Analysis and Interpretation of Financial

Statements
Week 8 (topic is a Continuation to week 7)

Solvency Ratios
Solvency ratios measure the capability of an entity to pay long term obligations as they
fall due. Creditors of the company’s long term payable and bond payable will be
interested in knowing its solvency ratios.
1. Debt to Total Assets Ratio
This is the proportion between the total liabilities of the company and its
total assets. The debt ratio shows how much of the assets of the company
were given by creditors. As much as possible, current and prospective
creditors want a very low debt to total assets ratio.
Formula: Debt to Total Assets Ratio = Total Liabilities / Total Assets Using the
GSM Company data, we would be able to compute the company’s debt to total
assets ratio for 2018 and 2019.
2018 2019
Total Liabilities 1,600,000.00 1,850,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Debt to Total Assets Ratio .69 .68

Analysis: Comparing the data for the two years involved, it can be seen that there
is a minimal change in the debt ratio of the company. This means that in 2018,
out of the total assets of the company, 69% was being financed by creditors. A
high debt to asset ratio implies a high level of debt.

2. Debt to Equity Ratio

Instead of assets, the debt to equity ratio compares the liabilities of the
company with its equity. A smaller debt to equity ratio would indicate a
healthier solvency position for the company.
Formula: Debt to Equity Ratio = Total Liabilities / Total Owner’s Equity Using
the GSM Company data, we would be able to compute the company’s debt to
equity ratio for 2018 and 2019.
2018 2019
Total Liabilities 1,600,000.00 1,850,000.00
Divided by: Total Owner’s 700,000.00 850,000.00
Equity
Debt to Equity Ratio 2.28 2.17
 Analysis: Comparing the debt to equity ratio of the company for two periods
concerned showed that the company was more solvent in 2019 than in 2018. A
high ratio suggests a high level of debt that may result in high interest expense.

3. Times Interest Earned Ratio

The Time Interest Earned Ratio shows the proportion between the EBIT of
the company and its interest expense. It is an indicator of how many times
the company’s EBIT can cover the finance cost of borrowing. Companies
want a high Times Interest Earned Ratio. A small or decimal number ratio
indicates that it is not advisable for a company to borrow money –
especially if the company would not be able to generate enough income to
cover it.
Formula: Times Interest Earned Ratio = EBIT / Interest Expense
Using the GSM Company data, we would be able to compute the company’s times
interest earned ratio for 2018 and 2019.
2018 2019
Earnings Before Income Tax 3,200,000.00 4,200,000.00
Divided by: Interest Expense 300,000.00 1,800,000.00
Times Interest Earned Ratio 10.66 2.33

Analysis: Comparing the times interest earned ratio of the company for two
periods, it can be seen that the company is very solvent in the year 2018
compared to that in 2019. It is 10 times more solvent to pay the interest with its
income before tax.

Profitability Ratios
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:
1. Gross Profit Ratio
This is the proportion of the gross profit of the company with its net sales.
Gross profit is the difference between the net sales of the company and its
cost of goods sold. A company should aim for a bigger gross profit ratio. A
large gross profit ratio shows that a company can generate more sales
from the smaller cost of goods sold that it has.
Formula: Gross Profit Ratio = Gross Profit / Net Sales

Using the GSM Company data, we would be able to compute the company’s gross
profit ratio for 2018 and 2019.
 2018 2019
Gross Profit 4,000,000.00 4,500,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
Gross Profit Ratio 80% 77.59%

Analysis: This means that for every P 1.00 the company sells, P .80 goes to the
gross profit in the year 2018. The company’s gross profit ratio slightly decreased
in 2019. This should be avoided or at least be minimized. The gross profit ratio
can be improved by continuously finding inventories with lower cost, without
sacrificing quality.
2. Profit Margin Ratio
The profit 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 a more precise measurement of the company’s
profitability because it has already considered the operating expenses and
other expenses of the entity. Companies want a high profit margin ratio.
Formula: Gross Margin Ratio = Net Income after Tax / Net Sales
Using the GSM Company data, we would be able to compute the company’s gross
margin ratio for 2018 and 2019.
2018 2019
Net Income after Tax 2,350,000.00 2,000,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
Gross Margin Ratio 47% 34.48%

Analysis: This means that company earned P .47 for every P 1.00 of sales in the
year 2018. The company’s gross margin ratio shows a decline for the year 2019.
This can be attributed to the lower NIAT coupled by an increase in Net Sales.

3. Operating Expenses to Sale Ratio

Operating expenses are 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. This ratio
should be minimized as much as possible. The goal is to generate as much
sales with the minimum operating expenses.
Formula: Operating Expenses to Sale Ratio = Operating Expenses / Net Sales
Using the GSM Company data, we would be able to compute the company’s
operating expenses to sale ratio for 2018 and 2019.
2018 2019
Operating Expenses 800,000.00 300,000.00
 Divided by: Net Sales 5,000,000.00 5,800,000.00
OE to Sale Ratio 16% 5.17%
Analysis: Comparing the data for the two years involved shows that there is a
huge improvement in the operating expenses to sales ratio. This can be attributed
to lower operating expenses and increase in net sales.

4. Return on Assets
Before profits can be realized, certain investments should be made. In this
case, assets will be used for the different projects of the company. The
goal is to generate profit based on the available assets during the year.
Thus, the company aims for a higher return on assets.
Formula: Return on Assets = NIAT / Total Assets
Using the GSM Company data, we would be able to compute the company’s
return on assets for 2018 and 2019.
2018 2019
Net Income After Tax 2,350,000.00 2,000,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Return on Assets 1.02 0.74

Analysis: Comparing the data for the two years involved shows that in the year
2018 the return on assets is very high compared to the year 2019. This can be
attributed to a much higher income compared to the assets of the company.

5. Return on Equity
This is a slight variation of the earlier formula. In this case, it is the average
owner’s/stockholder’s equity that will be used as a denominator. This is a
more specific computation of a company’s profitability because the
denominator being used is the one coming from stockholders/owners
alone.
Formula: Return on Equity = NIAT / Owner’s Equity
Using the GSM Company data, we would be able to compute the company’s
return on equity for 2018 and 2019.

2018 2019
Net Income After Tax 2,350,000.00 2,000,000.00
Divided by: Owner’s Equity 700,000.00 850,000.00
Return on Equity 3.36 2.35
 Analysis: In 2019, the return on equity decreased. This could be attributed to a
lower net income after tax and a larger owner’s equity.

6. Asset Turnover Ratio

This ratio measures the correlation between the assets owned by the
company and the net sales generated by such properties.
Formula: Assets Turnover Ratio = Net Sales / Total Assets
Using the GSM Company data, we would be able to compute the company’s
assets turnover ratio for 2018 and 2019.
2018 2019
Net Sales 5,000,000.00 5,800,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Assets Turnover Ratio 2.17 2.15

Analysis: The assets turnover ratio slightly decreased in 2019. This is something
not good because the company should aim for a higher assets turnover ratio. This
can be attributed to bigger net sales generated for that year.

What’s More

Activity 1.5.2 Compare and Contrast.

1. Compare and contrast liquidity ratio and solvency ratio.

2. Compare and contrast profitability ratio and solvency ratio.

3. Compare and contrast horizontal analysis and vertical analysis.

Activity 1.5.3 Classify and Complete Me.

Directions: Classify the following ratios by indicating whether liquidity, solvency or

profitability and complete the table with its corresponding formula.
 What I Have Learned

Activity 1.5.4 Supply the Missing Link

Instruction: Now that you have already finished learning the concepts, let us see what
you have learned so far by supplying the appropriate word(s) on the blank.

_________________ is the capacity of a company to pay its currently maturing

obligations. These would require a good amount of liquid assets like
__________________, ____________________, __________________ and other
assets such as inventory and prepaid expenses. ________________________ are very
important to the short terms creditors of a company.

__________________ ratios measure the capability of an entity to pay long term

obligations as they fall due. _______________ of the company’s long-term notes
payable and bonds payable will be interested in knowing its solvency ratios.

Lastly,_________________ ratios are used to determine the profitability or performance

of a company.
 What I Can Do

Activity 1.5.5. Solving the Problem

Presented below is the Comparative Financial Statements of Tan General Merchandise

for the year 2018 and 2019:

TAN GENERAL MERCHANDISE

Comparative Statement of Financial Position
For the Year 2018 & 2019
2018 2019
ASSETS
Cash 87,400.00 110,000.00
Accounts Receivable 69,920.00 90,000.00
Inventory 218,500.00 129,000.00
Prepaid Rent 4,370.00 12,000.00
Total Current Assets 380,190.00 341,000.00

Land 493,810.00 550,000.00

Building 500,000.00 600,000.00
Total Noncurrent Assets 993,810.00 1,150,000.00

TOTAL ASSETS 1,374,000.00 1,491,000.00

LIABILITIES
Accounts Payable 250,000.00 200,000.00
Notes payable 150,000.00 300,000.00
Total Current Liabilities 400,000.00 500,000.00

Mortgage Payable 160,000.00 180,000.00

Loan Payable 150,000.00 200,000.00
Total Noncurrent Liabilities 310,000.00 380,000.00

TOTAL LIABILITIES 710,000.00 880,000.00

OWNER’S EQUITY
Tan, Capital 664,000.00 611,000.00
Total Liabilities & Owner’s Equity 1,374,000.00 1,491,000.00
 TAN GENERAL MERCHANDISE
Comparative Statement of Comprehensive Income
For the Year 2018 & 2019
2018 2019
Net Sales 686,000.00 810,000.00
Cost of Goods Sold 348,300.00 301,750.00
Gross Profit 337,700.00 508,250.00
Operating Expenses 205,800.00 234,900.00
Earnings Before Interest and Taxes 131,900.00 273,350.00
Interest Expense 17,150.00 40,500.00
Net Income Before Tax 114,750.00 232,850.00
Income Tax 34,425.00 69,855.00
Net Income After Tax 80,325.00 162,995.00

Required:

1. Prepare a horizontal analysis for the Comparative Statement of Financial Position.

2. Prepare a vertical analysis for the Comparative Statement of Comprehensive
Income.
3. Compute the following ratios for the comparative periods. The company used 365
days in its computation for some of the ratios. Show your solution.
a. Working Capital
b. Current Ratio
c. Acid Test Ratio
d. Accounts Receivable Turnover Ratio
e. Average Collection Period
f. Inventory Turnover Ratio
g. Average Days in Inventory
h. Number of days in Operating Cycle
i. Debt to Total Assets Ratio
j. Debt to Equity Ratio
k. Times Interest Earned Ratio
l. Gross Profit Ratio
m. Profit Margin Ratio
n. Return on Assets
o. Return on Equity
p. Assets Turnover Ratio
Activity 1.3.6 Choosing the Right One.

Now, that you are finished accomplishing the module, let us check further what
you have learned. Answer the questions given below by encircling the letter of the correct
answer.

1. Which of the following cannot be used to analyze financial statements?

A. Liquidity ratios
B. Solvency ratios
C. Profitability ratios
D. None of the above.

2. This is the availability of resources to meet short term cash requirements.

A. Liquidity
B. Solvency
C. Profitability
D. None of the above

3. This is the excess of current assets over current liabilities.

A. Working Capital
B. Current ratio
C. Acid Test ratio
D. Quick ratio

4. Which of the following is not considered as quick assets?

A. Cash
B. Inventory
C. Accounts Receivable
D. None of the above

5. Which of the following is considered as quick assets?

A. Prepaid asset
B. Trading securities
C. Both A & B
D. None of the above

6. This measure the frequency of accounts receivable converted into cash.

A. Accounts receivable turnover ratio
B. Average collection period
C. Both A & B
D. None of the above

7. This is the entity’s ability to meet long term obligations as they become due.
 A. Liquidity
B. Solvency
C. Profitability
D. None of the above

8. This compares the liabilities of the company with its equity.

A. Debt to total assets ratio
B. Debt to equity ratio
C. Both A & B
D. None of the above

9. Is the quotient of the current assets divided by the current liabilities of the
company?
A. Current ratio
B. Working capital ratio
C. Acid test ratio
D. None of the above

10. This ratio measures the proportion between the net income after tax and the net
sales of the company.
A. Profit margin ratio
B. Gross profit ratio
C. Both A & B
D. None of the above

Congratulations! You have just finished Lesson 5 of this module.