Business Finance

CHAPTER 2
Review of Financial
Statement Preparation,
Analysis, and
Interpretation
Financial Statement
Analysis
 Learning Objective
• To know how to compute different financial
ratios such as liquidity, leverage, efficiency or
turnover, and profitability ratios
Uses of Financial Statement Analysis
What are the USES of FINANCIAL
STATEMENT ANALYSIS?

 It is used for investment and credit decisions.

 It is also used for regulating companies.

 It used by management for monitoring performance.

 It is used in identifying strategies to further improve the

company’s operations.
 Financial Ratios
For this chapter, the FINANCIAL
RATIOS given below will be discussed.

1. Profitability ratios
2. Liquidity ratios
3. Leverage ratios
4. Efficiency ratios
 Different Profitability Ratios
What RATIOS are used to measure the
PROFITABILITY of a company?

1. Return on Equity (ROE)

2. Return on Assets (ROA)
3. Gross Profit Margin
4. Operating Profit Margin
5. Net Profit Margin
 Profitability Ratio:
Return on Equity (ROE)
 ROE measures the amount of net income earned in
relation to stockholders’ equity.

 The formula for computing ROE is:

 Profitability Ratio:
Return on Assets (ROA)
 ROA measures the ability of a company to generate
income out of its resources.

 The formula for computing ROA is:

 Profitability Ratio:
Gross Profit Margin
 Gross Profit Margin is a profitability ratio that measures
the ability of a company to cover its cost of goods sold
from its sales.
 The formula for Gross Profit Margin is:
 Profitability Ratio:
Operating Profit Margin
 Operating Profit Margin measures the amount of income
generated from the core business of a company.
 Operating Profit Margin is computed as the difference
between revenues and the sum of cost of revenues or sales
and operating expenses.
 The formula for Operating Profit Margin is:
 Profitability Ratio:
Net Profit Margin
 Net Profit Margin measures how much net profit a
company generates for every peso of sales or revenues
that it generates.

 The formula for Net Profit Margin is:

Net income is the amount left after all expenses

including income taxes are deducted from sales or
revenues.
 Different Liquidity Ratios
What are the two commonly used
LIQUIDITY RATIOS?

1. Current Ratio
2. Acid-Test Ratio
 Liquidity Ratio:
Current Ratio
 The formula for computing Current Ratio is:
Current assets include cash and
other assets which are expected to
be converted to cash within 12
months such as accounts receivable
and inventories.
Current assets also include
prepayments such as prepaid rent
and prepaid insurance.
Current liabilities include
obligations that are expected to
be settled or paid within 12
months such as accounts
payable, accrued expenses
payable such as accrued
salaries, and current portion of
long-term debt.
 Liquidity Ratio:
Acid-Test Ratio
 Acid-Test Ratio is sometimes referred to as Quick
Asset Ratio.
 The quick asset ratio is a stricter measure of a
company’s liquidity position.
 The formula for computing Quick Asset Ratio is:

OR
 Different Leverage Ratios
What LEVERAGE RATIOS will be
discussed in this chapter?

1. Debt Ratio
2. Debt to Equity Ratio
3. Interest Coverage Ratio
 Leverage Ratio:
Debt Ratio
 Debt Ratio measures how much of the total assets are
financed by liabilities.

 The formula for computing Debt Ratio is:

 Leverage Ratio:
Debt to Equity Ratio
 Debt to Equity Ratio is a variation of the Debt Ratio.

 A Debt to Equity Ratio of more than one means that

a company has more liabilities as compared to
stockholders’ equity.

 The formula for computing Debt to Equity Ratio is:

 Leverage Ratio:
Interest Coverage Ratio
 Interest Coverage Ratio provides information if a
company has enough operating income to cover
interest expense.

 The formula for computing Interest Coverage Ratio is:

EBIT stands for earnings before

interest and taxes.
 Different Efficiency Ratios
What EFFICIENCY RATIOS will be
discussed in this chapter?

1. Total Asset Turnover Ratio

2. Fixed Asset Turnover Ratio
3. Accounts Receivable Turnover Ratio
4. Inventory Turnover Ratio
5. Accounts Payable Turnover Ratio

From these three ratios, operating cycle

and cash conversion cycle can be
computed.
 Efficiency Ratio:
Total Asset Turnover Ratio
 Total Asset Turnover Ratio measures the company’s
ability to generate revenues for every peso of asset
invested.
 Total Asset Turnover Ratio is an indicator of how
productive the company is in utilizing its resources.

 The formula for computing Total Asset Turnover

Ratio is:
 Efficiency Ratio:
Fixed Asset Turnover Ratio
 If a company is heavily invested in property, plant, and
equipment (PPE) or fixed assets, it pays to know how
efficient the management of these assets must be.

 The formula for computing Fixed Asset Turnover

Ratio is:
 Efficiency Ratio:
Accounts Receivable Turnover Ratio
 Accounts Receivable Turnover Ratio measures the
efficiency by which accounts receivable are
managed.
 A high Accounts Receivable Turnover Ratio means
efficient management of receivables.
 The formula for computing Accounts Receivable
Turnover Ratio is:
 Efficiency Ratio:
Inventory Turnover Ratio
 Inventory Turnover Ratio measures the company’s
efficiency in managing its inventories.
 Trading and manufacturing companies and
companies that are dealing with highly perishable
products and those that are prone to technological
obsolescence must pay close attention to this ratio to
minimize losses.
 The formula for computing Inventory Turnover
Ratio is:
 Efficiency Ratio:
Accounts Payable Turnover Ratio
 Accounts Payable Turnover Ratio provides
information regarding the rate by which trade payables
are paid.
 The formula for computing Accounts Payable
Turnover Ratio is:
 The Operating Cycle
How can the OPERATING
CYCLE be computed?

 By adding the average collection period and days’

inventories, the operating cycle can be computed.
 This operating cycle covers the period from the time
the merchandise is bought to the time the proceeds
from the sale are collected.
 The formula for computing Operating Cycle is:
 The Cash Conversion Cycle
How can the CASH CONVERSION
CYCLE be computed?

 To find out how long it takes the company to collect

receivables from the time the cost of the merchandise
sold was actually paid, a Cash Conversion Cycle or
sometimes called Net Trade Cycle can be computed.

 The formula for computing Cash Conversion Cycle is:

 Self-Test Questions
1. What are the four major groups of financial ratios
covered in this chapter? Explain each briefly.
2. Is it possible for a company to miss payment of its
maturing obligations in spite of having high current
ratio and quick asset ratio? Explain.