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Module 4

Financial Ratio Analysis

This topic might already be familiar with you for this was discussed in
your past courses. So let’s just have a review on ratio analysis.

In this lesson you should be able to compute, analyze, and interpret the
basic types of financial ratios

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4.1 Introduction to Financial Ratios

Ratio is a mathematical relationship between one number to another
number. This is used as an index for evaluating the financial
performance of the business concern. We can classify ratio in various
types. This includes liquidity ratio, activity ratio, leverage ratio and
profitability ratio.

4.2 Liquidity Ratio

These ratios are financial metrics that are being used to determine a
company's ability to pay off its short-terms debts obligations. The
following are some of the liquidity ratios

Current Ratio

The current ratio is a liquidity that measures a firm's ability to pay off
its short-term liabilities with its current assets. The current ratio is an
important measure of liquidity because short-term liabilities are due
within the next year.

Formula

Current Ratio =

Example

Charlie's Cake Shop sells cakes and other pastries in their

municipality. Charlie is applying for loans to help fund his dream of
building an indoor skate rink. Charlie's bank asks for his balance sheet
so they can analysis his current debt levels. According to Charlie's
balance sheet he reported Php100,000 of current liabilities and only
Php25,000 of current assets.

Charlie's current ratio would be calculated like this:

Current Ratio = = 0.25

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As you can see, Charlie has more liabilities than his current assets.
The current ratio is only 0.25. This means that Charlies only has
Php0.25 worth of assets that can be paid to Php1.00 worth of liability.
This means that his business is highly leveraged and highly risky. The
banks usually prefers that the prospective borrowers must have a
current ratio of at least 1. This is to ensure that all the current
liabilities of the business would be covered by its current assets. Since
Charlie's ratio false below 1, it is unlikely that his loan will be granted.

Quick Ratio

The quick ratio or acid test ratio is a liquidity ratio that measures the
ability of a company to pay its current liabilities when they come due
with only quick assets. Quick assets are current assets that can be
converted to cash within 90 days or in the short-term. Cash, cash
equivalents, short-term investments or marketable securities, and
current accounts receivable are considered quick assets. Quick assets
include all current assets except for inventories and prepaid expenses.

Formula

Quick Ratio =

Example

Carole's Clothing Store is applying for a loan to remodel the

storefront. The bank asks Carole for a detailed balance sheet, so it can
compute the quick ratio. Carole's balance sheet has Php21,500 total
current assets. There were Php5,000 inventories and the balance sheet
depicted a prepaid tax expense of Php500. In addition, she has
current liabilities worth Php15,000.

Carole's quick ratio can be computed like this

Quick Ratio = = 1.07

As you can see Carole's quick ratio is 1.07. This means that Carole can
pay off all of her current liabilities with quick assets and still have
some quick assets left over.

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4.3 Activity Ratio

This is also known as efficiency or turnover ratio for this measures
how effectively the firm is using its assets. This focus primarily on
how effectively the firm is managing two specific asset groups,
receivables and inventories, and its total assets in general. The
following are the activity ratios

Receivable Turnover

This can also be called as the accounts receivable turnover. This is a

type of efficiency ratio or activity ratio that measures the frequency of
turning accounts receivable into cash within a period of time. Simply
stated, this ratio measures how many times a business can be able to
collect its average accounts receivable throughout the year. This can
also be considered as a liquidity ratio. This ratio can also be converted
into days by dividing the turnover to the total number of days in a
year.

Formula

Receivable Turnover =

Average Collection Period =

Example

Bill's Grocery Store sells different types of merchandise that are

usually consumed by the people in their locality. At the end of the
year, Bill's balance sheet shows Php20,000 in accounts receivable,
Php75,000 of gross credit sales, and Php25,000 of returns. Last year's
balance sheet showed Php10,000 of accounts receivable.

In order to calculate the accounts receivable turnover, the first thing to

to be obtained are the values of net credit sales and average accounts
receivable.
Net credit sales can be obtained by deducting the sales returns from the
gross credit sales (Php75,000 – Php25,000 = Php50,000). On the other
hand, the average accounts receivable of Bill can be obtained by
adding the beginning and ending accounts receivable balances and
dividing it by two ((Php10,000 + Php20,000) / 2 = 15,000).

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Finally, Bill's accounts receivable turnover ratio and average collection

period can be like this.

Receivables Turnover Ratio = = 3.33

Average Collection Period = = 110 days

As you can see, the turnover of Bill’s Grocery Store is 3.33. This
means that the business entity collects its receivables about 3.3 times a
year. Within the 365 days of a year, we can say that the entity can be
able to collect its receivables every 110 days. In other words, when
Bill’s Grocery Store makes a credit sale, it will take the entity about
110 days to collect the cash from such sale transaction.

Note: If the beginning balance of accounts receivable is not given, you

may simply use the amount of ending balance. Do not apply the
averaging of amounts since only one amount is given.

Payable Turnover

This is also knows as the accounts payable turnover ratio. This is an

activity ratio that shows a business entity’s ability to pay off its
accounts payable. This is done by comparing the value of net credit
purchases to the average accounts payable of the entity during a
period. This ratio refers to how many times a business entity can be
able pay off its average accounts payable balance within the year.
This can also be considered as a liquidity ratio. This ratio can also be
converted into days by dividing the turnover to the total number of
days in a year.

Formula

Payable Turnover =

Average Payment Period =

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Example

BBB Construction Supplies buys constructions materials from

wholesalers and resells these inventories through its retail store.
During the current year, the entity purchased Php1,000,000 worth of
construction materials.
According to the balance sheet of BB Construction Supplies, the
beginning accounts payable was Php55,000 and the ending accounts
payable was Php958,000.

Here is how they would calculate the entity’s payable turnover ratio
and average payment period:

Payable Turnover = = 1.97

Average Payment Period = = 185 days

As you can see, the average accounts payable of BBB Construction

Supplies for the year was Php506,500. This is obtained by adding the
beginning and ending accounts payable and dividing the sum by 2.
Based on the formula of the turnover ratio, we obtained a value of
1.97. This means that BBB Construction Supplies pays back at an
average of 185 days after the date of incurring the liability.

Note: If the beginning balance of accounts payable is not given, you

may simply use the amount of ending balance. Do not apply the
averaging of amounts since only one amount is given.

4.4 Profitability Ratios

These are ratios that relate profits to sales and investment. From word
its self, this ratio deals with profitability. The following are some of
the profitability ratios

Gross Profit Margin

This is a type of profitability ratio that relates the gross margin or

gross profit of a business to the net sales. This financial ratio measures
how profitable a business entity is at selling its merchandise. In other
words, the gross profit margin or gross profit ratio is essentially the
percentage of markup on the price of the merchandise from its cost.

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Formula

Gross Profit Margin =

Example

Assume John’s Apparel is a business engaged in selling clothings and

accessories. It paid Php100,000 on inventory bought for the year. The
business was able to sell all of the inventory for Php450,000.

The gross profit margin is computed below.

Gross Profit Margin = = 0.78

The gross profit means total sales less the cost of sales. So for the
gross profit, we have Php450,000 less Php100,000. For the net sales
we have Php450,000. As you can see, John’s Apparel has a gross
profit ratio of 0.78. This means that after the business pays off the
inventory costs, it still has 78% of its sales revenue to cover the
operating costs.

Note: If given in the problem, sales returns are being deducted from
the total sales to get the net sales. This may as well affect the amount
of the gross profit.

Net Profit Margin

This is a type profitability ratio that measures the amount of net

income earned in every peso of sale made by the business. In other
words, this ratio shows what percentage of revenue was left after all
expenditures are paid.

Formula

Net Profit Margin =

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Example

Trisha's Tackle Shop is an outdoor fishing store that selling lures and
other fishing gear to the public. Trisha's net sales were Php1,000,000
and her net income was Php100,000.

Here is Trisha's net profit margin is computed below

Net Profit Margin = = 0.10

Trisha’s Tackle Shop has a net profit margin of 10%. This means that
the entity earns Php0.10 for every one peso worth of sale.

4.5 Leverage Ratios

This measures the long-term obligation of the business. Leverage
ratios helps you understand how the long-term funds are used by the
business entity. A few types of these ratios are discussed below.

Debt to Equity Ratio

The debt to equity ratio is a liquidity ratio that compares the total debt
to the total equity of a business entity. The debt to equity ratio shows
the percentage of entity’s financing that comes from creditors and
investors.

Formula

Debt to Equity Ratio =

Example

A company has loans amounting to Php600,000 and the equity of the

company is Php1,200,000.

The debt to equity ratio is computed below.

Debt to Equity Ratio = = 0.50

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Having a debt ratio of 0.5 depicts that there are half as many loans as
there is shareholder financing. In other words, the assets of the
company are funded 1-to-2 by creditors to investors.

Debt to Total Assets Ratio

The debt to asset ratio is a leverage ratio that measures the amount of
total assets that are financed by creditors. This can also depic the
percentage of assets that were paid with loans or credits. This may
also provide a measure of the business entity’s ability to meet its
financial obligations.

Formula

Debt to Total Assets Ratio =

Example

Mark’s Auto Shop is an automotive repair shop in the locality.

Currently, Ted has Php100,000 assets and Php50,000 liabilities.

His debt-to-equity ratio would be calculated like this:

Debt to Total Assets Ratio = =0.5

As you can see, the debt to equity ratio is 0.5. This means that Mark’s
Autoshop has Php1 assets for every Php0.50 worth liabilities.

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Glossary
Activity – effectiveness of the firm in managing specific asset groups

Leverage – the use of debt to finance assets and operations

Liquidity – ability to pay current obligations

Profitability – the ability of the business to earn profit

Ratio - a mathematical relationship between one number to another number

References
C. Valix and C.A. Valix, (2015). “Theory of Accounts”, GIC Enterprises &
Co. Inc.

R.S. Roque, (2013). “Management Advisory Services”, GIC Enterprises &

Co. Inc.

Investopedia, (2016).

My Accounting Course, (2016).

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