if the company fails to use the borrowed money wisely to improved operation the
interest expense from their borrowings will be higher than their operating income (operating
loss). It is also a blessing if the company is able to use the money wisely to improve operations
leading to higher income, and the higher income ultimately increases owners’ equity. The high
income exceeds the interest expense from the borrowings thus, making liabilities a blessing for
the company. This structure indicates the trade-off between risk and return.

The debt/equity ratio gauges the amount of risks involving the firm’s capital structure in so far as
the relationship of funds provided by the creditors (liabilities) and owners are concerned. The
higher the ratio, the riskier the capital structure.
Riel’s debt/equity ratio (144%) presents a high risk in the firm’s capital structure. Management
should be mindful of the efficient use of the company’s borrowings in improving operations to
ensure higher yields.

2. Debt Ratio

Total Liabilities of P598,930

(2015) = ______________________ = 0.59:1 or 59%
Total Assets of P1,014,082

(2014) =

The ratio could be interpreted to mean that for every P1.0 asset of the company, P0.59 was
borrowed or was provided or was provided by the creditors. It basically presents the proportion
of borrowings to total assets. Generally, as explained earlier, the higher the debt proportion, the
higher is the risk. In addition to this, the risk is higher because if the firm gets bankrupt, the
creditors must pay first. If the assets are not sufficient to pay all the debts, the owners will end
up with nothing.

Riel’s debt ratio (59%) presents a relatively high risk on the part of the company. Management
should be mindful of the risk from borrowings. In addition, to this, the ratio may bring about
some difficulty on the part of management to borrow when they need it. Low owners’ equity
structure decreases the margin of safety for creditors.

3. Number of Times Interest Earned

Net Income before interest and Income tax or

Operating Income of P220,367
(2015) = ______________________________________ = 5.26 times
Annual Interest Expense of P41,860

(2014) =

12
This ratio indicates the ability of the firm to pay fixed interest charges. It gauges the company’s
ability to protect long-term creditors. Riel’s times interest earned of 5.26 times indicate that the
firm is very much capable of paying its fixed interest charges from its operating income.

Profitability Ratios

1. Gross Profit Ratio

Gross Profit of P799,367

(2015) = __________________________ = P0.26 or 0.26:1 or 26%
Net Sales of P3,007,887

(2014) =

This presents the gross margin per peso sales. This used to ascertain if the gross margin or profit
is sufficient to cover the operating expenses and firm’s desired net income. It also gauges the
firm’s ability to control production/acquisition costs and inventories and including mark ups in
the selling of their products. The said mark ups must be more than adequate to cover not only
the inventory related costs but also operating expenses and achieve a desired profit for a period.

Riel’s gross profit ratio (P0.26) indicates their ability to earn more than adequate sales revenue
to cover their cost of selling the goods. However, a 26% gross profit ratio means a 74% cost ratio.
This is relatively too high. Management must come up with more stringent cost control measures
to decrease cost of sales thereby increasing the gross margin ratio in the succeeding years.

2. Net Profit Ratio or Profit Margin

Net Profit of P116,030

(2015) = __________________________ = P0.039:P1 or 3.9%
Net Sales of P3,007,887

(2014) =

The ratio can be interpreted to mean that for every P1.0 sales revenue, the firm has P0.39 net
income. This gauge the profitability of the firm after including all revenues and deducting all costs
and expenses, and taxes. Riel’s net profit ratio of 39% is positive. However, management should
look closely to come up with measures that would increase revenue and decrease costs in order
to ensure and achieve profit maximization.

3. Return on Assets (ROA)

Net Income of P116,030

(2015) = _______________________________________ = 0.12:1 or 12%
Average total assets of P1,014,082 + 966,290
2
OR
(Du Pont Method) = Net Profit ratio of 3.9% x Total asset turnover of 3.04 = 12%

(2014) =

4. Return on Equity
Net Income of P116,030
(2015) = ___________________________________________ = 0.29:1 or 29%
Ave. stockholders’ equity of P415,142 + P376,631
2
(2014) =

13
This could be interpreted to mean that for every P1.0 of invested capital by the owners and used
to generate revenue, it yielded P0.29 of net income. This ratio, just like the ROA, is used to gauge
the company’s efficiency in managing its total assets invested and in coming up with return to
shareholders.

5. Du Pont System of Analysis

After seeing and analyzing the ratios, you might think that they are too many. A man by the name
of Donald Brown who happened to be Du Pont’s chief financial officer thought of the same thing.
So, he came up with the Du Pont Equation or the Du Pont System Analysis. The Du Pont company
emphasized that satisfactory return on assets may be achieved by having high profit margins/net
profit ratio or by having a faster asset turnover, or a good combination of both.

A favorable net profit ratio would indicate that the company has good cost control measures,
and a high assets turnover rate would mean efficient use of assets. Various industries have
various operating and financial structures. Companies belonging to industries with heavy/high
capital produce emphasizes high net profit ratio with a relatively low asset turnover. On the other
hand, the food processing industries emphasize low net profit margin and high turnover of assets
indicating a satisfactory return on assets.

The model includes the following formula to compute return on equity:

Return on Assets = Profit margin or Net profit ratio x Asset turnover

Debt Ratio = Total liabilities/Total Assets
Equity Ratio = 1-Debt ratio

Return on Assets
Return on Equity = __________________
(Du Pont Method) Equity Ratio

Using the analysis for Riel Corporation:

Return Asset = 12%

(Du Pont)

Debt ratio = 59%

12%
Return on Equity = ______________ = 29%
1-59%

Ratio Used To Gauge Company Liquidity or Short-term Solvency

The following are the most common ratios to gauge a firm’s liquidity or short-term solvency:

Ratio Formula Significance

_Current Assets_
Current Liabilities
Signifies the firm’s capacity
Note: Some analyst does
1. Current ratio to pay or meet current
not include prepaid
financial obligations.
expenses in the
computation of the
current assets.
__Quick Assets__ A stricter test of liquidity.
2. Quick ratio
Current Liabilities Suggests the firm’s ability

14

QA =cash + trading
Securities + trade and
other receivables
3. Current Assets to
_Current Assets_
Total assets or
Total Assets
Working capital to
Total assets
4. Each current asset _Each Current Asset item_
item to total Total Current Assets
current assets
Cash & cash equivalents +
Trading Securities + Cash
5. Cash flow liquidity
flow from Operating
ratio
Activities
Current Liabilities
____Current liabilities____
6. Defensive Interval
Cash and cash equivalents
ratio
Ratios Used To Gauge Asset Management Efficiency and Liquidity
The following are the most common ratios to gauge a firm’s ability to efficiently manage their
assets and measure liquidity or short-term solvency:
Ratio Formula
Net Sales or Net Credit
1. Receivable Sales
Turnover Average Receivables
2. Average Collection
_365 days or 360 days_
Period or Number
Receivable turnover
of Days in
Receivables
____Cost of goods sold___
3. Merchandise
Average Merchandise
Turnover
inventory
____Cost of goods sold___
4. Finished Goods
Average finished goods
Turnover
inventory
15
to pay current financial
obligations by considering
more liquid current assets.
Suggests the relative
liquidity of the total assets
and shows the proportion
of current assets to total
assets.
Signifies the proportion of
each current asset item to
total assets. It also
indicates the liquidity of
the current assets and the
breakdown of each
component.
Gauges the firm’s ability to
pay current financial
obligations by considering
cash and other cash
equivalents.
Indicates the coverage of
current liabilities.
Significance
Signifies the number of
times the average
receivables are collected
during the year. It also
measures the firm’s
efficiency in collecting
their receivables.
This ratio is very much
related to accounts
receivable turnover. It
indicates the number of
days the firm collects its
average receivables. It
implies the efficiency of
the firm in collecting their
receivables.
Suggests the number of
times the average
inventory was disposed of
during the accounting
period. It also signifies the
over or under investment
of the firm in inventory.
Suggests the number times
the average inventory was
disposed of during the
accounting period. It also
signifies the over or under

Cost of Goods
5. Work in Process Manufactured
Turnover Average Work in Process
inventory
___Raw Materials Used__
6. Raw Materials
Average Raw Materials
Turnover
Inventory
365 days or 360 days_
7. Number of Days in
Inventory turnover
Inventory
Cost of Goods Sold +
Operating Expenses
8. Working Capital (excluding charges not
Turnover requiring working capital)
OR Net Sales
Average Working Capital
Cost of Goods Sold +
Operating Expenses +
Income taxes + Other
expenses (excluding
9. Current Asset
charges not requiring
Turnover
current assets like
depreciation and
amortization expenses)
Average Current Assets
Net Credit Purchases or
Net Purchases
10. Payable Turnover Average Trade and Other
Payables or Accounts
Payables
Day’s sales in merchandise
11. Operating Cycle
inventory + No. of days to
(Trading Concern)
collect receivables
No. of days’ usage in raw
materials inventory + No.
of days in production
12. Operating Cycle
process + No. of days’ sales
(Manufacturing
in finished goods inventory
Concern)
+ No. of days to collect
receivables
Average Cash Balance
Cash Operating Costs
13. Days Cash
365 days or 360 days
16
investment of the firm in
their inventory.
Signifies the number of
times average inventory
was produced during the
accounting period. It also
indicates the time taken to
produce the products.
Measures the number of
times average raw
materials inventory was
used during the period. It
also indicates the
sufficiency of the raw
materials available.
Indicates the number of
days by which inventories
are used or sold. Implies
the firm’s efficiency in
consuming or selling
inventories.
Signifies the pace by which
working capital is used. It
also indicates the
adequacy of working
capital in the firm’s
operations.
Signifies the pace by which
current assets are used. It
also indicates the
adequacy of current assets
in the firm’s operations.
Signifies the firm’s ability
to pay trade payables. It
also measures the number
of times the amount of
average payables is paid
during the accounting
period.
Measures the length of
time in order to convert
cash to inventory to
receivables and back to
cash.
Measures the length of
time in order to convert
cash to raw materials
inventory to work-in-
process to finished good
inventory to receivables
and back to cash.
Indicates the ability of the
firm’s cash to pay the

_____Net Sales____
14. Asset Turnover
Average Total Assets
15. Property, Plant &
Equipment _____Net Sales____
Turnover or Fixed Average PPE Assets
Asset Turnover
Ratios Used to Gauge Firm’s Utilization of Debt and Company Stability
The following are the most common ratios used to gauge a firm’s stability or long-term solvency:
Ratio Formula
1. Debt to Equity _____Total Liabilities____
Ratio Owners’ Equity
2. Equity to Debt _____Owners’ Equity____
Ratio Total Liabilities
3. Proprietary or _____Owners’ Equity____
Equity Ratio Total Assets
_____Total Liabilities____
4. Debt Ratio
Total Assets
5. Fixed Assets to
PPE or Fixed Assets (net)
Total Owners’
Owners’ Equity
Equity
6. Fixed Assets to PPE or Fixed Assets (net)
Total Assets Total Assets
7. Fixed Assets to
PPE or Fixed Assets (net)
Total Long-term
Total Long-term Liabilities
Liabilities
_______Net Sales_______
8. Plant Turnover Average PPE or Fixed
assets (net)
Ordinary Shareholders’
9. Book Value per Equity
Share Number of Ordinary
Shares Outstanding
17
average daily cash
obligations.
Indicates the firm’s ability
to efficiency manage their
assets to generate
revenue.
Indicates the firm’s ability
to efficiently manage their
PPEs to generate revenue.
Significance
Measures the relationship
or proportion of the
capital provided by
creditors to the capital
provided by owners.
Measures the margin of
safety of creditors.
Measures the proportion
of the firm’s assets coming
from its owners. Signifies
financial stability of the
firm and cautions the
creditors.
Measures the proportion
of the firms’ assets coming
from its creditors. It also
signifies the extent of
trading on equity.
Measures the portion of
the owners’ equity used to
acquire fixed assets.
Signifies whether the firm
over or under invested in
PPE.
Measures the extent
covered by the carrying
value of PPE to long-term
obligations.
Signifies the firm’s
efficiency in using their
PPE.
Measures the carrying
value of net assets for
every ordinary share
outstanding. It also
indicates the amount
which the shareholders
can recover if the firm sells
its assets upon liquidation
or converts them into cash
at their book values.
 Signifies the firm’s capacity
in paying fixed interest
Net Income before Interest
10. Number of Times charges. It measures the
and Income Taxes
Interest Earned number of times interest
Annual Interest Charges
charges is covered by the
firm’s operating income.
11. Number of Times
Measures the firm’s ability
Preference Shares __Net Income After Tax__
to pay the preference
Dividend Preference Shares
shareholders’ dividend
Requirement is Dividend Requirement
requirement.
Earned
Net Income before Taxes &
12. Number of Times Fixed Charges Indicates the firm’s ability
Fixed Charges are Fixed Expenses (Rent, to pay annual fixed
Earned Interest, Sinking Fund charges.
payment before taxes)

Ratios Used to Gauge Firm’s Profitability and Return to Owners

The following are the most common ratios used to gauge a firm’s profitability and returns to
owners.

Ratio Formula Significance

Measures the amount of
1. Rate of Return on the net income per peso of
Sales or Net Profit ___Net Income__ sales. It also shows the
Ratio or Net Profit Net Sales proportion of the net
margin income to the firm’s sales
revenue.
Measures the company’s
Return on Sales x Asset profitability in using their
turnover total assets. It indicates
the net income generated
2. Rate of Return to
OR by using the firm’s total
Total Assets (ROA)
assets. Signifies
_____Net Income____ management efficiency in
Average total Assets using their assets to earn
income.
Signifies management
_____Net Sales____ efficiency in using their
3. Asset Turnover
Average Total Assets assets to generate sales
revenue.
Measures the gross profit
per peso of sales revenue.
This ratio is important in
_____ Gross Profit_____
4. Gross Profit ratio ascertaining the adequacy
Net Sales
of gross profit to meet
operating expenses plus
their desired profit.
Measures the portion of
_Operating Income_
5. Operating Ratio sales revenue used to
Net Sales
cover operating costs.
Cash flow from Operating
Indicates the firm’s ability
6. Cash flow margin activities
to translate sales into cash.
Net Sales
Gauges management
7. Rate of Return on
______Net Income_____ efficiency in using current
Current Assets or
Average Current Assets assets to generate net
Working Capital
income.

18
8. Rate of Return on Measures management
______Net Income_____
Net working capital efficiency in using net
Average net working
(current assets – working capital to
Capital
current liabilities) generate revenue.
Indicates the amount of
return per peso of owners’
9. Rate of Return on ______Net Income_____ equity. Gauges
Owners’ Equity Average Owners’ Equity management efficiency in
using its invested capital to
generate revenue.
Net Income - Preference
Measures the peso return
share dividend
on each ordinary share
10. Earnings Per Share requirement
issued. Signifies the firm’s
No. of Ordinary Shares
ability to pay dividends.
Outstanding
Indicates the relationship
between the market price
11. Price-earnings _Market price per share_
of ordinary shares and the
Ratio Earnings Per Share
earnings of each ordinary
share.
Measures the rate at
12. Earing-Price Ratio
___Earnings Per Share__ which the share market is
or Capitalization
Market Price per Share capitalizing the value of
Rate
current earnings.
Dividends Paid or Declared Indicates the earnings
13. Dividends Per
Ordinary Shares distributed to the owners
Share
Outstanding on a per share basis.
Measures the percentage
14. Payout Ratio or __Dividends per Share__
of the company’s earnings
Dividends Payout Earnings Per Share
paid to owners.
Measures the probability
15. Retained Earnings __Retained Earnings__
of declaration of dividends
to Share Capital Share Capital
by the firm.
16. Market Price to
_Market Price per Share_ Signifies the under or over-
Book Value per
Book Value per Share valuation of shares.
share

19