FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND MANAGEMENT 2

FINANCIAL ANALYSIS – RATIO ANALYSIS

There are three kinds of FS analysis techniques:

- Horizontal analysis
- Vertical analysis
- Financial ratios (Note: Inform the learners that this lesson will focus on ratio analysis.)

Ratio analysis - expresses the relationship among selected items of financial statement data. The
relationship is expressed in terms of a percentage, a rate, or a simple proportion (Weygandtet.al. 2013).
A financial ratio is composed of a numerator and a denominator.

For example, a ratio that divides sales by assets will find the peso amount of sales generated by every peso
of asset invested. This is an important ratio because it tells us the efficiency of invested asset to create
revenue. This ratio is called asset turnover. There are many ratios used in business.

These ratios are generally grouped into three categories:

(a) Profitability,
(b) Efficiency
(c) Financial health.

2. Profitability ratios measure the ability of the company to generate income from the use of its assets and
invested capital as well as control its cost. The following are the commonly used profitability ratios:

- Gross profit ratio reports the peso value of the gross profit earned for every peso of sales. We can infer
the average pricing policy from the gross profit margin. Gross profit is the difference between the net sales
of the company and its cost of goods sold. A bigger gross profit ratio means that is was able to generate
more sales form the smaller cost of goods sold the it has.

- Operating income ratio-expresses operating income as a percentage of sales. It measures the percentage
of profit earned from each peso of sales in the company’s core business operations (Horngren et.al. 2013). A
company with a high operating income ratio may imply a lean operation and have low operating expenses.
Maximizing operating income depends on keeping operating costs as low as possible (Horngren et.al. 2013).

- Profit Margin Ratio – 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 the more precise
measure of the company’s profitability because it has already considered the operating expenses and other
expenses of the entity.

- Net profit ratio relates the peso value of the net income earned to every peso of sales. This shows how
much profit will go to the owner for every peso of sales made.

- Operating Expense to Sales Ratio – aside from the cost of goods sold, operating expenses is one of 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 for the period.
Formula: Total Operating Expenses / Net Sales

Return on Investment (ROI) classified into two:

Return on Assets
Return on Equity

- Return on asset (ROA) measures the peso value of income generated by employing the company’s assets.
It is viewed as an interest rate or a form of yield on asset investment. The numerator of ROA is net income.
However, net income is profit for the shareholders. On the other hand, asset is allocated to both creditors
and shareholders. Some analyst prefers to use earnings before interest and taxes instead of net income.
 There are also two acceptable denominators for ROA – ending balance of total assets or average of total
assets. Average assets is computed as beginning balance + ending balance divided by 2.

- Return on equity (ROE) measures the return (net income) generated by the owner’s capital invested in the
business. Similar to ROA, the denominator of ROE may also be total equity or average equity.
Sample Financial Statements to be used for the computations:

Cash P 200,000
Accounts Receivable 400,000
Inventory 250,000
Equipment 550,000
Total Assets P 1,400,000

Accounts Payable P 300,000

Notes Payable 400,000
Owner, Capital 700,000
Total Liabilities and equity P 1,400,000

Sales P 900,000.00
Cost of Goods Sold 400,000.00
Gross Profit 500,000.00
Operating Expenses 200,000.00
Operating income 300,000.00
Interest Expense 20,000.00
Net Income 280,000.00

3. Operational efficiency ratio - measures the ability of the company to utilize its assets. Operational efficiency is
measured based on the company’s ability to generate sales from the utilization of its assets, as a whole or
individually. The turnover ratios are primarily used to measure operational efficiency.

- Asset turnover measures the peso value of sales generated for every peso of the company’s assets. The higher the
turnover rate, the more efficient the company is in using its assets.
- Fixed asset turnover is indicator of the efficiency of fixed assets in generating sales.

- Inventory turnover is measured based on cost of goods sold and not sales. As such both the numerator and
denominator of this ratio are measured at cost. It is an indicator of how fast the company can sell inventory. The
goal is to have a high inventory turnover ratio. By having such, it would mean that the company is being more
effective in selling its inventory to customers.

The numerator for this formula would be the company’s Cost of Goods Sold.

- An alternative to inventory turnover is “days in inventory”. This measures the number of days from acquisition to
sale.

Average Days in Inventory – this ratio states the number of days that it would take before a group of inventory will
be entirely sold by the company. The company can make use of 360 or 365 as their numerator and will make use of
the Inventory turnover ratio for its denominator. The goal is to have shorter average days in inventory. A shorter
amount would mean that the cash of the company is note being tied to its inventory for a very long period of time.

Number of Days in Operating Cycle - this is the measure 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 days in operating cycle. A shorter number would indicate that the
company would have additional cash at an earlier time.

- Accounts receivables turnover the measures the number of times the company was able to collect on its average
accounts receivable during the year. For the numerator, the company should make use of the total Net Credit Sales,
as an alternative, the company could make use of the Total Net Sales if the Net Credit Sales is not available.

For the denominator, the average accounts receivable can be computed by adding the beginning and the ending
balances for the Accounts Receivable and dividing it by 2. The goal is to have a higher Accounts Receivable Turnover
Ratio.

- An alternative to accounts receivable turnover is “days in accounts receivable”. This measures the company’s
collection period which is the number of days from sale to collection

- or 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. For the numerator, the company makes use of either 360 or 365 days. The
goal is to have a shorter collection period for a more immediate cash to be used in their operations.
4. Financial Health Ratios look into the company’s solvency and liquidity ratios.

Solvency refers to the company’s capacity to pay their long term liabilities. On the other hand,

liquidity ratio intends to measure the company’s ability to pay debts that are coming due (short term debt).

- Debt ratio – (Debt to total Asset Ratio) indicates the percentage of the company’s assets that are financed by
debt. A high debt to asset ratio implies a high level of debt. As much as possible, current and prospective creditors
would want a very low debt to total assets ratio. There is a bigger probability of collection in the future if there are
fewer liabilities.

- Equity ratio – indicates the percentage of the company’s assets that are financed by capital. A high equity to asset
ratio implies a high level of capital

- Debt to equity ratio indicates the company’s reliance to debt or liability as a source of financing relative to equity.
A high ratio suggests a high level of debt that may result in high interest expense. . A smaller debt to equity ratio
wold indicate a healthier solvency position for the company.

- Interest coverage ratio measures the company’s ability to cover the interest expense on its liability with its
operating income. It shows the proportion between the EBIT (Earnings Before Interest and Taxes) of the company
and its interest expense. Creditors prefer a high coverage ratio to give them protection that interest due to them can
be paid. A small or a decimal number ratio would indicate that it is not worthy to borrow money from others if the
company would not be able to generate enough income to cover for it.

- Current ratio is used to evaluate the company’s liquidity. It seeks to measure whether there are sufficient current
assets to pay for current liabilities. Creditors normally prefer a current ratio of 2.

- Quick ratio or Acid Test Ratio is a stricter measure of liquidity. It does not consider all the current assets, only
those that are easier to liquidate such as cash and accounts receivable that are referred to as quick assets.
These ratios are important to the short term creditors of a company.
These would determine if the borrowing company is in a position to pay the borrowed principal and interest when
they fall due.

Working Capital – the difference between Current Assets and Current Liabilities.
CA – CL = Working Capital
The simplest liquidity ratio.
 A positive working capital is preferred because it would mean that there is enough current assets
to pay all the current liabilities at the moment.

Ratios can also be categorized as follows:

Different Financial Ratios
1. Liquidity Ratios
Liquidity – the capacity of a company to pay its currently maturing obligations. This would require a good amount of
Cash and other liquid assets like Accounts Receivable, Inventory, Trading Securities and Prepaid Assets.
2. Solvency Ratios
Solvency – measures the capability of an entity to pay long-term obligations as they fall due.
3. Profitability Ratios
Profitability is ability of a company to use its resources to generate revenues in excess of its expenses. In other
words, this is a company’s capability of generating profits from its operations.

Liquidity Ratios – measures of short-term ability of the entity to pay its maturing obligations and to meet unexpected
needs for cash.
1. Working Capital – a measure of liquidity (current assets – current liabilities)
2. Current Ratio – measures liquidity by expressing the relationship of current assets to current liabilities; (
current assets/current liabilities)
3. Acid Test Ratio – measure of company’s immediate short-term liquidity; (sum of cash, trading securities, and
current receivables / current liabilities) *Quick Assets – consist of cash, trading securities (short-term investments)
and current receivables)
4. Accounts Receivable Turnover Ratio – measures liquidity of accounts receivable; (net credit sales / average
net receivables)
5. Average Collection Period – average number of days that receivables are outstanding; (365 days /
receivables turnover)
6. Inventory Turnover Ratio – measures liquidity of inventory; (cost of goods sold / average inventory)
7. Average Days in Inventory – the number of days it takes to sell the inventory ; ( 365 days/inventory turnover)
8. Number of Days in Operating Cycle
Solvency Ratio – measures the ability of the entity to meet its long-term obligation as they become due.
1. Debt to Total Assets Ratio - the percentage of total assets provided by creditors; (total liabilities/total
assets)
2. Debt to Equity Ratio
3. Times Interest Earned Ratio – indicator of a company’s ability to meet interest payments (income before
income tax + interest expense / interest expense)
Profitability Ratios – measures operating success of an entity for a given period.
1. Gross Profit Ratio – indicator of a company’s ability to maintain an adequate selling price of goods above
their cost; (gross profit/net sales)
2. Profit Margin Ratio – measures net income generated by each peso of sales ( net income/net sales)
3. Operating Expenses to Sales Ratio
4. Return on Investment
a. Return on Assets
b. Return on Equity
5. Asset Turnover Ratio – measures how efficiently a company uses its assets to generate sales; (net sales /
average total assets)

COMMON-SIZE FINANCIAL STATEMENT – financial statement standardized by a measure of size, either sales or total
assets; all amounts are stated in terms of a percentage of the size measure.
Horizontal Analysis – technique for evaluating a series of financial statement data over a period of time to determine
the change (increase/decrease) that has taken.
Vertical Analysis – technique for evaluating financial statement data that expresses each item as a percent of a base
amount.

ENRICHMENT (60 MINS)

Using any spreadsheet application, i.e. MS Excel, create a worksheet model for financial ratio analysis. Use the
downloaded audited financial statement (2014 JFC audited SFP and SCI) from the Introduction section to test the
worksheet model.
EVALUATION (60 MINS)

Problem 1: Very Berry Company

Statement of Comprehensive Income

For the Year-ended December 31
2014 2013
Sales 10,040,000 8,760,000
Cost of Goods Sold 5,680,000 5,860,000
Gross Profit 4,360,000 2,800,000
Operating Expenses 1,160,000 1,680,000
Operating Income 3,200,000 1,220,000
Interest Expense 100,000 28,000
Net Income 3,1000,000 1,192,000

Statement of Financial Position

For the Year-ended December 31
2014 2013
Cash 400,000 180,000
Short-term investments 5,600,000 1,800,000
Accounts receivable 1,480,000 1,060,000
Inventory 1,380,000 1,640,000
Other Current Assets 8,860,000 4,680,000
Total Current Assets 10,860,000 5,040,000
Equipment 6,800,000 5,200,000
Total Assets 17,660,000 10,240,000
Accounts Payable 6,600,000 2,620,000
Notes Payable - long term 2,460,000 2,120,000
Owner, Capital 8,600,000 5,500,000
Total liabilities and equity 17,660,000 10,240,000

Requirements:
a. Compute for the company’s profitability and operating efficiency ratios for 2014.
b. Compute for the financial health ratios of the company in 2014 and 2013

ENRICHMENT (60 MINS)

Using any spreadsheet application, i.e. MS Excel, create a worksheet model for financial ratio analysis. Use the
downloaded audited financial statement (2014 JFC audited SFP and SCI) from the Introduction section to test the
worksheet model.

EVALUATION (60 MINS)

• Choose from the additional exercises below to assign as homework exercises for the learners to practice at home
as preparation for the quiz. Discuss the answers to the assignment in the next session. • Give a short quiz to
evaluate the learners’ understanding of the lesson. You may choose from the additional exercises below or prepare
your own questions. 86