Module 10 - Analysis and Interpretation of Financial Statements

LICEO DE LA SALLE SENIOR HIGH SCHOOL
SECOND SEMESTER | QUARTER 4

AY 2020 – 2021 | FUNDAMENTALS OF ACCOUNTANCY,
BUSINESS, AND MANAGEMENT 2
NAME AND SECTION:
TEACHER:
MODULE 10: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
Learning Objectives:
After reading and answering this module, I can…
• Explain the different kinds of Financial Statement analysis and interpretation.

• Perform the vertical and horizontal analysis.
• Understand the functions of the different financial ratios and their corresponding
computation.
• Compute and interpret the financial ratios in given scenarios.
BASICS OF FINANCIAL STATEMENT ANALYSIS
Analyzing financial statements involves evaluating three characteristics of an entity: its

liquidity, its profitability, and its solvency. For example, a short-term creditor, such as a bank, is
primarily interested in the ability of the borrower to pay obligations when they come due. The
liquidity of the borrower in such a case is extremely important in evaluating the safety of a loan.
A long-term creditor, such as a bondholder, however, looks to indicators such as profitability

and solvency that indicate the firm's ability to survive over a long period. Long-term creditors
consider such measures as the amount of debt in the entity's capital structure and the ability to meet
interest payments. Similarly, shareholders are interested in the profitability and solvency of the
enterprise when they assess the likelihood of dividends and the growth potential of the share.
STANDARDS FOR COMPARATIVE ANALYSIS
Every item reported in a financial statement is important. For example, when L. Victorino
Corporation reports cash of Php 35,000,000 on its statement of financial position, it is known that
the entity had that amount of cash on the reporting date. However, it is not known whether the
amount represented an increase over the prior year or whether the amount is adequate in relation to
the entity’s need for cash. To get this information, it is essential to have a comparison of the amount
of cash with other financial statement data. These comparisons can be made on a number of different
bases:
1. Intracompany basis. This basis compares an item or financial relationship within an

entity in the current year with the same item or relationship in one or more prior years. For
example a comparison of L. Victorino's cash balance at the end of the current year with
last year's balance will show the amount of the increase or decrease. Likewise, L. Victorino
can compare the percentage of cash to current assets at the end of the current year with the
percentage in one or more prior years. Intracompany comparisons are useful in detecting
changes in financial relationships and significant trends.
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NAME AND SECTION:
TEACHER:
2. Industry averages. This basis compares an item or financial relationship of an entity

with industry averages or norms published by financial ratings organizations. For
example, L. Victorino's profit can be compared with the average profit of all entities in
the same industry. Comparisons with industry averages provide information as to an
entity’s relative performance within the industry.
3. Intercompany basis. This basis compares an item or financial relationship of one entity
with the same item or relationship in one or more competing entities. The comparisons
are made on the basis of the published financial statement of the individual entities. For
example, L. Victorino's total sales for the year can be compared with the total sales of
its major competitors. Intercompany comparisons are useful in determining an entity’s
competitive position.
TOOLS OF FINANCIAL STATEMENT ANALYSIS

Various tools are used to evaluate the significance of financial statement data. Three
commonly used tools are the following:
1. Horizontal analysis - a technique that evaluates a series of financial statement data over
a period of time.
2. Vertical analysis - a technique that evaluates financial statement data that expresses each
item in a financial statement in terms of a percent of a base amount.
3. Ratio analysis - expresses the relationship among selected items of financial statement
data.
HORIZONTAL ANALYSIS
Also called trend analysis, it is a technique for evaluating a series of financial statement data
over a period of time. Its purpose is to determine the increase or decrease that has taken place,
expressed as either an amount or a percentage.
This method can be used to compare trends over time of any financial statement line items.
For example, managers often want to track changes on the statement of comprehensive income in
net sales and profit over time. If in a particular reporting period, net sales increased by 8% and profit
rose by 12% over the prior year, you can learn much information from this. First, compare the
performance of the line items with forecasts to determine the level of entity performance. Some
entities would consider an 8% increase in net sales a dramatic failure while others would consider
it a tremendous success; the relationship of performance to forecast is the key. Further, the
relationship between distinct line items can give you a lot of insight into the health of the entity. In
this example, it is likely a very positive indication that profit rose at a much higher rate (12%) than
did net sales (8%). When you use horizontal analysis over time, you can spot positive or negative
trends.
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NAME AND SECTION:
TEACHER:
Illustrative Example 1.
The recent net sales figures of L. Victorino Corporation are as follows:
L. Victorino Corporation
(Net Sales Stated in Millions)
2017 2016 2015 2014 2013
P6,562.8 P6,295.4 P6,190.6 P5,786.6 P5,181.4
Assume that 2013 is the base year, percentage increases or decreases from this base period
amount is computed as follows:
Current year amount — Base year amount
Base year amount
Using this computation, the net sales for L, Victorino Corporation increased approximately
11.7% from 2013 to 2014.
Computation:
Php 5,786.6 — Php 5,181.4
= 11.7%
Php 5,181.41
Similarly, net sales increased over 26.7%. from 2013 to 2017.
Php 6,562.8 − Php 5,181.4

= 26.7%
Php 5,181.41
Here is an actual example applying the horizontal analysis extracted from the Annual Report of
Metropolitan Bank & Trust Company for period ended December 31, 2019.
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NAME AND SECTION:
TEACHER:
VERTICAL ANALYSIS
Vertical analysis is a method of analyzing financial statements in which you can compare
individual line items to a baseline item such as net sales from the statement of comprehensive
income, total assets from the asset section of the statement of financial position, and total liabilities
and owner's equity in the liabilities and owner's equity section of the statement of financial
position.
For example, on the balance sheet, current assets are 22% of total assets with total assets
(the 100%) as the base amount. In the case of the income statement, distribution costs or selling
expenses are 16% of net sales with net sales (the 100%) being the base amount.
You can use vertical analysis to compare trends in the relative performance of any financial
statement line items over time. For example, from the income statement you may want to track the
cost of goods sold and the profit as a percentage of sales. These two indicators provide information
whether the year-to-year costs are becoming unreasonable and whether profit trends are within the
desired levels. Using such analysis over time, you can observe positive or negative trends so that
you can begin any corrective actions. The vertical analysis can also be used to compare an entity's
performance relative to the performance of other entities operating in similar industries. This is
called benchmarking.
Statement of Financial Position

The following illustration is the comparative statement of financial position of L. Victorino
Corporation for 2020 and 2019, analyzed vertically. The base, for the asset items is total assets, and
the base for the liability and equity items is total liabilities and equity.
Statement of Financial Position
December 31
2020 2019
Amount % Amount %
Assets
Current Assets Php 1,020,000 55.6 Php 945,000 59.2
Property and equipment, Net 800,000 43.6 632,500 39.7
Intangible Assets 15,000 8.0 17,500 1.1
Total Assets Php 1,835,000 100.0 Php 1,595,000 100.0
Liabilities
Current Liabilities Php 344,500 18.8 Php 303,000 19.0
Long-term Liabilities 487,500 26.5 497,000 31.2
Total Liabilities 832,000 45.3 800,000 50.2
Equity
Ordinary Share, Php 1 par value 275,400 15.0 270,000 16.9
Retained Earnings 727,600 39.7 525,000 32.9
Total Equity 1,003,000 54.7 795,000 49.8
Total Liabilities and Equity Php 1,835,000 100.0 Php 1,595,000 100.0
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NAME AND SECTION:
TEACHER:
Statement of Comprehensive Income

The vertical analysis of the comparative statements of comprehensive income of L.
Victorino Corporation revealed that cost of goods sold as a percentage of net sales declined
by 1% (62.1% vs. 61.1%) and total operating expenses declined by 0.4% (17.4% vs. 17.0%).
Consequently, profit as a percent of net sales increased from 12.3% to 13.4%.
Statement of Comprehensive Income
For Years Ended December 31
2020 2019
Amount % Amount %
Sales Php 2,195,000 104.7 Php 1,960,000 106.7
Sales Returns and Allowances 98,000 4.7 123,000 6.7
Net Sales 2,097,000 100.0 1,837,000 100.0
Cost of Goods Sold 1,281,000 61.1 1,140,000 62.1
Gross Profit 816,000 38.9 697,000 37.9
Distribution Costs 253,000 12.0 211,500 11.5
Administrative Expenses 104,000 5.0 108,500 5.9
Total Operating Expenses 357,000 17.0 320,000 17.4
Profit from Operations 459,000 21.9 377,000 20.5
Investment Revenues 9,000 0.4 11,000 0.6
Finance Costs 36,000 1.7 40,500 2.2
Profit before Income Taxes 432,000 20.6 347,500 18.9
Income Tax Expense 151,200 7.2 121,625 6.6
Profit Php 280,800 13.4 Php 225,875 12.3
FINANCIAL RATIOS
Analytical tool employing ratio or proportion of a certain item in the financial statement in
relation to other related items, in the same financial statement or other statements, to judge
comparative performance.
Basic Classifications of Financial Ratios:
Financial Ratios are generally classified into five such as liquidity, asset and debt management,
profitability, and market ratios. Each of these classification measures a certain component of the
firm’s over-all performance.
1. Liquidity Ratios
• measures the ability of the business firm to pay off short-term obligations as they
mature.
• shows the relationship of the current assets to current liabilities.
• Answers the question: Will the business firm be able to pay off its currently maturing
obligations when they fall due?
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NAME AND SECTION:
TEACHER:
The liquidity ratios include:

a. Current Ratio
o Indicates in which current liabilities are covered by current assets.
o This ratio is used to evaluate the entity’s liquidity and short-term debt paying
capacity.
o Higher ratios indicate an increased ability to pay short-term that obligations such as
accounts payable and interest payments on that. Lower ratios can indicate an inability
to meet short term debt obligations, which could lead to insolvency and bankruptcy.
o Formula:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
b. Quick (or Acid Test) Ratio
o Inventories and prepaid expenses are excluded from total current assets, leaving only
the more liquid assets to be divided by current liabilities.
o This ratio tells whether the entity could pay all its current liabilities even if none of
the inventory is sold.
o Formula:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 − 𝑃𝑟𝑒𝑝𝑎𝑖𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
Alternative formula:
𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 + 𝑆ℎ𝑜𝑟𝑡 𝑇𝑒𝑟𝑚 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

Required: Compute for the current and quick ratios.
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NAME AND SECTION:
TEACHER:
Solution:
a. Current Ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 330,000

= = 𝟐. 𝟔𝟒 𝒙 𝒐𝒓 𝟐. 𝟔𝟒 𝒕𝒊𝒎𝒆𝒔
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 125,000
b. Quick (or Acid Test) Ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 − 𝑃𝑟𝑒𝑝𝑎𝑖𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 330,000 − 130,000

=
200,000
= = 𝟏. 𝟔 𝒙 𝒐𝒓 𝟏. 𝟔 𝒕𝒊𝒎𝒆𝒔
125,000
2. Asset Management Ratios

• Provides an idea of how efficiently the firm is using its assets.
The following are the asset management ratios:

a. Receivable Turnover
o Measures the speed by which trade receivables are converted into cash during the
year by means of collection from credit customers.
o Formula:
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
Note: If the credit sales is not provided, you may use the Net Sales. The average
receivables will only apply if you are given 2 balance sheets. Otherwise, you may only
use the receivable value provided in the given balance sheet. The computation of the
average receivables is as follows:
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒, 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒, 𝑒𝑛𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 =
2
In general, the higher the ratio, the more successfully the business collects cash. However,
a turnover that is too high may indicate that credit is too tight, causing the loss of sales to
good customers.
b. Average Collection Period

o It represents the average length of time that the business must wait to received cash
after making a scale.
o Formula:
365 𝑑𝑎𝑦𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
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NAME AND SECTION:
TEACHER:
Note: Compute the Receivable Turnover first before computing the Average Collection
Period. Use 360 days as your numerator if it was specified in the problem. Otherwise, the
365 days should be used.
c. Inventory Turnover
o Measures the number of times inventories are acquired and sold during the year.
o Formula:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠
Note: The average inventories will only apply if you are given 2 balance sheets.
Otherwise, you may only use the inventory value provided in the given balance sheet.
The computation of the average inventories is as follows:
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦, 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦, 𝑒𝑛𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 =
2
Higher inventory turnover ratios generally increase entity profitability since an entity can
use the cash normally tied up in inventory for higher return investments. Higher inventory
turnover is easier to accommodate by improving production planning, scheduling,
capacity planning, product and equipment quality, relations with raw materials suppliers,
and inventory planning.
d. Average Age of Inventory

o Measures the length of time to acquire, sell, and replace inventory.
o Formula:
365 𝑑𝑎𝑦𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑔𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Note: Compute the Inventory Turnover first before computing the Average Age of
Inventories. Use 360 days as your numerator if it was specified in the problem. Otherwise,
the 365 days should be used.
e. Fixed Assets Turnover Ratio

o Measures how effectively the firm uses its plant and equipment.
o Formula:
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
f. Total Assets Turnover Ratio

o Measures how effectively the firm uses its total assets.
o Formula:
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
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NAME AND SECTION:
TEACHER:
Required: Compute for the relevant activity ratios.
Solution:
a. Receivable Turnover
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 2,000,000
= = 𝟒𝟒. 𝟒𝟒 𝒙 𝒐𝒓 𝟒𝟒. 𝟒𝟒 𝒕𝒊𝒎𝒆𝒔
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 45,000
b. Average Collection Period

365 𝑑𝑎𝑦𝑠 365
= = 𝟖. 𝟐𝟏 𝒅𝒂𝒚𝒔 𝒐𝒓 𝒂𝒑𝒑𝒓𝒐𝒙. 𝟖 𝒅𝒂𝒚𝒔
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 44.44
c. Inventory Turnover
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 1,300,000
= = 𝟏𝟎 𝒙 𝒐𝒓 𝟏𝟎 𝒕𝒊𝒎𝒆𝒔
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 130,000
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d. Average Age of Inventories
365 𝑑𝑎𝑦𝑠 365

= = 𝟑𝟔. 𝟓 𝒅𝒂𝒚𝒔 𝒐𝒓 𝒂𝒑𝒑𝒓𝒐𝒙. 𝟑𝟕 𝒅𝒂𝒚𝒔
10 10
e. Fixed Assets Turnover Ratio

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 2,000,000
= = 𝟎. 𝟒𝟒 𝒙 𝒐𝒓 𝟎. 𝟒𝟒 𝒕𝒊𝒎𝒆𝒔
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 4,570,000
f. Total Assets Turnover Ratio

= = 𝟎. 𝟒𝟏 𝒙 𝒐𝒓 𝟎. 𝟒𝟏 𝒕𝒊𝒎𝒆𝒔
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 4,900,000
3. Debt Management Ratios:

• measures the ability of the business firm to settle its financial obligations when they
mature and still remain stable.
• It affects the short and long-term debt, and shareholders’ equity.
• It reflects how the firm has financed its assets.
The Debt Management Ratios include:
a. Debt Ratio
o It measures the proportion of cash provided by the creditors.
o Reflects the percentage of total assets that are financed with debt.
o Formula:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑥 100
b. Equity Ratio
o Determines the proportion of resources provided by the owners of the business
firm.
o It presents the financial strengths of the business because it provides the margin of
safety that the company affords to creditors.
o Formula:
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑥 100
c. Debt to Equity Ratio
o It measures the proportion of debt and equity in the capital structure of the
company.
o Formula:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
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NAME AND SECTION:
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d. Times Interest Earned (TIE) Ratio

o It measures how readily an entity can meet interest payments with profit earned
from operations.
o This indicates the margin of safety provided by current earnings in meeting the
entity’s interest responsibilities.
o Formula:
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠
𝑇𝐼𝐸 𝑅𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
Please refer to the given balance sheet and income statement in Illustrative Example 2.
Solution:
a. Debt Ratio
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 2,825,000
𝑥 100 = 𝑥 100 = 𝟓𝟕. 𝟔𝟓%
b. Equity Ratio
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 2,075,000
𝑥 100 = 𝑥 100 = 𝟒𝟐. 𝟑𝟓%
c. Debt to Equity Ratio

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 2,825,000
= = 𝟏. 𝟑𝟔 𝒙 𝒐𝒓 𝟏. 𝟑𝟔 𝒕𝒊𝒎𝒆𝒔
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 2,075,000
d. Times Interest Earned Ratio

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠 501,000
= = 𝟏𝟕𝟖. 𝟗𝟑 𝒙 𝒐𝒓 𝟏𝟕𝟖. 𝟗𝟑 𝒕𝒊𝒎𝒆𝒔
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 2,800
4. Profitability Ratios:
• It reflects the combined effects of liquidity, management efficiency in handling the
assets, and liabilities on the operating results of the business.
• It shows the effectiveness of business operations.
• Enables analysts to evaluate the firm’s profits with respect to a given level of sales, a
certain level of assets, or owner’s investment.
The following are the Profitability Ratios:
a. Gross Profit Margin

o It measures the gross profit rate to sales.
o It indicates margin available to cover operating expenses.
o Formula:
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑥 100
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NAME AND SECTION:
TEACHER:
b. Operating Profit Margin

o Measure the percentage of profit available after deducting the cost of sales and
operating expenses from sales.
o Reflects the overall efficiency of the management in handling the production,
selling, and administrative costs.
o Formula:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑥 100
c. Net Profit Margin

o Measures the overall results of an entity.
o The measures considers all income recognized and all expenses incurred during
the period.
o Formula:
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑥 100
d. Return on Assets (ROA)
o Also known as the Return on Investment (ROI).
o Measures the amount of net income per peso of investment in the business.
o Reflects the profitability of every peso invested.
o Formula:
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑥 100
e. Return on Equity
o Measures the rate of return on the investment of the owner.
o Formula:
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑥 100
𝑂𝑤𝑛𝑒𝑟 ! 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Please refer to the given balance sheet and income statement in Illustrative Example 2.
Solution:
a. Gross Profit Margin

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 700,000
𝑥 100 = 𝑥 100 = 𝟑𝟓%
b. Operating Profit Margin
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 501,000
𝑥 100 = 𝑥 100 = 𝟐𝟓. 𝟎𝟓%
c. Net Profit Margin
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 352,240
𝑥 100 = 𝑥 100 = 𝟏𝟕. 𝟔𝟏%
d. Return on Assets
𝑥 100 = 𝑥 100 = 𝟕. 𝟏𝟗%
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NAME AND SECTION:
TEACHER:
e. Return on Equity
𝑥 100 = 𝑥 100 = 𝟏𝟔. 𝟗𝟖%
𝑂𝑤𝑛𝑒𝑟 ! 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 2,075,000
5. Market Ratios
• Gives an idea of what the investors think about the firm and its future prospects.
• This will be discussed next year during your Business Finance class.
Illustrative Example 5. Comprehensive Example

Presented below are the Income Statement and comparative Balance Sheets of Technica, Inc.
Required:
1. Compute for all the discussed ratios under the
different classifications.
2. For each of the ratios, evaluate the computed
values vs. the provided industry averages and
determine whether it is favorable or
unfavorable.
Ratio Industry Average
Current Ratio 1.50x
Acid Test Ratio 1.20x
Receivable Turnover 16.30x
Average Collection Period 22 days
Inventory Turnover 5.00x
Average Age of Inventory 73 days
Fixed Assets Turnover 2x
Total Assets Turnover 1.30x
Debt Ratio 60%
Equity Ratio 40%
Debt to Equity Ratio 2x
Times Interest Earned Ratio 5x
Gross Profit Margin 30%
Operating Profit Margin 23%
Net Profit Margin 10%
Return on Assets 15%
Return on Equity 25%
3. Prepare a vertical analysis for the given

financial statements and horizontal
analysis for the balance sheets.
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NAME AND SECTION:
TEACHER:
Solution: i. Debt Ratio
1. Compute for the following ratios: 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 225,000

𝑥 100 = 𝑥 100
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 408,300
a. Current Ratio = 𝟓𝟓. 𝟏𝟏%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 138,300 j. Equity Ratio

= = 𝟏. 𝟖𝟒𝒙
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 183,300
𝑥 100 = 𝑥 100
b. Acid Test Ratio 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 408,300
= 𝟒𝟒. 𝟖𝟗%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 − 𝑃𝑟𝑒𝑝𝑎𝑖𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
k. Debt to Equity Ratio
138,300 − 82,000 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 225,000

= = 𝟎. 𝟕𝟓𝒙 = = 𝟏. 𝟐𝟑𝒙
75,000 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 183,300
c. Receivable Turnover l. Times Interest Earned Ratio
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 600,000 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠

= 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 38,150
= 𝟏𝟓. 𝟕𝟑𝒙 80,000
= = 𝟖𝒙
10,000
d. Average Collection Period
m. Gross Profit Ratio
365 𝑑𝑎𝑦𝑠 365
= 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 140,000
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 15.73 𝑥 100 = 𝑥 100
= 𝟐𝟑 𝒅𝒂𝒚𝒔 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 600,000
= 𝟐𝟑. 𝟑𝟑%
e. Inventory Turnover n. Operating Profit Ratio
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 80,000

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 460,000 𝑥 100 = 𝑥 100
= = 𝟔. 𝟗𝟕𝒙 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 600,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 66,000 = 𝟏𝟑. 𝟑𝟑%
f. Average Age of Inventory o. Net Profit Ratio
365 𝑑𝑎𝑦𝑠 365 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 42,900

= = 𝟓𝟐 𝒅𝒂𝒚𝒔 𝑥 100 = 𝑥 100
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 6.97 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 600,000
= 𝟕. 𝟏𝟓%
g. Fixed Assets Turnover
p. Return on Assets
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 600,000
= = 𝟐. 𝟐𝟐 𝒙
𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 270,000 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 42,900
𝑥 100 = 𝑥 100
h. Total Assets Turnover = 𝟏𝟎. 𝟓𝟏%
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 600,000 q. Return on Equity

= = 𝟏. 𝟒𝟕 𝒙
!
𝑥 100 = 𝑥 100
𝑂𝑤𝑛𝑒𝑟 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 183,300
= 𝟐𝟑. 𝟒𝟎%
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NAME AND SECTION:
TEACHER:
2. Evaluation of computed ratios vs. industry averages
Ratio Industry Average Computed Ratios Evaluation

Current Ratio 1.50x 1.84x Favorable
Acid Test Ratio 1.20x 0.75x Unfavorable
Receivable Turnover 16.30x 15.73x Unfavorable
Average Collection Period 22 days 23 days Unfavorable
Inventory Turnover 5.00x 6.97x Favorable
Average Age of Inventory 73 days 52 days Favorable
Fixed Assets Turnover 2x 2.22x Favorable
Total Assets Turnover 1.30x 1.47x Favorable
Debt Ratio 60% 55.11% Favorable
Equity Ratio 40% 44.89% Favorable
Debt to Equity Ratio 2x 1.23x Favorable
Times Interest Earned Ratio 5x 8x Favorable
Gross Profit Margin 30% 23.33% Unfavorable
Operating Profit Margin 23% 13.33% Unfavorable
Net Profit Margin 10% 7.15% Unfavorable
Return on Assets 15% 10.51% Unfavorable
Return on Equity 25% 23.40% Unfavorable
3. Vertical Analysis
Technica Inc.
Statements of Financial Position
December 31
2003 2002
Assets Amount % Amount %
Cash $ 15,000 3.67 $ 16,000 3.99
Marketable Securities 7,200 1.76 8,000 1.99
Accounts Receivable 34,100 8.35 42,200 10.52
Inventories 82,000 20.08 50,000 12.46
Total current assets $ 138,300 33.87 $ 116,200 28.96
Land and buildings $ 150,000 36.74 $ 150,000 37.39
Machinery and equipment 200,000 48.98 190,000 47.36
Furniture and fixtures 54,000 13.23 50,000 12.46
Other Fixed Assets 11,000 2.69 10,000 2.49
Total gross fixed assets $ 415,000 101.64 $ 400,000 99.70
Less: Accumulated depreciation 145,000 -35.51 115,000 -28.66
Net Fixed Assets $ 270,000 66.13 $ 285,000 71.04
Total Assets $ 408,300 100.00 $ 401,200 100.00
Liabilities
Accounts Payable $ 57,000 13.96 $ 49,000 12.21
Notes Payable 13,000 3.18 16,000 3.99
Accruals 5,000 1.22 6,000 1.50
Total current liabilities 75,000 71,000
Long-term debt 150,000 36.74 160,000 39.88
Total Liabilities $ 225,000 55.11 $ 231,000 57.58
Stockholder’s Equity
Common stock equity $ 110,200 26.99 120,000 67.30
Retained Earnings 73,100 17.90 50,200 12.51
Total Stockholder’s Equity $ 183,300 44.89% 170,200 42.42
Total Liabilities and Equity $ 408,300 100.00 $ 401,200 100.00
Note: For the given balance sheets, the items in blue are to be considered separately since these are
subtotals. Totaling these values will also yield 100%.
15
NAME AND SECTION:
TEACHER:
Technica, Inc.
Income Statement
For the Year Ended December 31, 2003
Amount %
Sales Revenue $ 600,000 100.00
Less: Cost of Goods Sold 460,000 76.67
Gross Profit 140,000 23.33
Less: Operating Expenses
General and Administrative Expense 30,000 5.00
Depreciation Expenses 30,000 5.00
Total Operating Expenses 60,000 10.00
Less: Interest Expense 10,000 1.67
Net Profit before Income Taxes 70,000 11.67
Less: Taxes 27,100 4.52
Earnings available for common stockholders $ 42,900 7.15
Horizontal Analysis:
Technica Inc.
Statements of Financial Position
December 31
Assets 2003 2002 %

Cash $ 15,000 $ 16,000 -6.25
Marketable Securities 7,200 8,000 -10.00
Accounts Receivable 34,100 42,200 -19.19
Inventories 82,000 50,000 64.00
Total current assets $ 138,300 $ 116,200 19.02
Land and buildings $ 150,000 $ 150,000 0.00
Machinery and equipment 200,000 190,000 5.26
Furniture and fixtures 54,000 50,000 8.00
Other Fixed Assets 11,000 10,000 10.00
Total gross fixed assets $ 415,000 $ 400,000 3.75
Less: Accumulated depreciation 145,000 115,000 26.09
Net Fixed Assets $ 270,000 $ 285,000 -5.26
Total Assets $ 408,300 $ 401,200 1.77
Liabilities
Accounts Payable $ 57,000 $ 49,000 16.33
Notes Payable 13,000 16,000 -18.75
Accruals 5,000 6,000 -16.67
Total current liabilities 75,000 71,000 5.63
Long-term debt 150,000 160,000 -6.25
Total Liabilities $ 225,000 $ 231,000 -2.60
Stockholder’s Equity
Common stock equity $ 110,200 120,000 -8.17
Retained Earnings 73,100 50,200 45.62
Total Stockholder’s Equity $ 183,300 170,200 7.70
Total Liabilities and Equity $ 408,300 $ 401,200 1.77
References:
Ballada, W. (2018). Fundamentals of Accountancy, Business and Management 2 (2018 ed.). DomDane
and Made Easy Books.
Brigham, E. F., & Houston, J. F. (2019). Fundamentals of financial management. Boston: Cengage.
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LICEO DE LA SALLE SENIOR HIGH SCHOOL

SECOND SEMESTER | QUARTER 4

NAME AND SECTION: