Fundamentals of Accountancy, Business and Management 2

Accounting cycle is a sequence of operations used to account business transactions during a specified period.
Eleven steps in the accounting cycle:
1. Analysis of the transaction
2. Recording of the transactions in the journal
3. Posting of journal entries to the ledger.
4. Preparation of the trial balance.
5. Compilation of data needed to adjust the accounts.
6. Journalizing and posting of adjusting entries.
7. Preparation of the worksheet.
8. Preparation of the financial statements.
9. Journalizing and posting of closing entries.
10.Preparation of post-closing trial balance.
11.Journalizing and posting of reversing entries.

Worksheet
An accounting worksheet is a tool used to help bookkeepers and accountants complete the accounting cycle
and prepare year-end reports like unadjusted trial balance, adjusting entries, adjusted trial balances, and financial
statements. (See page 3 – Worksheet)
Review Problem 1:
Sure Freight Forwarders
Trial Balance
As of February 28, 2017

Cash 720,250
Accounts Receivable 50,000
Prepaid Insurance 16,250
Prepaid Rent 30,000
Office Equipment 58,000
Mechanical Tools 50,000
Delivery Truck 750,000
Furnitures and Fixtures 25,000
Accounts Payable 260,000
Juan D. Masipag, Capital 1,300,000
Freight Service Income 220,500
Wages expense 65,000
Rent expense 10,000
Utilities expense 6,000
Total 1,780,500 1,780,500

Adjusting entries made:

A Doubtful accounts expense 500
Allowance for doubtful accounts 500

B Insurance expense 1,250

Prepaid insurance 1,250

C Rent expense 5,000

Prepaid rent 5,000
D Depreciation expense-Office Equipment 1,000
Accumulated depreciation- Office Equipment 1,000

E Depreciation expense-Delivery Truck 6,250

Accumulated depreciation- Delivery Truck 6,250

F Depreciation expense-Furniture & Fixtures 1,050

Accumulated depreciation- Furniture & Fixtures 1,050

Required: Prepare the worksheet of Sure Freight Forwarders

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 Review Problem 2:
KALAYAAN COMPANY
Trial Balance
As of December 31, 20X1

Cash 400,000
Accounts receivable 600,000
Allowance for doubtful accounts 60,000
Merchandise Inventory, January 1,
20X1 900,000
Prepaid Rent 600,000
Prepaid Insurance 300,000
Equipment 7,800,000
Accumulated depreciation 1,000,000
Land 1,500,000
Accounts payable 220,000
Unearned Subscription revenue 240,000
Notes payable 2,000,000
R. Cruz, Capital 4,500,000
Sales Revenue 9,000,000
Purchases 2,500,000
Interest expense 120,000
Selling expense 400,000
Wages expense 1,100,000
General and administrative expense 800,000
17,020,00
Total 0 17,020,000

Adjusting entries made

A Merchandise Inventory, December 31, 20x1 700,000
Cost of Goods sold 2,000,000
Purchases 2,500,000
Merchandise Inventory, January 1, 20x1 900,000
B Depreciation expense 500,000
Accumulated depreciation 500,000

C Bad debts expense 90,000

Allowance for doubtful accounts 90,000
D Interest expense 40,000
Interest payable 40,000
E Wages expense 50,000
Wages payable 50,000

F Rent expense 300,000

Prepaid rent 300,000
G Insurance expense 150,000
Prepaid Insurance 150,000

H Unearned subscription revenue 80,000

Subscription revenue 80,000

Required: Prepare the worksheet of Kalayaan Company

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3
FINANCIAL STATEMENTS
1. Statement of Financial Position ( Balance Sheet)
2. Statement of Comprehensive Income / Income Statement
3. Statement of Changes in Equity
4. Statement of Cash Flows

Statement of Comprehensive Income / Income Statement

The Statement of Comprehensive Income or Income Statement is a is a financial statement providing information
about an entity’s past performance. Its purpose is to measure the results of the entity’s operations for some specific time
period.

The information presented in the Income Statement is a major concern of the investor because it shows whether
the business is profitable or not. It shows whether the business is earning, losing or breakeven.

Elements:
1. Revenues – inflows of assets to an entity from delivering or producing goods, rendering services, or carrying out
other activities. Revenues represent what a company’s customer pay for its goods or services and the rewards of
doing business.

2. Expenses – outflows of assets arising from delivering or producing goods, rendering services, or carrying out
other activities. Expenses are the sacrifices required to attain revenues.

3. Gains and losses – arise from sale or loss in value of assets other than merchandise. These assets may include
equipment, machinery, investments in marketable securities.

Sample questions:

1. Learning is Fun Company generated revenues amounting to Php 100,000. Expenses for the year totaled Php 76,000.
How much is the company’s net income for the year?

2. Happy Selling’s beginning inventory amounted to 250,000. Net purchases amounted to 70,000. Freight In totaled
15,000. Compute for the company’s cost of goods available for sale.

3. Happy Selling’s Sales amounted to Php 500,000. Sales returns and sales discounts amounted to Php 30,000 and Php
10,000 respectively. Purchases of the company totaled Php 100,000 while purchase returns and purchase discounts
amounted to Php 20,000 and Php 10,000 respectively. How much is the company’s Net Sales? Net Purchases?

4. Company’s Cost of Goods Sold amounted to Php 285,000. Net cost of purchases totaled Php 85,000. Beginning
inventory amounted to Php 250,000. Sales amounted to Php 500,000. Compute for the company’s Ending Inventory.

5. Gross profit of Happy Selling amounted to Php 175,000. Beginning Inventory totaled Php 250,000. Ending Inventory
amounted to Php 50,000 while Net Cost of Purchases totaled Php 85,000. Compute for Happy’s Net Sales.

Example 1: Statement of Comprehensive Income for Service Concern

   
POLO COMPANY
STATEMENT OF COMPREHENSIVE INCOME
For the month ended March 31, 2016
   
Revenue  
  Service Fee P 50,000
   
Operating Expenses  
  Salaries expense P 11,000  
  Advertising expense 7,000  
  Office Supplies expense 3,400  
  Rent expense 10,000  
  Depreciation expense 2,000  
Total operating expense 33,400
Net income P 16,600
           
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 Example 2: Statement of Comprehensive Income for Merchandising Concern
   
Teen Store
Statement of Comprehensive Income
For the Year Ended December 31, 2016
   
Gross sales P 1,070,000
Sales return and allowances (5,000)
Sales discounts (15,000)
Net sales P 1,050,000
Cost of Goods Sold  
 
Merchandise Inventory, Jan. 1 200,000
P  
  Purchases 610,000  
  Purchase return (40,000)  
  Purchase discount (70,000)  
  Total goods available for sale 700,000  
  Merchandise Inventory, Dec. 31 (100,000)  
  Cost of Goods Sold (600,000)
Gross income / Gross margin P 450,000
Operating Expenses  
  Salaries expense P 218,000  
  Advertising expense 80,000  
  Store supplies expense 50,000  
  Office supplies expense 12,000  
  Bad debts 10,000  
  Depreciation expense-Equipment 10,000  
  Depreciation expense-Building 40,000  
Total operating expense P (420,000)
Net income P 30,000
         

STATEMENT OF CHANGES IN EQUITY

The Statement of Changes in Equity summarizes the changes in equity for a given period of time. For a sole
proprietorship, the beginning equity of the owner is increased by additional investment and net income or profit for the
period and is decreased by withdrawal and loss.

Example 1: Statement of Changes in Owner's equity -

Single Proprietorship  
POLO COMPANY  
STATEMENT OF CHANGES IN OWNER'S EQUITY  
For the month ended March 31, 2016  
   
P. Cruz, Capital, March 1, 20x1 P 130,000  
Add: Net income 16,600  
Sub total 146,600  
Less: Withdrawals (2,000)  
P. Cruz, Capital, March 31, 20x1 144,600  
             

Sample questions:
1. Beginning owner’s equity amounted to P 300,000. Net loss for the year totaled P 45,000. No additional investments
and withdrawals for the period. Compute for total increase in equity for the year.

2. Ending owner’s equity amounted to P70,000. Additional investments during the year amounted to P30,000.

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 Withdrawals totaled P50,000. Compute for the company’s net income for the year assuming beginning equity is
P10,000.
3. Owner, Juan invested an initial capital amounting P50,000 in order to put up his janitorial services company. During
the first year of operations (2016), the company had a loss of P25,000. Because of this, Juan invested additional
capital amounting to P50,000 in 2017. In the second year (2017), the company had a net income of P100,000 and
Juan withdrew P10,000 for personal use. Compute for the ending capital balance of Juan for the year 2017

STATEMENT OF FINANCIAL POSITION

The Statement of Financial Position is a financial statement providing information about the entity’s resources
(assets), claims against those resources (liabilities), and the remaining claim accruing to the owner ( owner’s equity) as of
the end of a period. It may be used to evaluate such factors as liquidity, solvency, financial structure and the need of the
entity for additional financing.

Liquidity - ability of the company to meet currently maturing obligations

Solvency - the availability of cash over the longer term to meet maturing obligations
Financial structure – indicates how much is the equity of the creditors and how much is the
equity of the owners

Elements:
1. Assets – resources controlled by the entity as a result of past events and from which future economic benefits are
expected to flow to the entity

2. Liabilities – obligations of the entity arising from past events, the settlement of which is expected to result in an
outflow from the resources embodying economic benefits.

3. Equity – represents residual interest in the assets of the entity after deducting all its liabilities.

Sample questions:
1. Learning is Fun Company had current assets amounting to Php 100,000. Noncurrent assets for the year totaled
Php 76,000. How much is the company’s total assets?

2. Happy Selling Company’s total liabilities amounted Php 10,000. Total equity had an ending balance of Php 20,000. How
much is total assets?

3. Happy Selling’s had the following accounts at year end: Cash-250,000, Accounts Payable-70,000, Prepaid Expense-
15,000. Compute for the company’s current assets.

4. Happy Selling’s Accounts Receivable amounted to Php 500,000. Prepaid Expense and Unearned Income totaled
Php 30,000 and Php 10,000 respectively. Cash balance amounted to Php 100,000 while Accounts Payable and
Inventory totaled to Php 20,000 and Php 10,000 respectively. How much is the company’s current assets? Current
liabilities?

5. Company’s Total Liabilities and Equity amounted to Php 285,000. Total noncurrent assets ended at Php 85,000.
Cash totaled Php50,000. Inventory amounted to Php100,000. Assuming the company had no other assets, how much is
Accounts Receivable?

6. Total assets amounted to Php575,000. Total equity amounted to Php 250,000. Accounts Payable amounted to
Php 50,000 while Unearned Income totaled Php 85,000. Assuming there are no other current liabilities, compute for
the company’s noncurrent liabilities.

6
             
POLO COMPANY  
STATEMENT OF FINANCIAL POSITION  
March 31, 2016  
   
ASSETS  
Current Assets  
118,00
  Cash P 0  
  Accounts Receivable P 10,200  
Less: Allowance for bad
  debts (200) 10,000  
  Prepaid Rent 20,000  
  Office Supplies 600  
148,60
Total current assets P 0  
   
Noncurrent Assets  
  Office Equipment P 15,000  
Less: Accumulated (2,000
  depreciation )  
Total noncurrent Assets 13,000  
161,60
Total Assets P 0  
   
LIABILITIES AND OWNER'S EQUITY  
Current Liabilities  
  Accounts payable P 12,000  
  Salaries payable 5,000  
Total liabilities 17,000  
   
Owner's Equity  
144,60
  P. K Cruz, Capital 0  
Total liabilities & Owner's 161,60
Equity P 0  
             

7
Exercise 1 : Classification of Accounts
Classify the accounts given below and the financial statement:

CA - Current asset SCI - Statement of Comprehensive Income

NCA - Non-current asset SFP - Statement of Financial Position
CL - Current Liability SCE - Statement of Changes In Equity
NCL - Non-current liability
EQ - Equity
IN - Revenue / Income
EX - Expenses

Account FS Account FS
1 Juan dela Cruz, Capital 16 Accumulated depreciation
2 Depreciation expense 17 Allowance for bad debts
3 Delivery Equipment 18 Salaries payable
4 Utilities expense 19 Copyright
5 Service revenue 20 Note payable
6 Prepaid insurance 21 Advertising expense
7 Accounts payable 22 Bad debts expense
8 Kho Juan, Drawing 23 Accounts receivable
9 Offi ce supplies 24 Delivery trucks
10 Furnitures & Fixture 25 Accrued expenses
11 Merchandise Inventory 26 Notes receivable
12 Prepaid rent 27 Note payable, due in 3 yrs
13 Mortgage payable 28 Marketable securities
14 Prepaid rent 29 Income tax payable
15 Cash 30 Land

Review Problem 1:
MEGALINK INFORMATION CENTER
Trial Balance
For the year ended December 31, 2016

Accounts Payable 145,215

Accounts Receivable 711,634
Accrued Expenses Payable 50,000
Accumulated Depreciation-Furnitures & Fixtures 15,290
Accumulated Depreciation-Office Equipment 21,853
Cash 145,270
Chattel Mortgage Payable 150,000
Depreciation expense-Office Equipment 10,926
Depreciation expense-Office Furniture & Fixtures 17,675
Insurance Expense 16,000
Kho Juan Co., Capital 300,000
Kho Juan Co., Personal Drawing 38,500
Miscellaneous Expense 2,270
Office Equipment 109,265
Office Furnitures & Fixtures 75,154
Office Supplies 27,019
Office Supplies Expense 10,807
Prepaid Insurance 48,000
Prepaid Rent 36,000
Rent Expense 12,000
Salaries & Wages 148,170
Salaries Payable 12,347
Trucking Service Income 649,185
Unearned Trucking Income 41,176
Utilities expense 59,310
VAT Payable 82,934
Total 1,468,00 1,468,000
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 0

Required: Prepare the Statement Comprehensive Income, Statement of Changes in Equity and
Statement of Financial Position

Review Problem 2:
The following data was taken from the books of Hanson Retail Food Store for the year ended
December 31, 2014

Total sales Php 262,000.00

Interest Expense 350.00
Delivery expense 9,000.00
Cash 9,000.00
Prepaid rent 2,000.00
Machinery & Equipment 31,000.00
Interest Payable 1,000.00
Wages Payable 800.00
Merchandise Inventory, December 31 10,000.00
Mortgage Payable 80,000.00
Land 45,000.00
Accounts Payable 4,200.00
Telephone expense 2,250.00
License Expense 3,000.00
Advertising expense 12,400.00
Salaries and wages 45,000.00
Hanson, Capital, January 1 55,000.00
Cost of Goods Sold 159,000.00
Notes Payable 15,000.00
Rent Expense 6,300.00
Accounts Receivable 5,000.00
Office supplies on hand 1,000.00
Building 86,000.00

Additional Data:
a. Merchandise inventory as of January 1, P 25,000
b. Total purchases for the year, P 144,000

Required: Prepare the Statement Comprehensive Income, Statement of Changes in Equity and
Statement of Financial Position

STATEMENT OF CASH FLOWS

The Statement of Cash flows shows the sources and uses of cash of an entity for a given period of time. This
statement shows the net increase or decrease of cash during the period and the cash balance at the end of the period.

The sources and uses of cash are classified into the following activities:

a. Operating activities
These are the sources or inflows, and the uses or outflows of cash and cash equivalents from the normal
operating activities of the enterprise. These are the cash flow derives primarily from the principal revenue producing
activities of the enterprise.

Examples of these are:

1. cash received ( inflow) from the sale of goods and services
2. cash received (inflow) from collections from customers and rentals
3. cash paid (outflow) for payments of purchases and expenses of operating the company.

b. Investing activities

Investing activities are those centered in support of the operations. These are the cash flows derived from the
acquisition and disposal of long term assets and other investments not included in cash equivalents. These cash receipts
and disbursements arise from activities involving non-operating assets.

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 Examples of these are:
1. cash paid ( outflow) for purchase of property, plant and equipment
2. cash paid ( outflow) for purchase of equity investments in other companies
3. cash received ( inflow) from the sale of delivery equipment.

The transactions usually involve items in the non-current section of the balance sheet.

c. Financing activities
These are cash flows derived from the equity capital and borrowings of the enterprise. Cash inflow can be
derived from additional investment from the owner, and obtaining loans from banks or other lenders.

While repayment of loans as well as withdrawals by owners are financing transactions that are reported as cash
outflow under the financing activity category. The financing activity usually involves items that are reported in the long-
term liability or owner’s equity section of the balance sheet.

Exercise 1: Statement of Cash Flows

Classify the given transactions below into either (A) Operating, (B)Investing or (C) Financing activity.
_____1.Opening an account under the business’ name and depositing cash for initial capital
contribution of the owner
_____2.Paying barangay, municipal, and other related taxes for the creation of the business entity.
_____3.Contributing land to the business.
_____4.Puchase of a building for business use
_____5.Borrowing cash from a bank for additional working capital
_____6.Purchase of computers and printer for office use
_____7.Purchase of office tables and chairs
_____8.Selling and distributing merchandise sold by the company
_____9.Conducting advertising for public exposure of goods for sale
_____10.Paid electricity and water consumption during the month
_____11.Rendered services to customers
_____12.Paid internet subscription for office use
_____13.Mortgaged business property to acquire bank loan
_____14.Withdrawal of owner for personal use

_____15.Paid salaries of employees

  ROSE BOUTIQUE  
  STATEMENT OF CASH FLOWS  
  For the year ended December 31, 20XX  
  Cash Flows from Operating Activities  
  Cash Inflows  
  From sale of goods and services xx  
From interest earned on loans/
  accounts receivable xx xx  
  Cash Outflows  
  Payments to suppliers xx  
  Payment of expenses xx  
  Payment for interest on loans xx (xx)  
Net cash provided ( used) by operating
  activities xx  
   
  Cash Flows from Investing Activities  
  Cash Inflows  
From sale of property, plant &
  equipment xx  
  From sale investments xx xx  
  Cash Outflows  

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 Purchase of property, plant &
  equipment xx  
Purchase of investment to other
  companies xx (xx)  
  Net cash provided ( used) by investing activities xx  
   
  Cash Flows from Financing Activities  
  Cash Inflows  
  From additional investment xx  
  From bank loan xx xx  
  Cash Outflows  
  Withdrawal of capital xx  
  Payment of loans xx (xx)  
Net cash provided ( used) by financing
  activities xx  
   
  Net increase ( decrease) in cash xx  
  Add: Cash balance, January 1, 20xx xx  
  Cash balance, December 31, 20xx xx  
                   

Sample questions:
1. Identify which of the following transactions fall under operating, investing and financing activities:
a. Cash received from customers
b. Cash paid to suppliers
c. Cash paid to employees
d. Cash paid to purchase equipment (company does not sell equipment)
e. Cash received from sale of furniture (company’s main line of business is not related to furniture)
f. Sale of goods on credit
g. Purchase of goods on credit
h. Cash received from getting a loan from a bank
i. Cash paid to owners

2. Juana’s sari-sari store had the following transactions during the year:
a. Purchase of goods. Paid cash. 100,000
b. Sale of goods. Received cash. 150,000
c. Paid utilities 30,000
d. Paid rent 10,000
e. Sold equipment for cash 100,000
f. Owner withdraws investment 10,000
10
Compute for the net cash flow generated by/used in operating activities

3. Using the given above, compute for the net cash flow generated by/used in investing activities.
4. Using the given above, compute for the net cash flow generated by/used in financing activities.
5. Using the given above, prepare a Cash Flow Statement.

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial statement analysis involves careful selection of data from statements for the primary purpose of
forecasting the financial health of the company. This is accomplished by examining trends in key financial data,
comparing financial data across companies, and analyzing key financial ratios. Another important aspect of financial
analysis is the comparison of actual financial conditions with expected financial conditions. Expected conditions may be
represented by :
1. predetermined standards
2. past performance
3. competitor’s performance or industry average

Objectives of financial statement analysis

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 Managers, investors, and lenders analyze financial statements to identify an organization’s financial strengths and
weaknesses. Although financial statements are essentially historical documents and tell what has happened during a
particular period of time, most users are concerned about what will happen in the future.

The following major economic decision makers perform financial statement analysis:
1. Creditors (short-term and long-term)
2. Equity investors or owners (present and potential)
3. Company management

Objectives of creditors
Short-term creditors are those who provide funds, goods and services to a business and expect payment within
one year or whatever time period is a customary in the industry. Their primary objective in the analysis of a company’s
financial statement is to determine whether the company pays its bills on time and will be able to pay current obligations
as they mature.

Long-term creditors include banks and other institutions who lend money to companies for extended periods of
time. Their principal objective is to determine whether the company will be able to make its periodic interest payments
and to maintain the company’s ability to maintain successful earnings and cash flows to meet continuing financial
commitments.

Objectives of equity investors

Equity investors are those who purchase an ownership interest in a company. When analyzing a company’s
financial statement, equity investors want to determine if the business firm will be able to distribute earnings in the future
and will bring out an appreciation in the company’s ability to generate income in the future.

Objectives of the company management

Managers of the enterprise analyze the financial statements to guide them in making future plans, in directing
and controlling operations, and in making decisions to effect further improvement in the company’s financial position and
performance.

General Approach to Financial Statement Analysis

A general approach to financial statement analysis will cover the broad areas given below. In addition, each
analytical situation should be tailored to meet specific user objectives.

1. Background study and evaluation of firm industry, economy and outlook

Since economic developments and the actions of competitors affect the ability of any business enterprise to
perform successfully, it is necessary to start the analysis of a firm’s financial statement with an evaluation of the
environment in which the firm conducts business.

2. Short term solvency analysis

This refers to the analysis of the company’s ability to meet near-term demand for cash and normal operating
requirements. Some of the indications that a company enjoys satisfactory short term solvency position are:
a. Favorable credit position
b. Ability to pay current debts in the regular course of business
c. Ability to extend more credit to customers
d. Ability to replenish inventory promptly

3. Capital structure and long-term solvency analysis

This pertains to the evaluation of the amount and proportion of debt in a firm’s capital structure to assess its
ability to service debt. This will also cover the analysis of the of the use of financial leverage to maximize the returns to
the owners.

4. Operating efficiency and profitability analysis

This involves the evaluation of how well assets have been employed by management in terms of generating
revenues and maximizing returns on such resources. Some indicators of managerial efficiency is the use of such
resources are:
a. Ability to earn satisfactory return on investment of borrowed funds and owner’s equity
b. Ability to control operating costs within reasonable limits
c. Optimum level of investment in assets

How to analyze financial statements

1. Comparative Statements – the presentation of financial information for current and prior periods which
allows the statement user to compare changes in the individual items.

12
2. Horizontal analysis – the presentation of financial data on a percentage basis over time. The result is the presentation
of the relative growth or decline of each item in terms of the base year.

3. Vertical analysis – the presentation of each item on a financial statement as a percentage of an appropriate base
amount.

Comparative Statements

FINANCIAL RATIO ANALYSIS

Financial ratio is a comparison in fraction, proportion, decimal or percentage form of two significant figures taken from
the financial statements. It expresses the direct relationship between two or more quantities in the balance sheet and
income statement of a business firm.
Purpose:

Through ratio analysis, the financial statements user comes into possession of measures which provide insight into the
profitability of operations, the soundness of the firm’s short-term and long-term financial condition and the efficiency with
which management has utilized the resources entrusted into it.

Uses:

1. It provides an indication of the firm’s financial strengths and weaknesses and should generally be used in
conjunction with other evaluation techniques.
2. Ratios are useful tools of financial statement analysis because they summarize data in a form easy to understand,
interpret and compare.

Limitations:
1. Attempting to predict the future using past results can be problematic. Changes in the general economy, in the
economy of the particular industry, being studied, and in management are just some of the uncertainties that can cause
past results to be an unreliable predictor of the future.

2. The financial statements used as the basis of the ratios are based on historical cost. In a time of changing prices, this
makes comparison between years difficult.

3. Figures from the balance sheet ( assets, liabilities) used in the calculation of the ratios are year-round numbers. Since
most businesses have their fiscal year-end when the business is slow, the balances in such accounts as receivable,
payables and inventory at year-end may not be the representative of the rest of the year.

4. Comparing the ratios of a company in one industry with those of a company in another industry is difficult because
industry peculiarities will cause the ratios to differ. Even comparison of companies within an industry may not be
reasonable at times because different companies use different accounting methods ( example – depreciation method).

Measuring of Profitability

Profitability is the ease with which a company generates income. Profitability ratios are used to measure a firm’s
past performance and to help predict its future profitability level. Present and potential owners and creditors use these
profitability ratios to evaluate investments wile managers use them to monitor and evaluate their company’s performance.

13
Measuring Liquidity and Activity

Liquidity describes the ease with which an item, such as an asset can be converted into cash. It also refers to
the company’s ability to generate sufficient cash to meet its short-term obligations. Liquidity ratios are ratios that
measure the firm’s ability to meet cash needs as they arise ( example: payment of accounts payable, bank loans and
operating costs). Activity ratios are ratios that measure the liquidity of specific assets and efficiency in managing assets
such as accounts receivable, inventory and fixed assets.

Measuring Solvency and Stability

Solvency is the company’s ability to meet obligations created by its long-term debt. Obligations resulting from
the debt include paying back the amount borrowed and paying interest on the debt.

Solvency ratios have been developed to measure a company’s overall level of debt it carries as well
as its ability to make interest payments. They are of most interest to owners, long-term creditors
and company management.

Stability on the other hand measures the ability of the company to continue operations for a relatively
long period of time. Satisfactory capital structure as well as the fund sourcing strategy of the company
may be assessed through the use of these ratios.

LIQUIDITY AND ACTIVITY RATIOS

 
Ratio   Formula   Significance
1 Current Ratio Current assets Measures ability to meet maturing
Current liabilities obligations from existing current assets

2 Acid-test or Quick assets Provides a more sever test of immediate

Quick Ratio Current liabilities solvency. Measures ability to discharge currently
maturing obligations based on most liquid (quick)
assets
Quick assets = Cash + marketable securities+
accounts receivable (net)

3 Receivable Turnover Credit Sales Confirms fairness of receivable balance. Provides

an indication of the efficiency of credit policies
Average Receivable and collection

4 Inventory turnover Cost of goods sold Measures relative control over inventory
Average inventory investment

5 Net sales to working Net sales Measures the level of sales generated from a
capital Working capital given level of working capital

Working capital = currents assets - current liabilities

SOLVECY AND STABILITY RATIOS

1 Debt ratio or Total liabilities Measures the proportion of assets financed by

Debt to Asset ratio Total assets the debt
1
3
Debt to Equity ratio
2 or Total liabilities Directly compares the amount of debt financing
Total liabilities to Net worth to the amount of equity financing
Net Worth
14
3 Times interest earned Income before interest Measures the ability of the firm to meet
expense and income
or Coverage ratio taxes interest payment
Interest expense

PROFITABILITY
RATIOS
1 Gross margin ratio Gross margin Indicates the average mark-up available to
Net sales cover selling and administrative expenses

2 Profit margin ratio Net income Measures efficiency of earning net income
Sales generated by a peso of sales

3 Profit margin ratio Net income before tax Measures pretax earnings produced from a
before tax Sales given level of revenues

Return on Total
4 Asset Net income after tax +
interest expense
Average total assets

5 Return on equity Net income Measures the after-tax income generated from
Equity a given level of equity

6 Asset turnover ratio Net sales Measures how effectively assets are used to
Total assets produce sales

Illustrative problem 1
Presented below are the Statement of Comprehensive Income for the year ended December 31. 2016 and
Statement of Financial Position for the year December 31, 2016 and December 31, 2015.

Required: Calculate the following ratios for 2016:

1 Return on assets 8 Quick ratio
2 Profit margin before tax 9 Net sales to working capital
3 Asset turnover 10 Receivable turnover
4 Profit margin 11 Inventory turnover
5 Return on equity 12 Debt ratio
6 Return on total asset 13 Debt to equity ratio
7 Current ratio 14 Coverage ratio

BALLA COMPANY
Statement of Comprehensive Income
For the Year ended December 31, 2016
( in thousands)

Sales P 11,228
Less: Cost of goods sold 7,751
Gross profit 3,477
Less: Operating expenses P
Depreciation-Buildng and eqpt. 102
Other selling and administrative exp 2,667
Total operating expenses 2,769
Income before interest and taxes P 708
Less: Interest expense 168
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Income before tax 540
Less: Income tax 114
Net income P 426

BALLA COMPANY
Statement of Financial Position
December 31, 2016 and December 31, 2015
( in thousands)
2016 2015
ASSETS
Current assets
Cash P 1,618 P 1,220
Accounts receivable 1,925 2,112
Merchandise Inventory 1,070 966
Prepaid expenses 188 149
Total current assets P 4,801 P 4,447
Non-current assets
Plant and equipment
Buildings, net of accumulated depreciation P 4,457 P 2,992
Equipment , net of accumulated depreciation 1,293 1,045
Total plant and equipment 5,750 4,037
Total Assets P 10,551 P 8,484

LIABILITIES
Current liabilities
Accounts payable P 1,818 P 1,686
Notes payable 900 1,100
Total current liabilities 2,718 2,786
Long term liabilities 2,500 2,000
Total liabilities P 5,218 P 4,786

OWNER'S EQUITY
Bert Balla, Capital P 5,333 P 3,698
Total liabilities and owner's equity P 10,551 P 8,484

Sample Problems:

1
. Information from G Co.'s balance sheet is as follows:
Current assets Current liabilities
Cash P 2,400,000 Notes payable P 1,500,000
Marketable securities 7,500,000 Accounts payable 19,500,000
Accounts receivable 57,600,000 Accrued payable 12,500,000
Inentories 66,300,000 Income tax payable 500,000
Prepaid expenses 1,200,000 Current portion of
135,000,00
0 long-term debt 3,500,000
37,500,000

What is the acid-test ratio?

2 During 2008, R Inc. purchased P2,000,000 of inventory. For 2008, cost of goods sold is P 2,200,000,
and the ending inventory as of December 31,2008 was P 400,000. What was the inventory
turnover for 2008?

3 R Co.'s net accounts receivable were P 500,000 at December 31,2007 and P 600,000 at
December 31,2008. Net cash sales for 2008 were P200,000. The accounts receivable turnover for
2008 was 5.0. What was R's net sales for 2008?

4 B Corp's books showed the following information for 2008:

Mdse.
Net credit sales 2,000,000 Inventory,end 200,000
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Net cash sales 500,000 Accounts receivable,beg. 300,000
Merchandise purchases 1,000,000 Accounts receivble,end 700,000
Mdse. Inventory beg. 600,000 Net income 100,000

a. B's accounts receivable turnover is?

b. B's percent of net income on sales is?

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