FINANCIAL RATIOS

Financial Ratios can be used to compare a company’s current financial position and
performance with those of past years and identify strengths and weaknesses. It also
allows comparison of different companies in different industries. Their use is not only
limited to management but to stockholders and creditors as well. Some creditors or
financial institutions require the presentation of certain ratios before they extend credit.
This is to ascertain the return of their money together with the interest.

In the process of using financial ratios to evaluate a company, ratios are often divided
into four categories as follows:

a. Liquidity – is the ability of the company to settle its current obligations as they fall
due.
b. Solvency – is the ability of the company to settle its non-current of long-term
obligations and the interest related to these obligations.
c. Profitability – measures the company’s operating performance as a retun on its
investment. It gauges management’s efficiency in using company resources in
order to generate revenue.
d. Market value or valuation – measures the company’s potential for future
earnings, dividend payments and stock price growth.

LIQUIDITY RATIO calculates the company’s current or quick assets against its
outstanding liabilities. Generally, high ration indicates that the company has low risk
of defaulting payments.

Common types of Liquidity Ratios

1. Current Ratio – measures the ability of the business to pay its short-term
obligations as they fall due. Generally, a current ratio of 1 or 1.5 is considered
satisfactory to serve as a company’s cushion to its current liabilities although the
industry average has to be taken into consideration. However, some banks and
financial institutions require a current ratio of 2 or 3 before extending credit in
order to assure collection of the principal with interest. Nevertheless, this does
not mean that the higher the current ratio the better. Although a low current ratio
may mean that the company may not be able to pay its short term debts as they
mature, a very high current ratio ay mean that the company is holding too much
cash or liquid assets when in fact, a part of these could be put in long-term
investment which will yield higher income. The component of the current assets
should also be determined because a significant part of it might be inventory and
prepaid expenses.
 Current Ratio Current Assets
Current Liabilities

2. Quick Ratio – otherwise known as the acid test ratio, measures immediate
liquidity with the ability to pay current liabilities with the most liquid assets. The
quick ratio is a more conservative measure of liquidity since it only considers
current assets that can be converted to cash easily or quickly.

Current assets are composed of cash short-term investments, receivables,

merchandise inventory and prepaid expenses. From these, we can notice that
merchandise inventory is not easily convertible to cash as it has to be sold first
which does not guarantee instant cash because sometimes, it is sold on credit.
Furthermore, some inventory items are slow moving. Due to obsolescence, these
items may not even be sold in the long run. On the other hand, repaid expenses
will never be converted to cash since they are not sold but used in the normal
operating cycle of the business. It is because of these reasons that these two
accounts are not considered when computing for the quick ratio.

Quick Ratio = Cash + Short Term Investments+ Trade Receivables

Current Liabilities

3. Receivable Turnover – measures the efficiency to collect the amount due from
credit customers. Generally, a high trade receivable turnover is considered
favorable since it may indicate a company’s strict credit policies combined with
aggressive collection efforts while a low trade receivable turnover may indicate
loose credit policies combined with inadequate collection effort. However,
imposing a very strict credit and collection policy may lead to lesser sales as
some customers may opt to buy from other companies with more lenient credit
terms.

Receivable Turnover = Net Credit Sales

Average Trade Receivables

*Average Trade Receivable = Beginning Trade Receivable + Ending Trade Receivable

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4. Average Collection Period – otherwise called day’s sales outstanding, is the
approximate number of days it takes a business to collect its receivables from
credit or account sales. In assessing whether the average collection period is
favorable or unfavorable, the credit terms extended by the company to its
customers should be considered. Average collection period has two formulas as
follows:
 Average Collection Period = 360 days
Trade Receivable Turnover

5. Inventory Turnover – measures the number of times a company is sold and

replaced during the year.

Inventory Turnover = Cost of Goods Sold

Average Inventory

*Average Inventory = Beginning Inventory + Ending Inventory

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6. Average Sales Period – the average time to convert inventory to sales.

Average Sales Period = 360 days

Inventory Turnover

7. Working Capital – measures the short-term liquidity of a company.

Working Capital = Current Assets – Current Liabilities

SOLVENCY RATIO otherwise called leverage ratios, measures a company’s ability to

pay its maturing long-term debts while sustaining operations indefinitely.

1. Debt Ratio – measures business liabilities as a percentage of total assets.

Debt Ratio = Total Liabilities

Total Assets

2. Equity Ratio – measures the percentage of total assets financed by the owner’s
investments.

Equity Ratio = Total Equity

Total Assets

3. Debt to Equity Ratio – measures the financing provided by the creditors against
those provided by the owner.
 Debt to equity Ratio = Total Liabilities
Total Equity

4. Time Interest Earned – measures the company’s ability to pay the interest charge
to the company for its outstanding liabilities.

Times Interest Earned = Income before interest and taxes

Interest Expense

PROFITABILITY RATIO measures a company’s overall efficiency and performance

based on its ability to generate profit from operations relative to its available assets and
resources.

1. Gross Profit Ratio – measures the percentage of peso sales earned after
deducting cost of goods sold.

Gross Profit Ratio = Gross Profit

Net Sales

2. Operating Profit Margin – measures the percentage of income earned after

deducting the cost of sales and the operating expenses.

Operating Profit Margin= Operating Income

Net Sales

3. Net Profit Margin – measures the percentage of net income earned from net
sales after all other income has been added and all operating expenses and
other expenses including income taxes have been paid.

Net Profit Margin = Net Income

Net Sales

4. Return on Assets – measures the company’s efficiency in suing its level of

investment in assets in order to generate income.

Return on Assets = Net Income

Average Total Assets

*Average Total Assets = Assets at Beginning of the Year + Assets at Ending of the Year
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