FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

Core Subject Description

Students must know that the basic purpose of accounting is to provide information that is useful for making
economic decision. Accounting information is most commonly communicated to users of accounting information
through the financial statements.

Contents: Analysis and Interpretation of Financial Statements 2

Content Standards.
The learners demonstrate an understanding of the methods or tools of analysis of financial statements to
include financial ratios to test the level of profitability, efficiency and financial health (liquidity and solvency) of the
business.

Performance Standards.
The learners shall be able to: 1. Solve exercises and problems that require computation and interpretation using
various financial ratios. 2. Using the downloaded sample financial statements, learner computes various financial ratios
and interprets the level of profitability, efficiency and financial health (liquidity and solvency) of the business.

Most Essential Learning Competencies. The learners shall be able to

1. Define the measurement levels, namely, profitability, efficiency and financial health (liquidity and solvency)
2. Compute and interpret financial ratios such as current ratio, working capital, gross profit ratio, net profit ratio,
receivable turnover, inventory turnover, debt-to-equity ratio, and the like.

LESSON 4.2
Analysis and Interpretation
of Financial Statements 2
Financial Ratios

I. Objectives. At the end of the topic, learners should be able to define and appreciate the use of financial ratios.

II. Development of the lesson

A. Introduction

REVIEW
1. Horizontal analysis - (comparative analysis)
compares the same account in the financial
statements of two periods (current and past year)
determining the amount of changes and computing
its percentage change using a base year as
comparison.

2. Vertical analysis -known as common-size

analysis, shows the relationship of each part to
the whole in a single financial statement.
3. Trend analysis – analyzes not only two years in
comparison but covers three, four or five year’s
financial statements. This is to determine the
trends in the industry.

B. LESSON PROPER
The discussion of the lesson is also on your book FABM 2 pages 91-115.

LESSON 4.2
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS 2
FINANCIAL RATIOS

Financial Statement (FS) Analysis is the process of evaluating risks,

performance, financial health, and future prospects of a business by subjecting financial
statement data to computational and analytical techniques with the objective of making
economic decisions (White et.al 1998).

There are three kinds of FS analysis techniques:

- Horizontal analysis
- Vertical analysis
- Financial ratios
Financial Ratios
• used to compare a company’s current financial position and performance with those of past years
and identify strengths and weaknesses.
• Also allows comparison of different companies in different industries.

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 or long-term obligations and the
interest related to these obligations.
c. Profitability – measures the company’s operating performances as a return 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 RATIOS (Read FABM2 PAGES 93-99)

1. Current Ratio – measures the ability of the business to pay its short-term as they fall due.

Current Ratio = Current Assets

Current Liabilities
Example:
2016 2017
Current Ratio = Current Assets P 665.4 = 1.07 P 725.8 = 1.32
Current Liabilities P620.6 P 551.90

Analysis:
a. Current ratio for 2017 increased signifying more liquidity for the company.
b. In 2017, inventory and prepaid expenses form 30% of the current assets. 70% is cash and
receivable which can readily be used to pay short-term liabilities

2. Quick Ratio – measures immediate liquidity with the ability to pay current liability with the most
liquid assets. (otherwise known as acid test ratio)

- Merchandise inventory is not easily convertible to cash, and sometimes it is sold on credit. Some
inventory items are slow moving, and may not even be sold due to obsolescence.
- Prepaid expenses will never be converted to cash since they are not sold but used in the normal
operating cycle of the business.

= Cash + Short Term Investments + Trade Receivable

Current Liabilities

Example: 2016 2017

Quick Ratio = P 330.2 + P 172.10 = 0.81 P 229.9 + P282.5 = 0.92
P620.6 P 551.90
Analysis:
- A look into the company’s ratio in the past years as well as comparing it with other companies
in the line of business will help to conclude if the quick ratio of less than 1 is unfavorable.

a. Receivable Turnover – measures the efficiency to collect the amount due from credit
customers.

RTO = Net Credit Sales

Average Trade Receivable

Average Trade Receivable

 = Beginning T. Receivable + Ending T. Receivable
2
Example:
2016 2017
Receivable Turnover = P 1,738.7 = 10.6 times P2,213.30 = 9.74 times
P 164.05 P 227.30

Average Receivable = P 156.+ P172.1 = P164.05 P 172.1 + P 282.5 =P 227.30

2 2

Analysis:
- Generally, a high trade receivable turnover is considered favorable since it may indicate a
company’s strict credit policies combined with aggressive collection efforts
- The company was able to collect its average receivables of 10.6 times in 2016 and 9.74 times in
2017

b. Average Collection Period – the approximate number it takes a business to collect its
receivables from credit or account sales. (also called day’s sales outstanding)

Ave. Coll. Period = 360 days

Trade Receivable Turnover

Example: 2016 2017

Ave Coll Period = 360 days = 34 days 360 days = 37 days
10.6 times 9.74 times

Another formula:

Average Collection Period

= Average Receivables
Average Daily Sales

Average Daily Sales

= Annual Sales
360
Example: 2016 2017
Ave Coll Period = P 164.05 = 34 days P 227.3 = 37 days
4.8 6.1

Ave Daily Sales = P 1,738.7 = 4.8 P 2,213.3 = 6.1

360 days 360 days

Analysis
- In assessing whether the average collection period is favorable or unfavorable, the credit terms
extended by the company to its customers should be considered.
- If the ave coll period exceeds the terms of credit say 30 days, then it unfavorable for both years.

c. Inventory Turnover – measures the number of times a company’s inventory is sold and replaced
during the year.

Inv. TO = Cost of Goods Sold

Average Inventory

Average Inventory
= Beginning Inventory + Ending Inventory
2
 Example: 2016 2017
Inventory Turnover = P 831.80 = 9 times P 1,032.10 = 8.6 times
P 91.85 P 119.55

Average Inventory = P 90.9 + P92.8 = 91.85 P 92.8 + P 146.3 = 119.55

2 2

Analysis:
- The faster the movement of inventory, the higher the company’s net income.
- Low inventory turnover may indicate overstocking of inventory or the presence of obsolete items.
- High inventory turnover may indicate strong sales but may also indicate inefficient purchasing or
purchasing in small quantities
- As a general rule, the higher the inventory turnover, the more profitable it is for the company, with a
high demand for the product

d. Average Sales Period (average age of inventory) – the average time to convert inventory to
sales. (inventory conversion period)

Average Sales Period = 360 days

Inventory Turnover

Example: 2016 2017

Ave Sales Period = 360 days = 40 days P 227.3 = 41.9 days
9 8.6
Analysis:
- Average sales period increased from 40 days in 2016 to 41,9 days in 2017.
- This indicates the company might be overstocking some inventory items or the presence of slow
moving items in its inventory.

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

Working Capital = Current Assets – Current Liabilities

Example:
2016 P665.4 – P 620.6 = P 44.8
2017 P725.80 – P 551.90 = P 173.9

- In 2017, the company is more liquid in meeting its short-term obligations especially since its cash and
receivables occupy a big percentage of the current assets.

C.1. PRACTICE – LIQUIDITY RATIOS

FABM2 BOOK : DRILL 1 PAGE 101-102

Do the drill and exercise on your columnar worksheet (yellow columnar). Attached
the answered sheet to the Learning Packet upon submission.

SOLVENCY RATIOS (Read FABM2 PAGES 103-105)

Solvency Ratios – otherwise called leverage ratios, measure a company’s ability to pay it
maturing long-term debts while sustaining operations indefinitely.

1. Debt Ratio – measures the ability of the business to pay its short-term as they fall due.
- measures business liabilities as a percentage of total assets.
 Debt Ratio = Total Liabilities
Total Assets
Example:
2017 2016 2015
Debt Ratio = P 2,374.3 = 91.6 P 997.2 = 81.6 P 980.7 = 80.2
P 2,592.2 P 1,221.6 P 1 ,223.1

Analysis:
a. Generally, a lower ratio is favorable since it means that more funds are provided by the owner.
b. A slightly higher debt ratio is also acceptable although we have to take into account the
industry and the payment history of the company.
c. In 2017, debt ratio was high at 91.6%. The company heavily sourced its financing from creditors
(highly leveraged) and this is risky for the company because most of its assets are owned by
the creditors.

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

Equity Ratio = Total Equity

Total Assets
Example:
2017 2016 2015
Equity Ratio = P 217.9 = 8.4 P 224.4 = 18.4 P 242.4 = 19.8
P 2,592.2 P 1,221.6 P1 ,223.1
Analysis:
The rates are critically low for the company as these indicate dependence on creditors for sources
of funds, way below the optimal fair ratio.

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
Example:
2017 2016 2015
Debt to Equity Ratio = P 2,374.3 = 10.9 P 997.2 = 4.4 P 980.7 = 4.0
P 217.9 P 224.4 P 242.4
Analysis:
a. During 2017, the creditors heavily funded the assets of the company that for every P1 funded
by the owner, the creditors funded P10.90. This is very unfavorable since the company will
definitely pay huge interest for use of creditor funds in the business.

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

Times Interest Earned = Income before Interest and Taxes

Interest Expense
Example:
2017 2016 2015
Times Interest Earned = P 292.0 = 3.2 P 247.4 = 8.1 P 287.6 = 11.5
P 90.9 P30.5 P 25.0
Analysis:
a. The increase in number of times may be due to increasing interest payments form large amounts
of loans.
C.2. PRACTICE – SOLVENCY RATIOS
FABM2 BOOK : DRILL 2 PAGE 106
Do the drill on your columnar worksheet (yellow columnar). Attached the answered
sheet to the Learning Packet upon submission.

PROFITABILITY RATIOS (Read FABM2 PAGES 107-110)

Profitability Ratios – 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 – otherwise called Gross Margin Ratio, measures the percentage of peso sales
earned after deducting cost of goods sold. This is the percentage of mark-up a company adds to
the cost of its inventory which will later absorb the operating expenses related to the sale of
goods.

Gross Profit Ratio = Gross Profit

Net Sales
Example:
2017 2016 2015
Gross Profit Ratio = P 1,181.2 = 53.4% P 906.9 = 52.2% P 843.1 = 54.6%
P 2,213.3 P 1,738.7 P 1 ,543.2

Analysis:
a. The gross profit margin for three years was not bad as the mark-up was more than 50% which
will be used to absorb the operating expenses.

2. Operating Profit Margin – measures the percentage of income earned after deducting the cost
of sales and the operating expenses. It is the income earned per peso of net sales after the cost of
inventory and the related operating expenses are deducted.

Operating Profit Margin = Operating Income

Net Sales
Example:
2017 2016 2015
Operating Profit Margin = P 292.0 = 13.2% P 247.4 = 14.2% P 287.6 = 18.6%
P 2,213.3 P 1,738.7 P1 ,543.2
Analysis:
a. Operating margin has a downward trend. This indicates that the company is not efficiently
managing its expenses. If the trend will continue downward, the company will end up incurring
losses,

3. Net Profit Margin – otherwise known as Return on Sales, 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 taxes have been paid.

Net Profit Margin = Net Income

Net Sales
Example:
2017 2016 2015
Net Profit Margin = P 140.8 = 6.4% P 151.9 = 8.7% P 185.2 = 12%
P 2,213.3 P 1,738.7 P1 ,543.2
 Analysis:
a. The net profit margin continued to decrease every year from 2015 to 2017. Management should
exert effort to increase sales and cut on expenses if they want to improve net income for future
operations.
b. A high net profit Is favorable to the company.

4. Return on Assets – otherwise called as Return on Investment, measures the company’s

efficiency in using 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
2

Example:
2017 2016

Return on Assets = P140.8 = 7.4% P 151.9 = 12.4%

(P 2,592.2 + P 1,221.6)/2 (P 1,221.6 + P 1,223.1)/2
Analysis
c. The company assets were not fully utilized to generate income.

C.3. PRACTICE – PROFITABILITY RATIOS

FABM2 BOOK : DRILL 3 PAGE 111
Do the drill on your columnar worksheet (yellow columnar). Attached the answered
sheet to the Learning Packet upon submission.

ADDITIONAL READINGS:
QUALITATIVE FACTORS IN FINANCIAL STATEMENT ANALYSIS
(Read FABM2 PAGES 109-110)

FABM2 BOOK :
a) EXERCISE 2 on page 117
b) CHAPTER TEST - Multiple Choice pages 121-122
Write your answer on the box provided below:

D. ENRICHMENT
Exercise 2 Favorable or Unfavorable
1. 8.
2. 9.
3. 10.
4. 11.
5. 12.
6. 13.
7. 14.
 Chapter Test – Multiple Choice
1. _______ 4. _______ 7. ________

2. _______ 5. _______ 8. ________

3. _______ 6. _______

E. EVALUATION:
FABM2 BOOK : CHAPTER TEST II page 123-124 (Copy and answer)
Compute the missing information.
Tim Tam Tom Trading
Income Statement
For the Year Ended December 31, 2017

Tim Tam Tom Trading

Statement of Financial Position
As of December 31, 2017

MRS. ROSE JEANNIE G. NABONG

Subject Teacher