Topic V.

2
Analysis and Interpretation of Financial Statements 2
Learning Outcomes

At the end of the topic, you should be able to:

1. Solve exercises and problems that require computation and interpretation using various financial
ratios.
2. Using the downloaded sample financial statements, learner computes various financial ratios
and interprets the level of profitability, efficiency and financial health (liquidity and solvency) of the
business.

This module will focus on financial rations.

RATIO ANALYSIS
Ratio analysis expresses the relationship among selected items of financial statement data. The
relationship is expressed in terms of a percentage, a rate, or a simple proportion (Weygandtet.al. 2013). A
financial ratio is composed of a numerator and a denominator. For example, a ratio that divides sales by
assets will find the peso amount of sales generated by every peso of asset invested. This is an important
ratio because it tells us the efficiency of invested asset to create revenue. This ratio is called asset
turnover. There are many ratios used in business. These ratios are generally grouped into three categories:
(a) profitability, (b) efficiency, and (c) financial health.

A. Profitability
Profitability ratios measure the ability of the company to generate income from the use of its assets
and invested capital as well as control its cost. The following are the commonly used profitability
ratios:
- Gross profit ratio reports 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.
- Operating income ratio expresses operating income as a percentage of sales. It
measures the percentage of profit earned from each peso of sales in the company’s core
business operations (Horngren et.al. 2013). A company with a high operating income ratio
may imply a lean operation and have low operating expenses. Maximizing operating
income depends on keeping operating costs as low as possible (Horngren et.al. 2013).
- Net profit ratio relates the peso value of the net income earned to every peso of sales.
This shows how much profit will go to the owner for every peso of sales made.
- Return on asset (ROA) measures the peso value of income generated by employing the
company’s assets. It is viewed as an interest rate or a form of yield on asset investment.
 The numerator of ROA is net income. However, net income is profit for the shareholders.
On the other hand, asset is allocated to both creditors and shareholders. Some analyst
prefers to use earnings before interest and taxes instead of net income. There are also two
acceptable denominators for ROA – ending balance of total assets or average of total
assets. Average assets is computed as beginning balance + ending balance divided by 2.
- Return on equity (ROE) measures the return (net income) generated by the owner’s
capital invested in the business. Similar to ROA, the denominator of ROE may also be total
equity or average equity.

Let’s compute for the profitability ratios of the following entity:

Answers:
 B. Efficiency
Operational efficiency ratio measures the ability of the company to utilize its assets. 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.
- Asset turnover 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 is indicator of the efficiency of fixed assets in generating sales.
- Inventory turnover is measured based on cost of goods sold and not sales. As such both
the numerator and denominator of this ratio are measured at cost. It is an indicator of how
fast the company can sell inventory. An alternative to inventory turnover is “days in
inventory”. This measures the number of days from acquisition to sale.
- Accounts receivables turnover the measures the number of times the company was able
to collect on its average accounts receivable during the year. An alternative to accounts
receivable turnover is “days in accounts receivable”. This measures the company’s
collection period which is the number of days from sale to collection.

Let’s use the same data in our example in A. Profitability ratios and compute for the efficiency ratios of the
entity.
 Observe that turnover ratios are expressed as “number of times”. For example, asset turnover in
the example is 0.64x which reads as “zero point sixty-four times”. This means that sales generated
was 0.64 times of average assets.

C. Financial Health
Financial Health Ratios 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 (short term debt).
- Debt ratio 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.
- Equity ratio indicates the percentage of the company’s assets that are financed by
capital. A high equity to asset ratio implies a high level of capital.
- Debt to equity ratio indicates the company’s reliance to debt or liability as a source of
financing relative to equity. A high ratio suggests a high level of debt that may result in high
interest expense.
- Interest coverage ratio measures the company’s ability to cover the interest expense on
its liability with its operating income. Creditors prefer a high coverage ratio to give them
protection that interest due to them can be paid.
- Current ratio is used to evaluate the company’s liquidity. It seeks to measure whether
there are sufficient current assets to pay for current liabilities. Creditors normally prefer a
current ratio of 2.
- Quick ratio is a stricter measure of liquidity. It does not consider all the current assets,
only those that are easier to liquidate such as cash and accounts receivable that are
referred to as quick assets.
Let’s use the same data in our example in A. Profitability ratios and compute for the financial health ratios
of the entity.