BUSINESS FINANCE

WEEK 4: FINANCIAL RATIOS

 ANALYSIS AND INTERPRETATION

Background Information for Learners

Financial Statements for 2015 and 2016 of GHI Company will be used as illustration
GHI Company 
Comparative Financial Statement
For the Year 2015 & 2016

      Assets 2016 2015 2016 2015

Cash 450,000.00 400,000.00 Net Sales     6,000,000.00      5,200,000.00 
Accounts Receivables 280,000.00 250,000.00 Less: Cost of Goods Sold     1,500,000.00      1,200,000.00 
Trading Securities 30,000.00 120,000.00 Gross Profit     4,500,000.00      4,000,000.00 
Less: Operating
Inventories 420,000.00 370,000.00 Expenses (500,000.00)    (1,000,000.00) 
Earnings Before Interest
Prepaid Expenses 80,000.00 20,000.00 and Taxes       4,000,000.00          3,000,000.00 
Total Current Assets 1,260,000.00 1,160,000.00 Less: Interest Expense   (2,000,000.00)    (500,000.00) 
Total Non-Current
Assets 1,140,000.00 840,000.00 NI before Tax 2,000,000.00  2,500,000.00 
  Less: Income Tax   (600,000.00)        (750,000.00) 
Total Assets 2,400,000.00 2,000,000.00    
Liabilities 2016 2015 Net Income   1,400,000.00    1,750,000.00 
Total Current
Liabilities 450,000.00 400,000.00
Total Non-Current
Liabilities 1,380,000.00 1.100,000.00
    Owner’s Equity
Total Owner’s Equity 650,000.00 500,000.00
Total Liabilities & OE 2,400,000.00 2,000,000.00

 LIQUIDITY RATIOS

Liquidity refers to the company’s ability to satisfy its short-term obligations as they come due, also refers
to a company’s capability to quickly convert assets into cash

a.  Net Working Capital is the difference between the current assets and current liabilities
  Net Working Capital = Current Assets – Current Liabilities

 2015   NWC = 1,160,000 - 400,000 🡺 760,000

 2016   NWC = 1,260,000 - 450,000  🡺 810,000

b.  Current Ratio is the quotient of current assets divided by current liabilities

 Current Ratio = Current Assets / Current Liabilities

 2015   CR = 1,160,000/400,000 🡺 2.9

 2016   CR = 1,260,000/450,00  🡺 2.8

c.  Quick Ratio is a more strict variation of the current ratio formula. It removes Inventory and
Prepaid Expenses from the numerator.  Only Cash, Receivables, and Trading Securities (also
known as Quick Assets) will be left.

 Quick Ratio/Acid Test Ratio = Quick Assets / Current Liabilities

 2015 QR = 770,000/400,000 🡺 1.925

 2016 QR = 760,000/450,000 🡺 1.688

EFFICIENCY RATIOS

Efficiency refers to a company’s ability to be efficient in its operations. Specifically, it refers to the
speed with which various current accounts are converted into sales, and ultimately, cash.

a.  Accounts Receivable Turnover Ratio measures the frequency of conversion of the company’s
Accounts Receivables to Cash. It measures how many times the company was able to collect its
Accounts Receivable from its customers.

 A/R Turnover Ratio = Net Sales / Average A/R

 2015 A/R TR = 5,200,000/250,000 🡺 20.80 times
 2016 A/R TR = 6,000,000/265,000 🡺 22.64 times

b.  Average Collection Period states the usual number of days that it would take before the
company would be able to collect a certain group of receivables. This ratio is usually connected
with the previous A/R Turnover Ratio.
 Average Collection Period =   365 / A/R Turnover Ratio
 2015 ACP = 365/20.80 🡺 17.54 days
 2016 ACP = 365/22.64 🡺 16.12 days

c.  Inventory Turnover Ratio measures the number of times the company was able to sell its
entire inventory to customers during the year. As much as possible, the goal is to have a high
inventory turnover ratio. By having such, it will mean that the company is being more effective in
selling its inventory to customers.

 Inventory Turnover = Cost of Goods Sold / Average Inventory

 2015 IT= 1.200,000/370,000 🡺 3.24 times

 2016 IT= 1,500,000/395,000 🡺 3.79 times

d.  Average Age of Inventory Ratio computes the number of days that it will take before a group
of inventories will be entirely sold by the company. This follows the same concept in computing
the average collection period.

 Average Days in Inventory =  365 / Inventory Turnover

 2015 ADI = 365/3.24 🡺 112.65 days

 2016 ADI = 365/3.79 🡺 96.30 days

e.  Accounts Payable Turnover Ratio measures how quickly a business makes payments to
creditors and suppliers that extends lines of credit.
 Accounts Payable Turnover = Credit Purchases or COGS / Average Accounts Payable

 2015 APT = 1,200,000/400,000 🡺 3

 2016 APT = 1,500,000/450,000 🡺 3.33 

f.  Average Payment Period shows the average number of days that a payable remains unpaid.

 Average Payment Period = 365 / Accounts Payable Turnover Ratio

 2015 APP = 365/3  🡺 121 days

 2016 APP = 365/3.33 🡺 107 days 
 g.  Operating Cycle is the measure on how long it will take for the company to transform its
inventory back to cash. This is the combination of the average collection period and the average
age of inventory.

 Number of days in the OC = Collection Period + Average Age of Inventory

 2015 No. of days in the OC = 17.54 + 112.19 days 🡺 130.19 days

 2016 No. of days in the OC = 16.12 + 96.30 days 🡺 112.42 days

LEVERAGE RATIOS

Financial Leverage refers to the company’s use of debt, it defines the company’s capital structure which
indicates how much of the total assets are financed by debt and equity.

             a.  Debt Ratio measures the proportion of total assets financed by total liabilities or money
provided by creditors (not by the business owners).

 Debt Ratio = Total Liabilities / Total Assets

 2015 DR = 1,500.000/2,000,000 🡺 .75
 2016 DR = 1,750.000/2,400,000 🡺 .7291

b.  Debt Equity Ratio compares the liabilities of the company with its equity. A small debt equity
ratio would indicate a healthier solvency position for the company

 Debt Equity Ratio = Total Liabilities / Total Shareholder’s Equity

 2015 DER = 1,500.000/500,000 🡺 3
 2016 DER = 1,750.000/650,000 🡺 2.69

c.  Times Interest Earned Ratio shows the proportion between the Earnings Before Interest and
Taxes (EBIT) of the company and its interest expense. It is an indicator on how many times the
EBIT can cover the finance cost of borrowing.
 Times Interest Earned = EBIT / Interest Expense
 2015 TIE = 3,000,000/500,000 🡺 6
 2016 TIE = 4,000,000/2,000,000 🡺 2

PROFITABILITY RATIOS

Profitability is the ability to generate adequate profits to sustain the operations of the business and earn
satisfactory return to the owner/s.
 a.  Gross Profit Margin is the proportion of the gross profit of the company with its net sales.
This ratio shows
             how many pesos of gross profit is earned for every peso of sale.  It provides information
regarding the ability of a company to cover its manufacturing cost from its sales. Gross profit is the
difference between the net sales of the company and the cost of goods sold.

 Gross Profit Ratio = Gross Profit / Net Sales

 2015 GPR = 4,000,000/5,200,000 🡺 76.92%

 2016 GPR = 4,500,000/6,000,000 🡺 75%

b.  Operating Profit Margin shows how many pesos of operating profit is earned for every peso
of sale. It
measures the amount of income generated from the core business of a company. This is more
precise measures of the company’s profitability because it has already considered the operating
expenses and other expenses of the entity.
  Operating Profit Ratio = Operating Income / Net Sales

 2015 GPR = 3,000,000/5,200,000 🡺 57.69% 

 2016 GPR = 4,000,000/6,000,000 🡺 66.67%

c.  Net Profit Margin measures how much net profit a company generates for every
peso of sales or
revenues that it generates.

 Net Profit Margin = Net Income / Net Sales

 2015 GPR = 1,750,000/5,200,000 🡺 33.65%

 2016 GPR = 1,400,000/6,000,000 🡺 23.33%

d.  Return on Assets measures the ability of a company to generate income out of its
resources/assets.
            The goal is to generate as much profit based on the available assets during the year.
Thus, a
            higher return on assets is to be desired. 

 Return on Assets = Net Income / Total Assets

 2015 ROA = 1,750,000/2,000,000 🡺 .875

 2016 ROA = 1,400,000/2,400,000 🡺 .5833 

 e.  Return on Equity measures the amount of net income earned in relation to
 stockholders’ equity.

 Return on Equity = Net Income / Total Stockholder’s Equity

 2015 ROE = 1,750,000/500,000 🡺 3.5

 2016 ROE = 1,400,000/650,000 🡪 2.15

f.  Earnings per Share measures how many pesos of net income have been earned by
each share of
common stock during a certain period of time.

 Earnings per Share = Net Income - Preferred Dividends / Outstanding Common

Shares

Learning Competency with Code

              The learner performs vertical and horizontal analyses of financial statements of a
single proprietorship
 (ABM_BF12-IIIb-8); and compute, analyze, and interprets financial ratios such as current
ratio, working capital, gross
profit ratio, net profit ratio, receivable turnover, inventory turnover, debt to-equity ratio, and
the like (ABM_BF12-IIIb-9).
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Directions/ Instructions 
Read the contents of the Background Information for Learners carefully together with
the other resources available
 about the lesson. Also, watch the video lesson/s posted in you tube, chat groups and/or
facebook discussing the contents of 
this lesson. Then, accomplish the activities and exercises provided below.
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Exercises / Activities 
 Exercise #1:  Given below are the Statement of Financial Position and Statement of
Comprehensive Income Statement
 of Sam Company for Year 2018-2019. a.) Compute for the Horizontal and Vertical
Analysis; b.) Interpret the financial
 position based on the result. 
Exercise #2:  Read and analyze the problem below:
Nora Enterprises and Vilma Enterprises are both trading company.  Below is the
comparative financial data
of the two companies. 
 Nora Enterprises Vilma Enterprises
Cash 67,832 17,100
Accounts Receivable (net) 84,480 27,600
Inventories 71,280 26,496
Prepaid Expenses 12,000 3,000
Current Assets 235,592 74,196
Fixed Assets 353,388 173,124
TOTAL ASSETS 588,980 247,320
Current Liabilities 126,694 48,392
Mortgage payable 50,000 100,000
Total Liabilities 176,694 148,392
Owner’s Equity 412,286 98,928
TOTAL LIABILITIES & EQUITY 588,980 247,320
Sales (All on credit) 844,800 165,600
Cost of Sales  570,240 132,480
No. of Business Days 360 days

1. Determine which of the two companies is more liquid and solvent by developing the
following ratios: 
Quick Ratio, Inventory Turnover, Average Age of Inventory, Accounts Receivable
Turnover andAverage Collection Period. Write your interpretation based on your
computation.
2. Determine which of the two companies is generally more stable: Debt-utilization
ratio, Equity ratio, Debt-equity ratio. Write your interpretation based on your
computation.