NAME: TEACHER:

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STRAND AND SECTION: DATE:

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Fundamentals Of Accountancy, Business and Management 2 -

Grade 12- Quarter 1 Week 6A

DEFINING THE MEASUREMENT LEVELS, NAMELY, LIQUIDITY, SOLVENCY,

STABILITY, AND PROFITABILITY

BACKGROUND INFORMATION FOR LEARNERS

In the earlier discussion, the student was introduced to the different financial statements
that are being prepared by an entity. It is not enough that the accountant can prepare the said
financial statements correctly. Its importance lies in the ability of the company to make use of
such financial data in their decision making. The relevance of such documents can only be
achieved if it could make a positive impact on the day-to-day decisions being made by the entity.

Financial ratios are the most common tools of managerial decision making. A ratio is a
comparison of one number to another-mathematically, a simple division problem. Financial ratios
involve the comparison of various figures from the financial statements in order to gain
information about
that makes financial ratios a useful tool for business managers. Ratios may serve as indicators,
clues, or red flags regarding noteworthy relationships between variables used to measure the

valuation.

MEASUREMENT LEVELS:

LIQUIDITY

Liquidity is a measure of the ability of a debtor to pay their debts as and when they fall
due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity is the ability
to pay short-term obligations. The most common liquidity ratio is the current ratio which is the
-
term bills.

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Different ratios under liquidity ratio are shown below:

1. Working Capital-
liabilities with current assets. The working capital is important to creditors because it
shows the liquidity of the company.

Working Capital = Current Assets- Current Liabilities

Illustration

2017 (ABC Co.)

Current Assets 1,160,000
Less: Current Liabilities (400,000)
Working Capital 760,000

2018 (ABC Co.)

Current Assets 1,260,000
Less: Current Liabilities (450,000)
Working Capital 810,000

For both periods, the company has a positive working capital. This is something good.
However, comparing the two periods together, we can conclude that the company is in a
better liquidity position in 2018 than in 2017.

2. Current Ratio- is a liquidity and efficien

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 = Current Assets/ Current Liabilities

Illustration

statement of financial position included the following accounts:

...

Current Li
Current Ratio = 10,000+ 5,000+ 5,000+ 1,000+ 500/15,000= 1.43

liquid, considering it can pay off all the

current liabilities with current assets and still have some current assets left over.

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 3. Quick Ratio (Acid -test 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 into 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.

FORMULA: Quick Ratio = Cash + cash equivalents + Short Term Investments + Current
Accounts Receivables/ Current Liabilities

Illustration

statement of financial position included the following accounts:

Cash 10, 000

Accounts Receivable 5, 000
Inventory 5, 000
Stock Investments 1, 000
Prepaid taxes 500
Current liabilities 15,000
Quick ratio= 10, 000 + 5,000 + 1,000/ 15,000=1.07

assets and still have some quick assets left over.

4. Accounts Receivable Turnover Ratio- accounts receivable turnover ratio measures

how many times a business can turn its accounts receivable into cash during a period. In
other words, the accounts receivable turnover ratio measures how many times a business
can collect its average accounts receivable during the year.

FORMULA: Accounts Receivable Turnover = Net Credit Sales/ Average Accounts

Receivable

Example: 2017 Net Sales 5,200,000

÷
Average Accounts Receivable 250,000
A/R turnover Ratio 20.80 times
2018 Net Sales 6,000,000
÷
Average Accounts Receivable 265,000
A/R turnover Ratio 22.64 times

Comparing the computed A/R Turnover Ratios for the two periods, the company has a higher
ratio for 2018. This can be attributed to a better performance from its collection department.

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 5. Average Collection Period- the 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 compared with the previous A/R Turnover Ratio. In fact,
the A/R Turnover itself is a component for the computation of the average collection
period. It serves as the denominator in the formula.

For the numerator, the company makes use of either 360 or 365 days. This would
depend on the policy of the company. For our illustrative examples, we will use 365 days
as a numerator.

As much as possible, the goal is to have a shorter average collection period. This
would mean the company is efficient in collecting their outstanding Accounts Receivable
from their customers. A shorter average collection period means that the company has
more immediate cash that can be used in its operation.

FORMULA: 365 days /A/R Turnover Ratio

Example:

2017 365 365

÷
A/R Turnover Ratio 20.80 times
Average Collection Period 17.54 days

2018 365 365

÷
A/R Turnover Ratio 22.64
Average Collection Period 16.12 days

The shorter average collection period in 2018 shows that the collection increased its efforts
to collect company receivables as they fall due.

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 6. Inventory Turnover Ratio- this 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. A high turnover ratio shows how efficient
the company is in selling its inventory to customers.

FORMULA: CGS / Average Inventory

Example:

2017 CGS 1,200,000

÷
Average Inventory 370,000
Inventory Turnover Ratio 3.24 times

2018 CGS 1,500,000

÷
Average Inventory ____ 395,000
Inventory Turnover Ratio 3.79times

It can be seen in our computation that the inventory turnover increased in 2018. It means
that the sales department sold more products to customers in 2018.

7. Average Days in Inventory- this ratio states that the number of days that it would take
before an inventory would be entirely sold by the company. This follows the same concept
in computing the average collection period. The company uses 360 or 365 as the
numerator and the inventory turnover ratio as denominator. The goal is to have shorter
average days in inventory. A shorter amount would mean that the cash of the company
is not being tied up to its inventory for a very long period of time.

FORMULA: 360 or 365 / Inventory Turnover Ratio

Example: 2017 365 365

÷
Inventory Turnover Ratio 3.24
Average day in Inventory 112.65 days

2018 365 365

÷
Inventory Turnover Ratio 3.79
Average Day in Inventory 96.30 days

The average days in inventory of this company improved in 2018. This is because the
inventory turnover in 2018 also improved.

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 8. Number of Days in Operating Cycle-These are the measures on how long it would 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. The goal is to always have
a shorter number of operating cycles. A shorter number would indicate that the company
would have additional cash at an earlier time.
FORMULA:
Number of Days in Operating Cycle= Collecting Period/ Ave. Age of Inventory
Example:
2017 Collecting Period 17.54 days
÷
Average age of Inventory 112.65 days
Number of Days in OC 130.19 days

2018 Collecting Period 16.12 days

÷
Average age of Inventory 96.30 days
Number of Days in OC 112. 42 days

A comparison between the two periods shows an improvement of at least 17 days in the
operating cycle. It means that the company improved as a whole when it comes to selling their
products and collecting their receivables.

SOLVENCY OR STABILITY RATIOS

These are a group of financial ratios that measure the ability of a business firm to settle
its financial obligation when they mature and still remain stable. The different ratios under this
category also reflect the extent to which a firm utilizes debt financing: hence they are also called
financial leverage ratios.

The following are commonly used financial leverage ratios will be highlighted:

1. Debt To Total Assets Ratio-

pay off its liabilities with its assets. This shows how many assets the company must sell
to pay off all of its liabilities.

The debt ratio is computed as follows:

Debt ratio = Total liabilities / Total assets

Guitar Shop is thinking about building an addition at the back of its

existing building for more storage. Gino consults with the banker about applying for a

debt levels. The banker discovers that Gino has total assets of 100,000 and total liabilities

.25 = 25,000/ 100,000

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 4 times as many a
are only 25 percent of its total assets. Essentially, only its creditors own ¼ of the

2. Debt to Equity Ratio. The debt-to-equity ratio is a financial, liquidity ratio that compares
debt-to-equity ratio shows the percentage of
company financing that comes from creditors and investors. A higher debt to equity ratio
indicates that more creditor financing (bank loans) is used than investor financing
(shareholders)

FORMULA:

Debt to Equity Ratio = Total Liabilities / Total Equity

Illustration

Assume a company has 100,000 of bank lines of credit and a 500,000 mortgage on its property.
The owners of the company have invested 1.2 million. The debt-to-equity ratio will be as follows.

.50 = 100,000 + 500,000 / 1,200,000

A debt ratio of .5 means that there are half as many liabilities as there is equity.

3. Times Interest Earned Ratio- time interest earned is a tool that measures the debt
paying ability of the company. It reflects the degree of protection provided by an entity to
its long-term creditors. It is favorable to investors if the business firm has a higher ratio
of times interest earned.

FORMULA:

TIE = Income before interest and taxes / Interest expense

2015 2014

Operating income 600,000 460,000

Interest Expense 100,000 100,000

The times interest earned of Charm Company is computed as follows:

2015 (600,000/100,000) = 6.0 times

2014 (460,000/100,000) = 4.6 times

The ratio may indicate that Charm can cover interest payment from its operating income
6 times in 2015 against 4.6 times in 2014. The improvement in the measure gave better
protection to the creditors.

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PROFITABILITY RATIOS

Profitability, as its name suggests, is a measure of profit which business is generating.

Profitability ratios are basically a financial tool which helps us to measure the ability of a business
to create earnings, given the level of expenses they are incurring. These ratios take into account
various elements of the Income statement and balance sheet to analyze how the business has
performed. Higher the value of these ratios as compared to competition and market, better the
ance.

TYPES OF PROFITABILITY RATIOS

1. Gross Profit Ratio

As the term implies, this is the proportion of the gross profit of the company with its net
sales. Gross profit is the difference between the net sales of the company and cost of goods
sold.
As much as possible, the company wants to have a big gross profit ratio. It means that it
was able to generate more sales from its cost of goods sold.

FORMULA:

Gross Profit Ratio = Gross Profit / Net Sales

Example:

2017

Gross Profit 4,000,000

÷
Net Sales 5,200,000
Gross Profit ratio 76.92%

2018

Gross Profit 4,500,000

÷
Net Sales 6,000,000
Gross Profit ratio 75%

The
at least be minimized. The gross profit ratio can be improved by continuously finding inventories
with lower cost, without sacrificing quality.

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 2. Profit Margin Ratios

These ratios compare various profits of the business (gross profit, operating profit,
net profit, etc.) with its sales. The profit being mentioned here is the Net Income After Tax
(NIAT). This ratio measures the proportion between the NIAT and the net sales of the
company. This is a more
already considered the operating expenses and other expenses of the entity. Like the
gross profit ratio, companies would want to have a high profit margin ratio. This ratio can

FORMULA:
PROFIT MARGIN RATIO= NIAT/Net SALES

2017
Net Income After Tax 1,750,000
÷
Net Sales 5,200,000
Profit Margin Ratio 33.65%

2018
Net Income After Tax 1,400,000
÷
Net Sales 6,000,000
Profit Margin Ratio 23.33%

Comparing the ratios for the two periods, there

profit margin ratio in 2018. This can be attributed to the lower NIAT coupled by an
increase in net sales.

3. Operating Expenses to Sales Ratio

Operating expenses are the biggest expenses of every company. It can be further
classified into General and Administrative Expenses and Selling Expenses. These
expenses are needed to generate sales.

FORMULA:

Operating Expenses to Sale Ratio = Operating Expenses / Net Sales

Example:
2017 Operating Expenses 1,000,000
÷
Net Sales 5,200,000
OE to Sale Ratio 19.23%

2018 Operating Expenses 500,000

÷
Net Sales 6,000,000
OE to Sale Ratio 8.33%

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Comparing the data for the two years involved shows that there is a huge improvement in the
operating expenses to sales ratio. This can be attributed to lower operating expenses and
increase in net sales.

4. Return on Investment Ratio

The return-on-investment ratio has two variations: Return on Asset and Return

the computation.

a. Return on Assets
Before profits can be realized, certain investments should be made. In this case,
assets will be used for the different projects of the company. The goal is to generate profit
based on the available assets during the year. Thus, the company aims for a higher return
on assets.
FORMULA:

Return on Assets = Profit / Average total Assets

Example: 2017 Profit 1,750,000

÷
Average Total Assets 2,000,000
Return on Assets .875

2018 Profit 1,400,000

÷
Average Total Assets 2,200,000
Return on Assets .6363

There was a decline in the return on assets of the company. This is something
negative. This can be attributed to a lower profit and higher average total assets. It means
that it is taking more assets that are used to generate the same number of profits for the
company.

b. Return on Equity

This is a slight variation of the earlier formula. In this case, it is the average

denominator being used is the one

coming from stockholders alone. In the return on assets the average total assets being
used may come predominantly from creditors. Overall, a company should have a higher
return on equity.

FORMULA:
Return on Equity = Profit/ Average SHE

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 Example:

2017 Profit 1,750,000

÷
Average SHE 500,000
Return on equity 3 .5

2018 Profit 1,400,000

÷
Average SHE 575,000
Return on equity 2.43

In 2018, the return on equity decreased. This could be attributed to a lower net
income after tax and a larger return on equity in 2018.

5. Asset Turnover Ratio-

This ratio measures the correlation between the assets owned by the company
and the net sales generated by such properties.

FORMULA:
Asset Turnover Ratio = Net Sales / Average Total Assets
Example:
2017 Net Sales 5,200,000
÷
Average Total assets 2,000,000
Assets Turnover Ratio 2.6

2018 Net Sales 6,000,000

÷
Average Total assets 2,200,000
Assets Turnover Ratio 2.72

The Asset turnover ratio slightly increased in 2018. This is something positive.
This can be attributed to bigger net sales generated for in 2018.

LEARNING COMPETENCY

Define the measurement levels namely, liquidity, solvency, stability, and profitability.
(ABM_FABM 12-Ig-h-12)

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 ACTIVITIES

ACTIVITY 1: CHECK ME WHERE I BELONG!

DIRECTION: Put a check (/) in its respective column where the ratio belongs.

No. Ratio Liquidity Solvency Profitability

1. Debt to Total assets ratio

2. Return on Investment

3. Inventory Turnover ratio

4. Acid Test Ratio

5. Gross profit Ratio

6. Profit Margin Ratio

7. Current Ratio

8. Working Capital

9. Average Collection period

10. Debt To Equity Ratio

ACTIVITY 2:

Direction: Identify what is being described in each item then write your answer on the space
provided.

____________1. This ratio measures the number of times a company was able to sell its entire
inventory to customers during the year.

____________2. These are the biggest expenses of the company.

____________3. The quotient of the current assets divided by the current liabilities of the
company.

____________4. It compares the liabilities of the company with its equity.

Receivable to Cash.

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ACTIVITY 3

Direction: From the given table below match column A from column B then write your answer by
putting the number in the space provided found in the first column.

Answer COLUMN A Item COLUMN B

Inventory Turnover 1 Total Liabilities / Total Equity
Current Ratio 2 365 days /A/R Turnover Ratio
Debt to Equity Ratio 3 CGS / Average Inventory
Average collection period 4 Gross Profit / Net Sales
Gross Profit Ratio 5 Current Assets/ Current Liabilities

Direction: Put a check (/) in its respective column where the ratio belongs.

No. Ratio Liquidity Solvency Profitability

1 Times Interest Earned Ratio
2. Return on Investment
3. Average Days in Inventory
4. Number of days in Operating Cycle
5. Asset Turnover ratio

Direction: Identify the following items then write the answer in the space provided before each
number.

____________6. This is the proportion of the gross profit of the company and its net sales.

____________7. The difference between current assets and current liabilities.

____________8. This measures the ability of the company to settle its currently maturing
obligations.

____________9. A strict variation of the current ratio formula. It removes the inventory and
prepaid expenses from the numerator component. test of the ability to pay current
obligation.

____________10. This ratio states the number of days that will take before an inventory will be
entirely sold by the company.

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 REFLECTION

Congratulations! You have completed the lessons successfully. Rate yourself on how well you
understand the lesson. Please put a check (/) in the appropriate icons below.

PARAMETERS

1. I can define liquidity.

________ _________

2. tI can define solvency.

________ ________

3. I can define profitability.

________ ________

REFERENCES

Books:
Yabut, Josefina L. Beticon/ james Cristopher D. Domingo/ fermin Antonio D. 2016. Fundamentals
of Accountancy, Business and Management 2. Quezon City: Vibal Groups Inc.

Angeles A. De Guzman, DBA,CPA. 2018. Fundamentals of Accountancy, Business and

Management 2. Quezon city: LORIMAR Publishing Inc.

Websites:
https://www.educba.com/profitability-ratios-

formula/https://www.investopedia.com/terms/l/liquidityratios.asp

Profitability, Liquidity and Solvency (slideshare.net)

RO_FABM2_Grade 12_Q1_WK6_LP9 90